EL SALVADOR FACING SERIOUS FISCAL, LIQUIDITY

C O N F I D E N T I A L SECTION 01 OF 04 SAN SALVADOR 001238

SIPDIS
STATE FOR WHA, EEB
TREASURY FOR DAS ONEILL, LTRAN, SSENICH

E.O. 12958: DECL: 10/28/2028
TAGS: EFIN ECON PGOV ES
SUBJECT: EL SALVADOR FACING SERIOUS FISCAL, LIQUIDITY
PROBLEMS

REF: A. SAN SALVADOR 1228

B. SAN SALVADOR 1084

C. TEGUCIGALPA 937

Classified By: CDA Robert I. Blau, Reasons 1.4(b) and (d)


1. (C) SUMMARY. El Salvador faces a short-term fiscal and
liquidity crisis, caused by the costs of untargeted subsidies
and an inability to place short-term government debt.
Approximately $450 million in short-term debt will come due
before the end of the Saca Administration on May 31. Banks
and investors are no longer willing to roll over short-term
debt, preferring to increase liquidity in the face of
international constraints and domestic political uncertainty,
and lacking confidence in the government's fiscal
responsibility. The government's need for new debt in a
limited domestic market is also putting upward pressure on
interest rates, and its fiscal constraints prevent it from
using fiscal policy to combat an economic slowdown or
recession. The banking sector warns of the risk of possible
bank runs driven both by concerns over domestic political
instability and the international financial crisis. While
the banking sector has positioned itself well in terms of
reserve funds, the banking association is not confident that
it can contain a bank run. In the short-run, the Government
of El Salvador (GOES) may be able, with assistance from the
U.S. Treasury, improve liquidity through addressing
structural defects in the financial markets. In the
long-run, however, a solution will require improved fiscal
discipline, increased confidence between the government and
investors, and an accord on external debt between the
political parties. Post will report more on possible ways
forward septel. END SUMMARY.


2. (SBU) Because of the GOES's difficulty in placing
short-term debt (reftel A),representatives of the Technical
Secretariat to the Presidency, the Central Bank, and the
Ministry of Finance requested "emergency" technical
assistance from the U.S. Treasury during an October 13
meeting with Treasury DAS Brian O'Neill.


3. (SBU) From October 20-22, Treasury's Office of Technical
Assistance (OTA) team and Econoff met with GOES officials
including: Manuel Rosales, Director of Fiscal Policy,
Investment, and Public Credit, Ministry of Finance; Carlos
Salazar, Director of Treasury, Ministry of Finance; Luz Maria
de Portillo, President of the Central Bank of Reserve; Sonia
Gomez, Director of the Financial System, Central Bank; Luis
Aquino, Director of Studies and Statistics, Central Bank; and
Guillermo Funes, Deputy Technical Secretary to the President.
Outside the government, the team met with: Manuel Enrique
Hinds, former Minister of Finance; Dr. Armando Arias,
President of ABANSA (private banking association) and Amcham;
Macela de Jimenez, Executive Director of ABANSA; Luis
Membreno, Economist, Financial Consultant and former advisor
to the Minister of Finance; Rafael Barazza, former President
of the Central Bank; Carmenza McLean, Country Representative
of the Inter-American Development Bank; Gijs Veltman,
President of Citibank El Salvador; and Mauricio Choussy,
Executive Director of Fitch Ratings in El Salvador.

THE CURRENT SITUATION
--------------


4. (U) According to Ministry of Finance figures, the GOES has
approximately $450 million in Letters of Treasury, short-term
(less than one year) debt instruments commonly known as
"Letes," that will come due before the end of the Saca
Administration on May 31 (reftel A). $133 million of this is
due before the end of 2008. In the longer term, the GOES has
a $650 million Eurobond due in 2011, as well as normal
payments on other international loans.


5. (C) The biggest fiscal stress on the GOES is the continued
payment of subsidies, especially the subsidies for
electricity, propane gas, and bus transportation. When
budgeting for the original subsidies, the GOES used estimates
based on $70 per barrel oil, but the price was well above
that for most of the year, and additional subsides were added
for bus transportation. Former Central Bank President Rafael
Barazza reported that, from the figures he has been able to
obtain, the GOES will spend more this year on subsidies than
on public investment. Economist Luis Membreno shared that
he'd been told all Ministers were required to cut 10 percent
from their budgets this year. Membreno noted that the GOES
is still spending "like it's not a dollarized economy and can
still print money."


6. (SBU) According to Director of Fiscal Policy Manuel
Rosales, the $450 million figure for Letes includes all
subsidies except the general electricity subsidies, "which
are paid by CEL (the state-owned hydro company),not the
government." When pressed, Rosales later acknowledged that
the GOES was, in fact, responsible for these subsidies as
well. Rosales could not, however, provide a figure for all
short-term GOES financial obligations.


7. (C) Many in the private sector, according to ABANSA/Amcham
President Armando Arias, consider the GOES "effectively in
default" because of the non-payment of $93.7 million in
subsidies owed to energy companies as of October 12, which
has dramatically suppressed investor confidence. Former
Finance Minister Manuel Hinds and Luis Membreno both
described the GOES as "nearly bankrupt" because of the
subsidies. S&P downgraded El Salvador's sovereign credit
outlook to negative in September, and Fitch Ratings
downgraded El Salvador's Ratings Outlook to negative in early
October.


8. (SBU) Taking on new international debt requires a 2/3
super-majority in the National Assembly, and for the past
nearly 3 years, the (left-wing) opposition FMLN has refused
to approve any new debt or refinance any existing debt. To
get around this political impasse, the GOES created two
"trusts," or fidecomisos, one for pension fund debt and one
to finance new security, health, and education spending. The
legality of the trusts has been challenged in the courts, but
Embassy's economic contacts doubt the courts would rule
before the 2009 elections. The trusts had a hard time
selling their own debt, and, most of it is held by the
"semi-autonomous institutions" (e.g., the pension funds).


9. (C) While Letes are in law and in theory short-term
instruments to be used to smooth out revenue for the year, in
practice they have been used instead to finance deficit
spending. Barazza noted that this was nothing new -- when he
was Central Bank President in the Flores Administration
(1999-2004),the GOES at one time had issued more than $900
million in Letes -- but the difference was the current
inability to obtain new international financing. The Letes
were, in effect, now being used to pay off long-term debt.


10. (C) Within the GOES, the Central Bank and Ministry of
Finance offered different views of what led to the current
situation. Central Bank President Portillo described
structural problems within the market for Letes, political
risk, and the effects of the international financial crisis.
Manuel Rosales, on the other hand, blamed statements by Fitch
El Salvador Director Mauricio Choussy, and stated that in his
view the U.S. Treasury had promised to "pressure the banks to
buy Letes," not to provide technical assistance.

NEW LOAN PACKAGE NO HELP
--------------


11. (SBU) The National Assembly is currently discussing
approval of $950 million in new loans from the World Bank and
Inter-American Development Bank. $650 million would be used
to pay the 2011 Eurobonds, while $300 million would be used
for other debt restructuring and new social programs. The
bulk of the loans are back-loaded, so the money would not be
available until after the January and March elections.


12. (C) IDB Rep McLean said that the structure of the loans
was necessary to secure the support of the FMLN, who would
not accept new loans that would give the ARENA government
$300 million to spend right before the election.


13. (C) According to Former Minister Manuel Hinds, the main
impediment to the loans had not been the FMLN. Rather,
President Saca had resisted any proposal that would let the
FMLN clean up its obstructionist image, which is why the
proposal was only now going forward. This was now the most
opportune time to get the loans approved, because "both
parties still believe they're going win the election."

VIEW FROM THE BANKING SECTOR
--------------


14. (SBU) Overall, the banking sector is still well
positioned because it had been preparing for capital flight
because of the Salvadoran elections (reftel B). The Central
Bank had raised reserve requirements by 3 percent, and the
total reserves were effectively at 35% of deposits. The
banking sector is still concerned, however, about a possible
bank run caused either by worries about the international
crisis or the domestic political situation.


15. (C) Citibank El Salvador President Veltman said that his
bank's decision not to roll over any Letes was part of their
liquidity strategy to meet the new reserve requirements, and
they had notified the GOES some time ago. He opined that the
GOES didn't understand the banking sector was international
now, and had to act according to the banks' policies, not the
government's wishes. Early on, he noted, the banks,
especially Banco Agricola (owned by Bancolombia) had gone
ahead and bought a little bit of the "toxic debt" put out by
the GOES's two trusts, as "a favor" to the government. Now,
however, he regularly receives calls from the GOES asking him
to buy Letes, or artificially lower interest rates, or
support other proposals "that New York will never approve."


16. (C) The weakest link in the banking sector is Banco
Hipotecaria, a majority state-owned bank that lends primarily
to small and medium businesses and the agricultural sector.
According to ABANSA, the private banking association, it is
the only bank in their system that has experienced liquidity
problems. Former Finance Minister Manuel Hinds attributed
the bank's problems to the GOES "forcing the bank to keep
lending at low interest rates, regardless of the current
environment." Central Bank President Portillo acknowledged
that the GOES had recapitalized the bank by having the
"semi-autonomous institutions" (e.g., the pension funds) move
deposits to Hipotecaria.


17. (C) ABANSA President Arias (strictly protect) said that
the banks have been putting out a positive message to keep up
confidence in the system. Arias privately expressed doubts,
however, that the system could contain a run on the banks.
ABANSA had just met with the Technical Secretary and GOES
economic team, and was very concerned about overall liquidity
in the system, especially what the Central Bank was doing
with the banking sector's reserves. There was also not much
coordination among the banks about what to do in the event of
a bank run. According to Veltman, "it's every bank for
itself."


18. (C) Manuel Hinds thought the banking sector was stable,
but the weak link was in the stock market. The brokerages
(all but one of which are owned by banks) had "been acting
like banks," promising "higher returns with no risk." The
brokerages had also been pooling deposits, instead of
maintaining individual accounts, making it harder to pay when
a depositor wanted to pull out. He thought savvy investors
were already getting out of the market.


19. (C) Similarly, Veltman's most likely scenario for a bank
run started with the failure of a brokerage. The parent bank
would have to step in to support the brokerage, which would
weaken the bank's liquidity, potentially damaging confidence
in the bank and prompting a run on its assets. On the other
hand, Fitch Director Choussy thought the most likely scenario
for a run would be "after a big FMLN victory" in the January
18, 2009 legislative elections. The subsequent ARENA "fear
campaign," he worried, would prompt a run on the entire
system.

POSSIBLE EFFECTS ON THE ECONOMY
--------------


20. (U) Through the latest data available (August or
September),El Salvador's economy continues to grow,
especially in the export sector. Remittances have continued
to grow, albeit more slowly, in every month except August.
For 2008, the GOES projects 4% GDP growth, while the World
Bank projects 3.5%. For 2009, the GOES projects 3.5%, while
the IMF recently announced a projection of 2.6%.


21. (C) In economist Luis Membreno's view, however, El
Salvador is not just slowing down, but is likely to head into
an outright recession by December or January. Because of the
spending on subsidies and inability to place Letes, he added,
the GOES does not have the money to engage in
counter-cyclical fiscal policy to combat a slowdown or a
recession.


22. (C) Membreno also noted that the GOES's increasing need
for short-term debt, driven by the subsidies, was creating a
"crowding out effect" in the domestic credit market and
driving up interest rates. With current international credit
lines drying up because of the crisis, the government and
private sector were competing for resources in the domestic
market, and it was becoming a "zero-sum game."


23. (C) Fitch Director Choussy, noting the GOES was very
critical of Fitch and Choussy personally, warned that Fitch
was not the rating agency the GOES needed to worry about.
Only Moody's had given El Salvador an investment grade
rating, while Fitch and S&P have it one notch below. If
Moody's were to downgrade El Salvador, institutions required
to hold investment-grade debt would be forced to divest,
deepening the GOES's fiscal problems.

COMMENT
--------------


24. (C) El Salvador's current fiscal crisis is largely
self-inflicted, driven by an insistence on maintaining
untargeted subsidies, derided by economists on both the right
and left, through the 2009 elections. Even with oil prices
falling, the subsidies are not sustainable in the long-run,
and the question is not whether they will have to be reduced
but when. The subsidies, combined with the GOES's failure to
come to an agreement with the electricity companies, have
damaged investor confidence in the government. Tightening
credit markets and domestic political uncertainty have played
a role, too, making banks and investors more risk adverse and
less willing to continue to finance what they see as
misguided fiscal policy.


25. (C) There are, however, a few positive signs. Following
an October 21 meeting between President Saca, Manuel Hinds,
and Rafael Barazza, Saca appointed Barazza, a widely
respected economist and champion of dollarization, to help
come up with a solution. Seeking assistance from the U.S.
Treasury has also been taken as a good sign by the private
sector, assuming that the GOES listens to Treasury's advice.
While the Central Bank seems eager for technical assistance,
the Ministry of Finance's responsiveness is less certain.


26. (C) Treasury's OTA team will offer specific
recommendations on how to address the current fiscal and
liquidity situation. In the long-run, however, any solution
will require a political element. First, the GOES must
restore fiscal discipline, especially on subsidies, and not
continue to spend like it can still print money. Second, the
government and the financial sector will need to sit down and
work on ways to restore confidence between the two. Finally,
ARENA and the FMLN will need to come to some sort of accord
on approving external debt, so that El Salvador can roll over
and refinance debt in a normal, fiscally sound way. Post
will report more on possible ways forward septel. End
Comment.

BLAU