El Salvador: 2019 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for El Salvador
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International Monetary Fund. Western Hemisphere Dept.
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Publication Date:
23 May 2019
eISBN:
9781498316972
Language:
English
Keywords:
ISCR; CR; debt; IMF staff estimate; authority; dollar; financial system; transfer pricing; headline inflation; economic growth; baseline GDP growth projection; interest rate
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2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for El Salvador

Abstract

2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for El Salvador

Economic and Social Context

1. El Salvador made considerable strides in social development during the past decade. GDP grew by 15 percent over the past decade in real per capita terms (purchasing power parity). Sustained growth allowed for an increase in social spending, leading to a considerable decline in inequality and poverty (text chart and Figure 1). Human and social indicators also improved significantly. Migration to the U.S. declined, especially after 2015. The election in February of President-elect Bukele, who assumes office on June 1, marks a break from the two-party system that has dominated El Salvador politics since the end of the civil war in 1992.

Figure 1.
Figure 1.

El Salvador: Long-term Growth and Poverty

Structural bottlenecks have inhibited long-term growth

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Sources: Central Reserve Bank of El Salvador; IMF staff calculations; ECLAC; and World Development Indicators, The World Bank.1/ Gini coefficient for GTM and NIC are as of 2014. Simple average of Brazil, Chile, Colombia, Mexico, Peru and Uruguay.2/ El Salvador poverty line covers the percent of population lacking household income required to access a basket of goods and services needed to achieve adequate living conditions. Poverty numbers are as of 2014 for GTM and 2016 for PAN, NIC and DOM.3/ Simple average of Costa Rica, Guatemala, Honduras, Nicaragua, Panama, and the Dominican Republic.
Figure 2.
Figure 2.

El Salvador: Balance of Payments Developments

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Sources: Central Reserve Bank of El Salvador, Haver Analytics, and IMF staff calculations.
Figure 3.
Figure 3.

El Salvador: Fiscal Developments

Spending restraint helped cut primary deficit, but financing remains a concern

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Sources: National authorities and IMF staff calculations.
Figure 4.
Figure 4.

El Salvador: Financial Sector Developments

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

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.
uA01fig01

Real GDP per Capita Growth 2009–2018

(PPP Index, 2009 = 100)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Sources: National authorities and IMF staff calculations.
uA01fig02

Change in Inequality and Poverty

(Gini Index; Percent)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Source: World Development Indicators.Note: Change in indicators between 2009 and 2017 or latest data available.

2. Nevertheless, social challenges persist. Poverty remains high (30 percent of the population, national definition). The number of new jobs, generated every year, is not sufficient to eradicate poverty and curtail outmigration faster. Gangs continue to operate in the poorest areas and run extortion syndicates.1 Few firms expand, relegating economic activities to informal markets and depressing potential output. The 2018 Global Competitiveness Report (WEF) identifies corruption as the second most problematic factor for doing business, after crime and theft.

Economic Performance

3. The economy is performing well. In the first half of the year, real GDP grew by 2.8 percent (year-on-year) fueled by remittances and an increase in public capital expenditure. In the second half of the year, domestic demand remained strong, but the economy slowed because of stagnant merchandise exports2 and low agricultural production due to drought. Overall, real GDP growth in 2018 was 2½ percent, ¼ percent above the estimated potential. The solid performance continued into 2019, with economic activity growing at 2.7 percent in January (year-on-year), mostly driven by construction and services.

uA01fig03

Real GDP Growth

(Percent)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Sources: National authorities and IMF staff calculations.
uA01fig04

Contributions to Real GDP Growth

(Percent)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Sources: National authorities and IMF staff calculations.

4. Continued U.S. dollar appreciation led to a significant decline in inflation and widening of the current account deficit. Despite solid growth, core inflation remained low, and headline inflation declined to 0.4 percent in February 2019, reflecting the decline in oil prices in late 2018 (see chart). The current account deficit widened to 4.8 percent in 2018, owing to the sharp slowdown in exports and broad-based increase in imports, including oil imports. Remittance inflows reached a record-high level of US$5.4 billion in 2018 (20.7 percent of GDP), and continued to grow in 2019, but at a rate closer to the long-term average of 4 percent.3

uA01fig05

Headline and Core Inflation

(Year-on-year, percent)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Sources: National authorities and IMF staff calculations.
uA01fig06

U.S. Remittances to El Salvador and U.S. Hispanic Unemployment Rate

(3-months moving avg.)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Sources: National authorities and IMF staff calculations.

5. The primary fiscal surplus increased to about 1 percent of GDP in 2018. Tax revenues increased (Table 5), driven by higher import tax revenues4 and one-off tax measures, including a tax amnesty and a financial transaction tax.5 Capital expenditure rebounded after political stalemate caused a sharp decline in 2017. The pension reform generated savings of about 0.8 percent of GDP in 2018. Nevertheless, the primary balance was not sufficient to offset the rising interest bill, and the overall deficit deteriorated slightly, to 2.7 percent of GDP. Public debt (including pensions) remained around 70 percent of GDP at end-2018 (Annex I).

Table 1.

El Salvador: Selected Economic Indicators

article image
Sources: Central Reserve Bank of El Salvador, Ministry of Finance, and IMF staff estimates.

The baseline scenario does not include revenue measures such as the electronic invoicing, the monotributo , and the transfer pricing initiative.

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

Includes inventories.

Table 2.

El Salvador: Medium-term Baseline Scenario

article image
Sources: Central Reserve Bank of El Salvador, Ministry of Finance, and IMF staff estimates.

Includes inventories.

The baseline scenario does not include revenue measures such as the electronic invoicing, the monotributo, and the transfer pricing initiative.

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

Table 3.

El Salvador: Balance of Payments

article image
Sources: Central Reserve Bank of El Salvador and IMF staff estimates.

Presented in BPM6 format.

Assumed to include both private and potential public sector flows, including 70 percent of the fiscal financing gap.

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).

Expressed in terms of following year’s imports.

Table 4.

El Salvador: External Financing Requirements and Sources

article image
Sources: Central Reserve Bank of El Salvador and IMF staff estimates.
Table 5.

El Salvador: Operations of the Nonfinancial Public Sector

article image
Sources: Central Reserve Bank of El Salvador, Ministry of Finance, and IMF staff estimates.

The baseline scenario does not include revenue measures such as the electronic invoicing, the monotributo, and the transfer pricing initiative.

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.

uA01fig07

Change in Overall Balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Sources: National authorities and IMF staff calculations.
uA01fig08

Cyclically Adjusted Primary Balance

(Percent of Potential GDP)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Sources: National authorities and IMF staff calculations.

6. The banking sector remains solid and credit expanded in 2018. Banks reduced their external liabilities as global financial conditions tightened, remained well-capitalized, and used the remittance-fueled surge in deposits to expand credit. Credit to the private sector grew by 6.4 percent,6 was broad based, and particularly strong to businesses in the manufacturing sector. Although demand for credit has increased, balance sheet risks remained moderate as the deposit-to-loan coverage remained stable at 95 percent, and the cyclical position of credit expansion was within the norm (Table 9). Non-performing loans declined below 2 percent, provisioning increased, and profitability reached a three-year high.

Table 6.

El Salvador: Summary Accounts of the Financial System

article image
Sources: Central Reserve Bank of El Salvador and IMF 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).

Table 7.

El Salvador: Selected Vulnerability Indicators

(In percent of GDP; unless otherwise indicated)

article image
Sources: Central Reserve Bank of El Salvador, Ministry of Finance, Financial Superintendency, and IMF 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 8.

El Salvador: Public Sector Financing Requirements and Sources

article image
Sources: Central Reserve Bank of El Salvador; Ministry of Finance; and IMF staff estimates.

The entire amount of LETES is recorded under domestic financing given that the market has always been dominated by resident investors. However, a relatively small amount of LETES (about 80 million of U.S dollars at end-2017) has been held by foreign residents.

Table 9.

El Salvador: Financial Soundness Indicators Heatmap

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uA01fig09

Remittances and Household Deposits

Year-on-year growth (Percent)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Sources: National authorities and IMF staff calculations.
uA01fig10

Domestic Credit

Year-on-year growth (Percent)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Sources: National authorities and IMF staff calculations.

7. The external position in 2018 is assessed to be moderately weaker than the level implied by fundamentals and desirable policies, with a real exchange rate overvaluation of 4–6 percent (Annex II). In 2018 the real exchange rate appreciated by 3 percent. Gross international reserves increased by US$2 million, remaining at about US$3.6 billion. While reserves provide sufficient coverage for imports and short-term debt, they remain below the adequate level implied by the risk-weighted Assessing the Reserve Adequacy (ARA) metric and need to be increased.7

Outlook and Risks

8. The baseline GDP growth projections are closely aligned with the outlook for the U.S. economy and assume no major changes in domestic policies:

  • In 2019 staff expect real GDP growth to remain above potential, at 2½ percent, oil prices to decline and inflation to remain low. A continued elevated level of remittance inflows is expected to compensate for a high trade balance deficit. Remittance-fueled deposits would continue to support credit expansion in line with the robust economic activity.

  • In 2020–24, staff expects growth to slow down along with the U.S. economy through lower external demand and converge to its estimated potential of 2.2 percent. Inflation will remain anchored at around 1 percent as oil prices soften. An expected decline in remittances growth to its long-run trend rate will lead to a mild widening of the current account, despite contributing to lower import growth, as exports growth also declines.

9. Risks are tilted to the downside (Risk Assessment Matrix). Global downside risks stem from weaker-than-expected global growth and rising protectionism,8 which would moderate remittances9 and trade flows. There are also downside domestic risks: (i) policy slippages, including on the needed fiscal adjustment, if spending measures are adopted without identifying appropriate funding resources, and (ii) lower growth if the new administration fails to secure the required legislative support to implement its agenda. On the upside, global financial conditions may tighten less than expected.

Authorities’ Views

10. The authorities agreed with staff’s economic and fiscal outlook. They noted the good performance of the economy in 2018, and the high level of public and foreign direct investment, which has continued into 2019. The authorities agreed that debt would continue to drift upward in the absence of measures, and that weaker-than-expected global growth could have a negative impact on the domestic economy. The authorities emphasized their commitment to guarantee a smooth political transition by sharing information with the new administration and by inviting the Audit Office to oversee the handover process.

Frontload the Fiscal Adjustment

11. The Legislative Assembly approved several important fiscal laws in December 2018. The Fiscal Responsibility Law (FRL) was strengthened by requiring debt to be put firmly on a declining path and by introducing an anchor for the public debt (including pension liabilities) of 60 percent of GDP by 2030. For the first time in three years, the budget and its financing were passed on time, and with a significantly lower overall deficit compared to the initial proposal (by about 0.4 percent of GDP). Furthermore, the Assembly authorized external financing for US$1.3 billion (about 5 percent of GDP) mostly to cover the US$800 million Eurobond payment due in December. The law financing the implementation of the electronic invoicing was also approved; it is expected to improve tax compliance and the ease of doing business.

uA01fig11

EMBI Global Spreads

(Basis Points)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Source: Bloomberg.

12. The political cooperation to secure the agreements on fiscal laws and financing were well received by the credit rating agencies. Standard & Poor’s upgraded the rating of

El Salvador’s sovereign debt to B- in December 2018. The EMBI Global spread declined and is in line with regional peers.

Agency Ratings and Outlook of El Salvador’s Sovereign Debt

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13. Steadfast implementation of the FRL is necessary, as public debt would drift upwards under unchanged policies. The fiscal balance is expected to deteriorate in the near-term mainly due to the loss in the temporary revenues and the rising interest bill. Debt dynamics continue to be unfavorable, as borrowing rates remain higher than the GDP growth rate (text chart and Annex I),10 and medium-term financing needs remain sizeable. Fiscal buffers are needed to insure against macroeconomic and natural disasters shocks,11 and to ensure compliance with the FRL.

uA01fig12

Gross Public Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Sources: National authorities and IMF staff calculations.
uA01fig13

Contributions of Debt-Creating Flows, 2008–2018

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Sources: National authorities and IMF staff calculations.

14. A fiscal adjustment of about 2 percent of GDP over 2019–21 is needed to comply with the FRL. The FRL requires a primary fiscal adjustment of 3 percent of GDP over 2017–21 and that public debt (including pensions) reaches 60 percent of GDP by 2030. As the primary fiscal balance has already improved by 1.1 percent of GDP over 2017–18, a further adjustment of 1.9 percent of GDP by 2021 is needed to comply with the FRL primary balance operational target. However, the pace of the adjustment is crucial to achieve the debt target. If the adjustment is not frontloaded, the 60 percent target may not be achievable by 2030 without significant further consolidation, which may be more difficult to undertake under weaker cyclical conditions.

15. Frontloading the adjustment to 2019–20 would put debt firmly on a declining path and ensure compliance with the FRL. Implementing fiscal consolidation measures of 1.9 percent of GDP (implying primary balance improvement of 1.1 percent of GDP; see text table) during 2019–20 is feasible. It will enhance policy credibility and engender a further significant improvement in the public debt dynamics, as debt would decline to 50 percent of GDP by 2030, a level considered safe for El Salvador.12 Implementing this adjustment would not stall the growth momentum, as fiscal multipliers—the impact on growth of the fiscal measures—tend to be lower during periods of economic expansion (Box 1).

uA01fig14

Public Debt Path Scenarios

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Source: IMF staff calculations.

Fiscal Indicators in an Adjustment Scenario (percent of GDP) 1/

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Source: Fund staff estimates.

Consolidation measures of 0.6 percent of GDP in 2019 and 1.3 percent of GDP in 2020

Fiscal consolidation measures of 1.9 percent of GDP over 2019–20 will result in a primary balance improvement of only 1.1 percent of GDP, owed to a temporary deterioration of the baseline primary balance (0.5 percent of GDP) and the impact of fiscal measures on GDP growth (0.3 percent of GDP). However, the baseline primary balance will improve by 0.8 percent of GDP in 2021, as pension payments are expected to decline.

Timing and Composition of the Fiscal Adjustment

  • The strong economic performance is an opportunity to further improve the fiscal position. Estimated fiscal multipliers are 50 percent smaller in expansions than in downturns, as credit-constrained agents cannot borrow to smooth their consumption during recessions.1 In emerging economies, fiscal multipliers tend to be larger during recessions, given the high level of informality, the procyclicality of fiscal policy, and the lack of extensive automatic stabilizers (World Bank Semiannual Report, April 2017). In addition, high levels of remittance inflows, associated with expansionary periods, also help smooth consumption and contain the negative impact of fiscal consolidation on growth.

  • A frontloaded adjustment increases credibility. Well-designed fiscal consolidations trigger a surge in confidence, cushioning the public sector contraction through a private sector expansion. In countries with elevated public debt, such as El Salvador, confidence effects could ensue relatively quickly and have large effects (REO April 2018), given the known need for adjustment and credible measures.

  • The composition of the adjustment matters:

    • o Current spending cuts are recommended over public investment cuts. Current spending multipliers tend to be lower than the ones for capital spending.2 Well-designed reforms to curb the public wage bill have the most long-lasting effects and tend to have a lower drag on growth, while across-the-board cut measures, usually implemented during periods of duress, should be avoided (IMF Fiscal Monitor, April 2014). The Central Bank of El Salvador (2019) also notes that a fiscal adjustment is preferable during the expansionary phase of the business cycle, but through progressive taxation.

    • o A small VAT increase and excise taxes are easier to implement technically and have a limited impact on growth. These measures would generate sustainable revenues.3 Moreover, the multiplier effect of these measures is expected to be small as the current tax rate in El Salvador is low (Gunter et al, 2018). An increase in the VAT rate, as opposed to direct taxes, would not harm competitiveness as El Salvador’s VAT rate remains lower than those of regional peers and competitors.

  • Increases in tax rates should be accompanied by better compliance and stricter enforcement. The planned implementation of electronic invoicing will simplify tax payments, improve efficiency and reduce opportunities for corruption and evasion. Empirical evidence suggests that tax policy reforms in tandem with revenue administration measures yield larger gains (Akitoby, 2018).

1 See Battini et al. (2014) for details. 2 The IMF WHD REO (April 2018) finds that, in LAC, the two-year multiplier for public investment is 1.5 while the overall public expenditure multiplier is only 0.5. For El Salvador, multipliers are 0.1 for current spending and 0.4 for capital spending at the impact, and 0.7 cumulatively (Estevão and Samake, 2013). 3 VAT and excise taxes are preferred over alternative indirect taxes because: (i) the VAT is more broad-based and helps improve tax compliance; and (ii) the excise taxes can quickly raise revenue without major changes to the tax system (Akitoby, 2018).

16. Implementing fiscal consolidation measures of 1.9 percent of GDP in 2019–20 should be a policy priority. On the revenue side, staff strongly support the steadfast adoption of the electronic invoicing, the technical preparations for a simplified tax code for small businesses (“monotributo”), and the transfer pricing initiative. However, these tax administration measures are not sufficient to ensure compliance with the FRL, as their full yield will take time to materialize. Therefore, additional structural revenue measures are needed. Staff recommend introducing excise taxes on luxury goods and a small increase in the VAT rate13 from 13 to 14.5 percent (see text table). On the expenditure side, efficiency gains could be achieved by rationalizing current expenditure. Staff recommend containing the wage bill (through hiring freezes and by facilitating the retirement of some public employees) and approving and implementing the civil service reform as quickly as possible. Additional measures comprise centralizing the procurement system and extending competitive bidding processes, such as the reverse auction mechanism (“subasta inversa”), to the full set of public entities, and goods and services.

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17. Staff recommend improving the efficiency and quality of subsidies and social spending. Social assistance and subsidies to the top two quintiles of the income distribution represent about 0.7 percent of GDP. They could be eliminated and partly redirected to the poor. It is crucial to strengthen efforts in monitoring and evaluation of programs, investing in information systems to better target beneficiaries, and integrating social assistance programs under a common strategy. The government’s decision to adopt results-based budgeting is a step in the right direction.

18. Staff recommend finding comprehensive and long-lasting solutions in the medium-term to address fiscal challenges. A comprehensive fiscal reform is needed to eliminate distortions arising from temporary and ad hoc measures accumulated over the years and to expand the narrow tax base. Moreover, any public sector initiative should identify funding sources to avoid worsening public debt dynamics and preserve fiscal sustainability:

  • A property tax—a key progressive taxation measure—could help fund transfers to municipalities. Moreover, a clear delineation of responsibilities between the central and local governments, coupled with enhanced accountability framework for local governments, is also needed to provide public goods efficiently.

  • Any reform proposal to address the fairness and equity of the pension system should be budget neutral and fiscally sustainable in the long term. To this end, staff recommend improving benefits coverage for the poor, funded with an increase of the retirement age, and a reduction of pension fund fees.

19. Supporting financial market development and strengthening public debt management could help contain financing costs. Developing a well-functioning secondary market for LETES should complement the fiscal consolidation strategy. This would make public debt instruments more liquid, help extend current maturities, further deepen the domestic financial markets and lower domestic borrowing costs. Moreover, strengthening public debt management, including by developing a medium-term debt strategy framework, would help improve the profile of public debt, and ultimately lower borrowing costs.

20. Further strengthening of the FRL should be considered. The FRL could be improved further by incorporating a permanent operational target. The multiplicity of targets in the FRL (on tax revenues and expenditures) weakens the disciplining role of the main debt anchor. Moving the other targets to the medium-term fiscal framework appendix should help reduce the risk of conflicting fiscal policy objectives. An independent fiscal council could also be established given the poor track-record of compliance with the previous FRL.

Authorities’ Views

21. The authorities agreed with the size of the recommended adjustment. The authorities highlighted that several measures proposed by staff, both on the revenue and the spending side, are being prepared by the government. The authorities underscored progress in the technical preparation of several tax administration reforms, including electronic invoicing, the “monotributo”, as well as the initiative to combat base erosion and profit shifting (“precios de transferencia”). They recognized that these measures are not sufficient and would take time to yield higher revenue and agreed with staff on the need to adopt additional structural revenue measures, such as excise taxes on luxury goods. They believe that public procurement could be improved by extending competitive bidding processes (“subasta inversa”) to all public entities, and the wage bill could be curbed by facilitating the voluntary retirement of public employees.

22. The authorities underscored the need for a comprehensive fiscal reform over the medium term. The authorities thought that comprehensive fiscal reform is needed to eliminate distortions arising from temporary and ad hoc measures accumulated over the years. Harmonizing and simplifying the tax code could improve fairness, equity, competition and growth. They also agreed that any public sector reform, including the pension reform proposals and higher transfers to local governments, should identify funding sources to avoid worsening public debt dynamics and ensure fiscal sustainability.

Raise Long-Term Growth

23. Raising potential output would alleviate poverty and contribute to a faster decline in debt. The contributions of physical capital and TFP to output growth were lackluster in recent years, and El Salvador lags behind most regional peers in private investment rates and human capital (chart). About 45,000 additional jobs are needed annually to absorb new entrants to the labor market.14 Provisioning for public infrastructure and education, reducing crime and informality, improving the regulatory and governance frameworks, and increasing lending to businesses and fostering financial inclusion (see Financial Sector section) will boost private investment and help increase jobs.

24. Increasing the provision of public infrastructure could serve as a catalyst for private investment growth. The government should continue its efforts to improve transportation infrastructure and enhance the logistics platform (expansion of the airport and port concessions), particularly those financed through grants such as FOMILENIO. Public-private partnerships (PPP) could be explored to limit the fiscal impact of improvements in infrastructure. The PPP framework should be strengthened by improving fiscal accounting, ensuring proper oversight, and clearly delineating responsibilities and accountability of each partner. Improvements in the planning and execution of public investment projects would help raise their impact on output growth.

uA01fig15

Real GDP Growth Contributions

(Percent)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Sources: National authorities and IMF staff calculations.1/ Simple average of Costa Rica, Guatemala, Honduras, Nicaragua, Panama, and the Dominican Republic.
uA01fig16

Private and Public Investment

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Sources: National authorities and IMF staff calculations.1/ Simple average of Costa Rica, Guatemala, Honduras, Nicaragua, Panama, and the Dominican Republic.

25. Continuing to combat crime could have positive effects on investment and further reduce outward migration. The rehabilitation and prevention efforts of El Salvador Seguro plan have contributed to substantially lower the homicide rate (see Box 2 for details), thus starting to improve the business climate and the country’s competitiveness. Ensuring its continuity and increased funding is important. Strengthening police presence at the local level and improving its deployment, based on a systematic analysis of crime trends, would deter criminal activity, including extortions. Expanding technological surveillance programs beyond the capital15 and continuing to foster community involvement would also be effective deterrents. Better coordination between the police, financial intelligence unit, and the investigators in the General Attorney’s office would address extortions more effectively.

The Fight Against Crime in El Salvador and Lessons from International Experience

The government and the public opinion attribute the violence to gangs. The government’s fight against gangs in El Salvador went through several stages.

  • ‘Mano Dura’ and ‘Super Mano Dura’: Up to 2011 the fight against gangs had a repressive nature and did not lead to a reduction in violence.

  • The gang truce (2012–13): In 2012, the government negotiated a truce with the leaders of the two largest gangs, ‘MS-13’ and ‘Barrio 18’. While the truce was effective in drastically reducing the number of homicides, it did not prove to be a long-run solution.

  • El Salvador Seguro (2014-present): The plan combines repressive actions, such as the extraordinary measures introduced in 2016, with strong prevention and rehabilitation efforts to address the root causes of violence. It had very positive results in terms of reduction of the homicide rate.

uA01fig17

Number of Homicides

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Source: Own calculations based on data from El Salvador National Civil Police. Annualized monthly rates.

Successful strategies from international experience could be adopted in El Salvador to eradicate gang violence. Efforts to incorporate prevention as in Honduras and Jamaica, could be combined with a data-driven approach to fight crime, like in Colombia, which adopted a data-driven epidemiological analysis to fight crime in several cities. A mapping of crimes, through the compilation of detailed homicide statistics, combined with training of police officers and recovery of urban spaces, allowed Cali, Medellin and Bogota to reduce substantially their crime rates.

26. Investing in education will contribute to higher human capital accumulation and increase competitiveness. The early childhood education coverage in El Salvador is low, high school dropout rates are high, and the workforce lacks the skills demanded by businesses. Increasing investments in early childhood education would enable higher female participation in the labor force; it could be partially supported with grants and community involvement. The support and further development of flexible education and vocational training programs would facilitate the reinsertion of dropouts to the education system and prepare youth for the labor market. These initiatives should be focused at the secondary level to provide alternatives to crime and gang involvement.16 The authorities and experts expect that the 2017 amendment to the family code to ban child marriage and the development of a national policy to prevent teenage pregnancy will help reduce the gender gap in education attainment.

27. A concrete plan to reduce informality and the gender gap in labor force participation would also help raise potential output. Reducing the high degree of informality requires stronger tax enforcement efforts and incentivizing firms to formalize, through simplified taxes and regulations (see Governance and Fiscal sections) and enhanced access to affordable credit. As part of the plan to recover San Salvador’s downtown, two large markets will be created in the upcoming years to give street vendors (mostly women) a safe and clean space to operate in. While the gender gap in the labor force participation rate, at 30 percent, is lower than in neighboring countries,17 it is expected to be reduced further by leveraging the efforts of the recently introduced National Gender Equality Plan and the Gender Seal certification program.18

28. Removing barriers to trade and investment and facilitating diversification will also boost long-term growth. The regulatory improvements brought by the customs union, and better infrastructure at border crossing points, significantly reduced the costs and time in processing exports. To further enhance efficiency, staff recommend minimizing the processing time of acquiring construction permits, completing the adoption of the electronic signature, and simplifying the issuance of tax identification numbers. Staff recommend continuing the implementation of the development, diversification and productive transformation policy19 as, in recent years, it may have supported increases in labor productivity growth and labor reallocation out of the low-productivity agricultural sector into other sectors such as manufacturing (see chart).20

uA01fig18
Sources: National authorities and IMF staff calculations based on the methodology of McMillan and Rodrik (2011).

Authorities’ Views

29. The authorities are committed to boost inclusive growth through structural reforms. They highlighted the government’s achievements in reducing poverty, inequality and outmigration. They stressed the success of the government’s agenda to promote growth, based on cutting red tape, the implementation of the productive transformation strategy, and efforts to increase financial inclusion. Additional actions are also being taken, including expediting the process to obtain the tax ID, improving the platform to register a new enterprise and obtain the construction permits. Moreover, they believe that the completion of the Northern Triangle customs union with Honduras and Guatemala is a key step to increase intra-regional trade and investment, thereby boosting growth. On security, the authorities stressed the success of El Salvador Seguro Plan in reducing the homicide rate and acknowledged that further actions should be taken to combat extortion, including by expanding technological surveillance and police presence in the country, and by improving coordination between the police and the officials of the Extorsion Unit.

Enhance Financial Sector Stability

30. Maintaining financial stability is important to support long-term growth. Key elements include: (i) continuing efforts to appropriately fund the emergency lending assistance framework, (ii) approving the bank resolution legislation in line with best practices, (iii) continuing to strengthen supervision practices, and (iv) promoting greater financial inclusion.

  • Emergency Liquidity Assistance (ELA). Central Bank is working towards bolstering its ELA resources (Annex III), to provide liquidity, in response to a large idiosyncratic shock impacting one or more institutions, to ensure financial stability.21 Staff recommend ensuring that the reactivated interbank market functions smoothly to increase banks’ efficiency in managing liquidity, and that banks use first the money markets and access their own reserves, to decrease the need for emergency liquidity, and alleviate any burden on the public sector. Staff also recommend that any funding agreements reached for boosting ELA resources (reviving an expired Inter-American Development Bank credit line or acquiring new bilateral lines)22 should have terms and conditions that are well aligned with the function that they proposed to serve, particularly on BCR access.23

  • Crisis management and resolution. The draft law on the banking resolution framework has been benefitting from the Fund’s technical assistance and is currently going through negotiations between the Central Bank and the Superintendency. To complete the process, regulators need to agree on (i) additional regulatory requirements for systemically important financial entities and (ii) the legal framework for recovery process.

  • Supervision and regulation. The Central Bank and Superintendency are advancing efforts to align their regulations to Basel III standards, including by modifying the existing normative acts for liquidity, market, and credit risk management. Moreover, several measures need to be taken to enhance the current risk-based supervision by ensuring: (i) adequate access to credit information for all credit bureaus and (ii) that measures supporting credit growth in certain sectors fully comply with the risk-based supervision to avoid regulatory forbearance.24 Staff also welcome authorities’ plans to align reserve requirements for cooperative banks with other commercial banks.

  • Financial inclusion. Better intermediation of remittances through the financial sector is needed to support long-term economic growth.25 Staff welcome the authorities’ efforts to increase financial inclusion and encourage further actions on this front, including by promoting the use of simplified bank accounts for lower risk customers and facilitating wider access for fintech services (see Box 3).

Authorities’ Views

31. The authorities concurred with staff’s recommendations for enhancing financial sector stability. They agreed with the need to accelerate the approval of the bank resolution law, and they remain committed to further strengthen cross-border cooperation and appropriately fund the emergency lending assistance framework. They highlighted recent accomplishments in increasing banks’ efficiency in liquidity management, including the reactivation of the interbank market, cross-border cooperation, and supervision. The Superintendence highlighted progress in supervision and monitoring of financial flows, which are critical as the authorities prepare to rejoin the Egmont Group, a group of Financial Intelligence Units, supporting international efforts to combat money laundering.

Financial Inclusion in El Salvador

El Salvador has made progress in financial inclusion, although levels remain low relative to the region. Bank account ownership has doubled from 14 percent in 2011 to 30 percent in 2017, driven by increases in rural accounts and female-owned accounts. An obstacle for wider bank ownership is the tax ID requirement for individuals, which takes long time to obtain, as there are only five offices nationwide. Within the country, financial inclusion is uneven across regions, with lower financial inclusion in the remote regions.

uA01fig19

Financial Inclusion

(Percent of adults a bank account, in total population)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Source:World Bank Global Findex 2017.

Authorities are intensifying efforts to further advance financial inclusion. Presidential executive order in July 2018 established National Council for Financial Inclusion (CNIF), the inter-agency support group for financial inclusion and financial education program of El Salvador. Simplified bank accounts, for limited balances and transactions, was introduced in 2015. They do not require a tax ID; 400 of these accounts were opened since the end of 2018.

Financial inclusion could benefit from wider access of Fintech services. Mobile Money (MOMO) is expected to join the mobile money market in El Salvador. Considering that access to mobile services in El Salvador is one of the highest in the region—157 mobile accounts per 100 people—significant gains in financial inclusion could be achieved with the help of mobile/e-money. As opposed to the traditional bank accounts, which display gender disparity (24 percent women have a bank account versus 38 percent of men), there is no gender difference in mobile money use.

uA01fig20

Financial Inclusion and Mobile Phone Ownership

(Percent)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Source: Financial Inclusion Survey, 2016.

The microfinance sector is diverse and competitive, but capacity is an issue. There is high demand for microcredits; up to 40 percent of small and microenterprises continue to have limited access to credit. Existing regulations and information asymmetry prevent banks’ expansion of microfinance services. The Association for small enterprises (CONAMYPE) works with banks and entrepreneurs to help them obtain credit and by providing seed capital.

Strengthen the Governance Frameworks

32. The current administration has adopted several measures to improve the governance frameworks. The Attorney General has significantly strengthened investigation and prosecution activities to curb the illicit use of public funds at the highest level. To support the anti-money laundering/countering financing of terrorism (AML/CFT) efforts, the Superintendency of the Financial System has put in place a system for high-frequency monitoring of financial flows. The independence and autonomy of the Financial Investigation Unit has been legally ensured to restore the exchange of information with a worldwide network of financial investigative agencies, and to enhance the governance and anti-corruption framework. In addition, a plan has been developed and implemented by the Presidency to increase citizen participation in the design, implementation, and monitoring of public policies at the national and local level, and to receive direct corruption complaints.

33. Nevertheless, the governance framework should be strengthened further. There are two major governance framework weaknesses and corruption vulnerabilities that are macro-critical:

  • Fiscal governance: The main weaknesses relate to revenue outcomes, due to the high informality and low compliance (see Fiscal and Raising Long-Term growth sections). On fiscal transparency, there is room to improve accountability and spending controls. In particular, under the current regulation, the office of the presidency is entitled every year to a special fund, with no clear accountability requirements, thus giving rise to the risk for mismanagement or even illicit use of public funds.26

  • Regulatory framework: The ease of doing business has improved in recent years but, according to the World Bank’s 2019 Doing Business Report, setting up a new firm and dealing with construction permits still require long and costly procedures (rank 147 and 173 out of 190, respectively).

34. Staff recommend prioritizing the governance goals. Overhauling the entire governance framework takes time and resources. Therefore, staff recommend to strategically prioritize the following actions that could deliver high-yielding and rapid results, while reducing corruption vulnerabilities.

  • Fiscal governance: Building on the 2019 budget, which delineated the purpose of the presidency’s account, the budget law for 2020 should clearly ensure transparency and accountability by establishing proper auditing, and spending controls, especially for the account of the office of the presidency, according to international best practices.

  • Regulatory framework: Promptly implement electronic invoicing to make it easier to conduct business activities and improve tax collection.

35. Staff also recommend additional actions to fully address the weaknesses in the governance and anti-corruption framework. Changes to the anti-corruption legal framework should be comprehensive, ensuring harmonization of laws and considering their ultimate impact on the budget. The Audit Office should be strengthened by: (i) ensuring its supervisory power over the presidential funds; (ii) increasing its independence; and (iii) providing it with enough resources to conduct audits, including at the local government level, along with the Attorney General.

Additional Actions on Governance and Corruption

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Authorities’ Views

36. The authorities are intensifying efforts to strengthen the governance framework. The fight against corruption continues to be a top priority. Some officials acknowledged that the Law on Access to Public Information had not succeeded in significantly improving public perception of corruption in the country, despite the improvements in transparency and the recent actions to fight corruption. The authorities believe that public trust could be regained by ensuring the accountability and supervision of the use of public funds. Moreover, they stressed the need for further reforms to ensure a comprehensive audit of public accounts, such as (i) harmonizing the existing legal framework; (ii) strengthening the Audit Office by expanding its supervisory role to all public institutions; and (iii) modernizing the audit processes through extensive adoption of technology.

Statistics

37. National Accounts are adequate and governance statistics should be strengthened. The National Accounts were updated and published in early 2018. Revisions and improvements with the help of CAPTAC-DR technical assistance led to publishing updated statistics on March 29, 2019. El Salvador would benefit from strengthening governance indicators and from the development of unified and consistent crime statistics.

Staff Appraisal

38. El Salvador’s economy continues to perform well. The economy grew above its estimated potential in 2018, fueled by strong domestic consumption and investment. The growth momentum is expected to continue in 2019, as suggested by high frequency indicators and positive investment prospects. Public debt remains relatively high at about 70 percent of GDP at end-2018, and sizable gross fiscal financing needs are projected beyond 2019. The banking system remains solid, with low nonperforming loans, high provisioning, and abundant liquidity.

39. Staff welcome progress on fiscal consolidation so far and recommend further fiscal adjustment of 1.9 percent of GDP over 2019–20. The authorities’ fiscal consolidation efforts resulted in an improvement in the primary balance of 1.1 percent of GDP over 2017–18. Nevertheless, public debt is expected to drift upward under the baseline outlook as the stock of debt is high, and the rate of interest is higher than the rate of economic growth. Fiscal consolidation measures of 1.9 percent of GDP distributed over 2019–20 would ensure compliance with the Fiscal Responsibility Law, further improve the financing situation, and put debt on a firmly declining path. The drag on growth would be limited as fiscal multipliers—the impact on growth of the fiscal measures—tend to be lower during periods of economic expansion.

40. Improving the business environment and competitiveness is critical to boost growth. The government has laid the foundation for sustained growth, by implementing several structural reforms, including the productive transformation plan, El Salvador Seguro and introducing several regulatory improvements to complete the Northern Triangle customs union with Honduras and Guatemala. Potential growth could be further raised by (i) increasing the provision of public infrastructure, including through public-private partnerships, (ii) continuing to improve security, (iii) investing in education to improve human capital accumulation, (iv) reducing informality, by introducing the “monotributo” and cutting red tape further, (v) reducing the gender gap, and (vi) removing barriers to trade and investment, including by reducing the time to acquire permits, completing the adoption of the electronic signature, and simplifying the issuance of tax identification numbers.

41. Maintaining financial stability is important to support long-term growth. This could be achieved by (i) adopting the bank resolution legislation in line with best practices; (ii) ensuring that the reactivated interbank market functions smoothly to increase banks’ efficiency in managing liquidity, decrease their need for emergency liquidity, and the burden on the public sector; (iii) ensuring that measures supporting credit growth in certain sectors fully comply with the risk-based supervision framework, to avoid regulatory forbearance; and (iv) continuing to promote financial inclusion, including by expanding access to fintech services by allowing additional players in the mobile money market and enhancing microfinance capacity; these measures would help intermediate remittances more efficiently and raise long-term output.

42. The governance framework should be further enhanced. Staff recommend the following actions in the short-term: (i) increase the fiscal transparency of the 2020 budget law, building on the experience of the 2019 budget, strengthen the audit of fiscal operations, and establish better spending controls; (ii) promptly implement electronic invoicing to improve tax collection. Changes to the anticorruption legal framework should be comprehensive, ensuring harmonization of laws and considering their ultimate impact on the budget.

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

Risk Assessment Matrix Potential Deviations from Baseline (as of April 2019)1

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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 between 30 and 50 percent). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

Implementation of Fund Advice

Fiscal policy

Recommendations: Implement a primary fiscal adjustment of 2 percent of GDP (equally distributed) over 2019–20, relying on a mix of spending and revenue measures. Improve the fiscal responsibility law (FRL) in line with best practices, including a commitment to a more ambitious anchor. Advance in improving public financial management. Introduce additional reforms to strengthen the sustainability and fairness of the pension system.

Outcomes. Under current projections, the primary balance will deteriorate over 2019–2020 compared to 2018. The approved 2019 budget takes into account the loss in revenues, especially from the removal of the tax on financial transactions and transfer pricing, introduced in 2018 and then declared unconstitutional, and a rising interest bill. The authorities strengthened the FRL in December 2018 and updated the targets to incorporate the revised national accounts (in March 2018). The two major changes to the FRL were: (i) the extension of the fiscal adjustment of 3 percent of GDP period until 2021(by 2 years), and (ii) the introduction of an appropriate debt anchor of 60 percent of GDP or less by 2030, which would put debt on a declining path from the current level of around 70 percent of GDP. Progress in public financial management is generally slow, and additional reforms of the pension system are currently being analyzed by the Ministry of Finance.

Financial sector

Recommendations: Provide adequate funding for ELA facilities; approve legislation improvements to the bank resolution and crisis management framework; advance the implementation of risk-based supervision and Basel II/III; maintain sound AML/CFT standards.

Outcomes: Public ELA facility received funding from the BCIE, but it is insufficient. The Central Bank is currently negotiating additional funding for ELA with China; amounts and conditions remain unknown. The law on bank resolution and crisis management is in negotiations between the Central Bank, Financial Superintendency, and the Deposit Guarantee Fund. Progress on Basel II/III implementation is mixed: there are advances in a few areas but also delays in setting up the relevant working groups. The authorities have enhanced AML/CFT by establishing a high frequency monitoring system of capital flows and maintain international cooperation with the U.S. Department of Treasury.

Structural reforms

Recommendations: Increase execution of public investment; reduce barriers to trade; reduce informality; advance regulatory simplification to reduce red tape; continue to fight against crime and corruption.

Outcomes: Following years of low execution, public investment increased in 2018. Trade and competitiveness are expected to improve with the completion of the customs union with Honduras and Guatemala, the enhanced infrastructure at the border points, and the continued implementation of the productive transformation policy that increased productivity. Informality remains high at 70 percent of total employment, and the authorities are designing measures (including a simplified tax code), which will be implemented in 2019 and subsequent years, to address this problem. Progress in reducing red tape was made by approving the law of administrative procedures in early 2018 (became effective in February 2019), launching the National Registry of Procedures, and approving the law of regulatory simplification in December 2018. In terms of governance, the Attorney General significantly strengthened investigation and prosecution activities to ensure a transparent use of public funds. Continued implementation of “El Salvador Seguro” plan and the permanent adoption of some of the extraordinary measures introduced in 2016, brought further down homicides in 2018; extortions continue to be a problem, which mostly affects SMEs.

Statistics

Recommendation: Publish revised GDP statistics.

Outcome: The updated National Accounts were published on March 23, 2018, as planned. Further revisions and improvements were incorporated to the data, with support from CAPTAC-DR’s technical assistance, and updated statistics were published on March 2019.

Annex I. Public Debt Sustainability Analysis

The debt stock was 69.8 percent of GDP at end-2018, well above prudent levels for El Salvador. Primary deficit reduction and the pension reform have contributed to temporarily stabilizing the debt in 2018 and curb the projected debt path well below the historical trend. However, gross public financing needs remain relatively high for a dollarized economy, and debt remains vulnerable to risks, including growth and financing shocks. These risks are mitigated by the long maturity of the existing debt and a stable investor base.

A. Key Assumptions

1. Debt definition. The public debt sustainability analysis focuses on a definition of gross debt which comprises the nonfinancial public sector1 (NFPS) and the external debt of the central bank. The series is published by the Ministry of Finance regularly in their reports and public presentations. In staff’s definition, the NFPS includes pension-related debt (the so-called CIP-A bonds that are issued to finance current public pension payments).

2. Macroeconomic outlook. The baseline reflects the estimated growth potential of 2.2 percent. No further fiscal adjustment is assumed; hence the dynamics of the primary balance reflect mainly the declining pension payments due to the pension reform. The interest bill is projected to rise over the medium-term to reflect the current tighter global financial conditions, widening further the negative growth/interest differential. The latter is the main driver of the public debt dynamics. The scenario assumes that financing gaps are filled mainly with long-term loans from private external creditors and short-term domestic bonds. Inflation is expected to remain anchored at about 1 percent over the medium term.

B. Results and Assessment

3. Baseline scenario results. The public debt would drift to 72.2 percent of GDP by 2024 and continue its mildly upward trajectory thereafter (see first table and charts). Financing needs, averaging 8.2 percent of GDP over 2019–24, are driven by a deterioration of the primary balance and a rise in domestic amortization payments that reflect the observed increase in short-term debt (LETES) in 2018. The high public debt ratio and economic growth already at potential have de facto erased the fiscal space.

4. Drivers. Interest rates are the major contributor to the upward debt dynamics, averaging about 3 percent of GDP contribution on an annual basis (see second table). Primary surpluses and real GDP growth mitigate these increases, with annual contributions reducing debt, by about 1 and 1½ percent of GDP, respectively.

5. Stress scenario. Assumptions. Mostly standard shock scenarios (declines by one standard deviation of the main variable shocked) have been considered for comparability. The impact of a natural disaster assumes a decline of GDP growth by 3 percentage points the first year and 2 percentage points the following year. Results. Real GDP and contingent liability shocks have a relatively significant impact, the latter being particularly costly since it increases financing needs significantly. A combined macro-fiscal shock and a natural disaster shock would also be challenging.

6. Assessment. Most standard debt profile characteristics are of concern (heat-map). Moreover, the heat-map may understate some risks, because: (i) the gross financing threshold of the heat map (15 percent of GDP) does not account that it is harder for dollarized economies to mobilize financing, (ii) the measured share of “foreign currency” debt (close to zero) reflects the legal adoption of the U.S. dollar, not the implied benefits of issuing own-currency liabilities.

7. Idiosyncratic risks and issues. A major risk to the debt dynamics is the reversal of the recent deficit reduction. Moreover, under tightening global financial conditions, greater financing needs due to a higher interest bill or reversal of deficit reduction would magnify vulnerabilities.

8. Vulnerability. The main vulnerability of the El Salvador public debt stems from its high level. Simulations show that combined macro-economic shocks could increase debt by about 8 percent of GDP, and a natural disaster by about 33 percent.

9. Mitigating factors. The relatively long average debt maturity (12 years) of existing debt, and a stable investor base (over one-half of the debt is held by domestic pension funds and official creditors) partly mitigate debt vulnerabilities.

uA01fig21

Composition of Public Sector Debt by Creditor, 2018

(Percent)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Source: Ministry of Finance of El Salvador

10. Based on past fiscal performance and multiple methodologies, the appropriate public debt level for El Salvador is 50 percent of GDP.

  • Emerging market economies have been unable to generate adequate primary surpluses, in part due to weak revenue bases (lower yields and higher volatility) and less effectiveness to control expenditure during economic expansion. Mendoza and Oviedo (2004), building on Buiter (1985) and Blanchard et al. (1990), find that the sustainable level of debt for emerging markets is 45 percent of GDP. More recent research (e.g., Ostry et al. (2010)) recommends a median long-run debt level of about 50 percent of GDP.

  • Estimations for El Salvador, taking into account its features, including dollarization, suggested a prudent debt level of about 40 percent of GDP in 2015. Due to the downward revision of the national accounts in March 2018, which pushed debt as a percent of GDP up, the 2018 Staff report suggested subsequently 50 percent of GDP as a prudent and achievable level of debt by 2030.

Therefore, reducing the public debt from the current level of about 70 percent of GDP at end-2018 to 50 percent of GDP by 2030 would help create fiscal space and reduce financing needs.

Figure AI.1.
Figure AI.1.

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

(In percent of GDP unless otherwise indicated)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Source: IMF staff.1/ Public sector is defined as non-financial public sector.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.
Figure AI.2.
Figure AI.2.

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

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Source: IMF staff.
Figure AI.3.
Figure AI.3.
Figure AI.3.

El Salvador: Public DSA – Realism and Baseline Assumptions

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Source: IMF Staff.1/ Plotted distribution includes all 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, as it meets neither the positive output gap criterion nor the private credit growth criterion.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.Source: IMF staff.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.
Figure AI.4.
Figure AI.4.

El Salvador: Public DSA – Stress Test

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Source: IMF staff.
Figure AI.5.
Figure AI.5.

El Salvador: Public DSA Risk Assessment

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Source: IMF staff.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, 04-Jan-19 through 04-Apr-19.5/ 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.

C. External DSA

11. The current account deficit, after seeing a sustained improvement during 2014–17, worsened to 4.8 percent in 2018. This is mainly due to the sharp deterioration in the merchandise trade balance, while remittances continued to surge. After peaking in 2019, remittances are expected to fall back to its trend rate in the medium-term, which combined with steadily worsening income balance will result in a mild widening of the current account deficit to 5 percent by 2024. External debt is expected to remain stable, with an expansion of public sector debt offset by a reduction in private sector debt.

12. The external debt path does not show much sensitivity to the interest rate and growth shocks. The non-interest current account shock and combined shock have larger effects, along with the combination of interest rate, growth and current account shocks. The largest negative effect is observed in response to the real exchange rate depreciation shock, which in case of El Salvador assumes a one period shock to the nominal 1–1 peg given the dollarization.

Table AI.1.

El Salvador: External Debt Sustainability Framework, 2013–23

(In percent of GDP, unless otherwise indicated)

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Derived as [r – g – r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

Figure AI.6.
Figure AI.6.

El Salvador: External Debt Sustainability: Bound Test 1/ 2/

(External debt in percent of GDP)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Sources: International Monetary Fund, Country desk data, and staff estimates.1/ Shaded areas represent actual 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/ For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead.3/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.4/ One-time real depreciation of 30 percent occurs in 2019.

Annex II. External Sector Assessment

The sustained improvement in El Salvador’s current account balance since 2014 was reversed in 2018. This was the result of stagnant exports and a broad-based ramp up in imports. The external position for 2018 is assessed to be moderately weaker than that suggested by fundamentals and desirable policies, implying a real effective exchange rate overvaluation of 4–6 percent.

1. The current account deficit worsened, as the real effective exchange rate appreciated. The steady shrinking of the current account (CA) deficit observed since 2014 was reversed in 2018.1 The CA deficit widened to 4.8 percent of GDP in 2018 from a low of 1.9 percent in 2017, owing to the sharp slowdown in exports and broad-based increase in imports, including oil imports due to higher oil prices. Export stagnancy was the result of a decline in coffee and sugar prices, regional trade disruption due to unrest in Nicaragua, and slowdown in textile and clothing exports (largest export sector). The surge in remittances continued, which partly offset the worsening trade balance. The real effective exchange rate (REER) appreciated by 3 percent during 2018, owing to the strengthening of the U.S. dollar against currencies of the main trading partners. As a result, about half of the REER correction that took place during 2016–17, following the appreciation of 2014–15, has been erased.

uA01fig22

REER, NEER, RCPI

(Units)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Sources: National authorities and IMF staff calculations.

2. The external balance position for 2018 is assessed to be moderately weaker than the level implied by fundamentals and desirable policies.

  • The CA norm deficit, determined by desirable policies and current fundamentals, is estimated to be 5.0 percent of GDP. Though this is larger than the actual 2018 deficit of 4.8 percent, the resulting a CA gap is -0.3 percent (after accounting for cyclical and multilateral adjustments), of which the policy gap is -1.7 percent (largely due to changes in reserves and public health expenditure). The implied REER gap is 1.1 percent, and hence the EBA-lite approach signals an overvaluation of 1 percent.

  • The REER approach shows an overvaluation of 5.8 percent.

  • Given the sizeable negative net foreign asset position (NFA) of 62.3 percent of GDP for 2018, staff also puts weight on external sustainability. The External Sustainability (ES) approach estimates the CA gap to be -1 percent and implies an overvaluation of 4.3 percent.2

  • Therefore, overall the staff assesses the external balance to be moderately weaker, with an overvaluation of the REER in the range of 4 to 6 percent.

El Salvador: Current Account and Exchange Rate Assessment

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Source: Fund staff estimates and projections.

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

Positive REER gap implies overvaluation. In the CA approach, export elasticity is -0.44 and import elasticity is 0.29.

3. Improving export competitiveness will require a multi-pronged approach. The key

areas of focus include: (i) invest in education and training (exports tend to be of higher quality); (ii) increase access to finance (exporting involves high fixed/sunk costs); (iii) support for investment in research, technology, and innovation (to move up the product quality ladder); and (iv) provision of reliable infrastructure and an entrepreneur enabling regulatory environment. The global competitiveness rankings (2017–18) show that El Salvador lags behinds its peers in Central and Latin America in the domains of business dynamism, innovation capability, institutions, skills and labor markets. Additionally, the Doing Business (2019) indicators show that there are significant gaps to bridge in costs of starting a business and in dealing with construction permits, while there has been a significant reduction in time and cost of trading across borders. Lastly, according to the 2016 World Bank enterprise surveys, crime, theft and disorder was rated as the top constraint across firms, unfair competition from informal firms ranked second for small firms, lack of access to finance ranked third for medium sized firms, and cumbersome licensing and permits procedures ranked third for the largest firms.3

4. The level of international reserves continues to be significantly below the adequate level implied by the risk-weighted Assessing the Reserve Adequacy (ARA) metric. Despite the recovery since 2014, due to the improvement in trade balance and sustained increase in remittance inflows, reserves remain below the ARA benchmark at 62 percent of the level deemed adequate. Additionally, the level of reserves is also lower than the level determined adequate by the authorities’ metric. Against the traditional metrics—3 months of import coverage and 100 percent of short-term debt coverage—the level of reserves in 2018 appears to be adequate.

5. The adjusted ARA metric for a dollarized economy shows that reserves need to be at 18.3 percent of GDP. This is a level between the standard Fund’s ARA level for fixed exchange rate regimes and the authorities’ metric (chart).

uA01fig23

Reserve Adequacy Metrics, 2018

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

* – these funds have not been established yet.

Annex III. Liquidity Management and Emergency Liquidity Assistance

1. Statutory requirements in El Salvador are:

  • Reserves - 21.6 percent of deposits (currently). Banks tend to hold excess reserves as a precaution against volatility in liquidity flows (see text chart);

  • Liquidity - 3 percent of liabilities should be held in foreign liquid assets or El Salvador government securities. These are required to be of high-grade rating and easily tradable.

2. In case of liquidity needs, a bank can borrow liquidity from the interbank market, or access its required reserves deposited at the BCR. Salvadorans banks are well capitalized and have abundant liquidity (more so than regional dollarized peers, see chart). Capital adequacy ratio is well above the required limit, and credit portfolio is balanced. In case of liquidity needs, a bank could borrow funds from the interbank money market, or access its own reserves at the central bank. The latter could be done in three stages, sequentially on tighter terms: (i) the first tranche (25 percent of total banks reserves) at no cost, (ii) the second (25 percent) at LIBOR plus a penalty, and the third (50 percent), at no cost but subject to the approval by the Superintendence of Financial System (SSF), by submitting a regularization plan. After accessing tranches, I and II, banks could also access the required liquid assets to meet their liquidity needs.

3. The Central Bank can provide bilateral ELA to a bank that remains solvent and has exhausted the above-mentioned traditional facilities. When normal market functioning is disrupted, and solvent bank’s tranche II reserves are accessed, the central bank can provide emergency liquidity up to 100 percent value of the required capital of an individual bank under stress. The authorized ELA tools are: (i) repurchase agreements using appropriate capital, (ii) temporal acquisition of banks’ investments portfolio, and (ii) liquidity credits to banks.

4. Central bank is working to bolster the funds it could use in the case of a systemic shock, based on previous CAPTAC DR technical assistance (see Financial Stability section and IMF Country Report 18/151).

uA01fig24

Banks’ Reserves

12-month average (Percent of Deposits)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Sources: National authorities and IMF staff calculations.
uA01fig25

Ratio of Liquid Assets to Total Deposits

Percent (December 2018)

Citation: IMF Staff Country Reports 2019, 143; 10.5089/9781498316972.002.A001

Sources: IMF, International Financial Statistics; IMF staff calculations.1/ Holdings of central bank and central government securities.2/ Deposits at the central bank and abroad (incl. securities)
1

In 2017, ninety percent of SMEs were subject to extortion according to estimates by the National Council of Small Enterprises (CONAPES) and the Chamber of Commerce and Industry.

2

Coffee and sugar prices declined, and there was a temporary interruption in regional trade due to road blockades in Nicaragua.

3

Given that outmigration to the U.S. has been on a decline since 2010, the accelerated growth rate of remittances (11 and 8 percent respectively) during 2017–18 was mainly due to the steady improvements in the U.S. labor market (chart) and possibly also to precautionary motives related to the uncertainty surrounding the cancellation of the Temporary Protected Status (TPS).

4

VAT on imports increased by 0.4 percent of GDP in 2018, and it explains about 50 percent of the 2018 increase in tax revenue.

5

As the Supreme Court declared unconstitutional, the financial transaction tax is not part of the 2019 budget.

6

Nominal GDP grew by 4.5 percent.

7

Reserves are needed to respond to unexpected demand for liquidity in the banking system and to serve as a buffer for government financing, and not for stabilizing the exchange rate, since El Salvador is a fully dollarized economy. See Annex II for staff and authorities’ calculations for ARA metrics for dollarized economies.

8

While the fiscal impact of a cut in U.S. aid would be limited, it may have a perverse impact on migration as the loss of grants and technical assistance would slow trade facilitation and fight against crime and corruption.

9

There are currently 1.4 million Salvadoran migrants in the U.S., of which only 14 percent (195,000) have temporary protected status, extended until January 2020. Assuming 25 percent of TPS holders are deported, remittances would decline by US$225 million (4 percent of total inflows).

10

Despite a real growth rate around 2.4 percent over the past four years, and an improvement in the primary fiscal balance of about 2 percent of GDP, public debt increased by 4 percent of GDP during the same period.

11

These shocks could increase public debt by about 8 and 20 percent of GDP, respectively.

12

A safe debt level for El Salvador is considered to be 50 percent of GDP (In IMF Country Report 15/13 staff applied four different methods and took into account dollarization). The frontloaded adjustment ensures compliance with this debt target, and recommendations for emerging markets (Annex I).

13

Targeted fiscal transfers could be put in place to soften the regressive impact of the VAT increase on the most vulnerable in society.

14

In 2017 of the 70,000 Salvadorans who entered the working-age population, only 25,000 managed to obtain employment, most of them in the informal sector, according to the household survey (EHPM).

15

The “Smart City” project is expected to be implemented in San Salvador in 2019.

16

Youth in grades seven to nine are most prone to drop out, and vulnerable to gang recruitment or pregnancies.

17

Honduras, Guatemala, Nicaragua, and Costa Rica.

18

Over 60 units in charge of gender issues have been created in the public sector to institutionalize gender mainstreaming. The second program is implemented with support from UNDP.

19

The policy, in place since 2014, supports the development of strategic sectors by (i) creating technological centers to help firms move up the product quality ladder; (ii) facilitating financing through the provision of seed capital to entrepreneurs; and (iii) supporting the accumulation of human capital through alliances between the businesses and the Salvadoran Vocational Training Institute.

20

Between 2014 and 2017, the employment share in agriculture declined by 1 percentage point, while it increased by 0.9 and 0.3 percentage points in manufacturing and communication services, respectively.

21

ELA resources consist of: net international reserves in excess of liquid liabilities, government deposits, and a contingent credit line from the Central American Bank for Economic Integration; see also Annex III.

22

BCR is negotiating with China various lending opportunities, including a contingent credit line for ELA.

23

Conditions for banks accessing ELA are spelled in Annex III and are broadly in line with best practices.

24

Banks are allowed to hold less reserves than mandated by reserve requirements, by 10 percent of the credit extended to some sectors of the economy. This requirement is unrelated to return considerations or liquidity risks, which may compromise the effectiveness of the liquidity management measures.

25

Only 25 percent of remittances flowed through the banking system in 2018 and remained in deposits. Authorities should take more steps to alleviate regulatory obstacles and attract more remittances to banks for better intermediation (Box 3).

26

The General Attorney’s office initiated and advanced cases against two former presidents in 2017–18. Mr. Antonio Saca (ARENA) was convicted of diversion and laundering of US$300 million of public funds. Mr. Mauricio Funes (FMLN, 2019–14), has been accused of embezzling US$351 million, and his extradition from Nicaragua has been approved.

1

The NFPS debt definition excludes municipal debt (1½ percent of GDP), pension system’s recognition bonds (CIP-B bonds) and some SOEs debt.

1

Initiated by the oil prices decline after 2014 and later supported by a surge in remittances after 2015.

2

However, this estimate relies on data up to 2016, which is based on the old GDP series. After the data revision in 2018, the 2016 NFA position shot up to 66 percent of GDP from the pre-revision level of 60 percent. In the 2017 external sector assessment, staff estimated that improving the net IIP position to -50 percent would yield a CA norm of -2.5 percent and a CA gap of -2 percent which translated into an overvaluation of 15 percent.

3

Lack of political stability was among the top 3 constraints for firms of all sizes.

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Cover IMF Staff Country Reports
El Salvador: 2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for El Salvador
Author:
International Monetary Fund. Western Hemisphere Dept.
Volume/Issue:
Volume 2019: Issue 143
Publisher:
International Monetary Fund
ISBN:
9781498316972
ISSN:
1934-7685
Pages:
68
DOI:
https://doi.org/10.5089/9781498316972.002
Figure 1.

El Salvador: Long-term Growth and Poverty

Structural bottlenecks have inhibited long-term growth
Figure 2.

El Salvador: Balance of Payments Developments
Figure 3.

El Salvador: Fiscal Developments

Spending restraint helped cut primary deficit, but financing remains a concern
Figure 4.

El Salvador: Financial Sector Developments

Real GDP per Capita Growth 2009–2018

(PPP Index, 2009 = 100)

Change in Inequality and Poverty

(Gini Index; Percent)

Real GDP Growth

(Percent)

Contributions to Real GDP Growth

(Percent)

Headline and Core Inflation

(Year-on-year, percent)

U.S. Remittances to El Salvador and U.S. Hispanic Unemployment Rate

(3-months moving avg.)

Change in Overall Balance

(Percent of GDP)

Cyclically Adjusted Primary Balance

(Percent of Potential GDP)

Remittances and Household Deposits

Year-on-year growth (Percent)

Domestic Credit

Year-on-year growth (Percent)

EMBI Global Spreads

(Basis Points)

Gross Public Debt

(Percent of GDP)

Contributions of Debt-Creating Flows, 2008–2018

(Percent of GDP)

Public Debt Path Scenarios

(Percent of GDP)

Real GDP Growth Contributions

(Percent)

Private and Public Investment

(Percent of GDP)

Number of Homicides

Financial Inclusion

(Percent of adults a bank account, in total population)

Financial Inclusion and Mobile Phone Ownership

(Percent)

Composition of Public Sector Debt by Creditor, 2018

(Percent)
Figure AI.1.

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

(In percent of GDP unless otherwise indicated)
Figure AI.2.

El Salvador: Public DSA – Composition of Public Debt and Alternative Scenarios
Figure AI.3.

El Salvador: Public DSA – Realism and Baseline Assumptions
Figure AI.3.

El Salvador: Public DSA – Realism and Baseline Assumptions
Figure AI.4.

El Salvador: Public DSA – Stress Test
Figure AI.5.

El Salvador: Public DSA Risk Assessment
Figure AI.6.

El Salvador: External Debt Sustainability: Bound Test 1/ 2/

(External debt in percent of GDP)

REER, NEER, RCPI

(Units)

Reserve Adequacy Metrics, 2018

(Percent of GDP)

Banks’ Reserves

12-month average (Percent of Deposits)

Ratio of Liquid Assets to Total Deposits

Percent (December 2018)