POLITICAL IMPASSE FORCES PENSION REFORM

UNCLAS SECTION 01 OF 02 SAN SALVADOR 002351 SIPDIS E.O. 12958: N/A TAGS: ECON EFIN ES SUBJECT: POLITICAL IMPASSE FORCES PENSION REFORM Ref: San Salvador 712 Summary -------------- ¶1. On September 7 and 14, the Legislative Assembly passed a package of pension reforms that sets up a trust to fund the government's pension obligations incurred in a 1996 transfer from a pay-as-you-go to a funded pension system. The reform includes a refinancing of government debt issued to finance pension costs. More important, it eliminates the need to get FMLN votes to approve future financing--a point on which the FMLN threatens to file a constitutional challenge. The reform puts off at least for another decade--well beyond the 2009 presidential elections--the need to raise taxes to eventually pay for these pension obligations. End summary Legacy Costs of Pension Reform -------------- ¶2. In 1996, facing the possibility that its pay-as-you-go government pension system would go bankrupt or require large transfers from the general budget, El Salvador established a pension system based on individual retirement accounts managed by private pension fund administrators. The government allowed workers close to retirement to stay with the old system, with their pensions and the pensions of those already retired to be paid out of the general budget. It forced workers who had contributed to the old system but were still years away from retirement to join the new system, but provided them transfer certificates as credits for contributions made under the old system. In all, the government issued about $850 million in 15-year certificates, payable to retirees with 3.4 percent annual interest through the new pension fund administrators. ¶3. These two transition costs--payments due to retirees under the old system and debt incurred by issuing transfer certificates--are a significant burden on the government budget. In 2006, these costs were expected to reach $400 million, about 12 percent of the total budget, or 2.2 percent of GDP. Reluctant to raise taxes, in 2006 and in previous years the government financed pension costs with bonds sold on local and international markets; in 2006, the government raised $625 million. ¶4. The current composition of the Legislative Assembly makes it unlikely that the government can continue to cover pension costs by issuing debt. Although budget expenditures require only a simple majority for approval, financing a fiscal deficit with international loans or bonds requires a qualified majority (56 of 84 votes). In years past, getting that qualified majority meant convincing a handful of FMLN deputies to break ranks--a difficult but achievable task. Since March 2006 elections, with the FMLN legislative faction now under the firm control of hard-line communists, getting legislators to cross the aisle has become next to impossible (see reftel). In response, the government has found a financial solution to this political problem. New Reforms Bypass FMLN . . . -------------- ¶5. On September 7, the Legislative Assembly approved with a simple majority the creation of a trust that will assume the government pension liabilities created when the system was privatized in 1996. The trust fund, not the government directly, will finance the legacy costs of the old pension system, thereby obviating the need to seek a qualified majority from the Legislative Assembly. ¶6. Administered by the state-owned Multisectoral Investment Bank (BMI),the trust will issue public securities that, based on additional reforms passed September 14, the private pension fund managers must buy. These new securities, issued with a 25-year term, will pay interest at LIBOR 180 plus 75 basis points. According to Pension Fund Superintendent Francisco Sorto, in 2007 the trust will issue about $1.5 billion worth of these new securities to buy back $850 million in old transfer securities and cover about $420 million in new pension obligations, leaving the trust with about $230 million in capital. Although not technically sovereign debt, the government is betting that investors will see the government's obligation under the 1996 reform to pay pension costs as an implicit guarantee. [Note: In the debate leading up to the September 14 reform, a proposal to allow the pension funds to buy foreign securities (up to 10 percent of the fund value) was derailed by PCN deputies backed by owners of the local stock exchange. End note.] ¶7. In addition to political breathing room, the reform--essentially a refinancing exercise--eases the government's immediate fiscal burden. In 2007, the government's pension costs were to have reached $420 million, 2.1 percent of GDP. With the reform, costs for 2007 will fall to only $60 million, 0.3 percent of GDP. Over the long term, as yearly payments on the 25-year bonds add up, pension costs will increase and peak at 1.8 percent of GDP in 2018. Looking to take advantage of the reform early, Technical Secretary Eduardo Zablah announced on September 19 that the trust would be established in October 2006, freeing up for other capital projects an estimated $96.5 million that had been budgeted in 2006 for pension costs. . . . But at a Cost -------------- ¶8. This financial (and political) re-engineering is not without detractors. Alvaro Trigueros, a macroeconomist at prominent think tank FUSADES, warns that the pension reform increases the present value of the debt by $100 million (in other words, the sum of all future pension-related debt payments after the reform is $100 million higher than before). On the political side, some worry that by removing the FMLN's one legislative bargaining chip (approval of international financing),the left may further intensify its efforts to exercise power through often-violent street demonstrations. Meanwhile, FMLN deputies have said they will file a constitutional challenge against the reform in the Supreme Court. Comment -------------- ¶9. Government officials say the FMLN's obstructionist negotiating strategy on approving government debt left them with no choice but to create a trust to manage pension obligations. In coming to that conclusion, and with an eye toward ARENA's 2009 face-off with the FMLN, tax increases were not on the table. In the end, the government pushed-off the fiscal reform that should have accompanied the 1996 pension reforms for another ten years or so, gambling that by then political winds will have shifted to make raising taxes possible. End comment. Barclay