El Salvador IMF Mission Concludes Staff Visit

March 22, 2019

The IMF staff team visited San Salvador during March 11—22 for the 2019 Article IV consultation and held candid discussions with the current authorities, the President-elect, parliamentarians, business community, and social partners.

The strong economic performance is an opportunity to further strengthen the fiscal position. The government has laid the foundation for sustained growth, by implementing structural reforms, strengthening policy frameworks and facilitating a smooth political transition. Building on these achievements, the incoming administration should: (i) pursue fiscal consolidation to bring down public debt; (ii) step up reforms to improve public administration efficiency and lift long-term growth; and (iii) strengthen the governance framework to curb crime and corruption.

Context

1. The economy is performing well. Fueled by strong domestic consumption and investment, real GDP growth was 2½ percent in 2018, above the estimated potential of 2.2 percent. The primary fiscal surplus increased to about 1 percent of GDP driven by strong import tax revenues and one-off tax measures, including a tax amnesty. This improvement in the fiscal position was offset by the rising interest bill. The overall fiscal deficit deteriorated slightly to 2.7 percent of GDP and public debt (including pensions) reached about 70 percent of GDP at end-2018. Sustained social spending and a growing economy have resulted in a substantial improvement in social and human development indicators, including poverty and inequality, over the last decade.

2. In the near term, growth is expected to be closely aligned with the outlook for the U.S. and the global economy. In 2019, real GDP growth in El Salvador is expected to remain above potential and inflation to remain subdued due to the projected decline in oil prices. Sustained remittance inflows will compensate for a high trade balance deficit. In the medium-term, economic growth will converge to its estimated potential under unchanged policies. Downside risks to these projections stem from weaker-than-expected global growth, and domestic policy slippages if the new administration fails to secure political support in the Legislative Assembly. On the upside, global financial conditions may tighten less than expected.

3. A smooth political transition is currently underway. The new administration will take office on June 1. Reaching political agreements, especially with the parties dominating the Legislative Assembly, will be crucial for the successful implementation of the new government’s agenda.

Policy Messages

Fiscal Consolidation

4. Staff welcome the continued efforts to improve the fiscal position. The authorities’ fiscal consolidation efforts resulted in an improvement in the primary balance of 1.1 percent of GDP over 2017-18. Nevertheless, public debt is expected to drift upward under unchanged policies as the stock of debt is high, and the rate of interest is higher than the rate of economic growth. Additional measures are needed to consolidate the fiscal position and improve debt dynamics.

5. Staff recommend a primary adjustment of about 2 percent of GDP over 2019-20. The fiscal responsibility law (FRL) requires a 3 percent improvement of the primary balance over 2017-21. Staff recommend a frontloaded fiscal adjustment of 2 percent of GDP over 2019-20. This will help ensure compliance with the FRL and make some headway in reducing the high debt stock, the main vulnerability of the economy. Implementing this adjustment over 2019-20 would not stall the growth momentum, as fiscal multipliers—the impact on growth of the fiscal measures—tend to be lower during periods of economic expansion.

6. To achieve the primary adjustment target, revenue and expenditure measures are needed. On the revenue side, staff welcome the adoption of the electronic invoicing and the technical preparations for a simplified tax code for small businesses (“monotributo”). As the estimated yield of these tax administration measures are not sufficient to ensure compliance with the FRL, structural revenue measures are needed. Staff recommend introducing excise taxes on luxury goods and a limited increase in the VAT rate. Targeted fiscal transfers could be put in place to soften the regressive impact of the VAT increase on the most vulnerable in society. On the expenditure side, efficiency gains could be achieved by rationalizing current expenditure while protecting capital investment. Staff recommend containing the wage bill, and approving and implementing the civil service reform as quickly as possible. Additional measures comprise centralizing the procurement system and extending competitive bidding processes to the full set of public entities, and goods and services.

7. Staff recommend finding comprehensive and long-lasting solutions in the medium-term to address fiscal challenges. A comprehensive fiscal reform is needed to eliminate distortions arising from temporary and ad hoc measures accumulated over the years, and to expand the narrow tax base. A clear definition of responsibilities between the central and local governments in providing public infrastructure, along with an efficient delivery of public goods, is needed. These actions should be supported with adequate and permanent funding sources, accompanied by stronger accountability of local governments. Any reform proposal to address the fairness and equitability of the pension system should identify funding sources to avoid worsening the public debt dynamics and ensure fiscal sustainability.

Raising Long-term Growth

8. Maintaining financial stability is important to support long-term growth. This could be achieved by (i) approving the bank resolution legislation in line with best practices as soon as possible; (ii) ensuring that the reactivated interbank market functions smoothly to increase banks’ efficiency in managing liquidity and decrease the need for emergency liquidity and the burden on the public sector; (iii) promoting greater financial inclusion, by expanding access to fintech services and enhancing microfinance capacity, which could help intermediate remittances more efficiently and raise long-term output.

9. Bridging the public infrastructure gap and investing in education are critical to lift growth. Public-private partnerships (PPP) could be explored to limit the fiscal impact of improvements in infrastructure. The PPP framework should be strengthened by improving fiscal accounting, ensuring proper oversight, and clearly delineating responsibility and accountability of each partner. Investing in educational programs at the lower secondary level, including vocational training in partnership with the private sector, would help prepare youth for the labor market, and provide viable alternatives to crime and gang involvement.

10. Continuing to improve security will also have positive effects on investment and reduce migration. The rehabilitation and prevention efforts of the El Salvador Seguro plan have contributed to substantially lower the homicide rate. Ensuring its continuity and increasing its funding is important. Strengthening police presence at the local level and improving its deployment, based on a systematic analysis of crime trends, would deter criminal activity, including extortions. Expanding technological surveillance programs beyond San Salvador and fostering community involvement would also be effective deterrents.

11. Removing barriers to trade and investment, and facilitating diversification will also boost long-term growth. The regulatory improvements brought by the customs union and better infrastructure at border crossing points significantly reduced the costs and time in processing exports. To further enhance efficiency, staff recommend minimizing the processing time of acquiring permits, completing the adoption of electronic signatures, and simplifying the issuance of tax identification numbers. Staff recommend continuing with the implementation of the development, diversification and productive transformation policy as it has led to increases in productivity growth and shifted employment to higher productivity sectors in recent years.

Improving the Governance Framework

12. The current administration has adopted several measures to improve the governance framework, including anti-corruption measures. The former Attorney General has significantly strengthened investigation and prosecution activities to curb the illicit use of public funds at the highest level. The approval of the Attorney General’s law amendment establishing the independence and autonomy of the Financial Investigation Unit will enhance the capacity to thoroughly investigate corruption cases, by restoring the exchange of information with a worldwide network of financial investigative agencies. To support the anti-money laundering (AML/CFT) efforts, the Superintendency of the Financial System has put in place a system for high-frequency monitoring of financial flows. A plan has been developed and implemented by the Presidency to increase citizen participation in the design, implementation, and monitoring of public policies at the national and local level.

13. The governance framework should be strengthened further. Staff recommend the following actions: (i) increase the fiscal transparency of the 2020 budget law, building on the experience of the 2019 budget, and strengthen the audit of fiscal operations, and establish better spending controls to prevent the illicit use of public funds and misappropriations; (ii) promptly implement electronic invoicing to make it easier to conduct business activities and improve tax collection. Changes to the anticorruption legal framework should be comprehensive, ensuring harmonization of laws and considering their ultimate impact on the budget.