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
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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
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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 . . .
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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
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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
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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