OREANDA-NEWS. 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.

The IMF staff team visited San Salvador during April 25—May 6 for the 2016 Article IV consultation and held fruitful discussions with the Salvadoran authorities, parliamentarians, business community, academics, and social partners.

FOCUS OF THE ARTICLE IV: THE CHALLENGES OF INSUFFICIENT GROWTH

1. GDP growth has averaged 2 percent over 2000—2014, well below the Central American regional average of 4.5 percent. While the underlying causes of the low growth are complex, a key channel through which they are expressed appears to be low investment, which has averaged only 15.5 percent of GDP since 2000. Data gaps preclude strong conclusions, but the available evidence suggests that the likely culprits include: (a) political polarization; (b) high crime and outward migration; (c) rising unit labor costs and high logistics costs; (d) high exposure to natural disasters; (e) barriers to entry and expansion of business; (f) fiscal uncertainty; and (g) limited human capital.

2. For many of the candidate explanations El Salvador does not appear materially worse than its faster-growing neighbors. However, where El Salvador does stand out is in the inter-related forces of high levels of outward migration and violent crime. Most likely, it is the complex interaction of all of these factors that is at the core of the poor growth performance. Restoring sustained dynamic growth will therefore require action along multiple fronts.

3. The low-growth feeds a number of vicious cycles. It hinders efforts to reduce the high crime rate and improve educational attainment, it encourages outward migration and weakens labor force participation, and it creates fiscal pressures as social demands continue to increase while tax revenues remain subdued. El Salvador’s competitiveness problem has been exacerbated by the run-up in the U.S. dollar and the real effective exchange rate is now judged to be overvalued by around 10 percent.

4. Unfortunately, political gridlock is an obstacle to even incremental reform. The authorities’ 5-year plan appropriately puts growth as the overriding priority and many measures have been designed and pursued. There is broad agreement on the need to increase inclusive growth and public sector efficiency, and to reduce crime and corruption. However, the main political parties are far apart on how to achieve these objectives, resulting in a legislative stalemate which, itself, raises vulnerabilities.

OUTLOOK, AND RISKS

5. GDP growth is expected to be 2.3 percent in 2016 and 2.4 in 2017, falling over the medium-term toward a potential growth rate of 2 percent. There is some near-term upside risk if several significant investment projects get underway (notably a large gas project). Inflation is expected to remain subdued and the current account deficit is expected to slowly rise to 5.5 percent of GDP by 2021.

6. The fiscal deficit is expected to increase to around 4 percent of GDP in 2016 and widen further over the medium term without measures. Wage pressures, higher interest rates, additional security costs, and public investment projects are all expected to add to demands on fiscal resources. Public debt is projected to rise to above 70 percent of GDP by 2021.

7. Fiscal risks are rising. A parliamentary impasse that is blocking access to external financing has caused domestic financing to rise sharply in 2015 and early 2016, pushing up yields on short-term government securities. The tight financing situation has been making it more difficult to make timely payments to suppliers and exporters (for VAT refunds). EMBI spreads relative to other emerging markets have increased over the past six months and a recent Constitutional Court decision mandating an increase in interest rates on government bonds issued to pension funds would increase interest payments on new pension bond issuances.

8. The financial sector is stable but exposed to rising fiscal risks. Banking sector capital remains robust (16.7 percent of risk-weighted assets), substantially above the minimum statutory level of 12 percent. Provisioning is adequate (nearly 115 percent of NPLs) and asset quality continues to improve. However, bank profitability is relatively low, and credit to the public sector has been growing by nearly 15 percent.

9. Risks to the outlook arise from possible external shocks to international financial markets, a further upward move in the U.S. dollar, weak global growth, and the withdrawal of correspondent banking relationships by global banks. Domestic risks are largely concentrated in the fiscal area, particularly the near-term risk posed by the refusal of congress to approve access to external budget financing. On the upside, lower energy prices could have a bigger impact in supporting the economy and the balance of payments. Strong implementation of investment projects would also create an upside to growth.

FISCAL POLICIES

10. Without assertive fiscal consolidation public debt will continue to rise. We assess that a primary balance adjustment of 3 percent of GDP over 2017-19, with front-loading to lessen financing risks, is the minimum needed to reverse the upward debt dynamics. Going forward, more fiscal retrenchment will likely be needed, particularly given rising demographic pressures that will increase pension and health spending. The recommended fiscal adjustment would reduce growth below 2 percent in the short run. However, a more solid fiscal position, combined with vigorous structural reforms, would create the conditions for a quick rebound in growth toward 3 percent over the medium term. The authorities’ intention to undertake sustained fiscal adjustment of around 2.5 percent of GDP in the recently published Medium-term Fiscal Framework and the draft Fiscal Responsibility Law are steps in the right direction, but they need to be fully fleshed out and backed by specific effective measures.

11. Given the need to increase growth, revenue-raising measures should be accompanied by cuts in distortionary taxation. In line with this, our recommendations are to: raise the VAT rate to 15 percent; introduce property taxes; lower the corporate tax rate while reducing exemptions and loopholes; increase progressive taxation by introducing a wealth tax, taxing (highly inequitable) pensions, or increasing personal income tax on highest earners; consider reducing or eliminating the BTT and telecommunications tax, which have relatively low yield but hamper financial intermediation and inclusion, and; review all other taxes, phasing out those with low yield but high distortionary effects. Finally, ongoing efforts to boost tax collection should be pursued but carefully calibrated to avoid dampening the investment climate.

12. Durable consolidation will require addressing the sources of expenditure pressures. The wage bill has risen by 1 percent of GDP in the past 5 years, and is projected to rise by a further one percent of GDP by 2021 without measures. To contain this pressure, the generous wage indexation mechanism (escalafon) in the health sector needs to be eliminated, general wage indexation limited to increases below the rate of inflation, and nontransparent bonuses curbed. Also, hiring into the government sector—except law enforcement and security—should be significantly reduced. There is need to strengthen the efficiency of expenditure in other areas such as health and education services as well as rationalizing LPG, electricity, and transport subsidies. The space created from such measures could be used to increase public investment in infrastructure, continue to strengthen the social safety net (including with better targeting), and tackle crime.

13. There is also a need to upgrade the medium-term fiscal framework. This should include adopting a fiscal responsibility law (FRL) that:

    • Strengthens fiscal institutions, including by adopting strong procedures to increase transparency and comprehensiveness of budget presentation, improve forecasting and spending control, and reduce the upper limit on LETES issuance. Ideally, the regular budgetary process should also include an automatic approval of fiscal financing once there is congressional agreement on the broad budget parameters.

  • Includes formal numerical target(s) to entrench fiscal sustainability. A budget balance rule with well-designed countercyclical properties, incorporating a clear link to a prudent debt objective and corrective mechanisms to achieve it, could be appropriate for El Salvador’s political and economic circumstances. An expenditure-based rule, or a combination of rules, could also be viable options should they command bipartisan support. In either case, attention would be needed to ensuring a well-sequenced transition period before the rule becomes fully binding.

The authorities’ current draft FRL includes many of the above elements, including a combination of deficit-based and expenditure-based rules. It would be important to reach an agreement on the hierarchy of procedural and numerical rules that would be clear, receive broad political and societal support, and have good implementation prospects.

14. Pension reforms are essential. The transition to a fully funded defined contribution (DC) system has sputtered due to inadequate asset returns that have led the government to periodically top up and guarantee pension benefits. The pension deficit is currently about 2 percent and will rise substantially without policy change. Unfunded liabilities over the long run are estimated at around 100 percent of GDP in Net Present Value (NPV) terms, despite low coverage of the system and declining replacement rates. The authorities’ current reform proposal would (i) reverse some of the recent benefit top-ups, (ii) transfer to the public sector over half of contributions and private pension system assets (reducing measured deficits and debt), and (iii) offer lower-income contributors a flat pension. However, preliminary calculations suggest that it would not materially reduce the NPV of future unfunded pension liabilities.

15. Securing the sustainability of the pension system in the face of looming population aging pressures would require:

    • Parametric reforms to increase the retirement age and contribution rates (these are key to supporting long-term fiscal sustainability in the PAYG component and social sustainability in the DC component). Steps to better-align the number of years of contributions with benefits would also be important.

    • Greater coverage of the population through a means-tested expansion of the universal basic pension and incentive schemes and other steps to encourage labor force formalization.

  • A credible commitment to fund projected pension deficits from general revenue sources. The evolution of pension deficits over the long run would depend on the strength of the parametric reform package and coverage.

16. Differences over external financing should be reconciled. In the interests of El Salvador, the government and the parliamentary opposition should make every effort to resolve their disagreements over external financing as soon as possible. A failure to do so would create avoidable and unnecessary risks to the health of the economy.

FINANCIAL STABILITY, DEEPENING, AND INCLUSION

17. The authorities have made good progress on implementing the financial reforms including those recommended in the 2010 FSAP, the 2014 Financial Stability Strategy, and other Technical Assistance reports. Remaining steps include:

    • Fully dollarized economies face particular challenges in creating and maintaining a LOLR capacity. In its absence, institution-specific liquidity shocks could have systemic implications, while relying on high institution-specific buffers reduces the capacity of banks to lend to the economy. A plan for a liquidity fund based on a partial pooling of the banks’ liquid assets is being developed, which could be helpful in addressing non-systemic liquidity needs, but coordination and governance issues need to be fully resolved. We encourage the authorities to credibly increase annual budget allocations to the LOLR and resolve the remaining hurdles to establishing the liquidity fund in consultation with stake-holders. Given the key role of the central bank in the operation of the LOLR, its financial position should also be protected.

    • Regulation and supervision. Coordination between the financial supervisor and central bank has improved. Risk-based supervision is being implemented, and the implementation of Basel III has been initiated. The process of extending the supervisory perimeter to smaller and cooperative banks and savings and loans associations is ongoing and will need to be completed.

  • Bank resolution and crisis management. A first-best solution would be a passage of a comprehensive legislation that thoroughly addresses the key challenges. The authorities have developed a strategy to mitigate weaknesses while the legal solutions are being developed, which should be approved as soon as possible. In parallel, the authorities should expedite progress on the planned legal reforms which would make the Systemic Risk Committee permanent, strengthen crisis prevention and bank resolution authority and procedures, clarify procedures for the cooperative financial institutions, abolish the three-day notification to a bank before taking resolution measures, and strengthen legal protection for supervisors. Also, domestic interagency cooperation and coordination as well as cross-border cooperation should be strengthened with clear and comprehensive MoUs between relevant agencies. The preparation of contingent bank-by-bank recovery and resolution plans should be accelerated. Finally, the deposit insurance scheme should be strengthened by increasing bank contributions and protocols for its use in a crisis clarified.

18. Financial deepening and advancing financial inclusion could have a meaningful impact on both growth and poverty. Household access to financial services is relatively low with only 34 percent of individuals holding bank accounts. Steps to increase mobile banking and improve dispute resolutions mechanisms could boost the penetration of banking services, and in this regard the passage of the Financial Inclusion Law is an important step forward. However, recent legal changes limiting the acquisition, transfer, and storage of debtor information in credit bureaus increase credit risks and intermediation costs, and should be reconsidered. A modern law and improved corporate financial reporting standards are needed to support the expansion of the securities market, which could help pension funds increase returns and improve pricing and liquidity of government debt.

19. The authorities continue to work to maintain sound AML/CFT standards, and maintain active engagement with the US Treasury. Ensuring that the AML/CFT framework evolves in line with international standards will be important to prevent a loss of correspondent bank relationships. However, there is a need to undertake contingency planning to delineate the authorities’ response in the event of a broader loss of correspondent banking relationships.

SUPPLY SIDE REFORMS

20. Investment and inclusive growth can be improved by forging social consensus around sound policies that:

    • Enhance the flexibility of wages, given the fully dollarized economy. In this context, we believe that it would be advisable to contain minimum wage increases to low levels until there is clear evidence of rising productivity.

    • Ease barriers to entry and competition, curb anti-competitive practices such as price fixing in key sectors, and improve the staffing of the Competition Superintendency and the effectiveness of the sanctions that it can impose. Lowering entry barriers in transport and electricity sectors would help reduce utility and logistics costs.

    • Boost educational attainment (particularly for secondary and vocational education) by creating the necessary fiscal space for higher education spending and improving accountability for results.

  • Reduce crime and corruption—the authorities’ plan “For a Safe El Salvador” unveiled in early 2015, and recent follow-up plans, lay out a comprehensive strategy, but financing (estimated at 1.7 percent of GDP annually) is a key bottleneck.

We encourage the authorities to press on with their 2014–19 development plan which targets potential growth of 3 percent, taking advantage also of the FOMILENIO II grant from the U.S. and the funding for the “Northern triangle” countries to raise productivity and competitiveness.

OTHER

21. Finally, we welcome the authorities’ commitment to publish revised national accounts statistics with a methodology that more closely follows international best practices.

The mission would like to thank our counterparts for the excellent cooperation and warm hospitality we have received.