NEEDED CENTRAL BANK RESTRUCTURING NOT FORTHCOMING

UNCLAS SAN SALVADOR 001088

SIPDIS

SENSITIVE
SIPDIS

TREASURY FOR OTA
QUITO FOR D.TITUS

E.O. 12958: N/A
TAGS: ECON EFIN ES
SUBJECT: NEEDED CENTRAL BANK RESTRUCTURING NOT FORTHCOMING


1. (SBU) Summary. El Salvador adopted the dollar as legal
tender in 2001, but the Central Bank still maintains
institutional vestiges of a monetary authority, issuing
short-term and long-term debt and keeping on its balance
sheet more than $700 million in government debt. Completing
the institutional aspects of dollarization is a prerequisite
to making the Central Bank an effective lender of last
resort. Focusing instead on pension reform and maintaining
the country's split sovereign investment grade credit
rating, the Salvadoran Government is unlikely to take action
on this issue, despite recommendations that it do so in the
short term made by the International Monetary Fund (IMF) and
U.S. Treasury's Office of Technical Assistance (OTA). We do
not recommend further OTA assistance on this topic until the
Salvadoran Government demonstrates tangible progress on the
core recommendations first made in 2003 and effectively
reinforced in 2006. End Summary.


2. (SBU) A July 2005 IMF report on El Salvador's 2004
Article IV Consultations noted that the country has not
fully implemented the Monetary Integration Law that launched
dollarization on January 1, 2001. In particular, Article 11
of the law requires the Ministry of Finance to assume
outstanding Central Bank liabilities. Instead, the Central
Bank continues to issue short-term debt to meet operational
expenses, with $490 million currently outstanding, and it
also issues long-term debt, with $191 million outstanding.
The Central Bank also holds $704 million in illiquid long-
term government bonds. Finally, it is the custodian of the
banking sector's liquidity reserves, about $1.66 billion at
year-end 2005, to protect against deposit runs--these
reserves are also the Central Bank's foreign reserves. The
Central Bank debt and the government debt held by the
Central Bank are included in the IMF's estimate of total
public debt as a percentage of GDP, 46.2 percent for 2005.
Meanwhile, nonfinancial public debt for 2005 was estimated
at 40 percent.


3. (SBU) The July 2005 IMF report indicated that Salvadoran
officials had agreed to restructure the Central Bank's
balance sheet as envisaged in the dollarization law through
a plan approved by the Legislative Assembly in 2005 and
carried out over the next 2-3 years. A December 2004 IMF
Financial System Stability Assessment noted a similar
commitment from the Salvadoran government. Such
restructuring would improve transparency regarding
government debt policy, but is also a prerequisite to
converting the Central Bank into an effective lender of last
resort for the financial sector. The banks have access only
to their own liquidity reserves, and the Central Bank cannot
serve as a lender of last resort--it had a negative
liquidity mismatch of about $840 million by year-end 2005.


4. (SBU) Meanwhile, the Central Bank invited OTA to assess
its operations in 2003, with an eye toward shoring up
financial system vulnerabilities during a time of political
uncertainty, and OTA made specific recommendations on
cleaning up the Central Bank's balance sheet. A January
2006 OTA follow-up assessment found there had been no
progress on Central Bank restructuring, and recommended
again, among other things, gradually transferring the bank's
debt to the central government. Doing so would improve
transparency, but also give the Central Bank much-needed
liquidity.


5. (SBU) Central Bank First Vice President Marta Evelyn de
Rivera told econoff that the Central Bank and Ministry of
Finance are preparing a medium-term plan to implement the
OTA recommendations. She said in the short-term, however,
the Central Bank and Ministry of Finance would begin to
better coordinate their bond sales, and the Central Bank
would look to retire some debt used to finance the
Multisectoral Investment Bank (BMI),a state-owned
development bank. She said she felt pressured to show some
progress on these institutional issues in advance of IMF
consultations scheduled for May. She cautioned, however,
that dealing with the more difficult debt issues would take
more study and more time.


6. (SBU) Manuel Rosales, the Ministry of Finance's Director
of Public Credit and a top advisor within the government on
debt policy, reinforced the Central Banks's message telling
econoff recently that there were no plans to restructure the
Central Bank's balance sheet in the near future. Rosales,
who was well informed on conclusions of the IMF reports and
the OTA assessments, said this was an inopportune time to
deal with dollarization legacy issues. Highlighting the

work of an eminent persons group tasked by the government
and the G-14 (a center-left legislative coalition) to study
public debt issues, he stated categorically that there is no
debt crisis in El Salvador, but there are a number of thorny
issues that would challenge the government's ability to
maintain debt at a sustainable level over the next few
years. Dealing with those issues--rising pension costs and
pressure to increase spending on health and education--will
take priority over restructuring the Central Bank balance
sheet, Rosales said.


7. (SBU) Mauricio Choussy, Fitch Ratings' managing director
for Central America and a former Central Bank president,
also told econoff that El Salvador is unlikely to tackle
these Central Bank institutional issues in the near term.
Moving the Central Bank debt to the Ministry of Finance
would increase El Salvador's reported nonfinancial public
debt. Choussy said that Moody's, another influential U.S.-
based rating agency and the only one of the major agencies
to give El Salvador an investment-grade rating, has focused
on that measure of debt--not the financial public debt. He
reported that Moody's is looking to downgrade El Salvador,
but has been reluctant to do so without some change in the
status quo--consolidating the balance sheet would give
Moody's the excuse it needs. Choussy suggested there was
more at stake here than the price of Salvadoran Government
bonds. He cautioned that the banking sector in El Salvador
has been able to access cheap capital overseas riding on the
coattails of the government's investment-grade credit
rating. The banks would see the interests rates they pay
for offshore loans rise quickly, damaging their
profitability, and cutting-off a useful source of finance
for bank growth given falling savings rates in El Salvador.


8. (SBU) Roberto Rubio, a prominent center-left economist,
also suggested that now would be an inopportune time to
restructure the Central Bank balance sheet. In particular,
he pointed to ballooning pension costs that would challenge
the government's already tight fiscal position. Rubio, the
most well-known of the economists named to the eminent
persons group to study debt policy, suggested that the
government must focus on a second generation of pension
reform and look for ways to increase government revenue,
including new taxes such as a property tax.


9. (SBU) Comment: Government officials and independent
economists believe that, contrary to advice offered by both
the IMF and OTA, now is not the time to restructure the
Central Bank balance sheet. Until the Central Bank balance
sheet is restructured, the Central Bank is not a true lender
of last resort, and that task would fall on the central
government should a bank need more than its own prudential
reserves maintained by the Central Bank. Completing the
institutional aspects of dollarization would also make the
process harder to reverse in El Salvador, providing a strong
signal that the dollar is here to stay. OTA technical
assistance has been useful in focusing attention on the
issue, but we do not recommend further assistance until the
Salvadoran Government demonstrates tangible progress on the
core recommendations first made in 2003 and effectively
reinforced in 2006. End Comment.

Please visit San Salvador's Classified Website at
http://www.state.sgov/p/wha/sansalvador/index .cfm.

Barclay