El Salvador: Staff Concluding Statement of the 2021 Article IV Mission

November 22, 2021

A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

Washington, DC: The pandemic interrupted ten years of growth, but El Salvador’s economy has rebounded quickly. Robust external demand, resilient remittances, and sound management of the pandemic—with the help of the International Monetary Fund’s Rapid Financing Instrument (RFI, US$389 million) approved in April 2020—are supporting a strong recovery. Persistent fiscal deficits and high public debt service are leading to large and increasing gross fiscal financing needs. The discussions focused on the policies needed to secure inclusive growth, improve fiscal sustainability, ensure financial stability, and strengthen economic governance. The adoption of Bitcoin as legal tender, the regulation and supervision of Bitcoin services providers, and e-wallet Chivo were also discussed. The plans to issue sovereign bonds and use the proceeds to buy Bitcoin and fund infrastructure plans announced on November 20, occurred after the technical work of the mission concluded, and were not discussed with the authorities.

Pandemic and the recovery

1. El Salvador’s public health response to the pandemic helped save many lives. The authorities deployed early-detection and containment measures in a timely and effective manner, ramped up COVID-19 testing and ICU bed capacity, and advanced a successful vaccination campaign (62 percent of population with two doses as of November 17, 2021). As a result, El Salvador—one of the most densely populated countries in Latin America—recorded one of the lowest rates of COVID-19 infections and fatalities in the region (1,811 and 57 per 100,000 population, respectively, as of November 17, 2021).

2. Pro-active policies helped cushion the 2020 economic contraction. In spring 2020, the economy suffered two large shocks: a precipitous plunge in external demand and remittances, and a fall in domestic demand due to limited mobility. Two fiscal packages were implemented swiftly to support the fight against the pandemic and the economic recovery, with the help of a Rapid Financing Instrument (RFI, US$389 million) approved in April 2020. The implementation of temporary financial sector relief measures—such as the reduction in banks’ reserve requirements and debtor-relief measures—helped provide ample credit and relief to the economy. Staff estimates that in the absence of such measures the economy would have contracted considerably more than the recorded 7.9 percent fall in real GDP in 2020.

3. Supportive policies, buoyant external demand, and continuous growth in remittances are fueling a strong recovery. By the third quarter of 2021, industrial production, total employment, and wages had reached pre-pandemic levels. Merchandise exports and tax collection are well above pre-pandemic levels. On the back of buoyant exports, high remittances, and public investment, the economy is projected to grow by about 10 percent in 2021 and 3.2 percent in 2022. The unwinding of liquidity measures (notably through an increase in reserve requirements) that started in June 2021 and the SDR allocation in September 2021 helped increase gross international reserves in 2021 by US$0.8 billion to about US$3.5 billion by end-October 2021. The banking system appears to remain resilient: liquid and solvent, with large provisioning and adequate capital coverage.

4. At the same time, vulnerabilities are rising. Nonperforming loans increased, as expected due to the unwinding of the debt-relief measures, to 2.3 percent of total loans by-September 2021, from 1.6 percent in end-2020. Given the rapid growth in imports, the ratio of gross international reserves to imports is expected to dip below three months. Public debt (including pensions) is projected to have increased during the pandemic by 14 percentage points of GDP, to about 85 percent of GDP by the end-2021. Rising gross fiscal financing needs, alongside uncertainty about the direction of policies, pushed up the sovereign spreads to 1,200 basis points, considerably increasing borrowing costs (beyond 14 percent for ten-year bonds).

Outlook and risks

5. Under current policies, medium-term growth is expected to be constrained by high financing costs. The Salvadoran economy is expected to grow in line with the U.S. economy, to which it is closely intertwined. Real GDP growth in El Salvador is expected to converge to 2 percent by 2026, as the effects of extraordinary policy measures will wane in the U.S., and the high Salvadoran sovereign spreads will limit private investment. Gross fiscal financing needs are expected to be elevated in the medium term and increase to about 20 percent of GDP by end-2025 as regular biannual Eurobond repayments start in January 2023. Absent strong policy measures to correct fiscal imbalances and to ease these constraints on growth, public debt will grow beyond 95 percent of GDP (including pensions) by 2026. These projections do not include the recently announced plans to issue sovereign bonds, which would use proceeds to purchase Bitcoins and fund infrastructure investment. Uncertainty about these medium-term projections is unusually high, given the evolving policy landscape.

6. Risks to the economic outlook are sizeable. Key downside risks stem from a resurgence of the pandemic worldwide, further increases in borrowing costs due to the tightening of financial conditions, and unaddressed regulatory and supervisory gaps related to the use of Bitcoin. On the upside, gains from financial inclusion and improved payment systems due to the introduction of a public e-wallet in U.S. dollars could increase growth.

Policy discussions

7. A comprehensive economic strategy is needed to ease constraints on growth while lowering borrowing costs. Higher medium-term growth—around the historical average real GDP growth of 2¼ percent—is possible by removing financing constraints and sustaining investment. In addition, increasing productivity, private investment and improving human capital would allow for even higher medium-term growth (about 2½ percent). The authorities’ efforts to reduce crime, cut red tape, lower energy costs, diversify the energy matrix, foster economic diversification, and enhance financial inclusion are welcome, and should continue. Efforts to increase investment in education, health, and infrastructure are commended, but in the context of fiscal sustainability concerns, additional efforts need to be made elsewhere, to create fiscal space without increasing risks. In this respect, better targeting social spending, prioritizing infrastructure projects, and strengthening economic governance are critical to ensure inclusive growth.

Fiscal policy

8. A well-articulated fiscal consolidation strategy, supported by high quality measures amidst a coherent medium-term framework, is critical to restore fiscal sustainability. At 4½ percent of GDP, the proposed 2022 fiscal deficit is high, when taking into account the much-improved cyclical economic position and the high borrowing costs to finance it. Staff recommends implementing a fiscal consolidation package based on high quality measures amounting to about 4 percent of GDP over the next three years. Such an effort would restore fiscal sustainability, by putting public debt (including pensions) on a downward path—reaching about 80 percent of GDP by 2026. The measures should be distributed between revenue and spending, with emphasis on fast-yielding permanent measures like raising taxes on goods and services, better targeting subsidies, and realigning the public sector wage bill with private sector comparators. It is critical that the package supports the vulnerable population and minimizes adverse distributional effects. The authorities started the consolidation by implementing a reduction in transfers to local governments and have proposed revenue measures to the Legislative Assembly. The fiscal implications of recently announced plans to use proceeds of a new sovereign bond issuance to purchase Bitcoin and fund infrastructure investment have not been assessed by staff.

9. Other structural fiscal reforms and mitigation of fiscal risks are also needed. Modernizing the public financial management framework would also help reinforce fiscal discipline. Measures supporting the sustainability of the pension scheme by strengthening the link between contributions and entitlements would also contribute to restore fiscal sustainability. It is also essential to strengthen the capacity to identify, quantify, and design strategies to address fiscal risks, particularly those stemming from investments, climate/natural disasters, public corporations, and contingent liabilities.

Financial stability

10. Efforts to strengthen financial supervision and regulation are welcome. The unwinding of the exceptional financial sector interventions is appropriate. The increase of reserve requirements (up to 15 percent of liabilities by June 2022) should be completed as projected, and monitored to ensure it is sufficient for financial and external stability purposes. It should also be complemented by other measures such as improving the Emergency Liquidity Assistance framework. The unwinding of regulatory forbearance measures—including debt payment moratoria and risk classification flexibility—is also welcome and should be accompanied by a plan with tailored supervisory actions aimed at monitoring bank’s recovery strategies. Efforts to develop the banking crisis resolution framework should keep momentum as, once approved, it will be an effective tool to buttress the financial safety net. Over the medium-term efforts should be focused into transitioning to forward-looking and risk-based supervision.

Economic governance

11. Further progress in strengthening economic governance is critical in supporting growth. We commend the authorities for publishing the reports on the use of public funds for COVID-19, and many individual report audits by the Court of Accounts. El Salvador has a sound anti-money laundering framework in place and has achieved major advances in some high-profile anti-corruption cases. Further progress in economic governance is critical in supporting growth. In this respect, staff supports the authorities’ plans to further strengthen fiscal transparency and accountability (e.g., publish the overall recommendations and the authorities’ response to the audits of COVID-19 funds, and the public information on following up on audit reports in due process). Additional steps need to be taken to strengthen governance and anti-corruption frameworks in line with international standards: (i) improve transparency of public procurement processes (e.g., publication of beneficial ownership in all public contracts), (ii) limit the use of extra budgetary funds, and (iii) align domestic legislation to the UN Convention Against Corruption (UNCAC). Staff welcomes the central bank‘s efforts to comply with the 2020 safeguards assessment.

Bitcoin and e-wallet Chivo

12. El Salvador became the first country to adopt Bitcoin as a legal tender on September 7, 2021 . While the law maintains the U.S. dollar as the national unit of account, it mandates the acceptance of Bitcoin by agents, unless technical impediments exist. A new digital means of payments—the e-wallet Chivo operating in both U.S. dollars and Bitcoin—has been introduced and heavily supported by the government to promote financial inclusion (each qualifying citizen who downloaded the application received an endowment of US$30). The law also guarantees the automatic conversion from Bitcoin to U.S. dollars through a trust fund funded with US$150 million from the budget, and in practice the conversion is done in Chivo.

13. Efforts to improve financial inclusion and raise growth are welcome, but risks arising from Bitcoin as a legal tender, the new payments ecosystem and trading in Bitcoin should be addressed. Crypto-technologies and digital payment systems like Chivo have the potential to make payments more efficient, thereby enhancing financial inclusion and supporting growth. Given Bitcoin’s high price volatility, its use as a legal tender entails significant risks to consumer protection, financial integrity, and financial stability. Its use also gives rise to fiscal contingent liabilities. Because of those risks, Bitcoin should not be used as a legal tender. Staff recommends narrowing the scope of the Bitcoin law and urges strengthening the regulation and supervision of the new payment ecosystem. Like for other e-wallets, Chivo should be required to fully safeguard customers' funds, both in U.S. dollars and Bitcoin, by segregating and ring-fencing reserve assets. Stronger regulation and oversight of the new payment ecosystem should be immediately implemented for consumer protection, anti-money laundering and counter financing of terrorism (AML/CFT), and risk management. Banking regulation should incorporate prudential safeguards such as conservative capital and liquidity requirements related to Bitcoin exposure. Measures to limit fiscal contingent liabilities, such as winding down the trust fund or withdrawing public subsidies to Chivo, should also be promptly considered. Recently announced plans to use the proceeds of new sovereign bond issuances to invest in Bitcoin, and the implications of trading more broadly in Bitcoin, will require a very careful analysis of implications for, and potential risks to, financial stability.

Statistics and Accounting Frameworks

14. Upgrading the statistical and accounting frameworks are needed to better manage risks and enhance the decision-making process. Staff supports the central bank’s goal to report its financial statements based on the International Financial Reporting Standards (IFRS) and urges the implementation of IFRS standards for the entire banking system. Migration to the 2014 Government Finance Statistics manual (GFSM) with technical assistance from the IMF , Regional Technical Assistance Center for Central America, Panama and the Dominican Republic (CAPTAC-DR), is also planned. A sectorization of the nonfinancial public sector comprising all extra-budgetary entities and special purpose vehicles, including Chivo, should also be completed. Revisiting the coverage and adequacy of public debt statistics should be part of this comprehensive effort. The collection, classification, and separation of reporting of Bitcoin related transactions are needed to understand how the economy is impacted, closely monitor risks, and reclassify items in the future as needed.

The mission would like to thank the authorities and other counterparts for the warm, and productive discussions.

IMF Communications Department

PRESS OFFICER: Randa Elnagar

Phone: +1 202 623-7100Email: MEDIA@IMF.org