Mission Concluding Statement 

El Salvador: Staff Concluding Statement of the 2023 Article IV Mission

February 10, 2023

Washington, DC: An International Monetary Fund (IMF) mission, led by Mr. Raphael Espinoza, conducted virtual discussions during January 26-27, and visited San Salvador during January 30-February 8 for the 2023 Article IV consultation. At the end of the visit, the mission issued the following statement:

Economic Developments, Outlook and Risks

Policies to strengthen medium-term growth are a cornerstone of the government’s economic plan. Reforms to raise the growth potential are being implemented aimed at improving security (Plan Control Territorial), diversifying the economy (e.g., by promoting tourism through Surf City), reducing trade costs, and shortening the time needed to perform administrative tasks . Spending on education has risen (from 3.6 to 5.0 percent of GDP between 2019 and 2022) and efforts are underway to develop citizens’ digital skills by partnering with fintech firms. The positive and sustainable impact of these reforms hinges on efforts to strengthen macroeconomic stability.

Despite adverse shocks, the Salvadorean economy grew at a robust pace last year. The economy is estimated to have expanded by 2.8 percent in 2022, driven by domestic demand. The full recovery of activity from pre-pandemic levels was driven by the effective government response to the health crisis. Since March 2022, the unprecedented reduction in crime, and strong remittances and tourism revenues have contributed to the robust activity and investment dynamics. Meanwhile, annual average inflation reached 7.2 percent last year.

However, vulnerabilities have mounted in 2022 . The current account deficit is estimated to have risen to about 8 percent of GDP, on account of weaker terms of trade and import volume growth. While the overall fiscal deficit narrowed to about 2.5 percent of GDP, international reserves fell to around 2 months of imports, and the stock of short-term domestic debt stands at 8¾ percent of GDP. With the payment of a Eurobond in January 2023, EMBI spreads have continued dropping, but the Treasury still lacks access to international capital markets.

Under the baseline, growth is projected to moderate and macroeconomic imbalances will remain. Real GDP is projected to grow by 2.4 percent in 2023, above historical average, driven by private consumption, public investment and tourism, with average annual inflation moderating to 4.1 percent, on account of weaker global commodity prices. Improved terms of trade are expected to support some narrowing of the current account deficit this year, although it will remain high at 5.4 percent of GDP, and fiscal policy will be expansionary. Under a baseline without market access, short-term government debt is expected to grow, preventing the restoration of adequate reserve buffers.

In this context, risks to the outlook are high and tilted to the downside. On the external front, a pronounced slowdown in the United States could undermine exports and remittances, especially if the U.S. labor market cools. A drop in net private capital inflows could force a sharper correction of the current account, with negative implications for growth. On the domestic side, policy slippages could weaken investor confidence, and liquidity shocks could dampen private sector credit and growth. Shocks due to climate change and other natural disasters cannot be discarded. On the upside, the improvement in the security situation could lead to a stronger-than-anticipated boost to private investment and growth, reduce emigration, and encourage the return of migrants.

Fiscal Policy

Developing a comprehensive and ambitious fiscal and financing plan aimed at bringing debt back to a sustainable path and at facilitating international capital market access is the top priority. Public debt has fallen to 77 percent in 2022, but it remains high and is on an unsustainable path. However, efforts must continue to achieve its sustainability in the medium term. Against this backdrop, a growth-friendly and inclusive fiscal consolidation is needed, backed by structurally-sound measures amounting to around 3½ percent of GDP over the next three years, that boosts market confidence and protects priority social and infrastructure spending. The consolidation will need to be complemented with a comprehensive financing plan that gradually rebuilds reserve buffers, avoids overreliance on short-term domestic debt, and returns to international capital markets at lower costs over the medium term.

Starting this year, further efforts are needed in developing a balanced and well-articulated set of measures to support consolidation. While the approved 2023 budget keeps spending unchanged in real terms, more is needed to address financing constraints, in the context of projected declines in revenues. Key areas of focus include:

• Tax revenues . Following a period of cyclically high revenues, achievements of the anti-evasion plan should be preserved, and consideration should be given to increasing consumption tax rates.
• Public wage bill . Despite some efforts to reign in the wage bill in the 2023 budget, compensation spending is still projected to exceed 11 percent of GDP. As such, consideration should be given to repealing special wage indexation mechanisms and to a civil service reform that strengthens the link between qualifications and compensation, and right-sizes public employment.
• Energy subside s . While positive steps have been taken to unwind the 2022 gasoline and diesel price freeze (costing 1¾ percent of GDP), consideration should be given to eliminating the universal LPG subsidy ( Fondo de estabilización) and improving the targeting of the voucher-based LPG subsidy (Tarjeta solidaria). To strengthen controls and limit leakages, the capacity of the newly created subsidy unit in the Treasury should be developed.
• Pensions: Given demographic trends, strengthening the incentives and financial sustainability of the pension system remains necessary to limit contingent liabilities and encourage capital market development. In this regard, features of the pension system, following the recently enacted pension reform, should be assessed regularly based on a new independent actuarial study. Specifically, the 30 percent increase in pension entitlements will accelerate withdrawals from capitalization accounts and will likely result in larger Treasury liabilities over the medium term. Similarly, while the proposed debt exchange between the old bonds issued by the Fideicomiso de Obligaciones Provisionales (FOP) and the new bonds issued by the Instituto Salvadoreño de Pensiones (ISP) could provide some temporary Treasury cashflow relief, it would reduce the funds available for private investment and exacerbate the fund’s concentration in public sector securities. Importantly, the reform could create large contingent liabilities as the new law grants a blanket public guarantee for all pension-related claims.

Financial Sector Issues

The banking sector remains healthy, but timely measures are required to rebuild financial stability buffers. With most COVID-based forbearance measures lifted, bank solvency and asset quality have proven resilient, with NPLs at 1.8 percent. However, and in the context of financial constraints, reserve requirements have been halved since 2019, and system-wide liquidity buffers have decreased. As a result, banks’ exposure to the government has risen, reaching 11.1 percent of total bank assets. The proposed fiscal consolidation and financing plan, along with regulatory reforms restoring reserve requirements to at least 15 percent of deposits would strengthen bank liquidity buffers without undermining private credit. These should be complemented by approval of the Financial Stability Bill, efforts to recapitalize the central bank, and an overhaul of the legal framework for cooperative banks. The central bank payments infrastructure (Transfer 365) is rapidly improving retail payments with high potential for financial inclusion.

Bitcoin’s risks should be addressed. While risks have not materialized due to the limited Bitcoin use so far—as suggested by survey and remittances data—its use could grow given its legal tender status and new legislative reforms to encourage the use of crypto assets, including tokenized bonds (Digital Assets Law). In this context, underlying risks to financial integrity and stability, fiscal sustainability, and consumer protection persist, and the recommendations of the 2021 Article IV remain valid. Greater transparency over the government's transactions in Bitcoin and the financial situation of the state-owned Bitcoin-wallet ( Chivo) remains essential, especially to assess the underlying fiscal contingencies and counterparty risks.

Financing purchases of Bitcoin by issuing tokenized securities should be eschewed because of fiscal risks. Given the legal risks, fiscal fragility and largely speculative nature of crypto markets, the authorities should reconsider their plans to expand government exposures to Bitcoin, including by issuing tokenized bonds. The use of proceeds by the new Bitcoin Fund Management should follow regular expenditure controls and good governance practices. The guarantees given by new Digital Asset Law should be equivalent to those from traditional securities regulations.

Governance Issues

Strong governance, fiscal transparency, and accountability are critical to improve resource management, lower borrowing costs, and build trust.

• Fiscal transparency. Audits on pandemic-related emergency spending financed by the 2020 IMF Rapid Financing Instrument and the IDB emergency loan should be finalized in 2023. Chivo should be audited and the audit of the Bitcoin trust fund (FIDEBITCOIN) will be completed soon. Fiscal transparency standards in place before the suspension of the Fiscal Responsibility Law should be returned to the same level that existed prior to the start of the pandemic. Specifically, medium-term macro-fiscal and financing plans should be published, and reporting fiscal statistics should be aligned with international standards.
• Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT), anti-corruption, and procurement. The alignment of the Act of Illicit Enrichment of Public Officials and the Criminal Code with standards set by the United Nations Convention Against Corruption, the Financial Action Task Force, and the G20 is nearly completed. The revised AML/CFT legislation—which includes additional rules for Virtual Asset Service Providers (VASP)— is being aligned with the country’s national risk assessment and this work should be promptly finalized. The Financial Intelligence Unit is ramping up its institutional capacity to be able to properly monitor and investigate suspicious activities, including in VASPs. The proposed public procurement law, which requires the reporting of beneficiary ownership information, has the potential to improve the efficiency of public spending. The conditions under which special procurement frameworks can be approved should be tightened. Efforts should continue in protecting judicial independence and in ensuring impartial access to the court system to attract investment and enhance El Salvador’s business climate.

The mission thanks the authorities and other counterparts for their hospitality, constructive policy dialogue, and productive collaboration.