Report No. 32711-SV El Salvador Investment Climate Assessment (In Two Volumes) Volume I: Main Findings and Policy Recommendations July 12, 2005 Development Economics Research Group (DECRG) and Finance, Private Sector and Infrastructure Latin America and the Caribbean Region (LCSFR) Document of the World Bank GPD Gross Domestic Product HACCP Hazard Analysis Critical Control Point HACCP Hazard Analysis Critical Control Point IAAC Interamerican Accreditation Cooperation ICRG International Country Risk Guide ICs InvestmentClimate Survey ICT Informationand Communication Technologies IEC International Electrotechnical Commission ILAC International Laboratory Accreditation Cooperation IMF International Monetary Fund INCONTEC National StandardsBody of Colombia INSAFORP Government Training Institute I S 0 International Organization for Standardization IUDOP Instituto Universitariode Opini6n Publica MINEC Ministerio de Economia MME Mercado Mayoristade Energia ElCctrica MSMES Micro, Small and MediumEnterprises NAFTA North American Free Trade Agreement OECD Organization for Economic Cooperation and Development PAHO Pan-American HealthOrganization PPP PlanPuebla Panama R&D Researchand Development SGR Sociedadesde Garantias Reciprocas SIEPAC Central AmericanElectric Interconnection System SIGET Superintendenceo fElectricity and Telecommunications SME Small and MediumEnterprise TFP Total Factor Productivity UNDP UnitedNations Development Program USAID US Agency for International Development WBI World Bank Institute Vice President: Pamela Cox Country Director: Jane Armitage Sector Director: Makhtar Diop Sector Leader: Manuel Sevilla Sector Manager: Susan Goldmark Investment Climate Unit Manager: Axel Peuker ResearchManager: Luis Serven Task Manager: Pablo Fajnzylber 3 TABLE OF CONTENTS: ACKNOWLEDGEMENTS ......................................................................................................... 7 SUMMARY AND OVERALL ASSESSMENT ....................................................................... 14 IINTRODUCTION 16 I1 GOVERNANCEAND INSECURITY .. ................................................................................................................... ................................................................................. 22 CORRUPTION.............................................................................................................................. 22 POLICY RECOMMENDATIONSON CORRUPTION .......................................................................... 24 CRIME........................................................................................................................................ 25 POLICY RECOMMENDATIONSON CRIME .................................................................................... 29 CONTRACT ENFORCEMENT THE JUDICIARY AND ........................................................................ 30 POLICY RECOMMENDATIONSON CONTRACT ENFORCEMENT THE JUDICIARY AND .................... 35 BUSINESS-GOVERNMENT RELATIONS ........................................................................................ 36 POLICY RECOMMENDATIONSONBUSINESS-GOVERNMENT RELATIONS .................................... 39 I11 INFRASTRUCTURE . .......................................................................................................... 41 ELECTRICITY .............................................................................................................................. 41 POLICYRECOMMENDATIONSONELECTRICITY .......................................................................... 44 TELECOMMUNICATIONS ............................................................................................................. 45 POLICYRECOMMENDATIONSONTELECOMMUNICATIONS ......................................................... 50 TRANSPORT ................................................................................................................................ 51 TRANSPORT: POLICYRECOMMENDATIONS ................................................................................ 56 IV ACCESS TO FINANCE . ...................................................................................................... 58 58 ACCESS COSTOF CREDI.T ................................................................................................... THESTATEOFTHE SALVADORAN FINANCIAL SYSTEM.............................................................. AND 60 ACCESS CONSTRAINTSREPORTEDBY FIRMS ............................................................................. 62 SOURCESOF FINANCE ................................................................................................................ 65 POLICYRECOMMENDATIONS ON FINANCE ................................................................................. 66 V SKILLS, QUALITY AND TECHNOLOGY . ....................................................................... 69 EDUCATION LABOR AND SKILLS ................................................................................................ 69 POLICY RECOMMENDATIONSON EDUCATION AND LABOR SKILLS ............................................ 73 QUALITY .................................................................................................................................... 73 POLICY RECOMMENDATIONSON QUALITY ................................................................................ 77 TECHNOLOGY ............................................................................................................................ 78 POLICY RECOMMENDATIONSON TECHNOLOGY ......................................................................... 82 REFERENCES ............................................................................................................................ 86 4 LIST OF TABLES: Table 1.1: El Salvador's InvestmentClimate at a Glance .............................................................. 8 Table 1.2: Main findings and Recommendations (Summary Matrix) ............................................ 9 Table 1.3: Share of Firm Sales Sold on Credit ............................................................................. 32 Table 1.4: Firmswith Overdue PaymentsThat Have Filed Court Cases, by Size ....................... 33 Table 1.5: Tax Penalties and Proportion o f Sales Declared to the Tax Authorities ..................... 38 Figure 1.1: Sample composition by Sector and Province............................................................. LIST OF FIGURES: Figure 1.2: The Perspective o f Salvadoran firms: MainInvestmentClimate Constraints ...........17 17 Figure 1.3: Losses due to quantifiable constraints inInfrastructure and Governance., ............-18 Figure 1.5: Labor productivity differences derivedfrom investmentclimate advantages...........19 Figure 1.4: Labor productivity growth under optimistic counterfactual assumptions..................18 Figure 1.6: Labor productivity growth o f the average Salvadoran firm assuming investment 19 Figure 1.7: Labor productivity advantagesfrom investment climate conditions, by size..........20 climate improvements to the country's 75th percentile, by size range.................................. Figure 1.8: Inconsistency ofregulations, government inefficiency andbribery.................... -22 Figure 1.9: Bribes"to get things done" and to win public contracts............................................ 23 26 Figure 1.11: Kidnappings inEl Salvador between 1997 and August 2004 .................................. Figure 1.10: Homicide rates per 100,000 population, by gender and WHO region..................... 27 Figure 1.12: Victimized firms and firms constrained by crime....................................... Figure 1.13: Crime Losses and security costs (% of sales) - International Comparison., ..........-27 27 Figure 1.14: Firmswhich do not trust the Courts ...................................................... 30 Figure 1.15: Firmswhich perceive court efficiency as a severe obstacle............................. 31 Figure 1.16: Duration ofpayment disputes indays...................................................... 34 Figure 1.17: Index ofJudicial Complexity-A Cross-Country Comparison ............................... 34 Figure 1.18: Time for registration and renewal oflicenses andpermits ...................................... Figure1.19: Days Spent inInspections andMandatory Meetingswith Government Officials...37 39 Figure 1.20.Distribution and Transmission Losses as Percentageof Output .............................. 42 Figure 1.21:LossesDueto Power Outages............................................................... 42 Figure 1.22:Days for new Electricity Connection., ..................................................... 42 Figure 1.24. Internet Hosts per 1000pop. and GDPp/c in2003................................................. Figure 1.23: Mobile and Fixed Telephone Lines inEl Salvador, 1998-2003............................... 46 47 Figure1.25: Internet and emailuse, by country (%).................................................... 48 Figure 1.26: Internet and emailuse, by size(%) ........................................................ -48 Figure 1.27: Transport Constrained firms (%)............................................................ 51 Figure 1.29:Maritime transport costs to the U.S.from selectedports as % o f export value ........51 Figure 1.28:Transport Constrained firms ifCAFTA (%).............................................. 53 55 Figure1.31:Custom delays for Imports(investmentclimate data).............................................. Figure 1.30: Custom delays for Exports (investment climate data).............................................. 55 59 Figure 1.33: Share o f Firmswith Loans (%), International Comparison ..................................... Figure 1.32:Active and PassiveUSDInterest Rates, 1998-2003 ................................................ 60 61 Figure 1.35: Constraints preventingfirms from applying to a loan.............................................. Figure 1.34: Share o f firms demanding and obtaining loans, by size (%of firms) ....................... 63 5 Figure 1.36: Sources of collateral (as % of loan). by size. ElSalvador........................................ 64 Figure 1.38: Average years of schooling in 1960and2000-International comparison.............69 Figure 1.37: Main Sources of finance for investment capital. by country (%)............................. 65 Figure 1.39: Firmsthat provide internal and external training to their workers. by country (%).70 Figure 1.40: Labor Market Rigidity Indexes from Doing Business Database.............................. 71 Figure 1.41: Labor Regulations as constraints to business operation (% of firms) ...................... Figure 1.42: Current quality system inEl Salvador (planned certification indotted lines) .........72 Figure 1.43: Firmswith I S 0 9001:2000 quality certification, by country ( percent) ...................75 76 Figure 1.44: Firmswith I S 0 quality certification, by exporting status (%) ................................. 77 Figure 1.45: Main source of Technological Innovations, by size (%).......................................... Figure 1.47: Less frequent forms of technology acquisition.by country (% of firms) ................79 Figure 1.46: Main sources of technological innovations -International Comparison (%)............78 80 Figure 1.48: Imports of capital goods, by country (% of total imports) ....................................... 81 Figure 1.49: R&D Expenditures (% of GDP), by country (average 1980-1995)......................... 82 6 ACKNOWLEDGEMENTS This report was prepared by a team led by Pablo Fajnzylber and comprising Stefka Slavova (Contract Enforcement and Business-Government Relations), Jose Miguel Cruz (Crime), Francesca Recanatini and Juanita Riano (Corruption), Eloy Vidal and Juan Manuel Galarza Tohen (Telecommunications), Fernando Lecaros (Electricity), Andres Pizarro and Ximena Clark (Transport), Juan Miguel Crivelli (Access to Finance), Diane Thompson (Quality) and Isabel Sanchez-Garcia (Technology). Leonid Koriukinprovided valuable assistance with the descriptive analysis o f the data, Alvaro Escribano and Heisnam Singh performed total factor productivity estimates, Manoela Francisco provideduseful research assistance for the chapter on Access to Finance, Adolfo Rouillon providedvaluable insights into the aspects o f the Salvadoran legal system that affect the firms' access to Finance, Waleed Malik provided useful information on the functioning o f the Salvadoran Judicial system and the ongoing Judicial Reform Project, and Bernice van Bronkhorst provided useful comments and suggestions on the crime section. Additional valuable inputswere received from Marialisa Motta, Jordan Schwartz, Marianne Fay, Aquiles Almansi, Manuel Sevilla and August0 de la Torre. MarialisaMotta, inparticular, helped set up the team for this project and provided valuable guidance at the concept stage. Special thanks are also due to Natalia Angelucci and Eric Palladini for their editorial support. Peer reviewers are IrinaAstrakhan (ECSPF) and Caroline Freund(DECRG). 7 x L ' - c3 E c SUMMARYAND OVERALLASSESSMENT 1. This report identifies constraints to Salvadoran manufacturing firms in the areas of governance and insecurity, physical infrastructure, access to finance and skills, quality and technology. The report uses a survey o f manufacturing firms to benchmark El Salvador with respect to other countries o f the region and the world, as well as to estimate the impact o f investment climate constraints on firm performance. The report presents policy recommendations based on national and international data sources, the survey analysis and other Economic and Sector Work done by the World Bank. 2. In almost all investment climate indicators El Salvador performs substantially better than Honduras, Nicaragua and, to a lesser extent, Guatemala. The main exception i s the area o f technology, where Guatemalan firms appear to be ahead o f their Salvadoran counterparts. Despite these regional advantages, in global terms El Salvador faces important challenges associated with the need to enhance the skills o f its workforce and modernize the production technologies usedby local manufacturers, increase the use o f information and communication technologies by government and the private sector, reduce the relatively high levels o f insecurity, improve contract enforcement mechanisms, and decrease transportation and other logistic costs. 3. Statistical analysis indicates that improvements in all four areas o f the investment climate - governance and insecurity, infrastructure, finance and technology - have the potential to generate significant increases in firm productivity and exports. Our estimates also confirm that quality upgrading in the areas o f governance and infrastructure lead to higher employment growth, firm profitability, wages and skilled labor demand. Moreover, the enhancement o f workers skills, and investments inthe area o f quality and technology have a particularly large potential impact on manufacturing productivity, exports, skilledlabor demand and wages. 4. Within El Salvador, micro, small and medium enterprises (MSMEs) face generally worse investment climate conditions than large firms, with disadvantages that are particularly hefty in the areas o f infrastructure and technology. Firms located in L a Libertad face better investment climate conditions than firms from all other provinces, particularly inthe area o f infrastructure. 5. Even though the report includes a large number o f detailed policy recommendations to improve the Salvadoran investment climate, two sets o f policy measures deserve special attention because o f their combination o f high potential impact with a relatively limited financial cost in the short term. The first measure i s the development and implementation o f an Information and CommunicationTechnology (ICT) strategy for the country. The second measure i s the creation o f a high level entity in charge o f formulating, coordinating and evaluating the country's policies to promote technology adoption and innovation. 6. To make rapid and sustainable progress inthe area o f ICT, El Salvador could create a single, high level entity in the Government with enough authority to develop and implement the country's ICT strategy, encompassing actions to modernize public 14 procurement and simplify administrative procedures, develop electronic government, improve the legal framework to promote electronic commerce, reduce the costs o f internet access for Salvadoran firms and improve the educational programs in the area o f ICT. The new policy should lead to efficiency improvements in all areas o f government, ranging from law enforcement and the judiciary, to the control o f public spending and tax collection. In addition, the new ICT strategy should reduce the time and cost for obtaining government permits and licenses and diminish the incidence o f administrative corruption. Finally, a successful ICT strategy should reduce transaction and production costs o f private firms, and it should facilitate international transactions. 7. The suggestion of revamping the policies aimed at promoting technology adoption and innovation i s motivated by their large estimated potential impact on productivity and exports, and by considerable institutional weaknesses detected in this area. The responsibility for the policies related to the areas o f science and technology (S&T), as well as metrology, standards, testing and quality (MSTQ) i s attributed to CONACYT, which in practice lacks the necessary resources to fulfill that obligation. Other agencies implement interrelated programs - e.g. INSAFORP, BMI, the Office o f the Vice- president, the Ministries o f Education, Agriculture and Economy - but limited coordination mechanisms and the absence o f common strategic guidelines diminish the impact o f those programs. A high level entity, possibly with private sector participation, should ideally be granted the responsibility, the resources and the necessary authority to formulate, coordinate and evaluate the country's policies to promote technology adoption and innovation, encompassing the coordination o f policies in the areas o f S&T, MSTQ, education, worker training and export and foreign direct investmentpromotion. 8. The report detected three other policy areas as being highly important for improving the overall investment climate in El Salvador: crime and violence reduction, judicial reform, and the improvement o f the transport infrastructure for international trade. While the difficulties and costs associated with achieving success in these three areas are not small, the potential gains in terms o f reducing the costs o f doing business in El Salvador and improving the competitiveness o f Salvadoran firms are considerable. Specific measures in those and other areas where investment climate deficiencies were detected are provided inthe body o fthe report. 9. On the positive side, business registration and license and permit renewals take less time in El Salvador than in Guatemala, Honduras and, to a lesser extent, Nicaragua. However, further efforts are still needed to expedite environmental, sanitary and construction permits, as well as to publicize the services of one-stop-shops (ON1 and CONAMYPE), which currently reach only a small number o f firms - respectively foreign investors and some micro and small enterprises. 10. Credit constraints are also found to be less prevalent than in neighboring Central American countries. However, the use o f movable assets as collateral i s hampered by the lack of a unifiedregistry, and a pledge legislation that i s antiquated and limits the use o f some assets to secure loans. Moreover, access to finance could also be increasedthrough the modernization o f the legal framework for insolvency procedures and through judicial reform measures targeted at the improvement o f creditor rights enforcement. 15 I.INTRODUCTION 11.Improvementsin the investment climate could contribute to promote sustained growth and poverty reduction through higher levels of investment and productivity growth. After averaging 5.9% per year in 1990-1995, annual GDP growth was 3.2% in the second half of the 1990s and 2% in 2000-2003. This slowdown took place in the context o f deteriorating terms o f trade, severe earthquakes in 2001 and the slowdown o f the U.S. economy, and despite the country's impressive economic transformation and prudent macroeconomic policies. Positive future growth prospects are to a great extent associated with the achievement o f higher rates o f investment and productivity growth, which in turn depend on the risks and expected returns faced by potential investors. Those risks and returns are intrinsically associated with the policy, institutional, and behavioral environment in which investment decisions are made. This environment i s what we call the "investment climate." Inthe context o f this report, measures to improve the investment climate are grouped into four areas: (1) policies directed at improving governance and reducing insecurity, (2) increasing the quantity and quality o f available physical infrastructure, (3) strengthening the banking system and improving the conditions o f access to financial services, (4) promoting the development o f the national quality system and the firms' access to skilled workers and state-of-the-art technologies. 12. This report identifies the critical investment climate constraints on firms' productivity in El Salvador using survey data on manufacturing firms. The report also provides policy recommendations to address those constraints. The analysis presented in this report is based on a detailed evaluation o f the investment climate in El Salvador, using a unique database o f manufacturing firms interviewed between November 2003 and May 2004. The Investment Climate Survey (ICs) was based on a standard instrument that the World Bank i s applying in Latin America and other regions o f the world. Trained enumerators collected the data in face-to-face interviews o f company managers. The I C s covers a stratified sample of 465 manufacturing firms. About 60 percent o f the sampled firms were from San Salvador (the capital city), 16 percent from the province o f L a Libertad and the remaining 24 percent from eleven other provinces (see figure 1.1). The sample was drawn randomly from nine manufacturing sub-sectors, and encompassed companies o f all sizes.2 The subject areas on which this report focuses were covered in recently concluded Investment Climate Assessments for Nicaragua, Honduras and Guatemala. This makes it possible to compare the problems faced by Salvadoran firms with those in neighboring countries. The policy recommendations at the end o f each chapter are based on the analysis o f survey data collected for this report and on other Economic and Sector Work done by the World Bank inEl Salvador. ' These four areas are contemplated in the incoming Saca Administration's priorities, which include strengthening the real sector, building social and physical infrastructure, instituting public sector and institutional reforms, building a stronger financial system to reduce vulnerabilities in the context of dollarization, andimplementingCAFTA. FitchRatings,09/08/04. The samplewas drawnto berepresentativeby sector-with 90% confidenceanda samplingerror of 9% - andwas thenstratifiedby size andregion. 16 Figure1.1: Samplecompositionby Sector and Province Achuachapan HApparel 4.1% HFood&Bev HSantaAna OChemicals "0 LaLibertad URubber&PI. HNon-met. Min. 0SanSalvador HTextiles HSan Miguel HMetals 10.3% Footwear Province mother rgns Sector .Other Source: Investment Climate Survey 13. Deficiencies in all four areas of the investment climate affect the productivityof Salvadoranfirms and increase their cost of doingbusiness. A large percentage of the surveyed firms report that the main constraints to their operations are in the area o f governance and insecurity and access tofinance (see figure 1.2). In addition, the firms also report that in 2002 they lost 9.8 percent o f their revenues because o f problems inthe areas o f infrastructure and governance and insecurity (see figure 1.3). The monetary costs associated with problems in the areas o f finance and technology are harder to quantify. However, simulations based on the I C s indicate a potential for large productivity increases in the hypothesis o f substantial improvements in all areas o f the investment climate, with some o f the largest potential gains coming from the area o f technology (see figure 1.4). These simulations are intended to provide a general idea o f the potential benefits o f improving different components o f the investment climate. They are, however, subject to the caveats that apply to the econometric estimates on which they are based, namely the fact that the data i s for the manufacturing sector only, and the possible existence o f measurement error inboth the indexes that represent the quality o f the investment climate and inthe variables that represent firmperformance. Figure 1.2: The Perspective of Salvadoranfirms: Main InvestmentClimate Constraints (YOthat ratethem as "major" or "severe") C r i m e & V io le nce 4 9 Inform a i Practices Corruption A c c e s s to F n a n c n g 3 1 S o u r c e : I n v e s t m e n t C l i m a t e S u r v e y 14. Salvadoranfirms report substantially better investment climate indicatorsthan their counterparts from Honduras and Nicaragua. Guatemalanfirms are ahead in the technology and infrastructure indicators. Subject to the above caveats, our simulaltions also show that in terms o f the four areas o f the investment climate, the average Salvadoran firm has considerable productivity advantages over Nicaraguan and 17 Honduran firms. However, the average Guatemalan firm i s ahead o f its Salvadoran counterpart in the area o f technology and exhibits a small advantage in the area o f infrastructure. As a result, and despite the better governance and finance indicators, Salvadoran firms have a small investment-climate-related productivity disadvantage compared to their Guatemalancounterparts (figure 1S). Figure 1.3: Losses due to quantifiable constraintsin Infrastructureand Governance(YOof sales) P h o n e Interruptions W ater lnterru ptions Crime T o t a l losses: 9.9% o f sales Electricity Interruptions ( a v e r a g e for ail f i r m s ) Transport P r o b l e m s P a y m e n t s to g e t things d o n e S e c u r ty costs - , 0 0 0 1 0 0 2.00 3 0 0 4 00 5 0 0 Source: Investment Climate Survey Figure1.4: Laborproductivity growthunder optimistic counterfactualassumptions (investment climate improvementsto 50th,75'h and 90thpercentiles) f i n a n c e 2 3 O % ~ infra 6 Iru ctu re g o v e r n a n c e t e c h n 0 l o g y 0 0% 1 0 0 % 2 0 0 % 3 0 0 % 4 0 0 % 5 0 0 % 6 0 0 % I U m s d i a n m 7 5 t h p e r c 0 9 0 t h p e r c Source:InvestmentClimate Survey 15. Micro, small and medium enterprises (MSMEs) have much more to gain from improvements in the investment ~limate.~ This is due to the fact that large firms face much better investment climate conditions. While the differences across firms o f different sizes are particularly large in the areas of infrastructure and technology, sizable labor productivity gains can also be obtained by improving the investment climate conditions faced by smaller firms in the areas o f access to finance and governance (figure 1.6). Moreover, Salvadoran MSMEs report worse technology indicators than the average firm o f the same size from the three above mentioned neighboring countries and micro enterprises also lag behind in the area o f access to finance (figure 1.7). On the positive For the purpose of this study firms were dividedby size based on the number of permanent employees: micro enterpriseswere definedto haveless than 10 employees (22percent of the sample), small firms have 10 to 25 employees (29 percent of the sample), mediumfirms have 26 to 75 employees (25 percent of the sample) andlarge firms were definedto bethose with over 75 employees (24percent). 18 side, the infrastmcture and governance indicators reported by Salvadoran firms are considerably better than those o f their average counterparts o f the same size operating in neighboring countries. However, when compared to the average Guatemalan firm o f the same size, Salvadoran MSMEs exhibit net productivity disadvantages derived from inferior investment climate conditions inall areas except for governance and insecurity. Figure 1.5: Laborproductivitydifferencesderivedfrom investmentclimate advantages over Guatemala,HondurasandNicaragua (YO) Guat., Hond. 8 Nic. 9 .9 % Nicaragua 1 9 2 % Honduras 1 1 0 % -9 3 % G u 4 2 % h l a f i n a n c e ISinfrastructure Ogovernance Otechnology M t o t a l (Investment Climate) Source: Investment Climate Survey Figure 1.6: Labor productivitygrowthof the average Salvadoran firm assuming investmentclimate improvementsto the country's 75fhpercentile,by size range micro (112%) small (95.4%) medium (65.2%) large (32.4%) Iwfinance Binfrastructure Ogovernance Otechnology I Source: Investment Climate Survey 16. Potential productivity gains derived from improvements in the investment climate differ considerably across sectors and regions. Firms in the apparel and non- metallic mineral products sectors have more to gain from improvements inthe investment climate, as they have fewer o f the best practices found among other Salvadoran firms o f the same size. The mineral products sector is also the only one for which Salvadoran firms exhibit a net productivity disadvantage resulting from worse investment climate conditions than those reported by the average firms o f the same sector operating in Guatemala, Honduras or Nicaragua. This disadvantage i s driven mainly by a substantial lag in the area of technology, which i s also found among apparel manufacturers. As for regional differences, the ICs indicates that the largest potential productivity gains 19 associated with achieving national best practices are found in Santa Ana, Ahuachapan and other small provinces. These results are derived from comparisons with best practices inall four areas ofthe investmentclimate reportedby firms from the same size ranges. At the other extreme, firms from La Libertad face better investment climate conditions than firms located inall other provinces, with particularly large advantages ininfrastructure. Figure 1.7: Labor productivity advantagesderivedfrom better investment climate conditions,by size (comparison with average firm of the same size in Guatemala, Hondurasor Nicaragua) 18.2% large medlum s m a W mlcro IElfinance linfrastructure Ogovernance Otechnology l t o t a l (Investment Climate) 1 Source: InvestmentClimate Survey 17. Overall, intra-national and international simulations of the potential gains in manufacturingproductivity derived from improvements in the investment climate suggest,with the above mentionedcaveats, the followingconclusions. 1. There are important potential productivity gains associated with improvements inall the four areas o f the investment climate considered in thisreport. 2. The largest potential productivity gains from generalizing national investment climate best practices are obtained inthe area o f technology. 3. Micro, small and medium enterprises stand to benefit the most from the generalization to all firms o f national investment climate best practices, particularly inthe areas o f infrastructure and technology. 4. The apparel and non-metallic mineral products sectors and the provinces o f Santa Ana and Ahuachapan - among other small provinces -stand to gain the most from improvements inthe investment climate. 5. El Salvador i s well ahead o f Honduras and Nicaragua in all areas o f the investment climate, but trails behind Guatemala in the areas o f infrastructure and, to a much larger extent, technology. 20 6. The largest gaps with respect to Guatemalan firms in the area o f technology are found in the apparel and non-metallic mineral products sectors, and among MSMEs. 18. The next sections review the relative standing of Salvadoran firms in the four areas of the investment climate and provide policy recommendations for improving it. To that end, the report combines the results o f the ICs with other sources o f information, in an attempt to provide a diagnosis o f the problems that are found in each o f the areas o f the investment climate. At the end o f each section, we provide a series o f specific policy recommendations that could be considered in the context o f efforts to improve the Salvadoran investment climate. Summaries o f investment climate indicators for El Salvador and other Latin American countries and a list o f the policy recommendations made in this report are provided in Tables 1.1 and 1.2 (to be completed). These recommendations are classified by their probable timing-short term vs. medium and long term measures. 21 11.GOVERNANCEAND INSECURITY CORRUPTION 19. El Salvador's ranking in international perception-based indexes of the prevalence of corruption is below Costa Rica but above Guatemala, Honduras and Nicaragua. The most recent Transparency International Corruption Perception Index (CPI)4 places Costa Rica and El Salvador respectively inthe 72thand 66" percentiles o f a sample o f 145 countries, compared to the 24th percentile, on average, for Guatemala, Honduras and Nicaragua. A similar ordering can be derived from Kaufmann et al.'s (2003) indicator o f the control o f corruption and the International Country Risk Guide's (ICRG) index o f "corruption within the political system". However, in this index El Salvador was recentlydowngraded (inlate 2001) from 4 to 2.5 on a scale o f 1 to 6 -with 6 meaning the lowest corruption. Moreover, a recently collected survey on business environment - the Executive Opinion Survey (EOS) - conductedby the World Economic Forum (WEF) also places the quality o f governance in El Salvador above that o f the Central American average, but it suggests that the country's world ranking is lower with regard to bribery in the judiciary than for other governance aspects covered by the ~urvey.~ Nevertheless, it i s worth noting that, globally, El Salvador i s relatively well ranked in the corruption sub-components o f the World Economic Forum's Growth Competitiveness Index.6 Figure 1.8: Inconsistencyand unpredictabilityof regulations, governmentinefficiency and bribery 71 0 75 6 I ElSalvador Nicaragua Honduras Guatemala lblInterpretationsof regulationsinconsistentand unpredictable OBribes "to get Things Done" consideredcommon E4 Governmentconsidered Inefficient Source: Investment Climate Survey 20. The ICs confirms that corruption is lower in El Salvador than in neighboring Guatemala, Honduras and Nicaragua. The cross-country data presented above suggests that El Salvador faces important challenges interms o f reducing corruption and, more generally, increasing the quality o f governance to levels that are closer to those found inindustrialized countries and the larger Latin American and East Asian countries. Still, those challenges appear to be smaller than in neighboring Central American See http:/lwww.transDarencv.org for additional details. For more information on the ExecutiveOpinion Survey (EOS) see: htt~:/lwww.weforuni.or~/sitelhom~~~iblic.i~s~~ontent/Gl~bal~Coin~etitiveness+Pro~ranime. Ina group of 104countries El Salvadorranked3lS`,35`h and45`hinthe indexesofcorruptioninpublic services, corruption in foreign trade and corruption in tax collection, respectively.Incontrast the country's rankingswith respect to organized crime andjudicial independence are 84 and 71, respectively. 22 countries. Based on interviews with 465 manufacturing firms in El Salvador and more than 1,300 firms in Nicaragua, Honduras and Guatemala the surveys show that Salvadoran firms are less likely to describe the government as inefficient, or to state that government regulations are interpreted in an inconsistent and unpredictable way, or that bribes "to get things done" are a common practice intheir sector (figure 1.8). 21. The resources spent by private firms to bribe public officials are significant but generally smaller in El Salvador than in other countries for which comparable data are available. The ICs suggests that Salvadoran firms spend on average 1.7 percent o f their revenues on bribes "to get things done." The same or very similar figures are found inNicaragua (1.7 percent), Honduras (1.9 percent) and China (1-8percent), while higher values are obtained for Bangladesh (2.5 percent), Ecuador (2.6 percent) and Guatemala (3.2 percent). Corruption related to public procurement i s also a serious challenge, as highlighted in the Country Procurement Assessment (CPAR, World Bank, 2004). Indeed, the survey data indicates that, to secure government contracts, Salvadoran managers pay bribes equivalent to 3.7 percent o f the contract on average. This is slightly less than what was reported by firms in Nicaragua and Guatemala (bribes o f 4.4 percent o f public contracts) and about the same inHonduras. Incontrast, firms surveyed in China and Bangladesh report procurement bribes equivalent to respectively 2.1 percent and 4.3 percent o f government contracts. 22. Firms with more frequent contacts with the public sector are more likely to pay bribes. The econometric analysis o f the empirical determinants o f the practice o f paying bribes "to get things done" yields both expected and unexpected findings. The main unsurprisingresult is that this type of corruption affects to a larger extent the firms with a greater need o f public services and those that operate inmore heavily regulated sectors or locations. Both among Salvadoran firms and in a sample that includes companies surveyed in Guatemala, Honduras and Nicaragua, the firms that had more interactions with government officials or providers o f public services are more likely to report that administrative corruption i s common in their sectors, and that bribes consume a larger fraction o f their sales. This result supports the hypothesis that bribe payments are the result o f bargaining processes between firms and corrupt public officials, in which the firms that need to deal more frequently with the public sector are in a particularly weak negotiating position and, as a result, pay more and higher bribesa7 Figure 1.9: Bribes"to get things done" and to win public contracts Source: Investment Climate Survey Our econometric analysis follows Svenson (2003) and is describedinthe appendix to this chapter. 23 23. Firms that have low confidence in the judiciary and those that receive informationon government regulations from industry associations are more likely to report the use of bribes.The first result is far from unexpected, as firms that believe that their rights would not be adequately protected by the judiciary are understandably less likely to refuse offers from corrupt officials. The second result i s more surprising, as one would expect that the firms' bargaining position could be strengthened-and not weakened, as the results seem to suggest-by their access to information provided by chambers o f industry or commerce. One possible explanation i s that the firms' access to information collected by industry associations is positively related to their awareness o f corrupt practices, which i s our actual empirical proxy for the incidence o f corruption, but not necessarily with their direct involvement inthose practices. 24. Larger companies are more likely to report administrative corruption in their sectors but smaller firms reportlarger bribe payments as a percentage of their sales. Firms with larger capital stocks report a lower prevalence o f bribe payments, as do more profitable Salvadoran firms. The negative relationship between profits and bribe payments i s specific to El Salvador, as the opposite finding-profitable firms paying more bribes-was obtained for the other three countries. On the other hand, in all four countries it appears that larger firms are more targeted by corrupt public officials, but the value o f bribes does not increase in proportion with firm size. Moreover, corruption appears to affect to a lesser extent the more capital-intensive firms, possibly because they have greater means to defend themselves from corrupt officials, who may fear a greater chance o f getting caught when dealing with them. POLICY RECOMMENDATIONS ON CORRUPTION 25. Despite beinglowerthan in neighboringcountries, corruptionin El Salvador has a significanteffect on the costs of doing business and may thus affect the country's attractiveness to foreign investors. Import licenses, construction permits and transactions that involve public procurement are especially costly and burdensome for firms in El Salvador. Thus, it would be important to increase transparency in the affected public agencies, clarifying the requirements (in term o f costs and time) to complete the corresponding transactions. Moreover, to increase the accountability o f civil servants working inpublic agencies, the government should consider the introduction o f a system o f score cards (compiled by business people) for these services, whose results should be published regularly inlocalnewspapers. 26. Managersdealingwith the public sector pay an additionalcost due to corruption and limited information available. As emphasized in the CPAR, it is important to simplify the procurement process and make it more transparent. Inthis area, El Salvador can benefit from the experience o f other developing countries that have successfully modernized their procurement procedures. It will also help to establish internal and 24 external auditing mechanisms in key public agencies dealing with public contracts. These objectives could be achieved with the creation o f a public source o f information available on the Internet. The geographical heterogeneity o f corruption and poor governance * should also be addressed. Businesses in a few departments report a much higher cost o f corruption than in other parts o f the country. In response to this challenge, it would be important to strengthen accountability and transparency o f public institutions, especially inLa Libertadand San Salvador. 27. Collective action on the part of the business community-for instance through industry associations-may be a good strategy to reduce the incidence of administrative corruption. Indeed, the finding that corruption is more frequent among firms with more dealings with the public sector i s consistent with bribe payments being the result o f negotiations between firms and corrupt officials. This, in turn, leads to the conclusion that actions that strengthen the bargaining position o f individual firms could help reduce corruption. As argued by Svenson (2003) in a similar context, examples of such initiatives involving collective action by the business community include the collection and dissemination o f data on corrupt practices, and the provision o f information on service standards, guidelines and norms o f major service providers. 28. Corruption can also be reduced by taking measures to improve the honesty and efficiency of the judiciary. Our findings suggest that a higher distrust in the judicial system is associated with a greater incidence o f administrative corruption. Indeed, a perception o f generalized impunity can increase the aggressiveness o f corrupt officials, and reduce the incentives o f firms to refuse to pay bribes. As we will argue in the last section o f this chapter, the lack o f transparency and irregularities in court proceedings affect the quality and efficiency o f the court system, which can reduce its effectiveness in preventing and prosecuting corruption.' CRIME 29. El Salvador exhibits very high levels of crime and violence, even by Latin American standards. According to the World Health Organization the low and middle income countries o f the Americas exhibit the highest rates o f intentional homicide in the world: 27.5 homicides per 100,000 population in 2000, compared to 22.2 for the African region, 14.8 for low and middle income European countries and less than 10 for high income countries and other regions o f the developing world (see figure l.lO).'' In2003 El Salvador had 36.5 homicides per 100,000 inhabitants. International victimization surveys also place El Salvador among the most insecure countries in Latin America. Indeed, El Salvador is near the top o f the group o f 17 Latin American countries covered by the Latinobarometro survey. In 1996 it ranked second. In2003 it rankedfourth behind * An example is the system createdby the Government ofPeru: see www.inei.gob.pe, See Lothian (2003) for a detailedanalysis of corruptionwithin thejudiciary inEl Salvador. loSee Krug et al. (2002), Ayres (1998) andBuvinic et al. (2002). 25 Mexico, Venezuela and Argentina. A more recent survey conducted in early 2004 with the support of the United States Agency for International Development (USAID) also finds higher rates of victimization in El Salvador than in the other Central American countries. '' 30. Since the late 199Os, however, El Salvador has experienced a clear downward trend in homicide rates and considerable reductions in household victimization rates, Homicide rates averaged about 42 per 100,000 in 1999-2000 and 36 per 100,000 in 2002-2003. The results o f nation-wide victimization surveys done by Universidad Centroamericana since 1993 also suggest a declining trend. Data from the National Civil Police reveal drastic reductions in rates o f economically motivated crimes. Indeed, in 2000 there were only 10 bank robberies and in 2003 there were 127 commercial vehicles robberies, compared to respectively 35 and 1,258 cases reported to the police in 1998. The reduction in the number o f abductions reported nationwide i s another clear indicator o f the downward trend in violence related to organized crime (figure 1.11). Similarly, comparing the period from mid 2002 to mid 2003 with the preceding 12 month period, Police statistics indicate that the activities o f organized crime have been considerably curtailed. However, rape and homicides increased respectively by 10% and 4% over that period and during the first eight months o f 2004 the number o f homicides reported to the National Civil Police increased by 16% compared to the same period in2003. Figure 1.10: Homicide ratesper 100,000population, by gender and WHO region IUAll ElMales ElFernalesI 51.0 36 5 Source: Word Health Organization(Krug et al. 2002) " SeeCordova andCruz (2004). In this survey households were asked about criminal acts o f which they were victims over a period o f four months. El Salvador's victimization rate was estimated to be 17.1, behindMexico's 17.4, but above the rates for other Central American countries, which ranged from 12.8 to 15.2. 26 Figure 1.11: Kidnappingsin ElSalvadorbetween 1997and August 200 L 1 4 0 1 2 0 1 1 4 1 0 0 9 il 80 63 60 4 9 4 0 I 1 9 9 7 1 9 9 8 1 9 9 9 2 0 0 0 2 0 0 1 2 0 0 2 2 0 0 3 2 0 0 4 ( A s o f A u g u s t ) Y e a r Source: National Civil Police. 31. Despite the widespread perceptionthat juvenile gangs are responsiblefor a large fraction of the crimes committed in El Salvador, there is limited hard evidence to support this perception. According to conservative estimates there are 20,000 youths enrolled in juvenile gangs in El Salvador. The National Civil Police holds those organizations responsible for a good part o f the violence that occurs in the country. However, in spite o f their undeniable contribution to the creation o f a climate o f insecurity, the role o f gangs in explaining the incidence o f violent crime may have been to some extent exaggerated. A report by the Legal Medicine Institute, for instance, shows that out o f 2,388 homicides registered in2003, only 192 (8 percent) were known to have been committed byjuvenile gang-members. l2 32. Low levels of prosecution efficiency and effectiveness may help understand the high incidence of crime and violence found in El Salvador. Among the many factors highlighted in previous studies as possible determinants o f crime and violence in El Salvador, apparent weaknesses in the institutions that are in charge o f providing security andjustice are arguably one o f the most important. Inthis respect, the available statistics reveal that despite the considerable progress observed since the mid-1990s, great challenges remain to achieving acceptable standards o f efficiency and effectiveness in law enforcement. Figure 1.12: Victimizedfirms and Figure 1.13: Crime Losses and security costs firms constrainedby crime (% of sales) InternationalComparison - 5 8 0 1 Mvictimized (%) Wconstrained by crime I Osome sec. Cost Incrime losses Elsecuritycosts nsec cost (if any) Source: Investment Climate Survey Source: Investment Climate Survey l2Interview with Dr.Fabio Molina, director of the statistics unit o f the "Instituto de Medicina Legal El Salvador." 27 33. The impact of crime and violence on the activitiesof private Salvadoranfirms is smaller than in Guatemala but larger than in Nicaragua and Honduras. Almost 41 percent o f the surveyed Salvadoran firms report having been victims o f criminal acts in the year preceding the survey, and 49 percent indicate that crime and violence are major constraints. The percentage o f firms that describe crime as a major constraint i s higher than in Nicaragua (40 percent) but lower than in Honduras (62 percent) and Guatemala (81 percent). However, objective indicators o f the impact o f crime on the activities o f private firms suggest that while the problems faced by Salvadoran companies are smaller than those found in Guatemala, they are larger than in both Nicaragua and Honduras (figure 1.12 and 1.13). 34. Smaller firms are less likely to be victims of criminalactivitiesbut their average losses as a result of crime are higher those of medium and large firms. The percentage o f firms that report having been victims o f crime increases from around 30 percent among micro and small firms to more than 50 percent for large firms. Similarly, the fraction that report having some type o f security expenditures increases from 39 percent for micro firms to 93 percent for large companies. Despite these large differences, the average loss resulting from crime i s lowest as a fraction o f sales among large firms. Within El Salvador, the probability o f a firm being a victim o f crimes i s higher in the provinces o f San Salvador and La Libertad, and inthe sectors of food and beverages and chemical products. 35. Gang-related crime affects micro and small firms to a much greater extent than large firms. The share o f crimes committed by gangs i s similar inEl Salvador, Honduras and Nicaragua, and much higher in Guatemala. About one third o f the Salvadoran firms that report having been the victims o f criminal acts indicate that at least some o f them were committed by youth gangs. On average, gangs are responsible for 27 percent o f the crimes committed against the surveyed Salvadoran firms, compared to 67 percent in Guatemala and respectively 28 percent and 25 percent in Honduras and Nicaragua. InEl Salvador, gangs affect to a much larger extent the activities o f smaller firms: while 46 percent and 37 percent o f the crimes committed against micro and small firms are attributed to youth gangs, the corresponding figures for medium and large companies are 19 percent and 18 percent respectively. Similarly, for the firms that report having been the victim of criminal acts, one in two microenterprises indicate that youth gangs were responsible for some o f those crimes, compared to one in four large firms. Compared to other firms o f the same size, sector and province, Salvadoran maquilas are less likely to report security expenditures and to be victims o f criminal acts. Similar but quantitatively smaller differentials are found inother Central American countries. 36. The risk of victimization is lower for firms locatedin regions and sectors with a higher share of companies that invest in private security.A 50 percent increase inthe share o f firms that invest in security reduces in 18 percent the probability o f victimization o f firms o f the same size range, province and sector. Econometric estimates also confirm several o f the descriptive results previously reported: larger firms are more likely to report security costs and to be victimized, but they loose a smaller percentage o f sales when victimized. Firms that have been victimized are more likely to have security 28 expenditures; and the highest victimization risks are obtained for the food and beverages and chemicalproducts sectors. POLICY RECOMMENDATIONS ON CRIME 37. It is important to improve the collection of informationon the impact of crime on private sector activities. Despitethe large number o f studies available on the issue of crime and violence in El Salvador (see Moser and Winton, 2002), little information has been collected on the impact o f crime on the private sector. The ICs i s the first survey to systematically collect information on the impact o f crime on private firms. Inthis respect, a possible mechanism that could be used would be that o f including questions on crime victimization in the firm level surveys that are executed by the government's General Direction of Statistics and Census (DIGESTYC), as well as in the business surveys o f organizations like FUSADES. It would also be very important that business associations such as the chamber o f commerce develop databases on the frequency and importance o f crimes against their members. Finally, it is fundamental to improve the information systems o f the institutions in charge o f public security and justice, particularly those o f the Attorney General's Office and the courts, in order to evaluate not only the general trends of crime but also the effectiveness o f those institutions indeterring crime. 38. A security policy aimed at improving El Salvador's investment climate should encompass measures directed at curtailing the incidence of both property crimes and crimes against the integrity of individuals. Moreover, such a policy should not necessarily have its main focus on the problems created by youth gangs. As seen in this section, the efforts to reduce the incidence o f economically motivated crimes have been more successful than those aimed at reducing violence against individuals - e.g. homicides and rapes. However, high rates o f "social violence" also have detrimental effects on economic activity, as they increase the perception o f insecurity and lead to large unproductive expenditures in security and in the treatment and compensation o f victims. Thus, El Salvador's security policy should encompass actions directed at reducing both economic and social violence. As for the role o f gangs in explaining the highrates o f crime and violence, the ICs showed that gang members are responsible for less than one third o f the crimes committed against private businesses. Thus, the sole concentration o f police and judicial resources in fighting gang-related crime may not be totally warranted, and the fight against gang-related crime should be put inthe context o f a comprehensive vision o f the violence problem in El Salvador. A comprehensive national security policy should also incorporate measures aimed at curtailing the proliferation o f firearms, strengthening justice sector institutions, creating educational programs to promote the peaceful resolution o f conflicts, and broadening education and employment opportunities for at-risk groups. 39. The active participationof the private sector in formulating and supporting the country's policies against crime is fundamental. The participation o f the private sector in the design, support and execution of policies to face the problems of crime and violence has been very limited. The main exceptions have been a campaign to collect arms at the end o f the 199Os, the support given to the UNDP program "Sociedad din Violencia" (society without violence), and the participation o f the judicial teams o f the 29 National Association o f Private Enterprises in some high-profile criminal cases. However, the business sector can play a much more important role, not only by continuing its support o f campaigns to collect arms and by producing information on the criminal cases that affect the members o f business associations, but also by directly participating ineducational andjob training programs aimed at at-risk youth, as well as in other local and national crime prevention initiatives. CONTRACT ENFORCEMENT THE JUDICIARY AND 40. The functions of enforcing contracts andreducingthe uncertaintyfaced by firms when engaging in commercial transactions are not restricted to the courts. Those functions can be performed through both formal and informal mechanisms. While all contract enforcement mechanisms serve the same purpose, informal mechanisms may be potentially inefficient. For instance, firms may limit the range o f their new clients if they decide to commercially transact only with known, repeated customers, or ifthey structure transactions with a view to avoiding business disputes (for instance when requiring pre- payment). Figure 1.14: FirmsWhich Do Not Believethat the Courts Will UpholdTheir Contractualand PropertyRightsin a CommercialDispute Brazil 23 PnU 23 El Salvador Honduras 39 Nicaragua 41 Guatemala 48 Ecuador 56 0 10 20 30 40 50 60 Source: Investment Climate Survey. 30 Figure 1.15: FirmsWhich PerceiveProblems in Court Efficiencyand ContractExecutionto Be a Major or Very Severe Obstaclesto DoingBusiness 0 5 I O I 5 1 0 1 5 1 0 3 5 4 0 P e r E l n l Source: Investment Climate Survey. 41. El Salvador does reasonably well - as shown in Figure 1.14 - relative to other Central and South American countries-interms of private firms' confidence inthe judicial system. Still, a quarter o f respondents (26%) disagree fidly or at least in the majority o f cases, that the judicial system will uphold their contractual and property rights in the case o f business disputes. This i s substantially lower than in Honduras, Nicaragua, Guatemala, and Ecuador, but marginally higher than in Brazil and Peru, Salvadoran firms also report less severe problems associated with such aspects o f the contract enforcement regime as court efficiency and contract execution (see Figure 1.15). The proportion o f firms that consider the problems related to court efficiency and contract execution to be major or very severe obstacles to their operations i s smaller inEl Salvador than inthe other three Central American countries, Ecuador and Brazil. 42. The share of sales made on credit i s higher in El Salvador than in other Central American countries, but it is lower than in Peru and Brazil. Previous research has found that when countries' contract enforcement in court works well, firms would be more willing to extend credit to their customers as well as to engage in transactions with new, less known ones. The ICs asked firms what proportion o f their sales are paid by customers in advance (i.e. before the delivery o f the good), at the time o f the sale, or on credit. In81percent o f the cases firms report at least some sales on credit. This fraction i s higher than the share o f firms selling on credit inNicaragua, Honduras, Guatemala and Peru, but lower than the same in Brazil (94 percent) and Ecuador (90 percent). For those firms which do sell on credit to their customers the share o f credit sales i s about 66 percent o f their annual sales (see Table 1.3). Across all interviewedSalvadoran firms the share o f sales sold on credit i s 53 percent on average, which i s higher than inneighboring countries, but lower than inBrazil and Ecuador. 31 Share offirms which sell on Percentage sold on credit Percentage sold on credit Country credit acrossfirms which do sell across allfirms on credit Nicaragua 65% 50% 32% Honduras 65% 64% 42% Peru 69% 66% 46% Brazil 94% 84% 79% Ecuador 90% 76% 68% ElSalvador 81% 66% 53Yo Guatemala 77% 67% 51% 43. Salvadoran firms report that a relatively large share of their sales to private customers is paid with a delay. Only 11 percent o f the firms which deal with private clients report no payment delays. Consistent with the finding that a smaller proportion o f Nicaraguan and Honduran firms allow credit, a larger fraction o f respondents inthese two countries report not experiencing payment delays (19 percent inHonduras and 20 percent in Nicaragua). Accordingly, the size of delayed payments is similar in El Salvador and Guatemala (33 percent and 34 percent o f total annual sales respectively), and lower in Nicaragua and Honduras (25 percent and 28 percent respectively). This might possibly indicate a somewhat higher trust inthe judiciary or incontract enforcement institutions in El Salvador and Guatemala than inNicaragua and Honduras - which appears to be true for El Salvador based on the analysis o f perceptions o f trust in the judiciary, but not so for Guatemala. For those Salvadoran firms which experience payment delays in their sales on credit it takes about one and a half months on average (49 days) to resolve them. Compared to the rest o f Central America, Salvadoran firms take somewhat longer to resolve delayed payment disputes: the corresponding duration o f payment delays resolution i s 38 days inGuatemala, 33 days inHonduras and 26 days inNicaragua. 44. About 35 percent of the surveyed Salvadoran firms use business associations as an avenue for resolving commercial, labor and administrative disputes. Almost 60 percent o f the surveyed firms belong to a business association, and o f those 59 percent receive assistance from the association inresolvingbusiness disputes. Of the latter group, more than one third (37 percent) attach a high or critical importance to the dispute resolution services received, but more than a quarter (27 percent) attach zero or low value to the services received. In contrast, a similar firm-level survey -the 2002 Business Environment and Enterprise Performance Survey (BEEPS-2) - conducted in 2002 -- reveals that for a subset o f eight South Eastern European countries on average only 4 percent believe that the business association to which they belong provides a major or critical value inresolving disputes, and an average o f 84 percent believe that the business association to which they belong provides no value or, at best, only negligible value in resolving business disputes.l3Across Central America business association membership i s highest in Honduras (71 percent) followed by El Salvador at 59 percent o f interviewed l3 In both the BEEPS-2 and ICs questionnaires the format of the question about belonging to business associations and the value o f services they provide are very similar. The value of dispute resolution services i s assessedon a 5-point rating scale (0 -no value to 4 - critical (crucial) value). 32 firms. Business associationmembership i s somewhat lower inNicaragua (43 percent) and Guatemala (53 percent). Micro Firms Small Firms Medium Firms Large Firms El Salvador 7.5% 16.4% 30.6% 24.2% Guatemala 9.8% 10.4% 16.2% 28.9% Nicaragua 4.9% 18.3% 35.4% 40.0% Honduras 4.4% 16.9% 36.2% 25.3% 45. Salvadoran firms very seldom use the courts to resolve their overdue payments. More than three quarters o f Salvadoran firms which experience payment disputes (79 percent) do not bring these disputes before the courts. Similar shares o f firms experiencing overdue payments report filing court cases to resolve those: 21 percent inEl Salvador, 20 percent in Honduras, 19 percent inNicaragua and 17 percent in Guatemala, These shares, as shown inTable 1.4, vary across firms o f different size as a significantly higher share o f medium-sized and large firms bring their payment disputes before the courts. Nevertheless, the results indicate that firms are primarily resorting to direct negotiation and alternative mechanisms for resolving payment disputes when such occur.I4 Indeed, only about 2.0 percent o f cases of overdue payments were brought to the courts inthe two years preceding the ICs." 46. El Salvador has the lowest times to disposition of a business case in the courts, followed by Nicaragua, Guatemala and Honduras. Figure 1.16 shows the average duration o f these identical overdue payment cases from filing in court until the judge delivers a decision for the four Central American countries. It also shows the duration o f a payment dispute in court in the country's largest city for each o f the four Central American countries according to the World Bank Doing Business Database.I6 El Salvador appears ahead o f its neighbors on the basis o f the ICs, and trails only Nicaragua when usingthe DoingBusiness Database. l4 This is usually the case inother countries too -e.g., Hendley and Murre11(2002) for Romania, Broadman et al. (2004) for eight South Eastern European countries. The results on payment cases filed with the courts or tribunals for El Salvador generally apply to the other three Central American comparator countries. For instance, the percentage o f overdue payments brought to court over the preceding two years i s also 2.2% on average in Honduras, 2.3% inNicaragua, and 1.3% inGuatemala. l6 Since the ICs data on duration do not include time for execution o f the judgment, we would naturally expect that the Doing Business data would be higher than the ICs (which is the case in El Salvador). Other potential sources of difference between the ICs and Doing Business data in this particular example are the numerous specific assumptions which are made in the case considered by the Doing Business Project, 33 Figure 1.16: Durationof a PaymentDisputein Days: A Comparison of ICs andDoingBusiness Data - E l S a l v a d o r N I C B l a S Y ~ I I I 4 5 9 G v n l r m a l a I 4 6 0 H o n d u r . 8 0 1 0 0 4 0 0 6 0 0 8 0 0 I O 0 0 1 2 0 0 1 1 0 0 I 6 0 0 d a y 8 I = I C s O D o i n i B u i i n r i r Z O O 4 O D o l n n B u s l o c s ~2 0 0 5 I Source: Investment Climate Survey and Doing Business Database 47. El Salvador's judicial complexity appears to be quite high, as suggested by the Doing Business data. Apart from time and cost o f court enforcement o f contracts, many authorsI7 point to judicial formalism or complexity as being associated with court delays and judicial corruption. The index o f judicial complexity is a composite measure, covering such features of the judicial process such as the type o f judge, the necessity o f legal representation, the presence o f written versus oral elements in the process, the regulation of appeals, the regulation o f evidence, and i s built on a scale o f 0 to 100, with higher values standing for higher complexity. As seen in Figure 1.17, El Salvador ranks second after Guatemala - among the four Central American and three South American countries which we compare across the I C s data as well - in terms o f how complex and cumbersome its procedure is. Figure 1.17: Index of Judicial Complexity A Cross-countryComparison - 0 .10 2 0 30 4 0 5 0 6 0 7 0 S O 9 0 I O 0 ource: World Bank Doing Business Database 48. Anecdotal and additional availablesurvey evidence also point to major problems inthe Salvadorancourts and the public's trust in the judiciary. This is suggested, for instance, by a report commissioned by the World Bank to the University Institute o f Public Opinion o f the Central American University "Jose Simeon Canas" in El Salvador, aimed at evaluating public opinion about the courts and the judicial system. Confidence See Djankov et al. (2003), Henderson et al. (2004), Doing Business in2004, Chapter 4. 34 inthe fairness ofthe courts was found to be low: 35 percent ofrespondents answeredthat courts are never or seldom fair. As a measure o f the bias injudges' decisions, 72 percent o f surveyed individuals agreed strongly with the statement: " Judges favor the rich more than the poor". The report also revealed that both judges and lawyers are perceived as corrupt: on a rating scale o f 1 to 10, where 1 stands for "zero corruption" and 10 for "very corrupt", 45 percent o f respondents assigned values o f 7 to 10 for how corrupt judges are and 55 percent o f respondents do so for how corrupt lawyers are. About 73 percent o f surveyed individuals agreed that one has to pay ajudge to win a court case. In line with these findings, 53 percent o f respondents found thejudicial system having no or little honesty. POLICY RECOMMENDATIONS ONCONTRACTENFORCEMENT THE JUDICIARY AND 49.To improve court performance measures need to be taken to reduce case backlogs. One o f the symptoms of slow justice is the case backlog - and there is evidence that typical civil cases take 3 to 4 years from filing to disposition" - something which was confirmed by the Doing Business data on maximum times for case disposition. A typical recommendationto address high caseload i s to increase the number of judges or bring in more computers and equipment - but as studies have shown this seldom works. Instead, the focus should be on making sure that court procedures are less cumbersome, case management works well and certain types o f cases - such as small claim cases or commercial cases can go to a specialized court, or be put on a track for mandatory mediation, for instance by industry associations 19. Alternative dispute resolution mechanisms are governed in El Salvador by the 2002 Law o f mediation, conciliation and arbitration. 50. It is also importantto improve court management and to invest in the collection of judicial statistics- on numbers of cases filed per year, numbers of cases pending, types of cases, etc. The current World Bank Judicial Modernization Project (JMP) is already addressing some o f these concerns. Improving court case management through computerization and assigning these tasks to court clerks rather than the judges has produced good results in some countries which have undertaken similar reforms inrecent years (e.g. in some o f the courts in Slovakia2'). According to World Bank (2003), each judge currently has to spend 70 percent o f hidher time on administrative tasks, thereby reducing their time for their main task - case adjudication. This could be an area to work -both through the JMP and through other donors' support. See World Bank (2003b), "El Salvador: Social and Institutional Context, Profile and Challenges o f the Judiciary and the Judicial Modernization Project". This diagnostic reports that in 2003 there were about 260,000 cases pending in El Salvador, o f which about 60% in the First Instance Courts, and 25% in the Justice o f the Peace Courts. It states that in recent years there has been an increase in labor, family, small claim and commercial cases filed with the civil courts. The report mentions that backlogs have grown as a result of insufficient capacity and inefficiencies, and are more pronouncedat the first instance courts rather than at the appellate level and the Supreme Court o f Justice (SCJ). l 9This has proven very successful and reduced backlogs in Argentina. See World Bank (2001a), "Argentina: Legal and Judicial Sector Assessment", Legal Vice-Presidency. 2o See World Bank (2001b), "Administration o f Justice and the Legal Profession in Slovakia", Poverty Reduction and Economic Management Unit, Europe and Central Asia Region. 35 51. Cumbersome judicial processes should be simplified as they breed judicial corruption and create delays. As evidenced in the Doing Business data, procedural complexity i s high, and even though procedures are usually instituted to ensure fairness and impartiality o fjudgment, the empirical evidence suggests otherwise2'. Simplification can apply to many elements o fthe typical civiljudicial process -through instituting more oral rather than written procedures; through eliminating the need for plaintiffs to present legally motivated claims; through eliminating interlocutory appeals and motions, which debtor-defendants file just to delay payment; through improving the system o f notifications o f claim to the defendant and o fjudgment to both parties. 52.The Government of El Salvador should also address the perceived lack of independence and impartiality among judges and the alleged interference of politicaland economic power in court decisions. For example, Lothian (2003) argues that some o f the main problems o f the Salvadoranjudicial system are the political control over it (through judicial appointments to the SCJ), the centralized control o f the judiciary by the Supreme Court o f Justice, and the lack of transparency and openness injudicial proceedings and decisions. She proposes several sets o f reforms, such as changes in the appointment procedure for Supreme Court Justices, the separation o f administrative and judicial functions - which was mentioned earlier as well - and the creation o f a career judiciary at the level o f the first-instance courts through competitive examinations for judicial appointments and changes to the curricula in law schools. Finally, she proposes increased transparency - for instance, at present judicial decisions are not 'published and disseminated ina timely manner. 53. Finally, reforms should also target information-sharing, which supports both execution of judgments as well as informal contract enforcement. Public credit registries are often cited as an example o f information-sharing institutions, which can facilitate exchange by allowing a business to check the credit history o f another business, thus expandingtransaction opportunities. Credit andassetregistries can also be helpful in ensuring that the debtor's assets can be located and seized to pay the debt. Having a judgment without the ability to collect on it is not much use. Therefore, efforts could be made to institute and improve information-sharing among market participants. BUSINESS-GOVERNMENT RELATIONS 54. According to ICs data, El Salvador has a faster registrationsystem than other countries in the region. A comparison among four Central American countries (El Salvador, Honduras, Nicaragua and Guatemala) reveals that El Salvador ranks reasonably well interm o f days to register a business. A typical firm inEl Salvador takes 46 days to register compared to 29 days in Nicaragua, 56 days in Guatemala and 83 days in Honduras. Micro and small firms spend less time registering than their larger counterparts. Health permits and draft o f constitution o f society are the steps that take the longest time in El Salvador (30 and 16 days respectively), a fact also observed in neighboring countries. See Djankov et al. (2003). 36 55. Salvadoran firms take less time than their counterparts from Honduras and Guatemala but more than those from Nicaragua to obtain license and permit renewals.Countries where business registration takes longer also show longer processes for license and permit renewal. Overall re-registration and renewal duration i s shortest in Nicaragua (14 days), followed by El Salvador (26 days) and Honduras and Guatemala (42 and 34 days respectively). InEl Salvador renewal o f environmental permits takes the longest at 36 days, followed by renewals by the Health Ministry (35 days). Aside from these, all other types o f document renewals take no more than one week. As in El Salvador, environmental permit renewals take the longest in Honduras at 45 days. Altogether, environmental permit renewals take longer in El Salvador than in Nicaragua (36 versus 10 days) but less than in Guatemala (58 days) and Honduras (45 days). In terms o f health permit renewals, El Salvador trails both Nicaragua and Honduras, but does better than Guatemala. Survey data show that a significantly lower fraction of Salvadoran firms (26%) hire professional agents, lawyers and other intermediaries to assist them in getting their licenses and permits renewed compared to firms in Honduras (37%) and Guatemala (47%), but this fraction i s significantly higher than in Nicaragua (where only 16% o f interviewed firms resort to hiring agents for license renewal). This ranking mirrors the duration o f re-registration license and permit renewals across the four countries. Figure 1.18: - 1 and Permits .. __ .. . ..-.... ~. NioaragUa Y 9 ~ El Salvador 46 ~ PTotal duration of rsgisfration (msluding obtaining all necessuy Licenses and permits) l T o t s l duration of re-registration and rcnswal of licsnacn and permits (including all necessary l ~ c e n s ~ s pcrmifa) and Source: Investment Climate Survey. 56. Construction-relatedpermits take longer but are less expensive in El Salvador than in neighboring countries. The reverse is true for land-related permits, El Salvador exhibits the lowest costs o f construction-related permits (at 0.16% o f total annual sales), but has the second highest costs o f obtaining land-purchase-related permits (at 0.48% of annual sales). As for the duration o f the corresponding procedures, Salvadoran firms take the least time to comply with land registration requirements (51 days compared to 54 inHonduras and 58 inGuatemala and Nicaragua), but construction- related permits are slower than in neighboring countries (39 days, compared to 26 on average inthe other three countries). 57. A relativelylow fraction of Salvadoran firms (13%) report that they had to pay penalties and fines to the Tax Authority. However, the size of the tax fines is 37 relatively high compared to the other three Central American countries (0.66 percent of sales on average). In terms o f sales declared to the tax authority, Table 1.5 shows that El Salvador i s one o f the Central American countries where more sales are declared. Firms report declaring 76.9 percent o f their sales: almost the same as in Guatemala, but more than inNicaragua and Honduras (65.6 and 67.7 respectively). Inall four Central American countries, medium and large firms report a higher proportion o f their annual sales to the tax authorities, but the differences are only significant in Nicaraba, Honduras and Guatemala. This suggests that inEl Salvador micro and small f i r m s operating formally (informal firms are not covered by the survey) do not differ substantially from their larger counterparts interms o f reported sales for tax purposes. Country Share of Firms that Size of Tax Penalty, Percentage of Sales Declared had a Tax Penalty (%of sales) to Tax Authorities Nicaragua 23.9% 0.85 65.6 ~ Guatemala 23.7% 0.24 77.0 ' El Salvador 13.1% 0.66 76.9 Honduras 10.7% 0.62 67.7 58. Salvadoran firms are less constrained by labor regulations than their counterparts from Nicaragua, Honduras and, especially, Guatemala, Survey results show that in El Salvador 25 percent o f the firms would increase employment if restrictions were lifted -- a share significantly lower than in the Honduras, Nicaragua and Guatemala. At the same time, firms in El Salvador firms are also less likely to fire workers should regulations be eased - only 6.5% report an anticipated reduction in the numbero f their permanent employees. Salvadoran firms cite prospects for an increase or decrease in sales and labor costs (such as social security costs, salaries, etc.) as the two most important reasons for maintaining the level o f their workforce above or below their establishment's current needs. 59. Salvadoran managers devote more time to dealing with the Tax Authority (5 days) than to any other government agency. Figure 1.19 shows that in all the four Central American countries for which we have comparable data firms devote the longest time to meetings and inspections performed by officials o f the tax authorities. In El Salvador the second longest period o f time spent in inspections i s with officials o f the Ministry of Health (sanitary inspections), followed by the Salvadoran Institute of Social Security (2 days each). The overall number o f days spent in inspections per annum i s lower in El Salvador than in Nicaragua and Honduras, and close to that o f Guatemala. The number o f days spent in inspections with officials from all Government agencies, other than the Tax Authority, reveals that Nicaraguan firms bear the highest burden at about over 13 days per annum, followed by Honduras at close to 9 days per annum. In contrast, firms' total time spent in inspections by the same agencies i s substantially lower in El Salvador (under 7 days) and Guatemala (over 5 days). In El Salvador firms' managers spend on average about 7.4% o f their working time per year in meetings regarding differenttypes o f government regulations. This i s lower than the same measure 38 for the other three Central American countries (11% inGuatemala, 8.6% inHonduras and 8.0% inNicaragua). The share o f senior management time spent dealing with regulations increases with firm size. This pattern i s observed in the other three comparator countries as well. Figure 1.19: DaysSpent in Inspectionsand Mandatory Meetingswith Government Officials 9.018.0 1 8 0 7 0 6 0 v 5 0 3 4 0 3 0 2 0 I O 0 0 ~ OTax Inspectorate .Labor and Social Security OFireand BuildingSafety i OPublic Health .Pohce ElEnvironmmial ~ .Officials from the Municiealiw Source:World BankInvestmentClimate Surveys POLICY RECOMMENDATIONS ON BUSINESS-GOVERNMENT RELATIONS 60. As evidenced by the data, El Salvador ranks well region-wide in terms of days for re-registrationand license renewals. However some improvementscan be made, particularly with respect to renewal of environmental and sanitary permits. In the area o f construction and land permits there are some problems as well - although not as severe as in some o f the other comparator countries. Labor regulations are not seen as that problematic either - although other available evidence22suggests that labor laws are rigidand firms find it hardto hire and fire workers. 61. Tax reforms should target simplification of tax administration procedures and laws, the mechanisms for appeals and reclamation of corporate taxes paid. Inspections by the Tax Authorities are reported to take the longest among inspections by various public agencies with regulatory functions. At the same time a relatively low fraction o f Salvadoran firms complain that the working o f the tax administration i s a major problem, and Salvadoran firms declare a relatively high share o f their revenues for taxation purposes. Nevertheless, efforts can be made to further improve the interactions of firms with the Tax Authority and the Ministry o f Finance regarding corporate taxation. In addition, firms complain about ineffective mechanisms to re-claim taxes paid, or *' ~ See Doing Business in2004, Chapter 3. El Salvador's index of the flexibility o f hiring of workers (81 on a 0 to 100 scale, with highervalues signifying less flexibility) i s among the worst inthe Doing Business sample o f 130 countries, andalso equal to those of Mexico and Panama. 39 appeal taxation decisions, as well as about the frequent changes o f tax laws and tax rates. Some attention should be given to these issues. 62. Finally, policy reforms should aim at creating a level playing field for all firms through targeted reforms of administrative simplification for MSMEs, firms different industrialsectors or geographic regions. Certain types o f firms appear to be more disadvantaged than other firms - e.g. medium and large firms take longer to register, and are generally subjected to heavier regulations. The opposite usually holds for costs for different regulatory activities - micro and small firms seem to pay proportionately more than medium and large firms. While more analysis i s needed to ascertain the effects o f type o f firm, ownership, and other firm characteristics on time and cost of regulations, it i s clear that the playing field i s far from level. Accordingly, actions could be taken to alleviate some o f these differences. 40 111.INFRASTRUCTURE ELECTRICITY 63. Between 1996 and 2000 the Salvadoran electricity sector was restructured according to what i s now known as the standard model. This model entails the creation o f a competitive wholesale market, competition in generation, regulated transmission and distribution, and the introduction o f the supply business ("comercializadores"). With the exception o f some supplies from a few small generators, all electricity i s traded inthe wholesale market (Mercado Mayoristu de Energiu Ekctrica - MME). On the supply side, actors in the market comprise generating companies (GenCos) and suppliers ("comercializadores") who trade energy imported from other countries in the region. On the demand side, market participants include distribution companies (Discos), some large consumers, and suppliers. Interconnections with Guatemala and Honduras play an important role in the wholesale market. They allow power imports from these countries and, more broadly, from other Central American power systems (Panama, Costa Rica, Nicaragua, Honduras, Guatemala). In 2003, El Salvador's energy balance showed a net import o f 325GWh, equivalent to around 8 percent o f energy trades inthe MME. 64. Generation is divided between a state-owned company and several private thermal generators. There is a relatively high degree of concentration in distribution. Total installed capacity amounts to around 1,1OOMW and available capacity i s on the order o f 1,025MW. Generators in the wholesale market include a government owned company (CEL) which operates hydro power plants (427MW available capacity) and several thermal power generators with private sector participation -ofwhichthelargestisDukeEnergy(289MW). There arealso twolargeindustrialco- generators (50MW). There are five distribution companies (Discos) that supply final users. However, a single company (AES) controls four Discos and accounts for 79 percent o f all users and 73 percent o f retail energy sold. 65. Distribution and Transmission losses are lower than in neighboring Guatemala, Honduras and Nicaragua. Distribution companies appear to be relatively efficient. In2003, losses inthe distribution network amountedto 11percent of energy injected into the Discos' systems. This i s a very good indicator when compared to most utilities inthe region (e.g. Panama, with 15.5 percent losses in distribution for 2003). Overall losses, including transmission, amounted to 12 percent o f energy injected into the system. Although losses vary among Discos, allowable losses (those that can be passed onto consumers) are limited by SIGET in regulated prices, thereby providing an incentive to reduce them. Salvadoran Discos have between 900 and 1000 customers per employee, which i s substantially above that o f many companies in similar settings, which do not exceed 300 customers/employee. These figures point towards well-managed distribution operations that reflect on their financial statements through consistent profits as well as good credit ratings. 41 Figure 1.20. Distributionand Transmission Losses as Percentageof Output 35 T I Source: World Development Indicators. 66. The ICs indicates that average monetary losses due to power outages consume 1.3 percent of manufacturing firms' revenues. The ICs data places El Salvador well ahead o f Guatemala, Honduras and Nicaragua. The fraction o f manufacturing firms that report outages that lead to production stoppages and monetary losses is considerably lower in El Salvador. The survey data also indicates that Salvadoran firms have an average o f 10 power outages per year, compared to 14 in Guatemala, and around 30 in Honduras and Nicaragua. Not surprisingly, the monetary losses reported by Salvadoran firms are smaller than in the other three countries: they represent 1.3 percent o f sales for the average firm, compared to an average o f 3.5 percent for the other countries (figure 1.21). New installations also take less time in El Salvador: 17 days, compared to 18 in Nicaragua, 33 inHonduras and 65 inGuatemala (figure 1.22). Figure 1.21: LossesDueto Power Outages Figure 1.22:Daysfor new Electricity Connection Source: Investment Climate Survey. Source: InvestmentClimate Survey. 67. The degree to which problems in the electricity sector affect private sector operations varies with firms' characteristics, including size, location and sector of activity. Large firms, for instance, suffer to a smaller extent from the existing quality problems inelectricity supply and firms located outside o f San Salvador wait less for new electricity connections. Manufacturers o f chemicals and non-metalic mineral products experience the lowest losses resulting from power outages. Firms that report owning or 42 sharing a generator are less likely to stop production as a result o f outages, and have fewer related monetary losses as a percentage o f sales. Maquilas are also less likely to stop production as a result of power outages, and so are smaller firms. 68. Despite being ahead of some its neighbors, Salvadoran regulators still face important challenges in terms of achieving international standards in the quality of electricity supply. As o f December 2003 most o f the quality benchmarks set by SIGET had yet to be achieved. Moreover, it would appear that the reliability benchmarks set by SIGET should be tightened progressively and that Discos such as CAESS will require a significant effort to adjust to them. Thus, for instance, the actual number o f power outages per consumer per year during 2003 for the largest Salvadoran distributor (CAESS) was about 3.5 times larger than SIGET's benchmark for 2005. The latter i s in turn about twice as large as the actual numberof outages observedinPanama, and among the bottom quartile o f U.S.distributors. 69. Commercial and industrial users pay substantially lower tariffs than their counterparts from other Central American countries. Besides displaying relatively better quality indicators, the Salvadoran electricity sector also exhibits tariffs that are lower than those found inmost neighboring countries. Residential electricity prices at the lOOkWh and 1, kWhlevels are higher than inHonduras and Costa Ricabut lower than in Nicaragua, Guatemala and Panama. Moreover, most commercial and industrialusers pay substantially less than their counterparts from other Central American countries. 70. In spite of the relatively good regional standing of El Salvador in terms of the quality and pricing of its electricity supply, Salvadoran regulators are faced with the challenge of promoting new investments in generation. One o f the major current concerns o f the Government i s the need to maintain a balance between supply and demand o f electricity. In 2004, demand i s expected to reach 820MW for a supply o f 930MW. International interconnections have provided a much-needed backup, but there i s a limit to their capacity. For 2005, the situation i s expected to worsen, with installed capacity barely covering maximum demand; in 2006 two new geothermal plants are expectedto come on line and provide some respite. 71.The government i s also concerned about the possibility of the relatively high level of concentration in generation leading to excessive price volatility. Despite the fact that CEL, as a Government enterprise and the largest generator in the system, has sought to mitigate possible opportunistic pricing on the part o f other market participants, there have beenconsiderable variations inprices inthe spot market. Price volatility inthe spot market and the presence o f `price spikes' have been perceived as undesirable because o f their potential for disturbing regulated retail prices. As a result, in 2003 the Government moved to establish a ceiling for the spot market price based on the cost o f diesel-based generation, and to modify the price o f extracting energy from the spot market. 72. The Government i s considering various alternative policy changes to address the challenges of promoting new investments in generation and mitigating the impact of excessive market power. Those alternatives include introducing compulsory long term 43 contracts for suppliers and Discos to assure supplies, changing the current wholesale market scheme and implementing a cost-based approach in order to reduce the incidence o f market power, andor institutinga capacity charge to cover a proportion o f fixed costs and thereby provide an incentive for investing innew generation. POLICY RECOMMENDATIONSELECTRICITY ON 73. The government should take specific measures directed at increasing competitionin the wholesale market. Facilitating the operation o f suppliers within the market i s clearly needed to mitigate market power and to encourage further trade with generators in the regional market. Complaints by suppliers regarding bureaucratic obstacles put up by Discos to discourage what they perceive as `losing customers' should be addressed by streamlining procedures for accessing the wholesale market, as well as making sure that Discos are getting full compensation for the use o f their facilities. With regard to the questions associated to the various substantial changes currently being considered by the government, this report does not seek to provide definitive answers but rather to highlight some o f the trade-offs that should be taken into consideration when deciding about the various alternative^.^^ 74. The analysis of the possibility of adopting compulsory long term contracts should take into account their effects on the complementaryobjective of promoting more competition in the sector. If compulsory long-term contracts were to be implemented, this would probably force suppliers to seek new generators. However, the Discos, who currently dominate the supply market, are likely to oppose to any measures that would seek to stimulate competition in supply. Once committed to long-term purchases, a Disco would seek to guarantee its market by holding on to its customers ,therebymitigating the commercial risk o f its contracts. Compulsory long-term contracts could therefore runcontrary to focusing Discos on their `wires business' and opening up the supply market. Moreover, even though long term contracts would clearly create an opportunity for new investments in generation, the corresponding decisions would also depend on other factors, such as securing fuel supplies and overall guarantees for private sector investment.24 75. The merits of instituting a capacity charge are also controversial, while the alternative of switching to a cost-based wholesale market does not guarantee that dominant producers will not continue to exert undue influence. Instituting a capacity charge would provide an incentive for new generation by providing a degree o f income assurance to its investor, who would no longer be entirely dependent on the spot market. 23 A more detailed analysis of the policy options faced in the electricity sector will be undertaken in a separate report currently being prepared by the World Bank (El Salvador Recent Economic Developments in Infrastructure Report). That report will explore the potential role o f infrastructure in El Salvador's development strategy, and it will produce an integral assessment of the endowment, quality and pricing structure of El Salvador's infrastructure sectors. 24 It must also be noted that El Salvador does not appear to present particular comparative advantages that wouldjustify locating generation facilities inthe country with a view to export towards other markets, 44 Such a charge i s likely to replicate the existing cold reserve rem~neration~~terms o f (in $/kW), which i s translated to an equivalent energy charge (i.e. $/kWh), and added to transactions inthe wholesale market, thereby levying the charge from all consumers as it i s passed-through fiom the wholesale market to retail sales. However, insystems where a general capacity charge has been implemented, its concept has been the subject o f substantial criticism, and in some cases it hasn't had the desired effect o f attracting new investment. As for the alternative of switching to a cost-based wholesale market, it is worth emphasizing that in that scenario dominant producers could continue to exert undueinfluence through alternative means such as spurious availability declarations. 76. Major modifications to the sector's structure should be decided taking into consideration possible regional developments. In particular, the question o f urgency regarding the need for additional investmentin generation should be tempered by the real possibility o f securing supplies from neighboring systems. If the Salvadoran power system can depend on imports inthe near term, the question lies in orienting institutional reforms towards adapting to the ultimate market structure that could emerge ina regional context. Thus, even though establishing compulsory contracts or a capacity charge may be ways to ensure future supplies, they may become quickly outdated if the regional market expands rapidly. 77. From a strategic point of view, it is important to reinforce transmission in the context of El Salvador's SIEPAC commitments and to make an effort to avoid short-lived modifications to the sector's structure. Inthe event that the reforms that are being considered by the Government do not yield the desired results, an alternative plan would have to be formulated. In this context, insurance to maximize the eventual support available from the regional market can be obtained by providing ETESAL with the necessary resources (through its regulated income) for reinforcing transmission inthe context o f El Salvador's SIEPAC commitments. Moreover, the reforms under consideration, together with those already adopted in 2003, could give an impression o f successive `patching' o f the underlyingmodel, thereby projecting an image o f regulatory instability. Thus, consideration should be given to adopting reforms that are likely to be relatively long-lived. TELECOMMUNICATIONS 78. The 1998 reformsof El Salvador's telecommunications sector can be credited for an impressive growth in phone density. The new Telecoms Law and its regulations were designed to promote private sector investment and competition. The incumbent state company (ANTEL) was sold to a consortium o f French and local investors and the sector was opened to competition. Spectrum auctions were carried out to attract new investors to the mobile telephone market and a new regulator was created (SIGET). The reforms produced significant improvements in efficiency, competition, and private investment in the telecommunication sector. As a result o f the reforms the telecom sector has exploded. 25 As a consequence of Duke Energy's intention to dismantle gas turbines that were rarely dispatchedand weren't eaming their way, the Government implemented a `cold reserve remuneration' for units on extendedstandby. 45 As shown in figure 1.13, fixed lines grew from 386,700 units in 1998, to 752,600 in 2003, while mobile telephones grew from 137,100 units in 1998, to 1,149,800 in2003. In this year, the density of fixed and mobile phones was larger inEl Salvador than inmost Central American countries. Moreover, El Salvador displays phone densities that are substantially above that o f other countries with the same level o f income. 79. Competition has increased substantially, leading to drastic reductions in long distance tariffs. The structure of El Salvador's telecom market has changed substantially inthe last five years. While in 1998 there was only one company providing fixed lines and one company providing cellular lines, in 2003 the sector had expanded to include nine companies in the fixed line business, 4 mobile companies, 11 carriers, and 10 Internet providers. Thanks to the increased competition, prices for telecom services have been drastically reduced and duringthe last few years El Salvador has become one o f the Central American countries with the lowest long distance tariffs, both for both national and international calls - above only Costa Rica and Panama, respectively. New lines are also less expensive and take less time to be installed than in neighboring countries. Data from the investment climate surveys shows that it takes on average one week to get a new phone in El Salvador, compared to 50 days in Guatemala, four months in Nicaragua and almost six months inHonduras. Figure 1.23: Mobile and Fixed Telephone Lines in El Salvador, 1998-2003 1,I49,790 137,l 1998 1999 fixed 2000 2001 2002 2003 +Mobile I ' Source: Intemational Telecommunications Union (ITU) database 80. Service reliability is also higher in El Salvador than in the rest of Central America. According to data from the Investment Climate Survey, only six percent of the manufacturing firms surveyed in El Salvador considered the telecommunications infrastructure to be a major or severe constraint to their operations and growth, compared to 7 percent in Guatemala, 12 percent in Nicaragua and 18 percent in Honduras. These smaller concerns regarding the telecom sector are justified not only by the easier access to new lines and the lower cost o f long distance calls, but also by the fact that service interruptions are much less frequent inEl Salvador. Indeed, the average firm experienced less than one interruptionper year, and was without service less than six hours'per year. Firms in other countries o f the region report a much higher number of service intemptions and are left without phone services for much longer periods o f time. 46 Figure1.24. Internet Hostsper 1000pop. and GDPplc in2003 $ 4 6.00 5 .-8 4.00i Brazk 2.00 8 - -6.00 'I y = 16 4 4 4 ~ 12.705 Iyl RZ= 0.6845 -8.00J GDP per capita Source :ITUdatabase 81. Despite the impressive expansion of El Salvador's telecommunication infrastructure, there is evidence that the country is not exploiting all the available opportunities for increasing the use of informationand communication technologies (ICT). The number of internet accounts has not experienced the highrates of growth that are found for fixed and mobile telephones. There are only 2.5 personal computers per 100 inhabitants, compared to almost ten in Costa Rica. Moreover, in2003 there were only 6.3 internet hosts per 10,000 inhabitants, compared to more than twice that number in Nicaragua and Guatemala, and about four times that number in Panama and Costa Rica. It must be noted, however, that the density of Internet hosts found in El Salvador and Costa Rica i s very close to what would be expected from comparisons with countries o f the same level o f income (figure 1.24). Guatemala and Nicaragua, on the other hand, exhibit numbers o f internet hosts that are higher than what their incomes would lead to expect, and so do South American countries such as Argentina, Brazil and Chile. 82. Nevertheless, the ICs data shows that Salvadoran manufacturing firms use email and the internet with the same frequency of their Guatemalan counterparts and much more frequently than firms from Honduras and Nicaragua. About 63 percent o f the firms surveyedinEl Salvador report regularly using email to communicate with suppliers or clients, and 30 percent report using the internet for the same purpose (figure 1.25). The use o f electronic mail and the internet i s similar in Guatemala but much lower in Honduras and Nicaragua. These differences are found to persist when comparisons are made with firms o f the same size and sector. 47 Figure 1.25: Internet and emailuse, by country (YO)Figure 1.26: Internet and email use, by size(%) 77.3 94.6 65 2 63 4 Nicaragua Honduras Guatemala El Salvador Micro SmaU Medium Large minternet memail Source: Investment Climate Survey. Source: Investment Climate Survey 83. Within El Salvador, larger firms are more likely to use email and the internet, and so are exporters and firms that use importedinputs. As seen in figure 1.26, the percentage of firms that report using email and the internet increases sharply with employment size. Moreover, econometric estimates based on the I C s data indicate that even after controlling for firm size, sector and province, exporters and firms that use imported inputs are much more likely to use those technologies. Maquilas, however, do not behave differently from other exporters or importers. 84. One important obstacle to a larger use of ICTs in El Salvador is the high cost of internet access. Even though Internet providers advertise "Free Access" to the Internet, all dial-up users pay regular local phone tariffs to the telephone companies - about 2 cents a minute - to access the Internet. Thus, for instance, a company that wishes to use the Internet duringweekdays for one hour per day, would typically pay more than US$40 per month, and have only a low speed (56 Kb/s) dial-up connection. New broadband access is available through cable modem and DSL, but prices for those services are even higher (around US$50 per month). The result is that only large companies, and companies that use the internet as a substitute for international calls - e.g. to communicate with foreign suppliers or clients - have the resources to pay for broadband access. 85.Another impediment to a greater use of the Internet is the scarcity of local content. There are few Salvadoran web sites and there is little useful local content inthe web for Salvadoran users. The major Internet Service Providers (ISPs) are the telephone companies as no one can compete with their "Free Internet" plans. In many countries ISPs have significantly contributed to local content development, motivatedby the desire to increase their revenues through the supply o f higher value added services. However, in the case o f El Salvador, with only a few exceptions neither the Government nor the telephone companies have promoted local content development. 86. The young and specially the adult populationhave a low level of ICT exposure. HighSchools have recently acquired computer centers to train students. However, due to administrative reasons, these centers are not used to their fill capacity and students do not receive enough hours o f instruction inthe use o f personal computers and the Internet. Moreover, there are only a few adult training centers - mainly private - that teach 48 computer skills and, at the tertiary level, there are few programs to train technicians and programmers at the Associated Degree level (two year technical or vocational education), as opposed to a larger number o f University Degrees programs. As a result, El Salvador does not have enough technicians and programmers to meet demand, but has a surplus o f University graduates. 87. Another factor that limitsthe use of ICTs in El Salvador is the fact that, despite some successfulinitiatives in some specific agencies, the government does not have a detailed strategy for E-Government. The modernization o f the government's operations through the use o f ICTs has the potential to enhance service delivery, increase transparency, reduce costs and improve the relations between government and citizens. Moreover, international experiences show that the Government's leadership, by means o f a well coordinated and articulated E-government strategy, i s crucial for promoting the use o f ICTs by the private sector, thus promoting productivity growth both directly and indirectly. In El Salvador, some successful E-Government initiatives have been implemented - notably at the Customs Administration and the Ministry o f Finance (which now offers on-line Tax Preparation Forms) - but they have been isolated efforts. There i s no detailed E-Government strategy and the ICT Sector does not have a Head: there i s no Ministry, or high level Government Office in charge o f preparing, coordinating and executing a Strategy for E-Development, overseeing the efforts o f all the Ministries and public entities, in coordination with the private sector, and the civil society. 49 POLICYRECOMMENDATIONS ONTELECOMMUNICATIONS 88. SIGET should establish a reduced rate for Internet Access. Apart from the current local charge for fixed phone calls, SIGET should establish a special rate for internet access that would allow consumers to use internet services for much lower rates. This would stimulate purchases o f personal computers and the set up o f more Internet accounts, as well as the development o f more local content. Moreover, as a larger number o f people and businesses begin to use e-mail and visit web pages, the usefulness o f the service would increase, leading users to spend more time online, and stimulating further migration into broadband-based services. Eventhough competition inthe ISP market can be expected to increase, telephone companies would benefit from the increased number o f users and traffic. 89. The government should take complementary actions to stimulate the development of local internet content. The above described virtuous circle that is expected to follow a reduction in the rates charged for accessing the internet would by itself stimulate the development o f local internet content. However, the latter could be further promoted through government initiatives that reward local efforts in the area o f web site development, either through contests - in the lines o f the "arroba de oro" initiative - or by the promotion o f cooperation programs in which Universities and Technical Institutes would develop the ICT systems and content o f government agencies and private companies. In addition, the government could take advantage o f the opportunities providedby ICTs to promote more interactions with Salvadoran immigrants living abroad. For instance, the development o f local content could be stimulated by the possibility o f using the internet to make the goods and services offered by Salvadoran businesses available to the large population o f Salvadorans living inthe U.S.. 90. The government should create a single, high level entity in the Governmentwith enough authority to develop and implement an ICT Strategy for the country. Specifically, this entity would supervise the implementation o f an E-Government Strategy encompassing all ministries and government agencies. Eventually, E- Procurement should be made mandatory for all agencies, and most transactions involving businesses or the general public should be made available on-line. The objective would be that o f promoting greater transparency and increasing productivity and efficiency in both the public and the private sector. 91. The Telecom legislation and regulations should be updated and SIGET should be strengthened. The government should prepare, discuss with all sectors and submit to congress legislation for E-Commerce. In addition, some aspects o f the 1998 telecom legislation and the corresponding regulatory framework should be updated. A modern, flexible but adaptable telecommunications regulatory framework i s needed to protect consumers but also allow further private investment in ICTs. A revision o f the interconnection regulatory framework i s neededto promote competition and fair prices to consumers. In this respect, the role o f SIGET should be redefined, so that it has the ability to take the necessary measures to ensure competition and avoid unfair monopolistic practices. Moreover, in order to better contribute to this reform process, SIGET should be strengthened, possibly by means o f a Technical Assistance program 50 directed at reviewing the existing regulations, improving the procedures for processing consumer complaints, raising public awareness o f consumer rights, and purchasing o f a modern radio spectrum management and control system to improve licensing, reduce illegal transmitters and resolve interferences. 92. Finally, the Government should develop an adult ICT training initiative and improve the existing training programs for youth. More and better human resources are key to improve the productivity o f Salvadoran companies by means o f exploiting the opportunities provided by ICTs. In this respect, the existing educational and training programs should be reviewed to ensure that they respond to the needs o f the private sector, For instance, the Government should consider increasing the number o f technical training programs at the Associate Degree level (technician, programmer). TRANSPORT 93.Even though less than 10 percent of Salvadoran firms are constrained by problemsin the transport sector, the latter acquire much greater importance in the context of CAFTA. Only 9.5 percent o f the firms surveyed inEl Salvador reported that they face major or very severe constraints inthe area o f transportation (figure 1.27). This proportion is slightly higher than in Honduras (7.7 percent), but it i s lower than in Guatemala and Nicaragua (around 13 percent). However, a much larger proportion o f the surveyed firms - about 31 percent in the case o f El Salvador - indicated that transportation problems could create major or very severe constraints for taking advantage o f the potential benefits o f CAFTA (figure 1.28). As before, that proportion i s slightly larger than in Honduras (28.5 percent), but lower than in Guatemala and Nicaragua (respectively 41 percent and 38 percent). Figure 1.27: TransportConstrained firms (YO) Figure 1.28:Transport Constrainedfirms if CAFTA (%) 40 8% 38 1% 31 4% 28.5% 13.7% 128% Guatemla Nicaragua El Salvador HonmnaS Guatemla Nicaragua El Salvador Honduras Source: InvestmentClimateSurvey Source: InvestmentClimate Survey 94. The problems caused by failures in the transport sector appear to be relatively smaller in El Salvador than in neighboring countries but they affect to a greater extent the firms that importfrom or export to other CentralAmerican countries. On average, Salvadoran firms loose 4.8 production days per year due to delays in the delivery o f inputs, which amounts to about one day less than what i s reported in Guatemala and Nicaragua, and a half day less than in Honduras. However, within El Salvador our econometric estimates suggest that importers lose almost an additional day per year, and importers from Central American countries lose another 1.3 days, compared 51 to other importers with similar characteristics. Another indicator provided by the ICs i s the percentage o f sales that firms lose due to either interruptions in the transportation system or, more importantly, due to the breakage, spoilage or theft o f their products during their transportation. Salvadoran firms lose about 1.6 percent of their sales due to those reasons, compared to 1.5 percent for Honduran firms, and respectively 1.9 percent and 2 percent for Guatemalan and Nicaragua firms. However, the firms that report the highest losses are, according to our econometric estimates, those that have a higher employment size and those that export to other Central American countries -exporters whose main clients are located outside the region are actually less likely to experience such losses. This suggests that failures in the land transportation system are those that generate higher losses to Central American firms. 95. Partly as a result of the lack of an Atlantic coastline, Salvadoranimporters and exporters make an intensive use of foreign ports and land border-crossings. Even though in 2003 only 15 percent o f El Salvador's imports originated in Central America, and just 24 percent o f the total value o f exports was destined to the Central American region, a much higher fraction o f the country's international trade takes place through its land borders with Guatemala and Honduras. Indeed, the ports that are primarily used for the movement o f Salvadoran goods are located inthe Atlantic coast: Puerto Barrios and Puerto Santo Tomas de Castilla in Guatemala, and Puerto Cortes in Honduras.26In the Pacific coast, the main Salvadoran port o f Acajutla suffers the competition o f Puerto Quetzal, in Guatemala. As a result o f the intensive use o f foreign ports, El Salvador's land border-crossings are among the ones with more intense traffic inthe region. 96. The relatively low use of Acajutla by Salvadoran manufacturing firms i s consistent with high maritime transport costs when shipping from that port. According to data from the U.S. Department o f Transportation, the share o f maritime transport costs inthe total value of garments exported in 2000 to the U.S. from the port o f Acajutla was 8.4 percent for the east coast, and 25 percent for the west coast (figure 1.29). Shippinggarments from Acajutla to the U.S. i s more expensive than doing it from all the other main ports o f Central America, and in particular from Puerto Quetzal (Guatemala), which due to its location i s the most direct competitor o f Acajutla. Moreover, even Latin American and Asian ports located up to four times farther away from U.S. ports than Acajutla exhibit smaller transport costs, at least in the case o f garments. 97. High maritime transport costs from Acajutla are due to the fact that this port is used mainly for imports and charges relatively high fees. The latter are due to low efficiency levels and a small scale of operations (at least for container traffic). According to the public sector Autonomous Executive Port Authority (Comision Ejecutiva Portuaria Autonoma - CEPA), 4,546 metric tons were moved through Acajutla in 2002, with 79 percent of the movement corresponding to imports, and 5.5 percent to 26EstudioCentroamericano de Transportes, SIECA 2001. This is confirmedby the ICs data, which shows that only a minorityof the surveyed Salvadoranmanufacturingfirms use Acajutla as the mainport through which they importtheir inputsor exporttheir products. 52 container^.^^ As explained by FUSADES (2003), the fact that most o f the port's movement consists o f imports increases maritime transport costs, as shipping companies charge one-way users for the total cost of the round-trip - they charge also for the return trip o f relatively empty ships. In addition, the low level o f containerization leads to diseconomies o f scale that are reflected in relatively high port fees for the movement o f containers. Inefficiencies at the port level lead to higher waiting times and also contribute to high port fees. The latter are usually internalized in the tariffs charged by shipping companies.28It i s worth noting, however, that the impact o f some o f these problems has been minimized in recent years, as illustrated by the 26% growth in cargo movement through Acajutla reported by CEPA between 2002 and 2004 (compared to 2% growth between 2000 and 2002). Maritime TransportCosts for GarmentsExportsto the USA, East Maritime TransportCosts for Garmenls Exports to the USA, West Coast (TransportCost es % of Export (TransportCost BS% ofExport VaLe) I Source:U.S.Department of Transportation. 98. The intensive use of foreign ports increases the importance of developing and maintaining El Salvador's road infrastructure and increasing the efficiency of the freight transport industry. The Salvadoran road network experienced particular destruction during the years o f the civil war and as a result o f the 2001 earthquake. During the 1990s reconstruction efforts were concentrated on the primary road network and in the cities. By regional standards, the pace o f reconstruction was slow during the mid 1990s but accelerated after 1999. Indeed, beginning in that year the Government embarked on a substantial road investment program in which 40 percent o f the nation's principal road network was rehabilitated and repaired. Furthermore, a Road Maintenance Fund(FOVIAL) was created in 2000 and is providing steady hnds for the maintenance o f the primary road network, financed partially through a gasoline tax. Thanks to accelerated reconstruction efforts, El Salvador's paved road network increased from 1984 km in 1999 to 3017 km in 2004.29 Compared to other Central American countries, El Salvador's road density i s highwith respect to territory but relatively low with respect to the country's population. 27Acajutla has specialized historically indry bulk, which was 57% of total movement in 2001. Inthat same year, liquid bulk was 24% and general cargo 19% oftotal cargo. FUSADES (2003), p,207. 28 See Clark, Dollar and Micco (2004) on factors that affect maritime transport costs. According to FUSADES, Acajutla is competitive in dry and liquid bulk but port fees for Evergreen containers are higher than in Puerto Barrios (116%), Corinto (95%), Santo Tomas de Castilla (44%), Cortes (31%) and Quetzal (17%). 29Ministry of Public Works 53 99. El Salvador has a two-tiered freight transport system: large internationalfirms employ container-based multimodaltransport services but the majority of small and medium sized firms rely on relatively informal and unregulated service providers. According to the SIECA Central America Transport Study3o,during the late 1990s the Salvadoran freight transport service sector was characterized by having an old vehicle fleet made up o f 34,000 units o f more than 2 tons, largely composed o f second-hand U.S. vehicles. The majority o f the freight transport (70%) was destined to the domestic market, and it operated largely unregulated, with no restrictions on the duration o f the drivers' workdays or weekly rest periods. Moreover, most service providers rely on third party agents for obtaining freight and executing bureaucratic procedures which, their business is mostly one-way, and their profit margins are relatively low. On the other extreme, large multinational companies tend to rely on multimodal transport services provided by shippinglines, with much higher quality and reliability. However, the cost o f these services i s considered to be very high, which makes them inaccessible to most small and medium firms. 100. Custom-related constraints also tend to acquire much greater importancein the context of CAFTA. Less than 10 percent o f the firms surveyed in El Salvador reported that they face major or very severe constraints in the area o f customs. The percentage o f firms reporting such constraints i s practically the same than inNicaragua, it i s larger than in Honduras (7.7 percent), but much smaller than in Guatemala (23.7 percent). A similar ordering o f countries i s obtained when firms are asked whether problems at customs could constrain their ability to benefit from CAFTA: 51 percent o f Guatemalan firms report major or very severe constraints, compared to about 37 percent for El Salvador, 35 percent for Nicaragua and 25 percent for Honduras. Moreover, our econometric estimates indicate that importers are more likely to report general customs constraints, while exporters are less likely to mention customs as an area that could constraint them after CAFTA i s implemented. 101. El Salvador has made great progress in streamlining and modernizing customs procedures. Important gains have also been achieved in terms o f harmonizing and coordinating those procedures with those o f other Central American countries. Countries inthe region have increasingly adopted the Central American Unified Customs Code (CAUCA), which i s expected to result in reduced customs clearance times. In the case o f El Salvador, Custom operations have been certified under the I S 0 9000 quality standard. The adoption o f the regional regulatory framework, along with reforms introduced to streamline operations within the General Directorate o f Customs (DGRA) and make them compatible with regional guidelines, has resulted inimportant benefits in terms o f the simplification o f procedures. 102. Probably due to the recent modernization and simplification efforts, the delays faced by exporters at Salvadorancustoms are very low by regionaland world standards. However, importers face longer delays than in neighboring Honduras and Nicaragua.According to data from the ICs, Salvadoran exporters take an average o f 1.6 days to clear customs, and report having taken at most 3.3 days to perform the 30 EstudioCentroamericanode Transportes (ECAT), SIECA 2001, Appendix 412 54 corresponding procedures during the year preceding the survey (figure 1.30). On the other hand the average and longest delays reported by importers were between 6 and 12 days-more than in Nicaragua and Honduras but well below Guatemala and Brazil (figure 1.31). Inthis context, it is worth noting that despite the progress achieved, private custom agents and freight transporters still see room for improvement. Figure 1.30: Custom delays for Exports (investment climate data) A v e r a g e a n d l o n g e s t p e r i o d s to c l e a r c u s t o m s , f o r e x p o r t s ( I n t e r n a t i o n a l c o m p a r i s o n , d a y s ) I S 1 5 12 9 6 3 0 = a v e r a g e p e r i o d O i o n g c r t p e r i o d Source:InvestmentClimate Survey Figure 1.31: Customdelays for Imports(investmentclimate data) A v e r a g e a n d l o n g e s t p e r i o d s to c l e a r c u s t o m s , for i m p o r t s ( I n t e r n a tio n a I com p a r i s o n , d a y s ) 3 5 3 0 2 5 2 0 1 5 10 5 0 I l i L l a v c r a g e p e r i o d O l o n g e s t p e r i o d Source: InvestmentClimate Survey 103. For importers, custom-delays at Acajutla are longer than those reported at land border-crossings. Importers that report using only land transportation (that is, importing from neighboring countries) face average import clearance times o f 4.7 days, with peaks of 7 days. Incomparison, those importing mainly through the port o f Acajutla face clearance periods o f 9.9 days, with peaks o f 16 days. In addition, the econometric estimates reported in the appendix show that maquilas face substantially lower clearance times than other importers, and so do the firms whose inputs come mainly from other Central American countries. We also find that the firms that use mainly the port of Acajutla to import their inputs tend to have longer delays at customs than do the firms whose imports enter the country through land border crossings. The uncertainty associated with the duration o f customs procedures, particularly inthe case o f importers, leads firms to hold larger inventories. This latter decision adds an extra cost for those firms (see Guasch and Kogan, 2001), which may affect SMEs to a greater extent, given that they usually face bigger liquidityconstraints. 55 TRANSPORT: POLICYRECOMMENDATIONS 104. El Salvador needs to continue to pursue aggressively its investment plans for improving and maintainingits road infrastructure. The importance o f improving the land transport system results both from geographical imperatives - namely the need to access the Atlantic coast ports o f other countries in order to reach the U.S.east coast - but also from the finding that the manufacturing firms that experience larger losses as a result o f failures in the transportation system are those that trade with other Central American countries. Thus, it i s crucial that El Salvador pursues the investment priorities that are set up in the Plan Puebla Panama (PPP), actively participating in this initiative, and ensuringthat neighboring countries also comply as much as possible with their own road improvement agendas. Moreover, notwithstanding the accomplishments in terms o f extending and consolidating the maintenance of the road network., the historical neglect o f secondary and unpaved road network remains a major challenge for the country. In this respect, El Salvador should seek to improve the quality of its unpaved priority network, o f which 70 percent is currently inbad condition. 105. It is extremely urgent to develop adequate regulations that will add professionalism to the freight transport industry.Currentlythis sector is dominatedby informal individual service providers - the so-called "unitarios" - that are mostly unregulated and relatively inefficient. In order to reduce transport costs and increase the competitiveness of Salvadoran producers, the country needs to promote the development o f freight transport service companies that are capable o f providing more complex services, thus enhancing the overall quality and reliability o f the sector. These could be carried out with the development o f incentives to the formalization and professionalization o f freight transport service providers, and the setting up o f training programs that can help the sector on its way to diversifying its services and improving its level o f professionalization. Moreover, a reform should be envisaged regarding liability and accountability o f firms during transport, using a standard international transport contract that establishes clearly the responsibility of all stakeholders involved, thus facilitating claims and reducing insurance costs. 106. It is clear the El Salvador must improve the efficiency of its ports and make full use of the existing infrastructure if it is to cope with increased trade due to CAFTA. El Salvador is located in a strategic position that could allow the country to reach the U.S. west coast at relatively low maritime transport costs. Knowing that further efficiency improvements would require more investments and additional improvements inadministrative and operational procedures, the government is currently inthe process o f completing the implementation o f a 25-year management concession for Acajutla and i s also finalizing the details for choosing a contractor for building a new terminal in the currently inactive port of Cutuco. It must be noted, however, that it is crucial to frame El Salvador's national port strategy within an overall regional transport strategy, taking into account the potential impact o f the improvement sought by the PPP in the land transport linkages between the region's ports and capital cities. Indeed, these PPP sponsored investments, coupled to improvements in border crossings and customs, could greatly facilitate the access to Guatemalan and Honduranports. 56 107. I n the area of customs, El Salvador should continue its modernization and professionalizationefforts, with a focus on reducing the delays faced by importers, particularly at the port of Acajutla. During recent years El Salvador has made considerable progress in improving the efficiency of customs and facilitating border crossings. Nevertheless, there are still deficiencies in customs procedures and operations, some o f which are common to other countries in the region. In this respect, additional improvements could be achieved by facilitating inspections through the incorporation o f modern equipment and risk analysis techniques, as well as by increasing the professionalization o f the customs agency. Moreover, particular efforts should be devoted to reducing customs delays at the port o f Acajutla which, as shown by the ICs data, are relatively longer than those encountered by importers that use landtransportation. 57 IV.ACCESS TO FINANCE THESTATEOFTHE SALVADORAN FINANCIAL SYSTEM 108. The restructuring of the financial system and El Salvador's stable macroeconomic environment fostered rapid private credit growth during the first half of the 1990's. The period 1990-1995 was characterized by GDP growth rates averaging 6 percent. In this macroeconomic context and as financial liberalization took place, private credit growth rates averaged 20.4 percent in the 1990-1995 period. Since 1995 the Salvadoran economy has experienced lower GDP growth, which averaged 2.6 percent during the 1996-2003 period. Inthis context, duringthe second half o f the 1990's private sector credit expansion experienced a sharp reduction, with an average growth rate o f 7.9 percent in the 1996-2000 period. Apart from the economic slowdown, slower credit growth resultedfrom increased caution inbanks' lending practices and the fact that the private sector reached a limit inits capacity to borrow after five years of credit boom during the early 1990s. In addition, starting in 1996 the Central Bank enacted a tighter monetary policy which, by sterilizing capital inflows to limit the supply o f credit, partially offset existing weaknesses in the supervisory capacity o f the Financial Sector Superintendence. 109. Duringthe second halfof the 1990's' El Salvador enacted a series of reforms to strengthen its financial system. Despitethe reduction in credit growth after the mid 1990s, El Salvador has a relatively good level o f financial development. During the second half o f the 1990's, El Salvador enacted a series o f measures to strengthen the financial system, including the establishment o f a Superintendence for the financial system (1996) and a comprehensive banking law (enacted in 1999 and revised in 2002). Many positive features where introduced as a result o f the reforms, including: consolidated supervision o f financial conglomerates, increased capital requirements for the establishmento fbanks and to cover risky assets, tighter controls on lendingto related parties, creation o f a deposit guarantee scheme and improvement in the bank failure resolution system. 110. Even though dollarization led to lower inflationary pressures and interest rates, the absence of a lender of last resort affects the ability of the economy to deal with liquidity crisis. Starting in 2001, El Salvador adopted the U S Dollar as a legal tender which produced a reduction ininflationary pressures, as expectations o f monetary mismanagement disappeared. While during the 1990s inflation rates averaged 9.9 percent, they fell to 2.6 percent during the period 2001-2003. Dollarization also had effects on the downward trend o f interest rates in USD. Despite these benefits, dollarization implies that the central bank cannot create liquidity in times o f crisis and serve as a lender o f last resort. Thus, in a dollarized economy it i s vital to set beforehand an adequate set o f mechanisms aimed at minimizing the risks o f liquidity crisis and alleviating the consequences o f such crisis ifthey were to occur. 111. Currently the banking system is characterized by slow credit and deposit growth.Average credit growth was 4.6 percent between 2001 and 2004. Duringthe same period, deposits grew at 2.3 percent per year and banks had to increasingly fund their 58 operations through the use o f external credit lines in international markets, which they were able to do thanks to El Salvador's investment grade status. As shown in figure 1.32, the low levels of intermediation and credit demand led to a progressive decline o f active interest rates. Despite the fact that passive interest rates also decreased, the net interest margin has shrunk after 2000. As a consequence, financial institutions have begun to explore other areas of business and have increasingly relied on other sources o f income (e.g. credit cards), which in2003 represented around 20 percent o f total income. ,Figure1.32:Active and Passive USD Interest Rates, 1998-2003 2.0 6.0 - 4.0 - 2.0 - _ _ 1998 1999 2000 2001 2002 2003 112. Despite recent improvements in loan quality indicators, the level of non performing loans in the system remains high, and banks have increasinglyfocused on mortgage and consumer lending. Loan quality indicators improved during 2003. However, due to the slow growth o f the economy and the above mentioned external shocks the banking system portfolio still shows a high level o f non-performing loans. Overdue loans amount to 2.8 percent o f total loans as o f 2003. In addition to that, foreclosed assets represent 3 percent o f total assets in the system or 4.7 percent o f total gross loans. Recently, banks have shifted away from manufacturing: as o f June 2004, mortgages and consumer lendingrepresented 38.2 percent o f the loan portfolio o f banks, compared to 27.1 percent in 200131. Manufacturing, on the other hand, now accounts for 10 percent of banks' portfolios as opposed to 21.9 percent at the beginning o f 200132, It mustbe noted, however, that increased lending to the real estate and consumer segments also involves higher administrative costs and risks. Inthis respect, the Securitization law currently being debated would allow for the pooling o f loans and could thus potentially become an efficient mechanism by which risk associated to real estate lending could be allocated more efficiently among market participants. 113. Micro Lending operations have a good environment for development in El Salvador. The high level o f concentration in the banking system might cause concern since international evidence indicates that firms, especially as size decreases, face higher financing obstacles in markets that exhibit larger banking concentration.33 However, El 3'Mortgages and consumer lending increased during the period at a CAGR of 14.3 percent and 30.2 percent respectively. 32The total lendingto Manufacturingdecreasedduring the period at a CAGR o f 20.7 percent. 33Becket al. (2003). 59 Salvador has a well developed microcredit market, which i s integrated to the financial sector through the direct and indirect use o f.bank finance and the supervision o f the most important institutions. Furthermore, a securitization law currently under discussion could provide another vehicle to increase the participation o f financial institutions in the micro credit segment. ACCESS AND COST OF CREDIT 114. Financial constraints are mentioned more frequently by micro, small and medium firms as obstacles to their day to day operations and growth. Access to finance is reported as a major or very severe constraint by 31 percent o f the firms, and problems related to the cost and availability o f finance are mentioned by about 28 percent o f the surveyed companies. However, only about 20 percent o f the large firms covered in the ICs - with more than 75 employees -indicate that the availability o f external funds, or difficulties associated with accessing them (e.g. credit i s available but firms have difficulties in getting access to it due to high collateral requirements) are major constraints to their operations, and only 15 percent mention the cost o f finance as an important constraint. In contrast, between 34 percent and 39 percent o f small firms - with between 10 and 25 employees -mention the issues related to the cost of finance, its availability or access problems as major obstacles. 115. Survey data shows that Salvadoran firms objectively have a higher level of access to finance than their counterparts from neighboring Central American countries. However, the differences are smaller for micro and small firms. Figure 1.33 shows that 63.2 percent o f the firms in El Salvador34report having a loan from a financial institution, a level above that o f other Central and Latin American countries. However, as can also be seen inFigure 1.33, the percentage o f firms with access to loans in El Salvador is much lower than that found in export oriented countries such as Thailand and Malaysia. Moreover, a more detailed comparison with neighboring Guatemala, Honduras and Nicaragua shows that while the better access statistics found for El Salvador apply to all size ranges, the overall difference i s driven mainly by the better access to bank credit o f medium and large Salvadoran firms. Figure1.33: Share of Firmswith Loans(YO),International Comparison 07.3 a7 I 5 1 2 5 0 3 Source: Investment Climate Survey 34 A similar figure is reported by a March 2003 survey carried out by FUSADES. For more details see FUSADES (2003). 60 actually more constrained than non-exporters, while exporters to other Central American countries are the least likely to be credit constrained. 118. Firms that own real estate are less likely to be credit constrained and so are firms with externally audited financial statements and high levels of capacity utilization. These results are based on econometric estimates obtained using a two-step Heckman selection model in the spirit o f Bigsten et al. (2003). Those estimates also confirm the lower credit constraints faced by larger firms and "regional" exporters. We also find that firms operating in the textile and food and beverage sectors, and those located in the provinces o f Ahuachapan and L a Libertad are less likely to be credit constrained. 119. Firms in El Salvador pay lower interest rates than their counterparts from neighboring Guatemala, Honduras and Nicaragua. Moreover, our econometric estimates show that interest rates tend to be smaller for larger firms and for firms that are incorporated, have foreign ownership and own real estate. With regard to the differences ininterest rates related to exporter status we find that they are not significant inthe case o f El Salvador. However, when the analysis is performed incorporating data from Guatemala, Honduras and Nicaragua, we find that exporters pay lower interest rates than non-exporters, but the differences are much smaller for "regional" exporters than for other exporters - Le. the lowest rates are those paid by exporters whose main clients are located outside Central America. ACCESS CONSTRAINTSREPORTEDBY FIRMS 120. After the lack of demand for credit, the reason that is given most frequently for not applying to bank loans is the presence of high collateral requirements.As much as 87.8 percent o f the Salvadoran firms that report not having a loan never applied to one. For those that did apply to that type o f credit, the rejection rate suggested by the survey is 6.7 percent, which i s slightly lower than the figure obtained for the other three Central American countries for which we have data (7.9 percent). Among those firms that never applied to bank loans, the lack o f demand for that type o f credit i s mentioned by 60.3 percent o f Salvadorans firms - compared to 45 percent for the other three countries. The other reasons most frequently mentioned are high collateral requirements, high interest rates and cumbersome procedures. However, probably as a reflection o f the lower interest rates prevailing in El Salvador, interest rates play a much less important role in deterringfirms from applying to bank loans in El Salvador than inneighboring countries (figure 1.35). Indeed, survey data shows that 52.5 percent o f the firms that did not apply for bank loans - despite having a demand for them - report high collateral requirements as one o f the two main reasons for doing so, 42.3 percent cite high interest rates and 25.4 percent mention cumbersome procedures. While the first and the third reasons are mentioned by similar fractions o f firms inneighboring countries, problems related to high interest rates are much less frequent in El Salvador - e.g. they are mentioned by 82.4 percent o f Nicaraguan firms as a reason for not applying to bank credit. 62 Figure1.35: Constraintspreventingfirms from applyingto a loan 100 90 , 80 U." 70 60 50 40 30 20 10 1Cumbersome Procedures Collateral Requirements High Interest Rates ElHonduras .Nicaragua OGuatemala OEl Salvador 1 Source: Investment Climate Survey 121. Firms in El Salvador are required to provide collateral in an amount equivalent to 123 percent of the loans. Survey data shows that in El Salvador 86 percent o f the firms with loans were requiredto provide collateral. On average the value o f collateral represents 123 percent o f the loan amount, a figure that is in line with those obtained for other L A C countries.35 The data shows no variation in the amount o f collateral requested across size ranges, regions or industries. It is worth noting that the enforcement o f secured claims in El Salvador currently does not provide an efficient mechanism for the liquidation o f collateralized assets. Indeed, the Civil Procedures Code36requires a valuation o f the assets to be sold and anecdotal evidence suggests that many times appraisals are set well above market value. As a result, no bids are placed and banks are forced to absorb those assets. At the same time, delays in the enforcement o f secured claims and inefficiency in the judicial system also prevent a fast liquidation o f assets. 122. Real Estate is the main source of collateral. As in many other countries in the region, the primary source o f collateral i s real estate, which represents 69 percent o f total collateral sources37.In the case o f El Salvador, this i s facilitated by a modern real estate registry that has recently been unified. On the other hand, the use o f movable assets as collateral i s limited due to the non existence o f a unified registry, which creates the possibility o f duplicate pledges over the same asset. Moreover, antiquated legislation prevents the use o f certain assets as collateral and, as a result, machinery is not widely usedas a form o f collateral and represents only about 14 percent o f the collateral used in bank loans (see figure 1.36). Apart from anecdotal evidence collected in the field on the problems o f usingmovable assets as collateral, the results o f our regression analysis show 35 It i slower than inNicaragua, Ecuador and Honduras but similar to Peruand Guatemala. 36 Rules in the Civil Procedure Code establish that assets have to be valued prior to their auction and that offers for less than 2/3 o f that value are not admitted. Ifthere are no offers above this level, the auction can be repeated as many times as needed but the 2/3 threshold can not be broken or ,alternatively, the debtor can seize the asset. Besides these complexities o f the Civil Procedure Code, current regulations allow banks to keep the seized assets for a period o f five years, although accounting practices require provisioning each year a percentage o f the value booked. This regulatory practice could also act as a des-incentive for the development o f an efficient market for the sale o f assets. In any case, it is clear that procedural complexities associated with liquidations o f assets are high in El Salvador, not allowing for the development o f an efficient secondary market. 37 Real Estate represents 62 percent in the case o f Honduras, 38 percent in Nicaragua and 62 percent in the case o f Guatemala. 63 that firms that report owning real estate are 9 percent more likely to obtain a loan than those who don't. This finding i s particularly relevant for the case o f micro-firms, which often do not own real estate, and which would particularly benefit from a more widespread use o f movable assets as collateral. It i s also worth mentioning that the government has made efforts to increase access to collateral by allowing, since 2001, for the creation o f "Sociedades de Garantias Reciprocas". Nonetheless, the system has not experienced strong development yet. Moreover, the government i s working on the creation o f a registry for pledges on movable assets based on the OAS framework. Figure 1.36: Sources of collateral (as YOof loan), by size. El Salvador. Real Estate Machinery Intangible Personal and Others BMicro =Small O M e d OLarge =Total Source: InvestmentClimate Survey 123. Havingaudited statements increases the chances of obtaininga loan, but the costs of external audits prevent increases in their use among smaller firms. About 25 percent o f the firms inthe sample report that one o f the main reasons for not applying to a loan i s the cost and time consumed by the application process. Audited financial statements can improve the application process by expediting the review o f credit applications. Survey data shows that financial statements auditing is much more common in El Salvador than in neighboring countries. Around 79 percent o f the firms in the sample conduct auditing o f their financial statements, compared to less than 35 percent on average inthe other three countries. As expected, this number i s greater inthe case o f medium and large firm which audit their financial statements in more than 95 percent o f the cases, compared to,respectively 49 and 71 percent for micro and small firms.38 Given that audited financial statements are mandatory in El Salvador, one must conclude that the predominantly micro and small firms that report not having such audited statements are operating on an informal basis. As mentioned above, our econometric estimates show that after controlling for other firm characteristics (including size), firms that audit their financial statements are about 10 percent more likely to have a bank loan, provided that they have a demand for it. However, it i s also worth noting that external audits also have direct and indirect costs, with the latter being associated to the formalization o f the firms' activities (with the corresponding tax implications). Indirect costs, in particular, appear to be especially important, since only 17 percent o f the surveyed firms report that direct costs are a constraint for hiringexternal auditors. 38 The large differences with other Central American countries persist when comparisons are made by size range: the percentages o f micro and small firms that report extemal audits in the other three countries are respectively 14.3% and 27.9%, while the fraction of medium and large firms with extemal audits i s 58.1%. 64 SOURCESOF FINANCE 124. Firms rely mainly on retained earnings for both their working capital and their investmentneeds. Micro and small firms rely more heavily on internalfunds and use bank credit to a lesser extent. Retained earnings represent 45 percent o f the total working capital needs and 47 percent o f the firms' investmentresources. Banks, on the other hand, represent 25 percent o f working capital hnds and 30 percent o f investments. The composition o f the sources o f finance for working capital inEl Salvador i s relatively similar to that found in other countries in the region. In the case o f investment finance, however, as shown infigure 1.37, the percentage o f retained earnings i s lower than for most countries for which we have comparable data. The lower share o f financing associatedwith retained earnings i s replaced inEl Salvador by higher shares o f bank finance and supplier credit. Thus, bank loans represent only 14 percent o f investment finance in Brazil, 17 percent in Nicaragua and 20 percent in Guatemala, compared to 30 percent in El Salvador. Moreover, while in the latter country supplier credit finances 12 percent o f new investments, its fraction o f total investment finance i s only 6 percent on average inGuatemala, Honduras and Nicaragua. 125. In the absence of loans from banks or other financial institutions, credit constrained firms use retained earnings and loans from family and friends to a much greater extent than other firms. As mentioned before, 17 percent o f the firms in the sample are credit constrained and 20 percent express that they don't need a loan. Survey data shows that for firms that report that they don't need formal credit, retained earnings respond for respectively 75 percent and 83 percent o f their working capital and investment needs, compared to about 55 percent for credit-constrained firms, and 35 percent for firms with loans from banks or other financial institutions. On the other hand, credit constrained firms rely more on informal loans from family and friends: they use that source o f finance to fund respectively 12.5 percent and 9.6 percent o f their working capital and investmentneeds, compared to less than 3 percent for other firms. Figure 1.37: Main Sources of finance for investment capital, by country (YO) Banks Retained earnings Supplier Credit Source: InvestmentClimateSurvey 65 POLICY RECOMMENDATIONSFINANCE ON 126. The government should continue its efforts to strengthen the financial system. El Salvador's financial system faces challenges in the areas o f bank portfolio performance, supervision o f cross border lendingactivities and the lack o f a lender o f last resort. The Government i s already taking steps to mitigate some o f these risks by considering reforms that include: strengthening consolidated supervision o f financial groups and cross border lendingactivities o f banks, measures to address the weaknesses inthepublic sector financial institutions (for example Fondo Socialpara laVivienda) and strengthening the supervisory capacity o f the superintendence as well as imposing higher capital requirements for banks' portfolio^.^^ In addition, to ensure liquidity in times o f crisis, Velazco (2003) suggests that the government should conduct negotiations to obtain a conditional credit line from the IMF to provide hnds in times o f crisis. At the same time, inthe absence o f a lender o f last resort, strengtheningthe Deposit InsuranceAgency should be a priority, inorder to provide a first line o f defense against external shocks. 127. The Government should reform procedural legislationto allow for efficient creditor rights enforcement. Enforcement procedures o f secured and unsecured claims are lengthy in El Salvador, requiring the use o f highly inefficient mechanisms. This in turn reduces the willingness o f banks to lend as repayment expectations are lowered. Anecdotal evidence suggests that the "executive proceeding" (Juicio Ejecutivo) used in these cases takes more than 5 years. Even when the debtor does not dispute the claim, the average duration o f the enforcement proceeding is between one and two years. These delays are a result o f several practices (appeals, constitutional injunctions or amparos, and other procedural mechanisms) allowed by Salvadoran law, which are introduced by debtors and delay the resolution o f disputes. In addition, an as already described, the process for the liquidation o f assets in secured claims trials i s inefficient and often cause banks to keep those assets. In order to allow for more efficient resolution mechanisms, the Government should reform the current procedural legislation to allow for predictable and affordable proceedings. By eliminating barriers to the enforcement o f creditor rights, recovery rates on defaulted loans should increase and this could in turn increase the banks' willingness to lend. 128. Judicial inefficiency increases the uncertainty associated with the resolution of commercial disputes. Users o f the Judicial system express concerns with its efficiency and the limited experience and training o f judges when dealing with commercial law cases. Apart from the cumbersome procedures already described, court facilities and equipment are insufficient or deficient. Moreover, the management o f cases i s also inefficient and there i s not a well developed system for the selection and continuing training o f judges in commercial law. Improving court facilities and judges' experience with and knowledge o f commercial law would raise firms' trust inthe judicial system and improve creditor rights. Moreover, by providing a better framework for efficient creditor rights enforcement, the improvement o f commercial courts would reduce litigationcosts for banks and could lead to lower interest rates. ~~ 39 SeeFitch(2004) andFUSADES(2003), 66 129. Insolvency procedures are rarely used in El Salvador as the system is plaguedwith inconsistencies and is slow and costly. The government should enact a unifiedlegal framework to facilitate insolvency procedures. Although the Salvadoran law allows for the possibility o f bankruptcy as well for reorganization procedures involving suspension o f payments, the corresponding procedures are rarely used and are perceived as complicated, slow and The legislation for corporate insolvency is fragmented, as it i s governed by three different legal bodies which are applied simultaneously: the Code o f Civil Procedures, the Code o f Commerce and the Law o f Mercantile procedures. This legal fragmentation results in inconsistencies that make the enforcement of bankruptcy relatively unpredictable, and subject to a high degree o f discretionality on the part o f judges. The current state o f affairs does not facilitate the reorganization o f viable companies nor the liquidation o f insolvent ones and creates additional difficulties for effective creditor rights enforcement that ultimately translate in increased access constraints. The Government should thus enact a unified legal framework for the resolution o f insolvency procedures. 130. The Governmentshould continue to support the creationof a unifiedregistry of movable assets. El Salvador has done extensive reforms in the area of real estate registration but the use o f movable assets as collateral i s hampered by the lack o f a unified registry. Collateral availability is reported by 52.5 o f firms as a reason for not applying to bank loans. As discussed, the main source o f collateral used inEl Salvador i s real estate, The Real State registry i s now unified and is thought to be one o f the most advanced in the region.41 On the other hand, a unified system for pledges on movable assets does not exist in El Salvador, increasing the likelihood o f duplicating pledges over the same asset. A pledge may be subject to registration in the registry of Property or the registry o f Commerce and pledges over vehicles should also be filed at the vehicle registry, which i s under authority o f the Vice-Ministry o f economics. In addition, the pledge legislation is antiquated and limits the use o f some assets to secure loans. These problems limit the possibilities for usingmovable assets as collateral thus reducing access to finance, especially for firms that do not own real state. The government should continue to support the creation o f a single registry for pledges on movable assets in order to eliminate the current fears o f duplication o f pledges in the system - there i s on- going work by Government on the creation o f such a registry based on the OAS framework. 131. The government should make efforts to regulate adequately the market for the securitizationof assets which could increase the funds availableto Microfinance institutions. As mentioned earlier in the chapter the government has made important progress with regard to two new instruments for increasing access to finance: a Securitization law currently under discussion in Congress and a government decree creating the "Sociedades de Garantias Reciprocas" (SGR).42 The Securitization law ~~ 40 According to anecdotal evidence, there have been only one case of bankruptcy and only a few (less than five) reorganization proceedings inthe past twenty years. 4' The real estate survey (catastro), the registry o f Real Estate and Mortgages (Registro de la propiedad real e Hipotecas) and the registry of Commerce (Registro de Comercio) are now functioning under a common national registration center (Centro Nacional de Registros). 42 Decreto N o 553. September 2001 67 would allow to pool together micro credit loans, thus providing new hnding for micro finance institutions. To allow for an orderly development o f the market, the government should pay special attention to the regulation o f the standards for origination and administration o f the loan portfolios to be securitized under the new legal framework. As for the newly created "Reciprocal Guaranty Societies" (Sociedudes de Guruntias Reciprocus), they could also be a valuable tool to improve access to credit among companies that lack other sources o f collateral. 132. Adding insurance to common risk factors could help minimize loan non- performance and promote the growth of micro lending. As mentioned in the introduction, El Salvador has a well developed micro finance market. However, the credit risk practices of the financial institutions involved in that market could be hrther improved by insuring debtors against common risks, such as natural disasters or commodity price shocks, as opposed to using self-insurance mechanisms or treating individual credit risks as if they were statistically independent. Whenever the micro lender has a strong expertise in a specific segment, mitigating risk by lending to borrowers exposed to different types o f risk could be inefficient. Thus, in order to minimize loan non performance due to common factors affecting their portfolio, a better approach would be that including insurance in the finance packages offered by micro- lenders, which should then reinsure themselves in the market - as opposed to using self- insurance mechanisms by means o f inefficiently diversifyingtheir portfolio^.^^ 43Presently, only Fedecredito's system seems to have incorporated some degree of insurance in its micro loans, and that institution is already buying reinsurance from insurance companies. 68 V. SKILLS,QUALITYAND TECHNOLOGY EDUCATION LABOR AND SKILLS 133. Between 1960 and 2000 El Salvador made significant progress in increasing the average schooling of its population, which now surpasses that of Guatemala, Honduras and Nicaragua, but is still below that of most Latin American countries. Duringthe past four decades, the average years of schooling ofthe Salvadoran population increased from 1.7 to 4.5. This increase was among the largest o f Latin America. As a result, El Salvador i s now above most o f its Central American neighbors in terms o f the level o f schooling o f its population - the exceptions being Costa Rica and Panama. However, despite this progress the average schooling found inEl Salvador remains below that o f most Latin American countries, suggesting that there are important challenges ahead, particularly if one considers that even countries such as Chile and Peru - with among the highest levels o f schooling o f the region - are still well below the levels o f educational attainment found in East Asian countries (figure 1.38). Thus, more than 80 percent o f the Salvadoran population has at most primary education, while the fraction o f the population that has tertiary education (10.6 percent) surpasses that with secondary (8.8 percent). Figure 1.38: Average years of schooling in 1960and 2000 - International comparison 10.5 Source: De Ferranti et. al. (2003). 134. The shortage of secondary educated workers creates obstacles not only to continuing to reduce poverty levels but also to promoting higher rates of economic growth. The absence o f a considerable mass o f secondary educated workers has worrisome implications. Such a base is crucial if El Salvador i s to transit through a path o f sequential technological upgrading, which requires a high share o f the workforce with secondary schooling. Moreover, a considerable mass o f secondary educated workers i s crucial for attracting trade and FDIwith a hightechnological content, and to benefit from those investments and their spillovers inthe rest o f the economy. 135. Firms that employ more skilledworkers are relatively smaller, use imported inputs and either sell only in the domestic market or export mainly to other Central American countries. The shares o f non-production workers and that o f managers and professionals tend to be larger among smaller firms. This negative correlation between 69 size and the share o f skilled workers employed by manufacturing firms i s confirmed by econometric estimates, which also show that for a given firm size, and in given sectors and locations, exporters tend to employ relatively fewer skilled workers except when their main foreign clients are located in other Central American countries - skilled labor shares and average years o f schooling are similar among the latter type o f exporters and for the firms oriented towards the domestic market. This result i s hardly surprising, since exporters are likely to specialize inthe production o f products inwhich the country has a comparative advantage, and thus make an intensive use o f relatively abundant unskilled labor. Interestingly, we also find that there i s a complementarity between the use o f imported inputs and the demand for skilled labor, which suggests that those inputs serve as a channel for the absorption o f foreign technologies that embody a bias toward skilled labor. Figure 1.39: Firms that provide internal and externaltraining to their workers, by country (YO) 56 54 54 ElSalvador Guatemala Honduras Nicaragua Otraining Binternal training Oexternal training straining by lnsaforp (or equiv.) Source: Investment Climate Survey 136. With the exception of maquilas, exporters are more likely to provide training, and so are larger firms and firms that employ more skilled workers and use importedinputs. Salvadoran firms provide training to their workers more often than do their counterparts from Guatemala, Honduras and Nicaragua (figure 1.39). These differences are driven by the larger fraction o f Salvadoran firms that provide external training, and in particular by the larger percentage that use the services o f the government's institution in the area o f training -INSAFORPin the case of El Salvador. Both inEl Salvador and inthe above mentioned neighboring countries, and with the only exception o f maquilas, a higher proportiono f exporters provides training to their workers (econometric estimates). Larger firms are also more likely to train their workers, and so are firms that already use more educated workers and report the use o f imported inputs. Once again, this suggests that an increase in the degree o f international integration o f Salvadoran firms, through higher imports and exports should - unless it takes place exclusively through the growth in the maquilu sector -lead to a larger demand for training services. 137. Only about one half of the firms that report paying the 1 percent contribution to INSAFORP do in fact use the services of that institution, either directly or through certified training providers. Compared to neighboring countries, the percentage o f firms that contribute to the official training institution and do infact use its services i s relatively high: that proportion i s about 50 percent in El Salvador and 36 percent on average in Guatemala, Honduras and Nicaragua. Among the firms that 70 contribute to INSAFORP but do not provide training to their workers - neither internal nor external -89 percent indicate that on-the-job training i s sufficient for their particular needs, and 43 percent argue that they can hire workers with the necessary skills, acquired either through their formal education or by working in other companies. Moreover, 64 percent o f the surveyed firms consider that the external training services available in El Salvador are adequate to their needs, a proportion that increases to 82 percent for the companies that use the services o f INSAFORP. On the other hand, for the firms that consider the available services inadequate for their companies - and in fact 84 percent o f those companies do not use the services o f INSAFORP or its certified providers - the main problem o f the available training programs i s that their content i s irrelevant for the companies' specific needs (reason mentioned by 76 percent o f the firms). Additional problems mentioned by those firms are the limited supply o f training programs (51 percent), the lack o f qualified instructors (48 percent) and costs that are considered too high(35 percent) Figure 1.40: Labor Market Rigidity Indexes from Doing Business Database 80 80 94 Source: Investment Climate Survey 138. ElSalvador has relatively rigid regulations regardingthe hiring and firing of workers but more flexible regulations concerning hours of work. The norms that govern the hiring and firing o f workers are more rigid than inthe rest o f Central America and than in the average Latin American country, which in turn displays less flexibility than high income OECD economies and developing countries from East Asia and the Pacific (figure 1.40). Although hours o f work are relatively flexible, part time employment entails mandatory benefits and firing restrictions that are similar to those granted to full-time workers. Fixed-termcontracts are also allowed, but only for up to 12 months, and they are restricted to fixed-term tasks. Minimum wages, however, are relatively lower than in Nicaragua and Honduras. Indeed, while they are higher than in those countries in absolute terms, after adding mandatory non-wage labor costs the Salvadoran monthly minimumlabor cost represents 11percent o f annual per capita GDP, compared to 16 percent for Nicaragua and 23 percent for Honduras.44Inthe area of firing regulations, it i s worth noting that the Salvadoran legislation does not consider that 44 In Costa Rica, Panama and Guatemala minimum wages - including non-wage mandatory costs - are similar to those found in El Salvador: they also represent 11% of p/c GDP (on average). Calculated on the basis o f Anzueto et al. (2004). 71 redundancy is a "fair" ground for dismissal - e.g. as inthe case o f terminations motivated by economic reasons.45 139. A very small fraction of firms (3.9 percent) rate the government regulations that affect labor contracts as sources of major or very severe problems for their operations. Notwithstanding the above mentioned rigidities associated with the hiring and firing o f workers, the fraction o f firms concerned with labor regulations was much lower in El Salvador than inneighboring countries, even inthe context o f a possible Free Trade Agreement with the U.S.(figure 1.41). One possible explanation i s that compliance with the legislation is limited, due to low levels o f enforcement of labor market . regulations, an interpretation that would be consistent with the very low levels o f unionization found in Central America and especially in El Salvador. Indeed, only 1.9 percent o f the surveyed firms - 3.3 percent inthe case o f those with at least 25 employees -reported that some ofthe workers were unionized. Statistics collected by the labor Ministryindicate that 8.4 percent ofemployed urbanworkers are unionized. Moreover, in the presence of weak unions wage contracts can undue some of the distortions incorporated in the labor legislation, for instance by lowering base earnings, so high mandated benefits do not necessarily translate into higher take-home pay. While it i s also possible for firms to use temporary work or outsourcing as mechanisms to minimize their legal obligations towards workers, the ICs data indicates that in El Salvador permanent workers represent on average 89 percent of the workforce o f manufacturing firms, a fraction that i s similar to that found in neighboring countries. Finally, the firms' limited concerns with labor regulations - and their probable ability to avoid full compliance - could be associated with the presence o f excess labor supply, as suggested by the relative ease with which firms seem to able to fill their vacancies, particularly inthe case o f more skilledworkers. Figure 1.41: Labor Regulationsas constraintsto businessoperation (YOof firms) 29.1 29.2 17 2 El Salvador Nicaragua Honduras Guatemala EIGeneral Constraint .Constraint ir CAFTA Source: Investment Climate Survey 45See the World Bank publication Doing Business in 2005 for data on firing costs in El Salvador, comparedto other developingcountries. 72 POLICYRECOMMENDATIONS EDUCATIONAND LABOR ON SKILLS 140. One of the main challengesfaced by Salvadoranpolicy makersin the area of education is that of increasing the share of the workforce with secondary levels of schooling. Higher levels of secondary schooling are crucial not only in terms o f social policy goals - to sustain the positive achievements in the area o f poverty reduction - but also to facilitate the technological upgrading o f local manufacturers, to attract FDI with high technological content, and to benefit from the potential spillovers of those investments to the rest o f the economy.46 As indicated in the World Bank's poverty Assessment for El Salvador, in order to increase secondary enrollments and completion rates, it will be important to strengthen programs o f school construction and rehabilitation in areas where supply constraints appear to be binding and to develop public-private partnerships to exploit excess capacity inprivate schools. It i s worth noting that currently the firms that produce for the domestic or the Central American market are the ones that exhibit a greater demand for more educated workers. However, our results also suggest that an increase in the use o f imported inputs following an increase in the degree o f international integration o f the Salvadoran economy should lead to a positive shift in the demand for skilledworkers, at least inthe manufacturing sector. 141. Even though almost two thirds of the surveyed firms consider that the available training services are adequate for their needs, only 50 percentof the firms that pay the mandatory contributionto INSAFORP actually use the services of that public institution. Efforts in this area should be directed at making the content o f the training programs offered by INSAFORP - or other certified providers - consistent with the needs o f the private sector, in order to overcome what the great majority o f the surveyed firms views as the main problem affecting existing training programs - their irrelevancy with respect to the firms necessities in this area. In this respect, our results show that firms involved in imports and exports tend to demand more training services, suggesting that new Free Trade Agreements should increase the demand for training services and create different needs in terms o f the content o f the programs offered. Moreover, the supply o f training courses should also be integrated into a wider educational policy, so that vocational education and technical training can serve the goal o f complementing the formal schooling o f Salvadoran workers. QUALITY 142. Many components of the national quality system are functioning in El Salvador, while others must be enhanced or developed. To support domestic industries and promote trade, many countries have established a national infrastructure for standards development, accreditation o f testing laboratories and certification organizations, and other standards-related activities. The complexity o f a national quality system i s dependent upon the country's level o f industrialization, the extent o f its dependence on international trade, and the technical requirements o f its trading partners. In El Salvador the coordination of activities related to standards development, 46 For a regional perspective o f the challenges in the area of education, and international examples of educational policies followed by several Latin American countries, see De Ferranti et al. (2003). 73 accreditation, testing, and certification is the responsibility o f the Consejo Nacional de Ciencia y Tecnologia (CONACYT). As described in figure 1.42, CONACYT is an autonomous body under the responsibility o f the "Ministerio de Economia" (MINEC). It i s directed by a board o f directors comprised o f representatives from government, the private sector, professional associations, and academia. So far, CONACYT has been successful in developing the functions o f standards development and laboratory accreditation, but further efforts are needed in terms o f developing a local certification program, and institutingan independent accreditation authority. 143. CONACYT has a robust standards development program, especially when compared to some of the other countries in the region. CONACYT coordinates the development and adoption o f national technical standards with other government bodies and with the private sector and scientific institutions. By having all o f the stakeholders represented inthe standards development process, the resulting standards should be more relevant for Salvadoran industry and government. With 920 standards developed by CONACYT, El Salvador is ahead o f all other Central American countries, including Costa Rica and Guatemala, which follow more closely, respectively with 869 and 699 standards. Many o f the Salvadoran standards are based on international standards such as those developed by the International Organization for Standardization (ISO), the Codex Alimentarius Commission (CAC), and the International Electrotechnical Commission (IEC). Approximately 10 percent o f the Salvadoran standards are mandatory, while the rest are recommended standards. The subjects covered by the mandatory ones reflect the importance o f the food processing, beverage, petroleum, chemical, and textile industries in El Salvador. Recommended standards are optional but become mandatory when referenced inany procurement o f goods or services by the government o f El Salvador, or inother commercial contracts. 74 Figure 1.42: Current quality system in ElSalvador (planned certification in dotted lines) II MINISTERIO DEECONOM~A II Laboratorio de Departamento de Metrologia Normalizacih, Legal Metrologiay Certificacih de la Calidad Information 1 Laboratories j;; Services Products Quality Systems 1 Oualitv SvstemAuditors Source: Researchby Thompson Consulting, Inc. 144. CONACYT is also responsible for accreditation of testing laboratories and it has made much more progress in this area than other countries in the region. Accreditation i s the procedure by which an authoritative body gives formal recognition that a person or organization i s competent to cany out specific tasks. Testing laboratories and certification organizations are most often accredited. An increasing number of regulators responsible for trade policy use accreditation as a means for parties to demonstrate their compliance with trade or safety regulations. Twelve laboratories (9 private, 2 public, and 1 academic) in El Salvador have been accredited by CONACYT, which i s arelatively large number, compared to the other countries inthe region. 145. Even though by law CONACYT i s also responsible for the certification of products and services in El Salvador, including certification to I S 0 9001:2000, the certification program i s not yet functioning. Certification i s the practice o f providing assurance that a product, service, system, process, or material conforms to specific requirements. Conformity usually is validated by a neutral third party, independent of both supplier and purchaser, and is used most often where safety, health, or environmental impact are an issue. Management system certification applies to what an organization does to manage its processes. Management system standards are models to follow in setting up and operating management systems. Quality management system standards include those developed by the International Organization for Standardization (ISO) - I S 0 9001:2000, and quality practices used in the agriculture and seafood industries such as the Hazard Analysis Critical Control Point (HACCP) system, Good 75 Agricultural Practice (GAP) guidelines, and Good Manufacturing Practice (GMP) requirements. Environmental managementsystem standards, such as I S 0 14001, specify the requirements for a firm to manage processes influencing the impact of the firm's activities on the environment. Certification o f a firm under I S 0 9001:2000, HACCP, GAP, GMP, and I S 0 14001 standards is a mark o f approval recognized worldwide and may be required as a condition o f sale. Thus, the adoption o f internationally accepted quality standards facilitates entry into foreign markets, both for Salvadoran firms that seek to supply parts or components to foreign manufacturers, and for producers of finished products searching foreign distribution networks. Because El Salvador's own certification program i s not yet hnctioning CONACYT has partnered, in the interim, with the national standards bodies of Spain (AENOR) and Colombia (INCONTEC) to provide certification services inEl Salvador. It is interestingto note that a comprehensive reform o f the El Salvador customs system, supported by projects such as the IDB Program to Strengthen Custom Systems, has resulted in El Salvador having the first customs system inLatin America to meet the I S 0 quality standard. 146. According to the ICs, about 5.2 percent of Salvadoran firms have I S 0 9001:2000 certified quality standards and 1.5 percent are I S 0 14000 certified. I S 0 certification is much more frequent among larger firms. According to the ICs, the proportion o f firms that have I S 0 9001:2000 certification is slightly larger inEl Salvador than in Guatemala, Honduras and Nicaragua. It is, however, much lower than what has been found using ICs surveys in countries such as Ecuador, Brazil, Pakistan, Malaysia (3 1 percent of I S 0 certified firms) and China (50 percent), which signals the importance o f the challenges ahead (Figure 1.43). Within El Salvador, as in other countries, the incidence o f quality certified firms increases greatly with size, from 1 percent among microenterprises in the case o f I S 0 9001:2000, to about 3.5 percent for small and mediumfirms, and 12.5percent for large firms. Figure 1.43: Firms with I S 0 9001:ZOOO quality certification, by country (percent) 50.4 Source: InvestmentClimate Survey 147. Exporters are more likely to have internationally recognized quality certifications and to employ a larger share of their workforce in quality control activities. These effects are stronger for exporters whose main clients are located outside Central America. As seen in figure 1.44, both in El Salvador and in the other Central American countries for which ICs have been performed, the fraction o f firms with I S 0 9000 and I S 0 14000 quality certifications i s smaller for non-exporters. Among exporters, these simple tabulations show that the incidence o f I S 0 certification is larger for firms 76 whose main foreign clients are located outside Central America, and it i s also larger for maquilas than for non-maquilas. However, econometric estimates show that the differences in the frequency o f I S 0 certification between maquilas and other exporters tend to disappear when the comparisons are made controlling for other firm characteristics, such as sector, location, firm size and average worker schooling. When the estimates are obtained usingdata from the four countries pooledtogether, the results confirm that firms that export to countries located outside the Central American region have a greater probability o f being I S 0 certified, and employ a larger share o f their workforce in activities related to quality control. Moreover, maquilas also have a larger share o f their staff working in the area o f quality control. Finally, the results also show a complementarity between the incidence o f I S 0 9000 quality certification and the use o f importedinputs, the provision o f training to workers and the employment o f workers with higher levels o f schooling. Figure 1.44: Firmswith I S 0 quality certification, by exportingstatus (YO) 12.5 10 6 ElSalvador IS0 9000 Gua.-Hon.-Nic. ISO- - - El Salvador I S 0 - Gua.-Hon.-Nic. ISO. - 9000 14000 14000 Dnon-exporter .main export to CA (non-maqu.) Omain export out of CA (non-maqu.) Omaquila Source:InvestmentClimateSurvey POLICY RECOMMENDATIONS ON QUALITY 148. El Salvador should develop its own certification program to promote the adoption of internationally recognized quality standards, and respond to the demand of Salvadoran exporters. The results o f the survey show that compared to other firms o f similar sectors, locations and size, exporters are more likely to invest in quality certifications and quality standards. These effect i s stronger for firms that export mainly to clients located outside Central America, so that investments in the area o f quality certification and control should tend to increase inthe context o f a Free Trade Agreement with the U.S. In order to respond to that increased demand, the country needs to strengthen its national quality system, by creating local certification bodies, and establishing a separate accreditation authority - the same institution cannot act as both accreditation authority and certification body. In addition, promotional efforts should be made to create awareness in the manufacturing sector o f the benefits o f implementing appropriate quality and environmental management systems standards, the returns on investments in certification to these standards, and on how these measures can increase the firms' competitiveness in the world market. Finally, El Salvador should further stimulate quality certification through public procurement, as well as by means o f specific programs directed at promoting quality standards among small and medium 77 firms. It i s worth noting that most o f these measures are mentioned inthe National Action Plan for Trade Capacity Buildingfor El Salvador.47 TECHNOLOCY48 149. The ICs results suggest that Salvadoran manufacturingfirms are aware of the need to upgrade and renovate their product offerings in order to remain competitive. According to the ICs, inthe last three years 82 percent of Salvadoran firms claim to have upgraded their product line, 62 percent developed a new product line and 51 percent introduced new technology that substantially changed the production process. Such dynamic response i s similar to that o f firms located in other Latin and Central American countries. Although these results suggest a considerable amount o f innovation among Salvadoran firms, the scope o f the product or process innovations introduced has not been broad enough to foster the firms' successful participation in international markets with a diversified portfolio o f highvalue addedproducts. Figure 1.45: Main source of Technological Innovations, by size (%) 90 89 10Upg;ade Line DlNewLine 0New ProcessI Source: InvestmentClimate Survey 150. Self-reported innovations are much more frequent among larger firms, exporters, firms with a more educated workforce, firms that provide training and those that use importedinputs. The percentage o f firms that report process innovations duringthe two years preceding the surveyalmost doubles - from 34 percent to 65 percent -when one moves from microenterprises to large Salvadoran firms (figure 1.45). The fraction o f firms that report having introduced new product lines or improved their existing ones exhibits a similar pattern, with much lower rates o f innovation for smaller firms. For a given firm size, the rates o f self-reported innovation are significantly larger among exporters. These differences are also apparent in Guatemala, Honduras and Nicaragua, but they are much more pronounced in El Salvador. At least in the case o f El Salvador, and after controlling for other firm characteristics, " p i l u s are an exception to the above pattern, as they are less likely to report innovations, not only in comparison 47 The National Action Planfor Trade Capacity,Building: Meeting the Challenge of Globalization, dated July 2003, was preparedunder the direction of the Trade Policy Departmentwith the Ministry of Economy of El Salvador with technical support providedby the OAS-IDB-ECLAC Tripartite Committee. For the preparationof the Action Plan a broadconsultationwas organized by the Government o f El Salvador with public entities having responsibilities in the area o f trade, as well as with representatives of the private sector, academia, andresearchinstitutions. 48 For a detailed analysis of the institutions that compose El Salvador's National Innovation System see World Bank (2004), El Salvador Country Economic Memorandum. 78 with other exporters but also with respect to firms oriented exclusively towards the domestic market. On the other hand, our econometric work reveals a clear complementarity between innovation on one hand, and workers' skills - measured either by the average level o f education o f by the presence o f training activities -and the use o f imported inputs on the other. 151. The main form of technology acquisition at the plant level is the purchase of new machinery and equipment. The purchase o f machinery and equipment is indicated as the most important way o f introducing technological innovations by 64 percent o f the firms with self-reported innovations. It i s one o f the three most important channels o f technology acquisition for 79 percent o f the firms. The two other channels quoted most frequently are the hiring o f new key personnel, by 48 percent o f the firms, and in-house technology development, which i s mentioned by 38 percent o f the firms (Figure 1.46). Although the primacy o f embodied technological change i s not unique to El Salvador, its importance appears to be even larger than in most other countries for which we have comparable data. The percentage o f firms that mention foreign technology licensing as an important source o f innovations is only 6 percent, which i s slightly higher than in other countries o f the region, but much lower than in China, where it is mentioned by 24 percent o f the firms. China i s also the country where internal research and development activities are mentioned most frequently as one o f the three most important sources o f technological innovations - by 79 percent o f the firms, compared to 38 percent in El Salvador. Figure 1.46: Main sources of technologicalinnovations-InternationalComparison(YO) 79 OEmbodied in machinery t!lHiring key personnel HDeveloped in-house I?ILicensing ~~ ~~ Source: Investment Climate Survey 152. The incidence of technology licensing is lower than in neighboring Guatemalaand Honduras,but it is much higher amongmuquilas and foreign owned companies. In response to a direct question, 13 percent o f Salvadoran firms declare to use technology licensed from a foreign-owned company versus 9 percent in Nicaragua, 15 percent in Honduras and 19 percent in Guatemala. Higher licensing levels can be observed among large firms, muquilus, firms operating in the textile sector, and firms with foreign capital ownership. Investments in licensing foreign technologies have been historically low in El Salvador, although some advances were made in the late 1 9 9 0 ~ ~ ~ ~ ~~ 49 World Bank 2003c. Country Innovation Brief.The World Bank.Washington, DC. 79 Royalty payments are 0.19 percent o f GDP, compared to a LAC average o f 0.15 percent and 0.47 percent for the so-called East Asian tiger^".'^ 153. In order to gain access to technological innovations, Salvadoran firms rarely use any form of cooperation with clients, suppliers, industry associations or R&D institutions.Firms' weak integration inthe productive chain, which is a common pattern in Central and Latin American countries, prevents them (especially MSMEs) from benefiting from economies o f scale, knowledge spillovers and joint learning and innovation. In the case o f El Salvador it i s interesting to note that only 9 percent o f surveyed firms declare to have developed innovations by collaborating with suppliers, half the proportion encountered in Honduras, Guatemala or Nicaragua (figure 1.47). Not surprisingly, technological linkages among firms and universities and other research institutions are also missing in El Salvador. In contrast, Salvadoran firms seem to use - consultancy services more than their comparators, as a channel for incorporating new technologies. Figure 1.47: Less frequent forms of technology acquisition. by country (YOof firms) Honduras Nicaragua Guatemala ElSalvador New equipment I suppliers Equipment oTrade Fairs/Study Tours o l n cooperation with clients -Transferred from parent cornpan), 81 Consultants I assoc Business/industry 0 Universities, public institutions Source: Investment Climate Survey 154. The use of computers and computer-controlled production equipment is much higher for larger firms, exporters and firms that employ a larger fraction of skilled workers. Even though Salvadoran firms claim to innovate by acquiring new equipment, the technological content o f such equipment appears low. Indeed, while approximately 52 percent o f Salvadoran firms claim to innovate by introducing new equipment - 66.7 percent report innovations and 78 percent o f those mention the purchase o f new equipment as one o f the three main channels for such innovations - a substantially smaller fraction o f firms (24 percent) uses computer-controlled production equipment. This proportion i s close to that o f Guatemala and Honduras - respectively 24 percent and 21 percent, but much larger than that found in Nicaragua (11 percent). Similarly, on average 11 percent o f the workers o f the surveyed Salvadoran manufacturing firms use computers on their jobs: slightly less than inGuatemala - where 11.8 percent o f workers use computers - but above the 7.8 percent found in Nicaragua and Honduras. Even after controlling for the firms' sector and location, our econometric 50D e Ferranti et al. (2003). 80 estimates indicate that larger firms and firms that report exports are much better equipped than other firms, at least in terms o f the use o f computers and computer-controlled production equipment. Moreover, we also find a strong positive correlation between the use o f those types o f modern equipment and the employment o f a more educated workforce, the provisiono f worker training, and the use o f importedinputs. 155. Despite the importance of technological innovations embodied in new machinery and equipment, imports of capital goods have been historically low in El Salvador. The survey results suggest that in El Salvador, as in most low and middle income countries, technology transfer and innovation mainly take place through the incorporation o f new capital equipment into the production process. In most developing countries, demand for new machinery i s generally met with imports. However, while El Salvador's total import penetration is comparable to the Central American average and higher than the overall LAC average, imports o f capital goods represent only 16 percent o f total imports, which i s low even by Latin American standards. Indeed, that share i s about 25 percent in Chile and Peru, and more than 40 percent in Mexico and Malaysia (Figure 1.48). Figure 1.48: Importsof capitalgoods, by country (YOof total imports) Source: D e Ferranti et. al. (2003). 156. El Salvador's expenditures in the development or adaptation of new technologies have also been small relative to its population and GDP. Even for countries that rely heavily on the transfer o f technology generated abroad, domestic expenditures in research and development (R&D) o f new products and processes are crucial for adapting imported technologies to the specific characteristics o f domestic industries and consumers. Considering both public and private expenditures, the resources devoted to R&D in El Salvador represent about 0.19 percent o f GDP, which is much less than what i s observed in most Latin American countries - e.g. Costa Rica spends 0.25 percent o f GDP on R&D, and Chile and Brazil are close to spending 0.5 percent o f GDP (Figure 1.49). A potentially positive aspect o f the Salvadoran case i s that only 52 percent o f the R&D expenditures are performed by the public sector, a proportion that i s lower than in most countries o f the region - for which the public share i s 77 percent on average - and i s closer to the public share o f total R&D found in the OECD and inEast Asia - about 46 percent. 81 Figure 1.49: R&DExpenditures(YOof GDP), by country (average 1980-1995) Source: De Ferrantiet. al. (2003). 157. About 17 percent of the firms surveyed in El Salvador claim to invest in research and development (R&D) activities and less than 3 percent of the firms' staff i s allocated to that area. The incidence of R&D is higher among exporters and smaller firms. The proportion o f Salvadoran firms that report R&D activities i s smaller than in Guatemala (35 percent) but higher than in Honduras and Nicaragua (about 12 percent). However, within each o f those countries the share o f R&D staff in total employment is larger for smaller firms, as well as for firms that provide training to their workers, export some o f their output, use imported inputs and produce chemical products (see appendix). Among exporters, those that have their main clients outside o f Central America and are not organized as maquilas report the highest shares o f R&D staff in total employment. 158. Given the relatively small amount invested in technology development, it does not surprise to find a relatively small number of U.S. patents registered by Salvadoran inventors. Over the 1996-2000 period, there were only 0.1 patents registered per year by Salvadorans inventors for every million population. While most Latin American countries exhibit rates o f innovative activity that are much lower than those o f the East Asian economies -Korea has 81 patents registeredinthe U.S. for every million population, compared to 2.1 for Costa Rica - El Salvador's performance i s among the lowest o f the region. Moreover, El Salvador's patenting activity i s lower than that o f other countries with the same level o f income, the same labor force size, and the same value o f merchandise exports to the UnitedStates since the 1960s." POLICY RECOMMENDATIONSTECHNOLOGY ON 159. The government of El Salvador should work to improve the conditions for Salvadoran firms to benefit fully from the existing world stock of knowledge, thus increasing the absorption and diffusion of foreign technologies in the Salvadoran economy. Measures to promote this goal include those aimed at facilitating imports o f capital goods, by reviewing bureaucratic requirements for imports and improving the access to financing mechanisms for the acquisition o f machinery and equipment. In this respect, specific measures could be designed to facilitate the purchase o f capital goods - including the acquisition o f computers and related goods - by micro, small and medium firms. Licensing could also be positively affected by additional investments and efforts in ''WorldBank 2003c. Country Innovation Brief.The World Bank. Washington, DC. 82 the enforcement o f intellectual property rights. Moreover, to fully exploit the potential benefits offered by foreign direct investment, the Government o f El Salvador should focus on attracting high value added FDI which could improve the productivity o f the local industriesthat present the highest growth potential52.Additionally, specific efforts should be made to strengthen collaboration between existing foreign and local companies by creating specific linkages through a combination of different activities (e.g., providing market or business information, matchmaking services, managerial and technical assistance to foreign and local firms operating in the same production chains). These initiatives should be coupled to measures aimed at strengthening the specialized investment promotion agency (PROESA). 160. T o encourage technology diffusion, especially among MSMEs and firms operating in industries in which El Salvador has a comparative advantage, the Government should support the development of a modern innovation infrastructure,including centers offering information, technical assistance, training and quality services. Lack o f information or access to certain technological services is typically an important obstacle to technology acquisition and diffusion, especially for micro, small and mediumfirms.53 Inthis sense, technology extension services might be a useful tool. Technology services may offer different emphasis in terms o f the type and purpose o f the service provided. Bundling services -such as quality, training and technology extensions- may bring economies o f scale and scope in provision.54 Currently, some o f these services, especially training and consulting, are being offered by Salvadoran public institutions, but private firms perceive them as inadequate (too general and o f low quality) to meet their needs.55 161. The Government should promote an increase in the current level of public and private investments in research and development activities. To that end, El Salvador should gradually increase public expenditures on R&D for activities with commercial return, as well as guarantee their stability. Moreover, the Government could 52These actions should take into account those sectors identified by the Competitive Intelligence Unit o f the Ministry o f Economy, whose responsibility is to evaluate the competitiveness o fvarious sectors, and to develop international benchmarking. Infact, alignment o f overall economic policies and FDIpolicies is an essential requirement to ensure successful implementation o f the Government's strategy. 53The firms surveyed by FUSADES in 2003 report that the main obstacles to develop innovation activities are the lack o f technical information (56%), the lack o f professional and technical staff (49.5%) and the lack o f skilled labor (47%). The main barriers relate to the difficulties to access and absorb knowledge and point to the need to adjust the educational and training programs to the demands o f the productive sector. At the same time, a large proportion o f firms (80%) declare to spend not much or nothing in training. In particular, 56% of small firms do not invest at all intraining. 54The creation o f private-public business development and technology centers which have the specific purpose o f supporting firms --especially MSMEs or firms operating in clusters-- i s an option that has developed recently in countries such as Peru, Colombia, Mexico and are about to start in Ecuador or Honduras. These centers, often called CITES (Centros de Znnovacidn Tecnoldgica), provide specific training and advisory services (e.g., on equipment use, quality management and improvement o f production processes) as well as access to and information on new technologies (e.g., for raw material quality control, design, manufacturing, production and testing techniques, and packaging and labeling). See a detailed description o f the objectives and structure o f these Centers in the World Bank's Honduras Trade and Productivity Loan (Annex 2) and inFuster J. (2004), background paper for the Honduras Trade Project. 55According to results inthe survey by FUSADES, 2003. 83 consider introducing tax rebate schemes and competitively allocated matching grants to both domestic and foreign firms investing in industrial R&D. The allocation o f R&D resources, both profit and not-for-profit, should favour experimental development if a more output-driven innovation system i s to be achieved. The Government should provide incentives to strengthen cooperation in R&D between the private and public sectors, and encourage more direct involvement o f private firms in this area. To ensure that El Salvador better exploits its R&D potential, the Government should provide specific incentives to support information sharing, joint research and consulting activities between firms and universities. In addition, research funds should be allocated through transparent, competitive bidding processes that encourage participation by private institutions and firms. Finally, the Government could support a program o f technological intermediaries that would facilitate the development o f links between MSMEs and technology service providers. 162. The Governmentshould promote output-based and market-orientedR&D in public researchinstitutesand universities. Possible measures include those directed at gradually reducing the access o f those institutions to earmarked funds while at the same time expanding their autonomy to look for new sources o f funding, particularly through different partnerships with the private sector.56 In addition, the government should improve the existing economic incentives for technology transfer from public research institutes and universities to the private sector, by allowing researchers and their institutions to benefit from their discoveries through flexible assignment rules o f property rights. 163. Finally, the Government should take actions to improve the governance of the Salvadoran national innovation system (NIS) by building the capacity to formulate, implement, and evaluate coherent, incentive-compatible and cost- effective innovation and technology policies. Budget allocation for R&D, innovation program design and evaluation, as well as capacity and institution building for the promotion o f science and technology, have not been a main priority for the Government o f El Salvador over the past decades. CONACYT, the main authority in charge o f the formulation, design and implementation o f R&D strategies and programs and the promotion o f collaboration among various agents o f the National System o f Innovation, has had a very limited impact inthe 12 years since its creation. To date the Council is not highly active, partly due to weak organizational infrastmcture and very small budget, o f barely US$0.5 million. Measures to improve the governance o f El Salvador's N I S include: the definition o f a coherent national technology and innovation policy, establishing a set o f programs designed to achieve measurable objectives, as well as its main funds; the strengthening o f the policy-making, coordination and evaluation capacities o f CONACYT; an increase inprivate sector participation inCONACYT (at the CONACYT estimatedthat public R&D expenditures in 1998 were about US$6.2million and represented a 0.3% o f the budget. This amount i s much lower than the total public resources dedicated to science and technology activities (which cover payroll and operatingexpenses of universitiesand public research and technology centers) amounting to US$51 million and 2.7% of the budget. 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