NS4540 Winter Term 2018 El Salvador Up-Date 2018 Oxford Analytica, El Salvador: Low Growth to Dog Economy in 2018 January 12, 2018

Overview Over last two decades El Salvador has lagged neighboring countries in economic growth performance Not the result of a single factor Instead the interaction of a range of political and economic problems that have resulted in insufficient levels of investment Between 2000 and 2014 real GDP growth grew by 2.0% compared to 4.5% for the whole Central American region Things have not improved since, with El Salvador looking set to fare poorly again in 2018

Central America Growth Patterns

Pattern of Low Growth Low growth has been driven by insufficient investment Gross capital formation has averaged 15.5% of GDP since 2000 Far below figures for Central America which have often topped 20% and reached 26.0% in 2016 El Salvador’s economic problems somewhat surprising During 1990s country embraced Washington Consensus Developed stronger state institutions than Guatemala and Honduras Inequality also lower than in other Central American countries – 0.41 compared with Costa Rica at 0.48

Causes of Slow Growth A series of unresolved political and economic shortcomings have nevertheless driven low GDP and investment growth These include High Migration Violence and Crime Low Competitiveness Political Gridlock and Fiscal Challenges

High Migration I IMF estimates that around 20% of Salvadorans live in U.S. Compared to fewer than 10% of nationals from any other Central American country High migration levels have led to a reduction in labor supply – particularly of young, potentially productive workers Although migrants generate large amounts of remittances – 17% of GDP in 2016, overdependence on such payments a major long-term problem Revocation in January 2018 of El Salvador’s Temporary Protected Status (TPS) by US Department of Homeland Security has increased migrant and remittance concerns Prospect of up to 200,000 Salvadorans having to return home.

High Migration II While such an influx could bring valuable skills to the economy, any benefits likely outweighed by loss of remittance income Considerable extra pressure on housing, the job market and public services. In reality not all those subject to TPS will return to El Salvador But if a fraction do, government will struggle to cope – many may become victims of gangs

Violence and Crime Gangs, strengthened by already poor employment opportunities have driven rampant crime rates In 2015 (last date of available data) there were 109 homicides per 100,000 people in El Salvador – more than in any other reported country. Dialogue with gangs in 2012 was initially successful, but ultimately failed due to insufficient political consensus and electoral backing Government’s recent tough approach has not reduced crime significantly and has been widely criticized. Continued insecurity Affects labor supplies Necessitates excessive spending on security measures and Reduces incentives for investments

Low Competitiveness I El Salvador Suffers a lack of investment in human capital Many obstacles to starting a business and Corruption is high Nevertheless its competitiveness profile is similar to that of neighboring countries In the World Bank’s Doing Business 2018 report, El Salvador ranks above Guatemala, Nicaragua and Honduras.

Low Competitiveness II

Low Competitiveness III

Low Competitiveness IV

Low Competitiveness II More significant problem in this area is the management of the exchange rate Dollarization of the economy in 2001 contributed to macroeconomic stability, but also caused overvaluation IMF feels the overvaluation of the real effective exchange rate is around 10% Leads tp expensive exports and cheap imorts Impact of dollarization in Panama – Central America’s only other dollarized economy has been more positive because of its reliance on financial services and incme from the Panama Canal

Economic Elites I Salvadoran elite is probably the most internationalized in Central America Power family business groups have invested in Real estate Tourism and Trade Within the region and beyond Other members of the elite have sold their domestic business altogether and moved their money abroad Business groups sold their participation in the banking sector to international companies El Salvador now has no domestically owned banks.

Economic Elites II This business strategy negatively affects economic growth in a number of ways, by: Contributing to the low investment rate as some of the wealthiest business conglomerates invest their profits abroad and The foreign-owned financial sector is not particularly focused on domestic growth Reducing the elite’s commitment to solving some of the country’s worst problems including low wage growth, excessive migration and igh crime rates, and Limiting El Salvador’s capacity to invest in research and innovation and discover new products

Political Gridlock and Fiscal Challenges I Since the signing of the peace accords after El Salvador’s civil war (1980-92) the political system has been dominated by two polarized parties with quite different agendas Farabundo Marti National Liberation Front (FMLN) and The Nationalist Rebublican Alliance (ARENA) As neither has suatained a majority in Congress in recent years, implementing consistent policies has become increasingly difficult Political gridlock is a particular problem in the fiscal area. The public deficit has remained above 3.5% of GDP in recent years and public debt has increased steadily

Political Gridlock and Fiscal Challenges II Part of the problem is the pension system that has increased the financial demands on the Salvadoran state significantly. At the same time, pension fund returns have been insufficient, partly due to ineffective investment rules. A fundamental reform of the pension system is urgently needed, but unlikely

Assessment I None of these factors independently explains El Salvador’s poor growth performance Migration and violence are nearly as high in Honduras as in El Salvador Political paralysis is also a problem in Guatemala and Costa Rica and Low competitiveness and fiscal shortcomings are a bottleneck in several countries It is the combination of all these problems that complicates matters for El Salvador

Assessment II Specifically High levels of migration together with dollarization have led to an overvalued exchange rate which Has reduced employment opportunities feeding Crime and violence while Political gridlock and the preferences of the economic elite make policy change particularly difficult If El Salvador is to move on from it low growth equilibrium it will require drastic measures such as The introduction of a new national currency The rapid expansion of research and development and The establishment of political dialogue on key areas, including pensions

Assessment III With all such possibilities highly unlikely in the short-to-medium term, the economy looks set to sffer for some time. Summing up Economic growth is likely to remain subdued in the short-to medium term perpetuating low employment creation and sustained violence Neither political system nor economic elite is likely to find ways to collaborate towards a new growh agenda. Fiscal consolidation and market-friendly reforms alone cannot resolve the deep structural obstacles that hinder the economy.