El Salvador: IMF Executive Board Concludes 2016 Article IV Consultation
El Salvador continues to suffer from significantly lower growth than neighboring countries amid low investment, high outward migration, weak competitiveness, and political gridlock. GDP growth has averaged 2 percent over 2000-2014, well below the Central American regional average of 4.5 percent.
Low oil prices helped growth and the current account improve in 2015 alongside low headline inflation. GDP grew 2.5 percent in 2015, up from 1.5 percent in 2014, supported by steady growth in the US, robust exports to the rest of Central America, and a stimulus from lower oil prices. Investment also increased significantly. Headline inflation was slightly negative (-0.7 percent). The current account deficit fell 1.5 percentage points to 3.5 percent of GDP.
The fiscal deficit fell by 0.1 percentage point to 3.4 percent of GDP in 2015. Fiscal expenditure remained broadly constant as a percent of GDP, with conservative increases in wages and lower energy subsidies. Capital expenditure remained subdued. Revenues were helped by the banking transactions tax (BTT) but were lower than expected. New taxes on telecommunications services and large enterprise profits were introduced in late-2015 to finance a needed increase in law enforcement and security spending. However, fiscal risks are rising. Reflecting a parliamentary impasse over approval to access external financing, domestic financing has risen sharply in 2015 and early 2016, pushing up yields on government short term domestic securities and raising the prospect of disorderly adjustment if the impasse continues.
The financial sector is stable but is exposed to the rising sovereign risks. Banking sector capital adequacy ratio remains substantially above the minimum statutory level of 12 percent. Provisioning is adequate, and asset quality continues to improve while liquidity appears ample. However, bank profitability is relatively low. Deposits and credit to the private sector grew by around 6 and 5 percent, respectively, in 2015 as corporate credit picked up and household credit slowed. Financial sector credit to the public sector, on the other hand, increased by nearly 15 percent and now accounts for about 35 percent of private financial system assets.
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). However, US growth is projected to decline over the medium term. Moreover, oil prices are expected to trend upwards over the medium term, tempering the recent boost to demand and causing the current account deficit to rise to 5.5 percent of GDP by 2021. The fiscal deficit is expected to widen to 5.5 percent of GDP over the medium term absent measures, reflecting pressures from wages, interest payments, security-related expenses, and public investment. Alongside, public debt is expected to exceed 70 percent of GDP by 2021.
Executive Board Assessment2
Executive Directors noted that while favorable external conditions and low oil prices have contributed to some improvement in the economic situation, El Salvador continues to suffer from low growth due to a host of complex issues, including low investment, high crime and emigration, and weak competitiveness. Directors underscored that ensuring fiscal and debt sustainability and raising potential growth will require strong policies and far-reaching structural reforms supported by broad political consensus.
Directors generally emphasized that frontloaded fiscal consolidation is needed to reverse the upward trajectory of public debt, entrench fiscal sustainability, and create space to fund the lender of last resort (LOLR) facility and fully implement the authorities’ crime prevention strategy. They highlighted that both revenue and expenditure measures will be important to deliver the required adjustment while safeguarding social spending safety nets. Introducing less-distortionary taxes will be helpful in this regard. Directors took note of the authorities’ initiatives to reform the pension system and called for further steps to adjust the system to include changes essential to ensure its long-run fiscal and social sustainability. A sound medium-term fiscal framework will be essential going forward.
Directors noted that the authorities have made good progress in financial sector reforms and encouraged them to implement the remaining reforms, including those aimed at addressing liquidity risks. They also highlighted the importance of increasing annual budget allocations for the LOLR facility and making further progress in risk-based supervision along with comprehensive legislative reform to strengthen the bank resolution and crisis management framework.
Directors emphasized that structural reforms will be key to increasing investment and fostering inclusive growth. They encouraged the authorities to enhance the flexibility of wages and prices, including by containing minimum wage increases, ease barriers to entry and competition, and curb anti-competitive practices in key sectors and improving the effectiveness of the Competition Agency. Efforts should also continue towards improving the business climate, developing human and physical capital, and reducing crime and corruption.