Identifier
Created
Classification
Origin
06SANSALVADOR1910
2006-08-02 14:23:00
UNCLASSIFIED
Embassy San Salvador
Cable title:  

SALVADORAN ECONOMY GROWING, BUT STRUCTURAL PROBLEMS

Tags:  ECON EINV ES 
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VZCZCXYZ0051
RR RUEHWEB

DE RUEHSN #1910/01 2141423
ZNR UUUUU ZZH
R 021423Z AUG 06
FM AMEMBASSY SAN SALVADOR
TO RUEHC/SECSTATE WASHDC 3275
INFO RUEHZA/WHA CENTRAL AMERICAN COLLECTIVE
RUCPDOC/USDOC WASHDC
RUEATRS/DEPT OF TREASURY WASHINGTON DC
UNCLAS SAN SALVADOR 001910 

SIPDIS

SIPDIS
STATE PASS AID/LAC AND OPIC
USDOC FOR 4332/ITA/MAC/WH/MSIEGELMAN
3134/ITA/USFCS/OIO/WH/PKESHISHIAN/BARTHUR

E.O. 12958: N/A
TAGS: ECON EINV ES
SUBJECT: SALVADORAN ECONOMY GROWING, BUT STRUCTURAL PROBLEMS
REMAIN

REF: A. SAN SALVADOR 1719, B. SAN SALVADOR 0353, C. SAN SALVADOR

0090

Summary
-------
UNCLAS SAN SALVADOR 001910

SIPDIS

SIPDIS
STATE PASS AID/LAC AND OPIC
USDOC FOR 4332/ITA/MAC/WH/MSIEGELMAN
3134/ITA/USFCS/OIO/WH/PKESHISHIAN/BARTHUR

E.O. 12958: N/A
TAGS: ECON EINV ES
SUBJECT: SALVADORAN ECONOMY GROWING, BUT STRUCTURAL PROBLEMS
REMAIN

REF: A. SAN SALVADOR 1719, B. SAN SALVADOR 0353, C. SAN SALVADOR

0090

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

1. Despite adherence to Washington-consensus policy
recommendations, economic growth in El Salvador has been an
unimpressive 2.5 percent over the last decade. The economy is
picking up, however, with Central Bank data showing 3.2 percent
growth for the first quarter of 2006 and forecasted 3.5 percent for
the year. While natural disasters and weak rule of law are no doubt
partly responsible for this poor economic performance, structural
problems that limit El Salvador's export competitiveness may also be
to blame for slow growth. End summary.

Economic Growth Picking Up
--------------

2. After a decade of GDP growth that averaged 2.5 percent, barely
keeping up with population increases, the Salvadoran economy is
showing signs of life again, registering 2.8 percent GDP growth in
2005 and 3.2 percent for the first quarter of 2006. The Central
Bank estimated GDP growth for 2006 to average 3.5 percent for 2006;
the bank's index of economic activity suggests that growth may be
even higher.


3. FUSADES, a well-known Salvadoran think tank, agrees with the
Central Bank estimate and is also forecasting 3.5 percent growth.
In its most recent economic survey, FUSADES reported that sales were
up for most business during the first quarter of 2006 and business
confidence is high. The firms surveyed were optimistic about the
investment climate, identifying CAFTA-DR as the primary factor
behind this positive outlook, and most said they would expand their
businesses this year. The number of participants in the Social
Security health care system is another good indicator of positive
economic trends in El Salvador--an increase suggests growth in
formal sector employment. From February 2005 to February 2006 the
rolls increased by 3.9 percent, from 492,140 formal-sector jobs to
511,504 jobs.


4. Growth so far in 2006 has been spread evenly among most sectors,
with the construction and transportation sectors expanding most,
showing 5.8 percent and 5.2 percent, respectively, according to the
Central Bank. Growth in the construction sector, which averaged 3.4

percent in 2006, is boosted by housing development and large
infrastructure projects such as the port being built in La Union.
Meanwhile, transportation services grew in large part due to
increased business at the container port of Acajutla but also thanks
to an overall up-tick in economic activity.


5. Real estate and services, aggregated in Central Bank data,
showed 4.6 percent growth in the first quarter of 2006 while
financial services grew 4.8 percent. Despite dollarization,
increases in international interest rates have not been completely
transmitted to local interest rates. The rate for loans up to a
year increased from 6.95 in March of 2005 to 7.4 percent in March of
2006, only a 0.5 percent increase. Local interest rates remain low,
thanks to excess liquidity caused by low local credit demand and
strong competition among local and nonresident banks. Meanwhile,
Salvadoran banks continue to grow regionally and in the United
States.


6. Agriculture, which grew by 5.8 percent in 2005 despite flooding
caused by Hurricane Stan, posted 3.8 percent growth in the first
quarter of 2006. Favorable international prices for coffee and
sugar, as well as new investments in poultry and cattle, contributed
to these positive results. Also important was the expansion of
fruit and vegetable cultivation for domestic consumption, an
investment supported by USAID. Growth in the sector for 2006 is
forecast at 6 percent, with the expectation that coffee and sugar
prices will continue to increase and cotton cultivation will rebound
from crop damages caused by Hurricane Stan in 2005.


7. Among the few sectors that lagged behind was manufacturing,
which grew by only 1.5 percent in the first quarter, reflecting
losses in the apparel (maquila) sector but growth in other light
manufacturing. For the maquila sector, staggered CAFTA
implementation, with El Salvador coming on board with the United
States March 1, and Honduras and Nicaragua a month later, proved to
be a mixed blessing. Salvadoran assembly operations saw their
inputs from the latter two countries suddenly ineligible under
CAFTA-DR rules of origin. Many firms shifted production to Honduras
and Nicaragua and stockpiled inputs from the United States. There
were as many as 4,000 job losses in March 2006, and garment exports
contracted by 10 percent during the first quarter of 2006. Contacts
in the sector report that operations have recovered, and firms
continue to focus on full-package production, a business model that
has proven successful so far in competing with China and other

low-cost producers.

Inflation Stable Despite Oil Price Increases
--------------

8. Despite increasing oil prices, inflation remains stable, at
about 3.8 percent (annualized) for the first three months of 2006.
Inflation for 2005 was only 4.3 percent, the lowest in the region.
Price increases have hit the transportation sector hardest, and bus
fares were recently increased to reflect higher operating costs.
The Salvadoran Transportation Association now estimates that fuel
costs are 60 percent of operating costs for truck owners. Thermal
plants generate about 50 percent of El Salvador's electricity, and
high oil prices have prompted the government regulator to allow
distributors to raise rates by 14 percent. Meanwhile, generators
and distributors are working with the government to implement
regulations for purchasing power through long-term contracts, as
well as selling power on the wholesale market using a cost-based
model, to help stabilize energy costs and encourage new investment.


Comment
--------------

9. After the civil war, El Salvador aggressively launched a
Washington-consensus economic model that included trade
liberalization, cuts in government spending, privatizations, pension
reform, and dollarization. While some Salvadorans are quickly
taking advantage of CAFTA-DR business opportunities (Ref. A),
President Saca has launched several other initiatives to kick start
economic growth. However, these efforts do not stray far from the
laissez-fare course set by his ARENA predecessors.


10. Focusing on converting El Salvador into a logistics and
transportation hub for Central America, the government is
strengthening the Customs Administration's role as a trade
facilitator rather that revenue collector. There has also been
progress in improving the country's trade infrastructure both at
seaports and at the airport. To promote tourism, a new Tourism Law
established tax incentives for investment in tourism infrastructure
(Ref. C). Meanwhile, industrial policy has focused on improving
competitiveness by streamlining the role of government and reducing
transaction costs in addition to direct subsidies to promote the use
of cutting-edge technology in industrial processes. Initiatives to
promote further growth in the financial sector, although delayed,
have focused on streamlining the supervision of financial
conglomerates and establishing improved legal frameworks for
securitization, venture capital, or leasing.


11. Over the last decade, however, real economic growth has
averaged only 2.5 percent, barely enough to keep up with population
growth. Over the last five years, foreign investment has averaged
only 1.5 percent of GDP. Meanwhile, the trade gap continues to grow
and for the first half of 2006 was $1.9 billion, up from $1.6
billion the year before. There is no doubt that the back-to-back
earthquakes in 2001, a fall in world prices for coffee and sugar,
and an increase in violent crime have had a significant impact on
growth here, but many Salvadorans are concerned it is the economic
model--now pursued by four consecutive ARENA governments-- that is
flawed. That the economy grew by 3.5 percent is good news, but
there is still plenty of room for improvement.


12. Restoring the rule of law to stem violent crime remains a
prerequisite to getting the Salvadoran economy growing at its
potential (Reftel. B). However, there are two long-term issues may
have throttled growth over the last decade, and may continue to have
an impact for years to come. One is that the underlying structure
of the economy is still uncompetitive and businesses are unprepared
to take advantage of the benefits of trade liberalization. A
handful of families continue to dominate the economy, especially in
certain sectors: in 2002 the UNDP estimated that the richest 20
percent of El Salvador controlled nearly 60 percent of the country's
economy. According to this explanation, economic concentration has
led to a loss of competitiveness, and local businesses find
themselves unable to either sell their products successfully
overseas or compete with imports. The new Competition
Superintendency, created in January 2006, could have a strong role
in promoting competition among local businesses. However, early
indications are that the Superintendency will avoid confrontation
with the economic elite and instead focus on sectors dominated by
foreigners. CAFTA-DR, and the pressure of competition from U.S.
goods, also has the potential to improve local competitiveness.


13. The second explanation suggests that remittances, which reached
2.8 billion in 2005 and will likely exceed $3 billion in 2006, are
undermining El Salvador's export competitiveness. From 1992 to 2001
(the last time it was calculated),El Salvador's real effective
exchange rate appreciated 48 percent--since then, it has undoubtedly
further appreciated. This appreciation has made local goods

expensive overseas and made imported goods cheaper, undermining El
Salvador's trade-focused growth strategy just as the. Mitigating
this remittance-fueled worsening of El Salvador's terms of trade
will be difficult. Encouraging the use of remittances for
investment instead of consumption, a task on which the Salvadoran
Government and private sector are focused, would alleviate pressure
on the terms of trade and help create jobs at home for potential
migrants. End comment.

Butler