Public Information Notice No. 05/21

Public Information Notice: IMF Executive Board Concludes 2004 Article IV Consultation with El Salvador

February 14, 2005

On January 31, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with El Salvador.¹

Background

El Salvador has implemented a wide range of structural reforms over the last decade. Impressive reforms—including trade opening, privatization, and tax policy, civil service, and pension reform—have been supported by a broad national consensus. The reform effort was capped with official dollarization in 2001, which helped reduce interest rates and consolidated low inflation. This strategy has contributed to considerable improvements in per capita income and social conditions.

Nevertheless, economic growth in recent years has been dampened by adverse external conditions (including high oil prices), major earthquakes, and election-related uncertainties. Real GDP growth is estimated at about 1½ percent in 2004, while inflation picked up to over 5 percent, owing to higher oil prices. The public sector deficit is expected to decline to 3 percent of GDP in 2004 (from nearly 4 percent in 2003), although public debt remained at 45 percent of GDP and the debt of the nonfinancial public sector at 40.7 percent of GDP. A strong pick-up in family remittances more than offset the increase in oil imports, contributing to a decline in the external current account deficit to an estimated 4½ percent of GDP in 2004 (from 5 percent in 2003). International reserves remained around US$1.7 billion, covering close to 30 percent of bank deposits.

The new government that took office in 2004 has embarked on a renewed reform effort to improve growth prospects and social conditions. A recently approved package of tax measures, including steps to improve tax administration, is projected to raise revenue by about 1 percent of GDP. Because of budgeted increases in social spending and investment, however, the fiscal position in 2005 will remain about the same as in 2004 (i.e., a primary deficit of about 0.7 percent of GDP). Planned banking reforms (including tighter prudential norms and improved supervision) are aimed at further strengthening the banking system. congress recently ratified a free-trade agreement with the United States (CAFTA).

Executive Board Assessment

Executive Directors praised El Salvador's long-standing record of structural reform and commitment to sound macroeconomic policies, and considered that official dollarization has served El Salvador well. Prudent policies and political stability have underpinned economic growth, significant poverty reduction, low inflation, and increased market confidence as reflected in El Salvador's investment-grade credit rating. Directors noted, however, that major challenges remain. Central among these is the need to revive economic growth, which has been sluggish as a result of natural disasters, declining terms of trade, and the economic slowdown in the United States. In addition, Directors stressed that dollarization still presents significant challenges, and that additional efforts are required to ensure its sustainability. These efforts should focus on strengthening the public finances and achieving debt sustainability.

Against this background, Directors welcomed the new government's reform agenda designed to consolidate the economic gains and maximize the benefits of dollarization, improve growth and social prospects, reduce external vulnerabilities, and achieve the Millennium Development Goals. They supported the agenda's focus on fiscal consolidation and structural reforms to raise national savings and improve productivity and competitiveness. They put particular emphasis on efforts to deepen trade reform, address infrastructure bottlenecks, increase labor market flexibility, and improve incentives for private investment. Above all, Directors observed that it will be important to build society's support for the reform agenda.

Directors considered that moderate primary fiscal surpluses will be required to place the public debt firmly on a downward path. In this context, they endorsed the authorities' medium-term plans to substantially increase tax revenues, including by strengthening tax administration to reduce tax evasion, and welcomed congress' recent approval of a package of revenue measures. Most Directors considered that additional measures may be needed in light of plans to boost social and infrastructure spending. Apart from further steps to strengthen the revenue side, Directors also encouraged the authorities to improve public expenditure management—including through further pension reform, improved control over local government expenditure, better targeting of subsidies, and other measures recommended in the 2004 Fiscal Report on the Observance of Standards and Codes. At the same time, they welcomed the planned increase in social and infrastructure spending, while containing non-productive spending and the wage bill, noting that well-targeted social investment is crucial for building human capital. They also supported plans to involve the private sector in infrastructure projects. Directors welcomed recent reforms to the pension system, stressing at the same time the need for increases in the retirement age. Directors endorsed the authorities' debt management strategy, which aims at further lengthening maturities and reducing financing costs.

Directors welcomed the authorities' plans to make financial sector strengthening a priority in the coming years, including the restructuring of the central bank. They encouraged the authorities to push ahead with the planned transfer of the central bank's non-monetary liabilities to the government, in order to eliminate central bank liquidity risks and enhance fiscal transparency. Some Directors also recommended that the central bank develop further its lender of last resort function and raise net international reserves over the medium term.

Directors welcomed the findings of the 2004 Financial System Stability Assessment (FSSA) update, which indicate that the financial sector generally is in good health and that dollarization has strengthened financial stability. They commended the authorities' strategy for banking sector reform and the envisaged alignment of prudential rules with international best practice, in line with the FSSA recommendations. They stressed, in particular, the importance of plans to strengthen consolidated supervision—especially for cross-border activities—as well as the autonomy of the superintendency of banks and bank resolution practices. Directors also called for a strengthening of the two state-owned banks and the deposit insurance fund. They also considered enhanced access to financial services and financial literacy programs to be essential for raising the national savings rate and channeling El Salvador's significant remittance inflows into investment rather than consumption.

Directors welcomed congress' recent ratification of the Central American Free Trade Agreement. They supported plans to secure free-trade agreements with other important trading partners, but also stressed the importance of pursuing further trade integration within the framework of multilateral trade negotiations. They emphasized that enhanced competitiveness and productivity will be needed to enable El Salvador to take full advantage of trade and investment opportunities arising from these agreements. In this regard, Directors welcomed the steps being taken to maintain a prudent wage policy, while stressing that further labor market flexibility will be important to keep labor costs competitive. It will be important also to improve the environment for private investment, including by reducing crime and corruption, strengthening the legal and regulatory environment, and improving governance and transparency.

Directors welcomed the authorities' ongoing efforts to improve macroeconomic statistics in line with Fund recommendations. In particular, they commended plans to improve the national accounts and government finance statistics within a framework of strengthened inter-agency coordination and data sharing.