SALVADORAN ECONOMY SHOWS SIGNS OF LIFE

UNCLAS SECTION 01 OF 03 SAN SALVADOR 000131

SIPDIS

SENSITIVE
SIPDIS

STATE PASS USAID/LAC
STATE ALSO PASS USTR
USDOC FOR 4332/ITA/MAC/WH/MSIEGELMAN
3134/ITA/USFCS/OIO/WH/PKESHISHIAN/BARTHUR

E.O. 12958: N/A
TAGS: ECON ETRD EINV ES
SUBJECT: SALVADORAN ECONOMY SHOWS SIGNS OF LIFE

REFS: A) 06 SAN SALVADOR 2996; B) 06 SAN SALVADOR 2871; C) 06 SAN

SALVADOR 2756; D) 06 SAN SALVADOR 2543; E) 06 SAN SALVADOR 2475; F)
06 SAN SALVADOR 1131; G) 06 SAN SALVADOR 402; H) 06 SAN SALVADOR
353; I) 06 SAN SALVADOR 95; J) 05 SAN SALVADOR 113

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

1. (SBU) The Salvadoran economy grew 4.2 percent in 2006, ending a
six-year streak of anemic economic growth. President Saca has
expanded on the sound economic policy of his predecessors to
implement a sectoral growth strategy that positions El Salvador as a
logistics hub in the medium term, with agriculture, tourism, and
full-package apparel assembly (maquila) pushing growth in the short
term. He has expanded social services through the creation of
FOSALUD, a network of public health clinics, and Red Solidaria, a
poverty alleviation program. Both CAFTA-DR implementation and the
recently approved MCC compact are also important components of
Saca's strategy on economic and social issues. However, maintaining
economic growth and alleviating poverty in the run-up to 2009
elections will require new investment, which in years past has been
deterred by the security situation as well as regulatory and
competition issues, El Salvador's limited domestic market, and a
lack of small business financing. End summary.

GDP up 4.2 Percent in 2006
--------------

2. (U) Showing signs of life after six years of growth that never
exceeded 2.8 percent and was as low as 1.7 percent, the Salvadoran
economy grew 4.2 percent in 2006, according to the Central Bank.
The agricultural sector led the way in 2006, growing 7.1 percent.
Other leading sectors were transportation and communication, which
grew 5.3 percent, and services, which grew 4.9 percent. Industry
and manufacturing grew 3.2 percent in 2006 according to the Central
Bank, despite a 10.1 percent contraction in the apparel assembly
(maquila) subsector. For 2007, the Saca Administration projects
growth of 4.5 percent. Meanwhile, the results of a Ministry of
Economy household survey released in December 2006 suggest that
there has been little recent progress on poverty alleviation, with
35.2 percent of households living in poverty, up from 34.6 percent
in 2004. Overall, there has been good progress on poverty
alleviation since the Peace Accords were signed in 1992, when the
poverty rate was 58.7 percent


3. (U) Annual inflation in 2006 was only 4.3 percent, thanks to
dollarization and fiscal discipline that kept the government deficit
at 2.7 percent of GDP. Interest rates also remained low, with banks
lending at an average of 7.6 percent annual interest for a one-year
period. Remittances continued to grow in 2006, increasing to $3.3
billion from $2.8 billion the previous year. Imports were up 13.1
percent for the first 11 months of 2006, reflecting higher fuel
prices as well as increased imports of consumer goods. Exports,
meanwhile, grew 4.3 percent over the same period.

Saca Making Good on Economic Agenda
--------------

4. (U) In a marked departure from the strictly laissez-faire
economic policies of his ARENA predecessors, after taking office in
June 2004 President Saca announced an economic growth strategy that
bet on El Salvador becoming a logistics hub in the medium term, with
agriculture, tourism, and full-package apparel assembly (maquila)
pushing growth in the short term. He also continued the efforts of
previous governments to facilitate private-sector-led growth,
especially through CAFTA-DR implementation.


5. (U) The Saca Administration has made considerable progress in
carrying out that agenda. Infrastructure improvements to become a
logistics hub are already underway, including construction of a $169
million port in La Union that can handle post-Panamax ships;
construction will be completed in 2009. There are also plans to
build a new cargo facility at Compalapa airport that would build on
TACA's already large passenger hub and cement El Salvador's
leadership in regional aviation. Another important infrastructure
improvement is the road funded by the Millennium Challenge
Corporation (MCC) to be built across the northern part of the
country. Customs officials are also moving forward with USAID
funded CAFTA-DR reforms to speed cargo handling (Ref. G).


6. (U) Growth in the agricultural sector has benefited from a
Ministry of Agriculture program to provide farmers with improved
seeds for basic grains, but more important factors in 2006 were good
weather, higher prices for sugar and coffee, and expanded
cultivation of fresh fruits and vegetables. Tourism, meanwhile has
received a boost from a new tax exemption for investments in that
sector (Ref. I). The private sector has responded by adding nearly

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1,000 new hotel rooms, and the Tourism Ministry reports that tourist
spending is up 37 percent. Apparel assembly (maquila) has not fared
as well, however, and exports have fallen 10.8 percent during the
first 11 months of 2006 compared to 2005, due in part to sourcing
difficulties triggered by CAFTA-DR's staggered entry into force but
also due to increased competition from China (Ref. E).


7. (U) CAFTA-DR entered into force for El Salvador and the United
States on March 1, 2006. The Saca Administration views the
agreement, and its open-market trade policy, as a critical element
of El Salvador's economic growth strategy. The agreement has been
important to maintaining apparel assembly (maquila) investment in
the face of Chinese competition, and it is already paying dividends
for exporters of processed foods, sugar, and ethyl alcohol (Ref. D).
Officials at El Salvador's export promotion agency, EXPORTA, are
confident investors will take advantage of opportunities in other
sectors within the next few years. Perhaps as important as the
trade benefits are the opportunities for institutional
strengthening, especially in the area of investment dispute
resolution, intellectual property rights, customs administration,
and labor and environmental law enforcement.

Follow Through on Social Agenda as well
--------------

8. (U) After taking office, President Saca promised an expansion of
social programs, signaling a more direct role for the government in
poverty alleviation efforts. To a large extent he has followed
through on that promise. Three initiatives stand out--FOSALUD, Red
Solidaria, and the MCA Compact. FOSALUD, the Solidarity Fund for
Health, was launched in December 2004 to extend basic healthcare
services to underserved populations and ease overcrowding in
national hospitals (Ref. J). Funded by a sin tax that raised about
$20 million in 2005 and as much again in 2006, FOSALUD has opened
105 clinics to date.


9. (U) Red Solidaria, the Solidarity Network, is a poverty
alleviation program launched in March 2005 to provide assistance in
the poorest 32 municipalities in El Salvador, all of which have
poverty rates of above 50 percent (Ref. F). Families participate in
public health programs and enroll their children in school in
exchange for direct monetary support of $15-20 month. Red Solidaria
is also improving basic infrastructure such as water, roads,
electricity, and housing. The final component includes projects to
improve agricultural productivity and to support microfinancing.
Although funding has been in question thanks to ostensible FMLN
concern that a World Bank loan in support of the effort would
further indebt the government (Ref. C),Red Solidaria has now begun
working in all 32 targeted municipalities, providing support to an
estimated 24,000 families.


10. (U) Early in his term, President Saca recognized the
significant role the MCC could play in developing El Salvador's
northern zone. On November 29, 2006, the Government of El Salvador
and the Millennium signed a five-year, $461 million compact that
seeks to stimulate economic growth and reduce poverty in the
country's northern region. The 291 kilometer northern road is the
focus of most headlines, but MCC will also build 240 kilometers in
connecting roads and support rural electrification, water
sanitation, vocational training, and business development (Ref. A).


Comment: Challenges and Opportunities
--------------

11. (U) President Saca has expanded on the sound economic policy of
his predecessors to implement a sectoral growth strategy and expand
social services--while maintaining fiscal discipline. This year's
4.2 percent growth suggests that strategy is paying off, but El
Salvador needs new investment to maintain this positive momentum and
ensure that the benefits of growth are broadly distributed to
address poverty. In 2006, there was negligible foreign investment
inflow--the only exception was a Guatemalan bank's purchase of Banco
Americano, a failing local bank. Gross capital formation, a
measurement of overall investment, was only 15.2 percent in 2005,
the lowest in the region.


12. (SBU) Several factors explain the lack of investment in El
Salvador. Violent crime, which President Saca appears ready to
address, is the most significant deterrent to new investment, and it
poses enormous costs for businesses already in operation (Ref. H).
One large U.S. investor may open a plant that would employ up to
6,000 Salvadorans, but the firm has lingering concerns about
security. Ongoing regulatory uncertainty in the electricity sector
and recent calls for price controls in fuel distribution also deter
investment.

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13. (SBU) The small size of the Salvadoran economy and
anticompetitive practices in some sectors are other factors that
hinder investment. Outside of commercial and residential real
estate developments that seek to tap into remittances, local
investors are looking beyond El Salvador for new opportunities.
Finally, a lack of credit for small businesses also hinders
investment. The banking sector continues to undergo significant
restructuring as multinationals acquire local banks. We are hopeful
that these new banks will bring with them new approaches to dealing
with small businesses and also push forward pending legislation to
modernize the regulation of the financial sector (Ref. B). Dealing
with some or all of these constraints on investment will be key to
achieving 4.5 percent growth for 2007 and making additional progress
on poverty alleviation, especially before the 2009 elections. End
comment.

Butler