Mission Concluding Statement 

El Salvador: Concluding Statement of the 2018 Article Iv Consultation Mission

March 27, 2018

The IMF staff team visited San Salvador during February 5—16 for the 2018 Article IV consultation [1] and held productive discussions with the Salvadoran authorities, parliamentarians, business community, and social partners. The consultation was based on revised National Accounts statistics.

El Salvador has suffered from low growth, low investment, high public debt, and sovereign financing strains. The subpar growth reflects the interplay of structural bottlenecks, high inequality and crime, and large outward migration. The country has pursued a strategy based on (i) pro-growth measures and (ii) gradual fiscal adjustment combined with a recent pension reform, which was facilitated by a welcome improvement in collaboration across the political spectrum. The IMF staff compliments the authorities for the substantial efforts made in addressing these issues to date. In particular, progress has been made in reducing the fiscal deficit and stabilizing debt, though significant further efforts are needed to put debt on a declining trajectory. Priorities include: (i) stepping up structural reforms to durably raise growth, and make it more inclusive; and (ii) implementing further fiscal adjustment of 2 percent of GDP on the revenue and expenditure side.

RECENT DEVELOPMENTS, OUTLOOK AND RISKS

1. Growth is projected at 2.4 percent in 2017, slightly above its potential of 2.2 percent, helped by continued U.S. recovery, and a surge in remittances. The fiscal deficit has declined significantly due to higher revenues and expenditure restraint, and also due to a fall in capital expenditure. The sovereign financing situation was difficult at the turn of 2016/17, but has been improving since September 2017. Remittances’ growth accelerated in late-2016, most likely as a precautionary response to increased uncertainty about U.S. immigration policies.

2. The medium-term outlook remains tepid. In 2018-19, growth is expected to remain at 2.3 percent, supported by stronger U.S. growth and higher grant-financed investment. The fiscal deficit is projected to further fall to 2.2 percent of GDP in 2018, as savings from the pension reform kick in, but will increase to 2.7 percent of GDP in 2019, with public debt broadly stabilizing at close to 70 percent of GDP by 2021-23. The current account deficit is projected to increase both in 2018 and 2019 as remittances’ growth moderates while imports expand, and the income balance worsens due to a tightening of financial conditions. The effects of the recent decision by the U.S. authorities not to renew the TPS are not expected to be significant. Over the medium term, growth will remain close to its potential and inflation will be anchored by dollarization at 2 percent.

3. Risks to the outlook are tilted to the downside and dominated by spillovers from further potential policy shifts by the U.S. administration and domestic policy slippages. A more aggressive enforcement of the TPS termination, involving deportation of 50,000 individuals over 2019-20, would reduce GDP growth by 0.1 and 0.4 percentage points in 2019 and 2020, respectively. Higher deportations of illegal migrants would further dent remittances and growth, with more protracted effects than in the case of TPS migrants. Downward surprises in U.S. growth would also depress Salvadoran growth. Further, tighter global financial conditions could limit access or raise the cost of external fiscal financing, adding to fiscal strains. Finally, domestic policy slippages, such as a reversal of the recent fiscal deficit reduction or standoff over financing, or policy paralysis could also depress confidence and growth.

FISCAL POLICIES

4. The authorities’ adjustment efforts, combined with the pension reform, will result in a cumulative improvement in the primary balance of 1¾ percent of GDP over 2017-18. However, the following considerations argue for further adjustment efforts. (i) Debt level, dynamics, and risks: Despite improvements in the fiscal balance, public debt reached close to 70 percent of GDP at end-2017, but this mostly reflects the downward revision in GDP data. While it is projected to broadly stabilize over the medium term, risks still remain both due to possible external shocks and the risk of reversals of the recent gains in fiscal consolidation. Therefore, there is a need to bring debt on a firmly declining path. (ii) Financing gaps loom for 2019 and beyond: While the 2018 budget made a welcome breakthrough in authorizing the needed sovereign borrowing for the entire year, substantial gaps loom for 2019 and beyond. (iii) Growth interest differential: The differential has remained negative, and is projected to worsen.

5. Staff welcomes progress on fiscal consolidation so far, but recommends an additional fiscal adjustment of 2 percent of GDP phased in over 2019-20. This adjustment would put debt on a declining path, reducing it, as an intermediate target, below 60 percent of GDP by 2024. Under this scenario, debt would be reduced to a more comfortable level of below 50 percent of GDP before 2030. Staff believes that the output costs of fiscal adjustment are likely to be contained over the medium-term. Investor confidence could also be boosted by a better fiscal position.

6. Given the assumed fiscal multipliers, the adjustment would require measures of 2.3 percent of GDP both on the revenue and expenditure side that are efficient and support social objectives. On revenues, there is scope for raising taxes (e.g. VAT) and streamlining distortionary taxes. On spending, across-the-board cuts should be avoided in favor of targeted measures, and current spending should be rationalized to create room for public investment. Effort should be made to resolve technical challenges to the timely implementation of the property tax, as this is a key progressive measure to be actively pursued for a socially-balanced adjustment package. Similarly, regressive effects of a VAT increase should be carefully assessed, with targeted support to protect the most vulnerable.

7. The new FRL represents a step in the right direction, but the law and its supporting elements need to be upgraded. Staff recommends a more ambitious debt target of below 50 percent of GDP instead of 65 percent of GDP currently. The operational target should be re-calibrated in line with debt sustainability. Also, rule-based corrective mechanisms (e.g. after escape clauses are triggered) should be introduced. The FRL should be supported by: (i) further improvements in Medium- and Long-Term Fiscal Framework (MTLFF); (ii) a more comprehensive budget presentation; (iii) better spending controls, and monitoring of arrears (iv) improved government statistics; (v) enhanced efficiency and governance of tax and customs administration; (vi) implementation of results-based budgeting; and (vii) better evaluation, execution, and budgeting of public investment projects.

8. Further improvements in institutions and political will are needed to resolve sovereign financing bottlenecks going forward. (i) In line with the 2018 budget experience, the financing needs should be reported transparently in all budgets; (ii) the medium-term financing needs, including the maturing $800 million Eurobond payment in 2019, should be addressed early, and negotiations on the medium-term financing agreement should be carried forward; (iii) the authorities’ efforts to secure low-cost program loans from multilateral institutions should continue; and (iv) the approval process for low-cost high-quality investment projects by donors should be simplified.

9. The new pension reform is a positive step, and will reduce the fiscal deficit by around 0.8 percent of GDP over the next few years, but would fall short of a comprehensive fix to the system. The bulk of the fiscal savings (0.7 percent of GDP annually) results from the temporary diversion of social contributions to the Solidarity Guarantee Account (SGA), which would reduce public pensions spending. These flows, however, generate a long-term fiscal liability, initially very small, but projected to increase over time. The liability remains to be accurately quantified, and its size will be affected by public policies, such as future increases in the retirement age. Moreover, the reform only marginally tackles the key problems of high inequality of benefits and low coverage and replacement rates, which are estimated to increase only slightly.

10. Deeper reforms are needed to further strengthen the fiscal and social sustainability of the pension system . (i) Increasing the retirement age, which is among the lowest in the region. A modest increase by 1 year at most in 2022 is being considered. More ambitious increases in the retirement age would improve future replacement rates in the pension system and limit fiscal contingent liabilities arising from the SGA, particularly longevity benefits. (ii) Improving benefits coverage for the poor. The changes to the law improve coverage only among contributors to the system, and would not help the most vulnerable segments. Old age security could be enhanced via expanding the modest non-contributory basic pension. (iii) Enhancing cost-efficiency. Pension fund fees are still high and should be reduced given the low risk profile of their investments (mainly government bonds). (iv) Backstopping from the budget. The liquidity and solvency of the pension system ultimately hinge on the budget. The envisioned budget allocation would be insufficient to cover pension obligations in most years, while the broader fiscal guarantee mechanism is yet to be fully clarified. To ensure credibility, the pension system accounts should be integrated into fiscal decisions, with full costing of their implications.

FINANCIAL SECTOR STABILITY AND SUPPORT TO GROWTH

11. Despite good prudential fundamentals and ongoing progress, several long-standing reforms need to be accelerated. The authorities are making progress in risk-based supervision, cross-border supervision, AML/CFT compliance, and financial inclusion. However, efforts should be intensified in the areas of systemic liquidity, banking resolution and crisis management procedures, supervision and regulation. (i) Systemic liquidity. Adequate funding of lender of last resort (LOLR) facilities set up at the Central Bank and the creation of a liquidity fund are needed. (ii) Crisis management and resolution. Progress has been made on the draft law, but a prompt agreement between the Financial System Superintendency and the Central Bank is needed to accelerate the adoption of the new law. (iii) Supervision and regulation. Staff welcomes the steps taken in risk-based supervision. While the communication for the assessment of cross-border risks is adequate, memorandums of understanding specifying contingency plans between home and host supervisors should be established to avoid or mitigate the effects of a potential financial crisis. Staff recommends introducing the liquidity coverage ratio and legislation to adopt new capital requirements to cover for credit risks in line with Basel II/III standards.

SUPPLY SIDE REFORMS TO IMPROVE POTENTIAL GROWTH

12. To make the most of its demographic dividend, El Salvador needs more private investment, improved business climate, and higher formal job creation. El Salvador’s rise in the World Bank’s 2018 Doing Business ranking by 22 notches is encouraging, but there is scope for further progress. Areas of improvements include, for example, avoiding further increases in minimum wages. On the ease of doing business, staff recommend accelerating the implementation of the Law on Administrative Procedures (adopted in 2017), implementing the Electronic Signature Law (adopted in 2016), expanding the e-Regulations initiative, and enhancing the clout of the Regulatory Improvement Agency. The adherence to the customs union with Honduras and Guatemala will help in the facilitation of trade. Enhancing capacity and clout of the Competition Authority would support efforts to combat anti-competitive behavior. To spur public and private investment, it would be critical to adopt a coherent and integrated medium-term framework for public investment, the publication of comprehensive financial statements by public enterprises, the expansion of the PPP law to additional economic sectors, and the simplification of the congressional approval process, while controlling fiscal risks from the PPPs. To combat crime and corruption, implementing “El Salvador Seguro” plan and supplementing it with adequate resources and grant funding, and further strengthening the personnel and effectiveness of the Anti-Corruption Unit within the Prosecutor General office and the Ethics Tribunal, and enhancing the AML/CFT framework, would be important.

STATISTICS

13. Staff welcomes the publication of the revisions to the National Accounts. The improved GDP series will better inform policymaking and broader public debate.

[1] The assessment was based on preliminary data provided by the authorities as of February 9, 2018.