Public Information Notices
El Salvador and the IMF
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On July 18, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with El Salvador.1
Over the past decade, El Salvador has built a good macroeconomic policy track record and demonstrated considerable reform ownership. After the end of the civil war in 1992, the authorities maintained a sound fiscal policy, which helped reduce public debt from about 50 percent of GDP in 1992 to about 30 percent in 2000. They also implemented a comprehensive structural reform process, including privatization, trade liberalization, and civil service and pension reform.
In recent years, the authorities have reinforced their strategy. They introduced official dollarization in January 2001 to reduce domestic interest rates, exchange rate risk, and transaction costs and, thus, to reinvigorate private investment and exports. Structural reforms have strengthened public banks and financial supervision, expanded the role of the private sector, and further progress has been made regarding trade integration.
Partly due to adverse shocks, growth has weakened in recent years. These shocks include the earthquakes in 2001, adverse terms of trade developments (coffee and oil), and the global economic slowdown. Economic growth was 2.1 percent in 2002, consumer price inflation remains subdued (2 percent in 2002), and domestic interest rates have declined. Civil service reform has created room for the public sector wage bill to decline, and tax revenues increased to 11.2 percent of GDP in 2002 on account of measures to broaden the tax base and improve tax administration and enforcement. Still, the fiscal deficit increased to 4.6 percent of GDP in 2002, largely because of reconstruction expenditures following the 2001 earthquakes. Hence, public debt has reached almost 40 percent of GDP by end-2002.
The outlook for 2003 suggests that macroeconomic stability will continue. Economic growth is projected to remain practically unchanged from 2002 at 2.2 percent. The negotiations for a Central American Free Trade Agreement (CAFTA) with the United States are expected to encourage new investments as exporters start to position themselves for an expansion in trade. Some deficit reduction is projected for 2003 (to 4.1 percent of GDP), reflecting large cutbacks in capital expenditures, which will be partially offset by new expenditure commitments in the social area.
Executive Board Assessment
The Executive Directors commended the authorities for their strong record of sound fiscal policies and comprehensive structural reforms since the early 1990s, which have contributed to a marked reduction in inflation, a decline in public debt relative to GDP, a rapid growth of non-traditional and maquila exports, and impressive advances in social indicators. The new monetary regime introduced in 2001, with the U.S. dollar as legal tender in parallel with the colón, has contributed to halting the appreciation of the real exchange rate and reducing domestic interest rates, and appears to have gained broad domestic acceptance.
Directors welcomed the authorities' efforts to maintain overall sound economic policies in the face of the adverse shocks of recent years, including two major earthquakes, deteriorating terms of trade, and slower U.S. growth. At the same time, however, they observed that the recent weakening of the fiscal position and sluggishness of output growth pose challenges which will need to be addressed going forward. Directors therefore encouraged the authorities to build on the credibility of the new monetary regime by continuing to implement sound fiscal and financial sector policies and sustaining their structural reform efforts. This will require continued efforts to mobilize broad-based support for a further strengthening of the policy framework, notwithstanding the challenging political environment.
While recognizing that the rise in the fiscal deficit and public debt in 2002 were largely due to reconstruction expenditures following the earthquakes and to pension system reform, Directors observed that, absent further fiscal adjustment, the public debt could increase relative to GDP and public sector financing requirements would remain large. Directors therefore encouraged the authorities to pursue their fiscal consolidation efforts to put public debt on a declining path while, at the same time, buttressing the dollarization regime. They generally supported the view that a fiscal adjustment of about 3 percentage points of GDP would be appropriate, and would need to include a revenue enhancing effort by strengthening tax enforcement and taking, in due course, steps toward increasing VAT and excise rates. Directors also encouraged the authorities to continue to press for a modification of the generous early retirement provision, which allows many workers to retire before age 50. To reduce El Salvador's vulnerability to adverse shocks, they recommended that the authorities combine the fiscal adjustment with efforts to build up a strong international reserve cushion. Over the medium term, the authorities were encouraged to give consideration to the adoption of a fiscal rule to further enhance the credibility of their commitment to fiscal prudence.
Directors welcomed the progress made by the authorities in implementing FSSA recommendations aimed at reinforcing financial supervision, in particular the steps to strengthen the regulatory framework and modernize the payment system. They encouraged the authorities to continue their efforts to strengthen the supervision of cross-border lending and of financial conglomerates, and to address remaining vulnerabilities stemming from banks' exposure to impaired assets. To reduce the exposure of private pension funds to the government, Directors supported the authorities' efforts to allow the funds to invest a larger share of their portfolio in high-quality investments abroad. They looked forward to the follow-up FSAP exercise to identify areas for further improvements on financial sector issues. Directors commended the authorities for their exemplary efforts to combat money laundering and the financing of terrorism.
Directors welcomed the steps to strengthen the safety net under the financial system, including efforts to establish contingent credit lines with some multilateral institutions. They noted, however, that in view of the possibility of future adverse shocks, a further strengthening of the safety net would be helpful, and encouraged the authorities to consider steps to increase the capitalization of the deposit insurance fund and to keep under review the possible strengthening of a lender of last resort facility. They also encouraged further study of possible improvements in the central bank's liquidity operations in line with the new monetary regime.
While commending the authorities for the comprehensive structural reform agenda implemented over the past decade, Directors saw a need for sustained further efforts to enhance competitiveness and productivity growth. They encouraged the authorities to press ahead with their reform plans aimed at increasing private sector participation in the economy, including full privatization of the electricity company and the sale of concessions in the transportation sector. Directors also welcomed the steps to increase labor market flexibility, while stressing that the maintenance of a prudent minimum wage policy will be equally important to keep labor costs competitive in the maquila and nontraditional export sectors. While recognizing the considerable progress that has been made in recent years in addressing institutional and governance weaknesses, Directors encouraged the authorities to continue their efforts in these areas.
IMF EXTERNAL RELATIONS DEPARTMENT