## 1. Timing and Composition of the Fiscal Adjustment

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### Economic and Social Context
- GDP grew by 15 percent over the past decade in real per capita terms (purchasing power parity).
- Poverty: 30 percent of the population (national definition).
- Migration and TPS:
  - 1.4 million Salvadoran migrants in the U.S.; 14 percent (195,000) have Temporary Protected Status (TPS), extended until January 2020.
- Security and informality:
  - Gangs operate in poorest areas; in 2017, ninety percent of SMEs were subject to extortion (CONAPES and the Chamber of Commerce and Industry estimates).
  - High informality constrains firm expansion and potential output.
- Governance:
  - February election of President-elect Bukele (assumes office on June 1) marks a break from two-party dominance since 1992.

### Recent Economic Performance
- Real GDP growth:
  - First half of the year: 2.8 percent (year-on-year).
  - 2018 overall: 2½ percent (¼ percent above estimated potential).
  - January 2019: 2.7 percent (year-on-year).
- Sectoral shocks:
  - Stagnant merchandise exports; low agricultural production due to drought; declines in coffee and sugar prices; regional trade interruption from Nicaragua road blockades.
- Inflation and external sector:
  - Headline inflation: 0.4 percent in February 2019.
  - Real exchange rate: assessed overvaluation of 4-6 percent (Annex II); 2018 real exchange rate appreciated by 3 percent.
  - Current account deficit: widened to 4.8 percent in 2018.
- Remittances:
  - US$5.4 billion in 2018 (20.7 percent of GDP).
  - Growth in 2019 closer to long-term average of 4 percent; 2017 and 2018 saw 11 and 8 percent growth respectively.
- Fiscal and public debt:
  - Primary fiscal surplus: about 1 percent of GDP in 2018.
  - Pension reform savings: about 0.8 percent of GDP in 2018.
  - Overall deficit: -2.7 percent of GDP in 2018.
  - Public debt (including pensions): around 70 percent of GDP at end-2018.
- Banking sector and credit:
  - Banks reduced external liabilities, remained well-capitalized.
  - Credit to the private sector grew by 6.4 percent; nominal GDP grew by 4.5 percent.
  - Deposit-to-loan coverage: 95 percent.
  - Non-performing loans: below 2 percent.
  - Profitability: three-year high.
- Reserves:
  - Gross international reserves increased by US$2 million, remaining at about US$3.6 billion.
  - Reserves sufficient for imports and short-term debt but below ARA benchmark; need to be increased.

### Outlook and Risks
- Baseline projections:
  - 2019: staff expect real GDP growth at 2½ percent; inflation anchored around 1 percent; remittances elevated.
  - 2020-24: growth expected to converge to potential of 2.2 percent; remittances decline to long-run trend.
- Downside risks:
  - Global: weaker global growth, rising protectionism.
  - Domestic: policy slippages on fiscal adjustment; lower growth if new administration fails to secure legislative support.
- Authorities:
  - Agreed with staff’s outlook; committed to smooth political transition and handover oversight.
  - Acknowledged debt would drift upward in absence of measures.

### Rationale for Frontloading Fiscal Adjustment
- FRL requires:
  - Primary fiscal adjustment of 3 percent of GDP over 2017-21.
  - Public debt anchor of 60 percent of GDP by 2030 (including pension liabilities).
- Current progress:
  - Primary fiscal balance improved by 1.1 percent of GDP over 2017-18.
  - Further adjustment of 1.9 percent of GDP by 2021 needed to meet FRL operational target.
- Risks if not frontloaded:
  - 60 percent target may not be achievable by 2030 without significant further consolidation.
  - Borrowing rates exceed GDP growth; medium-term financing needs remain sizeable.
  - Macroeconomic or natural disaster shocks could increase public debt by about 8 and 20 percent of GDP, respectively.

### Frontloaded Adjustment Scenario (2019-20)
- Consolidation measures: 1.9 percent of GDP over 2019-20 (0.6 percent of GDP in 2019; 1.3 percent of GDP in 2020).
- Implied primary balance improvement: 1.1 percent of GDP (accounting for a temporary deterioration of baseline primary balance of 0.5 percent of GDP and impact of fiscal measures on GDP growth of 0.3 percent of GDP).
- Debt outcome:
  - Public debt would decline to 50 percent of GDP by 2030 under frontloaded adjustment.
- Feasibility:
  - Implementing adjustment during expansion is feasible; fiscal multipliers tend to be lower during expansions.

### Box 1 — Fiscal Multipliers, Credibility, and Composition
- Fiscal multipliers:
  - Multipliers are 50 percent smaller in expansions than in downturns.
  - 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).
- Credibility:
  - Frontloaded adjustment increases credibility and can spur private sector expansion.
- Composition matters:
  - Prefer current spending cuts over public investment cuts; current spending multipliers lower than capital spending multipliers.
  - Well-designed public wage reforms have long-lasting effects; avoid across-the-board cuts.
  - Small VAT increase and excise taxes technically easier and have limited impact on growth; VAT in El Salvador remains lower than regional peers.
- Revenue administration:
  - Tax rate increases should be accompanied by better compliance and stricter enforcement.
  - Electronic invoicing expected to simplify tax payments and reduce evasion.
  - Empirical evidence supports combining tax policy reforms with revenue administration measures.

---

### Recommended Fiscal Consolidation Priorities and Measures
- Overall priority:
  - Implement fiscal consolidation measures of 1.9 percent of GDP in 2019-20.
- Revenue-side measures and tax administration:
  - Steadfastly adopt electronic invoicing.
  - Prepare simplified tax code for small businesses (“monotributo”).
  - Implement transfer pricing initiative (“precios de transferencia”).
  - Additional structural revenue measures required beyond administration improvements.
- Recommended revenue measures:
  - Introduce excise taxes on luxury goods.
  - Increase VAT rate from 13 to 14.5 percent.
  - Implement targeted fiscal transfers to soften regressive impact of VAT increase.
- Expenditure-side and efficiency gains:
  - Rationalize current expenditure for efficiency gains.
  - Contain wage bill through hiring freezes and facilitating retirement.
  - Approve and implement civil service reform.
  - Centralize procurement and extend competitive bidding (e.g., “subasta inversa”) across public entities.
- Social spending and subsidies:
  - Eliminate social assistance and subsidies to the top two quintiles (~0.7 percent of GDP) and partly redirect to the poor.
  - Strengthen monitoring, evaluation, and targeting of social programs; integrate under a common strategy.
  - Adopt results-based budgeting.

### Exact Measures Table (figures in percent of GDP)
- Electronic invoicing: 0.3 (2019)
- Tax administration measures (monotributo, customs): 0.1 (2019)
- Excise tax on luxury goods: 0.2 (2019)
- VAT increase to 14.5 percent/other direct tax increases: 0.8 (2020)
- Goods and services savings: 0.2 (2019) and 0.2 (2020)
- Wage bill: 0.2 (2020)
- Other savings (elections, lower energy subsidies, etc.): 0.2 (2020)
- Social support to offset VAT regressive effects: -0.3 (2020)
- Total Measures: 0.6 (2019) and 1.3 (2020)

### Medium-term Comprehensive Reforms
- Objectives:
  - Eliminate distortions from temporary and ad hoc measures.
  - Expand narrow tax base.
- Specific proposals:
  - Property tax to help fund municipal transfers with enhanced accountability.
  - Pension reforms to improve benefits coverage for the poor, funded by increase of retirement age and reduction of pension fund fees; pension reforms should be budget neutral and fiscally sustainable.
- Fiscal responsibility:
  - All public sector initiatives should identify funding sources to avoid worsening public debt dynamics.

### Public Debt Management and Market Development
- Develop a well-functioning secondary market for LETES to:
  - Increase liquidity of public debt instruments.
  - Extend current maturities and deepen domestic financial markets.
  - Lower domestic borrowing costs.
- Strengthen public debt management via a medium-term debt strategy framework.

### Strengthening the Fiscal Responsibility Framework (FRL)
- Consider incorporating a permanent operational target into the FRL.
- Reduce multiplicity of targets; move other targets to medium-term fiscal framework appendix.
- Consider establishing an independent fiscal council given prior poor compliance with FRL.

---

### Financial Sector Stability — Findings and Recommendations
- Authorities concurred with staff recommendations and committed to accelerate approval of bank resolution law and fund ELA.
- Financial soundness (Q1 2019 and recent):
  - Credit to private sector increased 6.4 percent (year-to-year, Q1 2019).
  - Credit to enterprises grew 10.3 percent (year-to-year, Q1 2019).
  - Deposit-to-loan coverage: 95 percent.
  - Non-performing loans: below 2 percent.
  - Profitability: three-year high.
  - Total liquidity of the economy grew 4.9 percent.
  - Remittances increased 5.9 percent (first quarter 2019).
- ELA and crisis management:
  - Central Bank bolstering ELA resources; negotiating with China contingent credit line; BCIE provided some funding but insufficient.
  - Staff recommend ensuring interbank market functions smoothly and banks use money markets and reserves first.
  - Draft bank resolution law benefited from Fund technical assistance; regulators need to finalize requirements for systemically important entities and recovery framework.
- Supervision and regulation:
  - Align regulations with Basel III; modify normative acts for liquidity, market, and credit risk management.
  - Plans to align reserve requirements for cooperative banks with commercial banks welcomed.
- Financial inclusion:
  - Bank account ownership: 14 percent in 2011; 30 percent in 2017.
  - Simplified bank accounts opened since end-2018: 400.
  - Mobile accounts: 157 mobile accounts per 100 people.
  - Gender bank account ownership: 24 percent women versus 38 percent men.
  - Only 25 percent of remittances flowed through the banking system in 2018 and remained in deposits.
  - Microenterprises with limited access to credit: up to 40 percent.
  - Opportunities: fintech and mobile/e-money (MOMO expected to join market).

### Governance, Anti-Corruption, and Transparency
- Recent measures:
  - Attorney General strengthened investigation and prosecution; Financial Investigation Unit granted legal independence.
  - Presidency implemented plan to increase citizen participation and receive direct corruption complaints.
- Two macro-critical governance weaknesses:
  - Fiscal governance: weak revenue outcomes due to informality and low compliance; presidential special fund with limited accountability.
  - Regulatory framework: setting up new firm and construction permits remain onerous (Doing Business ranks: 147 and 173 out of 190, respectively).
- Recommended actions:
  - Short-term: increase fiscal transparency in the 2020 budget law; establish auditing and spending controls for presidential account; promptly implement electronic invoicing.
  - Additional: harmonize anti-corruption legal framework; strengthen Audit Office supervisory powers and independence; provide resources for audits including at local level; modernize audit processes with technology.

### Statistics and Data Improvements
- National Accounts updated and published: March 29, 2019.
- Recommendation: strengthen governance indicators and develop unified, consistent crime statistics.
- Data adequacy: generally adequate for surveillance; CRBS disseminates annual and quarterly national accounts for 2005-18; CPI weights based on 2005-06 survey.
- External sector datasets: key ESS datasets compiled except CPIS; authorities interested in CPIS dissemination in 2019; CDIS incomplete for outward direct investment.

---

### Public Debt Sustainability Analysis — Key Findings
- Debt definition:
  - Staff focus on gross debt of NFPS and external debt of central bank; NFPS includes CIP-A pension-related bonds; excludes municipal debt (1½ percent of GDP) and CIP-B bonds.
- Macroeconomic assumptions:
  - Estimated growth potential: 2.2 percent.
  - Inflation anchored at about 1 percent.
- Baseline results:
  - Debt stock: 69.8 percent of GDP at end-2018.
  - Public gross financing needs average 8.2 percent of GDP over 2019-24.
  - Public gross debt projected to drift to 72.2 percent of GDP by 2024.
- Drivers and vulnerabilities:
  - Negative growth/interest differential is main driver of upward debt dynamics.
  - Interest rates contribution: about 3 percent of GDP annually.
  - Primary surpluses reduce debt by about 1 percent of GDP annually.
  - Real GDP growth reduces debt by about 1½ percent of GDP annually.
  - Combined macro shocks could increase debt by about 8 percent of GDP; a natural disaster could increase debt by about 33 percent of GDP.
- Stress tests:
  - Contingent liability shocks and natural disaster scenarios are particularly costly.
  - Largest negative effect under a real exchange rate depreciation shock (assumed one-time real depreciation of 30 percent in 2019 for a dollarized economy).
- Mitigating factors:
  - Long average debt maturity: 12 years.
  - Stable investor base: over one-half of debt held by domestic pension funds and official creditors.
- Prudent target:
  - Staff assess appropriate public debt level for El Salvador is 50 percent of GDP and recommend policy to reduce debt from about 70 percent of GDP at end-2018 to 50 percent of GDP by 2030.

---

### External Sector and Reserve Adequacy
- Current account:
  - Worsened to 4.8 percent of GDP in 2018 (from 1.9 percent in 2017).
  - Projection: current account deficit projected to widen mildly to 5 percent by 2024.
- External debt path (selected baseline entries, percent of GDP):
  - External debt: 2018: 63.9; 2019: 64.3; 2020: 64.0; 2021: 64.0; 2022: 63.9; 2023: 63.9; 2024: 63.9.
  - Gross external financing need (US$ billions): 2018: 4.0; 2019: 4.9; 2020: 4.3; 2021: 4.4; 2022: 4.8; 2023: 5.8; 2024: 5.4.
  - Gross external financing need (percent of GDP): 2018: 15.3.
- External assessment and REER:
  - EBA-lite CA norm: -5.0 percent of GDP; actual CA: -4.8 percent of GDP; CA Gap: -0.3 percent.
  - REER overvaluation estimates range: 1.1 percent (EBA-lite implied) to 5.8 percent (REER approach); staff assessment: 4 to 6 percent overvaluation.
  - Net foreign asset position: sizeable negative NFA of 62.3 percent of GDP for 2018 (note data caveat).
- Reserves:
  - Gross international reserves: US$3,569 million in 2018; projected US$3,728 million in 2019.
  - Reserves below ARA benchmark at 62 percent of level deemed adequate (2018).
  - Adjusted ARA metric for dollarized economy: reserves need to be at 18.3 percent of GDP.

---

### Policies to Raise Long-Term Growth and Reduce Constraints
- Growth challenges:
  - Low contributions of physical capital and TFP; lagging private investment and human capital.
  - About 45,000 additional jobs needed annually to absorb new labor market entrants.
- Policy recommendations:
  - Provide public infrastructure and education; reduce crime and informality; improve regulatory and governance frameworks; increase lending to businesses and financial inclusion.
  - Continue improving transportation infrastructure and logistics (including airport and port concessions); leverage grants such as FOMILENIO.
  - Explore PPPs to limit fiscal impact; strengthen PPP framework (fiscal accounting, oversight, partner responsibilities).
  - Improve planning and execution of public investment projects.
- Crime reduction, education, and social inclusion:
  - Ensure continuity and funding for El Salvador Seguro plan; strengthen local police presence and technological surveillance; coordinate among police, FIU, and Attorney General to address extortion.
  - Invest in education: increase early childhood coverage, reduce high school dropout rates, expand vocational training at secondary level.
  - Legal and policy steps: 2017 amendment banning child marriage; national policy to prevent teenage pregnancy.
- Informality, gender gap, trade and investment:
  - Reduce informality via stronger tax enforcement, simplified taxes/regulations, enhanced access to affordable credit.
  - Support street vendors (mostly women) via markets in downtown recovery.
  - Gender gap: National Gender Equality Plan and Gender Seal program to reduce 30 percent participation gap.
  - Remove barriers to trade and investment; simplify permitting and tax ID issuance; adopt electronic signature.

---

### Risk Assessment Matrix (selected entries)
- Weaker-than-expected global growth
  - Likelihood: Medium.
  - Impact: Medium.
  - Policy response: Attract private investment; strengthen tax administration and expenditure management.
- Rising protectionism and retreat from multilateralism
  - Likelihood: High.
  - Impact: High.
  - Policy response: Improve external buffers; attract private investment; prioritize security, education and health.
- Sharp tightening of global financial conditions
  - Likelihood: Medium.
  - Impact: Medium.
  - Policy response: Implement fiscal consolidation; improve fiscal and external buffers.
- Natural disasters
  - Likelihood: Medium.
  - Impact: Medium/High.
  - Policy response: Ensure fiscal buffers; assess insurance schemes against natural disasters.
- Domestic policy slippages
  - Likelihood: Medium.
  - Impact: High.
  - Policy response: Forge consensus in Legislative Assembly and Executive on fiscal agenda; implement fiscal consolidation.

---

### Staff Appraisal — Summary Recommendations
- Fiscal:
  - Implement fiscal consolidation of 1.9 percent of GDP over 2019-20 to comply with the FRL and put debt on declining path.
  - Advance electronic invoicing, monotributo, and transfer pricing; accompany tax measures with strengthened compliance.
  - Prefer composition that protects public investment; target current spending efficiency and wage bill containment.
- Financial stability:
  - Approve bank resolution legislation in line with best practices.
  - Ensure interbank market functions to reduce emergency liquidity reliance.
  - Strengthen supervision, align with Basel III, and develop ELA funding consistent with intended function.
  - Promote financial inclusion and enhance microfinance capacity to intermediate remittances.
- Structural:
  - Improve business environment, security, education, infrastructure, and PPP frameworks to raise potential growth.
  - Reduce informality and gender gaps; streamline permits and tax ID issuance.
- Governance and statistics:
  - Increase fiscal transparency in 2020 budget law; strengthen Audit Office and anti-corruption legal framework.
  - Continue statistical improvements and publish revised GDP statistics.
- Institutional:
  - Staff recommend next Article IV Consultation on the standard 12-month cycle.

*Source: IMF staff report — 1. Timing and Composition of the Fiscal Adjustment (content unit 1slvea2019001).*

### 1. Timing and Composition of the Fiscal Adjustment ____________________________________________ 11

### 1. Timing and Composition of the Fiscal Adjustment

### Economic and Social Context
- GDP grew by 15 percent over the past decade in real per capita terms (purchasing power parity).
- Poverty remains high: 30 percent of the population (national definition).
- Migration to the U.S. declined, especially after 2015; 1.4 million Salvadoran migrants in the U.S., of which 14 percent (195,000) have Temporary Protected Status (TPS), extended until January 2020.
- Security and informality constraints:
  - Gangs operate in poorest areas and run extortion syndicates; in 2017, ninety percent of SMEs were subject to extortion (CONAPES and the Chamber of Commerce and Industry estimates).
  - Few firms expand, relegating activity to informal markets and depressing potential output.
- Governance: the February election of President-elect Bukele (assumes office on June 1) marks a break from the two-party dominance since 1992.

### Economic Performance (Recent)
- Real GDP growth:
  - First half of the year: 2.8 percent (year-on-year), fueled by remittances and increased public capital expenditure.
  - Overall 2018 real GDP growth: 2½ percent, ¼ percent above estimated potential.
  - January 2019 growth: 2.7 percent (year-on-year), driven by construction and services.
- Sectoral shocks: stagnant merchandise exports and low agricultural production due to drought; coffee and sugar prices declined; temporary interruption in regional trade due to road blockades in Nicaragua.
- Inflation and external sector:
  - Headline inflation declined to 0.4 percent in February 2019; core inflation remained low.
  - Continued U.S. dollar appreciation led to a significant decline in inflation and widening of the current account deficit.
  - Current account deficit widened to 4.8 percent in 2018.
- Remittances:
  - Remittance inflows reached a record-high level of US$5.4 billion in 2018 (20.7 percent of GDP).
  - Remittances continued to grow in 2019, but at a rate closer to the long-term average of 4 percent.
  - Accelerated remittance growth in 2017-18 (11 and 8 percent respectively) mainly due to U.S. labor market improvements and possibly precautionary motives related to TPS uncertainty.
- Fiscal and public debt:
  - Primary fiscal surplus increased to about 1 percent of GDP in 2018.
  - Tax revenues increased driven by higher import tax revenues and one-off measures (tax amnesty and a financial transaction tax).
  - Pension reform generated savings of about 0.8 percent of GDP in 2018.
  - Overall deficit deteriorated slightly to 2.7 percent of GDP.
  - Public debt (including pensions) remained around 70 percent of GDP at end-2018.
- Banking sector and credit:
  - Banks reduced external liabilities, remained well-capitalized, and used remittance-fueled deposits to expand credit.
  - Credit to the private sector grew by 6.4 percent (nominal GDP grew by 4.5 percent).
  - Deposit-to-loan coverage remained stable at 95 percent.
  - Non-performing loans declined below 2 percent; provisioning increased; profitability reached a three-year high.
- Reserves and external assessment:
  - Real exchange rate overvaluation assessed at 4-6 percent (Annex II); in 2018 real exchange rate appreciated by 3 percent.
  - Gross international reserves increased by US$2 million, remaining at about US$3.6 billion.
  - Reserves provide sufficient coverage for imports and short-term debt but are below adequate level implied by risk-weighted ARA metric and need to be increased.

### Outlook and Risks
- Baseline GDP growth projections (assuming no major changes in domestic policies and closely aligned with U.S. outlook):
  - 2019: Staff expect real GDP growth at 2½ percent; oil prices to decline; inflation to remain low. Elevated remittance inflows expected to compensate for a high trade balance deficit. Remittance-fueled deposits to support credit expansion.
  - 2020-24: Growth expected to slow along with the U.S. economy and converge to estimated potential of 2.2 percent. Inflation anchored around 1 percent as oil prices soften. Expected decline in remittances growth to long-run trend rate will lead to a mild widening of the current account.
- Risks (tilted to the downside):
  - Global: weaker-than-expected global growth and rising protectionism could moderate remittances and trade flows.
  - Domestic: (i) policy slippages including on needed fiscal adjustment if spending measures lack funding; (ii) lower growth if new administration fails to secure legislative support.
  - Upside: global financial conditions may tighten less than expected.
- Authorities’ views:
  - Authorities agreed with staff’s economic and fiscal outlook.
  - Emphasized commitment to guarantee a smooth political transition by sharing information and inviting the Audit Office to oversee handover.
  - Acknowledged debt would drift upward in absence of measures and weaker global growth could negatively impact the economy.

### Frontload the Fiscal Adjustment
- Legislative actions in December 2018:
  - Fiscal Responsibility Law (FRL) strengthened: requires debt to be put on a declining path and introduces anchor for public debt (including pension liabilities) of 60 percent of GDP by 2030.
  - For the first time in three years, budget and financing passed on time with overall deficit about 0.4 percent of GDP lower than initial proposal.
  - 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.
  - Law financing implementation of electronic invoicing approved; expected to improve tax compliance and ease of doing business.
- Market reaction:
  - Standard & Poor’s upgraded sovereign rating to B- in December 2018.
  - EMBI Global spread declined and is in line with regional peers.
- Fiscal challenge and need for frontloading:
  - Under unchanged policies, public debt would drift upwards; borrowing rates remain higher than GDP growth rate.
  - Medium-term financing needs remain sizeable; fiscal buffers needed to insure against macroeconomic and natural disaster shocks (such shocks could increase public debt by about 8 and 20 percent of GDP, respectively).
  - FRL requires primary fiscal adjustment of 3 percent of GDP over 2017-21 and public debt of 60 percent of GDP by 2030.
  - 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.
  - If adjustment is not frontloaded, the 60 percent target may not be achievable by 2030 without significant further consolidation.
- Frontloaded adjustment scenario:
  - Implementing fiscal consolidation measures of 1.9 percent of GDP over 2019-20 (consolidation measures of 0.6 percent of GDP in 2019 and 1.3 percent of GDP in 2020) implies a primary balance improvement of 1.1 percent of GDP (accounting for a temporary deterioration of the baseline primary balance of 0.5 percent of GDP and impact of fiscal measures on GDP growth of 0.3 percent of GDP).
  - Under frontloaded adjustment, public debt would decline to 50 percent of GDP by 2030 (considered a safe level for El Salvador).
  - Implementing the adjustment during expansion is feasible and would not stall growth momentum because fiscal multipliers tend to be lower during expansions.

### Box 1 — Timing and Composition of the Fiscal Adjustment (Key Points)
- Fiscal multipliers:
  - Estimated fiscal multipliers are 50 percent smaller in expansions than in downturns.
  - In emerging economies, multipliers tend to be larger during recessions due to informality, fiscal procyclicality, and limited automatic stabilizers.
  - 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).
- Credibility:
  - A frontloaded adjustment increases credibility; well-designed consolidations can spur confidence and private sector expansion.
- Composition matters:
  - Current spending cuts preferred over public investment cuts; current spending multipliers tend to be lower than capital spending multipliers.
  - Well-designed reforms to curb public wage bill have long-lasting effects and lower drag on growth; avoid across-the-board cuts.
  - Small VAT increase and excise taxes easier to implement technically and have limited impact on growth; generate sustainable revenues.
  - VAT rate in El Salvador remains lower than regional peers; increasing VAT would not harm competitiveness.
- Revenue administration:
  - Increases in tax rates should be accompanied by better compliance and stricter enforcement.
  - Planned implementation of electronic invoicing will simplify tax payments, improve efficiency, and reduce opportunities for corruption and evasion.
  - Empirical evidence suggests tax policy reforms combined with revenue administration measures yield larger gains.

*Source: IMF staff report — 1. Timing and Composition of the Fiscal Adjustment.*

### 16.      Implementing fiscal consolidation measures of 1.9 percent of GDP in 2019-20 should

### 1slvea2019001 - 16.      Implementing fiscal consolidation measures of 1.9 percent of GDP in 2019-20 should

### Fiscal consolidation priority
- 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 electronic invoicing;
  - technical preparations for a simplified tax code for small businesses (“monotributo”);
  - the transfer pricing initiative (“precios de transferencia”).
- These tax administration measures are not sufficient alone because their full yield will take time to materialize; additional structural revenue measures are needed.

### Recommended revenue measures
- Introduce excise taxes on luxury goods.
- Increase the VAT rate from 13 to 14.5 percent.
- Targeted fiscal transfers could be put in place to soften the regressive impact of the VAT increase on the most vulnerable.

### Expenditure-side measures and efficiency gains
- Rationalize current expenditure to achieve efficiency gains.
- Contain the wage bill through hiring freezes and facilitating retirement of some public employees.
- Approve and implement civil service reform quickly.
- Centralize the procurement system and extend competitive bidding processes (such as the reverse auction mechanism “subasta inversa”) to the full set of public entities, and goods and services.

### Social spending and subsidies
- Social assistance and subsidies to the top two quintiles represent about 0.7 percent of GDP and could be eliminated and partly redirected to the poor.
- Strengthen monitoring and evaluation of programs, invest in information systems to better target beneficiaries, and integrate social assistance programs under a common strategy.
- The government’s decision to adopt results-based budgeting is a positive step.

### Medium-term comprehensive reforms
- A comprehensive fiscal reform is needed to:
  - eliminate distortions from temporary and ad hoc measures accumulated over the years;
  - expand the narrow tax base.
- Any public sector initiative should identify funding sources to avoid worsening public debt dynamics and preserve fiscal sustainability.
- Specific proposals:
  - A property tax—a key progressive taxation measure—could help fund transfers to municipalities, combined with clear delineation of responsibilities and an enhanced accountability framework for local governments.
  - Pension system reforms addressing fairness and equity should be budget neutral and fiscally sustainable; staff recommend improving benefits coverage for the poor funded with an increase of the retirement age and a reduction of pension fund fees.

### Measures table (exact figures)
- Measures (2019 / 2020):
  - Electronic invoicing: 0.3 (2019)
  - Tax administration measures (monotributo, customs): 0.1 (2019)
  - Excise tax on luxury goods: 0.2 (2019)
  - VAT increase to 14.5 percent/other direct tax increases: 0.8 (2020)
  - Goods and services: 0.2 (2019) and 0.2 (2020)
  - Wage bill: 0.2 (2020)
  - Other savings (elections, lower energy subsidies, etc.): 0.2 (2020)
  - Social support to offset VAT regressive effects: -0.3 (2020)
  - Total Measures: 0.6 (2019) and 1.3 (2020)

### Financial market development and public debt management
- Develop a well-functioning secondary market for LETES to:
  - make public debt instruments more liquid;
  - help extend current maturities;
  - deepen domestic financial markets and lower domestic borrowing costs.
- Strengthen public debt management by developing a medium-term debt strategy framework to improve the debt profile and lower borrowing costs.

### Strengthening the fiscal responsibility framework (FRL)
- Consider further strengthening the FRL 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.
- Move other targets to the medium-term fiscal framework appendix to reduce the risk of conflicting fiscal policy objectives.
- Consider establishing an independent fiscal council given the poor track-record of compliance with the previous FRL.

### Authorities’ views on fiscal measures and reforms
- Authorities agreed with the size of the recommended adjustment.
- They highlighted that several measures proposed by staff (electronic invoicing, monotributo, transfer pricing) are being prepared and acknowledged these will take time to yield revenue.
- Authorities agreed on the need for additional structural revenue measures, such as excise taxes on luxury goods.
- They believe public procurement could be improved by extending competitive bidding processes (“subasta inversa”) to all public entities and that the wage bill could be curbed by facilitating voluntary retirement of public employees.
- Authorities underscore the need for a comprehensive fiscal reform over the medium term, harmonizing and simplifying the tax code to improve fairness, equity, competition and growth, and ensuring funding sources for public sector reforms to preserve fiscal sustainability.

### Raise long-term growth: findings and recommendations
- Low contributions of physical capital and TFP to output growth; El Salvador lags regional peers in private investment rates and human capital.
- About 45,000 additional jobs are needed annually to absorb new entrants to the labor market.
- Policies to raise potential output:
  - Provision public infrastructure and education, reduce crime and informality, improve regulatory and governance frameworks, and increase lending to businesses and financial inclusion.
  - Continue improving transportation infrastructure and logistics platform (including airport and port concessions), with emphasis on grants such as FOMILENIO.
  - Explore public-private partnerships (PPP) to limit fiscal impact; strengthen PPP framework by improving fiscal accounting, ensuring oversight, and delineating partner responsibilities.
  - Improve planning and execution of public investment projects to raise their impact on output growth.

### Crime reduction, education, and social inclusion
- Continuing to combat crime can improve the business climate and competitiveness; ensure continuity and increased funding for El Salvador Seguro plan.
- Strengthen local police presence and deployment using systematic analysis of crime trends; expand technological surveillance beyond the capital; foster community involvement; better coordination among police, financial intelligence unit, and General Attorney’s investigators to address extortions.
- Invest in education to increase human capital: increase early childhood education coverage, reduce high school dropout rates, expand flexible education and vocational training focused at the secondary level.
- Recent legal and policy steps: 2017 amendment to the family code banning child marriage and the development of a national policy to prevent teenage pregnancy expected to help reduce the gender gap in education attainment.

### Informality, gender gap, and trade/investment
- Reduce informality by stronger tax enforcement and incentives for firms to formalize (simplified taxes and regulations) and enhanced access to affordable credit.
- Initiatives to support street vendors (mostly women) include creating two large markets as part of San Salvador downtown recovery.
- Gender gap in labor force participation rate at 30 percent (lower than neighboring countries) expected to be reduced by the National Gender Equality Plan and the Gender Seal certification program.
- Remove barriers to trade and investment, facilitate diversification, minimize processing time for construction permits, complete adoption of the electronic signature, and simplify issuance of tax identification numbers.
- Continue implementation of the development, diversification and productive transformation policy to support labor productivity growth and labor reallocation.

### Enhance financial sector stability
- Key elements to maintain financial stability:
  - Continue efforts to appropriately fund the emergency lending assistance framework (ELA).
  - Approve bank resolution legislation in line with best practices.
  - Continue to strengthen supervision practices and promote greater financial inclusion.
- Emergency Liquidity Assistance (ELA):
  - Central Bank is working to bolster ELA resources to provide liquidity in response to large idiosyncratic shocks.
  - Staff recommend ensuring a smoothly functioning interbank market and that banks use money markets and own reserves first to decrease emergency liquidity needs and alleviate public sector burden.
  - Any funding agreements to boost ELA resources should have terms aligned with their intended function, particularly on BCR access.
- Crisis management and resolution:
  - Draft law on banking resolution framework has benefited from Fund technical assistance; regulators need to agree on additional regulatory requirements for systemically important financial entities and the legal framework for recovery process.
- Supervision and regulation:
  - Central Bank and Superintendency advancing efforts to align regulations to Basel III standards and modify normative acts for liquidity, market, and credit risk management.
  - Need for adequate access to credit information for all credit bureaus and to ensure sectoral credit growth measures comply with risk-based supervision.
  - Plans to align reserve requirements for cooperative banks with other commercial banks are welcomed.
- Financial inclusion:
  - Better intermediation of remittances through the financial sector needed.
  - Encourage promoting simplified bank accounts for lower risk customers and facilitate wider access for fintech services.

*Sources: National authorities and IMF staff calculations.*

### 31.      The authorities concurred with staff’s recommendations for enhancing financial sector

### 1slvea2019001 - 31.      The authorities concurred with staff’s recommendations for enhancing financial sector

### Financial sector stability — findings and authorities’ actions
- Authorities concurred with staff’s recommendations for enhancing financial sector stability and agreed on the need to accelerate the approval of the bank resolution law.
- Authorities remain committed to further strengthen cross-border cooperation and appropriately fund the emergency lending assistance (ELA) framework.
- Recent accomplishments highlighted:
  - Increased banks’ efficiency in liquidity management, including the reactivation of the interbank market, cross-border cooperation, and improved supervision.
  - The Superintendence put in place a system for high-frequency monitoring of financial flows to support AML/CFT efforts.
- Conditional and operational notes:
  - BCR is negotiating with China various lending opportunities, including a contingent credit line for ELA.
  - Conditions for banks accessing ELA are spelled in Annex III and are broadly in line with best practices.
  - 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.
  - 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.

### Financial inclusion — status and opportunities (Box 3)
- Progress and current levels:
  - Bank account ownership increased from 14 percent in 2011 to 30 percent in 2017.
  - Within-country inclusion is uneven, with lower financial inclusion in remote regions.
  - Only 400 simplified bank accounts (which do not require a tax ID) were opened since the end of 2018.
- Constraints:
  - Tax ID requirement for individuals is an obstacle; there are only five offices nationwide to obtain a tax ID.
  - The microfinance sector faces capacity constraints; up to 40 percent of small and microenterprises continue to have limited access to credit.
- Opportunities and policy suggestions:
  - Fintech and mobile/e-money could substantially expand inclusion: Mobile Money (MOMO) is expected to join the mobile money market.
  - Mobile access is high: 157 mobile accounts per 100 people.
  - Gender patterns differ by instrument: 24 percent of women have a bank account versus 38 percent of men; there is no gender difference in mobile money use.
  - Authorities introduced simplified bank accounts in 2015 and established the National Council for Financial Inclusion (CNIF) by presidential executive order in July 2018.

### Governance frameworks — recent measures and remaining weaknesses
- Recent measures:
  - Attorney General strengthened investigation and prosecution activities to curb illicit use of public funds.
  - Independence and autonomy of the Financial Investigation Unit legally ensured to restore information exchange with international agencies and to enhance governance and anti-corruption framework.
  - A plan implemented by the Presidency increases citizen participation in policy design, implementation, and monitoring, and to receive direct corruption complaints.
- Two macro-critical governance weaknesses identified:
  - Fiscal governance:
    - Main weaknesses relate to revenue outcomes due to high informality and low compliance.
    - On fiscal transparency, the office of the presidency is entitled every year to a special fund with no clear accountability requirements, creating risk of mismanagement or illicit use of public funds.
  - Regulatory framework:
    - Ease of doing business improved, but setting up a new firm and dealing with construction permits remain onerous (rank 147 and 173 out of 190, respectively, per World Bank’s 2019 Doing Business Report).

### Governance policy recommendations (short-term and additional)
- Prioritized short-term actions (high-yielding, rapid results):
  - Fiscal governance:
    - Building on the 2019 budget, the 2020 budget law 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.
- Additional recommended actions to fully address weaknesses:
  - Comprehensive changes to the anti-corruption legal framework to ensure harmonization of laws and consider ultimate budget impact.
  - Strengthen the Audit Office by:
    - Ensuring its supervisory power over presidential funds;
    - Increasing its independence;
    - Providing enough resources to conduct audits, including at the local government level, along with the Attorney General.
- Authorities’ views:
  - Fight against corruption remains a top priority; officials stressed the need to ensure accountability and supervision of public funds, harmonize legal framework, expand Audit Office supervisory role to all public institutions, and modernize audit processes through technology adoption.

### Statistics and data improvements
- National Accounts:
  - Updated and published in early 2018; revisions and improvements with CAPTAC-DR technical assistance led to publishing updated statistics on March 29, 2019.
- Recommended statistical enhancements:
  - Strengthen governance indicators and develop unified and consistent crime statistics.

### Staff appraisal — macroeconomic assessment and policy recommendations
- Macroeconomic performance and risks:
  - Economy grew above estimated potential in 2018, fueled by strong domestic consumption and investment; momentum expected to continue in 2019.
  - Public debt remains relatively high at about 70 percent of GDP at end-2018, and sizable gross fiscal financing needs are projected beyond 2019.
  - Banking system remains solid, with low nonperforming loans, high provisioning, and abundant liquidity.
- Fiscal policy recommendations:
  - Staff welcome progress on fiscal consolidation and recommend further fiscal adjustment of 1.9 percent of GDP over 2019-20.
  - Authorities’ efforts resulted in an improvement in the primary balance of 1.1 percent of GDP over 2017-18.
  - Fiscal consolidation measures of 1.9 percent of GDP distributed over 2019-20 would ensure compliance with the Fiscal Responsibility Law and put debt on a firmly declining path.
- Structural and financial stability priorities:
  - Improve business environment and competitiveness to raise potential growth via:
    - Increasing public infrastructure provision, including through PPPs;
    - Continuing to improve security;
    - Investing in education to improve human capital;
    - Reducing informality by introducing the “monotributo” and cutting red tape;
    - Reducing the gender gap; removing barriers to trade and investment, reducing time to acquire permits, completing adoption of the electronic signature, and simplifying issuance of tax identification numbers.
  - Maintain financial stability by:
    - Adopting bank resolution legislation in line with best practices;
    - Ensuring the reactivated interbank market functions smoothly to increase banks’ liquidity efficiency and decrease need for emergency liquidity and burden on public sector;
    - Ensuring measures supporting credit growth comply with risk-based supervision to avoid regulatory forbearance;
    - Promoting financial inclusion, including expanding fintech access and enhancing microfinance capacity to intermediate remittances more efficiently and raise long-term output.
- Governance recommendations reiterated:
  - Short-term: increase fiscal transparency in the 2020 budget law, strengthen audit of fiscal operations, establish better spending controls, and promptly implement electronic invoicing.
  - Anti-corruption legal framework changes should be comprehensive and harmonized, considering budget impact.
- Institutional recommendation:
  - Staff recommends the next Article IV Consultation be held on the standard 12-month cycle.

### Key statistics and exact figures cited
- Bank account ownership: 14 percent in 2011; 30 percent in 2017.
- Simplified bank accounts opened since end-2018: 400.
- Mobile accounts: 157 mobile accounts per 100 people.
- Gender bank account ownership: 24 percent women versus 38 percent men.
- Remittances through banking system in 2018: Only 25 percent flowed through the banking system and remained in deposits.
- Microenterprises with limited access to credit: up to 40 percent.
- Public debt: about 70 percent of GDP at end-2018.
- Recommended fiscal adjustment: 1.9 percent of GDP over 2019-20.
- Improvement in primary balance: 1.1 percent of GDP over 2017-18.
- National Accounts updated and published on: March 29, 2019.
- World Bank Doing Business ranks: setting up a new firm rank 147; dealing with construction permits rank 173 out of 190.

### Risk Assessment Matrix — selected risks, likelihood, impact, and policy responses
- Weaker-than-expected global growth
  - Likelihood: Medium.
  - Impact: Medium.
  - Policy response: Implement reforms to attract private investment, strengthen tax administration and expenditure management.
- Rising protectionism and retreat from multilateralism
  - Likelihood: High.
  - Impact: High.
  - Policy response: Improve external buffers; implement reforms to attract private investment and foster job creation; prioritize investment in security, education and health.
- Sharp tightening of global financial conditions
  - Likelihood: Medium.
  - Impact: Medium.
  - Policy response: Implement fiscal consolidation; improve fiscal and external buffers; implement structural reforms to improve competitiveness.
- Large swings in energy prices
  - Likelihood: Medium.
  - Impact: Medium/High.
  - Policy response: Save part of the windfall from lower energy prices.
- Spillovers from Nicaragua's political turmoil
  - Likelihood: Medium.
  - Impact: Low.
  - Policy response: Coordinate with regional trading partners for alternative trade routes.
- Domestic policy slippages
  - Likelihood: Medium.
  - Impact: High.
  - Policy response: Forge consensus in the Legislative Assembly and Executive on fiscal agenda; implement fiscal consolidation.
- Political fragmentation
  - Likelihood: Medium.
  - Impact: Medium.
  - Policy response: Ensure broad-based policy dialogue to support macroeconomic stability.
- Natural disasters
  - Likelihood: Medium.
  - Impact: Medium/High.
  - Policy response: Ensure fiscal buffers are adequate; prepare and assess enrollment in insurance schemes against natural disasters.

*Source: IMF staff report content provided in the specified content unit.*

### Box 4. Implementation of Fund Advice

### Box 4. 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.

### Fiscal policy — Outcomes
- Under current projections, the primary balance will deteriorate over 2019-2020 compared to

*Source: 1slvea2019001 - Box 4. Implementation of Fund Advice*

### 2018. The approved 2019 budget takes into account the loss in revenues, especially from the removal of the

### 1slvea2019001 - 2018. The approved 2019 budget takes into account the loss in revenues, especially from the removal of the 

### Fiscal framework and 2019 budget
- Approved 2019 budget accounts for loss in revenues from removal of the tax on financial transactions and transfer pricing (introduced in 2018 and then declared unconstitutional) and a rising interest bill.
- Fiscal Responsibility Law (FRL) strengthened in December 2018 and targets updated to incorporate revised national accounts (March 2018).
- Two major FRL changes:
  - Extension of the fiscal adjustment of 3 percent of GDP period until 2021 (by 2 years).
  - Introduction of a debt anchor of 60 percent of GDP or less by 2030 to put debt on a declining path from the current level of around 70 percent of GDP.
- Public financial management progress described as generally slow; additional pension system reforms are being analyzed by the Ministry of Finance.

### Financial sector — recommendations and outcomes
- Recommendations:
  - Provide adequate funding for ELA facilities.
  - Approve legislation improvements to the bank resolution and crisis management framework.
  - Advance 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.
  - Central Bank negotiating additional ELA funding with China; amounts and conditions remain unknown.
  - 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: advances in a few areas but delays in setting up relevant working groups.
  - AML/CFT enhanced by establishing a high frequency monitoring system of capital flows and continued international cooperation with the U.S. Department of Treasury.

### Structural reforms — recommendations and outcomes
- Recommendations:
  - Increase execution of public investment.
  - Reduce barriers to trade.
  - Reduce informality.
  - Advance regulatory simplification to reduce red tape.
  - Continue to fight crime and corruption.
- Outcomes:
  - Public investment increased in 2018 after years of low execution.
  - Trade and competitiveness expected to improve with completion of the customs union with Honduras and Guatemala, enhanced border infrastructure, and continued implementation of productive transformation policy.
  - Informality remains high at 70 percent of total employment; authorities are designing measures (including a simplified tax code) to be implemented in 2019 and subsequent years.
  - Progress in reducing red tape: law of administrative procedures approved in early 2018 (became effective in February 2019), National Registry of Procedures launched, law of regulatory simplification approved in December 2018.
  - Governance: Attorney General strengthened investigation and prosecution activities for transparent use of public funds.
  - Security: Continued implementation of “El Salvador Seguro” plan and permanent adoption of some extraordinary measures introduced in 2016 brought further down homicides in 2018; extortions remain a problem, mostly affecting SMEs.

### Statistics
- Recommendation: Publish revised GDP statistics.
- Outcome: Updated National Accounts published on March 23, 2018, as planned. Further revisions and improvements were incorporated with CAPTAC-DR technical assistance and updated statistics were published on March 2019.

### Growth, poverty, and structural constraints (selected messages)
- Structural bottlenecks have inhibited long-term growth despite solid recent economic growth and a decline in inequality to the lowest level in the region.
- Poverty declined over the last decade but remains high compared to some peers.
- Low potential growth limits job and investment opportunities.
- Crime remains high and, along with poverty and low growth, has contributed over time to outward migration.

### Balance of payments and external sector — key developments
- After shrinking during 2014-2017, the current account deficit increased due to stagnant exports and broad-based increase in imports.
- Real appreciation hurt export volume growth while imports grew, also fueled by a surge in remittances starting in 2016.
- FDI and other private sector borrowing are major contributors to the financial account surplus; reserves broadly stable.

### Fiscal developments — key statistics and trends
- Overall fiscal deficit slightly deteriorated in 2018 despite higher revenues, mostly from VAT, and broadly stable spending.
- Lower petroleum prices helped contain subsidies.
- Interest bill continues to rise; public debt trending up despite improved primary balances.
- Selected figures (percent of GDP and other):
  - Interest bill rising (see tables and figures for levels).
  - Public sector debt around 69.8 percent of GDP in 2018 and projected 70.8 percent of GDP in 2019 (Table 2 and Table 5).
  - Gross tax revenue reached 17.9 percent of GDP in 2018 (Table 1 / Table 5).
  - Primary balance of the nonfinancial public sector was 0.9 percent of GDP in 2018; projected 0.7 percent in 2019 (Table 2 / Table 5).
  - Overall nonfinancial public sector balance was -2.7 percent of GDP in 2018; projected -3.4 percent in 2019 (Table 2 / Table 5).

### External and financing indicators — selected figures
- Current account balance:
  - -4.8 percent of GDP in 2018; projected -4.4 percent in 2019 (Table 2 / Table 3).
- Remittances:
  - 20.6 percent of GDP in 2018; projected 21.2 percent in 2019 (Table 2 / Table 3).
- Gross international reserves:
  - US$3,569 million in 2018; projected US$3,728 million in 2019 (Table 3).
- Gross external financing requirement:
  - 15.3 percent of GDP in 2018; projected 18.2 percent of GDP in 2019 (Table 3 / Table 4).
- External public debt service:
  - US$987 million in 2018; external amortization and interest pressures reflected in projections (Table 3 / Table 4).

### Financial sector performance and vulnerabilities
- Banks' capital buffers remain high; asset quality is strong.
- High provisioning and low net interest spreads strain profitability.
- Credit to the private sector continues recovering but maturity profile shifted toward short-term loans.
- Financial soundness indicators (selected):
  - Bank Capital (percent of risk-weighted assets) around 16.1–16.8 range in recent years (Figure/Table series).
  - Nonperforming Loans around 1.9 percent in 2018 (Figure 4 / Table 7).
  - Provisions to Nonperforming Loans and provisioning ratios remain high (Figures and Tables).
  - Return on assets about 0.9 percent in 2018; return on equity around 7.6 percent in 2018 (Figure 4 / Financial Soundness Heatmap).

### Medium-term baseline projections (selected)
- Real GDP growth:
  - 2.5 percent in 2018; projected 2.5 percent in 2019, 2.3 percent in 2020, 2.2 percent in 2021 (Table 2).
- Inflation (average):
  - 1.1 percent in 2018; projected 0.6 percent in 2019, 1.3 percent in 2020 (Table 2).
- Public sector gross debt:
  - 69.8 percent of GDP in 2018; projected 70.8 percent in 2019, 71.2 percent in 2020 (Table 2).
- Nonfinancial public sector balance:
  - -2.7 percent of GDP in 2018; projected -3.4 percent in 2019 and -3.5 percent in 2020 (Table 2).

*Source: 1slvea2019001 - 2018. The approved 2019 budget takes into account the loss in revenues, especially from the removal of the*

### Annex I. Public Debt Sustainability Analysis

### Annex I. Public Debt Sustainability Analysis

### Key assumptions
- Debt definition
  - Focuses on gross debt comprising the nonfinancial public sector (NFPS) and the external debt of the central bank.
  - 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).
  - NFPS debt definition excludes municipal debt (1½ percent of GDP), pension system’s recognition bonds (CIP-B bonds) and some SOEs debt.
- Macroeconomic outlook and financing assumptions
  - Estimated growth potential: 2.2 percent.
  - No further fiscal adjustment is assumed; primary balance dynamics reflect mainly declining pension payments due to the pension reform.
  - Interest bill projected to rise over the medium-term reflecting tighter global financial conditions, widening the negative growth/interest differential.
  - Financing gaps assumed filled mainly with long-term loans from private external creditors and short-term domestic bonds.
  - Inflation expected to remain anchored at about 1 percent over the medium term.

### Baseline results and key statistics
- Debt and financing
  - Debt stock: 69.8 percent of GDP at end-2018.
  - Public gross financing needs average 8.2 percent of GDP over 2019-24.
  - Public gross debt projected to drift to 72.2 percent of GDP by 2024.
- Fiscal dynamics (contributions to debt)
  - Interest rates are the major contributor to upward debt dynamics, averaging about 3 percent of GDP contribution on an annual basis.
  - Primary surpluses reduce debt by about 1 percent of GDP annually.
  - Real GDP growth reduces debt by about 1½ percent of GDP annually.
- Other baseline indicators (selected)
  - Real GDP growth (projection): 2.2 percent (medium term).
  - Inflation (GDP deflator): about 1 percent (anchored).
  - Effective interest rate (example projection values shown): 6.0, 5.8, 6.1, 6.3, 6.6, 6.9 (yearly entries in table).

### Drivers, vulnerabilities, and risks
- Main drivers of debt dynamics
  - Negative growth/interest differential is the main driver of public debt dynamics.
  - Rising domestic amortization payments reflect the observed increase in short-term debt (LETES) in 2018.
- Vulnerabilities
  - High public debt ratio combined with economic growth already at potential has effectively erased fiscal space.
  - Debt remains vulnerable to shocks, including growth and financing shocks.
  - Gross public financing needs remain relatively high for a dollarized economy; the heat-map gross financing threshold of 15 percent of GDP may understate risk for dollarized economies.
  - The measured share of “foreign currency” debt (close to zero) reflects legal dollarization, not the implied benefits of issuing own-currency liabilities.
  - Idiosyncratic risk: reversal of recent deficit reduction would be a major risk to debt dynamics.
  - Under tightening global financial conditions, higher interest bills or reversal of deficit reduction would magnify vulnerabilities.
- Quantified shock impacts (simulations)
  - Combined macro-economic shocks could increase debt by about 8 percent of GDP.
  - A natural disaster could increase debt by about 33 percent of GDP.

### Stress test scenarios and results
- Stress test approach
  - Mostly standard shock scenarios (declines by one standard deviation of the main variable shocked) for comparability.
  - Natural disaster assumption: decline of GDP growth by 3 percentage points in the first year and 2 percentage points in the following year.
- Stress test findings
  - Real GDP and contingent liability shocks have a relatively significant impact; contingent liability shocks are particularly costly as they increase financing needs significantly.
  - A combined macro-fiscal shock and a natural disaster shock would be challenging.
- Examples of stress outcomes (chart summaries)
  - Under various shocks (primary balance shock, real GDP growth shock, real interest rate shock, real exchange rate shock, combined shock, contingent liability shock), gross nominal public debt trajectories and public gross financing needs rise relative to baseline, with particularly large increases under the contingent liability and natural disaster scenarios.

### Mitigating factors and assessment
- Mitigating factors
  - Relatively long average debt maturity: 12 years.
  - Stable investor base: over one-half of the debt is held by domestic pension funds and official creditors.
- Assessment and prudent target
  - Most standard debt profile characteristics are of concern (heat-map).
  - Based on past fiscal performance and multiple methodologies, the appropriate public debt level for El Salvador is 50 percent of GDP.
    - Research context: Mendoza and Oviedo (2004) find sustainable level for emerging markets of 45 percent of GDP; Ostry et al. (2010) recommends a median long-run debt level of about 50 percent of GDP.
    - Earlier estimation for El Salvador suggested a prudent level of about 40 percent of GDP in 2015; after the March 2018 national accounts revision, staff suggested 50 percent of GDP as a prudent and achievable level by 2030.
  - Policy implication: reducing public debt from about 70 percent of GDP at end-2018 to 50 percent of GDP by 2030 would help create fiscal space and reduce financing needs.

*Source: IMF staff (Annex I. Public Debt Sustainability Analysis).*

### 11.      The current account deficit, after seeing a sustained improvement during 2014-17,

### 11.      The current account deficit, after seeing a sustained improvement during 2014-17, 

### Current account developments and projections
- The current account deficit worsened to 4.8 percent in 2018 after sustained improvement during 2014-17.
- Deterioration drivers in 2018:
  - Sharp deterioration in the merchandise trade balance due to stagnant exports and a broad-based ramp up in imports, including higher oil imports.
  - Exports stagnated because of a decline in coffee and sugar prices, regional trade disruption due to unrest in Nicaragua, and slowdown in textile and clothing exports.
  - Remittances continued to surge and partly offset the worsening trade balance; remittances are projected to peak in 2019 and then fall back to trend in the medium term.
- Projection: Combined with a steadily worsening income balance, the current account deficit is projected to widen mildly to 5 percent by 2024.

### External debt dynamics and stress tests (DSA)
- Baseline external debt path (selected entries from Table AI.1, in percent of GDP unless otherwise indicated):
  - Baseline: External debt: 2014: 65.5; 2015: 64.9; 2016: 67.8; 2017: 66.1; 2018: 63.9; 2019: 64.3; 2020: 64.0; 2021: 64.0; 2022: 63.9; 2023: 63.9; 2024: 63.9.
  - Change in external debt: 2014: 1.7; 2015: -0.6; 2016: 2.9; 2017: -1.7; 2018: -2.1; 2019: 0.4; 2020: -0.3; 2021: -0.1; 2022: 0.0; 2023: 0.0; 2024: 0.0.
  - Identified external debt-creating flows (4+8+9): 2014: 2.9; 2015: -0.1; 2016: -0.8; 2017: -5.2; 2018: -0.2; 2019: 1.0; 2020: 1.2; 2021: 1.6; 2022: 1.7; 2023: 1.8; 2024: 2.1.
  - Current account deficit, excluding interest payments: 2014: 2.4; 2015: 0.0; 2016: -1.2; 2017: -1.9; 2018: 0.7; 2019: 0.2; 2020: 0.2; 2021: 0.3; 2022: 0.5; 2023: 0.6; 2024: 0.8.
  - Deficit in balance of goods and services: 2014: 19.6; 2015: 17.1; 2016: 15.9; 2017: 16.5; 2018: 19.7; 2019: 19.9; 2020: 19.8; 2021: 19.7; 2022: 19.7; 2023: 19.7; 2024: 19.7.
  - Exports (percent of GDP): 2014: 29.3; 2015: 29.5; 2016: 28.4; 2017: 29.0; 2018: 28.9; 2019: 28.6; 2020: 28.4; 2021: 28.4; 2022: 28.4; 2023: 28.5; 2024: 28.5.
  - Imports (percent of GDP): 2014: 48.9; 2015: 46.6; 2016: 44.4; 2017: 45.5; 2018: 48.6; 2019: 48.5; 2020: 48.2; 2021: 48.1; 2022: 48.2; 2023: 48.1; 2024: 48.2.
  - Net non-debt creating capital inflows (negative): 2014: -0.8; 2015: -0.9; 2016: -1.2; 2017: -4.9; 2018: -2.1; 2019: -1.8; 2020: -1.8; 2021: -1.6; 2022: -1.6; 2023: -1.6; 2024: -1.5.
  - Automatic debt dynamics: 2014: 1.3; 2015: 0.8; 2016: 1.5; 2017: 1.7; 2018: 1.2; 2019: 2.7; 2020: 2.8; 2021: 2.9; 2022: 2.9; 2023: 2.8; 2024: 2.8.
  - Contribution from nominal interest rate: 2014: 3.0; 2015: 3.2; 2016: 3.5; 2017: 3.8; 2018: 4.1; 2019: 4.3; 2020: 4.2; 2021: 4.2; 2022: 4.2; 2023: 4.1; 2024: 4.1.
  - Contribution from real GDP growth: 2014: -1.1; 2015: -1.5; 2016: -1.6; 2017: -1.5; 2018: -1.6; 2019: -1.5; 2020: -1.4; 2021: -1.4; 2022: -1.3; 2023: -1.3; 2024: -1.3.
  - Residual, incl. change in gross foreign assets (2-3): 2014: -1.2; 2015: -0.5; 2016: 3.7; 2017: 3.5; 2018: -1.9; 2019: -0.7; 2020: -1.5; 2021: -1.7; 2022: -1.8; 2023: -1.8; 2024: -2.1.
  - External debt-to-exports ratio (percent): 2014: 223.6; 2015: 220.1; 2016: 238.3; 2017: 228.0; 2018: 221.2; 2019: 225.2; 2020: 225.4; 2021: 225.0; 2022: 224.9; 2023: 224.3; 2024: 224.1.
  - Gross external financing need (in billions of U.S. dollars): 2014: 3.9; 2015: 3.4; 2016: 3.2; 2017: 3.4; 2018: 4.0; 2019: 4.9; 2020: 4.3; 2021: 4.4; 2022: 4.8; 2023: 5.8; 2024: 5.4.
  - Gross external financing need (in percent of GDP): 2014: 17.2; 2015: 14.5; 2016: 13.3; 2017: 13.6; 2018: 15.3; (additional entries truncated in source).
- Sensitivity analysis findings:
  - External debt path shows limited sensitivity to interest rate and growth shocks.
  - Non-interest current account shock and combined shocks (interest rate + growth + current account) have larger effects.
  - Largest negative effect occurs under a real exchange rate depreciation shock; for El Salvador this scenario assumes a one period shock to the nominal 1-1 peg given dollarization (the combined “real depreciation shock” scenario applies a one-time real depreciation of 30 percent in 2019).

### External sector assessment and REER
- 2018 assessment:
  - Current account (CA) deficit widened to 4.8 percent of GDP in 2018 from 1.9 percent in 2017.
  - REER appreciated by 3 percent during 2018 due to strengthening of the U.S. dollar against currencies of main trading partners; about half of the 2016-17 REER correction was erased.
- External balance assessment (multiple approaches):
  - EBA-lite CA methodology:
    - CA norm: -5.0 percent of GDP.
    - CA actual: -4.8 percent of GDP.
    - CA Gap (cyclically and multilateral adjusted): -0.3 percent.
    - Policy gap: -1.7 percent (largely due to changes in reserves and public health expenditure).
    - Implied REER gap: 1.1 percent; EBA-lite signals an overvaluation of 1 percent.
  - REER approach: overvaluation of 5.8 percent.
  - External Sustainability (ES) approach: CA gap estimated at -1 percent and implies an overvaluation of 4.3 percent.
  - Overall staff assessment: external balance for 2018 is moderately weaker than implied by fundamentals and desirable policies, with a REER overvaluation in the range of 4 to 6 percent.
- Net foreign asset (NFA) position: sizeable negative NFA of 62.3 percent of GDP for 2018 (data note: this estimate relies on data up to 2016 based on old GDP series; after 2018 data revision the 2016 NFA rose to 66 percent of GDP from pre-revision 60 percent).

### Reserve adequacy
- Reserves remain below the ARA benchmark at 62 percent of the level deemed adequate (2018).
- Traditional metrics:
  - Under 3 months of import coverage and 100 percent of short-term debt coverage, 2018 reserve level appears adequate.
- Adjusted ARA metric for a dollarized economy:
  - Reserves need to be at 18.3 percent of GDP (this level lies between the standard Fund’s ARA level for fixed exchange rate regimes and the authorities’ metric).

### Policy recommendations and areas for structural reform
- Improving export competitiveness requires a multi-pronged approach, including:
  - Invest in education and training (exports tend to be of higher quality).
  - Increase access to finance (exporting involves high fixed/sunk costs).
  - Support investment in research, technology, and innovation (to move up the product quality ladder).
  - Provision of reliable infrastructure and an entrepreneur-enabling regulatory environment.
- Structural weaknesses and constraints highlighted by external indicators:
  - Global competitiveness rankings (2017-18) show El Salvador lags peers in business dynamism, innovation capability, institutions, skills and labor markets.
  - Doing Business (2019) indicates significant gaps in costs of starting a business and dealing with construction permits; notable reduction in time and cost of trading across borders.
  - World Bank enterprise surveys (2016) top firm constraints:
    - Crime, theft and disorder rated 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.
    - Cumbersome licensing and permits procedures ranked third for the largest firms.
  - Lack of political stability was among the top 3 constraints for firms of all sizes.

### Liquidity management and Emergency Liquidity Assistance (ELA)
- Statutory requirements:
  - Reserves: 21.6 percent of deposits (currently).
  - Liquidity: 3 percent of liabilities should be held in foreign liquid assets or El Salvador government securities (high-grade and easily tradable).
- Bank liquidity framework:
  - Banks may borrow in the interbank market or access required reserves deposited at the BCR.
  - Central bank tranches for accessing reserves (sequential, tighter terms):
    - First tranche: 25 percent of total banks reserves at no cost.
    - Second tranche: 25 percent at LIBOR plus a penalty.
    - Third tranche: 50 percent at no cost but subject to SSF approval with a regularization plan.
  - After accessing tranches I and II, banks can also access required liquid assets.
- Central Bank ELA provisions:
  - Bilateral ELA can be provided to a solvent bank that has exhausted traditional facilities.
  - When normal market functioning is disrupted and a 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.
  - Authorized ELA tools: (i) repurchase agreements using appropriate capital, (ii) temporal acquisition of banks’ investments portfolio, and (ii) liquidity credits to banks.

*Source: IMF staff estimates and projections as presented in the provided chapter.*

### 4.      Central bank is working to bolster the funds it could use in the case of a systemic

### 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).

### Central bank liquidity and liquid assets
- Charted indicators (12-month average, Percent of Deposits) show historical series points at Jan-04, Jan-07, Jan-10, Jan-13, Jan-16, Jan-19 for:
  - Excess Reserves
  - Reserve Requirements
  - Banks' Reserves
- Ratio of Liquid Assets to Total Deposits, Percent (December 2018) reported across El Salvador, Panamá, Ecuador with components:
  - Cash
  - Domestic securities 1/ (Holdings of central bank and central government securities.)
  - Deposits 2/ (Deposits at the central bank and abroad (incl. securities))

### Financial stability and sector resilience
- Banking sector performance (Q1 2019 and recent):
  - Credit to the private sector increased 6.4 percent (year-to-year) in the first quarter of 2019.
  - Credit to enterprises grew 10.3 percent (year-to-year) in the first quarter of 2019.
  - Deposit-to-loan coverage remained stable at 95 percent.
  - Non-performing loans declined below 2 percent.
  - Profitability reached a three-year high.
  - Total liquidity of the economy grew 4.9 percent.
  - Remittances increased 5.9 percent (first quarter 2019), higher than 5.3 percent observed over the same period in 2018.
- Authorities’ actions and commitments:
  - Agreed with staff recommendations to enhance financial sector stability.
  - Need to accelerate approval of the bank resolution law.
  - Committed to further strengthening cross-border cooperation.
  - Committed to appropriately fund the emergency lending assistance framework, which includes creation of a liquidity fund facility in line with prior Fund recommendations.
  - Banks reduced their external liabilities as global financial conditions tightened and used remittance-fueled surge in deposits to expand credit.
  - Superintendence enhanced supervision and monitoring of financial flows; preparations underway to rejoin the Egmont Group.

### Fiscal and macroeconomic context relevant to systemic shock preparedness
- Macroeconomic performance and outlook:
  - Economy’s performance in 2018: growth above potential at 2.5 percent.
  - Economy is expected to grow at 2.4 percent in 2019.
  - Inflation remained low and stable; inflation was 0.7 percent (first quarter 2019).
  - Primary fiscal surplus was 0.4 percent (first quarter 2019) compared to 0.3 percent (first quarter 2018).
  - Fiscal discipline: primary fiscal balance improved 1.1 percent of GDP between 2017 and 2018.
- Fiscal policy and debt anchors:
  - Fiscal Responsibility Law (FRL) strengthened, introducing an anchor for public debt of 60 percent of GDP by 2030.
  - Authorities aware that a further fiscal adjustment of about 1.9 percent of GDP by 2021 is needed to comply with the FRL.
  - Legislative approvals in December 2018 included authorization of external financing for US$1.3 billion, including to cover the US$800 million Eurobond payment due in December and an IADB loan to finance tax administration strengthening (includes electronic invoicing).
  - Standard & Poor’s upgraded El Salvador’s sovereign debt rating to B in December 2018; EMBI Global spread declined and is in line with regional peers.

### Policies and reforms to reduce vulnerabilities and bolster shock absorption
- Planned and ongoing measures:
  - Preparing revenue and expenditure measures to achieve the needed fiscal adjustment of about 1.9 percent of GDP by 2021.
  - Progressing in technical preparation of tax administration reforms, including:
    - Electronic invoicing
    - “Monotributo”
    - Initiative to combat base erosion and profit shifting (“precios de transferencia”)
  - Authorities agreed on need to adopt additional structural revenue measures, such as excise taxes on luxury goods.
  - Authorities do not see plausible an increase in the VAT in the short term.
  - Plans to improve public expenditure efficiency by centralizing the procurement system and extending competitive bidding processes such as reverse auction mechanism; reform to the procurement law in process.
  - Working on strengthening public debt management and have requested Fund technical assistance.
  - Enhancing financial inclusion: bank account ownership rose from 14 percent in 2011 to 30 percent in 2017; simplified bank accounts introduced in 2015 with 400 opened since end-2018; MOMO-Mobile Money in process to join mobile money market.
- Governance and anti-corruption measures strengthening systemic resilience:
  - Attorney General strengthened investigation and prosecution to curb illicit use of public funds.
  - Superintendency implemented high-frequency monitoring of financial flows.
  - Independence and autonomy of the Financial Investigation Unit legally ensured.
  - Plan implemented by the Presidency to increase citizen participation in public policy design, implementation, monitoring, and to receive direct corruption complaints.
  - Proposed further reforms to ensure comprehensive audit of public accounts, including:
    - Harmonizing the existing legal framework;
    - Strengthening the Audit Office by expanding its supervisory role to all public institutions;
    - Modernizing audit processes through extensive adoption of technology.

### Data, surveillance, and technical assistance relevant to liquidity planning
- Data adequacy and reporting:
  - Data provision is adequate for surveillance.
  - Central Reserve Bank of El Salvador (CRBS) disseminates annual and quarterly national accounts for 2005-18, benchmark year 2005; rebased national accounts and monthly index published on March 23, 2018.
  - Price statistics disseminated monthly; CPI weights based on the 2005-06 Household Income and Expenditure Survey.
  - CRBS compiles and disseminates monetary and financial statistics broadly in line with the Monetary and Financial Statistics Manual (MFSM) 2000; reports monthly financial soundness indicators (FSIs) to the IMF, currently reports all core and 5 encouraged FSIs with plans to compile the rest of the encouraged FSIs.
  - External sector statistics: all key ESS datasets compiled and reported except CPIS; authorities expressed interest in disseminating CPIS in 2019; CDIS is incomplete (inward direct investment reported, limited coverage for outward direct investment).
- Technical assistance and cooperation:
  - Central Bank capacity building: CAPTAC-DR regional program participation for harmonization of GFS; prior technical assistance referenced from CAPTAC-DR; next TA mission under program scheduled for August 2018.
  - The central banking department received MCM technical assistance to strengthen projection and overall analysis and to strengthen capacities for producing and evaluating systemic risk indicators (missions dated 7/18/2016; 3/12/2018; 3/26/2018; 10/16/2017; 10/25/2017).
  - Financial supervision and regulation received multiple MCM TA deliveries focused on liquidity risk supervision, credit risk supervision, insurance supervision, IT risk supervision, and market risk supervision (missions listed across 2016–2019).

*Prepared by: The Western Hemisphere Department; May 7, 2019.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2019/1slvea2019001.pdf_