## 1. Implementation of Fund Policy Advice ## Source details **Canonical URL:** [1. Implementation of Fund Policy Advice](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2013/_cr13132.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2013/_cr13132.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2013/_cr13132.pdf.json) --- ### Overview - El Salvador’s economy recovered slowly from the global financial crisis of 2008-09; output growth was sluggish in 2010-11 due to low domestic investment, low competitiveness, and a weather related-shock. - The large fiscal stimulus in 2009-10 elevated the fiscal deficit and public debt. - Under the fully-dollarized regime, inflation remained low. ### Performance under the Stand-By Arrangement (SBA) - The 3-year precautionary SBA preserved financial stability and prompted successive tax reforms. - Fiscal consolidation stalled in late 2011; the third review of the SBA was completed in September 2011 and the SBA expired in March 2013. ### Recent Economic Developments - Real GDP grew by 1½ percent in 2012 and continued at that pace in early 2013. - Potential growth estimated at about 1½ percent recently (Annex I). - Headline inflation was less than 1 percent (y/y) by end-2012 and remained low through March 2013. - External current account deficit widened to 5¼ percent of GDP in 2012. - Gross international reserves at end-2012 were US$3.2 billion, about three-fourths of the level that may be considered “adequate” (Annex II). - Overall fiscal deficit stayed at about 4 percent of GDP for the third year in a row. - Government financing requirements in 2012: $1.9 billion (7.9 percent of GDP). - In November 2012 the government issued a 12-year Eurobond for US$800 million (3¼ percent of GDP); resources used to prepay short-term debt. - Excluding the Eurobond operation, public debt rose to 54¼ percent of GDP at end-2012, from 52¼ percent a year earlier. - Bank indicators: exposure of the banking system to public debt was 45 percent of capital at end-2012 (declined by more than one-half after debt pre-payment); banks appear well capitalized and liquid with low overdue loans and adequate provisioning. ### Macroeconomic Outlook and Risks - Staff baseline scenario assumptions: - Continuation of current policies. - Real GDP growth of 1½ percent in 2013-14 and 2 percent over the medium term. - Domestic investment remains subdued. - Inflation projected to hover around the level of key trading partners. - External current account deficit projected at about 4½ percent of GDP per year. - Identified vulnerabilities: - Fiscal deficit stabilizing at about 4 percent of GDP under current policies would make public debt dynamics unsustainable over the long term. - Reliance on short-term financing increases borrowing costs and rollover risks (Annex IV). - External competitiveness remains low; planned minimum wage increase of 10 percent could intensify competitiveness pressures. - Risks to the baseline (tilted to the downside): - External conditions: weaker-than-expected U.S. growth, higher world oil prices, or increased investor risk aversion could widen the current account and fiscal deficits and raise borrowing costs. - Policy implementation: election-period spending pressures may increase the fiscal deficit above 4 percent of GDP in 2013-14, accelerating debt deterioration. - Confidence shocks: electoral uncertainty and fiscal solvency concerns may trigger deposit outflows; absence of a lender-of-last-resort could necessitate a strong front-loaded fiscal adjustment. ### Illustrative Macroeconomic Scenario — Selected Projections and Indicators - Staff projections and estimates (selected): - Real GDP growth (percent): 2.0 1.6 1.6 1.6 1.7 1.8 2.0 2.0 - Inflation (percent, end of period): 5.1 0.8 2.3 2.6 2.6 2.6 2.6 2.6 - Nonfinancial public sector balance: -3.9 -3.9 -3.9 -3.8 -3.8 -3.8 -3.8 -3.8 - Primary balance: -1.7 -1.6 -1.4 -1.3 -1.3 -1.2 -1.1 -1.1 - Public sector gross debt: 52.3 54.3 56.4 58.0 59.5 60.8 62.0 63.1 - External current account balance: -4.6 -5.3 -5.0 -4.8 -4.6 -4.5 -4.4 -4.4 - Gross domestic investment: 14.4 14.6 14.6 14.6 14.6 14.7 14.7 14.7 - National savings: 9.8 9.3 9.5 9.8 10.1 10.2 10.3 10.3 - Eurobond yields and comparisons: - The November 2012 Eurobond carries a yield of 5⅞ percent, some 400 basis points above comparable U.S. Treasury bills. - Previous Eurobond placements in 2009 and 2011 had maturities of 10 and 30 years and carried average yields of 7⅜ and 7⅝ percent, respectively. ### Policy Discussions — Near-term Priorities - Near-term shared priorities: reduce vulnerabilities during the electoral period and transition by strengthening the fiscal position and increasing banks’ liquidity buffers. - Authorities’ stated fiscal aim: - Lower fiscal deficit to 3.3 percent of GDP in 2013 and 3 percent in 2014. - Authorities estimated these actions would yield fiscal savings of about 1 percent of GDP on an annual basis. - Staff recommendation: more ambitious fiscal targets to stabilize the debt ratio: - Fiscal deficit target of 3 percent of GDP in 2013 and 2 percent in 2014. - Staff acknowledged possible adverse effects on activity but argued costs are smaller than those of delayed adjustment. - Staff proposed measures to attain the reduction in the deficit: - Revenue-side (in line with FAD TA recommendations): - Removal of income tax exemptions (including on high-income pensioners). - Broadening the scope of the new property tax. - Consider a financial activity tax instead of a financial transaction tax. - Expenditure-side: - Keep the nominal wage bill at the 2012 level. - Exercise firm control over expenditures on goods and services. - Reduce subsidies that do not benefit low-income families. - Financing-side: - Amortize short-term debt to reduce costs and rollover risks. - Secure long-term financing early to cover projected deficits for 2013-14. - Additional Fiscal Measures Proposed by Staff (Cumulative; percent of GDP, as presented) - Overall balance (passive policies): -3.9 (2013), -3.8 (2014) - Measures: 1.0 (2013), 1.8 (2014) - Removal of tax exemptions: 0.3 (2013), 0.4 (2014) - Adoption of property tax: 0.1 (2013), 0.2 (2014) - Freezing of wage bill: 0.3 (2013), 0.6 (2014) - Saving on goods and services: 0.1 (2013), 0.2 (2014) - Targeting of subsidies: 0.2 (2013), 0.4 (2014) - Overall balance (after measures): -3.0 (2013), -2.0 (2014) - Authorities’ response: - Broad agreement with staff recommendations but stressed feasibility depends on consensus with other political parties. - If consensus is elusive, priority would be to secure new external financing at reasonable terms. - Financial stability measures: - Agreement that banks should maintain relatively large liquidity buffers during the electoral period. - Banks could accommodate moderate deposit losses (of up to 10 percent of total deposits), but higher buffers desirable given large share of short-term deposits. - Resource constraints hinder activation of newly-created lender-of-last-resort facility; authorities considering a transitory increase in liquidity requirements. ### Medium-term Challenges and Policy Guidance - Need for a broad-based consensus on a medium-term growth strategy to raise potential growth. - Closing the investment gap (of up to 10 percent of GDP) with the region or with Chile, Mexico, and Peru could raise potential growth to 4-4½ percent per year (Annex I). - Staff-supported government initiatives to promote investment, with caveats: - Avoid dependence on costly tax exemptions or new fiscal contingencies. - Continue reducing crime and perceived corruption by mobilizing the anti-money laundering (AML) framework; include enhanced CDD measures for politically exposed persons in accordance with FATF standards. - Authorities’ investment and business-climate initiatives: - Private sector participation in infrastructure: port management, airport expansion, electricity generation, public transportation, coastal development, support to low-income farmers, and PPP framework. - Staff advice: strengthen capacity to manage PPPs; establish a sound legal framework including value for money, transparency, and inclusion of contingent liabilities in the budget and fiscal sustainability analysis. Authorities expect congressional approval of the PPP framework by year-end. - Business climate steps: reduce red tape; clarify investment rules (contract enforcement, dispute/resolution, electronic signature, insolvency); strengthen AML framework; efforts to continue lowering crime; upgrade key business indicators with World Bank assistance. ### Staff recommended framing the national dialogue on fiscal policy in terms of Medium-term public debt targets and fiscal consolidation - Current level of debt described as "high and a major source of risks." - Authorities and staff jointly assessed alternative debt targets and sustainability gaps and "concluded that a return to the public debt ratio attained in 2008 (42 percent of GDP) by the year 2020 would allow to gradually rebuild fiscal buffers, and keep financing requirements manageable without unduly stifling growth." - It was recognized that "a sustained increase in the primary balance (by 5 percentage point of GDP relative to 2012 levels) would be necessary to attain those targets in the seven-year horizon." - Staff recommends framing the national dialogue in terms of medium-term targets for the public debt-to-GDP ratio and "aiming at reducing the public debt ratio to about 40 percent of GDP by 2020." - Staff projections and recommendations: - Under current policies the fiscal deficit would "stabilize at about 4 percent of GDP during 2013-14"; this would keep the public debt ratio on an upward path. - Staff urges the authorities to lower their fiscal deficit targets for 2013-14. - A transitory increase in liquidity requirements to strengthen banking-system buffers during the electoral period is advisable. ### Revenue measures and tax administration - Recent improvements welcomed: creation of a special unit to monitor large taxpayers; improved coordination between tax and customs agencies; further strengthening tax auditing capacity. - Agreement on necessity to increase tax revenue intake given relatively low tax effort. - Staff suggestions on revenue-side measures: - Draw lessons from the government's initial strategy to raise tax revenues in the context of a "fiscal pact." - Consider focusing on specific areas such as reducing tax expenditure and raising the rate of the value-added tax (VAT) rate closer to levels prevailing in peer countries. - Broaden the scope of revenue measures currently contemplated to attain fiscal targets and reduce risks. ### Expenditure-side measures and public financial management - Recent and planned improvements welcomed: plans to adopt a treasury single account by mid-2014; shift to a programmatic coverage of the budget to facilitate adoption of a medium-term expenditure framework by 2015. - Staff encouraged developing a plan to gradually unify the budgets of various government entities. - Expenditure policy guidance: - Staff argued current primary spending should be lowered gradually to levels prevailing prior to the 2009 crisis. - Authorities highlighted difficulties compressing expenditure because of demand for security, education, health, and social infrastructure. - Agreed focus areas: improving targeting of subsidies; reforming the civil service; reducing the earmarking of revenue; increasing the effectiveness of social spending. ### Subsidies and savings potential - Subsidies on electricity, liquid propane gas (LPG), and public transportation averaged "1½ percent of GDP yearly during 2008-12." - Distributional findings: - Low-income households received only one-third of the amount spent on subsidies. - Over 80 percent of households receive a subsidy on electricity and LPG, both granted to those consuming up to 200 kWh of electricity. - Subsidies represent "up to 70-75 percent of recovery cost." - Fiscal impact: - Reducing eligibility of subsidies to low-income families and lowering their size could produce fiscal savings of "up to 1 percent of GDP per year." ### Pension system issues and reform priorities - Authorities’ preliminary assessment: unfunded fiscal liabilities of the pension system (public and private component) range from "65 to 75 percent of GDP." - Distributional concern: half of those liabilities represent benefits accruing to only "10 percent of affiliates." - Additional pension statistics: - Pension payments reached "almost 2 percent of GDP per year during the last five years." - Government debt held by private pension funds reached "10 percent of GDP at end-2012 (one-fifth of total public debt)." - Pension payments would "rise gradually to 2-3 percent of GDP yearly by the end of this decade" (authorities’ estimate). - Staff recommendations on pensions: - Urgent need for parametric changes to lower benefits, increase contributions, and extend retirement ages. - Staff advised against changes in the accounting treatment of pension liabilities (absorbing private defined-benefit accounts into government accounts), arguing this would not remedy underlying imbalances or enhance transparency. ### Financial stability and regulatory reform - Authorities intend to complete pending financial reforms; pace of adoption of 2010 FSAP Update recommendations has slowed. - Staff encouraged: - Continue progress toward risk-based supervision and improved cross-border consolidated supervision. - Secure resources to activate the new liquidity framework of the central bank, especially the lender-of-last-resort facility. - Strengthen the reserves of the deposit insurance fund and set up a liquidity fund in line with the central bank’s liquidity framework. - Move forward with frameworks to facilitate bank resolution and broaden the perimeter of supervision. - Basel III transition: - Staff advocated gradual adoption of Basel III standards. - Noted banks already maintain levels of capital and liquidity that comply with Basel III (Annex V). - Recommended adoption of stricter definitions of capital and new capital requirements, but advised against reducing liquidity requirements to Basel III standards until the lender-of-last-resort facility and the liquidity fund were activated. ### Staff appraisal and strategic recommendations - Economic context: - Since 2010 growth has been sluggish; recovery did not gain strength. Output growth has been the lowest in Central America, largely due to weak private investment and severe supply constraints. - Fiscal consolidation supported by a Fund arrangement stalled in late 2011; fiscal deficit has hovered around "4 percent of GDP since 2010" and public debt-to-GDP ratio has risen. - Policy guidance: - Initiate a national dialogue on short- and medium-term priorities aiming at improving growth prospects, restoring fiscal sustainability, and enhancing resilience of the dollarized economy. - Promote a national dialogue to develop a medium-term growth agenda, leverage initiatives for PPPs and private participation in infrastructure, and reduce red tape while avoiding new tax exemptions or fiscal contingencies. - Fiscal consolidation strategy should combine revenue and expenditure measures: improve targeting of subsidies; lower earmarking of revenue; further reduce tax expenditure and evasion; raise the VAT rate to levels observed in other Latin America countries; and include comprehensive pension reform to strengthen finances and reduce inequalities. - Staff recommends the next Article IV Consultation on the standard 12-month cycle. ### Risk Assessment Matrix — selected downside scenarios and policy responses - A fiscal policy shock in the United States leading to lower U.S. growth. - Impact: M - Policy response: Given limited fiscal space, move forward investment reforms, including on business climate and competitiveness, and strengthen tax policy to offset revenue losses. - Emerging markets capital flow reversal (lower access to external financing). - Impact: M - Policy response: Move forward the proposed fiscal effort to reduce external financing needs. Lower liquidity mismatches in the banking system. - Global oil shock (driving oil prices to US$140 per barrel). - Impact: L / H - Policy response: Allow full pass-through, maintain strict wage policy, and strengthen the social safety net aided by tax policy. - Weakened fiscal policy stance (driven by electoral pressures). - Impact: H / H - Policy response: Reach immediate consensus with stakeholders on a fiscal and growth agenda to protect stability. - Confidence shock to depositors (triggered by electoral uncertainty and large fiscal deficits). - Impact: M / L - Policy response: Use existing liquidity buffers. Strengthen the insurance deposit scheme and the supervision of small cooperatives, as advised by the FSAP. - Natural disasters. - Impact: M / M - Policy response: Deepen use of official loans to accommodate fiscal costs from targeted assistance. ### Box 4. Main Recommendations from the 2010 FSAP Update (selected) - Financial Supervision Status: - Approve modifications to the law on financial system supervision and regulation to broaden the autonomy and remedial action powers of the supervisory authority, and strengthen legal protection for supervisors. — PI - Gradually shift to risk-based supervision by: (i) issuing and adopting norms for key risks and corporate governance; and (ii) bringing qualitative assessments in line with international best practices and appoint dedicated manager responsible for the overall supervision of each bank. — PI - Intensify supervision of credit concentration and debtor repayment capacity. — PI - Liquidity Management: - Amend the central bank law granting it powers of lender of last resort. — FI - Implement a comprehensive liquidity policy, which includes objectives, creation of a liquidity fund, and contingency plans. — PI - Bank Resolution: - Undertake a comprehensive bank resolution simulation exercise. — FI - Elaborate manuals to formalize procedures for banks resolution and crisis management. — PI - Update the legal framework for bank resolution by: (i) eliminating the 3-day notification period for resolution measures; (ii) requiring removal of a bank’s board at judicial intervention; (iii) ensuring least-cost solution; and (iv) increasing the funding of the deposit insurance scheme. — PL - Update the legal framework for the cooperative banks and their resolution process. — PL - Capital Markets: - Approve an investment funds law to potentially broaden the investor base and develop domestic capital markets. — PL - Approve an overhaul of the regulatory framework of the securities market. — NI - Amend the pension funds law to broaden investment opportunities for private pension funds. — NI - FI: fully implemented; PI: partially implemented; PL: pending legislation; NI: Not implemented. ### Annex I. El Salvador: Assessing Potential Output — key findings - Historical and structural context: - Real GDP growth decelerated from nearly 4 percent during 1993-2002 to under 2 percent during 2003-12. - Over two decades, the rate of domestic investment amounted to 16 percent of GDP in El Salvador compared to 23 percent in regional peers. - Education indicators (UNESCO, 2010): over 40 percent of population had either no schooling or incomplete primary education compared to 23 percent in Latin America. - Vulnerability to natural disasters: Direct and indirect costs estimated at 20 percent of GDP over 2000-12, compared to an average of only 1½ percent in other countries in the region. - Potential output estimates and trends: - Average potential output growth of El Salvador in 1998-2012: 2 percent, compared to 4½ percent in the region. - Potential output growth declined over time from about 2½ percent in 1998 to 1½ percent by 2012. - The negative output gap reached about 1½ percent during the 2008-09 global crisis and narrowed to ¾ percent in 2012. - Growth accounting and scenario projections (contributions in percentage points): - 1998-2012: Real GDP 2.0; Capital 1.1; Labor 0.6; Productivity 0.3. - 2010-2012: Real GDP 1.7; Capital 0.9; Labor 0.9; Productivity -0.1. - 2019-2023 (pessimistic): Real GDP 1.2; Capital 0.4; Labor 0.6; Productivity 0.2. - 2019-2023 (baseline): Real GDP 2.0; Capital 0.9; Labor 0.6; Productivity 0.5. - 2019-2023 (optimistic): Real GDP 4.0; Capital 2.2; Labor 0.6; Productivity 1.2. - Policy implication: - Bringing domestic investment to 25 percent of GDP and extending average education by two years could boost potential growth to about 4-4½ percent (GMM evidence). ### Annex III. El Salvador: Assessing Spillovers — key linkages and shocks - Trade: - Trade flows are over 60 percent of GDP. - Main trading partners: United States about 40 percent; CAPDR countries 25 percent; other Latin American countries 15 percent. - China accounted for 7 percent of total imports. - Remittances: - In 2012 remittances were close to 17 percent of GDP. - Nearly 90 percent of total remittances originated in the United States. - Financial and investment links: - Stock of foreign direct investment amounted to 35 percent of GDP at end-2011. - International banks' claims on Salvadorian borrowers reached 30 percent of GDP as of 2012. - Foreign banks operating in El Salvador account for 95 percent of the banking system’s total assets. - Shock scenarios (VAR results): - United States shock: Growth in El Salvador would decline by 0.2 percentage points in 2013 and 1 percentage point in 2014. - CAPDR shock: Growth in El Salvador would decline by 0.2 percentage points in 2013 and 0.9 percentage points in 2014. - China shock: Similar intensity to CAPDR shock. - Europe shock: Negligible effect. - Banking and sovereign stress spillovers: - Combined losses in U.S. and Canadian assets: nearly 5 percent of GDP impact; implied reduction in credit to El Salvador about 8 percent. - Default shock in European assets: 3½ percent of GDP impact; implied reduction in credit to El Salvador about 6 percent. - Caveats: exposures of resident banks not reporting to BIS and indirect effects are not captured. ### Annex IV. El Salvador: Public Debt Sustainability Analysis — highlights - Recent debt developments: - Public debt-to-GDP ratio rose from about 42½ percent at end-2008 to 54¼ percent at end-2012. - Drivers (change in public debt, percent of GDP): 2003-08 = 3.1; 2009-12 = 11.9. - Implicit nominal interest rate: 2003-08 = 6.0; 2009-12 = 4.9. - Baseline projections: - Public debt ratio projected to rise to 63 percent by 2018 and to 66 percent by 2020. - Projection driven by a primary deficit remaining at over 1 percent of GDP in the medium and long terms. - Stochastic simulations show the median public debt forecast would exceed 80 percent of GDP by 2018. - Financing needs and debt structure: - Projected gross financing needs are 7-9 percent of GDP per year under assumption stock of short-term public debt remains at 2 percent of GDP and financing gaps covered with long-term loans. - Gross financing needs would reach 11 percent of GDP by 2018 if one-half of projected financing gaps were covered with short-term debt financing. - Average maturity of public debt: 8 years. - Only 15 percent of the stock maturing over the next 5 years (average amortization 1½ percent per year). - 70 percent of debt subject to fixed interest rates. - Stable investor base: domestic private pension funds and official creditors hold 70 percent of public debt. - Spreads averaged 450 basis points in 2012. - Restoring debt sustainability — targets and required adjustments: - Debt stability (maintain public debt ratio at 55 percent from 2013 onward) requires a sustained fiscal effort of 2 percent of GDP (primary surplus of 0.2 percent of GDP). - Pre-crisis debt level (reduce public debt ratio to 42 percent of GDP by 2020) implies a sustainability gap of 5 percent of GDP relative to 2012 levels and would raise the primary surplus to 3¼ percent of GDP. - Debt level to improve risk perceptions (reduce public debt ratio to 35 percent of GDP by 2020) would require a sustained effort of 7 percent of GDP. - If fiscal consolidation also strengthens foreign reserves to adequacy level, the gradual adjustment would need an additional 0.8 percent of GDP per year. - Illustrative consolidation path (pre-crisis scenario): - Discretionary fiscal adjustment by year: 2013 = 1.3; 2014 = 0.9; 2015 = 0.7; 2016 = 0.7; 2017 = 0.7; 2018 = 0.7; 2019 = 0.0; 2020 = 0.0; 2021 = 0.0; 2022 = 0.0. - Fiscal sustainability gap by year: 2013 = 3.4; 2014 = 2.6; 2015 = 1.9; 2016 = 1.3; 2017 = 0.6; 2018 = 0.0; 2019 = 0.0; 2020 = 0.0; 2021 = 0.0; 2022 = 0.0. - Output gap (percent of potential GDP) by year: 2013 = -0.6; 2014 = -0.5; 2015 = -0.4; 2016 = -0.4; 2017 = -0.4; 2018 = -0.4; 2019 = -0.2; 2020 = -0.1; 2021 = 0.0; 2022 = 0.0. - Consolidation sequencing: - Moderate up-front fiscal effort (about 2 percent of GDP in 2013-14) and smaller additional adjustments over the following 4 years would keep output gaps small. ### Annex V. El Salvador: Implementing Basel III Standards — key points - Capital and liquidity positions (end-2012): - Banks had capital adequacy ratios of 17 percent. - Required levels: 8 percent under Basel I standards and 12 percent under Salvadorian rules. - Basel III adjustments: - Risk-weighted assets (RWA) would increase by some 20 percent. - Common equity would decline by only 1½ percent. - Application of a recommended countercyclical buffer of 2½ percent of RWA would result in a capital gap of 1½ percent of RWA. - Liquidity under Basel III methodologies: - Banking system’s liquidity would be more than three times the minimum implied by the 30-day liquidity requirement. - Liquidity would be some 30 percent above the level suggested by the one-year funding requirement. - Macroeconomic impact: - Raising the capital adequacy ratio by one percentage point would lower economic activity in El Salvador by 0.05 percent; the effect would dissipate in two years. - Aligning to stricter rules should have no transitory impact on credit nor economic activity, unless a countercyclical capital buffer is introduced. - Sequencing and priorities: - Short-term: upgrade capital definitions and introduce new capital requirements; do not reduce required liquidity levels until central bank liquidity facilities are activated. - Medium-term: strengthen supervisory processes (Pillar II) and market discipline (Pillar III). - Long-term: introduce macroprudential instruments; consider capital charges for systemically important financial institutions. ### Data, reporting metadata, and selected indicators - Public Information Notice (PIN) No. 13/59 — FOR IMMEDIATE RELEASE — May 22, 2013. - Table of Common Indicators Required for Surveillance (As of April 30, 2013) — examples: - International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Date of latest observation Mar-2013; Date received Mar-2013; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M. - Reserve/Base Money: Date of latest observation Feb-2013; Date received Apr-2013; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M. - Consumer Price Index: Date of latest observation Mar-2013; Date received Mar-2013; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M. - External Current Account Balance: Date of latest observation Dec-2012; Date received Mar-2013; Frequency of Data Q; Frequency of Reporting Q; Frequency of Publication Q. - GDP/GNP: Date of latest observation Dec-2012; Date received Mar-2013; Frequency of Data Q; Frequency of Reporting Q; Frequency of Publication Q. - Selected economic indicators (selected rows preserved exactly): - Real GDP (annual percent change): 2008: 1.3; 2009: -3.1; 2010: 1.4; 2011: 2.0; 2012: 1.6; 2013: 1.6 (projection); 2014: 1.6 (projection). - Consumer prices (end of period): 2008: 5.5; 2009: 0.1; 2010: 2.1; 2011: 5.1; 2012: 0.8; 2013: 2.3 (projection); 2014: 2.6 (projection). - Current account balance (percent of GDP): 2008: -7.1; 2009: -1.5; 2010: -2.7; 2011: -4.6; 2012: -5.3; 2013: -5.0 (projection); 2014: -4.8 (projection). - Public sector debt (percent of GDP): 2008: 42.4; 2009: 51.0; 2010: 52.2; 2011: 52.3; 2012: 54.3; 2013: 56.4 (projection); 2014: 58.0 (projection). - Credit to the private sector (percent of GDP): 2008: 43.0; 2009: 42.4; 2010: 40.9; 2011: 39.8; 2012: 40.1; 2013: 39.6 (projection); 2014: 38.9 (projection). - Net Foreign Assets of the Financial System (Millions of U.S. dollars): 2008: 2,208; 2009: 3,028; 2010: 3,378; 2011: 2,811; 2012: 3,370; 2013: 2,708 (projection); 2014: 2,797 (projection). ### Executive Board assessment and recommended priorities (selected) - Short-term priorities: - Maintain macroeconomic stability and investor confidence during the electoral period (presidential elections early 2014; congressional elections one year later). - Exercise restraint on public sector wages and poorly-targeted subsidies. - Broaden the scope of envisaged revenue measures. - Temporary increase in banks’ liquidity buffers to safeguard financial stability during the election cycle. - Medium-term priorities: - Build a broad consensus on a short- and medium-term strategy to ensure fiscal and debt sustainability and bolster growth potential. - Gradual reduction in the public debt ratio to pre-2009 levels by the end of the decade. - Fiscal consolidation should encompass revenue and expenditure measures: improve targeting of subsidies; lower the earmarking of revenues; reduce tax expenditure and evasion; increase the rate of the value-added tax. - Pension reforms to ensure sustainability and reduce inequalities. - Implement outstanding recommendations of the 2010 FSAP Update, including: activate the newly-created lender-of-last-resort facility; facilitate bank resolution; raise the reserves of the deposit insurance fund; gradual implementation of key Basel III standards. - Growth and competitiveness: - A sustained increase in investment is necessary to raise potential growth. - Support initiatives to promote private investment in key infrastructure, set up an effective framework for public-private partnerships, and reduce red tape. *Source: _cr13132 - 1. Implementation of Fund Policy Advice (IMF staff report content provided in the prompt).* ### 1. Implementation of Fund Policy Advice _______________________________________________________ 14 ### 1. Implementation of Fund Policy Advice ### Overview - El Salvador’s economy recovered slowly from the global financial crisis of 2008-09; output growth was sluggish in 2010-11 due to low domestic investment, low competitiveness, and a weather related-shock. - The large fiscal stimulus in 2009-10 elevated the fiscal deficit and public debt. - Under the fully-dollarized regime, inflation remained low. ### Performance under the Stand-By Arrangement (SBA) - The 3-year precautionary SBA preserved financial stability and prompted successive tax reforms. - Fiscal consolidation stalled in late 2011; the third review of the SBA was completed in September 2011 and the SBA expired in March 2013. ### Recent Economic Developments - Real GDP grew by 1½ percent in 2012 and continued at that pace in early 2013. - Potential growth estimated at about 1½ percent recently (Annex I). - Headline inflation was less than 1 percent (y/y) by end-2012 and remained low through March 2013. - External current account deficit widened to 5¼ percent of GDP in 2012. - Gross international reserves at end-2012 were US$3.2 billion, about three-fourths of the level that may be considered “adequate” (Annex II). - Overall fiscal deficit stayed at about 4 percent of GDP for the third year in a row. - Government financing requirements in 2012: $1.9 billion (7.9 percent of GDP). - In November 2012 the government issued a 12-year Eurobond for US$800 million (3¼ percent of GDP); resources used to prepay short-term debt. - Excluding the Eurobond operation, public debt rose to 54¼ percent of GDP at end-2012, from 52¼ percent a year earlier. - Bank indicators: exposure of the banking system to public debt was 45 percent of capital at end-2012 (declined by more than one-half after debt pre-payment); banks appear well capitalized and liquid with low overdue loans and adequate provisioning. ### Macroeconomic Outlook and Risks - Staff baseline scenario assumptions: - Continuation of current policies. - Real GDP growth of 1½ percent in 2013-14 and 2 percent over the medium term. - Domestic investment remains subdued. - Inflation projected to hover around the level of key trading partners. - External current account deficit projected at about 4½ percent of GDP per year. - Identified vulnerabilities: - Fiscal deficit stabilizing at about 4 percent of GDP under current policies would make public debt dynamics unsustainable over the long term. - Reliance on short-term financing increases borrowing costs and rollover risks (Annex IV). - External competitiveness remains low; planned minimum wage increase of 10 percent could intensify competitiveness pressures. - Risks to the baseline are tilted to the downside (Box 3): - External conditions: weaker-than-expected U.S. growth, higher world oil prices, or increased investor risk aversion could widen the current account and fiscal deficits and raise borrowing costs. - Policy implementation: election-period spending pressures may increase the fiscal deficit above 4 percent of GDP in 2013-14, accelerating debt deterioration. - Confidence shocks: electoral uncertainty and fiscal solvency concerns may trigger deposit outflows; absence of a lender-of-last-resort could necessitate a strong front-loaded fiscal adjustment. ### Illustrative Macroeconomic Scenario — Selected Projections and Indicators (as presented) - Staff projections and estimates (selected): - Real GDP growth (percent): 2.0 1.6 1.6 1.6 1.7 1.8 2.0 2.0 - Inflation (percent, end of period): 5.1 0.8 2.3 2.6 2.6 2.6 2.6 2.6 - Nonfinancial public sector balance: -3.9 -3.9 -3.9 -3.8 -3.8 -3.8 -3.8 -3.8 - Primary balance: -1.7 -1.6 -1.4 -1.3 -1.3 -1.2 -1.1 -1.1 - Public sector gross debt: 52.3 54.3 56.4 58.0 59.5 60.8 62.0 63.1 - External current account balance: -4.6 -5.3 -5.0 -4.8 -4.6 -4.5 -4.4 -4.4 - Gross domestic investment: 14.4 14.6 14.6 14.6 14.6 14.7 14.7 14.7 - National savings: 9.8 9.3 9.5 9.8 10.1 10.2 10.3 10.3 - Eurobond yields and comparisons: - The November 2012 Eurobond carries a yield of 5⅞ percent, some 400 basis points above comparable U.S. Treasury bills. - Previous Eurobond placements in 2009 and 2011 had maturities of 10 and 30 years and carried average yields of 7⅜ and 7⅝ percent, respectively. ### Policy Discussions — Near-term Priorities - Near-term shared priorities: reduce vulnerabilities during the electoral period and transition by strengthening the fiscal position and increasing banks’ liquidity buffers. - Authorities’ stated fiscal aim: - Lower fiscal deficit to 3.3 percent of GDP in 2013 and 3 percent in 2014. - Authorities estimated these actions would yield fiscal savings of about 1 percent of GDP on an annual basis. - Staff recommendation: more ambitious fiscal targets to stabilize the debt ratio: - Fiscal deficit target of 3 percent of GDP in 2013 and 2 percent in 2014. - Staff acknowledged possible adverse effects on activity but argued costs are smaller than those of delayed adjustment. - Staff proposed measures to attain the reduction in the deficit: - Revenue-side (in line with FAD TA recommendations): - Removal of income tax exemptions (including on high-income pensioners). - Broadening the scope of the new property tax. - Consider a financial activity tax instead of a financial transaction tax. - Expenditure-side: - Keep the nominal wage bill at the 2012 level. - Exercise firm control over expenditures on goods and services. - Reduce subsidies that do not benefit low-income families. - Financing-side: - Amortize short-term debt to reduce costs and rollover risks. - Secure long-term financing early to cover projected deficits for 2013-14. - Additional Fiscal Measures Proposed by Staff (Cumulative; percent of GDP, as presented) - Overall balance (passive policies): -3.9 (2013), -3.8 (2014) - Measures: 1.0 (2013), 1.8 (2014) - Removal of tax exemptions: 0.3 (2013), 0.4 (2014) - Adoption of property tax: 0.1 (2013), 0.2 (2014) - Freezing of wage bill: 0.3 (2013), 0.6 (2014) - Saving on goods and services: 0.1 (2013), 0.2 (2014) - Targeting of subsidies: 0.2 (2013), 0.4 (2014) - Overall balance (after measures): -3.0 (2013), -2.0 (2014) - Authorities’ response: - Broad agreement with staff recommendations but stressed feasibility depends on consensus with other political parties. - If consensus is elusive, priority would be to secure new external financing at reasonable terms. - Financial stability measures: - Agreement that banks should maintain relatively large liquidity buffers during the electoral period. - Banks could accommodate moderate deposit losses (of up to 10 percent of total deposits), but higher buffers desirable given large share of short-term deposits. - Resource constraints hinder activation of newly-created lender-of-last-resort facility; authorities considering a transitory increase in liquidity requirements. ### Medium-term Challenges and Policy Guidance - Need for a broad-based consensus on a medium-term growth strategy to raise potential growth. - Closing the investment gap (of up to 10 percent of GDP) with the region or with Chile, Mexico, and Peru could raise potential growth to 4-4½ percent per year (Annex I). - Staff-supported government initiatives to promote investment, with caveats: - Avoid dependence on costly tax exemptions or new fiscal contingencies. - Continue reducing crime and perceived corruption by mobilizing the anti-money laundering (AML) framework; include enhanced CDD measures for politically exposed persons in accordance with FATF standards. - Authorities’ investment and business-climate initiatives: - Private sector participation in infrastructure: port management, airport expansion, electricity generation, public transportation, coastal development, support to low-income farmers, and PPP framework. - Staff advice: strengthen capacity to manage PPPs; establish a sound legal framework including value for money, transparency, and inclusion of contingent liabilities in the budget and fiscal sustainability analysis. Authorities expect congressional approval of the PPP framework by year-end. - Business climate steps: reduce red tape; clarify investment rules (contract enforcement, dispute/resolution, electronic signature, insolvency); strengthen AML framework; efforts to continue lowering crime; upgrade key business indicators with World Bank assistance. *Source: _cr13132 - 1. Implementation of Fund Policy Advice (IMF staff report content provided in the prompt).* ### 20. Staff recommended framing the national dialogue on fiscal policy in terms of ### 20. Staff recommended framing the national dialogue on fiscal policy in terms of ### Medium-term public debt targets and fiscal consolidation - Current level of debt described as "high and a major source of risks." - Authorities and staff jointly assessed alternative debt targets and sustainability gaps and "concluded that a return to the public debt ratio attained in 2008 (42 percent of GDP) by the year 2020 would allow to gradually rebuild fiscal buffers, and keep financing requirements manageable without unduly stifling growth." - It was recognized that "a sustained increase in the primary balance (by 5 percentage point of GDP relative to 2012 levels) would be necessary to attain those targets in the seven-year horizon." - Staff recommends framing the national dialogue in terms of medium-term targets for the public debt-to-GDP ratio and "aiming at reducing the public debt ratio to about 40 percent of GDP by 2020." - Staff projections and recommendations: - Under current policies the fiscal deficit would "stabilize at about 4 percent of GDP during 2013-14"; this would keep the public debt ratio on an upward path. - Staff urges the authorities to lower their fiscal deficit targets for 2013-14. - A transitory increase in liquidity requirements to strengthen banking-system buffers during the electoral period is advisable. ### Revenue measures and tax administration - Recent improvements welcomed: creation of a special unit to monitor large taxpayers; improved coordination between tax and customs agencies; further strengthening tax auditing capacity. - Agreement on necessity to increase tax revenue intake given relatively low tax effort. - Staff suggestions on revenue-side measures: - Draw lessons from the government's initial strategy to raise tax revenues in the context of a "fiscal pact." - Consider focusing on specific areas such as reducing tax expenditure and raising the rate of the value-added tax (VAT) rate closer to levels prevailing in peer countries. - Broaden the scope of revenue measures currently contemplated to attain fiscal targets and reduce risks. ### Expenditure-side measures and public financial management - Recent and planned improvements welcomed: plans to adopt a treasury single account by mid-2014; shift to a programmatic coverage of the budget to facilitate adoption of a medium-term expenditure framework by 2015. - Staff encouraged developing a plan to gradually unify the budgets of various government entities. - Expenditure policy guidance: - Staff argued current primary spending should be lowered gradually to levels prevailing prior to the 2009 crisis. - Authorities highlighted difficulties compressing expenditure because of demand for security, education, health, and social infrastructure. - Agreed focus areas: improving targeting of subsidies; reforming the civil service; reducing the earmarking of revenue; increasing the effectiveness of social spending. ### Subsidies and savings potential - Subsidies on electricity, liquid propane gas (LPG), and public transportation averaged "1½ percent of GDP yearly during 2008-12." - Distributional findings: - Low-income households received only one-third of the amount spent on subsidies. - Over 80 percent of households receive a subsidy on electricity and LPG, both granted to those consuming up to 200 kWh of electricity. - Subsidies represent "up to 70-75 percent of recovery cost." - Fiscal impact: - Reducing eligibility of subsidies to low-income families and lowering their size could produce fiscal savings of "up to 1 percent of GDP per year." ### Pension system issues and reform priorities - Authorities’ preliminary assessment: unfunded fiscal liabilities of the pension system (public and private component) range from "65 to 75 percent of GDP." - Distributional concern: half of those liabilities represent benefits accruing to only "10 percent of affiliates." - Additional pension statistics: - Pension payments reached "almost 2 percent of GDP per year during the last five years." - Government debt held by private pension funds reached "10 percent of GDP at end-2012 (one-fifth of total public debt)." - Pension payments would "rise gradually to 2-3 percent of GDP yearly by the end of this decade" (authorities’ estimate). - Staff recommendations on pensions: - Urgent need for parametric changes to lower benefits, increase contributions, and extend retirement ages. - Staff advised against changes in the accounting treatment of pension liabilities (absorbing private defined-benefit accounts into government accounts), arguing this would not remedy underlying imbalances or enhance transparency. ### Financial stability and regulatory reform - Authorities intend to complete pending financial reforms; pace of adoption of 2010 FSAP Update recommendations has slowed. - Staff encouraged: - Continue progress toward risk-based supervision and improved cross-border consolidated supervision. - Secure resources to activate the new liquidity framework of the central bank, especially the lender-of-last-resort facility. - Strengthen the reserves of the deposit insurance fund and set up a liquidity fund in line with the central bank’s liquidity framework. - Move forward with frameworks to facilitate bank resolution and broaden the perimeter of supervision. - Basel III transition: - Staff advocated gradual adoption of Basel III standards. - Noted banks already maintain levels of capital and liquidity that comply with Basel III (Annex V). - Recommended adoption of stricter definitions of capital and new capital requirements, but advised against reducing liquidity requirements to Basel III standards until the lender-of-last-resort facility and the liquidity fund were activated. ### Staff appraisal and strategic recommendations - Economic context: - Since 2010 growth has been sluggish; recovery did not gain strength. Output growth has been the lowest in Central America, largely due to weak private investment and severe supply constraints. - Fiscal consolidation supported by a Fund arrangement stalled in late 2011; fiscal deficit has hovered around "4 percent of GDP since 2010" and public debt-to-GDP ratio has risen. - Policy guidance: - Initiate a national dialogue on short- and medium-term priorities aiming at improving growth prospects, restoring fiscal sustainability, and enhancing resilience of the dollarized economy. - Promote a national dialogue to develop a medium-term growth agenda, leverage initiatives for PPPs and private participation in infrastructure, and reduce red tape while avoiding new tax exemptions or fiscal contingencies. - Fiscal consolidation strategy should combine revenue and expenditure measures: improve targeting of subsidies; lower earmarking of revenue; further reduce tax expenditure and evasion; raise the VAT rate to levels observed in other Latin America countries; and include comprehensive pension reform to strengthen finances and reduce inequalities. - Staff recommends the next Article IV Consultation on the standard 12-month cycle. ### Risk Assessment Matrix — selected downside scenarios and policy responses - A fiscal policy shock in the United States leading to lower U.S. growth. - Impact: M - Policy response: Given limited fiscal space, move forward investment reforms, including on business climate and competitiveness, and strengthen tax policy to offset revenue losses. - Emerging markets capital flow reversal (lower access to external financing). - Impact: M - Policy response: Move forward the proposed fiscal effort to reduce external financing needs. Lower liquidity mismatches in the banking system. - Global oil shock (driving oil prices to US$140 per barrel). - Impact: L / H - Policy response: Allow full pass-through, maintain strict wage policy, and strengthen the social safety net aided by tax policy. - Weakened fiscal policy stance (driven by electoral pressures). - Impact: H / H - Policy response: Reach immediate consensus with stakeholders on a fiscal and growth agenda to protect stability. - Confidence shock to depositors (triggered by electoral uncertainty and large fiscal deficits). - Impact: M / L - Policy response: Use existing liquidity buffers. Strengthen the insurance deposit scheme and the supervision of small cooperatives, as advised by the FSAP. - Natural disasters. - Impact: M / M - Policy response: Deepen use of official loans to accommodate fiscal costs from targeted assistance. *Source: IMF staff discussions and staff report material contained in the provided content unit.* ### Box 4. Main Recommendations from the 2010 FSAP Update ### Box 4. Main Recommendations from the 2010 FSAP Update ### Financial Supervision Status - Approve modifications to the law on financial system supervision and regulation to broaden the autonomy and remedial action powers of the supervisory authority, and strengthen legal protection for supervisors. — PI - Gradually shift to risk-based supervision by: (i) issuing and adopting norms for key risks and corporate governance; and (ii) bringing qualitative assessments in line with international best practices and appoint dedicated manager responsible for the overall supervision of each bank. — PI - Intensify supervision of credit concentration and debtor repayment capacity. — PI ### Liquidity Management - Amend the central bank law granting it powers of lender of last resort. — FI - Implement a comprehensive liquidity policy, which includes objectives, creation of a liquidity fund, and contingency plans. — PI ### Bank Resolution - Undertake a comprehensive bank resolution simulation exercise. — FI - Elaborate manuals to formalize procedures for banks resolution and crisis management. — PI - Update the legal framework for bank resolution by: (i) eliminating the 3-day notification period for resolution measures; (ii) requiring removal of a bank’s board at judicial intervention; (iii) ensuring least-cost solution; and (iv) increasing the funding of the deposit insurance scheme. — PL - Update the legal framework for the cooperative banks and their resolution process. — PL ### Capital Markets - Approve an investment funds law to potentially broaden the investor base and develop domestic capital markets. — PL - Approve an overhaul of the regulatory framework of the securities market. — NI - Amend the pension funds law to broaden investment opportunities for private pension funds. — NI - FI: fully implemented; PI: partially implemented; PL: pending legislation; NI: Not implemented. *Box 4. Main Recommendations from the 2010 FSAP Update.* ### Annex I. El Salvador: Assessing Potential Output ### Annex I. El Salvador: Assessing Potential Output ### Background and key constraints - El Salvador’s growth performance has lagged the CAPDR region for many years, largely due to low rates of domestic investment associated with a weakening business climate, loss of competitiveness, and vulnerability to external shocks. - Raising potential growth would require reforms to substantially increase investment and productivity. - Historical performance: - Real GDP growth decelerated from nearly 4 percent during 1993-2002 to under 2 percent during 2003-12. - Regional growth accelerated from 4 percent to 5 percent over the same period. - Over two decades, the rate of domestic investment amounted to 16 percent of GDP in El Salvador compared to 23 percent in regional peers. - During the most recent decade, foreign direct investment attracted by El Salvador was only half of the level received by other CAPDR countries (5 percent of GDP). - Investment gaps with the region also persisted during 1960-90. - Structural constraints identified: - Weak productivity and high cost of doing business, including those arising from violent crime. - Deficiencies in physical infrastructure, human capital, and financing to small- and middle-sized businesses. - Education indicators (UNESCO, 2010): over 40 percent of population had either no schooling or incomplete primary education compared to 23 percent in Latin America. - Emigration constitutes a major drain on skilled workers. - Vulnerability to natural disasters: - Direct and indirect costs associated with losses estimated at 20 percent of GDP over the period 2000-12, compared to an average of only 1½ percent in other countries in the region. ### Potential output estimates and trends - Methodologies used: Hodrick-Prescott (HP) filter and production function (PF) approach (Cobb-Douglas, elasticity of labor 0.5, depreciation rate 5 percent). - Sample period: 1998-2012 chosen to exclude post-civil-war rebound. - Key estimates: - Average potential output growth of El Salvador in 1998-2012: 2 percent, compared to 4½ percent in the region. - Potential output growth declined over time from about 2½ percent in 1998 to 1½ percent by 2012. - The negative output gap reached about 1½ percent during the 2008-09 global crisis and narrowed to ¾ percent in 2012. - Sensitivity to sample period: - Potential growth for El Salvador was 2.6 percent for 1964-2012; 3 percent for 1990-2012; and between 2.5-2.8 percent for 1994-2011. - Structural breaks (Bai-Perron): declines in potential output growth identified in 1994, 1997, and 2007; increase captured in 2003. ### Growth accounting and scenario projections - Growth accounting (contributions in percentage points): - 1998-2012: Real GDP 2.0; Capital 1.1; Labor 0.6; Productivity 0.3. - 2010-2012: Real GDP 1.7; Capital 0.9; Labor 0.9; Productivity -0.1. - 2019-2023 (pessimistic): Real GDP 1.2; Capital 0.4; Labor 0.6; Productivity 0.2. - 2019-2023 (baseline): Real GDP 2.0; Capital 0.9; Labor 0.6; Productivity 0.5. - 2019-2023 (optimistic): Real GDP 4.0; Capital 2.2; Labor 0.6; Productivity 1.2. - Under current investment trends: - Keeping the rate of domestic investment at the level observed over the last three years (14 percent of GDP), the PF approach projects average growth of 2 percent over 2013-23. - Macroeconomic projections prepared for the staff report imply that El Salvador would broadly grow at its potential over the medium-term. - Illustrative scenarios: - Pessimistic scenario: A decline in investment (by one-standard deviation) would lower potential growth to 1.2 percent over the long term (low-growth trap). - Optimistic scenario: Restoring the rate of growth of 4 percent observed in 1993-2003 would require a substantial increase in both the contribution of capital (consistent with domestic investment of 20 percent of GDP) and the contribution of productivity through efficiency-enhancing reforms. ### Alternative estimates and policy implications - GMM (dynamic panel) evidence (Swiston and Barrot, 2012): - Bringing physical and human capital to levels comparable to Chile, Mexico, and Peru (domestic investment to 25 percent of GDP and extending average education by two years) would boost potential growth to about 4-4½ percent. - Additional reforms (deepening the financial system and broadening the export base, including through greater regional integration) could further increase potential growth by 1-1½ percentage points. - Implication: Raising potential output requires substantial increases in investment and improvements in productivity via structural reforms. ### Key statistics and indicators (selected) - Domestic investment: - El Salvador: 16 percent of GDP (two-decade average). - Regional peers: 23 percent of GDP (two-decade average). - Recent three-year domestic investment: 14 percent of GDP. - Optimistic target referenced: 20 percent of GDP; GMM target: 25 percent of GDP. - Growth rates: - Real GDP growth 1993-2002: nearly 4 percent. - Real GDP growth 2003-12: under 2 percent. - Potential output average 1998-2012: 2 percent. - Regional potential: 4½ percent. - Potential growth decline 1998 → 2012: from about 2½ percent to 1½ percent. - Output gap: reached about 1½ percent (2008-09) and narrowed to ¾ percent in 2012. - Education: over 40 percent of population had no schooling or incomplete primary education (UNESCO, 2010) vs. 23 percent in Latin America. - Natural disaster costs: estimated at 20 percent of GDP over 2000-12 vs. 1½ percent regional average. *Source: Annex I. El Salvador: Assessing Potential Output (IMF staff).* ### Annex III. El Salvador: Assessing Spillovers ### Annex III. El Salvador: Assessing Spillovers ### Key Linkages - Trade - Trade flows are over 60 percent of GDP. - Main trading partners (shares of Salvadorian trade): United States about 40 percent; CAPDR countries 25 percent; other Latin American countries 15 percent. - China accounted for 7 percent of total imports. - Remittances - In 2012 remittances were close to 17 percent of GDP. - Nearly 90 percent of total remittances originated in the United States (construction and service sectors). - Investment - Stock of foreign direct investment amounted to 35 percent of GDP at end-2011. - United States and Panama together account for a combined 60 percent of the total inward FDI stock; Mexico follows. - El Salvador’s stock of direct investment abroad is small and concentrated in Nicaragua. - Financial - As of 2012 international banks' claims on Salvadorian borrowers reached 30 percent of GDP. - One-third of these claims originate from the United States and one-third from Europe; the United Kingdom is the main European player. - Foreign banks operating in El Salvador (mainly from the United States, Canada, Colombia, and Panama) account for 95 percent of the banking system’s total assets. ### Impact on Growth — VAR Analysis and Shock Scenarios - Method - Real GDP decomposed into long-run growth, domestic factors, and foreign factors using a multi-country VAR (approach per Poirson and Weber (2011)). - VAR included countries for 1975-2012: Belgium, Canada, China, Germany, Hong Kong, Italy, Mexico, Peru, Spain, Sweden, United States, and CAPDR countries. - Findings on drivers - Foreign factors drove deviations from long-run growth in El Salvador, boosting the economy prior to 2008 and depressing growth during the global crisis; domestic factors played a marginal role. - Shock scenarios (each: reduction of one-half standard deviation in the domestic growth component for 2013 for the United States, China, CAPDR, and European main trading partners; impacts estimated for 18-country sample) - United States shock - Growth in El Salvador would decline by 0.2 percentage points in 2013 and 1 percentage point in 2014. - Large sensitivity reflects close trade linkage with the U.S. and indirect effects via CAPDR. - CAPDR shock - Growth in El Salvador would decline by 0.2 percentage points in 2013 and 0.9 percentage points in 2014. - Effect large due to close regional trade linkages. - China shock - Similar intensity to CAPDR shock; propagates mainly via effects on U.S. growth. - Europe shock - Negligible effect on El Salvador, as U.S. growth would not be significantly affected. - Fiscal spillovers - U.S. fiscal sequestration would slow growth in El Salvador by 0.2 percent in the near term and by up to 0.6 percent cumulatively over a two-year period. This effect was incorporated into the staff report baseline. - Anticipated fiscal consolidation in Europe would have a negligible effect on El Salvador. ### Banking and Sovereign Stress Spillovers - Method - Assessed using the RES/MFU Bank Contagion Module based on BIS banking statistics. - Analysis focuses on potential vulnerability from international banks operating in El Salvador or involved in cross-border lending. - Foreign credit availability shocks - If international banks realize large losses and deleverage, credit lines to El Salvador would be squeezed. - Combined losses in U.S. and Canadian assets: nearly 5 percent of GDP impact; implied reduction in credit to El Salvador about 8 percent. - Default shock in European assets: 3½ percent of GDP impact; implied reduction in credit to El Salvador about 6 percent. - Sovereign exposure shocks (simulated) - A default shock on the sovereign debt of selected European countries would have virtually zero direct effect on foreign credit availability to El Salvador because banks actively lending to El Salvador have limited sovereign exposure to these European countries. - Caveats - Analysis may understate potential spillovers because exposures of resident banks not reporting to BIS (e.g., Colombian banks owning about two-fifths of the Salvadorian banking system) are not captured. - Negative indirect effects of deleveraging on global market confidence, corporate balance sheets, and nonperforming loans are not included. - Bank recapitalization and supportive policy actions at host/home countries are not assumed. ### Outward Spillovers - Real and financial channels from El Salvador to neighbors are limited: - Salvadorian share in individual neighbors’ trade is modest, implying small potential for real spillovers. - Cross-border bank lending, portfolio, and foreign direct investment links between El Salvador and neighbors are also small. - Potential for market contagion via investor perception exists but is not evident at present. --- ### Annex IV. El Salvador: Public Debt Sustainability Analysis ### Overview — Debt Developments and Baseline Projections - Recent debt dynamics - Public debt-to-GDP ratio rose from about 42½ percent at end-2008 to 54¼ percent at end-2012. - Drivers, 2003-08 vs 2009-12 (change in public debt, percent of GDP): - Change in public debt: 2003-08 = 3.1; 2009-12 = 11.9. - Primary deficit: 2003-08 = 3.4; 2009-12 = 8.3. - Growth contribution: 2003-08 = -6.4; 2009-12 = -1.1. - Real interest rate contribution: 2003-08 = 4.2; 2009-12 = 4.9. - Other: 2003-08 = 1.8; 2009-12 = -0.3. - Memo: Public debt (end period) 2003-08 = 42.4; 2009-12 = 54.3. - Implicit nominal interest rate: 2003-08 = 6.0; 2009-12 = 4.9. - Compared regionally, El Salvador experienced one of the largest increases in public debt over 2009-12 and had the highest debt ratio in the region by end-2012 (excluding pension transition debt). - Baseline projections - Public debt ratio projected to rise to 63 percent by 2018 and to 66 percent by 2020. - Projection driven by a primary deficit remaining at over 1 percent of GDP in the medium and long terms. - Risks and stochastic results - Bound tests indicate debt path is sensitive to slippages in the primary deficit, lower growth, or higher interest rates. - Stochastic simulations show the median public debt forecast would exceed 80 percent of GDP by 2018. ### Financing Needs and Debt Structure - Gross financing needs - Projected gross financing needs are 7-9 percent of GDP per year under assumption stock of short-term public debt remains at 2 percent of GDP and financing gaps covered with long-term loans. - Gross financing needs would reach 11 percent of GDP by 2018 if one-half of projected financing gaps were covered with short-term debt financing. - Debt structure strengths (end-2012) - Average maturity of public debt: 8 years. - Only 15 percent of the stock maturing over the next 5 years (average amortization 1½ percent per year). - 70 percent of debt subject to fixed interest rates. - Stable investor base: domestic private pension funds and official creditors hold 70 percent of public debt. - Risk perception - Spreads averaged 450 basis points in 2012. - El Salvador stands three notches below investment grade level; it maintained investment grade during 2002-09 but ratings have been downgraded since. ### Restoring Debt Sustainability — Targets and Required Adjustments - Alternative long-term debt targets and required fiscal effort - Debt stability (maintain public debt ratio at 55 percent from 2013 onward) - Requires a sustained fiscal effort of 2 percent of GDP. - Would shift primary balance into a small surplus of 0.2 percent of GDP. - Pre-crisis debt level (reduce public debt ratio to 42 percent by 2020) - Sustainability gap of 5 percent of GDP relative to 2012 levels. - Closing gap would raise the primary surplus to 3¼ percent of GDP and move the overall fiscal balance into a small surplus. - Financing needs would decline to manageable levels (3-4 percent of GDP). - A gradual adjustment with moderate front-loading over a 6-year period through 2018 is projected to result in moderate output gaps. - Debt level to improve risk perceptions (reduce public debt ratio to 35 percent of GDP by 2020) - Would require a sustained effort of 7 percent of GDP, assuming adjustment spread over the same six-year period. - If fiscal consolidation also strengthens foreign reserves to adequacy level discussed in Annex II, the gradual adjustment would need an additional 0.8 percent of GDP per year. - Illustrative fiscal consolidation path (pre-crisis debt level scenario) — discretionary fiscal adjustment and fiscal sustainability gap (Percent of GDP) and output gap (percent of potential GDP): - Discretionary fiscal adjustment by year: 2013 = 1.3; 2014 = 0.9; 2015 = 0.7; 2016 = 0.7; 2017 = 0.7; 2018 = 0.7; 2019 = 0.0; 2020 = 0.0; 2021 = 0.0; 2022 = 0.0. - Fiscal sustainability gap by year: 2013 = 3.4; 2014 = 2.6; 2015 = 1.9; 2016 = 1.3; 2017 = 0.6; 2018 = 0.0; 2019 = 0.0; 2020 = 0.0; 2021 = 0.0; 2022 = 0.0. - Output gap (percent of potential GDP) by year: 2013 = -0.6; 2014 = -0.5; 2015 = -0.4; 2016 = -0.4; 2017 = -0.4; 2018 = -0.4; 2019 = -0.2; 2020 = -0.1; 2021 = 0.0; 2022 = 0.0. - Consolidation sequencing to mitigate output losses - Simulations based on a model of optimal fiscal consolidation with quadratic preferences imply a moderate up-front fiscal effort (about 2 percent of GDP in 2013-14) and smaller additional adjustments over the following 4 years under the pre-crisis debt scenario, with the output gap remaining small (-0.6 percent of potential GDP in the first year and closing slowly thereafter). *IMF staff annexes: Annex III and Annex IV from the El Salvador staff report.* ### Annex V. El Salvador: Implementing Basel III Standards ### Annex V. El Salvador: Implementing Basel III Standards ### Overview and context - Basel III aims to enhance the soundness of the banking system through stricter capital and new liquidity guidelines; stricter rules could transitorily curtail credit supply and affect economic activity. - El Salvador is positioned to perform a gradual transition to Basel III without dampening credit supply and economic activity in the near term, due to comfortable capital and liquidity levels in the banking system. ### Capital position and projected gaps under Basel III - At end-2012, banks had capital adequacy ratios of 17 percent. - Required levels: 8 percent under Basel I standards and 12 percent under Salvadorian rules. - Under Basel III adjustments: - Risk-weighted assets (RWA) would increase by some 20 percent. - Common equity would decline by only 1½ percent. - With current capital positions, banks would be able to meet all new capital requirements. - Application of a recommended countercyclical buffer of 2½ percent of RWA would result in a capital gap of 1½ percent of RWA. ### Liquidity position under Basel III methodologies - Adjusting for Basel III methodologies, the banking system’s liquidity: - Would be more than three times the minimum implied by the 30-day liquidity requirement. - Would be some 30 percent above the level suggested by the one-year funding requirement. - Both liquidity requirements provide for full coverage of liabilities maturing within a 30-day and one-year period, respectively. ### Macroeconomic impact of Basel III capital transition - A vector autoregression (VAR) estimation suggests: - Raising the capital adequacy ratio by one percentage point would lower economic activity in El Salvador by 0.05 percent. - The effect would dissipate in two years. - The estimated impact is low compared to estimations made for other countries by the BIS Macroeconomic Analysis Group. - Broad conclusion: Aligning to the stricter rules should have no transitory impact on credit nor economic activity, since the system already exceeds most of those standards, unless a countercyclical capital buffer is also introduced. ### Policy sequencing and priorities for implementation - Standards should be tailored to the size and complexity of El Salvador’s banking system and guide improvements in supervision, regulatory, and risk management frameworks. - Short-term priorities: - Upgrade capital definitions and introduce the new capital requirements. - Countercyclical buffers may take longer to implement. - Do not reduce required liquidity levels until central bank liquidity facilities—including the lender-of-last-resort window—are fully activated. - Medium-term priorities: - Strengthen supervisory processes (Pillar II). - Upgrade practices for market discipline and transparency (Pillar III). - Long-term considerations: - Introduce macroprudential instruments. - Consider capital charges for systemically important financial institutions. ### Implementation responsibilities and challenges - Most regulatory changes associated with Basel III implementation fall under the powers of the central bank. - Presence of large international financial groups in El Salvador should facilitate the transition, as these banks are subject to stricter prudential practices dictated by home countries. - Overall, challenges to the transition appear manageable. *Prepared by F. Delgado. Based on Basso, O., Delgado, F. and M. Meza, 2012, “Strengthening Bank Capital and Liquidity in Central America: the Road to Basel III,” IMF, Working Paper (unpublished).* ### 1998. El Salvador is taking a flexibility option for the periodicity of the labor market and ### _cr13132 - 1998. El Salvador is taking a flexibility option for the periodicity of the labor market and wages/earnings data category and will continue at this time to publish annual data with a timeliness of one quarter after the end of the reference year. ### Data and reporting metadata - Public Information Notice (PIN) No. 13/59 — FOR IMMEDIATE RELEASE — May 22, 2013. - Table of Common Indicators Required for Surveillance (As of April 30, 2013) — latest observations and reporting frequencies shown for multiple series (examples below preserve original timing and frequency): - International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Date of latest observation Mar-2013; Date received Mar-2013; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M. - Reserve/Base Money: Date of latest observation Feb-2013; Date received Apr-2013; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M. - Consumer Price Index: Date of latest observation Mar-2013; Date received Mar-2013; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M. - External Current Account Balance: Date of latest observation Dec-2012; Date received Mar-2013; Frequency of Data Q; Frequency of Reporting Q; Frequency of Publication Q. - GDP/GNP: Date of latest observation Dec-2012; Date received Mar-2013; Frequency of Data Q; Frequency of Reporting Q; Frequency of Publication Q. ### Background and macro developments (staff findings) - Growth and recovery: - Output growth was sluggish in 2010-12 due to low private investment, declining competitiveness, and weather-related shocks. - After dropping 3.1 percent in 2009, real GDP growth averaged 1.5 percent during 2010-2012. - Staff projections indicate that under current investment trends potential growth would remain around 2 percent over the long term. - Inflation and monetary regime: - Inflation remained low and firmly anchored by the fully-dollarized regime. - The authorities committed to maintaining dollarization despite concerns that it affected competitiveness and did not sufficiently lower local interest rates. - External sector: - External current account deficit widened to 5.25 percent of Gross Domestic Product (GDP) in 2012. - This deficit exceeded the underlying capital account surplus. - Foreign reserve position as of end-2012 "may not be sufficient to absorb large adverse shocks." - Fiscal position and public debt: - Overall fiscal deficit in 2012 remained close to 4 percent of GDP (same level as in 2010-11). - Revenue gains from income tax measures in early 2012 and control over current expenditures were offset by higher public investment and spending on security, health, and social projects. - Government financing needs amounted to nearly 8 percent of GDP in 2012. - Stock of public sector debt reached 54.25 percent of GDP at end-2012. - Public sector debt rose from about 42½ percent at end-2008 to 54¼ percent at end-2012. - Roughly half of 2012’s fiscal deficit is explained by pension liabilities; pension liabilities averaged 1.7 percent of GDP per year between 2009 and 2012. - Banking sector: - At end-2012, average capital adequacy ratio was 17 percent. - Overdue loans declined to under 3 percent of total loans, with provisioning fully covering these loans. - During 2012, total bank deposits increased by 2.5 percent, while credit to the private sector grew by 4 percent. ### Executive Board assessment and recommended priorities - Short-term priorities: - Maintain macroeconomic stability and investor confidence during the electoral period (presidential elections early 2014; congressional elections one year later). - Exercise restraint on public sector wages and poorly-targeted subsidies. - Broaden the scope of envisaged revenue measures. - Temporary increase in banks’ liquidity buffers to safeguard financial stability during the election cycle. - Medium-term priorities: - Build a broad consensus on a short- and medium-term strategy to ensure fiscal and debt sustainability and bolster growth potential. - Gradual reduction in the public debt ratio to pre-2009 levels by the end of the decade. - Fiscal consolidation should encompass revenue and expenditure measures: - Improve targeting of subsidies. - Lower the earmarking of revenues. - Reduce tax expenditure and evasion. - Increase the rate of the value-added tax. - Pension reforms to ensure sustainability and reduce inequalities in the system. - Implement outstanding recommendations of the 2010 Financial Sector Assessment Program (FSAP) Update, including: - Activate the newly-created lender-of-last-resort facility. - Facilitate bank resolution. - Raise the reserves of the deposit insurance fund. - Gradual implementation of key Basel III standards. - Growth and competitiveness: - A sustained increase in investment is necessary to raise potential growth. - Support initiatives to promote private investment in key infrastructure, set up an effective framework for public-private partnerships, and reduce red tape. ### Selected economic indicators (selected rows preserved exactly as in source) - Social indicators: - Rank in UNDP Development Index 2012 (of 186): 107 - Population (million): 6.2 - Per capita income (U.S. dollars): 3,864 - Life expectancy at birth in years: 71 - Percent of pop. below poverty line (2010): 43 - Infant mortality (per 1,000 live births): 15 - Gini index: 47 - Primary education completion rate (percent): 89 - Economic indicators (annual percent change or percent of GDP; select series with 2008–2014 columns preserved in format): - Real GDP (annual percent change): 2008: 1.3; 2009: -3.1; 2010: 1.4; 2011: 2.0; 2012: 1.6; 2013: 1.6 (projection); 2014: 1.6 (projection). - Consumer prices (end of period): 2008: 5.5; 2009: 0.1; 2010: 2.1; 2011: 5.1; 2012: 0.8; 2013: 2.3 (projection); 2014: 2.6 (projection). - Credit to the private sector (percent of GDP): 2008: 43.0; 2009: 42.4; 2010: 40.9; 2011: 39.8; 2012: 40.1; 2013: 39.6 (projection); 2014: 38.9 (projection). - Broad money (percent of GDP): 2008: 45.0; 2009: 47.3; 2010: 47.2; 2011: 43.7; 2012: 43.2; 2013: 42.8 (projection); 2014: 42.1 (projection). - Current account balance (percent of GDP): 2008: -7.1; 2009: -1.5; 2010: -2.7; 2011: -4.6; 2012: -5.3; 2013: -5.0 (projection); 2014: -4.8 (projection). - Exports (f.o.b. including maquila) (percent of GDP): 2008: 21.9; 2009: 19.0; 2010: 21.4; 2011: 23.4; 2012: 23.0; 2013: 23.0 (projection); 2014: 23.1 (projection). - Imports (f.o.b. including maquila) (percent of GDP): 2008: -43.8; 2009: -34.1; 2010: -37.8; 2011: -41.8; 2012: -41.7; 2013: -42.1 (projection); 2014: -42.3 (projection). - Overall balance (Nonfinancial Public Sector, percent of GDP): 2008: -3.2; 2009: -5.7; 2010: -4.3; 2011: -3.9; 2012: -3.9; 2013: -3.9 (projection); 2014: -3.8 (projection). - Primary balance (percent of GDP): 2008: -0.8; 2009: -3.1; 2010: -1.9; 2011: -1.7; 2012: -1.6; 2013: -1.4 (projection); 2014: -1.3 (projection). - Public sector debt (percent of GDP): 2008: 42.4; 2009: 51.0; 2010: 52.2; 2011: 52.3; 2012: 54.3; 2013: 56.4 (projection); 2014: 58.0 (projection). - Foreign direct investment (percent of GDP): 2008: 3.8; 2009: 1.8; 2010: 0.5; 2011: 1.7; 2012: 2.2; 2013: 1.0 (projection); 2014: 1.1 (projection). - Net Foreign Assets of the Financial System (Millions of U.S. dollars): 2008: 2,208; 2009: 3,028; 2010: 3,378; 2011: 2,811; 2012: 3,370; 2013: 2,708 (projection); 2014: 2,797 (projection). - Net Foreign Assets (percent of deposits): 2008: 24.4; 2009: 32.4; 2010: 34.5; 2011: 28.8; 2012: 34.0; 2013: 26.1 (projection); 2014: 26.2 (projection). ### Authorities’ statement (key points from Mr. Rojas and Mr. Acevedo Flores — May 20, 2013) - Growth: - Boosting growth remains the main challenge; growth has been modest for many years. - Real GDP growth averaged 1.5 percent during 2010-2012 after a 3.1 percent drop in 2009. - Low productivity, physical infrastructure deterioration, low private investment (including low FDI), poor security conditions, and political uncertainty are cited as key constraints. - Authorities note that under current investment trends potential growth would remain around 2 percent over the long term (as in staff projections). - Fiscal stance: - Fiscal deficit declined from 5.7 percent of GDP in 2009 to 3.4 percent in 2012; objective is to reduce it to 3.3 percent of GDP in 2013. - Public debt-to-GDP rose from about 42½ percent at end-2008 to 54¼ percent at end-2012. - Authorities express concern that electoral politics could complicate further fiscal consolidation; they caution against too drastic adjustment that might undermine growth prospects. - Monetary regime and policy stance: - Government is committed to maintaining full dollarization adopted in 2001; authorities believe costs of abandoning dollarization exceed potential benefits in the medium term. - Government focuses on boosting productivity and lowering crime to promote investment. - Economic policy measures and reforms: - Introduced pro-investment laws and decrees in early 2013: cutting red tape for construction projects; a new public-private partnership law (now in Congress); reforms to free-trade zones. - Working with the U.S. Partnership for Growth initiative focusing on crime and security and raising productivity in the tradable sector. - Potential funding from a second Millenium Challenge Corporation program could provide modest impetus for GDP growth, with impact during the next presidential term. - Fiscal measures: hiring freeze in much of the public sector; efforts to reduce transport subsidies; plans to introduce new tax measures in Congress alongside laws to promote investment and growth. - Conclusion by authorities: - Authorities agree key challenges are to increase growth, reduce fiscal deficit and public debt, and rebuild buffers of the dollarized economy. - They welcome the goal of increasing potential output to regional levels and seek IMF support to start a national dialogue on key economic challenges, especially fiscal sustainability, during the political transition. *Source: IMF Public Information Notice No. 13/59; IMF staff report materials, May 20–22, 2013.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2013/_cr13132.pdf_