CAFTA BRINGS HOPE TO SLUGGISH SALVADORAN ECONOMY

UNCLAS SECTION 01 OF 03 SAN SALVADOR 002541

SIPDIS

STATE PASS AID/LAC
USDOC FOR 3134/USFCS/OIO/WH/MKESHISHIAN/BARTHUR
USDOC ALSO FOR ITA/MAC/MSIEGELMAN

E.O. 12958: N/A
TAGS: ECON ETRD EINV ES CAFTA
SUBJECT: CAFTA BRINGS HOPE TO SLUGGISH SALVADORAN ECONOMY

REFS: A) San Salvador 587, B) 2004 San Salvador 3181

Summary
--------------

1. GDP grew by a lackluster 1.6 percent during the first
quarter of 2005. Official data have not been released yet
for the second quarter, but a Central Bank indicator based
on real production data suggests that the economy continued
to perform poorly. High oil prices are taking a toll on
economic activity, and the government lowered its forecast
for 2005 GDP growth from 2-3 percent to 1.5-2.5 percent.
CAFTA ratification has improved expectations for economic
growth, but whether that promise is delivered depends on how
well El Salvador takes advantage of not only CAFTA-DR's
trade benefits but opportunities for institutional reform as
well. End summary.

Lackluster Economic Growth
--------------

2. The Central Bank reports the economy grew at an annual
rate of 1.6 percent during the first quarter of 2005, not
much better than the 1.5 percent growth reported during the
last quarter of 2004. For the second quarter of 2005,
official data have not yet been released, but the Central
Bank's Index of the Volume of Economic Activity (IVAE),
based on real production data, suggests that the economy
continued to perform poorly. Overall, the IVAE shows a 1.1
percent fall in economic activity for May and 1.8 percent
fall for April. Think-tank Foundation for Economic and
Social Development (FUSADES) recently released its second
quarter economic report, which also reported that growth was
weak during the quarter. High oil prices are taking a toll
on economic activity overall, and the Central Bank lowered
its forecast for 2005 GDP growth from 2 to 3 percent to 1.5
to 2.5 percent.


3. Looking at the economy sector by sector, performance
remains poorest in the construction sector, where the IVAE
showed a 21.3 percent contraction. The retail sector was
flat during the second quarter according to the Central Bank
indicator--FUSADES' survey of businesses confirms this
result. Meanwhile, the agricultural sector continued to post
positive results, thanks to favorable international prices
of the traditional crops, coffee and sugar. Other sectors
showing expansion were financial services, transportation,
and energy.


4. As in previous FUSADES surveys, businesses blamed higher
energy costs for the deceleration in economic activity.
Crime has also become a significant factor according to
survey respondents (septel). For the first time in more than
a year, businesses surveyed by FUSADES have a negative
perception of the investment climate, and consumer
confidence is weak as well. The FUSADES survey was completed
prior to the U.S. passage of CAFTA-DR, however, so these
survey results may not reflect current sentiment.

Formal Employment Growing Slowly
--------------

5. The FUSADES survey of local businesses shows that formal
sector employment may have grown by as much as 2 percent
during the second quarter of 2005. The number of maquila
workers, about 16 percent of total social security
contributors, fell by 8 percent, while the number of workers
in other sectors increased by 5 percent, offsetting the
maquila decline. What is unclear, however, is whether there
were actually new jobs created during the period, or more
previously informal employment is now covered under Social
Security--either would be a welcome development.

High Oil Prices Drive Inflation
--------------

6. The inflation rate during the second quarter of 2005
increased slightly over the first quarter of the year.
Ministry of Economy data show a 2.1 percent rate for April
and a 2.9 percent for May and June. Annual inflation for the
period ending June 2005 reached 5.1 percent, well above the
previous year's rate of 2.8 percent. Oil prices are the main
factor behind price increases during the period. In response
to U.S. Federal Reserve Bank rate increases, lending rates
for short-term loans increased by 6.9 percent during the
second quarter, but for loans over one year they only
increased by 0.6 percent. Deposit rates have shown a more
mixed behavior, with some increasing and some diminishing.
Excess liquidity in the system and low levels of economic
activity have helped to maintain these rates relatively
stable.

Trade Deficit Growing
--------------

7. The trade deficit grew by 11.5 percent between January
and June of 2005, reaching $1,543.5 million. Total exports
grew by 7.3 percent, while imports increased by 9.3 percent.
The increase in exports was led by nontraditional goods such
as ethnic foods, tuna and packaging materials, which
increased by 10.4 percent to $700 million, and also by the
recovery of traditional exports, which increased by 42.9
million up to $156.6 million. Coffee exports grew by 37.7
percent due to the recovery of coffee prices. Sugar exports
also benefited from good international prices and a larger
demand increasing by 28 percent. Maquila exports grew by
only 1.1 percent to $883.8 million.

Remittances Continue Steady Growth
--------------

8. Remittances have continued their steady growth, reaching
$1,379.3 million by the end of June of 2005, 14.3 percent
higher in relation to the same period of 2005. With the
reduction of the Hispanic unemployment rate in the United
States, remittance flows are expected to continue to perform
well during the rest of the year and eventually surpass the
$2.7 billion mark by December 2005.

Tax Reforms Bolster Government Revenues
--------------

9. Fiscal reforms implemented in January 2005 (Ref. B) have
led to a substantial increase in tax revenues during the
first half of 2005, up 16 percent in relation to the first
half of 2004; revenues reached $1,145 million, $48 million
higher than expected. VAT revenues grew by 13 percent,
reaching $579.9 million. Income tax revenues increased by
21.1 percent, up to $422.3 million. FUSADES projects that
under certain assumptions tax collection could grow to 12.6
percent of GDP by the end of 2005.


10. FUSADES' quarterly report highlights the budget pressure
created by pension costs and rising international interest
rates. Although impressive, the increase in tax collection
will not be enough to service existing debt for 2005. By
June 2005, the fiscal deficit was an accumulated $53
million, higher than the $23 of the previous year, and
public debt as a percentage of GDP climbed to 44.3 percent
of GDP. However, with municipal and legislative elections on
the horizon, it is unlikely the government will either cut
spending or increase taxes until Summer 2006.

High Hopes for CAFTA-DR Trade Benefits
--------------

11. Optimism--although tempered by rising oil prices--is the
rule among government officials and the private sector now
that CAFTA-DR is law in the United States. CAFTA-DR is
viewed as the panacea for the sickly Salvadoran economy; it
will boost exports, generate new employment, and attract
foreign investment. Government officials, especially at the
Ministry of Economy, are energized and actively working to
assist exporters in taking advantage of CAFTA-DR trade
benefits. The government is working toward implementation of
CAFTA-DR in anticipation of the January 1, 2006
implementation date. Long before CAFTA-DR ratification, the
government had instituted a comprehensive trade capacity
building program, with the aid of international donors,
especially USAID.


12. Federico Colorado, President of the National Association
of Private Businesses (ANEP),which represents big business,
said after passage that CAFTA-DR is what the country needed
to push economic growth: "There were firms waiting for the
signature of the agreement to invest in the country. This
agreement will have an impact in many aspects--investment,
employment generation, and wealth--in a very positive way."
Ricardo Esmahan, President of agricultural sector
organization CAMAGRO, is also looking at the bright side,
and he recently said that CAFTA-DR is a valuable opportunity
for the country, but the challenge is how to take advantage
of it. Maximiliano Portillo, representative of a small
business association, called on his members to be prepared
to export to the U.S. market and take advantage of the
opportunities offered.

Comment: CAFTA-DR Institutional Reform also Essential
-------------- --------------

13. Trade benefits under CAFTA-DR are the most tangible
aspect of the agreement, so it is understandable that
Salvadorans focus on them. In the long term, however, much
of CAFTA-DR's promise for El Salvador lies in the
institutional changes that it could bring about. Post is
working to remind Salvadorans that CAFTA-DR's potential to
transform the Salvadoran economy also requires faithful
implementation of provisions related to telecommunications,
banking, and electronic commerce, environmental and labor
rights, intellectual property rights, investment, and
dispute resolution. So far, we are encouraged by the
commitment demonstrated by the government, especially in the
Ministry of Economy.


14. The United Nations Development Program (UNDP) recently
released its human development report, which warns that
pursuing export-led growth--without complementary measures
to improve the competitiveness of the country--has produced
poor economic results for El Salvador. UNDP argues that El
Salvador's export-led growth strategy introduced in 1989,
combined with dollarization and the immigration/remittances
flow, eroded the country's export competitiveness by pushing
up the real exchange rate. The lesson we hope the
Salvadorans will take away from this report is not that they
should abandon export-led growth, but that they should do so
while also pushing forward with "second generation" economic
reforms needed to make their private sector more
competitive, especially in the financial sector to improve
access to credit (Ref. A) and in the judiciary to resolve
commercial disputes fairly and quickly. We hope CAFTA-DR
implementation will give them the political cover they will
need to undertake these difficult reforms. End comment.

BARCLAY