,5~~ ~ ' - . A.; .'t.~~JP1A? fJ,, X,1 ' t5&bf. < . ' ' .t''.' 4~~~~A fJ AU.'IO 'IV .ICI V' ;,''- . '- . :' A WORLD BANK COUNTRY STUDY El Salvador Meeting the Challenge of Globalization The World Bank Washington, D.C. Copyright ©) 1996 The International Bank for Reconstruction and Development/ THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing August 1996 World Bank Country Studies are among the many reports originally prepared for internal use as part of the continuing analysis by the Bank of the economic and related conditions of its developing member countries and of its dialogues with the governments. Some of the reports are published in this series with the least possible delay for the use of governments and the academic, business and financial, and development communities. The typescript of this paper therefore has not been prepared in accordance with the procedures appropriate to formal printed texts, and the World Bank accepts no responsibility for errors. Some sources cited in this paper may be informal documents that are not readily available. The World Bank does not guarantee the accuracy of the data included in this publication and accepts no responsibility whatsoever for any consequence of their use. The boundaries, colors, denominations, and other information shown on any map in this volume do not imply on the part of the World Bank Group any judgment on the legal status of any territory or the endorsement or acceptance of such boundaries. The material in this publication is copyrighted. Requests for permission to reproduce portions of it should be sent to the Office of the Publisher at the address shown in the copyright notice above. The World Bank encourages dissemination of its work and will normally. give permission promptly and, when the reproduction is for noncommercial purposes, without asking a fee. Permission to copy portions for classroom use is granted through the Copyright Clearance Center, Inc., Suite 910, 222 Rosewood Drive, Danvers, Massachusetts 01923, U.S.A. The complete backlist of publications from the World Bank is shown in the annual Index of Publications, which contains an alphabetical title list (with full ordering information) and indexes of subjects, authors, and countries and regions. The latest edition is available free of charge from the Distribution Unit, Office of the Publisher, The World Bank, 1818 H Street, N.W., Washington, D.C. 20433, U.S.A., or from Publica- tions, The World Bank, 66, avenue d'Iena, 75116 Paris, France. ISSN: 0253-2123 Library of Congress Cataloging-in-Publication Data El Salvador: meeting the challenge of globalization. p. cm. - (A World Bank country study) Includes bibliographical references. ISBN 0-8213-3720-3 1. El Salvador-Economic policy. 2. Structural adjustment (Economic policy)-El Salvador. 3. Economic stabilization-El Salvador. I. Grandolini, Gloria M. II. World Bank. III. Series. HC148.E437 1996 338.97284- dc2O 96-32304 CIP CONTENTS PREFACE ....................................... vii ACKNOWLEDGMENTS ....................................... ix CURRENCYEQUIVALENTSAND GLOSSARY ................ ....................... xi EXECUTIVESUMALIRY ....................................... xiii ADDENDUM ....................................... xxv Chapter I. ENTERINGA NEWSTAGE OFDEVELOPMENT: CHALLENGESAND OPPORTUNITIES .......................................1I Economic andpolitical achievements: 1989-94 ........................................1 The new development strategy: goals and genesis ............... ........................I Lessons from East Asia .4.................,.,.,.,...4 The public - private sector interaction: policy implications ..............................................7 ChapterII. ENHANCING MACROECONOMICSTABILITY .....................................9 Improving fiscal performance ...........................................................9 Fragility offiscal performance ...........................................................9 Increasing revenues ...........................................................11 Modernizing the public sector .......................................................... 13 Adjusting to highforeign exchange flows .......................................................... 13 Background: foreign exchange flows and Dutch disease .................................. 14 Key macroeconomic management issues and the role of the Dutch disease in El Salvador ..........................................................1 7 Sterilization policies: impact and effectiveness ................................................... 27 Recommendations: macroeconomic management with high foreign exchangeflows .......................................................... 30 Chapter III. IMPROVING LABOR AND INFRASTRUCTURE ............... ................. 33 Developing human resources and labor markets .......................................................... 33 Labor market characteristics and trends .......................................................... 33 Developing human resources and enhancing productivity ........................................ 35 Lowering direct and indirect labor costs .......................................................... 35 Contractingflexibility and labor management relations ........................................... 36 Modernizing infrastructure .......................................................... 37 Overview .......................................................... 37 Infrastructure provision: approaches and lessons of experience ................ ............... 38 Seizing opportunities: general recommendations ...................................................... 39 Telecommunications .......................................................... 40 iv Contents Power ..................................................... 41 Roads ..................................................... 42 Ports and rail ..................................................... 42 Water and sanitation ..................................................... 43 Chapter IV. MODERNIZING THE LEGAL AND REGULATORYFRAMEWORK.45 Establishing and securing property rights ............................................................. 45 Improving contract law ............................................................. 46 Facilitating company entry, operation, and exit ............................................................. 46 Strengthening competition policy and consumer protection ............................................. 48 Eliminating tax distortions and disincentives ............................................................. 49 Improving enforcement capacity and judicial institutions ................................................ 50 Chapter V. FACILITATING TRADEAND TECHNOLOGICAL DIFFUSION ........ 53 Trade Policy: deepening and sustaining liberalization .................................................... 53 Removing export-specific constraints ........................................................ 54 Addressing import-related issues ........................................................ 54 Addressing export-related administrative and institutional weaknesses ...................... 55 Facilitating technology diffuision and quality control ................................................ 57 Strengthening trade negotiation capabilities ........................................................ 57 Improving government-business consultation ........................................................ 58 Chapter VI. STRENGTHENING THE FINANCIAL SECTOR .................................... 59 Improving access to credit ........................................................ 59 Addressing collateral security issues ........................................................ 59 Promoting the use of new financing instruments ....................................................... 60 Lending to microenterprises. policy options and lessons from experience ................. 61 Strengthening the banking system ........................................................ 61 Increasing competition ........................................................ 61 Lowering illiquidity risks ........................................................ 62 Strengthening supervision of the banking system ......................................... ............. 62 Establishing a deposit insurance fund ........................................................ 63 Developing capital markets ........................................................ 63 Catalyzing the supply of securities ........................................................ 64 Ensuring reliable and timely disclosure of information ............................................. 64 Strengthening supervision ........................................................ 64 Facilitating the development offinancial intermediaries ........................................... 65 ANNEX: Constraints to Private Enterprises: A Summary of Survey Results ................ 69 BIBLIOGRAPHY .......................................................... 83 Contents V TEXT TABLES 1.1 Key Macroeconomic Indicators, 1980-95 .............................................................2 1.2 Sectoral GDP Shares and Growth Rates .............................................................3 1.3 El Salvador: Sources of Growth .............................................................6 I.4 Total Factor Productivity (TFP) Growth, 1960-90 (%) ...................................................6 1.5 Ratio of Total Trade to GDP .............................................................6 II. I Remittances and National Income Accounting, 1975-94 (as % of National Income) .. 15 11.2 Variability Indicators (MRER - Quarterly Data) ........................................................... 21 II.3 Savings, Investment, and the Current Account Deficit, 1980-94 (as % of GNP) ......... 26 11.4 External Deficit and Financing Mechanisms (as % of GDP), 1975-94 ......................... 26 III.I Telecommunications, Road and Power Infrastructure in the Region, 1992 .................. 38 V.l Tariff Structure, 1988-94 ............................................................ 53 TEXT FIGURES I.1 GDP and GDP per Capita, 1960-94 .............................................................3 1.2 Exports, 1960-94 .............................................................3 1.3 Average Growth of GDP, 1965-90 ............................................................4 1.4 Income Inequality and GDP per Capita, 1965-90 ............................................................4 I.5a Savings and Investment .............................................................5 1.5b El Salvador: Savings and Investment, 1975-94 .............................................................5 I.6a Mean Years of Education, 1987 .............................................................5 1.6b Primary School Enrollment Ratios 1975, 1984, 1991 .....................................................5 II.1 Savings of the NFPS, 1980-94 ............................................................ 10 11.2 Consolidated NFPS Deficit, 1980-94 ............................................................ 10 I1.3 Expenditure Trends of the NFPS, 1980-94 ............................................................ 10 11.4 Budgetary Expenditures by Sectors, 1985-94 ............................................................ 10 11.5 Trends in Tax Revenues, 1971-94 ............................................................ 11 11.6 Total Expenditures, 1993 (as % of GDP) ............................................................ 13 11.7 Total Inflows, 1975-94 ............................................................ 14 11.8 Capital Inflows and Remittances, 1975-94 ............................................................ 14 11.9 Trends in Total Inflows, 1975-93 ............................................................ 15 11.10 Emigration Trends, 1985, 1987, and 1991 ............................................................ 1S 11.11 Worker Remittances, 1975-94 ............................................................ 15 II.12 Inflation Rates (1990=100), 1960-94 ............................................................ 17 II. 13a International Reserves of the Banking System, 1989-94 ............................................... 18 II. 13b International Reserves of the Central Bank as % of currency in Circulation, 1989-94 ............................................................ 18 II.13c Ml, Quasi-Money, M2, and Monetary Base, in Constant Colones, 1989-94 ............... 18 II.13d Money and Quasi-Money Multipliers, and Income Velocity, 1989-94 ......................... 18 II.14 Monetary Indicators in 1990 Colones, 1960-93 ............................................................ 19 II.15a BRER, MRERxm Top 10, and MRERxm Top 6 Non-LAC 1961-94 (1985=100) ............................................................ 20 II.S5b BRER using Wage Index 1980-92 (1985=100) ............................................................ 20 II.16 BRER and TplNTp Index, 1975-94 (1985=100) ........................................................... 21 11.17 Expansion of Non-Tradable Sector, 1975-94 ............................................................ 21 Vi Contents 11.18 BRER and Total Inflows, 1975-94 (1985=100) ...................................................... 22 I1.19 Public Consumption and Tp/NTp, 1975-94 ...................................................... 22 11.20 BRER, NER, and CPI, 1961-94 (1990=100) ...................................................... 23 11.21a Exports and Imports, 1975-94 ...................................................... 24 11.21 b Export and Import Trends, 1960-94 ...................................................... 24 11.22 Export Growth Rates (in Constant 1985 US$), 1979-94 ............................................... 24 II.23a Capital and External Accounts, 1975-94 ...................................................... 25 II.23b Current Account Deficit, 1975-94 ...................................................... 25 11.24a Monetary Stabilization Certificates, in Million Colones, Jul.9 1-Aug.95 ...................... 28 II.24b Monetary Stabilization Certificates, as % of Monetary Base, Dec.91-94 and June 95 ...................................................... 28 11.25 Nominal and Real Interest Rates for CEMs (180 days) and Deposits (180 days), Jul.91-Aug. 95 ..................................... 28 III. I Education Level of Employed Labor, 1993 ..................................... 33 111.2 Urban Labor Force Participation, 1988-93 ..................................... 34 III.3 Urban Unemployment Trends, 1988-93 ..................................... 34 111.4 Urban Labor Market Flexibility, 1988-93 ..................................... 34 III.5a Industrial Wage Gap, in Real 1980 Colones, 1980-93 ..................................... 34 II:5b Increase in Real Earnings, 1970-80 and 1980-91 ..................................... 35 III.5c Average Urban Public and Private Real Wages, Private Min.Wage Industrial, and Private Consumption per Capita, 1980-93 (1980=100) ......................... 35 ANNEX TABLES I Characteristics of El Salvador Sample ..................................................... 70 2A Sources of Inputs for Salvadoran Firms ..................................................... 70 2B Destination of Sales for Salvadoran Firms ..................................................... 70 3 Financial Constraints to Salvadoran Firms ..................................................... 79 ANNEX FIGURES I Sample Characteristics ..................................................... 69 2 Obstacles to Salvadoran Enterprise Operation and Growth .......................................... 72 3 Constraints to Salvadoran Enterprises by Size ..................................................... 73 4 Constraints to Salvadoran Enterprises by Sector ..................................................... 74 5 Regulatory Constraints to Salvadoran Enterprises ..................................................... 76 6 Severity of Labor Regulations as Constraint in 6 Latin American Countries ............... 77 7 Infrastructural Constraints to Salvadoran Enterprises ................................................... 78 8 Sources of Finance for Salvadoran Firms ..................................................... 79 PREFACE _ Stabilization and adjustment measures implemented since 1989 and the return to peace have laid the foundations for sustained growth in El Salvador. However, there is a need for more rapid growth to consolidate peace and alleviate poverty. Facing a turning point, El Salvador has decided to take a dramatic leap forward to try to rise above this relative success and rapidly catch up with high-performing economies. The vision is to achieve rapid and equitable growth by increasing global competitiveness and entering a new stage of development. El Salvador is currently undertaking bold economic reforms to become a more open economy with a dynamic export-oriented private sector keyed into international markets and a small and strong State facilitating private sector activities. The premise of this report is that El Salvador's vision may be attained. The return to peace and changes in the global economic environment provide favorable opportunities. However, for it to become a reality two main challenges must be met. First, peace must be consolidated. Bold economic reforms will be a key factor in accelerating investment, exports, and growth, but not a sufficient one. Persistent security concerns must be eliminated to lower the risks of operating in the country and attract investors. At the root of the civil conflict were both economic and social problems, particularly land-related issues and income inequalities.' Only a combination of economic growth and the implementation of policies specifically addressing social and land-related issues will ensure continued social peace. The second challenge is to seize the opportunities arising from globalization by removing existing constraints to increased competitiveness and accelerated growth. Key constraints lie in weak support systems for private enterprise that inhibit accumulation, productivity growth, and international competitiveness. The Government can remove these constraints by acting in two areas: reforming the State and implementing policy reforms supportive of outward-oriented private sector-led growth. This report seeks to support the Government's reform effort by proposing a policy agenda to increase El Salvador's global competitiveness. It identifies constraints to accelerated outward-oriented private sector-led growth and policy options to address them. Chapter I summarizes developments since 1989 and discusses the genesis, characteristics, and policy implications of the Government's vision and the public-private sector interaction. Chapter II reviews the remaining agenda to further strengthen macroeconomic stability, focusing on the need to improve fiscal performance and to address macroeconomic management concerns associated with high foreign exchange flows. Chapter III discusses policies to develop human resources and increase labor productivity and presents options for infrastructure modernization. Chapter IV discusses policies to improve the legal and regulatory framework. Chapter V reviews options to minimize distortions and remove constraints in the trade regime and to accelerate technological catching up. Chapter VI focuses on measures to strengthen the financial sector to enhance allocation toward high-productivity investments and increase the level of financial savings. Poverty and income inequality issues are covered in "El Salvador - The Challenge of Poverty Alleviation", June 9, 1994, Report No. 1231 5-ES (The World Bank) and land-related issues are being addressed through on-going (Agricultural Sector Reform Project) and future (Land Administration Project) projects. ACKNOWLEDGMENTS This report was prepared by a team led by Gloria M. Grandolini (LA2CO) based on a series of missions to El Salvador during 1993-95 and reflects joint efforts by the Government (GAES/MIPLAN, the Central Bank, and the Ministries of Finance and Economy) and the World Bank. Contributors to the report were: Ian Bannon (Lead Economist, LA2CO); Harold Bedoya (macroeconomic analysis, data, and graphics, LA2CO); Sara Calvo (trade, EDIEM); Richard Clifford (infrastructure, LA2IN); Luis Guasch (labor markets and regulatory framework, LATAD); Andrew Stone (private enterprise survey, PSD); Saud Siddique (capital markets, IFC-CLACM); Charles Thomas (infrastructure, PSD); and the following consultants: Suphan Andic (taxation), Manuel Lasaga (financial sector), and FUSADES (private enterprise survey). The Department Director is Edilberto L. Segura, the Division Chief is Donna Dowsett-Coirolo, and the Lead Economist is Ian Bannon. CURRENCY EQUIVALENTS AND GLOSSARY Currency Unit = col6n (c) US$1.0 = 8.75 (August 1995) c 1.0 = US$0.11 FISCAL YEAR January I to December 31 GLOSSAR Y OFACRONYMS AND ABBREVI TIONS ANDA = National Water Company (Administraci6n Nacional de Acueductos y Alcantarillados) ANTEL = National Telecommunications Administration (Administraci6n Nacional de Telecomunicaciones) BCR = Central Bank (Banco Central de Reserva) CACM = Central American Common Market CEL = National Power Company (Comisi6n Ejecutiva Hidroelectrica del Rio Lempa) CENTREX = Export Processing Center (Centro de Trdmites de Exportaciones) CEPA = National Ports Authority (Comisi6n Ejecutiva Portuaria Aut6noma) FMLN = Farabundo Marti National Liberation Front (Frente Farabundo Marti de Liberaci6n Nacional) FTZ = Free Trade Zone FUSADES = Salvadoran Foundation for Economic and Social Development GAES = Economic and Social Advisory Group (Grupo Asesor Econ6micoy Social) IDB = Inter-American Development Bank IMF = Intemational Monetary Fund INPEP = Public Sector Pension Institute (Instituto de Previsi6n de Empleados PuTblicos) ISSS = Social Security Institute (Instituto de Seguridad Social) MIPLAN = Ministry of Planning MOE = Ministry of Education NAFTA = North American Free Trade Agreement NRP = National Reconstruction Plan NTBs = Non-Tariff Barriers ONI = National Investment Office (Oficina Nacional de Inversiones) PSMP = Public Sector Modemization Program RDC = Commercial Registry (Registro de Comercio) RER = Real Exchange Rate SFF = Superintendency of the Financial System (Superintendencia del Sistema Financiero) USAID = United States Agency for Intemational Development VAT = Value Added Tax EXECUTIVE SUMMARY El Salvador's achievements since 1989 have been formidable but more rapid growth is needed The Government's vision Is to accelerate equitable growth by increasing global competitiveness. The return to peace and changes In the globd economic environment provide favorable opportunities. Current bottlenecks are low human and physical resource accumulation, low productivity, and limited outward- orientation. The main challenges are consolidating peace and quickly transforming polices to seize the opportunities arising from globalizaiion. This transformation requires reforming the State and supporting outward-oriented private'sector-led growth To leapfrog into a new stage of development the Government mutt act quickly and concurrently on six policy areas: enhancing macroeconomic stability; developing human resources and increasing labor productivity; modernizing infrastructure; improving the legal and regulatory framework ,faciliting trade and technological innovation, and strengthening the financi sector. El Salvador's achievements since 1989 have current growth trends may not be sustainable beenformidable... unless exports expand considerably. Third, recent trends in international economic El Salvador has made a dramatic leap integration - the globalization phenomenon - forward since the late 1980s. In 1989, the 10 highlight that to raise welfare developing year old civil war was still ongoing, GDP per countries must become globally competitive in capita was 15 percent lower than 1978 levels, technologically more advanced goods and and a full fledged economic crisis had emerged. services. By the mid 1990s, the Government had ended the civil war, stabilized the economy and The Government's vision: accelerate equitable reactivated growth, and initiated a systematic growth by increasing global competitiveness attack on poverty. These efforts have lifted the country from the economic crisis of the 1980s The challenge now facing the Government and placed it on a path of relative stability and is to fulfill its vision of raising El Salvador economic growth. above this relative success by seizing the opportunities arising from globalization and ... but more rapid growth is needed rapidly catching up with high-performing economies. The goal is to achieve rapid and Notwithstanding these achievements, three equitable growth by becoming a more open and considerations have led the Government to competitive economy with a dynamic export- reassess the development strategy followed over oriented private sector keyed into international the last few years. First, even more rapid markets and a small and strong State facilitating economic growth is a necessary condition to private sector activities. This report identifies consolidate peace and alleviate poverty. existing constraints to the achievement of this Although growth improved in the post-war vision and proposes a policy agenda to increase period, GDP per capita remains at pre-war El Salvador's global competitiveness. levels and the trickle down effects of prosperity have not yet been felt widely enough. Second, xiv Executive Summary The opportunities: the return to peace and o inadequate human capital stock, especially changes in the global economic environment low primary enrollment ratios which do not bode well for a rapid increase in the stock, Domestic and international changes have and low educational quality; created opportunities for the attainment of El o low allocative efficiency and productivity Salvador's vision: growth; and Q in the domestic arena, the return to peace 4 low exports and limited outward orientation. and the implementation of a coherente and comprehensive economic strategy have set Two challenges: consolidating peace the stage for an acceleration of private sector activity and foreign direct Economic reforms will be a key factor in investment; and accelerating investment, exports, and growth, '* in the international arena, globalization - but these will not be sufficient. To consolidate driven by widespread adoption of peace, lower the risk of doing business in El liberalization policies, buoyant world trade, Salvador, and attract investors, the Peace technological catching up, increasing capital Accords must also be fully implemented and flows, and the internationalizationof security concerns addressed. Policies services - represents a fundamental specifically addressing social and land-related opportunity for raising welfare. issues at the root of the civil war must be ˘ in the domestic arena, the return to peace implemented. and the implementation of a coherent and comprehensive economic strategy have set ... and quickly transforming policies to meet the the stage for an acceleration of private challenge of globalization sector activity and foreign direct investment; and El Salvador is currently developing Q in the international arena, globalization - economic reforms to remove existing driven by widespread adoption of bottlenecks to increased global competitiveness liberalization policies, buoyant world trade, and accelerated growth. The focus should be technological catching up, increasing capital on: flows, and the internationalization of Q transforming policies and structures to services - represents a fundamental support outward-oriented growth, opportunity for raising welfare. * assuring adequate human and physical The bottlenecks: low accumulation, low infrastructure, productivity, and limited outward-orientation C* acquiring technology by plugging into the world economy and attracting foreign The experience of high performing investment, and economies elsewhere, most notably those in facilitating resource shifts toward East Asia, suggests that to accelerate growth exportable goods and services. governments need to focus on augmenting This transformation requires: reforming the physical and human resource accumulation, statirm enhancing the allocative efficiency and the State productivity of resources, and increasing To achieve this vision, the interaction and outward orientation. complementarity between the State and the El Salvador has: private sector is critical. Key constraints to '> low investment and savings levels; meeting the challenge of globalization lie in weak support systems for private enterprise that Executive Summary xv inhibit accumulation, productivity growth, and r strengthen fiscal performance, and international competitiveness. > adjust macroeconomic management to high foreign exchange flows. The State should reform itself to ensure the efficient provision of essential public goods and Improvements in fiscal performance since services and to reorient public resources to 1989 have been impressive, but much remains support economic growth and attend to the most to be done to address low public savings, low urgent needs of the poor. The public sector capital expenditures, inertial and inflexible should concentrate on core activities, improving expenditure patterns, and dependence on the quality, efficiency, and coverage of the external financing. A stronger fiscal services which the State will continue to performance is necessary to: meet peace-related provide, while working to strengthen its expenditures, address large unmet social needs, capacity to formulate and implement policies and ensure the credibility of exchange rate and that enable the private sector to thrive. The full monetary policies. Two priority areas should be and timely implementation of the on-going addressed: Public Sector Modernization Program is the X further increasing tax revenues to augment necessary condition for successfully entering the public savings and decrease reliance on new stage of development. external financing by broadening the tax base, strengthening tax administration, and ... and supporting outward-oriented private enforcing compliance; and sector-led growth by... r* modernizing the public sector to improve efficiency, with particular emphasis on -In parallel, the Government should remove privatization and civil service reform. existing constraints to the acceleration of outward-oriented private sector-led growth by Notwithstanding their positive impact on acting rapidly and concurrently on six living standards and on the balance of payments, fundamental policy areas: high foreign exchange inflows have complicated * further enhance the stability of the macroeconomic management and the attainment macroeconomic framework, of other policy fundamentals. In particular, * develop human resources and increase labor abundant foreign exchange flows have productivity, contributed to inflationary pressures, real * modernize infrastructure, exchange rate appreciation and variability, and * improve the legal and regulatory external sector vulnerability. Sterilization framework, policies - aimed at containing monetary > facilitate trade and technological diffusion, expansion and maintaining a stable nominal and exchange rate - have further complicated t strengthen the financial sector. macroeconomic management by putting pressure on interest rates and on the Central ... Enhancing macroeconomic stability.. Bank's operational deficit. In an increasingly more open, integrated, Although foreign exchange flows will and competitive global economy, economic stabilize at lower growth rates, they are likely to management must ensure stability to maintain be a permanent feature. This entails a change the confidence of domestic and international in the underlying structure of the economy. The markets and flexibly respond to capital flows. challenge is to adjust to the higher level of El Salvador has shown remarkable inflows. While in the short-run, the macroeconomic improvements since 1989 but Government should continue open market the Government still needs to: operations to sterilize excess inflows, these xvi Executive Summary impose costs in the financial system and have a ... developing human resources and labor limited impact. In the long-run, the challenge is markets.. to adjust to the higher level of inflows by continuing implementation of policies which, in The labor market appears to be relatively addition to improving fiscal performance, competitive, with wages determined largely by should aim at: market conditions However, the lack of skilled c* raising national savings by: (i) increasing workers and low labor productivity may be the the depth and efficiency of the financial key bottleneck to accelerating growth. The sector; (ii) reforming the social security Government should address these constraints system; and (iii) increasing public savings; by: c* containing inflationary pressures by: (i) * ensuring a growing supply of skilled labor encouraging higher domestic savings; (ii) through education sector reforms; lowering government consumption, which is c* enhancing the productivity of existing usually biased toward non-traded goods; capital stock by supporting private sector (iii) fostering private investment, which is efforts to develop an active and usually more traded good-intensive; and (iv) comprehensive training policy; and in the longer-term, ensuring that a larger > contributing to the quality and efficiency of percentage of private inflows are in the form labor supply through health sector reforms. of foreign direct investment; and 4 pursuing a credible exchange rate policy In addition, actions should be taken to lower while limiting real exchange rate direct and indirect labor costs through wage appreciation; the continuation of high policy and public sector employment reformns. inflows and economic growth entail a change in the underlying structure of the ... modernizing infrastructure.. economy, and in particular, a lower real exchange rate. To avoid short-run real El Salvador cannot fulfill its potential for exchange rate misalignment, the authorities export-led growth without overhauling and should continue to focus on ensuring modernizing its telecommunications, power, consistent macroeconomic polices and transport, water and waste networks. The poor moderating inflation. There are a number of condition of infrastructure saps the policy actions the Government can focus on competitiveness of the private sector, as to generate a long-run real depreciation: (i) efficient services are increasingly important to accelerate trade liberalization (to increase firms' capacity to compete in world markets. demand for traded goods); (ii) lower foreign The foundation for this transformation has been exchange flows by improving fiscal established and some steps have been taken performance and decreasing the external already. financing needs of the public sector; and (iii) increase national savings; and The agenda of comprehensive policy and * facilitating expansion and diversification of institutional change in each infrastructure sector exports, within a framework of a lower real involves: exchange rate by: (i) ensuring a stable * revising the basic legal framework of macroeconomic environment; (ii) removing governance; general constraints to private investment; '' reforming market structures within sectors; and, (iii) removing specific constraints to * articulating in detail the new government export growth. role in regulation, particularly to ensure a politically independent approach for formulating tariff policy based on sound economic and financial criteria; Executive Summary xvii * specifying the financial role of government; of laws and regulations, and fostering the * promoting private sector participation; and use of arbitration. ' in those activities which remain, transitionally or for the longer term, under ... facilitating trade and technological public ownership and operation, innovation... restructuring of the responsible entity may be needed to create incentives for efficient, A stable macroeconomic environment and commercial operation and to permit even the removal of general constraints to private limited private sector involvement, such as sector development will be key to increase the through contracting-out of specific services, outward-orientation of the economy. However, or management contracts. to accelerate export supply response, parallel efforts are necessary to address policies and ... improving the legal and regulatory administrative mechanisms which impede the framework.. achievement of policy neutrality between domestic and international markets and that The legal and regulatory framework needs negatively influence export competitiveness by to be revised, focusing on: raising costs, diminishing quality, and slowing Q establishing and securing real and order response time. intellectual property rights by modernizing the Registry of Real Property and fighting The Government can enhance export supply piracy; response and competitiveness by: c* improving contract law by providing Q deepening and sustaining trade general rules for calculating extra- liberalization by moving to a uniform tariff contractual liabilities and damages; rate, eliminating remaining administrative * facilitating company entry, operation, and instruments regulating import flows, and exit by: (i) further simplifying and speeding responding to the challenges of NAFTA; up the registration process and centralizing > eliminating remaining policy and ONI's institutional structure; (ii) institutional obstacles to trade expansion by: strengthening the supervision of companies; (i) further reducing import-related (iii) simplifying the Commercial Code by administrative costs and procedures; and (ii) eliminating unnecessary procedures; (iv) simplifying export-related administrative harmonizing and simplifying foreign procedures, addressing issues related to the investment rules to eliminate procedural and functioning of the Free Trade Zones and structural entry barriers; and (v) improving Fiscal Areas, and improving the functioning the speed and efficiency of bankruptcy of the duty drawback system; proceedings; 4 facilitating private sector efforts to gain * strengthening competition policy and access to technology and enhancing its consumer protection by enacting a modern capability of adapting to these new competition policy and anti-trust legislation technologies by: (i) adopting and addressing monopolistic and restraints of maintaining a liberal trade and investment trade practices; regime; (ii) ensuring supportive human and Q improving tax rules and administration by: physical infrastructure; and (iii) supporting addressing distorted incentives; controlling private sector initiatives; unfair competition; and diminishing 4 continue strengthening trade negotiation compliance costs; and capabilities to take full advantage of c* improving the predictability and speed of opportunities created by the Uruguay conflict resolution and of the enforcement Round, the internationalization of services, and regional integration efforts; and xviii Executive Summary c> improving business-government supervision; and (iv) establishing a deposit consultation mechanisms. insurance fund; and * contributing to the development of financial ... and strengthening thefinancial sector markets by: (i) acting as a catalyst by issuing public securities; (ii) enforcing Financial sector reforms implemented since standards of fairness in trading and broad 1989 have set the foundations for the disclosure of information; (iii) strengthening development of a modern financial system. prudential regulation; and (iv) developing Nevertheless, more needs to be done to sustain enabling legislation for the reform and more and deepen these reforms and develop a active involvement of institutional financial system which can support accelerated investors, such as contractual savings growth. institutions (insurance companies and pension funds) and other financial Government efforts should continue intermediaries, such as mutual funds and focusing on: leasing companies. c* improving access to credit by: (i) addressing collateral security issues to ensure effective Seizing opportunitiesfor accelerating growth creation, perfection, and enforcement of security interests; (ii) promoting the use of Peace and globalization have created new new financing instruments such as leasing, opportunities to accelerate growth but to seize factoring, and liens on inventory and on these opportunities the Government must act commercial equipment; and (iii) promoting rapidly and concurrently on all policy areas. El access to credit by microenterprises through Salvador has an entrepreneurial, innovative, and new approaches, along the lines of resilient private sector. If the State is able to successful international experiences; consolidate peace, reform itself, and remove r* further liberalizing and strengthening the constraints to outward-orientation and private banking system to enhance its capacity to sector development, the shared vision for the absorb large changes in liquidity by: (i) twenty first century will be within reach. eliminating ownership limitations; (ii) lowering illiquidity risks; (iii) strengthening Executive Summary xix A Road Map for El Salvador a CONSTUWA1N- -- . -.:- - T :-- ',;: -,, '-: ; -. . . . . . . . .. . . .MACROECONOfIC FRAMEWORKi~.~i: Fiscal Policy Low public savings: fiscal 000 Increase tax revenues by broadening the 00 MT improvements mostly associated with tax base, strengthening tax lower capital expenditures. inertial and administration, and enforcing inflexible expenditure patterns; and compliance. Modernize the public dependence on foreign sources of sector to improve efficiency financing Macro High foreign exchange inflows have *o@ In the short-term, continue open market @0 MT Management complicated macroeconomic operations to sterilize excess inflows. management and the attainment of a In the long-run, the challenge is to number of policy fundamentals: (i) adjust to the higher level of inflows by inflationary pressures: (ii) real continuing the implementation of exchange rate appreciation and policies which, in addition to improving variability; (iii) external viability fiscal performance, should aim at: (i) concerns; and (iv) interest rate encouraging high levels of national pressures. savings; (ii) containing inflationary pressures; (iii) pursuing a credible exchange rate policy while limiting real exchange rate appreciation; and (iv) facilitating expansion and diversification of exports, within a framework of a lower real exchange rate. ,. -..- . -. - -,--.--,,----- , ---:-:-. . .-.: : -. . - ,. . --.. . .- - .......... . i.UMAN9: - .O VRCE$ :ND --i'0* -A S . - Humn mLow skill level keeps productivity and see Re-orient public expenditure to invest *e LT Resources wages low, limits labor supply for non- more in primary education and health traditional export industries; low health services; allow private provision, levels also lower quality of labor force. explore private and NGO routes to deliver publicly-financed services; and strengthen institutional capacity of Ministries of Education and Health. Insufficient levels of on-the job human *se Encourage and support private sector 00 LT capital accumulation I_ I industry-based vocational training I I The Road Map is an analytical tool to: (i) identify, prioritize, and analyze constraints inhibiting private sector-led growth, (ii) identify solutions and assess their technical feasibility, and (iii) develop a strategic agenda. For each constraint, an assessment is made of the degree of importance and the extent to which relieving the constraint would facilitate private sector growth. Over time, as more important constraints are relieved. less important constraints become more prominent. The categories of importance used are high (000), medium (00), and low (0). High indicates that the constraint is critical and is a binding or very important constraint on firm activity. Medium indicates that the firm can still operate with this constraint, but with a fair amount of difficulty. Low indicates that while the constraint increases firms' difficulties in conducting business, they are able to overcome this constraint with relatively minimal effort. Technical difjiculty measures the level of specialized expertise required and the administrative difficulty involved in implementation. Finally, for each constraint, the Road Map identifies a period of implementation. This should again reflect two components: sequencing and gestation. The measures of timing are: Short-Term (ST) - less than I year; Medium-Tern (MT) - 1-3 years; and Long-Term (LT) - more than 3 years. This strategy should give a sense of the time frame in which actions will occur. The final step is to identify who will undertake them. Executive Summary =L= ~~~~~~~~~~~~~~~~~~~~~~1 Wage Policies Sector-specific wage policies, overtime *@ Unify minimum wage at hourly rate. *ST and fringe-benefit provisions cause Permit/encourage productivity-linked distortions or artificially increase labor compensation. Reduce overtime and costs. _____ night shift wage._____ ____ Labor Limited use of oral procedures. Lack of * Expand the use of oral proceedings. so MT Management compulsory mediation. Establish a requirement for compulsory arbitration, beyond the essential services clause, with a legal right of appeal. Extend compulsory mediation and arbitration to individual conflict cases. Public Sector Public sector employment and wage *@0 Strengthen public sector human *0 LT Employment policies distort labor markets and resource management. Revise Civil influence private management Service Law to eliminate job guarantee. practices. Public agencies suffer from Extend working hours, reduce personnel management weakness, wage overstaffing, revise salary scales, distortions, short working hours, implement competitive and objective overstaffing, lack of competitive procedures for selecting, evaluating and recruitment procedures, lack of promotion of public employees that incentive-based compensation. measure performance and reward merit. HY ~~~~~~~~~~~~~~~~~.......... ,.,,,..,.,.,.,....... Wnfrastructure Deficiecies in the quality and quantity *i Reassess Govenmment role and (general) of frinfrastruct resing from poor implement an agenda of comprehensive performance of state-owned enterprises policy and institutional change: and lack of commercial considerations. * permit greater private ownership and management arrangements; * revise the basic legal framework of governance, separating policy-making and regulatory functions of government from operational functions. * implement tariff reform in all public utilities; and * run on commercial basis, with any subsidies provided in a direct and _____________ _______________________________transparent manner. ____ Telecom Poor quality of service, especially on *ee Improve internal management and *@ MT local calls. Underinvestment. oversight and broaden scope for private provision, competition. Roads Poor quality, with substantial regional Os Improve quality through increased road *5 MT variation. Underinvestment. maintenance. Introduce budgetary reform in MPW to permit sufficient and sustainable financing for road maintenance; permit greater private incentive-based__ _ compensation._ _measure__perf_participationracnderd ri Executive Summary xxi _ m Power Voltage/frequency fluctuations. @00 Complete reforms introduced, grant new *- MT Underinvestment concessions for private power generation. Water Inadequate supply and regional * lmplement tariff reform, address *s LT variations, with disjointed institutional governance issues, permit private framnework, participation, strengthen the project pipeline. .. ..... ..;s-. :Sg., . S,,,, . ..- NS-^s Legal, Inadequate protection of real and e * Modemrize and improve efficiency of * MT Regulatory and intellectual property rights. Registry of Real Property; upgrade Administrative capacity to register and protect Issues. intellectual property. Difficulties for domestic and foreign *0 Simplify' and harmonize rules and * ST business entry and operation. institutional structures. Inadequate laws and procedures for Revise laws allowing speedy 0 ST bankruptcy. proceedings and introduce alternatives for defaulting debtors. Inadequate regulation of competitive an Strengthen competition policy and 0 MT behavior and little enforcement of consumer protection by enacting consumer protection law. modern competition/ antitrust law, streamlining consumer protection law, creating autonomous enforcement agency. Poor functioning and enforcement 0e Set up bar association to regulate legal oso LT capacity of judicial system; no profession, establish standards for alternative dispute resolution judges, train and inform commercial mechanisms. judge, and facilitate use of alternative dispute resolution mechanisms. Tax Rules and Exemptions and evasions of VAT, Include construction industry, electricity * ST Administration income tax combined with uneven consumption in VAT; tax financial enforcement distorts incentives, creates instruments and personal interest sense of unfairness that undermines income, business confidence. Complex procedures and slowand *e Strengthen capacity; improve 00 MT discretionary processing increase information systems, develop strategic private sector compliance costs. audit plan, streamline regulations and procedures, enforce laws uniformly. .xxii Executive Summary ,gw , ,,.,,,,, S ................ .. ... ... .,,, .., ....... ......................................... Foreign Trade Trade policy: high tariff dispersion *e Deepen and sustain trade liberalization * MT Regime and trade biases; administrative by moving to a uniform tariff rate and regulations on imports still exist, eliminating remaining administrative instruments regulating import flows. Import procedures are lengthy, *Establish one stop window for imports; * ST complicated and non-transparent. Accelerate on-going customs reforms. *o MT Export procedures and institutions see Accelerate document processing by * ST suffer from poor service, long CENTREX; add user fee to finance new procedures, extra costs. offices away from center. FTZ and Fiscal Areas Scheme: *Further streamline FTZ and fiscal areas. * ST complicated, non-transparent procedures, discretionary practices in customs. The duty drawback system does not * In the medium-temm eliminate the duty *@ MT function well and is discriminatory, drawback. In the interim, improve functioning and eliminate discrimination. Technological Lack of access and absorption *- Support greater access to foreign see MT Innovation and technologies through trade, licensing Enterprise agreements, and FDI. Encourage Development development of private sector support services and initiatives. Ensure supportive human and physical infrastructure Trade Need to seize opportunities to gain _Continue strengthening trade *5 MT Negotiations access to new markets and market new negotiation capabilities. products. Government- Lack of systematic means for *e Establish one or more focused *@ MT Business businesses to communicate concerns consultative committees of government Consultation and opportunities to key government and business representatives to discuss agencies and for government to concrete steps to promote growth- disseminate information on policy and oriented, equitable, market-based collect information on its economic reforms. impact at the firm level. Executive Summary xxiii . E.'4~..'"* ........... FNANL~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~CC7~~~~~~~~~~~~~~~~~~~~~*..~............. Access to Lack of an efficient system to create *00 Address collateral security issues by 0 0 MT Credit and enforce collateral security. revising the legal framework and improving public registries to ensure effective creation, perfection, and enforcement of security interests. Limited use of new financing * 0 Revise laws and guidelines on use of * ST instruments (e.g., leasing). financing instruments and liens on inventory and commercial equipment. Limited access by small and micro *0- Try new approaches along the lines of *e LT enterprises successful experiences (e.g., Grameen Bank, Banco Solidario) Banking Lack of adequate regulatory and see Strengthen prudential and regulatory *. MT System: prudential framework. system by: (i) developing regulation to Prudential decrease illiquidity risks, (ii) Regulation and establishing deposit insurance fund, (iii) Supervision implementing a rating system, strengthening information accounting standards, and developing ongoing training programs. Lack of accurate interest rate * Ensure more accurate interest rate 0 ST information. information through periodic Central Bank or SSF publication. Deposit Lack of deposit insurance * Accelerate efforts to establish a well *0 ST Insurance functioning deposit insurance fund. Competition Limitations on ownership restricts * Eliminate ownership limitations 0 ST and Bank competition, raising of new capital and including 5% rule and restrictions on Ownership imposes heavy administrative burden. foreign ownership. Capital Market Dearth of potential private sector *e Catalyze supply by: (i) using public *ee LT Development issuers. issues to establish pricing benchmark and provide liquidity, and (ii) enhancing collaborative efforts with CACM. Insufficient disclosure of financial | Ensure reliable and timely information *0 MT information and insufficient quality of by: (i) supporting development of risk information on current market trends. rating agencies, (ii) encouraging accounting firns to establish a self- regulatory body and (iii) ensuring provision of information on transactions. Weak supervision of securities | * Strengthen supervision by further *-c LT exchange, insurance and pensions. developing capabilities of SSF. Lack of financial intermediaries. | * Facilitate development of financial * * 0 LT intermediaries by developing new legislation for contractual savings institutions (insurance companies and pension funds) and creating enabling legislation for mutual funds and leasing I _____________ I ____________________________________ I _ _ I__ com panies. _om an es ADDENDUM During the finalization of this report, the Central Bank developed a new system of national accounts, including rebasing from 1962 to 1990 prices. The tables and figures included in the text of this report reflect data at 1962 prices, since overall economic trends remain unchanged with the rebasing. This addendum highlights methodological changes and major differences between the two data sets. The national accounts were rebased because 1962 prices no longer reflected current economic behavior as the production structure has undergone substantial qualitative changes. In 1962, coffee had a predominant weight in the economy, petroleum prices were low, inflation was non-existent, and consumption patterns and the tax structure were markedly different. The new system of national accounts introduced the following methodological changes: r* the valuation of exports and imports of goods and non-factor services was modified using market exchange rates to convert from US dollars to colones; ˘ the composition of GDP by sector of origin was modified by methodological changes in the valuation of the financial sector, of net subsidies, and of import duties; and 6 the value added of productive activities was affected by changes in the treatment of the different stages of production; adjustments for seasonal activities in agriculture; and changes in the calculation of production credited to the financial sector and commerce. The main data implications of the new system of national accounts are: t, nominal GDP is lower by approximately 10 percent in 1993 and 8 percent in 1994; T real GDP growth is higher: 7.5, 7.4, and 6.0 percent in 1992, 1993, and 1994, respectively, at 1990 prices, compared with 5.3, 5.1 and 5.8 for those same years at 1962 prices; r> the contribution of the primary sector to GDP is higher, the contribution of secondary production is approximately the same, and the contribution of the service sector is lower, although it remains the most important sector; ' exports and imports as percentage of GDP are higher, reaching 20 and 35 percent, respectively, in 1994, compared with 13 and 27 percent in the previous data set; however, resource balances are approximately the same with the two data sets during the 1990s; and ' gross domestic expenditure as percentage of GDP is approximately the same in the two data sets, although consumption is slightly lower and investment is higher, reaching 18.8 percent of GDP in 1994, compared with 17.8 percent in the previous data set. CHAPTER I ENTERING A NEWSTAGE OF DEVELOPMENT: CHALLENGES AND OPPORTUNITIES "Our vision as a nation is to transform El Salvador into a land of opportunities, with equity.... We want to make the country attractive to national and foreign investment, and incorporate ourselves into the world production chain... .EI Salvador has a magnificent opportunity to make a great leap forward in quality. We either enter the process of globalization now, or other countries will do it. We either are among the first, or we get there at the end, to take what is left in the world market.... The country demands a mod- ern, efficient, and competitive private sector, who in turn demands a modern and effi- cient public sector capable of creating an enabling environment for private sector devel- opment. " (Excerpts from a speech by President Calder6n Sol on February 2, 1995). This chapter summarizes achievements since 1989; presents the main features of the new develop- ment strategy aiming at accelerating equitable growth by enhancing global competitiveness; identifies the necessary conditions to achieve this vision; and summarizes the key features of the public-private sector interaction. It concludes that the necessary conditions to successfully implement the new devel- opment strategy include: higher investment and savings; greater levels and quality of human capital; en- hanced allocative efficiency and productivity growth; and higher exports. In parallel to public sector modernization, the challenge is to remove existing constraints to outward-oriented private sector-led growth. ECONOMIC AND POLITICAL ACHIEVEMENTS: 1989-94 Since 1989, El Salvador's policy makers have accomplished three remarkable achievements: end the civil war; implement a coherent economic strategy leading to the stabilization of the economy and the reactivation of growth; and initiate a systematic attack on poverty. These efforts have lifted the country from the economic crisis of the 1980s and have led it to a path of relative stability and economic growth, compared to other developing countries. In June 1989 the authorities initiated the implementation of a comprehensive economic stabilization and adjustment program. As the adjustment program took hold and peace prospects improved, the economy stabilized and began to recover. The country's economic performance during the past six years is a remarkable success story. During the 1990s, El Salvador has registered among the highest growth rates in the hemisphere and this has occurred despite the migration of the best of its labor force to the United States (Table I- I). THENEWDEVELOPMENTSTRATEGY: GOALSAND GENESIS The objective of the bold economic reforms presented by President Calder6n Sol on February 2, 1995, is to achieve more rapid and equitable growth by enhancing global competitiveness. The aim is for El Salvador to enter the 21 st century as a more open and equitable economy. The two main intermediate economic goals are to rapidly: (i) promote domestic and foreign investment and incorporate the country into the global production chain by lowering the costs of operating in the country; and (ii) reduce the size of the State through accelerated privatization, while strengthening the public sector's role as facilitator of private sector development. The Government has announced actions in four main policy areas: * accelerating trade liberalization; t modernizing the public sector, focusing on six areas: decentralization, regulatory framework, privati- zation, civil service reform, reform of the pension system, and procurement; Q strengthening fiscal discipline by increasing revenue collection and rationalizing expenditures; and c˘' maintaining nominal exchange rate stability and allowing voluntary dollarization. 2 Chapter I Table 1.1 Key Macroeconomic Indicators, 1980-95 7.0 GDP and Per Capita GDP Growtbh (%change) 3 Inflaton Rate 250 (End- Year and A verage % Change) A 500 420.0_ 4.0 3.0 l9oo - 9.4 y6 GDP) 65.0 2.0 10.0 I)perCapijtal 1i 6.oot-* 5.0 5.0 t 2 2 3.3 i I I ~~~~~~~~~~~~~~~~~~0.0 4 (1.0) i190 1990 1991 1992 1993 1994 1995 18 90 19 92 19 94 19 Current Account Deficit Non-Financial Public Sector Deficit 10a0 94 (%ooGDP) 5.8 (% of GDP) 9.0 6.0 59 539 80 70 S 5.0 44. 70 58 ~~~~~~~~~~~~~~~4.0 6P0 5 0 3.3 5P0 . 3.0 2.5 2. F 4.6 3.2 3.3 240 3Urnteene0 161 103 1 .1 0 16 1.3 1.4 1.6. 3.0 ~ 20 ~~~~~~~~~~~~~~~~~~1.0 1.0 /0W0 4 0.0 1989 1990; 1991 1992 1993 1994 1995 1989 1990 1991 1992 1993 1994 1995 Ave rage Prj. Natinal OAccounts (as % of GDP) EXProS OfGNveSt t 13.2 15.3 11.8 13.8 16.1 16.6 17.8 19.7 PubOic 4.7 3.5 2.3 2.5 3.6 3.6 3.5 4.0 Private 8.5 11.8 9.5 11.3 12.4 13.0 14.3 15.7 Gross National Savings 8.7 5.9 4.8 8.8 10.3 12.7 14.6 16.4 Public 0.4 (1.6) (0.3) (0.7) 0.2 0.7 1.9 3.1 Private 8.2 7.5 5.1 9.5 10.1 12.0 12.7 13.3 Foreign Savings a! 4.6 9.4 7.0 5.0 5.8 3.9 3.2 3.3 Non-Financial Public Sector (as % of GDP) Current Revenues a/ 16.1 10.3 11.1 11.6 12.3 12.5 14.5 16.5 olw Tax Revenues 11.1 7.6 8.1 8.5 8.7 9.4 10.5 11.5 Current Expenditures 15.7 11.8 11.4 12.3 12.1 11.8 12.6 13.4 PubliC Savings 0.4 (1.6) (0.3) (0.7) 0.2 0.7 1.9 3.1 Overall Balance a! (7.2) (5.8) (2.5) (4.4) (5.9) (3.3) (2.0) (1.6) Balance of Payments (as % of GDP) Exports of GNFS 24.8 15.4 16.8 14.9 13.6 14.0 13.4 Imports of GNFS 29.8 27.5 28.6 27.3 29.2 28.1 27.4 Trade Balance (5.1) (13.4) (13.3) (13.8) (16.8) (15.5) (I5.0) (15.7) Remittances 2.8 4.8 6.8 9.2 10.8 10.8 10.7 10.8 Current Account Balance (4.6) (9.4) (7.0) (5.0) (5.8) (3.9) (3.2) (3.3) Overall Balance 0.1 (0.7) 1.8 (0.9) (0.3) 2.0 1.5 1.9 Bflat. Real Exch. Rate b/ 134.7 93.8 107.3 110.0 103.7 92.4 88.2 Creditworthiness Indicators Total DOD/GDP 39.9 41.9 42.0 36.8 34.4 26.4 TotalIDOD/Exports G&S 161.4 258.8 237.1 234.4 234.0 172.1- Total Debt Service/Expor 19.3 26.9 23.0 26.7 24.8 26.0- Note: Based on 1962 prices, a/ Excluding grants and Central Bank losses, b/ Index 1985=100. Sources: Central Reserve Bank of El Salvador and World Bank Debt Tables. Entering a New Stage of Development 3 Notwithstanding the achievements of the 1989-94 period, three main considerations led the Govern- ment to reassess the country's development strategy: * The need for more rapid growth. More rapid .: ;st^i 4 economic growth is a necessary condition to alle- , - viate poverty and consolidate peace. Although . . 3 growth improved in the post-war period, GDP per 51000 10500 capita remains at pre-war levels and the trickle A down effects of prosperity have not yet been felt 46000 widely enough. Real GDP levels are only ap- 41000 / 00 proximately equal to those of the late 1970s and .9 GDP per capita in 1994 was still below 1970 lev- 36000 els (Figure 1.1). 8500 ˘31000 /\ /80 * Growth sustainability concerns. El Salvador's s000 pattern of growth in recent years presents some n 20/ 7500 risks: (i) increasing reliance on the non-tradable 21000i 7000 sector; recent relatively high growth rates have d been associated with a service and construction 16000 H1H l l 11 ii H i i .6500 boom (Table I.2) spurred by repressed demand g o: o o a a'. during the war and high remittances; and (ii) ex- .. ..* *-** tremely low export levels (Figure I.2). -:_ -_.___x_________________ Table 1.2 Sectoral GDP Shares and Growth Rates *rld Prim. icom C.ary , *fl .. 44 - a. .ns U. . >. 4 xot fGF GDP Shares (percent) 40.0 Exports ofGNFS 1975-94 19.3 16.9 3.4 2.1 58.4 35.0 / 1975-78 27.7 16.2 4.3 1.5 50.2 30.0 1979-91 19.0 16.6 3.1 2.2 59.2 1992-94 9.2 19.0 3.1 2.5 66.2 .X2. ' / & t. Sectoral Growth Rate (average) 1975-94 1.0 1.8 4.0 5.5 1.5 0 200 1975-78 3.9 5.8 17.3 10.8 5.5 150 . 1979-91 -0.6 -0.7 -1.6 2.8 -0.4 15. .0\{ g 1992-94 4.2 7.2 10.5 9.9 4.5 10.0 Contribution to GDP Growth ate 1975-94 0.1 0.4 0.2 0.1 0.9 5.0 - qr ors of Goods (FOB) 1975-78 1.2 1.0 0.8 0.2 2.8 0.0 11 H ! i i iii H H1 H 1979-91 -0.2 -0. I 1 -1 . 0. 0 v. c es CDo 1992-94 0.4 1.4 0.3 0.2 3.0 0. 0 0 0 0 0'. 0'o Note: Primary=agric.and mining; Serv.=commerce, banking, -; a 2c f . - $Z & housing. Source: Central Bank of El Salvador. _ . rQ The challenge of globalization. Globalization - driven by widespread adoption of liberalization policies, buoyant world trade, technological catching up, increasing capital flows, and the interna- tionalization of services - represents a fundamental opportunity for raising welfare in both develop- 4 Chapter I ing and industrial economies (World Bank 1995). However, recent trends in international economic integration also highlight the need for developing countries to move away from narrow dependence on commodity exports and become globally competitive in technologically more advanced goods and services. To benefit from the new opportunities in trade and finance, developing economies must: (i) transform policies and structures to support outward-oriented growth; (ii) move resources toward more knowledge-intensive goods and services to take advantage of shifting relative prices and expanding boundaries of tradability; (iii) acquire high technology by plugging into the world economy and by attracting foreign investment; and (iv) ensure adequate human and physical infra- structure, since they are more important than low wages in attracting investment. u1tureOis Average Growth of GDP. 1965.90 Figure L4 Income Inequality and GDP per Capita, 1965-90 Singapore l a Korea l Singap ore ae H ong K ong 26 1 Taiwan (1970-90) - 5 Indonesia Hong Kong~~~~~~~~~~~~~~~Idoei Hong Koing ;>} ; ;; ig: i 0 1 r | 0Thailand * I alay sia Thailand _____ _____ _____ r Brazil ±~~~~~~~~~~~~~~~~~~~~ > Malaysia I; 7; i :, 2 t I @ Colombia Indonesia Chile El Salvador 0Fl Salvador * Peru iEl Salvador _;0 * 0 5 10 15 20 25 30 F l Salvador (1991-94) : _ Income Inequality 0 2 4 6 8 10 Note' Income inequality is measured by the ratio of the income shares }i _ a j of the richer 20 percent and the poorest 20 percent of the population. Sourcsa IM F. IFS and Central Bank of El S4lvador. Soarer: BESD. LESSONS FROM EASTASIA The Salvadoran authorities have been looking at East Asia as an example of a successful develop- ment model characterized by rapid and equitable growth (Figures 1.3 and 1.4), although they have dis- tanced themselves from interventionist public policies. The comparison with East Asian economies sug- gests that to accelerate growth in El Salvador, the focus should be on augmenting physical and human resource accumulation, enhancing the allocative efficiency and the productivity of resources, and increas- ing outward orientation. ˘ Low investment and savings levels. The East Asian economies have higher growth of physical capital and higher national savings. Notwithstanding improvements during the last four years, El Salvador continues to show relatively low investment and savings levels (Figures 1.5a and 1.5b). Low investment levels are due to the impact of the civil war and a very regulated and distortionary macroeconomic environment during the 1980s, and to existing constraints to private sector develop- ment which increase the costs and the risks of doing business. Although worker remittances have in- creased national savings, continued low domestic savings levels reflect inadequate public savings, the increase in private consumption fueled by remittances, and the lack of opportunities for financial savings. Entering a New Stage of Development 5 KoTea ~ ~ ~ ~ ~ ~ 195FiueLZb El SAlVador. Savings and Invesatinent O~54 o., K 25 0 ....... C,ross Domestic Savings El Salvadora -____ _____--_________- -20.0 Gr__ . oss National Savings 0.0 10.0 20.0 30.0 40.0 50.0 Thailad . Wag .. .ofGDP) . Singapore - Malaysia _ 97 . ,. ~. ~.. - :: ,;,~~~~~~~~~~~~~~~~~~~~~~~~~1 0 190T1. HoIndonesia A,, Qu19'Gorr E Salvador 0 ,<<0.0 10.0 20.0 30.0 40.0 50.0-cf ; h/4e ya2 1993ul S t~p fnor Hon K o GDP (1991 a' IQ 15 0 rQ9 - Sigaoe Wa- 1ui ,A -TJ~ . loo IIh(P W 4 Inadoesuathua caia.TeEsAsa eonm s _hwe hihe iniia levels an growt X 1X~~~~~~~~ ~~~~~1978 .. ,-j st (ailaand Ii low ci q lty l by hg r a logically and outward-or.ented st , w h ruirs an e d ad f e l r f . T *KHong Kong year E3 Salvador .~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~r --,: o.o 10.o 20.0 30.0 40.0 50 0 9 liiWt ysZ. 1993 ex*t for Hong Kong (1991) and El Sahnidoro"94 - 7tTb ,Wodd Da*a FAM STARS snd IM F, IFS. *~~~~~~~~~~~ oiW 4 c> Inadequate human capital. The East Asian economies showed higher initial levels and growth tates of human capital. El Salvador is currently characterized by: (i) a low human capital stock (Figure 1.6a); (ii) low primary enrollment ratios which do not bode well for a rapid increase in the stock (Figure 1.6b); and (iii) low educational quality exemplified by high repetition and dropout rates. IThese constraints are critical given the Government's goal of moving toward a more techno- logically and outward-oriented strategy, which requires an educated and flexible labor force. The Government has been accelerating efforts to address these constraints to counter domestic pressures to slow down the opening up of the economy. Flguire 1.6i M tan Ye uys of Education, 1987 maur rlm Selapol Enrollmenat Ratios.; "tix~ ~~~ ~ W < ;. i5> 4, 1991 (oxcept as noted} << - Korea .... .. a77 .7 < hiad<. ...Singapore 7 -VQ . ° S|73 .... f-Sripr L8)t Malaysia 6 & HongKong _) , ; Thailand :K,. 157Q> Kore, 9S -El Salvador 5.0 ,i.*V ai e 9 1 . , ° ~ ~ ~ ~ 2 4 6 S rM ablysU _ - - i * '- ;, 3t. '- :(UNsll 3 L T he W o B uf °~~~~~~~~~~~~~~~ 20 40) 60 so O 2 on~~~~~ ' ,- ..5Sfi;.s-w--t8eIi+ 'tt Vii "'j<>Xta'= 6 Chapter I Table 1.3 El Salvador: Sources of Growth Low allocation efficiency and ~ ,rwbr Aea.4ultscerluo ogOt productivity growth. While two thirds of East Asia's growth is due to rapid physical and human 60-90 2.56 5.53 2.36 0.45 3.05 1.08 -1.53 60-73 5.24 6.57 3.14 0.53 3.09 1.66 0.49 capital accumulation, the remain- 73 90 0.00 4.05 1.71 0.39 2.49 0.66 -3.14 ing third is attributed to total fac -SoeIha A. Dhane_I tor productivity (TFP) growth. Source. V Nehru and A. Dhaneshawar (June 1994); staff estimates. Estimates of the determinants of economic growth for El Salvador based on work by Nehru and Dhareshwar (1994) suggest: (i) a negative TFP contribution (i.e., overall inefficiencies) for 1960-90, which exceeded increases in output attributed to labor; (ii) overall inef-ficiencies (low or negative TFP) fared worse during the second period, which included the war years; and (iii) during 1960-73, when TFP was positive, its relative contribution to growth was approximately 10 percent. TFP growth in East Asian countries Table L4 Total Factor Productivity (TFP) Growth, 1960-90 (%) has been much larger than in El Sal- f;s|>s; . AM DT;;˘d:>:f; cru ad Dbaresbivar vador (Table 1.4). The main sources Coel.y TW 190 - 1 l1-72 9. of high TFP growth in East Asia are: A _____ . -W T T "; A| (i) efficient resource allocation, ESalador . - . .-153 0.58 1.51 2.42 -2.1 146 through market mechanisms, in the Taiwan 3.76 0.41 2.21 4.39 7.08 2.61 2.60 labor market, the capital market, and Hong Kong 3.64 - - - - international trade; and (ii) techno- KoTea 3.10 0.71 2.43 4.16 5.65 2.90 3.38 Thailand 2.50 0.09 1.73 3.15 4.81 1.90 2.56 logical catching-up accompanied by Indonesia 1.25 0.19 1.05 1.77 2.24 0.70 1.30 high and rising levels of human Singapore 1.19 -0.61 1.22 3.67 6.47 1.50 1.92 capital which ensured effective use Malaysia 1.08 -0.18 1.11 1.98 3.60 0.95 1.69 of new technologies. A . J AA:level regression, using an error-correction model considered by the authors more appropriate for capturing long-term relations from the data. B: using first difference regressions. Source: World Bank, 1993, 64; and Nehru and Dhareshwar, 1994. Low exports and outward orientation. Table 1.5 Ratio ofTotal Trade to GDP Table 1.5 highlights the dramatic decline in exports and trade ratios since 1980. In 1994 .ipi.ofGoods/GDP (E;or"+ Pe 1970 19841 199 1.970 1[398_0. 1992, exports of goods increased to almost 10 per- cent of GDP - reaching 15 percent of GDP if Singapore 83 162 135 214 363 289 ,; maquila"exports areincluded - thanks to HongKong 56 50 31 137 130 159 "maquila" exports are mcluded - thanksto Malaysia 40 53 70 74 97 138 macroeconomic stability and accelerated Thailand 10 20 29 28 49 66 trade liberalization. Notwithstanding recent Korea 9 28 25 32 63 51 improvements, the attainment of much higher Indonesia 11 28 27 21 42 48 export levels and a more diversified export Eudor 22 20 8 43 48 32 base are critical for the achievement of the Sources: The W Government's goal of accelerating growth. TFP is the variation in output not explained by input changes and measures the efficiency with which inputs are used (i.e., changes in output per unit of all inputs combined). Increases in TFP may result from improved resource allocation, economies of scale, innovation, absorption of new technologies, gains from specialization, and in general any factors reducing real production costs (World Bank 1991 and 1993). 2 Empirical estimates of source sof growth provide a simplified framework to analyze the contribution to economic growth (GDPgr) of accumulation of factor inputs (capital [K] and labor [L] amd TFP growth. Entering a New Stage of Development 7 THE PUBLIC-PRIVATE SECTOR INTERACTION: POLICY IMPLICATIONS The return to peace, the existence of a comprehensive long-term economic strategy, and changes in the global economic environment have created the opportunities for the attainment of El Salvador's vi- sion. Key constraints to meeting the challenge of globalization are not economic distortions or excessive government activity and regulation, per se. Instead, they lie in weak support systems for private enter- prises that inhibit productivity growth and international competitiveness. Public sector modernization and private sector development are two sides of the same coin, and their interaction and complementarity are critical. To accelerate growth, the Government should continue removing existing constraints to outward-orientation and private sector growth, productivity, and competitiveness by reforming the State and, in parallel, implementing a comprehensive private sector development strategy. Key constraints. The share of the public sector in GDP and investment, and the regulatory frame- work are not excessive by international standards. The main constraints are related to weak support sys- tems for private enterprises. As identified in the Enterprise Survey these include: c* Inefficiencies and underinvestment in infrastructure, education, and health: the State as owner and operator. Deficiencies in infrastructure services severely inhibit international competitiveness. Innovation in Salvadoran industry is likely to be slow unless there is a significant increase in foreign investment. That, in turn, will not come if physical infrastructure is inadequate for businesses op- erating in international markets. In addition, inefficiencies in social sector services have led to in- adequate levels and productivity of human capital. c* Human and financial resource management weaknesses: the State as administrator. A key problem underlying the poor quality and inefficiency of public sector human resources is the lack of an effective management structure and process. In addition, financial management issues exist in: expenditure planning, budget preparation, and resource allocation; treasury and payments systems; budget execution; auditing; and responsibility and accountability incentives and procedures. These weaknesses have a direct impact on the capacity of the State to: (i) ensure a stable macroeconomic environment; (ii) ensure social peace and political stability; and (iii) foster a meritocratic and politi- cally independent bureaucracy. Q Constraints related to the formulation, implementation, and enforcement of rules and regula- tions in the business environment and the financial sector: the State as regulator. Distortions and inflexibilities exist in the legal and regulatory framework, labor markets, financial sector rules and supervision, and trade and export development policies. Public sector modernization. The State should reform itself to ensure efficient provision of essen- tial public goods and services and to reorient public resources to support economic growth and attend to the most urgent needs of the poor. Key areas will be: (i) increasing private participation in the provision of public services, through privatization, contracting out of service delivery, and decentralization; (ii) improving the quality, efficiency, and coverage of the public services which the State will continue to provide; and (iii) strengthening the policy-making and management capacity of the public sector. To this end, the Government is implementing a comprehensive Public Sector Modernization Program supported by bilateral and multilateral donors. Its full and timely implementation is the necessary condition for entering the new stage of development. Private sector development. In parallel, the Government is developing a policy agenda to support the private sector, which already plays a predominant role in the economy. With the privatization of the financial sector, the dismantling of state agricultural marketing, and the offering for sale of most state- owned productive assets, the private sector now produces over 90 percent of GDP and accounts for about 8 Chapter I 93 percent of total employment. To remove existing constraints to the acceleration of outward-oriented private sector-led growth the Government should act rapidly and concurrently on six fundamental policy areas: (i) further enhancing the stability of the macroeconomic framework; (ii) developing human re- sources and increasing labor productivity and flexibility; (iii) modernizing infrastructure; (iv) improving the legal and regulatory framework; (v) facilitating trade and technological diffusion; and (vi) strengthen- ing the financial sector. CHAPTER H_ ENHANCING MACROECONOMIC STABILITY This chapter assesses the need for further macroeconomic adjustment within the framework of the Government's new development strategy. It analyzes constraints and proposes a policy agenda to improve fiscal performance and to address macroeconomic management issues related to high and sus- tained foreign exchange flows. It concludes that to successfully meet the challenge of globalization and accelerate growth further macroeconomic adjustment is needed. In an increasingly more open, inte- grated, and competitive global economy, economic management must ensure stability to maintain the confidence of domestic and international markets, and flexibly respond to more mobile and potentially volatile cross-border capital flows. El Salvador has shown remarkable macroeconomic improvements since 1989 but the Government should continue implementing polices to: * further improve fiscal performance; '* relieve inflationary and interest rate pressures; ˘ ensure a credible exchange rate policy; and '* address external viability concerns. To improve fiscal performance, the tax base should be broadened, compliance enforced, and the on-going public sector modernization program should be fully and timely implemented. To address macroeconomic management issues related to capital inflows, in the long-run, the challenge is to adjust to the higher level of foreign exchange inflows. This can be achieved by implementing policies which, in addition to improving fiscal performance, should aim at encouraging high levels of savings and in- vestment and further trade liberalization, and at pursuing a credible exchange rate policy while limiting real exchange rate appreciation. Finally, to ensure external sector viability, the Government should fa- cilitate private sector efforts to increase productivity and global competitiveness and expand and diver- sify the export base within a framework of a lower real exchange rate. IMPROVING FISCAL PERFORMANCE Improvements in fiscal performance since 1989 are fragile because of low public savings, low capital expenditures, inertial and inflexible expenditure patterns, and dependence on external financing. Within on-going efforts to reform the public sector, two priority areas must be addressed: V increasing tax revenues to increase public savings and decrease reliance on external financing; and V modernizing the public sector to improve efficiency. Fragility of fiscal performance El Salvador's fiscal deficits are decreasing and total public expenditures are not excessive (Figure II.1). However, much remains to be done in four areas: r* increase public savings, mostly through a greater tax effort while increasing the efficiency of ex- penditures (Figure II.2); * avoid relying on lowering capital expenditures to ensure fiscal improvements, a trend which has constrained public investment in social sectors and infrastructure (Figures ID.3 and II.4); * address inertial and inflexible expenditure patterns, resulting from a relatively high share of spend- ing on wages and salaries (which averaged 55 percent of current expenditures over the past four 10 Chapter II years) and serious rigidities and deficiencies in financial and human resource management. The suc- cess of the Government's development strategy depends on an efficient reorientation of resources toward priority areas, such as social sectors and infrastructure, and away from wages and salaries; 4 and improve fiscal performance to limit financing vulnerability issues; deficits are being financed exclusively through foreign sources, limiting the inflationary impact of the deficits but further complicating monetary management of foreign exchange inflows and increasing the vulnerability to external shocks. | >nouQi4aed NFP SE fl.kit, 1ibKQ; F 20 - _, 16 - - - ___ _Consol. Fiscal Deficit (excl. grants) a! 18mnt Revenues ': 14 . NFPS Deficit (excl. grants) .>' 16 / A A ....... Consol. Fiscal Deficit (incl. grants) a/ 12 F: 14 // / . i a / V _I NFPS Deficit (incl. grants) 10 2 Current Expenditures 8-r- 6 jS~~~~~~~~Pbi 2 Savings 4L 4 . 4 -2 - .of ;xoe 4- l S -X 18; | Current Expenditures | :1 si 6j~~~~~~~~~~~~~~~~~~~~~~1 16 00\ / 4lh 3 -2 -0 l0 l0 l0 l l l A,°Nt S~ S~ S~ oX S f 1985f 1986 1987 1988 1989 1990 1991 1992 1993 19 94 Since 1991, legislation has banned Central Bank lending to the Governmnent to finance public sector deficits. A proposal to include this prohibition in the Constitution is currently under discussion. Enhancing Macroeconomic Stability 11 Increasing revenues Tax revenues accounted for 10.5 percent Fgure I.S Trends IlTax Revvenves, 1971-94 of GDP in 1994 (Figure 11.5), well below interna- _ tional standards, although expenditures were also 16T below international averages. The tax base cur- 15 rently relies on a 13 percent value added tax (VAT, 14 -,- accounting for over 40 percent of tax revenues), 13 T income taxes (27 percent), and trade taxes (18.3 percent). 12 0 Although reforms implemented since 1990 lo have increased revenues and produced a more ef- 9 ficient and equitable tax system, they have not \ raised sufficiently its revenue generating capacity 8 and its buoyancy. If the public sector deficit is to 7 be reduced, while providing a reasonable level of 6 1 essential services, reforms must raise the country's w > o tax effort beyond the levels it had reached in the . mid-1980s (12-13 percent of GDP). Key constraints are a narrow tax base and weak administration. Structural and exogenous fac- tors, such as the land tenure pattern, the large number of small establishments, the armed conflict, and falling coffee prices contributed to the erosion of the tax base. To raise the revenue generating capacity of its tax system to at least 14 percent of GDP per year by the end of the century, the Government should consider: (i) further steps to broaden the tax base; and (ii) improving tax administration to significantly increase compliance and reduce evasion. Broadening the tax base The low tax effort can be partly explained by the narrow coverage of some taxes resulting from exclusions, generous deductions, exemptions, fraudulent non-compliance, and non-reporting. The tax reform of 1992 has done away with some of the limitations, but has not broadened the tax base suffi- ciently. The repeal of the net wealth tax in April 1994 narrowed the tax base even further. Areas where there is scope for broadening the tax base include: ˘ Eliminate VAT exemptions in: (i) the construction industry where only contractual work involving alterations, repairs, and maintenance is subject to VAT; (ii) financial services; and (iii) public utili- ties (electricity, water, and sewerage). These exemptions narrow the base and generate distortions, since exempt items and sectors cannot claim credit for VAT paid on input purchases. The feasibility of incorporating the entirety of the construction industry needs to be evaluated, but new construction should be subject to the VAT. Although equity and efficiency arguments favor the taxation of fi- nancial instruments under the VAT, their inclusion would create difficulties. Hence, it would be preferable to tax them separately under a stamp duty or registration fees to fill the gap created by re- peal of the stamp tax. In the public utilities the sales-to-purchase ratio is quite high while the debit- to-credit ratio is very low. This suggests that their incorporation into the VAT could yield substantial additional revenue. ' Limit high personal income tax exemptions and deductions, especially since the personal income tax is levied on individual persons and not on families. The 1992 reform left a large majority of wage and salary earners and a large number of unincorporated enterprises outside the tax net. 12 Chapter HI c Incorporate the interest income received by individuals into the personal income tax base. Cur- rently, dividends are taxable under the income tax; so is interest income received by businesses, but not interest income received by individuals from their deposits in banks and other financial institu- tions. Q Introduce presumptive methods in taxing incomes,2 not only to raise revenue, but also to enhance equity and efficiency. Presumptive methods are an administratively convenient way to collect taxes from hard-to-tax groups. Since wages and salaries are taxed much more effectively than incomes of the self-employed, presumptive methods of taxing professionals (e.g., by establishing minima for different categories), broaden the base, improve horizontal equity, and enhance efficiency. Applica- tion of the profit margin of small taxpayers to all taxpayers in a given category to assess their income could encourage enterprises to increase their efficiency, since any surplus would have a marginal rate of zero. ˘ Extend to VAT the applicability of presumptive methods of taxation, as is done in many coun- tries.3 This requires the development of guidelines for various economic activities based on careful studies of particular trades, industries, and professions. c* Revise motor vehicle registration fees to reflect purchase values or revise specific fees frequently. Strengthening tax administration and enforcing compliance Improving tax and customs administration, enforcing compliance, and ensuring that taxes are assessed and collected correctly should be key policy objectives. Unless compliance is raised consid- erably, tax reforms will have limited impact. Notwithstanding initiation of a comprehensive tax and customs administration program supported by USAID, IDB, and the World Bank, tax administration is still deficient in assessing, collecting, and enforcing compliance. While fully implementing the on-going reform program, the Government should: '* Implement an efficient tax penalty system by improving the effectiveness of the Ley del Delito Fiscal which has been hampered by: imprecise definitions of punishable fiscal crimes; lack of har- monization with VAT and Income Tax Laws; and lengthy procedures. E* Make examples of tax evaders. Large VAT payers (businesses with annual sales exceeding 36 million colones) represent a mere 0.5 percent of the universe, but account for 60 percent of total sales and 48 percent of the total VAT collected. Similarly, according to unaudited tax returns, corporate income taxpayers in the highest net taxable profit group represent only 1.1 percent of the universe, but account for 60 percent of total taxable profits and 63 percent of the corporate tax yield. * Intensify efforts to improve border controls and customs administration to reduce corruption and smuggling. Smuggling is particularly rampant in cigarettes, alcoholic beverages, shoes, apparel, textiles, and electronic equipment. Privatizating customs operations should be considered. r* Intensify efforts to improve income tax administration by training staff to enforce tax rules and strengthen the system of collecting due taxes. Information systems are inadequate, personnel are not sufficiently trained and coordination between tax administration units is weak. '* Improve the auditing capacity of the Ministry of Finance, especially for VAT collection, and en- force strict auditing to prevent evasion by small and micro enterprises and possible bookkeeping mismanagement by large taxpayers. The Government should intensify on-going efforts to improve strategic audit planning by issuing audit manuals and uniformly applying auditing techniques and procedures. 2 This is a common practice in many countries, such as Chile, Colombia, Mexico, Honduras, and Costa Rica. More than half of the countries that levy a VAT also use presumptive assessment methods to cover firms that are too small to be treated as regular taxpayers, yet large enough not to be exempted. Enhancing Macroeconomic Stability 13 Modernizing the public sector Although the room for further -- - - . - (- - - . expenditure reduction is limited by _ _ ________________-.________--__ the need to address large unmet social Nicaragua a I K needs and a relatively low level of - expenditures, efficiency gains are Honduras I I ' possible by: (i) containing current Panama :_._____ -__ e,___ '._'___._____, expenditure increases; (ii) reallocating l I - Costa Rica _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ public resources to priority invest- C i ments, particularly the social sectors Venezuela I . and infrastructure; and (iii) improving Mexico . i expenditure management and increas- ing the efficiency of public invest- Dominican Republic . ; , ment. The Government can generate ElSalvador 7 these substantial efficiency gains ' l through full and timely implementa- Guatemala . tion of the on-going Public Sector 5 10 15 20 25 30 35 40 Modernization Program (PSMP). Although the Program is comprehen- LtiAua.rkancotiU4i;< sive, there have been delays in setting up the institutional framework for timely implementation, and in the privatization and civil service re- form components. ADJUSTING TO HIGH FOREIGN EXCHANGE FLOWS Notwithstanding their positive impact on living standards and on the balance of payments, high foreign exchange inflows have complicated macroeconomic management and the attainment of other policy fundamentals. In particular, large foreign exchange flows have contributed to inflationary pres- sures and to the equilibrium appreciation of the real exchange rate. Sterilization policies - to contain monetary expansion and maintain a stable nominal exchange rate - have further complicated macro- economic management by putting pressure on interest rates and on the Central Bank's operational defi- cit. In addition, high inflows have contributed to external sector vulnerability. The high level of foreign exchange flows appears to be permanent in nature although the flows should stabilize at lower growth rates. This entails a change in the underlying structure of the economy. While, in the short-run, the Government should continue open market operations to sterilize excess in- flows, these have a limited impact and impose costs in the financial system. In the long-run, the chal- lenge is to adjust to the higher level of inflows by continuing implementation of policies which, in addi- tion to improving fiscal performance, aim at: V raising national savings; V containing inflationary pressures; V pursuing a credible exchange rate policy while limiting real exchange rate appreciation; and V facilitating expansion and diversification of exports, within a framework of a lower real exchange rate. 14 Chapter 11 Background: foreign exchange flows and Dutch disease Foreign exchangeflows: characteristics and trends High foreign exchange flows are a key contributing factor to current macroeconomic manage- ment issues. It is important to summarize trends and characteristics of these flows because a consensus has emerged in the literature that the appropriate policy response depends in great part on their sources and permanence (Calvo, Leiderman, and Reinhart, 1993; and van Wijnbergen, 1984). El Salvador is characterized by: (i) high levels of inflows; (ii) large percentage of remittances which are mostly spent on non-tradable goods; and (iii) prospects for continued total flows in the order of 10 percent of GDP per year. Since the early 1980s, there have been large increases in net foreign exchange flows, which ac- celerated after 1989, and again after 1991 as a result of the Peace Accords and reactivation of the econ- omy (Figure 11.7). Higher flows are largely due to increasing worker remittances, while capital inflows (excluding remittances) have showed greater variability (Figure 11.8). Total inflows or net foreign ex- change flows include official transfers, official medium and long term debt flows, private capital,4 and worker remittances. In addition, high coffee export receipts also contributed to the increase in the supply of foreign exchange during 1994. Figure 1L7 Total Infois, 1975-94. Figure ILU Capital Inflo%s and Remittances, 1975-94 1400 T 20 12 T CtalI nofl o ws 1200 rT,2afloUSwInus$ to 10A 1010 800t 6 t 10~~~~ 600 U, \ A -+ tio4I- 400~ 0 200 ol Q~al ,Itnov ofP -2 l l a, 0 o o I oi as o - - o-4 -200 f _ _ ){- -- ~01-5 -6 0 00 Sm:CAotii Bnk ofa Salvador.Sm:Ca,lan f avdr Worker remittances have increased faster than any other inflow and currently represent approximately 70 percent of total foreign exchange flows, while official transfers represent about 20 percent (Figure 11.9). Remittances began increasing in the early 1980s as a number of Salvadorans emigrated to the US to escape the civil war (Figures 11.10 and 11.1 1). It is estimated that almost 20 percent of the population currently resides abroad, and about 84 percent in the US (FUSADES 1994). It is only in the 1 990s that remittances have reached very high levels, but this has been due less to an actual increase in remittances than to an increase in recorded remittances, as a consequence of the legalization of the parallel foreign exchange market in 1991. 4 Including foreign direct investment (FDI) and private short, medium, and long-term capital flows. Enhancing Macroeconomic Stability 15 Inflows have relaxed the foreign exchange constraint and have led to international reserve ac- Figure IL9 Trends Ik Total Inflows, 197593 cumulation. In particular, remittances have signifi- cantly raised national income and national savings 100% T (Table 11.1). They have allowed increases in private consumption, which have cushioned the fall in real 80% wages and have had a favorable impact on the bal- 80% ance of payments (akin to increased exports of labor in this case). Estimates show that, on average, over 60%+ 70 percent of remittances are consumed, mostly in non-tradable goods (FUSADES 1994; and MIPLAN, 1993),4 N _ 0Private Capital Official transfers and official medium and 20% 0Off,cial M LTCapital long term capital have originated in great part from aOfficial Transfers the US and multilateral financial organizations, re- U Remittances spectively. These have greatly limited the inflation- 0% ary impact of fiscal deficits, especially since 1990, a ,_ "I _ b a a, and contributed to the consolidation of peace by fi- Sourc: Ccntral Bank of El Salvador nancing peace-related expenditures. Fig Ire 11.10 Emigration Trends, 1985, 1987, and 1991 Figure 11.1 I Worker Re mittance s, 1975-94 __46 thousand 1000 - 80 1000T (18% of Pop.) 90 900 _ 727 thousand t B00 4 (15°/ofPoP) 800 W Remittances 60 700 516thourindj 700 1 as % of Exports 4 600 ( 1%/oofpop.) 600 I \ / 50? 500 F 400 T - I I I I - 500 _ _40. | 300 _ Remittances 400 i smlin'3 O; t 20300/ 1001 {~~~~~~~~~~~~~~~~~~ 0020 0~~~~~~~~~~~~~~~~~~~~~~~~ 1985 1987 1991 I o F g 9.S.Legafmirnngr_ants --U.S. [ie-gallm-migrants| gUnaccounted (residual) 0 ° _ _______ __ ____ 1951 (a %fionlome) 1993s Sosce: EDmsti Stoags are om Salvadorean sour!m; the rest9.t6 7.tom 3. 0. 2. 3.4 Statior Yencomrbook, 19e9, U.S. -1m.-r2atio-n2 a-nd N t-zatio1.6 -0.8 -0.s 0 Statistical Ahstia of tbr United Stmes, 1993, Souerce: Centntl Bank of El Salvador, Table 11.1 Remittances and National Income Accounting, 1975-94 (as % of National Income) 175-79 g 190 1989t 1990 1991 1L992 1 993 1994 National Savings 19.4 7.6 5.8 4.6 8.2 9.4 1 1.5 13.2 Gross Domestic Savings a/ 19.6 7.0 3.1 0.1 1.3 0.4 2.2 3.4 Net Factor Income -1 .5 -2.9 -2.0 -1 .9 -1 .6 -0.8 -0.5 0.1 Remiiaaccs 1.3 3.4 4.6 6.4 8.5 9.8 9.8 -: 9. Remittances as% ofNational Savings 6.7 45.1 80.6 140.3 104.1 104.4 85.0 73.2 a/ Data may differ from data in Table 2.7 due to inconsistencies between National Accounts and Balance of Payments. Source: Central Bank of El Salvador. 16 Chapter II Permanence of flows. Inflows are likely to continue at high levels - in the order of 10 percent of GDP - at least during the next 5 years: ' Remittances. As long as emigrant workers remain in the US, and the US economy continues grow- ing, remittances will continue. However, they should not increase much beyond current levels, re- maining at 8 -10 percent of GDP. * Official grants are expected to gradually decline in the next two years from current levels of about 3 percent of GDP to about 1 percent of GDP, as donors reduce assistance. * Bilateral and multilateral gross disbursements, are expected to gradually decline as a result of lower peace-related investment requirements. ˘ FDI prospects will depend on the success of the Government's new development strategy which hinges critically on a marked improvement in the investment climate. * Short-term private capital inflows increased during 1993-94 as a result of wider domestic- international interest rate differentials and peace. Short-term capital inflows may increase in the fu- ture as long as: (i) there is a wide interest rate differential; and (ii) El Salvador maintains a consis- tent, credible market-oriented economic reform program. The Dutch disease: conceptualframework The mechanisms through which foreign exchange flows affect the Salvadoran economy are similar to the "Dutch Disease" phenomenon5 associated with an export boom (in this case remittances or exports of labor) and to the effects of increased capital inflows as experienced by a number of develop- ing countries, particularly in Latin America and East Asia. However, there are two critical differences: (i) duration - remittances tend to be more permanent than export booms; and (ii) uses offoreign ex- change receipts - a much higher portion of remittances tend to be spent on consumption, particularly on non-tradables (NT) relative to imported (or tradable [T]) goods, or re-invested. These flows have important effects on domestic expenditures, resource allocation and monetary variables. The starting point is an increase in foreign exchange inflows which leads to a higher level of domestic expenditures' on both imports and NT goods. The portion spent on imported goods worsens the trade deficit, but has no effect on the money supply or the exchange rate, since it directly accommo- dates part of the increased supply of foreign exchange. If the whole increase in inflows were spent on imported goods the only concern would be on the sustainability of the financing inflows. The portion spent on NT goods - in a supply-constrained situation - generates a standard macroeconomic transfer problem similar to a Dutch Disease7 and may lead to: c' inflationary pressures: higher demand for NT goods drives up their prices; o real exchange rate appreciation (4'RER): higher NT prices lead to a real exchange rate (RER=Tp/NTp) appreciation, i.e., a rise in the price of NT relative to T goods; the larger the propor- tion of foreign exchange flows spent on NT goods, the larger the RER appreciation; c* a decline in the export sector: the increase in the relative price of NT goods will create incentives to reallocate resources from the export sector to the NT sector and to switch expenditures from NT goods to imports; and See Corden and Neary, 1992; Corden, 1984; van Wijnbergen, 1984; Corbo and Hernandez, 1994; and Calvo, Leiderman, and Reinhart, 1993. 6 Remittances represent an increased transfer from abroad which directly increases income and demand, while capital inflows relax the foreign exchange liquidity constraint. In the case of El Salvador, these problems are exacerbated by the fact that the marginal propensity to consume NT goods is higher in the case of remittances than for export receipts. Enhancing Macroeconomic Stability 17 Kt short-run monetary disequilibrium: in an export boom, increased foreign exchange flows (not spent on T goods) result in a balance of payments surplus, an accumulation of international reserves (TIR), and an expansion of the money supply beyond increases in money demand, generating a short-run excess supply of money. Under a fixed or pre-determined exchange rate regime, NT prices will tend to increase and so would the demand for imports. In the short-run, the monetary expansion will place additional pressure on the RER (>l) but, eventually, the increased demand for imports will solve the disequilibrium. Under flexible exchange rates, the excess supply of money would also put pressure on the nominal exchange rate, generating forces toward a depreciation. However, if the in- crease in NT prices exceeds the nominal depreciation, in the short-run, the RER will tend to appre- ciate (Edwards, 1984 and 1986). Key macroeconomic management issues and the role of the Dutch disease in El Salvador Inflationary pressures, monetization and domestic credit High foreign exchange inflows have complicated monetary policy, and in particular, the achievement of the Government's inflation objectives. High foreign exchange flows have contributed to continuing inflationary pressures through two channels: (i) the domestic expenditure effect, i.e., higher NT prices associated with increased consumption driven by remittances; and (ii) monetary disequilib- rium, i.e., through the impact of reserve accumulation on monetary expansion. Government efforts at offsetting the inflationary impact of inflows through sterilization policies have been only partially suc- cessful. Inflationary pressures persist as a result of the high and inelastic demand for NT goods largely stemming from remittances and from capital inflows to finance public sector expenditures. Inflation trends. Infla- to i urats 0io'uOOn 94 44 tion has been falling but remains 35 well above US and international -El Salvador (CPI) levels (Figure 11.12). The con- 30 _ International(MUV) tainment of inflationary pres- 25 |--- U.S. (GDP Deflator) sures is critical to the success of the Government strategy since it 20 would enhance competitiveness by limiting the RER apprecia- tion. In addition, lower infla- 10 tionary expectations will facili- 5 tate domestic investment by al- i - 0 lowing further expansion of real domestic credit to the private 5. sector. a- a1e .~~~~~~~Y 4oi# WW' Inflows and monetary disequilibrium. High inflows have exacerbated demand-driven infla- tionary pressures in El Salvador by raising NT prices and increasing money supply through reserve ac- cumulation. The increase in the money supply (M2)8 since 1989 reflects the expansion of the monetary base (Figure Il.13) associated with high inflows, since net domestic assets have been decreasing during Although mitigating forces included the RER appreciation which has lowered the price of T goods and the financing of the fiscal deficit entirely with foreign resources. 18 Chapter 11 the same period and have been negative since 1993.9 The pressure of inflows on international reserves has occurred through two reinforcing mechanisms: (i) the portion of foreign exchange spent on NT goods has resulted in a balance of payments surplus (tIR) and has put pressure on the monetary base; and (ii) Central Bank purchases of foreign exchange to maintain a stable nominal exchange rate led to additional reserve accumulation and further increased the monetary base. Sterilization policies10 have not been sufficient to completely offset the liquidity-creating effects of inflows because of their high level and the high and inelastic demand for NT goods. In an export boom, the excess money supply is generally only a short-term phenomenon. However, in the case of El Salvador, the impact of inflows on money creation is greater than in an export boom and the automatic adjustment of the monetary sector is much slower, because the marginal propensity to consume NT goods is higher and the demand for NT goods is inelas- tic owing to the high share of remittances in foreign exchange flows. I}Ignre Il In f ternatlousl Reserves Figre HUb laterntlonal e tf them;es Z;~ ~ ~ su }ysrn 109~ Cenra Dan asb % of eure~ In k=lrtuL 1989 700 - 240- 650- {urnLColonej 220{ .K r 600 1 . , o e- 200/ , 555 -> /4 80 / I U ~~~~~~~~~~~~1801 500 1 60-~ E450] I 400 /- 140 350 / { n 120 3 00 0 - - 0 - 0 00 i0' i' i' i - ol ol C~~~~~~~~~~~~~5, CY, 'O ISO a> O 0 g A MoearRs In CiiB iinstattCoI6u*i, I98 < fg 94 7;Mufl1pliIerwsaw^ mud 2 17,000 -M2 4.5 : 15,000 - - Quasi-Money 4.0 C~13,000 3 sQ | ~~~~Monetary Base /t 35+\.s : U 13,000 ------ Ml /I } 3. i 3.01 71,000 " 9.000 2.0 0 . 0 ~ ~ ~ ~ ~ ~~~~~~~~10 O 5,000 + - - - ,, 0 - Income Velocity (M2) 0.5 ---Money Multiplier (M2) 3,- ...Quasi-Money Multiplier 3, 00 0.00 9 M2 (money [Ml] plus quasi-money [QMI) is used as a proxy for money supply; M2 represents over 90 percent of total banking sector liabilities to the private sector. '0 Sterilization policies are defined as measures implemented by the Central Bank to offset the impact of the accumulation of international reserves with the objective of containing domestic credit to a level compatible with inflation targets. Enhancing Macroeconomic Stability 19 Inflows, reserve accumulation, - . and domestic credit to the private sec- Mgi - r Ž ~ ;' tor. To expand private investment and 18iO M accelerate growth, inflationary expecta- 16,0004 DCPR tions must decline to allow for the neces- 14,0 1 - DCPS sary increases in credit to the private sector in a non-inflationary manner. The 12,O0 + amount of real credit available to the pri- 10o000 vate sector depends on the real cash bal- - ances (i.e., money demand, proxied by 8,0O M2 in real terms) that the public is will- 6,0 . ing to hold and the amount of net inter- 4 national reserves accumulated by the consolidated banking system. The higher 2,000 the accumulation of reserves, the lower o .-II -- - I, i-- the availability of real credit. (2,) As a result of increasing inflows, (4,O0) total domestic credit has been contracted OO to offset the growth in international re- SowlMF, : serves, contain the increase in money supply and maintain inflation targets. Beginning in 1990, despite continued tight credit policies, an in- crease in real credit to the private sector was possible thanks to economic growth, increased reliance on foreign financing of the fiscal deficit, and the Government's success in controlling inflation - which was reflected in increasing real cash balances (Figure 11.14). Real exchange rate appreciation Since the mid-1980s the real exchange rate (RER) has appreciated and exhibited greater vari- ability relative to the previous 25 years. The lower RER is not a problem by itself since it is due to an equilibrium appreciation resulting from an excess supply of dollars associated with higher inflows. However, a certain degree of misalignment is also present, associated with high demand and higher in- flation than the main trade partners. The lower RER has contributed to the decline of the export sector, although the decline in real wages has limited the impact of the appreciation on the competitiveness of labor-intensive exports. Given that flows - particularly remittances - are not a temporary phenomenon, policies should aim at ensuring a competitive long-run RER through higher savings (public and private) levels and at avoiding RER misalignment through improved fiscal performance. Degree of aiV reciation and variability. A number of bilateral (BRER) and multilateral (MRER) RER indices were computed for 1961-94 (Figure 11. 15). Three conclusions can be drawn from these indices: (i) the BRER and the MRERs behaved in a sirnilar manner throughout the period, there- The RER measures the relative price of tradable with respect to non tradable goods (RER=Tp/NTp). When the real exchange rate is falling it is appreciating. The bilateral real exchange rate (BRER) is calculated as: BRER = (NER*WPIus)/CPles, where: NER= the nominal exchange rate; WPlus = the US wholesale price index; CPles = the Salvadoran consumer price index. The BRER was computed using the dollar because the US is El Salvador's main trade partner. A number of multilateral real exchange rate (MRER) indices were constructed using a basket of currencies. Three groups of countries were used: (i) the top 10 trading partners; (ii) the top 6 non-Latin American trading partners; and (iii) the Central American trading partners. The following weights were used: (i) trade (imports plus exports) [MRERxm]; (ii) exports [MRERx]; and (iii) imports [MRERm]. The weights were calculated for 1978, 1985, and 1991. The gap between the BRER and the MRERs is larger for the periods in which the US dollar was depreciating relative to other currencies. 20 Chapter II fore in the rest of this report the BRER will be used when discussing RER trends; (ii) all indices show a much lower RER for 1980-94 compared to 1961-80;13 and (iii) since 1985 the RER has remained at a much lower level than in the previous 25 years although with greater variability. 1250 22 5 M RERxm(85)Top 6 / s 100 + _ d :Non-LACV 0,' 175 L><\ . If a wage index is used to calculate the RER - rather than the IV" iigr . s 125 + | _ M RERxm(85)Top 10 Ai tj' -hA price index-the BRER exhibits a / , ;0 100 + Non-LAC J V ;120.0. real depreciation during the last i0.0 decade. Thus, El Salvador has r _. BRER El Salvador remained competitive - in labor- 1000. BRERo GuatemalaA intensive exports - relative to its T l BRERGuatemala trade competitors. This relative ....... BRER Honduras 800.0 advantage, nevertheless, may be T BRERCostaRica lost if in the future higher real . . . . R....aRIca wages are not associated with 600.0 T rapid productivity growth. Finally, it should be stressed that low 400.0 .- wages confer comparative advan- tage only in some goods. In fact, a number of products tend to be ex- 200.0 , ported by high-wage countries, - - - E presumably because high wages K . . indicate availability of skilled $ o.o a, O 0 l workers (Leamer and others, X 1995). 13 The two brief RER depreciation episodes after 1985 reflect two large nominal devaluations in 1985 and 1990. Enhancing Macroeconomic Stability 21 Table 11.2 Variability Indicators Cross-country (MRER - Quarterly Dats) comparisons of varia- .n.sps .& I77W5 bility indicators,' as ~ crcr Ifee ~u~~¶ ~ ~ LU!fo)J~RS calculated by Edwards V iS w (1989) show: (i) in- 1l-.Sr -m7 1t8-' - 2r-87 creasing variability in Korea 8.80 42.60 4.87 11.17 6.61 32.70 the 1970s and 1980s, Thailand 8.14 29.22 3.16 10.10 5.98 25.36 compared to the 1960s; Malaysia 7.59 26.23 3.02 9.70 7.79 26.23 Singapore 6.32 25.15 3.45 10.58 7.23 25.15 and (ii) an increasing Source: Edwards, 1989 gap between the vola- tility of El Salvador's RER compared to high performing East Asian economies (Table 11.2). RER vari- ability is important for foreign investors since the higher it is, the higher the risk of operating in the country. Higher inflows have contributed to the decline of the export sector by lowering the relative price of tradables and leading to resource shifts from the T to the NT sectors. However, relatively lower real wages have benefited the competitiveness of labor-intensive exports. Notwithstanding the strong per- formance of non-traditional exports, 1994 exports of goods and non factor services as percentage of GDP were less than half their 1974 level (Figure 11. 17). .BjWt$RER lpNTp luls., 19154 (insetS) U N T7iE; 250 70 604 50 15 N ont-Tradabies (Sv a *, ~~~~~~~~~~~~~~~~~40 fTrdables(Eors ofGNFS) 30K 20 S f > > > R ! ..gTradables (Exports of GNFSexclCoe e) q g X i ff K A 14 Based on calculations of MRERs for 33 countries. The second column shows the difference between the maximum and the minimum values of the indices. These trends are consistent with calculations by Dollar (1992). 22 Chapter 11 RER determinants. RER appreciation reflects structural changes in fundamentals - higher sup- ply of foreign exchange and higher demand for NT goods - which have appreciated the equilibrium RER (ERER) and monetary disequilibria which have contributed to short-run RER misalignment:'5 r* Role of fundamentals: high and sustained increases in transfers and capital inflows (Figure 11.18) generated forces toward an equilibrium real appreciation through three channels: the direct impact on income; the indirect impact though higher demand for NT goods and higher NT prices; and the indi- rect impact through short-term monetary disequilibrium. The impact of higher inflows was large enough to compensate for trends in government expenditures, terms of trade, and trade liberalization (Figure 11.19) which could have been associated with an equilibrium real depreciation, particularly during 1991-94. r* Role of monetary variables: the pursuit of policies to maintain a stable NER since mid-1991 may have also contributed to real appreciation as a result of a Dutch Disease expenditure effect of in- flows. In addition, the impact of inflows on monetary expansion through reserve accumulation (1989-94) has reinforced the RER appreciation. As discussed above, in the case of El Salvador this monetary disequilibrium has persisted as a result of the high demand for NT goods. :~gure i 1.18 BRf aadTdYeU 1of, , 1975.94 (1985-fOe) Figure IL19 Public Consumption and Tp/NTp, 1975-94 250 t T 1400 18.0 T Pub Fc -rm 180.0 200 / 1200 160 160.0 200 4 rX / I looo 1 ffi 14.0 t / 812 9 t 140.0 0 :: , P 0 °12. 4 /t4R 140.0M *;~~~~~~~ Eq 100 1 40E8.0 8\8. di: i & / ; : IJ 6~~~~~~~~~~~~~~~~~~1.0 r ,/) 6.0ooj 8 /00 o S tso4 \0 7ol\/\ { __ 2 C 4.0' 100.0 600 0 IC AC E~~~~~~~~~~~ 804 80.0 : l 00 }- Total Inlows \14 ° ~1 a 1 . 1620.0 l 4200 jj~~~2~~jj lo~~ 6 .0. 40.0 f' 4 ° / + *S+++;4 ++1 -200 0 0.0 i I 200t 4 'CC -' -N - -N ~C r- - - . 0 _ _-0-- __ 2_ _0 20 r- N N 00 00 00 --20 0. 1~0.0 S.vrtW2World Bianiitffoinats. : Sowvce: Centml8BnkofHf Salvadorand World Bankstaffestinztes. Exchange rate policy and behavior: historical phases. Figure 11.20 suggests that fixed NER periods have been associated with a competitive and stable bilateral RER (BRER) only when inflation has been low and stable. During 1961-74, the BRER slowly depreciated - notwithstanding a fixed NER - as a result of low inflation associated with a very stable macroeconomic environment consistent with the fixed exchange rate regime. During 1975-85, there was a steady RER appreciation to an accumulated 55 percent by 1985; this resulted from: (i) the inflationary impact of the two oil shocks; (ii) the existence of 5 RER misalignment (overvaluation) occurs when the actual RER is below the equilibrium level (RER < ERER), i.e., the actual RER appreciates relative to its long-run equilibrium level; if the RER appreciates in response to an ERER. appreciation (resulting from a change in fundamentals) there is no misalignment. Enhancing Macroeconomic Stability 23 trade and exchange controls, which contributed to the establishment of a parallel foreign exchange mar- ket; and (iii) increasing transfers beginning in the late-1970s.16 Two characteristics stand out in the 1986-91 period: (i) limited impact of nominal devaluations; the effects of a 100 percent devaluation in January 1986 and a 60 percent devaluation after the unifica- tion of the exchange rate (and the establishment of the current flexible exchange rate system) in June 1990 eroded quickly as a result of the increasing supply of dollars. The 1990 devaluation eroded more slowly thanks to trade liberalization, the pre-payment of external debt, and the lifting of restrictions on capital transactions. In 1991 the RER was approximately at the same levels as in 1985; and (ii) siignif cantly lower RER level (more appreciated) compared to the previous two periods. Since 1989, the authorities have attempted to limit the appreciation of the RER through: (i) poli- cies to lower the excess supply of dollars by accelerating trade liberalization (1989-95) and pre-paying the external debt and oil bills (1991-93); and (ii) policies to contain inflation (1992-95). Since 1991, the Central Bank has pursued sterilized intervention to limit fluctuations of the col6n with respect to the US dollar, which has resulted in a very stable NER (a de facto fixed exchange rate). The RER, however, has continued to appreciate during 1994-95 - albeit at a lower rate - as a result of the continued high level of inflows and inflationary pressures. Figure 1.20 BRER, NER, god CPI, 1961-94 (1990400) - 250 -+ 200 , ~~~~~~~~~~~~~~~~~~~~~~~~~~/ , 150 100 ___NER 50 _ _ _ _ _ _ _ _ _ m n -J1r a,i 0 a- + I -- I--I -- I I I4I I Iii I I I I III Source: World Ba* staff estimates. - . 16 Trade and exchange controls and increasing transfers beginning in the late- 1970s also contributed to the appreciation. 17 In 1990, a flexible exchange-rate system was introduced, but in early 1991, as a result of increasing inflows, the Central Bank began a policy of sterilized intervention, buying foreign exchange to contain the nominal appreciation and in parallel carrying out open-market operations to offset the impact of reserve accumulation on the monetary base. 24 Chapter 11 External viability concerns There are three key external vulnerability concerns: (i) worsening trade deficits resulting from higher imports associated mostly with remittances coupled with low exports; (ii) current account deficits reflecting high private consumption rather than investment; and (ii) dependence on official grants and short-term flows - rather than medium and long-term flows - to finance current account imbalances. These concerns highlight the need for the Government to support private sector efforts to expand and diversify exports. J^FlgureIL21a ENportsandinports,1975-94t wtjndgurlmL2b tdpotTre, 2200 145.0 2000 L 40.0 1800 35.0 ss! ,6001 1 Imports f 0 /''/ g 1600!4 ; 1400 0 ~ ~ ~ ~ ~ ~ ~~~~~~~ ~~~~20.0 12000 20.0 800 T5. 600 ~~~~~~~~~~~~~~~~~10.0 400 Exports 5.0 r f .. 200 0.0_S1 - t+;+-t++H 00 °°t- t-4 i4 1 t--+ +Xt |F!| ,. rN ' - x N CN - .E 'C C'1 el) 'C 0' C N Wm - : N N 00 00 co 00 00 L' 'C It - - - N - 00 00 co -- C' C C'C' ' C C'C' ' C CI C' C'F a, C Z' C' C C' a, F' $0urce. Centml Bank of ElAldor., Sustainability of trade imbalances. Trade deficits have been increasing mostly as a xFigure i2 .rport Growt R.te.0 e result of low export growth, rather than high im- a I.. C tatz Al95uSS,i9 9.jj port growth (Figure 11.21 a and b). Exports have been declining since 1978, although this declin- 50 ing trend has been slowly reversing since 1989. IT Editixonal_Eiportj I The decline in traditional exports (coffee, cotton, 30 l sugar, and shrimp) has been partially offset by TraditinalExp higher non-traditional exports (Figure 11.22), which have significantly expanded and diversi- 10 fied in recent years. By end-1994, however, ex- - I A 4 7 ports in dollar terms had reached only 1978 lev- -10 -X els and as percentage of GDP they were lower than in 1960. Higher inflows, particularly remit- tances, have also contributed to higher imports, through their impact on national income and do- mestic expenditurec imports more than douibled I -in in dollar terms 1iu i9X,8, afThugh as percent- , _ I CI ' & & C age of GDP they remain well below the mid- X40111 .y ? - 1970s peak. gr4~ A. 4fiii Enhancing Macroeconomic Stability 25 Higher imports are currently not a key concern; their levels are still reasonable by historical standards and their impact on the current account has been mitigated by the offsetting impact of remit- tances (Figure Il.23a). It is the performance of the export sector which is particularly worrisome be- cause it also reduces technological progress through learning by doing which is largely confined to the traded goods sector, lowers economic growth, and endangers external viability. There is consensus that sustainable current account deficits are, at the most, in the order of 25 percent of exports of goods and services. Currently, El Salvador is below this level but higher export levels are necessary to attain a less vulnerable external position (Figure II.23b). 5 r 0.3& Captal imu4 ,1500 - - Total Inflows 125 s; | CA...CAD (exc. Off. Trans.) e 1000 t /8 L 1OO -~~~~~~~CA D/XGSRem,' 1000 0 Trade Balance ; I<.- _ ...... .... (CAD-Rem)/XGS i,500 } ,^\~ Rs_R\/i ..,...... 5,~: I .2~~~~~~~~~~~~~~~~ .E0 -500 .'> ] < ... ~~~~~~~~~~~~25 'h \ -1000 -, -15001 l'ji a, _ _ _ - -- - N N oo0 0 00 00 c0 The main reasons for the slow growth of exports are: t> worsening terms of trade and high vulnerability to movements in commodity prices, particularly coffee and cotton. Prospects for improved traditional commodity prices are grim, highlighting the need to further expand and diversify non-traditional exports; structural factors resulting from remaining constraints to private sector development in general and to exporters in particular; especially, in the areas of infrastructure, technology, production and business services where firms may face difficulties in reaching international technical standards; and, in part, real exchange rate appreciation and resource shifts to the NT sector resulting from high foreign exchange flows (discussed above). Low savings and investment. On the expenditure side, current account deficits reflect an ex- cess of expenditure over income; they have been decreasing due to: (i) remittances which have permitted the lowering of the private sector gap despite high private consumption; and (ii) higher public savings. Current account deficits, however, reflect increases in consumption; private consumption is expanding 26 Chapter II faster than the im- Table 11.3 Savings, Investment, and the Current Account Deficit, 1980-94 (as % of GNP) provement in public savings. What is of ___________i:_i___-________ t o T D59i I98W 1991 19J9 R199 } WE.1 is not the in- Private Investment 8.6 11.5 9.1 10.5 11.3 11.8 12.9 concern ss not the In~ Private Savings 6.9 7.3 4.9 8.9 9.2 10.9 11.5 crease in consumption - Private Domestic Savings 5.9 5.9 3.0 6.3 6.3 7.9 8.6 since it has been Estimated Savings from Remittances 1.0 1.4 1.9 2.6 2.9 2.9 2.9 closely associated with Private Sector Gap *. 1.7: 4.2 4.2 1.7 ;A 2 0.9:f A.5, iL0 remittances - but the Public Investment 3.9 3.4 2.2 2.4 3.3 3.3 3.2 slow growth of invest- Public Savings 0.1 -1.5 -0.3 -0.7 0.2 0.6 1.7 slow growthof Invest-Pubhe SttorSt3apf 3.8 4,9 1>25 3.0: 3.1 .I 2i l\ ment and private say- Pl:~tra . ~ : . . . 6 L Current Account Gap 5.5 9.2 6.7 4.7 5.2 3.6 2.9 ings (Table 11.3). Memo: Investment 12.5 14.9 11.3 12.9 14.6 15.1 16.1 Consumption 92.9 94.2 95.4 91.8 90.6 88.5 86.8 Private Consumption 78.0 82.7 84.5 80.4 79.6 77.8 75.5 Public Consumption 14.9 11.5 10.9 11.4 11.0 10.7 11.4 Source: Central Bank of El Salvador. Increased dependence on grants and unidentified flows. The basic balance'8 has been increas- ingly fnanced through official transfers and errors and omissions. On average, throughout 1975-88, cur- rent account deficits were almost completely financed by medium and long term (MLT) capital flows. However, the basic balance became negative beginning in 1983. During 1989-94, while the current ac- count worsened only by about 1.5 percentage points of GDP compared to 1975-88, the basic balance worsened by over 4 percentage points of GDP as a result of lower MLT capital. This raises the risk of a sudden decrease of current financing flows, i.e., official grants and uni- dentified sources - possibly short-term private inflows. The current assessment is for external flows to continue at high levels, although their growth rate should be lower. Their composition could continue shifting toward a higher percentage of remittances and possibly larger private flows (foreign investment and short-term flows). As a result, in the medium-term the financing of external deficits should not be an issue, although the balance of payments does remain vulnerable to an unexpected decrease in these flows. Table 11.4 External Deficit and Financing Mechanisms (as % of GDP), 1975-94 ;s.. 9588- .1979 89 199U 1991 1992 9Y ,. 1994 Current Account Bal. a/ -4.2 -5.7 -9.4 -7.0 -5.0 -5.8 -3.9 -3.2 Trade Balance -3.7 -14.6 -13.4 -13.3 -13.8 -16.8 -15.5 -15.0 Exports 23.5 9.9 10.0 11.4 9.9 9.1 9.6 9.4 Imports 27.2 24.5 23.4 24.7 23.8 25.9 25.1 24.4 Remittances 2.4 8.8 4.8 6.8 9.2 10.8 10.8 10.7 MLT Capital a/ 3.7 1.1 4.1 0.0 -0.9 1.3 1.3 0.5 Basic Balance a/ b/ -0.5 -4.7 -5.3 -7.0 -5.9 -4.4 -2.7 -2.7 Overall Balance 0.3 0.6 -0.7 1.8 -0.9 -0.3 2.0 1.5 a/ Excluding official tranisfeers. b/ Equals Current Account Balance + MLT Capital. Source: Central Bank of El Salvador. Is The current account deficit is not necessarily the most appropriate indicator to judge the sustainability of external balances in countries where it is structurally in deficit and has been traditionally financed "autonomously" through long term capital flows. A more appropriate indicator is the basic balance, i.e.. the current account adjusted for medium and long term capital flows. This indicator shows that economic growth can be maintained with a current account deficit if it is financed with sufficient medium and long term flows, as occurred in El Salvador, and Central America in general, during the 1960s and 1970s. Enhancing Macroeconomic Stability 27 Sterilization polices: impact and effectiveness Since 1991, the authorities have been using sterilization policies to counter the liquidity-creating effects of foreign exchange flows and of their interventions in the foreign exchange market. Concerns have been expressed regarding: (i) the impact of these policies on interest rates and on the Central Bank's operational deficits; and (ii) the effectiveness of these policies. Notwithstanding these concerns, the Salvadoran authorities in the short-term should continue relying on sterilization policies as the main instrument to control monetary expansion because: (i) the level of inflows has stabilized; (ii) the impact on interest rates has not been unduly large, and in any case, the largest component of inflows - remit- tances - have a low sensitivity to interest rate differentials; and (iii) there is room to improve the opera- tional position of the Central Bank. The Government announced in mid-1995 its intention to allow a voluntary and gradual dollari- zation of the economy19 by eliminating all restrictions on financial operations in US dollars to: (i) en- hance the consistency of exchange rate policy with the opening up of the economy and the globalization process; (ii) reducing inflation (by providing a nominal anchor) and interest rates20 toward US levels; (iii) creating confidence by protecting the domestic currency against speculative attacks and curtailing exchange rate risk; and (iv) enhancing credibility by promoting fiscal and financial discipline. Instruments of monetary control. The Government's aim of reducing inflation required re- straining the growth of bank credit pursued by: (i) decreasing the domestic borrowing requirements of the public sector by increasingly relying on external financing of the fiscal deficit; and (ii) restraining the expansion of credit to the private sector through the use of rediscount, reserve requirements, and open market operations. During 1992-93 the Central Bank used rediscounts to manage liquidity through the unified redis- count window and the automatic liquidity window. In July 1994 the Central Bank closed its rediscount operations and increased reliance on indirect monetary instruments. Since 1994, the Central Bank has relied exclusively on reserve requirements and open-market operations. After several increases between 1989 (19 percent for local currency deposits) and 1993 (between 20 and 30 percent), reserve require- ments on bank liabilities in local currency have remained unchanged. However, in July 1994 the Central Bank established temporary investment requirements in the form of holdings of Stabilization Certificates (CEMs - Certificados de Estabilizaci6n Monetaria). In addition, to further tighten credit policy, the Su- perintendency of the Financial System (SSF) increased provisioning requirements on certain loans. The Central Bank initiated open-market operations - with CEMs - in July 1991. CEMs have shown: (i) de- creasing volume, particularly since late-1994 (Figures 11.24a and b); (ii) continued prevalence of Bank and non-bank financial institutions as major holders; and (iii) increasing share of longer term (360 days) bonds. Impact on interest rates. The need to issue CEMs has put upward pressure on interest rates. Although in relation to dollar rates, domestic interest rates are significantly higher, in view of the rela- tively low level of real interest rates on deposits, and considering that bank interest rate spreads are in the range of 5 - 10 percentage points, the real cost of borrowing might not be characterized as high, after in- corporating credit and market risk factors. 19 Originally, the Government had announced on February 3, 1995 its intention of moving to a currency board-type system, sanctioning the return to a fixed exchange rate regime as a transition measure prior to the move to full dollarization. 20 Reflecting the fall in devaluation expectations. 28 Chapter 11 2,500 t25 1V 2,000 20 - X ; 20 - - - ---- -.sS ° Z I 1 1-++ I I +- I I I + 1-1 ' F ta - a' Se. ,a' ' 1,50 X 5 t - - - - - - - - j tu~iBntra ak ofE SaIvadr :?.. At least since mid-1993, interest rates on commercial bank deposits have remained consistently above the equivalent rate on CEMs. It appears that active intervention by the Central Bank has led to a market-determined premium on deposit rates over the CEM rate as financial intermediaries have used the GEM rates as a floor for their own deposit rates. lThe interest rate on 180 , day deposits has been consis- X t000- i0iFL;arc 115 Nomhia1 a4 Real Jmteu'st Re*eafor tt tently above the implied rate on 01SX ttd ˘ Pil8^" "3-g9$0 i00 US dollar deposits based on the tn20 't US Fed Funds rate. This yield ;a differential could induce the fol- . lowing market responses: (i) do- -t!,, mestic investors will have a pref- : l \/~- erence for domestic interest- lo1\.. | bearing deposits; and (ii) domes- i tic investors may repatriate some i \ of the capital invested abroad in 54AAf order to benefit from the higher d ^-\ domestic interest rate. However, i0 ___/ __/_// l , _______ the latter source of capital in- o5^l l,, l l 1vI ,I 6 s :' flows should be regarded as ____Dpsi_ac lO as) 0; volatile deposits, which could .\ |,,,,CMre(8dy) '0 swiftly be taken out of the coun- .VRelDpstre try if domestic/foreign interes t ___RealCEM rate .. rates fall/rise, or if a currency > l ,^< .k devaluation is anticipated. Re -___________________X_____X____> X interest rate differentials since -˘t i2gl;'.gS .8<>@g > Enhancing Macroeconomic Stability 29 most of these transfers are used to support the consumption needs of the beneficiaries. Impact on Central Bank operational losses. The costs of sterilization have contributed to the operational losses of the Central Bank21 through : (i) the interest differential between higher holdings of low-yield foreign assets and the costs of servicing high-yield domestic bonds; and (ii) the debt service cost of CEMs. During 1994-95, interest on CEMs is expected to be the second largest component of the Central Bank's interest expense, after interest on reserve requirements. During 1990-92, Central Bank deficits represented about 0.9 percent of GDP. In 1993, losses fell to about 0.2 percent due mostly to the renewed payments of interest obligations by the Central Government. There is still room to further lower Central Bank operational losses, through actions to: (i) ensure timely payment by the Government of market determined interest rates on its liabilities to the Central Bank (already incorporated in the proposed Central Bank Reform Law); (ii) promote issuance of the Government's own paper to cover short-term financing needs. This will be introduced under the Central Bank Reform Law, although the issuance of Government instruments should include both Treasury Notes (short-term) and Bonds (long-term); and (iii) establish a reserve account to cover interest arrears and non-recoverable assets from the operations of FOSAFFI.22 This reserve should be funded by the Govemment directly, or through a special assessment on the commercial banks to be derived from net profits. Effectiveness and sustainability. The key variables in analyzing the effectiveness of steriliza- tion operations and the appropriate response to large inflows are: (i) the exchange rate regime; (i) the degree of financial liberalization and development; (ii) the source of the disturbance; and (iii) the dura- tion of the inflows (Frankel, 1994). The conventional view is that sterilization policies are ineffective under fixed exchange rates and perfect capital mobility (i.e., there is no scope for an independent mone- tary policy as measured by both interest rates and the money supply). The assumption being that the domestic interest rate is tied to the exogenous foreign interest rate and potentially infinite rates of capital flows will respond to changes in domestic interest rates. Sterilization under a fixed exchange rate regime can be effective, but only in the short-run. In the longer-run, sterilization tends to exacerbate capital in- flows because of the differential between domestic and foreign interest rates (Calvo, 1991; and Calvo, Leiderman, and Reinhart, 1993). El Salvador is currently characterized by: (i) a flexible nominal exchange rate which, however, has been maintained at a stable rate of approximately 8.75 colones per dollar since 1993 through Central Bank intervention; (ii) high level of remittances which are largely insensitive to interest rate differentials; (iii) the source of the disturbance - high inflows, mostly remittances - is similar to an export boom; and (iv) continuing high inflows but more stable. Under these conditions, interest rates will indeed be higher than they would have been in absence of the flows but sterilization polices should continue to be effec- tive in limiting monetary expansion given the low sensitivity of remittances to interest rate differentials. Eventually, the more integrated El Salvador becomes with the world capital market, the more elastic the supply of funds will become and relatively high real domestic interest rates would trigger interest- sensitive flows. 21 Additional causes include: (i) sizable holdings of low interest Govemment debt which is frequently in arrears; and (ii) costs incurred during the restructuring and privatization of banks and finance companies. The interest cost of the bonds fluctuates with market interest rates, and represented the largest component of interest expense in 1993. 22 The Fondo de Saneamiento y Fortalecimiento Financiero, the entity which carried out the restructuring and recapitalization of the commercial banks ard finance companies prior to privatization. 30 Chapter II Recommendations: macroeconomic management with high foreign exchange flows Policy constraints. The analysis in this Chapter highlights the following considerations and constraints in the development of the remaining macroeconomic agenda: C* Implications and requirements of peace. As has been the case in other countries in the after- math of a prolonged civil war there has been little peace dividend in the short-run (World Bank 1994). This is mostly because private investment and government revenue are slow to recover and there is a pending need to repair damaged infrastructure. In addition, at least in the short- run, the consolidation of peace requires additional outlays to not only finance peace-related ex- penditures (particularly the reintegration of ex-combatants into economic life) but also to allevi- ate poverty and address the social roots of the civil war. Sustained high foreign exchange flows and equilibrium RER appreciation. There is a con- sensus in the literature that the sustainability of capital inflows is the critical parameter for policy design. The higher level of foreign exchange flows entails a change in the underlying structure of the economy, and in particular the equilibrium appreciation of the RER. Moreover, as the country develops, increases productivity, maintains high growth rates, and continues to attract capital, a gradual appreciation of the RER is to be expected. The impact of high and sustained increase in demand for NT goods, as a result of remittances and the fact they are mostly used to buy non-tradable goods. This exacerbates the monetary implications of inflows and worsens the RER appreciation. D* Implications of the Government's commitment to maintaining the stability of the nominal exchange rate. This position constrains the use of the exchange rate as an instrument of macro- economic policy and highlights the critical importance of fiscal policy. Policy recommendations. In the short-term, the Government should continue open market op- erations to sterilize excess inflows. However, sterilization polices impose costs in the financial system and in the longer-term more fundamental cures must be implemented to adjust to the higher level of for- eign exchange flows. These policies would not only be beneficial per se, but would also have a buffer effect in the event of further increases in private capital inflows resulting from on-going economic re- forms. The authorities should therefore focus on: > First, and foremost, strengthen fiscal performance, while ensuring enough fiscal space to finance peace-related and social expenditures. The macro policy balance should favor relatively tighter fis- cal rather than monetary policy. The credibility of exchange rate and monetary policy does not de- pend on fixing the exchange rate, but pursuing consistent and credible macroeconomic policies. A stronger fiscal performance is key to: (i) ensure moderate inflation and the credibility of exchange rate and monetary policy; i.e., a fiscal anchor is the only way to enhance credibility and lower infla- tionary expectations; (ii) lower the level of inflows by decreasing external financing requirements; (iii) ensure non-inflationary increases in domestic credit to the private sector, which will be possible only if domestic financing requirements of the public sector continue to decline and inflationary ex- pectations decrease; and (iv) counter the effect on interest rates by both the growth in private demand and any required open market operations to reduce excess liquidity. The experience of successful East Asian economies (Corbo and Hemrndez, 1994; and Wang and Shilling, 1995) shows that a mix of fiscal-monetary policy seems to be more appropriate in the short- run since fiscal policy usually lacks the required flexibility to deal quickly with volatile capital flows. However, sterilized intervention is also most effective when accompanied by fiscal restraint. Tight fiscal policy seems to be the best way to maximize benefits from capital inflows while reduc- ing their side effects, especially real exchange rate appreciation. In the long-run, increased public Enhancing Macroeconomic Stability 31 savings appear to be the only way to protect the real exchange rate. This is also the type of policy perceived more favorably by international investors. '* Raise national savings. Higher savings are critical to reduce absorption and improve management of inflows in the long-run. Results from a recent international comparative analysis of savings be- havior (Edwards 1995) suggest a number of possible policy measures to begin raising savings, in- cluding: (i) increasing the depth and efficiency of the financial sector; (ii) reforming the social se- curity system; and (iii) increasing public savings, since higher public savings appear not to be fully offset by declines in private savings, thus increasing overall savings rates. c* Relieve inflationary pressures fueled by the high proportion of inflows spent on NT goods by: (i) encouraging higher domestic savings; (ii) lowering government consumption, which is usually bi- ased toward NT goods; (iii) fostering private investment, which is usually more T good-intensive; and (iv) in the longer-term, ensuring that a larger percentage of private inflows are in the form of foreign direct investment. E* Pursue a credible exchange rate policy. The col6n has experienced an equilibrium real apprecia- tion. The continuation of high inflows and economic growth entail a change in the underlying structure of the economy, and in particular, a lower RER. To avoid short-run RER misalignment, the authorities should continue to focus on ensuring consistent macroeconomic polices and moderating inflation. Moreover, there are a number of policy actions the Government can focus on to generate a long-run RER depreciation: (i) accelerate trade liberalization (to increase demand for T goods); (ii) lower foreign exchange flows by improving fiscal performance and decreasing the external financing needs of the public sector; and (iii) increase national savings. If the economy does voluntarily dollar- ize, the Government should accelerate on-going policies to: (i) improve fiscal performance; (ii) strengthen the efficiency and depth of the financial system through improved prudential supervision, deposit insurance, and capital markets development; and (iii) ensure continued labor market flexibil- ity. o Facilitate expansion and diversification of exports. External sector vulnerability and sustainabil- ity concerns highlight the need to increase the level of exports. Moreover, given price and demand expectations for traditional commodities, efforts should be geared at shifting resources so as to fur- ther diversify products and markets. A distortion-correction approach to export promotion is the most consistent with optimal trade policy theory, policy experience, and political economy consid- erations. As a result of the equilibrium appreciation of the RER the scope for increasing export profitability though a higher RER is limited The Government should continue supporting private sector efforts to increase productivity and improve global competitiveness within a context of a lower RER, by: (i) assuring a stable macroeconomic environment; (ii) removing general constraints to private investment through the implementation of reforms to improve labor and infrastructure (Chapter 111); modernize the legal and regulatory environment (Chapter IV) and strengthen the fi- nancial sector (Chapter VI); and (iii) removing specific constraints to export growth (Chapter V). CHAPTER III IMPROVING LABOR AND INFRASTRUCTURE An educated and skilled labor force, coupled with efficient and flexible labor markets are key conditions for the success of the Government's development strategy. In a dollarized economy, labor market flexibility is even more critical to respond to external shocks and to contain inflation. In El Sal- vador the labor market appears to be relatively competitive, but the lack of skilled workers and low labor productivity may be the key bottleneck to accelerating growth. This chapter reviews labor market charac- teristics and trends, and discusses constraints and policy options to: ensure the availability of skilled labor and enhance its productivity; lower labor costs; and improve contractual flexibility and labor management relations. El Salvador cannot fulfill its potential for export-led growth without overhauling its infrastruc- ture. Its poor condition saps the competitiveness of the private sector, as efficient services are increas- ingly important to firms' capacity to compete in world markets. This chapter also provides: an overview of infrastructure; approaches to the provision of infrastructure services; and suggested guidelines for managing change including a summary of issues and opportunities in key sectors. DEVELOPING HUMAN RESOURCES AND LABOR MARKETS Labor market characteristics and trends Characteristics. Despite high migra- tion, El Salvador has high labor force growth . lgurEm1ont ve loyploY.edi rates, in the order of 3 percent per year since 1980, compared to East Asia (between 2 and 2.6 Skilled(33%) percent) and Latin American (2.4 percent) during 1 a the same period. However, the labor force re- 13oarned mains largely unskilled (Figure 111.1). It is no- (/None table that while the mean years of education for (1-12 years(23%) the Salvadoran labor force is around 4.4, it is 8.7 for Salvadoran immigrants to the US (Montes, 79years 1987). Labor force participation is high and ris- (14%) L ing (55 percent urban and 37 percent female). , _ -- 1-3 years Urban Labor Market Trends, 1988-93. 6 years (21%) The urban labor market shows: (i) increasing _3 labor force participation (Figure 111.2) to some Unskilled (67%) extent due to the end of the civil war, resulting in the absorption of ex-combatants and increased e 1993HowboldSuny M y ofP I'' economic activity; and (ii) increasing employ- ment and lower open unemployment rates (Figure 111.3). The informal sector has became an important source of additional employment opportu- nities. El Salvador has a relatively flexible urban labor market, at least by Latin American standards. Labor turnover rates (over 10 percent) and the relationships between real wages, employment and GDP growth are fairly consistent with a flexible and competitive labor market (Figure 111.4), which holds for 34 Chapter III total and formal employment. Sectoral shifts in employment and individual periods of unemployment are also consistent with flexible labor markets. I jgure flu iLbor Ferce Partlclalmen, 1988-93 FIgure L3 Li rbo Onio aent Trend, 1988-93 .,§1 54 5 A ' 12.0T 't: a 52 / M~~~~~~~~~~~~, 8.0 - /0.0 53 48 / E 4.0 80 so t~~ ~~~~~~ E 6.0. 2.0 4.t467 ------------ 1988 1989 1990 1991 1992 1993 0.0 + _ -__ Note: -abor5xvepai*~ndeflncdasther- oof b rforccto K 1988 1989 1990 1991 1992 1993 NoGcf i e pEit#iatioPdefiedas the ratio of labor force to; popalft.on a~e 10 mid ;abZ6ov neys.Sources. 19M-993 Holwhd Swvq.Minbtry ofPl.naug- $oitrces 19S-2 9 Ilovadtio Surveys."' lfMmnistiy ofPlazii lg' Recently, there has been a halt in the sharp decline in real wages observed during the 1980s. Falling real wages indicate that labor market adjustments have been achieved largely through changes in real wages. Private consumption per capita, however, has remained approximately constant due to rem it- tances. Finally, there is a modest gap between skilled and unskilled wages, which appears to indicate a non-segmented market (Figures lII.5a, b, and c). v'Igu 43d__ Sfr l _ _ gurue JS5Rhhzslrlul Wge Goep ,i. B1I1980 C 1o1e,1980-93 20.0 cP --1 600 {.lf 20.0 T = Real SS Min. Wage T 15.0 ....... Real SS Private Wage :: i _ _ _ _ f----EiTvpoymnent 500 ; 10.0 1 -~~ Avi 0 / «erage IndustrialWage 400 i;X5.0 \\'' \,/ 50 T - ~~~~~~~~~~~~300 20.0 - i-- - (5.0) *0 (100) i' /:100 Unskilled Industrial Wage :: (15.0) t '\ .. 1988 1989 1990 1991 1992 1993 1980 1983 1985 1987 1989 1991 1993 Souw&198-1993Householdwry.Ml f~an1L Sw oil~rIsiu~fI Savao mi oo " erve Ilank. The most flexible sectors appear to be agriculture and services. The last job of the unemployed in the whole labor force is 43 percent in agriculture, 13 percent in services, and 10 percent in industry, and, for urban workers, 20 percent in services, 13.5 percent in agriculture and 13 percent in industry. Individual periods of unemployment are relatively short, less than three months on average. Only 20 percent of the unemployed have individual unemployment periods of over a year. Improving Labor and Infrastructure 35 @^Piguw. IILSb hcre.ue in Real Fhriings, 1970.80 and 1980.91 Figure WeS Avrug. Utr vkblli& sdPrint. Re"t61 Wa1*. '-.S < : ~Ł . Privt. M.m. W dtlogis b mtwrl, skod "xAu8 Can potr Capita, 1930~-93 (130 I) Korea _ _T _____________________,____ 120 Private Consumption per Capita Hong Kong Singapore [ 1970-1980 *1980-1991 80PrivateWag Thailand l _ 60 ,,.:' "\\\":60 Malaysia Real Public Wagj1 \ s _ 40 d = El Salvador Avg. Latin 20 1 Real Minimum Wage - Industrial| Amer. _i -12 -lo -8 -6 -4 -2 0 2 4 6 8 lo 198(I 1983 1985 1987 19S99 19 19 S5urcea: World Development Report 1994 and BESD (UNIDO). Sources: Social Security Institute of El Slvador and Centmal RIeive R-a. Developing human resources and enhancing productivity The lack of skilled workers and low productivity is the key bottleneck to accelerating growth and the leading problem in labor markets. The seriousness of this constraint was confirmed by the survey re- sults, where the most important labor constraint was the availability of skilled workers. What is even more worrisome, the human resource constraint came in first place when entrepreneurs were asked an open ended question (a general question, with no multiple choice answers) on constraints to firms. The potential for productivity growth is hampered by: (i) education and health sector weaknesses and a surplus of largely unskilled labor; and (ii) the limited absorptive capacity of high-return sectors and firms' limited ability to adopt new technologies. A comprehensive review of the education and health sectors is contained in two recent World Bank reports - The Challenge of Poverty Alleviation (June 1994) and Decentralization and Community Education Strategy (December 1994) - and in the background documentation of two projects currently under preparation - a Basic Education Project and a Health Reform Project. To address this bottleneck, the authorities should continue ongoing efforts to: V ensure a growing supply of skilled labor through education sector reforms; v support private sector efforts to develop an active and comprehensive training policy; and / contribute to the quality and efficiency of the labor supply through health sector reforms. Lowering direct and indirect labor costs Decreasing and simplifying direct labor costs. Constraints include stratified minimum wages, excessive overtime premia and lack of productivity compensation. First, minimum wages are set by sector, economic activity, and crop (in agriculture). There is little economic justification for such a practice since there is little evidence of monopsony power or lack of mobility. Second, the wage differ- ential between the formal and the informal sectors suggests that the opportunity cost of leisure is low and thus that the hardship compensation for overtime (100 percent) and night shifts (25 percent) is excessive. The premia unreasonably raise economic costs and can have adverse substitution and scale effects. Third, while there are no legal obstacles to productivity-linked compensation schemes, they are generally absent in the private sector. 36 Chapter 1II To decrease and simplify direct labor costs the Government could: (i) unify minimum wages; (ii) set the minimum wage unit as the hourly rate, rather than the daily rate, to facilitate measurement, usage and accounting; and (iii) introduce productivity-linked compensation. There has been an apparent, al- beit imperfect, attempt at indexing the minimum wage since 1990, which should be discouraged. It has affected employment in the formal sector and in parts of agriculture. The emphasis should be on linking compensation with productivity gains. Higher real wages should follow. Decreasing non-wage labor costs. Non-wage labor costs are significant, particularly given the low quality of services provided from the proceeds of employment taxes. However, these costs are be- low the regional average. These non-wage costs are distortionary as they are assessed against the wage bill and encourage inefficient substitution between labor and capital. They can also have undesirable scale effects. The generally weak link between payments and expected benefits compounds the distor- tion. To decrease non-wage labor costs, overtime and night shift wage premia should be cut signifi- cantly. Premia of 50 percent for overtime and 15 percent for night shifts are common elsewhere. Eliminating the negative impact of public sector wages and employment policies. The most severe employment and wage distortions appear in the public sector, including: (i) human resource man- agement weaknesses; (ii) full job security granted to civil servants by the Civil Service Law; (iii) wage distortions created by the remuneration policy for public servants; (iv) shorter working hours than in the private sector (a 7.3-hour working day compared with 8 hours in the private sector); (v) overstaffing; (vi) lack of competitive procedures in recruitment; and (vii) lack of an incentive-based compensation system. The impact of these public sector wage and employment distortions on private sector development is multiple: the remuneration of public employees affects the level of wages paid by the private sector; the extent of overemployment and its cost has an impact on the fiscal burden borne by the private sector; and the quality and efficiency of public services affects the costs and productivity of private sector opera- tions. To address the negative impact of public sector wages and employment policies the Government should accelerate implementation of the on-going civil service reform, and in particular: (i) strengthen human resource management; (ii) revise the Civil Service Law so as to eliminate job security and bring daily working hours in line with the private sector; (iii) reduce overstaffing through incentives and volun- tary retirement programs; (iv) revise salary scales and introduce performance-linked compensation schemes, particularly in state enterprises; and (v) implement competitive and objective procedures for the selection, evaluation and promotion of public employees. Contracting flexibility and labor management relations Maintaining contracting flexibility. There are no major obstacles, legal or otherwise, to con- tracting or shedding labor and the cost-severance payments are relatively low by Latin American stan- dards. This conclusion was confirmed by the survey. Obstacles related to contracting inflexibility, labor management relations, labor regulations, and union activity were ranked the lowest among Latin Ameri- can countries surveyed to date. Some 14 percent of enterprises had unionized workers, concentrated primarily among construction firms and roughly correlated with size. However, only 6 percent had ex- perienced a strike in the last five years. Firing appears to be easy, and some 64 percent of enterprises reported having dismissed a worker in the last year for any reason. The process averaged about three days, depending on the enterprise's own policies. Labor turnover rates, while slightly lower than international standards, are reasonable and do not appear to show locking-in of employment. Furthermore, the data are for 1992-93, a period of significant growth of the kind usually characterized by lower than average turnover rates. As might have been ex- Improving Labor and Infrastructure 37 pected, turnover rates are higher for small firms (10.5 percent) than for larger ones (2.7 percent). This is the result of the lower separation costs - direct and indirect - of small firms. Indirect costs of separation arise from sunk training costs and potential labor strife costs, particularly in unionized firms. Both costs are higher for larger firms. The sectors with the highest turnover rates, agriculture and services, are those with the highest contracting flexibility, little training and minimal unionization. To some extent, voluntary training costs could be the major constraint to labor adjustment, since the poor quality of the labor force makes it difficult and costly to replace trained workers. Improving dispute resolution procedures. Effective procedures to resolve labor-management conflicts are even more important with the approval of reforms to the Labor Code (April 21, 1994) which will likely produce an increase in unionization. An increase in conflicts and disputes is therefore likely, which adds to the importance of effective conflict resolution procedures that diminish the likelihood and duration of strikes. Key areas are the limited use of oral procedures and the lack of compulsory media- tion. Oral procedures are used only when disputes are below 200 colones (about US$23). Otherwise, written proceedings are used, which are more costly and time consuming, and place and added burden on the court system. Moreover, the reformed Labor Code provides for mediation if demanded by one of the parties. Compulsory arbitration is possible only if demanded by both parties (except for essential serv- ices). Furthermore, arbitration and mediation are used only in collective conflict cases, not in individual conflict, which is unwarranted. In 1991 2,069 individual conflicts were registered compared with 26 collective conflict cases. More than half the individual cases ended up in court, thus clogging up the court system, increasing costs and causing unnecessary delays. To improve dispute resolution proce- dures the Government could: (i) expand the use of oral proceedings, allowing for exceptions; (ii) estab- lish a requirement for compulsory arbitration, beyond the essential services clause, with a legal right of appeal; and (iii) extend compulsory mediation and arbitration to individual conflict cases. MODERNIZING INFRASTRUCTURE Overview Mounting problem. El Salvador entered the 1990s with under-developed and under-maintained infrastructure, poorly adapted to the demands of a dynamic, export-led market economy. Telecommuni- cations, power, transport, water and waste services deteriorated during the civil war. Security expendi- tures crowded out spending on basic maintenance and investment, and acts of war heavily damaged the power and transport networks. The wartime economy was also marked by strong state intervention in the pricing and delivery of services. Energy, telecommunications and water were merged into vertically- integrated, state-owned monopolies. Regulatory and executive functions were not clearly separated, and worse, the companies performed both but were not responsible for either. Rate-setting, investment deci- sions, procurement, financial oversight, and other key responsibilities were diffused across many institu- tions. Large numbers of surplus employees were hired. Competition in service provision was minimal, with little private participation. Prices were not adjusted for two decades, and then only for inflation or devaluation. With the exception of the lucrative telecommunications monopoly, the utility companies became dependent on ever larger government bail-outs. By the war's end, the Government was saddled with a daunting backlog of maintenance and investment, which translated into large unmet demand and frequent interruptions of service (Table 111.1). 38 Chapter HI1 Table 111.1 Telecommunications, Road and Power Infrastructure in the region, 1992 Td-Tep l wio i nmaho ' 'le ctri.l geneain y acitypidEleridt i p tIon oomnectxms w km' I ____ e 00p. w in w per 100 pop, Central America Costa Rica 364,100 11.8 5,600 2.00 1,009,000 33 4,109 132,600 a d..04 :3.9 < 19936. . 0A37. 697,900 13 2,382 44,970 Guatemala 231,100 2.3 3,485 0.38 769,000 8 2,822 28,090 Honduas 117,100 2.2 2,400 0.47 540,500 10 2,315 44,090 Nicaragua 66,800 2.1 427,000 13 1,616 49,840 Panama 265,500 1I1 2,360 0.98 956,200 40 3,030 126,220 Mexico 6,753,700 75 82,022 0.95 29,274,000 34 122,482 142,090 Notes: Paved roads figures are from 1992 for El Salvador, and 1990 for alI other countries. Electricity generation and production figures are from 1990 for the U.S. and Mexico. Source: World Development Report 1994, ANTEL, CEL, Ministerio Obras Publicas El Salvador. The view from the private sector. Deficiencies in the quality and quantity of infrastructure continue to hamper private sector growth, according to the survey, particularly the relative severity of telecommunications, highway and power problems. Not only did they top the list of infrastructure- related concerns for the sample as a whole, but they were the uppermost infrastructure concerns of im- portant groups of firms: industrial and commerce, large and medium-sized, export-oriented and non- exporting, and those in San Salvador where one quarter of the country's population resides. Exporting firms are bothered most by the poor condition of the highways. Moreover, developers of Free Trade Zones reported serious delays in obtaining sites, telephone, power and water services. Infrastructure provision: approaches and lessons of experience The Government recognizes that poor performance of state-owned enterprises is largely respon- sible for infrastructure bottlenecks, lagging investment and unmet demand, and the lack of access of the poor; that technological change and advances in applied economics have stripped some infrastructure monopolies of their "naturalness," lowering barriers to entry and subjecting sectors to competition, if not in the market, then for the market; and that good economic regulation of natural monopolies can promote economic welfare and afford investors and consumers sufficient protection against potential abuses. The Govemment also recognizes practical constraints. The scale of investment required to satisfy pent-up demand, let alone support an export-led growth strategy, is far beyond its financial capacity. Significant private investment, foreign and domestic, will have to be mobilized to close the infrastructure gap. The success of the export-led growth strategy will hinge partly on closing this gap. Surveys of multinationals often cite infrastructure quality as one of the most critical factors in influencing decisions on the location of investments in manufacturing and high-technology sectors. As the Government reassesses its role in each infrastructure sector, it is useful to frame the analysis with four broad considerations: t* whether a service is publicly or privately owned and managed, it should be run on a commercial ba- sis with prices covering costs, and any subsidies, provided directly and transparently; * creating a market structure that maximizes opportunities for competition is critical; * as non-competitive elements are unbundled from competitive or potentially-competitive ones, as a rule, the forner will require continuing oversight or regulation to protect investors and consumers from abuses. While the form of regulation will depend on a country's institutional endowment, it should ideally be organized at arm's length from the Government, and operate under rules that are clear, expeditious, credible, and stable; and Improving Labor and Infrastructure 39 Q a growing body of research and recent Latin American experience suggest that private ownership and management are most effective in locking in gains from commercialization and competition. Seizing opportunities: general recommendations The legacy of the 1980s has been highly negative for infrastructure. The Government must overcome the huge backlog of maintenance and investment in order to improve the quantity and quality of infrastructure while, at the same time, transforming the role of the state and inviting the private sector to become a new partner in these activities. This change in the relationship between the state and the private sector is, indeed, the only way to address the needs for increased management skills and finance. The foundation for this transformation has been established and some steps, e.g., in power, have been taken. The agenda of policy and institutionil change in each infrastructure sector involves: / revising the basic legal framework of governance, to separate the policy-making and regulatory functions of government (national, subnational, or municipal) from the operational functions, and clearly define responsibilities for all public and private entities involved in the sector; / reforming market structures within sectors (breaking down the vertically integrated entities), to unbundle truly natural monopoly components from competitive or potentially competitive activities- thereby permitting competition both in andfor market segments; 'V articulating in detail the new government role in regulation, which involves: (i) for natural mo- nopolies defining regulatory policies to protect investors and the public interest, stipulated in statutes or contracts between public and private entities; and (ii) creating institutional mechanisms and im- plementation capacity to carry out this regulatory function. A key will be to ensure a politically in- dependent approach for tariffpolicy based on sound economic and financial criteria; ' specifying the financial role of government. (i) the subsidy policy, if any, that is justified to com- pensate operators for non-remunerative but essential services; any subsidies transferred directly to target groups need to be identified and financed; (ii) in activities where the State will retain a signifi- cant role, (e.g., non-toll roads) a secure institutional framework is needed to ensure financing of maintenance and accountability to users (e.g., a road board funded by road user charges); ' promoting private sector participation in the reformed system, which may require proactive sup- port for at least a transitional period. At a minimum, there is a need to create a transparent, stream- lined process of contract design, competitive bidding, and screening/approval of transactions; ensur- ing that new entrants compete fairly with incumbent operators; and removing constraints to competi- tion, such as limited access to market information. 'V in those activities which remain, transitionally or for the longer termn, under public ownership and operation - such as (in most countries) the transmission of power and the main road network - re- structuring of the responsible entity is needed to create incentives for efficient, commercial op- eration and to permit even limited private sector involvement, such as through contracting-out serv- ices or management. This restructuring may require corporatization, downsizing, decentraliza-tion, and improvement of financial and management information systems. These six broad categories of policy and institutional reforms are not a chronological sequence, although most countries begin with the first and the last; each step is mutually reinforcing and needs to progress in concert. However, the full agenda is enormously demanding to countries with limited institutional capacity and each country has to find its own pace and sequence. Moreover, there is a range of choices regarding strategies and organizations to meet reform objectives. International experience suggests two clear lessons, with special significance for countries with limited institutional capacity such as El Salvador: (i) choices which allow greater scope for competition provide stronger incentives for 40 Chapter III good performance, while reducing regulatory requirements; and (ii) allowing extensive private participation (in management, financing, and ownership) - in ways that permit it to absorb risks as well as the rewards of good performance - improve the prospects for successful outcomes. Telecommunications Structure. Since 1963, the state-owned company, Administraci6n Nacional de Telecomunica- ciones (ANTEL), has been the sole provider of basic telephone service, with the power to license or grant concessions for value-added services. In recent years, ANTEL has allowed private operators to offer value-added services, although competition remains weak. A cellular operator was granted a five-year concession and by 1994 had 1,500 subscribers. Its charges are high by international standards: firms paid US$1,000 for a connection and 35 cents a minute in 1993, compared, for example, with only US$100 and 16 cents a minute in Sri Lanka, where there are four licensed operators. Data transmission facilities have been leased to a private operator, with three to four more leases to be negotiated soon. A paging service has also been licensed. Performance. El Salvador's telecommunications sector has been among the weakest in Latin America. In 1989 there were just 2.9 lines per 100 inhabitants, which compared favorably only with the poorer neighboring countries of Nicaragua (1.2), Honduras (1.9) and Guatemala (2.2). Network expan- sion, though, lagged even these neighbors. In 1981-91, the network grew 5.9 percent annually compared with 11.4 percent in Honduras and 7.5 percent in Guatemala. As a result, El Salvador had by 1992 the longest waiting list for telephone lines in Central America. Many of the sector's weaknesses are due to the inefficiency of ANTEL. In 1989, it operated with fewer lines per employee (22) than all Central American carriers, except Nicaragua (16). Unrelated activities have yet to be contracted out or sold off, including a hospital, and furniture and construction companies. About 10 percent of ANTEL's 7,052 employees in 1992 were employed in health and security, and over 17 percent were working in non- economic rural offices, some of which generate only 20 colones (US$2.3) a month in revenue. Like many monopoly carriers, ANTEL generates large revenues for the general budget. It posted earnings of 500 million colones (US$57.8 million) in 1993. But 87 percent of its revenues come from expensive international calls, which in 1991 were 22 to 34 percent more expensive than in other coun- tries in the region. Were the company subjected to greater competition, its sterling financial record would tarnish quickly. Basic telephone rates were not increased for 20 years, and adjustments are made ad hoc to meet cash needs and political objectives. The under-investment that has plagued the sector owes much to recurring government interference. On the strength of its profits the company could have borrowed on capital markets, but it was not permitted to do so. Since 1989, the company has managed with donor support, to upgrade and expand the network. The number of lines doubled to 302,492, or 5.5 lines per 100 inhabitants. About two-thirds of the lines are now digital, and San Salvador has a fiber op- tic network. But demand for services is racing ahead of supply: the waiting list for lines increased from 162,000 in 1992 to 200,000. ANTEL estimates that by the year 2000 the number of lines would have to rise by 90 percent to catch up on the backlog of orders and accommodate private sector needs. Reform. Besides stepping up investment, ANTEL's management and the Government have in- troduced measures since 1989 to increase efficiency. One-time improvements in productivity were achieved partly by cutting staff by about 14 percent over the past three years. Repair response time similarly improved: 90 percent of down lines are now repaired within four days. In addition, ANTEL recently developed a restructuring plan that would divest many non-core activities and public works contracts are increasingly bid out to the private sector. The implementation of turn-key projects by the private sector has helped reduce the project cycle. Time needed for feasibility studies has fallen from 36 to 18 months, and construction from 24 to 18 months. Finally, with IDB support, a review of the legal Improving Labor and Infrastructure 41 and institutional framework was completed in February 1994, and with World Bank technical assistance, an action plan was completed in July 1994 for the reform of key public enterprises including ANTEL. Deepening reform. Modernizing the communications system is critical to the country's export- led growth strategy. It will require large investments in expansion of the basic network; sufficient supply of high-quality fax, data transfer, packet switching, cellular, and other services essential to modern commerce; competition in service delivery to keep prices down; and a regulatory function - clearly sepa- rated from telecommunications operations - with responsibility for protecting investors and consumers. These investment requirements can only be met by attracting significant private participation which will require that a clear and credible regulatory regime for entry and prices be established. Power Structure. All planning, regulatory and executive functions are vested in the Comisi6n Ejecu- tiva del Rio Lempa (CEL), a state monopoly. Almost all electric power for public services is generated by CEL (there is a very small amnount of self generation), which sells the bulk of its electricity to distri- bution companies and the remainder to large end-users. In the past, the distribution of electricity (except for rural areas) was in the hands of the private sector through concessions. These expired in 1986, how- ever, and since then four of the seven distribution companies have been under the administration of CEL. The Electric Power Company of El Salvador, formerly one of the private distributors but now controlled by CEL, distributes electricity in the capital area. Performance. The degree of electrification in El Salvador is low compared to that of other Latin American countries, although access to electricity has increased from 33 percent in 1980 to 61 per- cent in 1993. Power interruption and voltage irregularities were among the most severe constraints cited in the survey. Although outages have subsided in the past two years, one-third of the survey firms had their own generating capacity, most likely in response to the uncertain power supply. Among large en- terprises, 55 percent had their own capacity. During the 1980s CEL entered into a period of prolonged decline. During the civil war there were over 2,000 attacks on substations and 3,800 on the transmission system costing CEL about US$200 million. Moreover, during the last decade there was significant gov- ernment intervention in setting tariffs. Rates were not based on economic criteria, and CEL was not al- lowed to make automatic adjustments for inflation, devaluation or other cost increases. By the end of the decade the average tariff was 33 percent of long run marginal cost (LRMC). In the early 1990s a pro- longed drought required CEL to purchase energy from Guatemala and to increase fuel purchases to sub- stitute for hydro power. These events strained the already weakened capacity of CEL, and as a conse- quence power interruptions and voltage fluctuations became frequent. Although, the situation is improv- ing, the capacity of CEL to meet demand is inadequate. Demand grew by about 10 percent p.a. during 1991-93 immediately following the peace accord, and is expected to grow at 9 percent p.a. through the end of the decade. The power sector now faces an enormous backlog of investment. Reform. The power sector has been a high Government priority and significant progress has been achieved. In May 1991 the Govemment adopted an Energy Sector Policy consistent with an open, market-based economy. It set four objectives: (i) an appropriate legal and institutional framework; (ii) adoption of pricing policies based on economic costs; (iii) significant private sector participation; and (iv) establishment of an institutional and policy framework to address environmental issues. A package of energy legislation establishing planning and regulatory agencies, a framework for power tariffs and a corporatized CEL has been submitted to the Assembly. The first independent power generation project (80 MW) was announced in October 1993. The Government has also decided to re-privatize power dis- tribution. CEL's efficiency has been high in spite of the events of the last decade. Compared to other Central American countries, CEL has the highest number of customers per employee and ranks second in 42 Chapter III energy sales per employee. A tariff increase of 32 percent was applied in late 1992, and the Government has further committed to reach 85 percent of LRMC by 1996 and 100 percent by 1999. Deepening reform. The critical next step is to establish a track record of implementation of the necessary policy and institutional reforms. Significant additional tariff increases are required to reach the 85 percent of LRMC goal in 1996. New concessions need to be granted for private power distributors. Additional independent power projects are planned for 1995 (80 MW) and 1997 (50 MW). Implicit in the new structure of the sector is a re-shaped role for CEL, partitioned between generation and transmission, with each organized as an independent commercial enterprise. In the future CEL-Generation would gen- erate power, buy it from independent power producers through power purchase arrangements, or com- pete directly with them to supply energy to large consumers or distribution companies. CEL- Transmission would retain its central role in power transmission but would be established as an inde- pendent company and guarantee open access to generators. CEL's current activities in urban power dis- tribution would effectively cease with the sale of its current franchises to private operators. Roads Structure. The Ministry of Public Works (MOP) is responsible for the transport sector. The Vice Ministry of Public Works is responsible for highway maintenance, rehabilitation and construction, through the Direcci6n General de Caminos (national roads) and Direccion de Urbanismo y Arquitectura (urban roads). Municipalities have responsibility for portions of the urban road network. Performance. El Salvador has approximately 12,400 kms of roads: (i) 1,936 kms paved with 38 percent in bad condition, 30 percent in fair condition, and 32 percent in good conditions; (ii) 7,890 kms unpaved with 57 percent in bad condition, 31 percent in fair condition, 12 percent in good condition (iii) 112 kms in San Salvador (fair to good condition); and (iv) other municipalities, 2,474 kms in generally bad condition. The primary road network consists of two East-West axes, the Panamerican Highway and the Coastal Highway, and four North-South axes. Supply of roads and highways is sufficient, except for rural penetration roads in the ex-conflict areas. However, deficiencies in the transport sector were the most severe infrastructure constraint noted in the survey. Maintenance suffers from under-execution and inefficiencies and salaries and benefits comprise about 80 percent of the road maintenance budget. Reform. A Vice Ministry of Transport has recently been established to direct and coordinate policy. It will assume functions that were previously handled by other ministries (transport regulation, user fees and tolls), eventually becoming the transport regulatory authority. In parallel a number of regulatory actions have been taken (establishing weight limits and facilitating border crossings), and a number of institutional changes in MOP have been initiated. Staff levels in the MOP have been reduced significantly, particularly in the Direccion General de Caminos. Deepening reform. Improving the quality of existing roads through increased maintenance, re- habilitation and modernization is the principal challenge. MOP has prepared a five year rehabilitation and maintenance plan but it must secure budget allocations for road maintenance over the long term. Funds are assigned to MOP as part of the central government's budget process, based on last year's level of expenditures with no analysis or evaluation of programs. Moreover, there is a bias toward external funds which, however, are for discrete programs with defined time frames. Ideally they can supplement but not substitute for long term road maintenance funds. Improving Labor and Infrastructure 43 Ports and Rail Structure. The Comisi6n Ejecutiva Portuaria Aut6noma (CEPA) has responsibility for the ports of Acajutla and Cutuco, the state owned railroad and the airport. CEPA was created in 1952 to manage Acajutla, and added responsibilities during the 1970s. Planning, regulatory and executive func- tions are vested in CEPA, although with significant intervention from line ministries. Performance. Acajutla is an open access port on the Pacific Coast about 85 kms southwest of San Salvador. It has capacity for about 1,500 million metric tons, and is close to reaching that level, with total traffic of about 1,300 million metric tons in 1993. Cutuco, also on the Pacific coast about 185 kms from San Salvador, handled 50,00 tons in 1991, one-fifth of its 1978 traffic level. The railroad is se- verely deteriorated with 50 percent of its sleepers damaged. Rolling stock is in a similarly deteriorated state. CEPA estimates that only 2 percent of the nation's cargo traffic moves by rail. The airport dates from 1978, has a small role in exporting (about I percent of all exports), but is increasingly important in non-traditional exports. CEPA is relatively stable financially. It earns a modest profit due to airport op- erations, while the railroad loses money and the ports break even. Acajutla suffers from labor and op- erational problems, which leads to a lack of competitiveness with some other Central American ports. Labor concessions in the 1980s have led to a salary structure and work rules that are increasingly con- straining CEPA's competitiveness. The most important competition is from Puerto Queztal in Guate- mala. Additionally the lack of maintenance and investment during the 1980s created a backlog at Aca- jutla that is slowly being addressed by CEPA. Cutuco has limited installations, is only accessible by rail- road, and must compete with the nearby privately owned port of Punta Gorda. Reform. The Government has initiated a number of changes and is actively exploring privatiza- tion options, including granting operating concessions, divesting storage facilities and contracting out maintenance. CEPA has improved its financial situation through tariff increases and has taken steps to reduce personnel at Acajutla by about half (650 out of 1,400 workers). Deepening reform. Although CEPA has achieved financial stability and is improving effi- ciency, it faces a number of strategic issues. It must recover traffic lost during the civil war and com- pete, in price and services, with Central American ports. This will require greater private sector partici- pation, and the transformation of CEPA into a regulatory authority. Water and Sanitation Structure. The Administraci6n Nacional de Acueductos y Alcantarillados (ANDA) is the prin- cipal water and sanitation institution, but responsibilities are spread across many institutions. Wa- ter/sanitation production and distribution is split between ANDA for most urban systems, some munici- palities, and the Ministry of Health for rural systems. The Social Investment Fund (FIS) also participates in the construction of rural systems. Performance. All water produced in El Salvador is sub-surface. For the most part rivers and lakes are too contaminated for use. Water coverage was 55 percent in 1992, of which 78 percent was urban and 16 percent rural. Sanitation coverage was 69 percent, of which 87 percent was urban and 52 percent latrines. There are ten waste water treatment plants but these handle only 3 percent of produc- tion. Demand is projected to grow at 4 percent p.a. through the end of the decade. To reach 100 percent coverage in the municipalities covered by ANDA, investments on the order of US$150 million p.a. would be needed over the next five years. Losses are estimated at 40 percent and service is intermittent. In San Salvador it was estimated in 1993 that users received water about 16-18 hours per day. Of the 44 Chapter III 350,000 connections, about two-thirds have working meters. ANDA's financial problems are largely the result of the tariff structure, as well as weaknesses in its billing and collection systems. Reform. Some initial steps have been taken toward sectoral reform. A draft diagnostic study of the water/sanitation sector has been prepared and new draft legislation is currently under review. In the last five years ANDA has been able to improve its financial situation. Operating losses have been re- duced by about two-thirds, and the overall deficit by about one-third. Tariff increases in 1990 and 1992 contributed to the improved financial performance. Deepening reform. The Government must implement tariff reform, and address simultaneously the rehabilitation and expansion of production and distribution systems. Establishment of planning and regulatory agencies is essential. The Govemment lacks a water resources strategy and policies for con- servation and usage. Too little attention is given to environmental issues, especially in view of the de- cline in aquifers and the low coverage of waste water. The institutional framework is disjointed, and there is a multiplicity of institutions operating in an uncoordinated and ineffective fashion. CHAPTER IV MODERNIZING THE LEGAL AND REGULA TORY FRAMEWORK Laws and regulations and their proper enforcement are essential in facilitating competitive markets and defining the rules of the game. Uniform and clear interpretation of the laws leads to lower transaction costs and increased economic activity. In El Salvador many business laws are outdated and impose burdensome requirements, mainly related to the conditions for doing business (commercial code, foreign investment law, bankruptcy law, and competition law). To a lesser extent, laws related to property rights and the mechanism of their transfer (contracts) could benefit from revision. Poor application and enforcement also adversely affects private sector activities. To improve international competitiveness and increase economic activity and private sector development, the legal and regulatory framework needs to be revised. Reforms should focus on: establishing and securing property rights; improving contract law; facilitating company entry, operation, and exit; strengthening competition policy and consumer protection; eliminating tax distortions and disincentives; and improving enforcement capacity and judicial institutions. ESTABLISHING AND SECURING PROPERTYRIGHTS Real property. Property rights over land and other durable goods should be secure so as to allow them to be used as credit collateral and encourage land owners to make investments. This is achieved through effective real property registration systems. Property rights are well defined in El Salvador and the only limits on ownership are for rural real property exceeding 245 hectares. However, there are issues related to backlogged and inefficient registration, and lengthy resolution of conflicts. The Registry of Real Property (Registro de la Propriedad Raiz e Hipotecas [RPRH]), a department of the Ministry of Justice, records all rights and real property contracts. Registration is manual and in some cases can take more than a year. In addition, the process of securing information is lengthy and unreliable, mostly due to inconsistencies between cadastre (handled by the Instituto Geografico Nacional [IGNI a Directorate of the Ministry of Public Works) and land registry information. The Government is currently initiating a pilot program in Sonsonate, with World Bank support, to improve the land registry and cadastre services. Currently any land conflict must be resolved in Court; the Govemment, is preparing proposals for alternative dispute resolution methods to solve conflicts related to registration and cadastral matters. To modernize and improve the efficiency of RPRH: (i) combine land registry and cadastre information in single records in one institution under the Ministry of Justice; (ii) carry out a national area-based land registry and cadastral updating; (iii) computerize and decentralize data to facilitate access; and (iv) develop and implement alternative extra- judicial dispute resolution methods. Intellectual property rights. Effective protection of intellectual property rights (IPR) (patents, trademarks, copyrights) is essential for technological innovation and technology transfer. Registration and filing are usual prerequisites for acquiring, transferring and protecting a right. A revised IPR law was enacted in August 1993, but institutional and enforcement shortcomings still exist. Trademark and copyright piracy is a serious problem (there is not much experience of patents), which discourages national and foreign investors. More specifically, IPR protection is handicapped by delays in registration and weak enforcement. The Registro de Comercio is excessively slow: up to 3 years to register a trademark and up to 5 years to file a patent. As of early 1994, there was a backlog of almost 2,000 unregistered trademarks with only three people processing them. Penalties for IPR infringement are not large. In copyright cases, criminal penalties are greater than civil ones, but fines are not a strong 46 deterrent. Furthermore, the aggrieved parties have to seek protection through the courts, which is slow and inefficient. Litigation involves sophisticated issues, where the poor training of the judiciary leads to unpredictable outcomes and lengthy delays. To fight piracy and to improve IPR protection: (i) increase the fee for the filing of a patent, trademark, or copyright to finance office technology upgrading and additional staff; (ii) combine civil (filing claims) and ex-officio enforcement by the Competition Policies Agency; (iii) create a specialized administrative agency to register, supervise and police the market, which could also act as the administrative forum (at least of first instance) for the adjudication of claims; (iv) provide for regional offices; and (v) revise legal remedies and set stricter penalties. IMPROVING CONTRACTLAW Contracts set business rules between parties and provide the mechanism for transferring property rights. In El Salvador contract law is contained in the Civil Code. Contract rules do not appear to impose limitations on contracting, although the relevant Civil Code provisions date from 1860. However, there is a need to better define: (i) extra-contractual responsibilities, which are narrow and outdated in comparison with real-life claims; and (ii) guidelines for calculation of damages (which are non-existent). Although assessing extra-contractual claims is always complicated and can be arbitrary, guidelines should be developed to make court awards more predictable. FACILITA TING COMPANY ENTRY, OPERA TION, AND EXIT Registration process. Entry appears to be reasonably free, although it is time consuming and costly. Currently 14 laws regulate the registration process, which requires 16 forms to be submitted and 32 visits to different institutions. This makes the process slow, complex, costly and constitutes a disincentive to formalize. Mandatory steps take approximately 40 days while additional special ones take approximately one week. Registration time and costs are not high when compared to other Latin American countries that have not reformed the registry process, but are quite high when compared to countries that have done so (Chile, Colombia, Uruguay and Peru). To address this constraint a one-stop-window (Proyeclo de la Ventanilla Unica) administered by the Oficina Nacional de Inversiones (ONI) began to operate in mid-1994. Originally envisaged to facilitate foreign investment, ONI also handles domestic investors. It is expected to significantly streamline registration since it encompasses the whole process and nullifies any legal inconsistencies. However, a number of additional steps should be considered: E centralize the institutional structure: ONI was conceived as a department of the Ministry of Economy (MOE) to assume full responsibility for all registration of national and foreign investment and reduce duplication. In that event, registration at the Registro de Comercio (RDC - under the Ministry of Justice) would have been eliminated. However, it appears that ONI will start functioning under the MOE and will transfer all documents to the Ministry of Justice. This will relieve the investor from having to visit different offices but will not change core procedures; > assess the purpose and value of remaining steps: while the one-stop-window has accelerated the approval process the number of steps remains the same. There is still room to streamline registration by eliminating unnecessary steps. The requirements imposed by the 1973 Ley de Registro de Comercio and the 1973 Ley de la Superintendencia de Sociedades y Empresas Mercantiles, sometimes include the submission of the same documents to different authorities. For example, one authorization permit is needed from the RDC qualifying the businessman (with a copy to the Superintendencia), and another for the company and each of its locations. In addition, many Modernizing the Legal and Regulatory Framework 47 requirements set in the Superintendencia de Sociedades (SS) are outdated and need to be revised. For example, a company with assets equivalent to 10,000 colones (US$1,200) needs to have its accounting system authorized before it can start operations; and '* further streamline microenterprise registration: microenterprises are subject to procedures similar to those that apply to other enterprises. For example, all enterprises including microenterprises need to renew their operation permits annually at the RDC by submitting their balance sheets. To further simplify and speed the registration process: (i) promote the autonomy of MOE in the ONI project, making it solely responsible for registration; (ii) reduce or eliminate the notification/publication requirement; (iii) enact simplified rules for the registration of microenterprises, setting a 'one-stop, one-day' window for their registration, as successfully used in Peru; (iv) computerize RDC; and (v) institute time limitations for licenses and other approvals. Supervision of companies. The SS has a national staff of 17 auditors and two desktop computers. In addition to the workload from San Salvador, it also deals with documents from all regional offices, which simply receive documents and do not act. To strengthen the supervision of companies: (i) create one entity to register and supervise; (ii) replace a priori controls with ex post verification by a strong and competent authority. For example, the accounting system needs to be authorized by SS and legalized by RDC, which could be replaced by strict ex post verification; (iii) provide SS with resources to assume a more dynamic role in information and supervision; and (iv) strengthen regional offices. Commercial Code provisions. A number of unnecessary procedures in the Commercial Code should be eliminated, such as: (i) to renew operating permits, all firms have to submit balance sheets and performance results annually, whether they are microenterprises or incorporated societies; (ii) all installment contracts for the sale of movable durables have to be registered; (iii) all credit contracts for production (quite broadly defined) have to be registered; (iv) there are unwarranted restrictions on the maximum term for production credit contracts (Art. 1149); (v) there is an urgent need to revise and simplify the list of items subject to the Commercial Registry (Arts. 3-7, Chapter II, Commercial Registry Law), which are mostly unneccesary; and (vi) similar unnecessary burdens appear in a number of other areas such as the Solvencias Municipales, health permits for foodstuff producers, and the requirement that VAT filings be signed and submitted only by the head of the company. To simplify the Commercial Code: (i) require renewal of annual operation permits only by incorporated enterprises that have a fiduciary responsibility to their shareholders. All other companies should submit documents every five years, with the exception of microenterprises, which should be exempt; (ii) set a threshold to exempt goods from the sale registry; and (iii) eliminate unnecessary procedures and restrictions built into the Commercial Code and Commercial Registry. A small Comite de Desburocratizaci6n should be set-up with responsibility for eliminating unnecessary procedures, and consolidating the remainder (as used in Uruguay with great success and at a very low cost). It should ask the private sector for suggestions for the reduction of investigation costs. Foreign investment rules. Foreign investors still face a number of procedural and structural entry barriers, and a number of sectoral restrictions,' although a more liberal foreign investment regulation was enacted in 1988. In addition to the requirements described above for Salvadoran companies, a foreign company needs to be registered with MOE.2 The company has to prove I The Constitution prohibits FDI in rural real property; certain fishing activities; and "small" commerce, industry, and services. 2 Registration of foreign investment is not mandatory. However, in practice most foreign investors register in order to be eligible for tax credits for dividends and reinvested profits, and to be able to remit dividends and repatriate capital. 48 compliance with the minimum capital requirements for foreign investment, and SS has discretion in establishing the minimum capital of the foreign company, which can be higher but not lower than the amount imposed by the law. Once authorization has been obtained from the Ministry of Justice in the form of an executive agreement, it has to be legalized by the Ministry of Foreign Affairs and registered at the Commercial Registry. Another license for commerce and industry has to be obtained from the Commercial Registry, which seems to overlap with the authorization referred to above. Requirements are even more onerous for the establishment of a foreign subsidiary. In addition, the FDI legal regime does not provide guarantees relating to national treatment and protection against expropriation. The Law should be amended to: (i) modify the onerous provisions of the SS and the LRC; (ii) eliminate the SS foreign investment requirement - and its discretion - defining minimum capital; and (iii) reduce to one the authorizations required by the Ministry of Justice and the Commercial Registry. Exit: bankruptcy and liquidation. Fast and efficient bankruptcy proceedings are an important mechanism to protect creditors and facilitate the reallocation of resources. The key objective is to maximize the value of assets under bankruptcy through reorganization or liquidation. In El Salvador bankruptcy proceedings are cumbersome and practically never used. They are set in the 1973 Ley de Procedimientos Mercantiles, which is drafted in the spirit that companies will resist going out of business. On the one hand, going out of business is considered more difficult than entering the market; even companies in great financial distress prefer abandoning the company to filing for bankruptcy. On the other hand, creditors prefer to execute their secured rights through the courts rather than initiate bankruptcy proceedings. Thus, all creditors require first mortgages to secure credits. Proceedings are lengthy and there are no alternatives to judicial declaration of bankruptcy, such as extra-judicial declaration and reorganization. Additional constraints include: (i) costly procedures; (ii) criminal implications of bankruptcy if debts are not paid; and (iii) insufficient processing capacity and expertise in the court system. To provide guarantees to creditors for the protection of their rights, as well as to allow flexible allocation of resources, the law should be revised to: (i) allow for speedy proceedings by imposing time limits at different stages; and (ii) introduce alternatives for defaulting debtors, offering flexibility to insolvent companies. Business reorganization would allow continued operation under court supervision - if there was hope of recovery - until a reorganization plan was approved by creditors. STRENGTHENING COMPETITION POLICYAND CONSUMER PROTECTION Unfair competition appears to be a serious problem in El Salvador. Survey results show that 59 percent of firms experienced problems with informal or illegal competition. It was most common in commerce, where 74 percent of firms identified the problem. The key concerns where: evasion of the VAT and other taxes; firms selling below cost; avoidance of trade and customs regulations; avoidance of labor regulations and taxes; and anti-competitive practices. A Consumer Protection Law was enacted in 1992, but questions remain on its focus and enforcement. Article 110 of the Constitution prohibits monopolistic practices, but there is no complementary enacted law or enforcement of any sort against that kind of practice. There is a need for a comprehensive antitrust policy and for its proper enforcement: Q price fixing and other agreements, cartels and geographical market segmentation: examples appear in: beer, advertising agencies, radio and TV, airlines, pharmacies, hardware stores, financial institutions, hotels, milk, and distribution of basic products. The welfare loss from collusive practices can be quite significant, yet no effort is being made to discourage or punish them. The legislation in this area is deficient and needs revisions; Modernizing the Legal and Regulatory Framework 49 * smuggling, and tax and social security (ISSS) payments evasion: the loss of economic activity caused by smuggling is quite significant in some sectors (shoes, textiles, liquor, cigarettes and some durable goods). Tax and ISSS payments evasion provide an unfair competitive advantage by lowering the costs of the offenders relative to those of the compliers, and increases the fiscal burden on the tax compliers. Apparently a number of firms, while registered, do not pay ISSS taxes; and r* procurement and government contracts: while improvements have been achieved, there are apparently valid complains of more than occasional lack of transparency and competitive bidding. The Government should enact a modern competition policy and antitrust law addressing monopolistic practices and restraints of trade agreements. It should treat any agreement among competitors as illegal per se, as well as some vertical restrictions such as tie-ins and resale price maintenance. Other anti-competitive practices should be treated under the rule of reason. In addition, although the Consumer Protection Law is adequate, it should be streamlined and the focus sharpened as a secondary priority. To strengthen enforcement, the Government should create an autonomous enforcement agency with investigative and judicial powers, albeit in separate commissions and in parallel to the proposed new competition legislation. The present Direcci6n General de Protecci6n al Consumidor could be restructured into this type of agency, with jurisdiction over both activities. In fact, it would be desirable to have a single agency responsible for enforcing antitrust, consumer protection and intellectual property law and trade policies. It could be modeled along the lines of the Peruvian INDECOPY agency. The complementarity among these themes and the scarcity of qualified staff would make such institutional arrangement ideal, capturing synergism and enhancing on-the-job learning. The main focus should shift from consumer protection to agreements of all types among competitors and restraint of trade issues, where welfare losses are larger. It should also increase efforts by agencies dealing with smuggling and tax evasion, increase penalties, and improve the inspection system. ELIMINA TING TAX DISTORTIONS AND DISINCENTIVES, Addressing distorted incentives. The 1992 income tax law has simplified company income taxation and eliminated some of the allocative distortions of the previous statute. Additional steps should be taken to eliminate the differentiations in treatment of various types of financial instruments, with respect to each other, or with respect to other forms of income. Currently: (i) interest from Government and Central Bank bonds is exempt from taxes, which introduces a tax wedge between public and private debt instruments, and the existence of taxable and tax exempt private bonds discriminates between private institutions; (ii) income from loans made by foreign-based banks is exempt from taxes, while income from loans by national banks is subject to income tax; and (iii) all financial instruments traded in the stock exchange and held by persons are tax exempt. This discriminates in favor of the stock exchange and against other financial institutions. In addition, eliminate VArs differential treatment of the stock exchange and commercial banks. The latter are exempt from levying the VAT on the fees associated with lending to a corporation. In contrast, the sale of a corporate bond in the stock exchange gives rise to a VAT on the commission charged, raising borrowing costs through the stock exchange relative to commercial banks. Controlling unfair competition. Evasion of the three major taxes - the VAT, customs, and the income tax - and of employment taxes are stated to prevail in all sectors. Evasion is singled out as a 3 As discussed in Chapter II, the tax system rests on income taxes (personal and corporate), import duties, and VAT. Businesses also pay employment taxes and municipal taxes. The former consist of social security contributions of 7.5 percent, contributions to the social housing fund of 5 percent, and professional training institute charges of I percent. The cost of labor is thereby raised by 13.5 percent, assuming these labor charges are absorbed by the employer and not shifted back onto wages and salaries. Municipal taxes are levied on the assets of the corporations and are a deductible cost. In 1992 they were estimated to amount to around 28 million colones which represent about 4 percent of the corporate income tax yield of that year. so significant factor especially in trade (particularly at the retail level), but also in industry, and for all sizes of enterprises. Some firms evade the income tax by simply not registering which also leads to non- compliance with payroll taxes. The evasion of the VAT and customs duties is singled out particularly in the leather goods industry, pharmaceutical products, and in machinery and equipment (especially electronic appliances). Smuggling of imported goods apparently continues to prevail despite the reductions in tariffs. To control unfair competition and corruption the Government should consider: (i) easing the administrative process; reducing the need to resort to higher echelons; eliminating corruption in the tax and legal systems through civil service reform; (ii) reducing smuggling; and (iii) reforming and strengthening municipal tax administration. Diminishing compliance costs. Administrative procedures are deemed burdensome, but especially in VAT and tax and customs administration. Although the VAT is assumed to finally rest on the final consumer and, therefore, is not a direct cost for businesses, it carries relatively high compliance costs, since it involves sophisticated book-keeping and a great number of transactions in recording debits and credits. In addition, the fiscal credit of the VAT should legally be refunded within 3 months but takes longer than a year. Finally, tax and customs administration is heavily bureaucratic, complicated, and time consuming, hence costly. The administrative system contains a number of loopholes which make it inefficient and leave room for evasion and corruption. Its modernization is a top priority. To diminish compliance costs the Government should: (i) streamline regulations and simplify and expedite procedures, particularly payments and refunds; (ii) implement cross-referencing; (ii) improve customs administration; and (iii) consider the privatization of customs administration to reduce corruption and broaden the tax base. IMPROVING ENFORCEMENT CAPACITY AND JUDICIAL INSTITUTIONS Addressing court-related issues. For disputes regarding non-mainstream contract breaches the main issue is predictability. The Commercial Code is silent on a number of important areas and grants judges discretion to look for commercial custom when adjudicating cases in those areas. In practice, judges are timid and uncomfortable with commercial transactions not expressly mentioned in the Code. This leads to unpredictable and often arbitrary outcomes, due mostly to lack of exposure and knowledge of the new instruments and arrangements being introduced. There is also an issue related to the lack of functional autonomy; excessive power is concentrated in the Supreme Court, which regulates practically everything. It appoints judges and exercises disciplinary authority over notaries and lawyers. While it pronounces on the constitutionality of laws and executive actions, at the same time it acts as the forum of last resort for the adjudication of claims. However, instead of providing guidance by its jurisprudence, it has consistently abstained from any substantive interpretation of laws and has merely focused on legalisms. Finally, procedures for civil actions contained in the 1857 Civil Procedure Code are outdated. Fostering alternative dispute resolution mechanisms. Alternative dispute resolution mechanisms (such as arbitration, conciliation and mediation) are neither well known nor used. Such mechanisms could increase predictability, reduce costs to the parties and provide better chances of enforcement. Although the Civil Procedure Code and Commercial Code permit arbitration, their use is inhibited by cumbersome procedures, lack of awareness of their existence, and obligation to conduct arbitration in court. To increase the predictability and speed of conflict resolution and enforcement of laws and regulations: (i) set up a bar association to supervise and discipline lawyers and notaries, and introduce public examination for the selection of judges; (ii) revise the 1857 Civil Procedure Code to introduce oral proceedings and to review terms of law suits; and (iii) provide commercial judges with education and more training on new commercial transactions. Seminars and conferences on recent financing developments would provide much needed information and understanding of this growing area. To foster use of arbitration undertake research to determine the most appropriate arbitration mechanisms, Modernizing the Legal and Regulatory Framework 51 and in the interim, revise the arbitration law to reduce intervention by the courts and to make arbitration more accessible. An arbitration forum could also be created. Finally, to reform procedures for commercial dispute resolution a comprehensive review of the following areas should be undertaken: (i) court procedures costs, including an estimation of foregone credit opportunities due to creditors' lack of confidence in enforcement; (ii) laws governing court procedures; and (iii) the practical side of court procedures for commercial dispute resolution, including an identification of unnecessary and time- consuming steps, and of formal arbitration laws. CHAPTER V FA CILITA TING TRADE AND TECHNOLOGICAL DIFFUSION To meet the challenge of globalization El Salvador must improve policies and structures to support outward-oriented growth. It should continue ensuring a friendly environment for trade and address technology constraints which limit productivity and international competitiveness. Trade reforms have been impressive and accompanied by increased private sector efforts to adapt to new market conditions. Results are promising, but further efforts are needed to ensure the sustainability of trade reforms and fully remove constraints to the expansion and diversification of exports. A stable macroeconomic environment and the removal of constraints to private sector development will be key, but parallel efforts are necessary to eliminate remaining policy and institutional obstacles to trade expansion and to support technological diffusion. TRADE POLICY: DEEPENING AND SUSTAINING LIBERALIZA TION Moving to a uniform tariff rate. Table V.1 Tariff Structure, 1988-94 Since 1989, tariffs have been reduced from 0-290 percent to 5-20 percent and Year No.ofTarlf Tar . - the number of rates from 25 to 3. The Government announced in February 1995 Before Sept. 1989 25 0-290 the lowering of tariffs on capital goods to September 1989 a/ 9 1, 5, 10, 20, 25, 30, 35, 40, and 50 April 1990 a/ 6 5, 10, 20, 25, 30, and 35 1 percent and a schedule for further June 1991 b/ 5 5, 10, 20, 25, and 30 reductions which is being discussed with December 1991 b/ 4 5, 10, 20, and 25 the Central American Common Market March 1992 a/ 5 5, 10, 20, 25 and 30 (CACM). Coefficients of variation and December 1994 a/ 3 5, 10, and 20 unweighted means have also been Proposed reforms announced February 1995: significantly lowered. However, tariff 1995 1% on Capital Goods dispersion is still high and the structure 1996 1-15 still reflects significant trade biases. For 1997 1-12 example, producers of final agriculture 1998 1-9 example, ~~~~~~~~~~~1999 1-6 manufactured products enjoy levels of protection higher than producers of a/Including Part Ill. b/ Excluding Part Ill agriculture inputs. To eliminate Sources: Compilation of legislations provided by GAES/MIPLAN. dispersion and lower evasion, the Government should consider moving to a uniform tariff rate. Eliminating remaining administrative instruments regulating import flows. Although remaining NTBs cover less than 5 percent of all tariff lines, administrative regulations on imports still exist. At the root of the problem are lawsI which regulate remaining import permits and cause considerable overlap in administrative procedures. Draft decrees modifying these four laws were submitted to the Assembly in late 1994, but have not yet been approved. Responding to the challenge of NAFTA. There is uncertainty regarding the impact of NAFTA on the Salvadoran export sector. Nevertheless, NAFTA adds urgency to the need to increase global competitivenss, rather than waiting for the granting of preferential access. While there are on-going discussions on the possible granting of NAFTA parity to the Central America region, it is clear that I Ley de SanidadAgropecuaria; the Health Code; the Ley de Farmacia (6/30/1927); and Decree No. 647. 54 Chapter V economies such as El Salvador will face increasing competition for foreign investment and trade, particularily in clothing and textiles. However, a recent study concludes that El Salvador could benefit from NAFTA, provided it can access the Mexican market, which has great incentives to divert its production to the higher-priced US market (Leamer and others, 1995). REMOVING EXPORT-SPECIFIC CONSTRAINTS The Government can enhance export supply response by acting in three policy areas: * ensuring a stable macroeconomic environment (Chapter II); * removing general constraints which lower productivity and affect all private firms through the implementation of reforms to improve human and physical infrastructure (Chapter III), modernize the business environment (Chapter IV) and strengthen the financial sector (Chapter VI); and c> removing export-specific constraints, through a distortion-correction approach to export promotion. This approach is the most consistent with optimal trade policy theory, policy experience, and political economy considerations.2 To have a positive impact, export development policies should be designed to address in a non-targeted, universal fashion, export-specific public sector management issues and microeconomic non-price supply side constraints at the firm level. Despite reforms implemented since 1989, a number of policies and administrative mechanisms impede the achievement of policy neutrality between domestic and international markets and negatively influence export competitiveness. These constraints include: (i) lengthy, complicated, and non- transparent import procedures; (ii) export-related administrative and institutional weaknesses; (iii) inadequate support for technology diffusion and product quality; (iv) weak trade negotiation capabilities; and (v) weak government-business interaction. Addressing import-related issues Lengthy, complicated, and non-transparent import procedures are the most important remaining obstacles to trade. Survey results show that import duties and other import taxes are perceived by the private sector to be moderately high. However, other import costs, such as services of customs brokers and special payments, add a substantial margin to the cost of importing, not counting the time lost by bureaucratic red tape which is mentioned as a not insignificant obstacle. This margin adds 3 percentage points to the cost of importing in manufacturing, trade, and constructions and 5 percentage points in services, and rises with the size of the enterprise. To further reduce import-related administrative costs the Government should: Q establish a one-stop window for imports, along the lines of the existing export-processing center (para. 5.10): the issuance of import licenses by the MOE is discretionary and document processing by the Treasury and the Court of Accounts is lengthy and cumbersome; and ˘ accelerate on-going customs reforms: the most time consuming procedures are document verification, acquiring a customs certificate, and merchandise valuation processes. The Government's ongoing customs administration reforms should be accelerated. 2 Recent developments in trade theory (the "new trade theory") suggest an active Government role in trade policy, particularly support to specific export activities. Its relevance to developing countries has been questioned. Support to specific activities can be accommodated within a framework of distortion-correction, but only after a number of fundamental export promotion conditions are satisfied (including the maintenance of macroeconomic stability and the adoption of policies to offset the anti- export bias). In addition, specific support should be at the initiative of the private sector, subject to evaluation as an investment in knowledge, and should be time-bound (Rajapatirana,1993). Facilitating Trade and Technological Diffitsion 55 Addressing export-related administrative and institutional weaknesses In addition to tariff and NTB reduction, the Government has reduced the anti-export bias by: (i) simplifying export administrative procedures through the creation in 1989 of a one-stop export processing center (CENTREX) in the Central Bank; (ii) introducing a regime for free trade zones (FTZs) and Fiscal Areas; and (iii) adopting a duty drawback system. However, administrative and institutional weaknesses persist and a number of additional steps should be considered. Improving CENTREX. Public sector support services for foreign trade activities are weak. Survey results indicated that firms use special agents to facilitate procedures and that, in addition to devoting around 10 percent of their time to solving procedural problems, firm costs due to institutional obstacles may go up to 4 percent of the CIF import value. The establishment of CENTREX was an important step, but a CENTREX survey suggests that its operations could be further improved. The processing period is still long and the documents delivery date is typically not honored; the rationale behind application rejections is not transparent, making it difficult to comply with requirements. The survey also suggests that users would like the Center to operate on Saturdays and in other areas such as Santa Ana and San Miguel. Users would be willing to be charged for these services. Improving the functioning of FTZs and Fiscal Areas. One of the main objectives of the new development strategy is to move the whole economy toward a free trade regime. In the interim, the Government should further streamline FTZs and Fiscal Areas procedures, and establish a one-stop window for both. The Government promotes nontraditional exports through a regulatory framework embodied in the 1990 FTZs and Fiscal Areas Law and in the Law to Reactivate Exports, which aim to reduce the anti-export bias created by restrictions on trade. The schemes grant tax benefits such as exemptions from income tax, import duties, VAT, and the net wealth tax to extra-regional non-traditional exports. Although there has been some recent improvement, the schemes do not work well and product leakages to the domestic market are frequent. FTZs and Fiscal Areas are growing productive sectors of the economy thanks to the combination of: (i) duty-free access to the US market of products assembled using components produced in the US; (ii) good quality products; and (iii) competitive wages. The only public FTZ is currently being privatized. Private investment in FTZ and Fiscal Areas amounted to US$25.6 million in 1993 (FUSADES). Operating FTZs do not have room for new firms and the Government has allowed new firms to operate in the Fiscal Areas enjoying the same incentives as FTZ firms. There are 20 firms in FTZs and 161 firms in Fiscal Areas. The FTZ and Fiscal Areas scheme does not operate satisfactorily. An MOE survey confirmed that the main bottlenecks are: (i) complicated, non-transparent registration procedures; (ii) discretionary practices in customs; the fiscal and customs controls are done by the Treasury Department, but Customs officials may contest the classification of an import even though it has already been authorized by MOE; (iii) lack of adequate infrastructure; and (iv) complicated immigration procedures. To help eliminate these bottlenecks the Govemment has established an office to support foreign investors (Oficina de Apoyo al Inversionista Extranjero), complementing private efforts to attract foreign investment. Addressing duty drawback-related issues. The Law to Reactivate Exports grants exports of goods (with the exception of coffee, sugar, and cotton) and services to countries outside the CACM a rebate of 6 percent of their f.o.b. value (for goods) and of their invoice value (for services), for duties 3 Steps include: (i) present qualification documentation including a feasibility study to the MOE; (ii) present application documentation to the MOE; (iii) present the statutes of the FTZ to the MOE; (iv) MOE inspects the zone; and (v) MOE approves or rejects project. 56 Chapter V paid on imported products utilized in their production. The drawback is also extended to the domestic value added content of assembly or "maquila" operations. These export operations are also exempt from the net wealth tax in proportion to the share of exports within total production, or in the case of assembly operations, in proportion to the domestic value added of exports. Despite recent improvements, the scheme has a number of weaknesses: c* Delays in obtaining the rebate are the most important regulatory constraint for firms that export more than 25 percent of their production. Currently, the rebate period is around 65 days for the import duty and 50 days for the value-added (compared with the 45 day maximum period stipulated by law). Delays are due to the many steps and Government agencies involved in processing the rebate request: the Central Bank and Customs issue several export documents; the Ministry of Finance receives the rebate application; the MOE reviews the application; the Ministry of Finance reviews the MOE evaluation; the Corte de Cuentas reviews the Ministry of Finance evaluation and gives clearance; and finally, the Treasury issues the rebate; c* It discriminates among regional and extra-regional markets, since the rebates apply only to exports outside the CACM region and it discriminates among products, in that it only applies to exports of non-traditional items; ' It is a single average rate that does not take into account the structural differences among industries. A single average rate facilitates its administration and makes it easier to determine and control its magnitude, but it does not assure that the drawback actually corresponds to the duties paid on imported inputs by a particular exporter;4 and * The VAT, because of its fiscal credit mechanism, eliminates the indirect taxes on inputs used in export production and extends it to indirect inputs as well. Thus the import duty rebate cum VAT reduces the cost of exports with reference to taxes. This, however, does not totally eliminate problems of resource allocation, since duty free import of inputs for the production of exported goods discriminates against similar inputs produced domestically if their prices are duty inclusive.5 In the medium-term, the drawback should be eliminated as El Salvador moves toward a freer trade system. To continue with the drawback system will imply transfers to exporters from other taxpayers. In the interim, the Government should consider the following improvements: (i) allow commercialization of drawback rebates in the financial system, which may ease credit constraints for exporters. For those free of this constraint, it should make no difference whether to sell the rebates in the market or not, since it will be transacted at a discount equivalent to that created by the refund delay; (ii) recognize drawbacks to compensate for import duty costs to all exports, traditional or not; (iii) define the drawback clearly to prevent an implicit subsidy so that the relative price of importables and exportables is not affected and the relative price with respect to non-tradables is not raised; (iv) consider repealing the import duty rebate combined with exemption of exports from duties on imported inputs; and (v) extend the drawback to duties embodied on indirect inputs to fully compensate duties paid on imported inputs. 4 Depending upon the technical input coefficients of a given export commodity, the average drawback may over- or under- compensate for the duties paid, thereby subsidizing or adding to costs, as the case may be. One could consider the exemption of local input producers from duties on their input requirements to give protection to these producers. The measure, however, does not fully offset the lack of protection from imported inputs on their portion of their sales, if any, to exporters of the final product. Hence an export drawback cum duty exemption on inputs utilized by local input producers would not in this case eliminate the discrimination against domestically produced inputs. Facilitating Trade and Technological Diffiusion 57 Facilitating technology diffusion and quality control Globalization greatly increases the necessity to accelerate access to technology and upgrade related skills. Survey responses to questions on technology, production and business services illustrate the difficulties some firms face in reaching international technical standards. For a country like El Salvador it is hard to expect the development of indigenous technologies. In addition, private sector- driven initiatives are better suited to provide support services in the area of technology and production. The Government's role is to remove constraints and facilitate private sector efforts to gain access to technology and to enhance its capability of adapting to these new technologies by: (i) adopting and maintaining a liberal trade and investment regime; (ii) ensuring supportive human and physical infrastructure; and (iii) supporting private sector initiatives. Supporting greater access to foreign technologies through trade and licensing agreements and foreign direct investment. The opening of the economy to trade and foreign investment is the most expedient route to the introduction of new technologies. For this to be possible, an adequate regime of intellectual property rights protection, hospitable to the inflow of foreign technology is needed. The signing of the property right agreement with the US is a step in that direction. Ensuring supportive human and physical infrastructure. The most important constraints relate to human resource development, including the lack of basic vocational skills, the inability to diffuse and adapt to new technologies, and lack of attention to product quality. The focus should be on improving the quality of the human capital, but the Government can also facilitate innovation by supporting the development of telecommunications and information technology networks. Encouraging development of private sector support services and initiatives. The private sector has been promoting efforts to modernize firms technologically and administratively but private- and public-sector provision of information about new production technologies as well as foreign markets is not fully satisfactory. The private and the public sector together should improve existing complementary support services to: (i) increase efforts to reach more exporters, particularly micro, small and medium firms, (ii) support firms in their efforts to comply with quality, technical and phytosanitary rules and to have greater access to technological innovations through support seminars and other dissemination activities; (iii) continue supporting promotional efforts to attract foreign direct investment. A review of issues and proposals to develop the public-private institutional framework supporting technology development, diffusion, and training may be found in the documentation of the World Bank Competitiveness Enhancement Technical Assistance Loan. Strengthening trade negotiation capabilities The Government should continue strengthening its trade negotiation capabilities to take full advantage of opportunities to increase access in new products and markets created by the successful conclusion of the Uruguay Round, the internationalization of services, and regional integration efforts. First, the Uruguay Round's achievements in improving market access and security are significant and are expected to accelerate globalization, but further unilateral and multilateral efforts will be necessary to take full advantage of opportunities. Second, the next stage of globalization is expected to be led by the internationalization of services, and countries will have to be actively involved in developments and negotiations relating to the General Agreement on Trade in Services. Third, in addition to attempting to revitalize the CACM, Central American countries, are trying to negotiate free trade agreements with non- CACM countries. El Salvador is currently holding free trade negotiations with Colombia and Venezuela, the Dominican Republic, Belize, and Mexico. El Salvador is also participating in the definition of the agenda for the implementation of the Free Trade Agreement of the Americas. 58 Chapter V Improving government-business consultation To accelerate private sector led-growth it is important to improve business-government interaction, by enhancing collaboration between the private and the public sector. In a number of countries, consultation between government and the private sector has enhanced decision making, strengthened government credibility, and generated greater consensus, transparency and follow-through on market oriented reforms. The establishment of FOMEX (Comisi6n Nacional de Fomento de las Exportaciones) to coordinate private and public sector efforts to encourage export development in February 1993 is a step forward. To strengthen this process, the Government should institutionalize one or more focused consultative committees of government and business representatives to discuss concrete steps to promote market-based reforms. CHAPTER VI STRENGTHENING THE FINANCIAL SECTOR The dynamic recovery of the private sector owes much to the implementation of a credible stabilization and structural reform program since 1989. In particular, financial sector reforms - including the liberalization of interest rates, the restructuring and privatization of the banking system, and the creation of the capital market - have set the foundations for the development of a modem financial system. Nevertheless, more needs to be done to sustain and deepen these reforms. This chapter discusses constraints and policy options to improve access to credit; strengthen the banking system; and develop capital markets. IMPROVING ACCESS TO CREDIT Government efforts to ensure access to credit are focusing on: (i) creating space for the non- inflationary expansion of credit to the private sector (Chapter II); (ii) addressing collateral security issues; (iii) promoting use of new financing instruments; and (iv) facilitating access to credit by micro enterprises. Addressing collateral security issues Legal and regulatory constraints on using movable property as collateral limit access to credit. An efficient system for creating and enforcing security interests is key to improve access to credit and enable lenders, upon payment default, to foreclose and sell the security promptly and efficiently. In addition, such a system enables access to credit to those who do not own land or a title to land. In El Salvador most credit to the private sector is supplied by commercial banks. Survey results showed that bank loans were the second principal source of financing (36 percent of total) after own capital to start an enterprise, and 60 percent of total anticipated financing for future investment. The most common collateral is real estate; followed by warehouse receipts and moveable assets, factoring, and discounting of financial paper. Many contemporary financing forms involve two steps. First, taking security interest in moveable and non-moveable property, largely possible through the Commercial Code. Second, lenders must be able to protect their security interests against claims of third parties by registering the security interest.' The collateral registration procedure is lengthy due to an unwarranted pre-registration procedure and does not provide creditors sufficient confidence in their security interests due to difficulties in perfecting and enforcing security interests. Based on World Bank experience2 the Government should consider: Creation of security interests: change the legal framework to permit the creation of a wide variety of security interests in a wide variety of property; Perfection of security interests: make public the records of registries, restructure the public registries, change the incentives by introducing competition among public registries or permit private registries to compete with public ones; and Enforcement of security interests: change the law to permit private parties to contract for non- judicial enforcement of debt contracts. Not all documentary security interests need to be filed at the registry in order to be secure, as possession of the original document is in some cases required to collect on pledged assets (Hansen ,1994). In fact, there are some receipts (e.g., warehouse), which are by nature secured by possession and cannot be claimed as collateral by a third party. 2 Summarized in FPD Note No.43 (World Bank, April 1995). 60 Chaper VI In addition, the Government should consider: (i) removing all pre-registration requirements when a potential borrower plans to grant a security interest in his land or movable property; and (ii) computerizing the registration of security interests. Promoting the use of new financing instruments Because of remaining issues related to establishing and securing property rights (Chapter IV) it is particularly important in the case of El Salvador to address the adequacy of the Commercial Code and related laws for contemporary financing contracts and commercial paper. Although the Code, which is based on the Mexican one, can accommodate innovations in certain areas, such as commercial financing, it is silent on a number of important areas (leasing, factoring, and warehousing) and grants judges discretion to look to commercial custom when adjudicating cases. In addition, other obstacles, such as lack of information networks and lack of explicit legal guidelines for advanced financing, suppress much financing activity, which is particularly important for microenterprises. The draft Ley de Instituciones Auxiliares de Credito begins to address these issues by clarifying the operating parameters of financial institutions such as factoring houses, lease financing, and warehouse deposits, but a number of constraints still limit their use. General constraints. El Salvador needs new financing vehicles. While most companies finance investments with internally generated funds, the ability of the private sector to become rrore competitive, and to seize new opportunities, will depend on the availability of medium- and long-term financing, as well as on the capacity to attract new investors via equity participation. Larger corporations have generally not encountered problems in financing working capital and, in some cases, qualifying for over one-year financing of fixed assets. But most companies that need to finance plant expansion, must rely on short-term revolving lines of credit with the consequent risk that the bank may cancel the line at any time. General constraints are related to the lack of explicit legal guidelines for advanced financing. Leasing and factoring. Current issues relate to: title to and possession of leased goods; insurance and risk of loss; sales and subleasing of goods by lessee; priority of liens; and other rights of lessor and lessee. Leases are covered by basic contract provisions of the Commercial Code. Despite the lack of specific regulation, factoring and discounting of commercial paper are available through individuals and at least one company. Liens on inventory. The Commercial Code allows liens on inventory, but the provisions are limited because: (i) liens on commercial inventory held in a warehouse are excluded. This type of liens has advantages over warehouse receipts in that the entrepreneur may freely trade the warehoused goods; and (ii) banks do not favor liens on inventory because recording at the Commercial Registry requires listing every item in the inventory in order to secure each of them. In addition, to secure floating liens on inventory, the security interest must be self-executing, which means creating a public document that is authorized by the court, notarized, etc. This is expensive and cumbersome. Liens on commercial equipment. Lenders often take liens on equipment, usually as part of a larger collateral package, such as a mortgage. Decision-making regarding these liens rests with the Government as: (i) the Commercial Code regulates what property can be pledged as collateral, as well as time limitations on the loans themselves; and (ii) article 1158 allows only one lien to exist on any moveable good at one time, regardless of its amount. Although this may seem to protect lenders, it is not consistent with market principles and may unnecessarily tie up valuable collateral. Strengthening the Financial Sector 61 To expand use of advanced financing: C* set guidelines on the use of new financing instruments in the Ley de Instituciones Auxiliares de Credito, particularly for leasing, factoring, and discounting of commercial paper; ensure uniform treatment of issues related to specific business financing instruments; E* expand use of liens on inventory by: (i) including in the Commercial Code provisions for liens on commercial inventory held in a warehouse; (ii) allowing a more general description of the inventory to satisfy security registration; and (iii) streamlining the procedure to secure floating liens on inventory; and C* in the area of liens on commercial equipment, shift economic decision-making and risk-taking from the Government to the private sector by: (i) liberalizing articles 1144 and 1148-55 of the Commercial Code to shift risk assessment and term negotiation to private actors; and (ii) removing unwarranted provision in Article 1158 permitting only one lien on moveable assets. Lending to microenterprises: policy options and lessons from experience To improve access to financing by microenterprises, the Government should try new approaches, taking into consideration the following lessons:3 Strategy: the best programs - in terms of impact and financial viability - are a small number of large micro-credit operations which reach a significant number of enterprises primarily with financial services and limited technical assistance, typically in loan application and follow-up. Successful examples include: the Grameen Bank of Bangladesh, Indonesia's BRI/Kupedes program, Banco Solidario in Bolivia, ADEMI in the Dominican Republic, and the Kenya Rural Enterprise Program; Packaging: experience shows that: (i) building viable micro-credit systems takes several years and (ii) that financial services need to be provided in a businesslike way if programs are to be sustainable; micro enterprise borrowers should pass merit tests by demonstrating their qualifications to operate small enterprises and to undertake the responsibility of a loan; Delivery: strengthening the capacity of intermediaries, usually NGOs, to manage programs and appraise loans is critical; and Terms and conditions: three features have been key: (i) price services based on costs; (ii) focus on providing working capital; and (iii) include savings mobilization. STRENGTHENING THE BANKING SYSTEM The banking system has been restructured and privatized, but the Government now needs to further liberalize and strengthen the banking system to enhance its capacity to absorb large changes in liquidity and ensure the existence of a strong and independent superintendency. The authorities should continue focusing on upgrading the regulatory and prudential framework by: (i) increasing competition; (ii) lowering illiquidity risks; (iii) strengthening supervision; and (iv) establishing deposit insurance. Increasing competition Current regulations impose two types of limitations on ownership based on nationality and on a 5 percent rule for privatized institutions. These limitations should be reconsidered. In addition, the Central Bank should ensure the availability of more accurate interest rate information to enhance transparency. 3 Summarized in FPD Note No.23 (World Bank, September 1994). 62 Chaper VI Eliminating ownership limits. Total assets of the banking system represent about 50 percent of GDP. Most of these institutions were privatized beginning in 1991, after being restructured and recapitalized. Seven banks initiated operations between 1994 and early 1995, stimulated by high returns on capital (in the order of 20 percent). The two largest banks control almost 50 percent of the market and there are no foreign banks. Legislation requires that only Salvadoran nationals (or Central American nationals if reciprocity exists) can be majority stockholders in banks or finance companies incorporated in El Salvador. This forces foreign banks to either become minority partners or create a new institution, such as a branch office. The Government is currently preparing draft legislation to address this limitation to foster the participation of foreign banks in the financial system, both through the incorporation of new institutions or through the purchase of existing banks. It should also consider the relaxation of the 5 percent rule (per individual, corporation, affiliated groups or related individuals) for privatized institutions, since it does not apply to new banks or finance companies. Banks subject to the 5 percent ownership rule could be at a disadvantage in raising new capital compared to the unrestricted banks which could raise capital from just one or several large stockholders. Ensuring accurate interest rate information. To enhance transparency in the credit market, the Central Bank or the Superintendency of the Financial System (SSF) should calculate and publish - at least weekly - an average adjusted costs of funds rate. Currently each institution calculates and publishes its own arbitrary reference rate. The proposed change would ensure that interest rate differentials among institutions reflect only a spread over a common reference rate. Lowering illiquidity risks The Central Bank should develop regulations to decrease existing illiquidity risks. Illiquidity risks result from the increase in the volume of funds being intermediated by the financial system without well developed bank supervision. Given the preference for short-term deposits, banks may increase their risk exposure by mismatching the maturities of loans (long-term) and deposits (short-term). The structure of deposits highlights the continued preference for short-term instruments: 13 percent of total deposits are sight deposits, 32 percent are savings deposits, and 55 percent time deposits. Since savings account are 100 percent liquid, this deposit structure increases illiquidity risks because approximately 45 percent of total deposits are completely liquid. The Government should consider establishing minimum liquidity requirements or enacting, as in the case of Panama, regulations requiring banks to maintain open foreign credit lines equivalent to 10 percent of their assets. Strengthening supervision of the banking system While much progress has been achieved in training of bank examiners, preparation of procedures manuals, and implementing risk asset classification standards, additional work is needed to strengthen SSF's preventive supervision capabilities. Action to strengthen SSF was taken in December 1990, with the passage of a new Organic Law of the Financial System Superintendency which empowers SSF to act as primary supervisor of the financial system. To perform its new responsibilities, SSF was reorganized around four divisions: (i) banks and finance companies; (ii) insurance and pension funds; (iii) securities exchange; and (iv) administration and finance. However, specific SSF responsibilities in regulating the capital markets and the insurance and pension industries need to be defined by additional legislation. Implementing a rating system. Although there are a limited number of banks, the rating of banks would strengthen SFF prudential supervision. At the same time, a quantitative rating index would give a financial intermediary a more precise gauge of its performance, and could also be used in determining at what point the regulators could begin to take preventive action with respect to a weakening institution. An often used methodology that could be utilized in evaluating financial Strengthening the Financial Sector 63 intermediaries is the CAMEL rating system which reviews capital adequacy, asset quality, management capabilities, earnings performance, and liquidity. Strengthening information and accounting standards. Since transparency of information is crucial for investors to properly evaluate risks of financial institutions, the SFF has been publishing extensive information on bank financial statements and the classification of risk assets by individual institution. This already excellent source of information could be enhanced with selected financial ratios including the capital ratios based on the regulatory definition of capital and risk assets. Accelerating training and development. The need for ongoing training and development of supervision cannot be over-emphasized. The integrity of the financial system rests on the capabilities of its regulatory agencies. This analysis does not necessarily conclude that more regulations are needed, but rather that stronger enforcement of existing rules should be emphasized. Establishing a deposit insurance fund The authorities should accelerate efforts to implement a well functioning deposit insurance fund. Deposit protection has three positive effects: (i) it offers the Government and the taxpayers some protection against contagious bank runs; (ii) it protects small depositors which do not have the information to evaluate the financial condition of individual banks; and (iii) may foster higher savings and promote financial intermediation. The establishment of deposit insurance is contemplated in the Banking Law but is not functioning yet. Deposit insurance systems are complex to design and implement and the IMF is providing technical assistance in this process. In general, the authorities should consider:4 * Amount of protection: protection should be by depositor and limited (i.e., small depositor-oriented) to a relatively small amount; a Proper funding: it is difficult to predict the losses that the deposit insurer will have to absorb over the years and at the same time it is extremely dangerous for the insurer to become illiquid. The best way to ensure proper funding is by: (i) providing the insurer with adequate initial capital to give the insurer credibility; (ii) having insured banks make reasonable periodic premium payments into the fund; and (iii) giving the insurer legal authority to borrow or receive equity injections from the Government to honor its obligation to protect depositors; and Q Flexibility: the deposit insurer should be given maximum flexibility in resolving failing bank situations, so long as the method employed is consistent with the stated objectives of the fund. DEVELOPING CAPITAL MARKETS Financial markets complement banking institutions in mobilizing and delivering investment resources, particularly in the case of longer-term, larger-scale, and higher risk investments. The public sector can play an important role in helping build local financial markets by: (i) issuing public securities thus acting as a catalyst; (ii) enforcing standards of fairness in trading and broad disclosure of information; (iii) strengthening prudential regulation; and (iv) developing enabling legislation for the reform and more active involvement of financial intermediaries. 4 FPD Note No. 12 (World Bank, June 1994). 64 Chaper VI Catalyzing the supply of securities One of the main constraints behind the development of the securities market in El Salvador is the dearth of potential private sector issuers. Factors limiting private sector participation include: (i) private companies are not very large and those that could access the public market, have relied on traditional sources of finance, such as bank loans, and private placements with insurance companies; and (ii) most businesses are closely held family enterprises; which generally do not view a pubic issue favorably because of disclosure requirements and, in the case of share issues, the possibility of management interference or even loss of management control. As the private sector develops, companies will probably begin issuing shares through the stock market but the "cultural change" of opening up companies to the public will take time. In the interim, the public sector can play an important role in building up the securities market by establishing benchmarks as an active security issuer and to help provide liquidity to the markets. It should actively manage the issuance of its own debt securities and the equity in state-owned enterprises to be privatized. These public issues play an important role in catalyzing private sector development by offering simple structural design, pricing benchmarks, and liquidity. In addition, the Government should enhance collaborative efforts within CACM to allow regional trading of securities. Initial steps have been taken to consider alternative market schemes and the establishment of a common regulatory environment. While full integration within a regional capital market is still far off, the outlook is encouraging. Through the formation of a regional securities exchange, CACM countries could overcome scale constraints faced by each market. Ensuring reliable and timely disclosure of information Current issues include: (i) insufficient disclosure of financial information; tightly-held corporations have little interest in revealing the financial condition of their businesses or diluting ownership. When these companies approach the capital market, they resist public disclosure. This is the case of the prospectuses that have been issued for all public offerings of investment certificates. Financial statements are highly condensed with little information other than a few financial ratios. It is imperative to develop greater transparency of information in the securities market to protect investors from undue risk, and to improve market access to profitable but not well known companies; (ii) public accounting firms do not follow generally accepted industry standards, which compromises the reliability of audited financial statements to assess the financial position of borrowers. Lending is therefore done primarily on the basis of collateral; and (iii) periodic informnation on current market trends is lacking. To ensure reliable and timely disclosure of information the Government should: (i) support the development of reliable risk rating agencies; (ii) encourage public accounting firms to establish a self- regulatory body which adopts and enforces generally accepted accounting principles; and (iii) ensure availability of periodic information on transactions in the exchange, including summary statistics on prices, volumes and yields. Financial information on listed companies should be compiled by industry in order to provide useful indicators on sectoral trends and performance. Strengthening supervision While substantial progress has been achieved in bank supervision, supervision of the securities exchange as well as insurance and pensions needs strong institutional development within SSF. The lack of adequate supervision in these areas is attributed to: (i) the emphasis given so far, and rightly so, to the development of banking supervision; (ii) the absence of comprehensive legislation regarding capital markets, insurance, and pensions that would provide SSF a clear mandate; and (iii) lack of resources to Strengthening the Financial Sector 65 develop an effective supervisory role. Technical assistance from IDB will strengthen supervision of the securities exchange; substantial resources will be needed to improve staffing, hardware and software. In addition, the development of capital markets should be monitored closely by SSF in terms of the impact on the banking system. The issuance of investment certificates directly by corporate borrowers will intensify competition with banks who must retain their good corporate customers by offering better terms than what they can receive in the securities market. Since banks are allowed to own brokerage houses, financial institutions are planning to expand into this area. Facilitating the development of financial intermediaries The development of institutional investors, such as insurance companies and pension funds, and investment companies is essential to deepen capital markets. The priority is to draft and enact enabling legislation for institutional investors while overhauling the contractual savings system. Insurance companies. The liberalization of the insurance industry is an indispensable step to promote new products, while generating a solid base of long-term funds that could be invested in private sector projects. The insurance industry has developed without an effective legal and regulatory framework. The Government is discussing new legislation to govern the insurance and pension industries. The overriding objective should be to establish a level playing field for all financial intermediaries within an effective regulatory environment. The insurance industry has grown through sales of property and casualty products and all but two companies offer life, property and casualty coverage. The lack of a sufficient array of investment instruments in the market has limited insurance company investments to bank deposits, government securities, and certain private placements. These companies are eager to see the securities market develop to diversify their investments, and have recently started to offer new products such as universal life which competes with other savings instruments. The Government should focus on the drafting and enactment of new insurance legislation, to: (i) enhance supervision and greater flexibility in market development; (ii) probably separate life and non- life insurance business considering that risks are quite distinct, although they could operate under a single holding company; (iii) supplement minimum capital requirements with a system of dynamic solvency margins. The margins should be designed to protect policy holders as they automatically supplement shareholder equity and are set aside in a guarantee fund. Minimum capital standards should be increased, and companies that fail to meet these requirements should be encouraged to merge with larger firms; and (iv) improve the supervisory role of SSF. This will require raising the standards and effectiveness of off-site supervision and on-site inspections of insurance companies. One option would be to split the Superintendency division for insurance companies and pension funds into two. Social security reform and pension funds. The Government is undertaking a fundamental reform of the social security system to move toward fully funded defined contribution accounts The immediate priority for the social security and pension fund system is financial restructuring and recapitalization. The Salvadoran Social Security Institute (ISSS) and the National Civil Servants' Retirement Fund (INPEP) are struggling with rising payouts relative to contributions. Both systems work on a pay-as-you-go basis. Key issues include the following: ˘ Solvency problems. Barring prompt action, both institutions are likely to face solvency problems. Privatization of the pension industry is being studied but its restructuring is likely to require sizable transfers from the Government in order to re-capitalize the two funds (ISSS and INPEP); > Inappropriate structure: The current structure could be characterized as three separate entities involved in the same activities, but each using different pricing mechanisms, and offering a mixture of services not directly related to the underlying activity of retirement benefits. The pension system 66 Chaper VI only covers about 18 percent of the economically active population with the vast majority in urban areas. The rest of the population must rely on their own resources, and any other limited Government benefits they can access; * Commingling of finds: The commingling of health care and pension funds seriously undermines the financial integrity of the pension component. The health care portion of ISSS has experienced deficits which were covered with pension fund reserves. ISSS, the country's largest pension fund, receives direct contributions from the Government, as well as compulsory salary deductions from employees and payments by employers. In addition to pension coverage, the ISSS provides basic health care benefits to both public and private sector contributors but it does not provide unemployment insurance. Both the pension and the health care programs are combined within ISSS's global fund, even though they are strictly separate operations. The separation of the pension and health care funds should be considered; and * Restrictive investment strategies: Investment strategies are constrained by rigid rules, and generate low returns. Several factors account for this, among them, a lack of management expertise, an excessive number of low-paid, under-qualified staff, and a high degree of evasion and avoidance by employers. For example, about 80 percent of ISSS investments are in time deposits, the rest mostly in mortgage certificates and Government bonds. Greater flexibility in investment policy, within a manageable risk profile, could significantly enhance earnings. The Government is undertaking a fundamental reform of the contractual savings system to move from a pay-as-you-go defined benefit system to fully funded defined contribution accounts, along the Chilean approach.5 The immediate priority is a financial restructuring and recapitalization by the Government, followed by implementation of adequate policies and procedures regarding pricing of coverage and investment of accumulated reserves. Mutual funds and leasing companies. The establishment of mutual funds and leasing companies could become an important source of institutional demand for securities. No mutual funds exist in El Salvador, and their introduction would require additional legislation to permit the formation of investment companies. The appeal of the mutual fund as an investment vehicle is the ability to pool many small investors, while it could invest in certain private placements of securities. Through this arrangement, a small investor could participate in potential profits from a company that goes public, while the company pursues the less restrictive alternative of a private placement. Investment advisers and investment companies are still not allowed to operate, but the development of mutual funds hinges on the availability of investment management firms to manage customer portfolios. Leasing companies are another type of financial intermediary which can act as a catalyst to the development of the medium-term funds market. Leasing companies could become an option for small- to mid-sized companies that do not have access to capital markets. The advantage of a leasing company is that the lender retains title to the goods, while the borrower has the tax advantage of full deduction of lease payments. Leasing companies issue medium-term notes in the market to finance the acquisition of machinery and equipment, they then offer leases to their customers on terms which usually coincide with the economic life of the asset. Typically, a lease contract would include an option to purchase the fixed assets, at some predetermined residual price, at the end of the lease. The Government should consider enacting legislation to allow the establishment of mutual funds and leasing companies. In particular, consideration should be given to the promotion of domestic mutual funds, that could be established initially to invest in those securities available in the market, such as 5 Chile instituted a Government-regulated but privately-run mandatory savings system supplemented by a pay-as-you-go public plan that guarantees a minimum benefit to workers with low incomes or interrupted employment careers who are not able to save enough for adequate pensions. Strengthening the Financial Sector 67 Government securities and investment certificates, and eventually expand their portfolio to incorporate equities. All properly regulated financial intermediaries, such as commercial banks and finance companies, should be allowed to offer their own mutual funds through an affiliate investment company. The establishment of investment companies should also be promoted, which could offer money market mutual funds by investing in existing bank CDs and investment certificates. The minimum purchase amnount for an investment certificate is about 10,000 colones (about US$1,100) which leaves out a large percentage of savers. Whereas a mutual fund could offer the samne investment opportunity at a much lower minimum amount. ANNEX Constraints to Private Enterprises: A Summary of Survey Results' Introduction. El Salvador's economy is in a dynamic period of adjustment and growth. Stabilization and liberalization have already enhanced opportunities for private enterprise and there seems to be a broad social commitment to peace and growth. Yet a large agenda for reform and institutional strengthening remains and its priorities must in part be guided by the needs of private entrepreneurs starting, operating and expanding their firms. It is now well-recognized that private sector development (PSD) will be critical to overall economic prosperity and increased standards of living. Thus it is essential to identify those factors that limit this development. One key instrunent that has proven effective is the enterprise survey, which elicits the judgments of entrepreneurs and senior managers on the severity of constraints to PSD. Sample Characteristics. This annex describes the results of a survey of 210 firms designed by the World Bank and refined and implemented by FUSADES (Fundacion Salvadorefia para el Desarrollo Economico y Social). Figure 1 describes the size and sectoral composition of the stratified sample. The main sample consisted of 177 large, medium and small enterprises, while a supplementary, shorter questionnaire was administered to a sample of 33 microenterprises. Geographically, the survey was carried out in three urban areas: San Salvador (58% of firms sampled), Santa Ana (22%), and San Miguel (20%). The sample was a combination of a panel, which comprised part of an ongoing FUSADES study of the business climate, and firms randomly selected within strata. Larger and industrial firms are over-represented in the sample. Construction Mcro 11% 16% Services Smal l Large 15% Inds 13% 44% 45% Commerce Fbdium - 29% 27% Figure 1: Sample Characteristics Enterprises in the sample are generally fairly old -- averaging over 23 years in operation. While age is somewhat correlated with size, even micro-enterprises averaged over 14 years old. 1 All tables and figures in this annex are based on the results of the World Bank/FUSADES private enterprise survey. 70 Annex This suggests that much of the economic dynamism is coming from the growth of existing firms rather than from new firms. It may also draw attention to the possibility of entry barriers.2 Some 94% of firms in the sample are registered (including 74% of microenterprises), so the samnple may have favored somewhat formal and more established firms. Table 1: Characteristics of El Salvador Sample Size Small Medium Large Ave. No. Employees 16 120 590 Ave. Annual Sales 2.9 43.4 143.3 (millions of Colones) The survey gathered data on firm procurement, sales and investment. One striking pattern is the "trade deficit" and inward orientation: firms purchase 49% of their inputs from abroad, yet export only 12% of their production. For example, over 21% of inputs are purchased from El Salvador's principal trading partner, the United States, yet only 4.5% of products and services are sold there. Industrial and commercial firms import the most (47.9% and 35%), but commercial firms export little (2%) while industrial firms export some 22% of their production. This inward orientation may help to explain why, in a time of recovery, many firms report having excess capacity. Enterprises reported operating at 73% of installed capacity, on average. Industrial sector firms, operating at 75%, did somewhat better than average, and both large and microenterprises were closer to capacity than small and medium ones. When asked why they don't produce more, 27% of firms explained that internal demand was insufficient and 13% said there was too much competition -- signs of too many firms competing in a small domestic market. Table 2A: Sources of inputs for Salvadoran Firms PERCENT TOTAL SECTOR SIZE A Industry Commerc Servics Construction Larg= Medium Small Produced in El 50.8 47.9 35.0 60.2 81.8 47.1 53.9 56.9 Salvador Imported from Ctrl.. 13.1 14.9 15.3 5.9 8.1 143 10.5 12.6 America and Mexico Imported from U.S. 21.2 23.4 22.6 22.6 9.8 23.6 21.5 12.6 ImportedfromRestof 15.1 13.7 27.1 11.3 0.3 15.0 14.1 17.2 World Table 2B: Destination of Salesfor Salvadoran Firms PERCENT TOTAL SECTOR SIZE . Industa Commerw Services Construction Lage Medium Small Sold to Domestic 87.9 77.8 97.7 92.5 100.0 83.2 92.1 95.2 Market Exported to Central 5.9 11.5 1.3 1.4 0.0 8.6 3.9 1.5 America and Mexico Exported to U.S. 4.5 7.7 0.7 4.8 0.0 6.4 2.4 2.2 Exported to Rest of 1.7 3.0 0.4 1.3 0.0 1.8 1.7 1.1 World 2 It could potentially reflect a sampling bias, if the list from which the survey was drawn includes only older firms. However, the list used was the most complete available and the newest firns in the sample were only I year old. Annex 71 Nearly 40% of enterprises make some sales to the Government or public enterprises, accounting for an average of 21% of sales for the entire sample. Sales to the Government sharply increase with firm size, with 56% of large firms having government sales versus only 6% of microenterprises. By sector, fully half of construction firms sell to the government or public enterprises, which accounts for 46% of their sales. By location, firms in San Salvador are far more likely to have public business with half making public sector sales. Firms making sales to the government identified two moderate problems: excessive paperwork and bureaucracy, and late payment. Construction firms also complained of limited competency of public officials supervising their contracts. General Constraints. Firms were asked in the survey to rank a number of constraints to their operation and growth on a scale from 1 to 5, where a one indicated the constraint imposed "no obstacle", a 3 indicated a "moderate obstacle", and a 5 indicated a "very severe" obstacle. It was quite striking that few firms ranked any constraints a 4 or 5, and average scores were generally low compared to other similar country studies. Figure 3 demonstrates the low average ranking of constraints in El Salvador compared to other countries where similar surveys have been conducted. While cultural factors may partially explain these low scores, much can be explained by the relative improvement of the business environment resulting from the end of the civil war and the reform policies already in place. Compared to how bad things were, few constraints appear "very severe" now. Nonetheless, most firms identified some constraint as major or very severe: 66% of the main sample and 79% of the microenterprise sample identified at least one constraint as at least "major". Figure 2 illustrates the rankings of constraints provided by the survey responses. While new-found stability helps explain the overall low ranking of constraints, the survey shows that instability of prices and government remain the dominant concerns of enterprises, even in the post-civil war era. The desire for stability and security in the business climate is reinforced by the next constraints: problems of security -- mostly related to increasing "common delinquency": theft and other crimes -- policy instability and the exchange rate. Close behind are concerns about finance, human resources and the level of taxes. While these rankings accurately reflect the firms' relative assessment of these constraints, it should be noted that when entrepreneurs were asked at the beginning of the survey what were their leading problems (and no specific categories of constraints were offered), the two most commonly cited constraints were the lack of competent workers and problems of finance. Smaller firms are especially concerned with financial constraints (Figure 3). Micro firms felt particularly concerned with the functioning of the judicial system and with problems of acquiring inputs (possibly tied to limited working capital and an inability to import directly). Construction firms, currently booming by most accounts, identified themselves as more constrained than firms in other sectors in a number of areas, led by inflation, political and policy uncertainty, finance, and the exchange rate (Figure 4). Driven by the building boom, some of these firms appear to be pushing at the boundaries of their production frontiers, confronting limitations in policies, institutions and markets. Although taxes and regulations did not rank as major constraints, firms were quite disturbed by informal competition, suggesting significant cost advantages to those who evaded these constraints (see below). 72 Annex FIGURE 2 Obstacles to Salvadoran Enterprise Operation and Growti Inflation/Price Inhtability I m Political Unce tainty m m Exchange Ra t m m Policy Uncertainty PmoblemsofSecunty Infr struc ture Human Resources m Finance m High Love of Taxes m m m Re g ul atio. Production and Technolog Functioning ofJudicialSyem m| *I Acquiring Inputs Protegiona Servie _ Quality/ Capacity Airporu¶aPortst | ____| 1 1.2 1.4 1.6 1.8 2 2.2 2.4 2.6 No Obstacle Minor Moderate |Severity of Constraint Annex 73 Figure 3. Constraints to Salvadoran Enterprises by Size Political Uncertainty Exchange Rate Security Problems __ Micr i O Small E MediumI Lack of Qualified _ Large Human Resources High Level of Taxes Problems with Regulations Production and Technology External Professional Services 0 0.5 1 1.5 2 2.5 3 Severity of Constraint (l=No Obstacle, 3=Moderate, 5=Severe) Note: Some questions not asked of microenterprises. 74 Annex Figure 4. Constraints to Salvadoran Enterprises by Sector Political Uncertainty Exchange Rate Security Problems Lack of Qualified Human Resources High Level of Taxes Problems with Regulations Production and Technology Ra Exteral Professional 0 0.5 1 1.5 2 2.5 3 3.5 Severity of Constraint (1=No Constraint, 3=Moderate, 5=Severe) Annex 75 Regulation. Regulations were not in general regarded as very constraining, and constraint rankings were extremely low by international standards (table 4). Nonetheless, the prevalence of informal competition and direct data from firms about compliance costs suggests that regulatory requirements impose significant costs on firms. It is important to note that 72% of firms in the main sample and 85% of microenterprises found no area of regulation more than moderately constraining. In their responses, only construction firms found any regulatory constraint more than minor: they identified obtaining permits and the number of permits and licenses required as excessive, rating it a moderate constraint. Although firms found no major constraints among regulations, qualitative responses suggest they found an annoying excess of minor obstacles: in obtaining licensees and the number of permits and licenses required; and in tax regulations. Microenterprises found few difficulties among regulations, although a small minority found tax procedures and, especially the value added tax, difficult. Despite regulation's low ranking, its costs are significant. Firms reported that their senior managers or owners spend on average over 7% of their time on activities required by government. For construction firms, this is substantially higher -- almost 12% of senior management time is spent working with permits, taxes, labor regulations and customs. A further 5% of employee time is required to comply with regulations. Furthermore, although firms did not single out customs or ports, it takes them an average of 15 days from the time goods arrive in customs to the time they can be claimed. Firms offered surprisingly strong responses about the problem of informal competition, providing further evidence of the costs of regulation and the advantages realized by to those who avoid it. 59% of firms experienced problems with informal or illegal competition. It was most common in commerce, where some 74% of firms identified the problem. The four topmost concerns were: competitors evading the value-added and other taxes, firms selling below costs, firms avoiding customs and trade regulations, and firms avoiding labor regulations and taxes. Note that three of the four topmost concerns in this regard involve avoidance of taxes and regulations. Formal entry appears neither especially difficult nor expensive. Some 67% of enterprises indicated that they had encountered no difficult steps in registering. Formalizing an enterprise (including official fees and costs of facilitation) cost an average of 3,800 colones, but for some firms cost as little as 500, and for one industrial enterprise cost as much as 15,000. Industrial and construction firms generally paid more to register. According to FUSADES analysis, of firms that registered in the last three years, the average cost of registration (2015 colones) amounted to only 1.83% of annual sales. However, for firms that registered in the last 10 years, registration appears to have been time consuming. Omitting a few outliers -- it took firms an average of 15 weeks to become formal. 76 Annex Regulatory Constraints to Salvadoran Enterprises Union Restnctions Export Regulations LaborRegulations Police Actions Otherimport Regulations . :Construction Investment Regulation O Services *Commerce L Ilndustry Cost of Permits Customs TaxRegulations Numberof Pe mn its Lic enses Obtaining Permits 0 0.5 t i.5 2 2.5 3 3.5 Severity Figure S Annex 77 Labor regulations and union activity were not _ constraints for most firms sampled, and were Severity of Labor Regulations as ranked the lowest among Latin American Constraint in 6 Latin American countries surveyed to date (Figure 6). Some 14% Countries of enterprises had unionized workers, concentrated primarily among construction firms and roughly correlated with size. However, only 6% had experienced a strike in the last five years. Brazil Among those firms, the average strike duration was 13 days and the cost was 1.5 million colones Equador - I (an average influenced heavily by large and I I I construction firms). Firing appears to be easy, and Pru V - some 64% of enterprises reported having bxico dismissed a worker in the last year for any reason. I On average, the process took about 3 days, Uruguay depending on the enterprise's own policies. More El Salvador important in labor constraints was the availability - -= of capable workers -- a constraint that came in 1 1.5 2 2.5 3 35 4 ! first in the open-ended question on constraints to No Obstrale M ior M oderate M qor firms. Among supply constraints, finding skilled workers ranked slightly ahead of problems finding - rgureih technicians and managers, but all were considered to be minor constraints. Infrastructure. Infrastructure imposed only minor to moderate constraints on most firms. It is nonetheless worth noting that 40% of firms, including 58% of construction sector firms, said that problems of transportation and communication created difficulties in fulfilling agreements for the timely delivery of their products. The three leading constraints were the state of roads, problems with telecommunications, and voltage fluctuations. Roads are especially limiting to those firms that export the most -- larger and industrial firms. Construction firms were most frustrated with the state of telecommunications, ranking it their leading infrastructural constraint. Finally, voltage fluctuations imposed a moderate constraint on firms, more so on large and medium finrs. Geographically, firms in San Miguel were especially bothered by infrastructural limitations, including roads, telecom and electricity, perhaps a residual of the physical damage caused by the civil war. Almost all firms had telephones, with the exception of 27% of the microenterprise subsample (disproportionately concentrated in San Miguel). Although telephone service ranked low as a constraint, over half of respondents were dissatisfied with the number of lines they had. The overwhelming reason cited for not having more telephones was that ANTEL had no additional lines to give them. The waiting time for a new line was estimated at 21 weeks in San Salvador, 18 weeks in Santa Ana, and 70 weeks in San Miguel. Firms in San Miguel were also worse off in terms of the number of weeks per year their telephones were out of service (an average of 2.9) and the number of times they had to dial to complete a local (5.8) or international (3.5) call. Perhaps one reason telephones were not more severe constraints is that 45% of firms owned radios to communicate, led by 56% of firms in San Salvador. Access to land did not seem to be a severe constraining: 67% of respondents owned all or part of the land where their firm was located (ownership was correlated with size), and all but 0.5% of firms owned or leased their property. 78 Annex Infrastructural Constraints to Salvadoran Enterprises Anp orts Ports __ Ra ilrnad - - Sewerage -- EKtemal Transport Services -- Bimination of Wage - Obtaining Industnal Space - -_ Problemswih WaterSipply Shortages i BEergy Sipply Voltage FRuctuations'Freq. Vaerns Problemsof Telecommunications Ouality of Roads_ o os5 1 1,5 2 25 3 Severfty Figure 7 Finance. In the area of finance, firns were most concerned with high interest rates (table 5). Firms in construction especially noticed this moderate constraint (in part due to their customer's cost of mortgages). Collateral imposed a minor constraint on firms but, again, was more severe for those in construction. Small firrns were more constrained than medium and large firms by collateral requirements, while medium-sized firms found interest rates most limiting. To start an enterprise, the principal source of financing is own capital (just over half), followed by bank loans - - 36% of total. Small and micro firms rely more heavily on their own funds than do medium and Annex 79 large firms. One finding that violated our expectations was a low reliance on friends and family overseas. We had expected to find substantial reliance on relatives working overseas and lending capital, but this was not identified as important. For some service firms and microenterprises, friends and family in El Salvador provided more than 10% of funds, but friends and family outside of El Salvador were not important. For future investment, commercial banks (60%) and own funds dominated. Table 3. Financial Constraints to Salvadoran Firms Average Constraint Scores (1-5) SECTOR SIZE Industry I Commerce Services Construction Large Medium Small Micro Guarantees/Sec'ty Required 2.3 2.3 2.0 2.7 2.1 2.5 2.7 2.3 Documentation Required 1.7 1.9 1.7 1.7 1.5 1.9 2.0 2.0 Interest Rates 2.6 2.7 2.3 2.9 2.6 2.8 2.5 2.5 Reqm't of Deposit/ Track Record 1.8 1.8 1.7 1.9 1.4 1.7 1.8 2.0 Don't have right Connections 1.6 1.7 1.5 1.7 1.4 1.7 1.8 2.0 Table reflects average constraint scores where a I means "no obstacle ", a 2 a "minor obstacle " and a 3 a "moderate obstacle One important constraint to business transactions evidenced by survey responses relates to credit information and collection. Firms indicated through several responses that they have a difficult time determining the reliability of customers and a tough time with repayment. First, the results show that fewer than half (46.2%) of firms extend credit to new customers who are not personal acquaintances. This is much lower than several other Latin American countries. Sources of Finance for Salvadoran Firms When they do offer such credit, ,-r W 0 z oOther- --1 they must principally rely on -- 7,,< I directly checking references, 100%- Y 90%; ,=W' U< _ Suppliers although some 30% sometimes 0 80% make use of a credit agency. (0% , 70% a Salvadoran Family and Credit checking through an W 60% Friends agency is much more common E 50% gForeign Sources among large and medium firms s 40% (small firms don't do it) and in C 30% . a Local Moneylends San Salvador, where half of firms U. 20% Is 10%- E3 Other Financial sometimes use this means. Firms 0% Institutions estimate that some 27% (median A °D og Commercial Banks value of 20%) of clients pay their - t 8 @, 1 debts late, and 5% allow their LL X*' Internal FundsoftheI debts to become delinquent 0(D3 Enterprise _ (median value of 2%). When z clients don't pay, over 30% of cases are simply written off. Figure 8 About 61% are resolved through a negotiated partial payment. However, a surprisingly high 19% end up in court. In fact, the average firm identified nearly 6 cases in the last two year that it had taken to court. Large firms were most likely to pursue this 80 Annex formal means and commerce firms far more active in resolution of debts than other firms, including through the courts. Security Concerns. Problems of security or "common delinquency" were the fifth leading obstacle cited by firms in the open-ended question. Some 44% of firms said they had taken special measures to protect their enterprise, led by 61% of large enterprises. (Microenterprises were not asked this question). Of those taking such measures, 66% employed guards, 27% took out insurance, 14% installed grills or bars, and 13% built special walls. Among those firms taking such measures, the average monthly expenditure was 29,000 colones, a figure heavily influenced by large firms, which averaged a monthly expenditure of 44,000 colones. Only one third of small firms took special security precautions, and those that did spent an average of 3,600 colones per month. Enterprises estimated that, in nominal terms, their expenditures on security had increased 85% over the last five years, led by an increase of almost 300% for small enterprises. Business Services. Finally, lack of business or professional services were of little concern to the firms surveyed. However, about 48% of firms acknowledged receiving some complaints about the quality of their product or service and 5% said they had regular complaints. Businesses reported that their most important sources of technical production information were suppliers and clients. Microenterprises. As noted at the beginning, microenterprises were included in a special supplementary sample and administered a shorter questionnaire. The microenterprises in the sample were, to a surprising extent, formal enterprises and, unlike micros in many other countries, did not identify themselves as disproportionately constrained by either the cost of or access to credit. The Salvadoran micros we sampled are predominantly oriented toward final consumers -- only 7% of their output went to larger domestic enterprises. This may indicate that microenterprises are not linked to larger firms through supply or subcontractual ties. If this is true, then policies that encourage the growth of larger enterprises may not directly benefit the growth of microenterprises (except insofar as they increase consumer demand for microenterprise goods and services). Like their larger counterparts, formal microenterprises were moderately troubled by inflation and by problems of security. Formal microenterprises are moderately constrained by the state of roads and telephone service, and by insufficient demand. Regulations, however, impose either a minor or no constraint at all for fornal microenterprises. Informal microenterprises are especially constrained by financing problems, which is their leading general concern. Unlike their formal counterparts, informal microenterprises find both collateral requirements and interest rates moderately constraining, and perceive their lack of adequate connections to banks and bankers a moderate constraint. Informal microenterprises are also particularly constrained by their problems in accessing space or land to run their businesses (a major constraint), by power supply problems (moderate), and by a general lack of demand (a moderate difficulty, but nonetheless ranked higher than by formal firms). However, informals are remarkably unconcerned with security and, as might be expected, find regulations no problem at all. Annex 81 Exporters. Further analysis determined the differences in problems faced by major exporters (here defined by those enterprises that export 25% or more of their production), minor exporters (here defined as those that exported something less than 25% of production) and non- exporters (who exclusively supply the domestic market). In general, those firms that export 25% or more of their sales rank leading constraints lower than do other firms. Non-exporters are most constrained by inflation and price instability. Minor exporters feel most acutely affected by political and policy uncertainty, and by the level of the exchange rate. This may indicate that those firms just entering export activity are more sensitive to these factors, hence export growth is critically dependent on stable economic policies and a consistent policy regime. Minor exporters also identify themselves as more constrained by informal competition than do other firms, particularly in the areas of competitors avoiding taxes, trade regulations, and labor regulations, and in competitors undercutting their prices and offering goods of a lesser quality than they advertise. Major exporters also find informal competition constraining, and are somewhat more constrained than other firms by competitors selling below international prices. In regulation, there are few differences to report and all no category of regulation imposes more than a minor constraint, but minor exporters are a bit more constrained than other firms by required permits, customs procedures, and other import procedures. In the area of infrastructure, minor exporters are also much more constrained by the state of roads than are major- and non-exporting firms. Major exporters, which tend to be larger firms, are more likely to have their own generator (58% do) and to use radios to augment the telephone system. Given these investments, it is not surprising that they are no more constrained by power concerns and less constrained by telecommunications than other firms. Beyond basic communication, however, fewer major exporters (16%) than other firms (21%) identified telecommunication services they would like but could not obtain. And there was some indication that international transport and telecommunications services are better than domestic transport: major exporters were less likely than other firms to complain that transport and telecom created problems in meeting commitments to customers. In addition, while firms report having to make 3.9 attempts to complete a local call, they average only 2.3 attempts per completed international call. Responses to questions on technology, production and business services suggest the difficulties some firms may face in reaching international technical standards. Minor exporters found greater difficulties (although still moderate to minor) than major exporters or nonexporters in meeting orders in a timely way, in accessing information on new products, technology and equipment suppliers, in obtaining foreign technology, in finding qualified technicians, and in obtaining market information. Industrial Subsectors. Finally, responses were disaggregated by industrial subsector to determine if, although, overall, firms found no constraint more than moderate, particular sectors did encounter major or severe constraints. This disaggregation made clear that a number of traditional sectors are relatively untroubled. For example, for the food, drink and tobacco, textile, and leather and footwear products sectors, the only moderate obstacle was inflation/price instability. For the clothing manufacture industry, only financial problems were considered moderate. By contrast, there were numerous moderate and even major constraints identified by the chemical industry, led 82 Annex by the fertilizer and pesticide subsector which found regulations, inflation and the functioning of the judicial system each to impose major obstacles. The chemicals sector generally led other sectors in concerns about inflation, policy uncertainty and security. The pesticide and fertilizer subsector and the machinery and equipment subsector each had greater difficulties in the business dealings with the government than did other sectors. Both found the slow process between tendering and contract award and the excessive bureaucracy and permits involved in supplying public agencies to be major obstacles, while the machinery subsector also found late payment to be a major problem. Informal competition imposed major constraints on four subsectors: shoes and leather, medicine and cosmetics, other chemicals, and machinery and equipment. Each had major difficulties with competitors avoiding taxes, and three of four encounter major problems with competitors evading trade laws and labor laws. Medicine and cosmetics companies had particular problems with competitors fraudulent or misleading claims for their products and with competitors selling below international prices (dumping). Machinery and equipment respondents sector was especially constrained with competitors selling below their own costs. Although regulation was generally not constraining, fertilizer and pesticide companies felt that the permits and licenses required of them and tax regulations each imposed major constraints. Finally, infrastructure appear to constrain paper products manufacturers the most: they found energy supply, telecommunications and roads each to be major constraints. The subsectors manufacturing fertilizer and pesticide and medicine and cosmetics also found roads to impose a major constraint, while other chemical companies found telecom a major limitation. In finance, the fertilizer and pesticide and other chemicals subsectors were disproportionately constrained by interest rates. In technology and business service issues, machinery and equipment producers found it especially difficult to access foreign technology, fertilizer and pesticide producers found lack of domestic market information and major constraint, and machinery and equipment producers were similarly constrained by lack of export market information. BIBLIOGRAPHY Andic, S. (1992), "El Salvador: Tax System and Its Reform," Washington D.C.: Report prepared for the World Bank. _______. (1993), "A Review of El Salvador's Tax System," Washington D.C.: Report prepared for the World Bank. Azam, J.P., D. Bevan, P. Collier, S. Dercon, J. Gunning, and S. Pradhan (1994), "Some Economic Consequences of the Transition from Civil War to Peace," The World Bank - Policy Research Working Paper #1392 (December). Bennett, Adam G. G. (1994), "Currency Boards: Issues and Experiences," IMF Paper on Policy Analysis and Assessment (September). Calvo, G., L. Leiderman, and C. Reinhart (1993), "The Capital Inflows Problem: Concepts and Issues," IMF Paper on Policy Analysis and Assessment (July). Calvo, G., and C. A. Vegh (1992), "Currency Substitution in Developing Countries: An Introduction," IMF Working Paper (May). Corbo, V. and L. Hemrndez (1994), "Macroeconomic Adjustment to Capital Inflows - Latin American Style versus East Asian Style," World Bank - Policy Research Working Paper #1377 (November). Corden, W.M. (1984), "Booming Sector and Dutch Disease Economics: Survey and Consolidation," Oxford Economics Papers 36(3): 359-80. Corden, W.M., and J.P. Neary (1992), "Booming Sector and De-Industrialization in a Small Open Economy," Economic Journal (92): 825-48. Edwards, S. (1995), "Why are Savings Rates so Different Across Countries? An International Comparative Analysis," NBER Working Paper Series (5097). . (1993), "Exchange Rates as Nominal Anchors," Weltwirtschaftliches Archiv (129): 1-33. . (1989), Real Exchange Rates. Devaluation and Adjustment. Exchange Rate Policy in Developing Countries. Cambridge, Mass: MIT Press. . (1986), "A Commodity Export Boom and the Real Exchange Rate: The Money-Inflation Link," in J. Neary and S. van Wijnbergen, eds. Natural Resources and the Macroeconomy. Cambridge, Mass: MIT Press. _______. (1984), "Commodity Export Prices and the Real Exchange Rate in Developing Countries: Coffee in Colombia," in S. Edwards and L. Ahamed (eds.) Economic Adjustment and Exchange Rates in Developing Countries. Chicago: University of Chicago Press. 84 Bibliography Frankel, J. A. (1994), "Sterilization of Money Inflows: Difficult (Calvo) or Easy (Resien)?" IMF Paper on Policy Analysis and Assessment (December). FUSADES (1993), "Desafios de la Reconversion Industrial," Boletin Econ6mico v Social #96 (November). ___ . (1994), "La Emigraci6n de Salvadorenfos y su Impacto Econ6mico y Social," Boletin Econ6mico y Social # 98 (January). _______. (1995), "La Empresa y el Reto de la Globalizaci6n," Boletin Economico y Social #110 (January). Gregory, P. (1993), "The Labor Market of El Salvador," Report prepared for USAID (April). Hlanson, R. J. (1993),. "An Assessment of the Legal and Regulatory Framework for Enterprises in El Salvador." Report prepared for the IDB, Washington, D.C. (October). Harberger, A. C. (1993), "Las Exportaciones y El Tipo de Cambio Real en El Salvador". Report prepared for FUSADES (October). ______. (1995), "Reflections on the Economy of El Salvador," Report prepared for FUSADES (June). IDB (1991), El Salvador: Private Investment Diagnostic Study (October). Leamer, E.E., A. Guerra, M. Kaufman, and B. Segura (1995), "How does the North American Free Trade Agreement Affect Central America?" World Bank - Policy Research Working Paper #1464 (May). Lopez, J.R. and M. A. Seligson (1991), "Small Business Development in El Salvador: The Impact of Remittances," in S. Diaz-Briquets and S. Weintraub, eds. Migration, Remittances. and Small Business Development: Mexico and Caribbean Basin Countires. Boulder, Co: Westview Press. Montes, S. and 3.J. Garcia Vasquez (1988), Salvadoran Migration to the United States: An Exploratory Study Washington D.C.: Georgetown University. Nathan Associates, Inc. (1994), "El Salvador: Revision of Laws Governing International Trade and Investment," Report prepared for USAID (June). Nehru, V. and A. Dhareshwar (1994), "New Estimates of Total Factor Productivity Growth for Developing and Industrial Countries," World Bank - Policy Research Working Paper #1313 (November). Rajapatirana, S. (1993), Policy Recommendations for Export Promotion, paper presented at the Annual Meeting of the Chilean economic Society held on May 7-8, 1993. Talley, S. (1994), "Deposit Protection and the Spread of Deposit Insurance - Some Guidelines for Developing Countries," World Bank FPD Note #12, (June). Bibliography 85 van Wijnbergen, S. (1984), The "Dutch Disease:" A Disease after All?," The Economic Journal 94 (May):41-55. Wang. Y. and J. Schilling (1995), "Managing Capital Flows in East Asia," World Bank Discussion Paper, Washington D.C.: The World Bank. Webster, L. (1994), "Lending for Microenterprises - A Review of the World Bank's Portfolio," World Bank FPD Note # 12. (June). World Bank (1995), Global Economic Prospects and the Developing Countries. Washington, D.C.: World Bank. _______. (1993), The Asian Miracle - Economic Growth and Public Policy. Washington, D.C.: World Bank. _. (1991a), World Development Report Washington, D.C.: World Bank. . (1991b), Developing the Private Sector. The World Bank's Experience and Approach Washington D.C.: World Bank. Younger, S. D. (1992). "Aid and the Dutch Disease: Macroeconomic Management When Everybody Loves You," World Development 20 (11): 1587-97. Distributors of CHINA GREECE ffALY NORWAY SINGAPORE. TAIWAN, Van Diemen EdritisTechnee Distributors Of ChFCnaFanoal & Ecornmic P*aslrni SSA. Lrova CormnssiornanaSansoniSPA NarvesenInMormaionCenle MYANMAR, BRUNEI Ch.de Lcueze4 W orld Bank PunolshegHr use 35,tWounarStr ViaDimcaDrCalabna, /t BookDepartment Asahgate Putkshng Asia CHi8O7 Blonay 8, DaFo9SiDofio Jie 106 82 Athw CrrseabPostate 552 P.O. Box 6125 Etterstad PaaflrPte Ltd Tel i021) 943 2673 Publications e-ing Tel(1)364-182 50125 Frneze N06020slo6 41KatarrgPuddegRoad104o03 FFa (021)9433605 Prices antd credit termns ziary Tet: (1) 333-8257 Far (1) 364-8254 Tet (55) 645-415 Tel: (22) 57-3300 Golden Wheel BuRking front coun1try to country. Fan (1)401-7365 HONKN,ACAO Far (55)641-257 Fax (22)68-1901 S9ngapDre349316 TANZNPress Costult your local distributor COLOMBLA Asia 2W It JAMYACA PAKISTAN Fax: (65) 742-9356 Maktaba Street before plttcinrg tii order. Inloentace Lit. Sales & Coiabhan Deparlmrent tan Radrde Pitthees Ltd t4rza Book Agency e-mai ashgateoasnancnmnr-cL.con, PO Box 5299 Apartado Aeneo 34270 Seabid House, url 1101 -02 20r Old Hope Road 65, Shahrah-e-Ouad-e-Azam Dar es Sataam BogotA D0E 22-28 Wyrinem Street Cedral Kxrgslon 6 P.O. Box No. 729 SOVAK REPUBLIC Tel. (51) 29200 ALBANIA Tel: (1)285-2798 HrngKrig TeL809-927-2085 LahereSC4000 SxovarlG.TG Ud Fax(51)46822 Adrion Ud Fax: (1) 285-2798 Tet 852 25301409 Far 809-977.943 Tel: (42) 7353601 Krupinska 4 Peilal Rexhept Str Far 852 2526-1107 Far (42) 7585283 PO Box 152 THAILAND Pall 9Shk 1, Ap 4 COTE DlVOIRE UIL hlp-hirwwsakes@asa200oxrm-lk JAPAN 85299 Bratislava S Cenral Books rstidirw Trtana Cenire crEtton el de Druson Easeem Book Servmce Oxtord University Press Tel: (7) 89472 306 Sinem Road Tel: (42) 274 19, 221 72 Arns (CEDA) HUNGARY Hmge 3-Chroe, 5 Barrgaeo Town Fax. (7) 839485 Bangkok Fax (42) 274 19 04 BP 541 Foandalon lor LMae BurIryku 113 SharaeFalsat Tel. (2)23554400 Abidjan 04 Plateau Ecrrr Tryo PO Box 13033 SOUTH AFRICA, BOTSWANA Fax. (2) 237-8321 ARGENTINA Tel: 225-24-6510 Dorxtovarb nn 17-19 TeL (03)3818.51 Karacht-75350 Forsingle Ues- Oficrsa det Lbro lnernadonal Fan: 225-25-0567 H-1117 Bulapest Far (03) 3818-0864 Tel (21)446307 Oidord Universty Press TRINIDAD & TOBAGO, JAM. Av. Cordoba 1877 Tel- 361 204 2951 or UlLt htip-vitmbekkoame orzpt-sl-ebs Fax (21) 454-7640 SothernAfrica Syslematics Sluties Ufl 1120 BuenosAres CYPRUS 361 204 2948 P.O Bon 1141 19 Wats Shreet Tel (1) 815-8156 Center ol Appited Research Far 36 1 204 2953 KENYA PERU Cape Town 8000 Curepe Far. (1 815 8354 Cyprus Coltge Arnca Book Serie (EA.) Ud Editonal Desanollo SA Tel (21) 45-7266 Trinidad, West Ilries 6, Diogenes Street, Engormi WINA Quaran House, Mtangano Street Aoarltado 3824 Fax- (21) 45-7265 Tel. 800662 5654 AUSTRALIA, FPJ, PAPUA NEW GUINEA, PO. Box 2006 Aied Pubishers Lid. PO Box 45245 Lim I Fan: 809-662 5654 SOLOMON ISLANDS, VANUATU, AND Nicosia 751 Moat Road Narob Tel: (14) 285380 Forsubscnpeon orders WESTERN SAMOA Tel 244-1730 Madras 600 002 Tel: (2) 23641 Faxn (14) 286628 Iniernallonal Subseupon Service UGANDA DA Intormation Servces Fax 246-2051 Tel (44) 82-3938 Fax (2)330272 P.O. Box 41095 Gustro Ltd. 648 Whitehorse Road Fan (44) 852-0649 PHILPPINES Craighal Madhtan Buiaing Mitcharn 3132 CZECH REPUBLIC KOREA, REPUBLIC OF International Booksource Center inc. Johannesburg 2024 PO Box 9997 Victor,a Natmrat Itnersati n Cenler INDONESIA Daelon Trading Co. Ltd Sune 720, Citytand 10 Tet (11)880-1448 Plot 16/4 Jrr5a Rd Tel (61)39210 7777 prepna, KonnkLska 5 Pt liba Limnled PO. Box 34 Condominium Tower2 Fax (i11) 806248 Kampala Fax (61)392107788 CS -11357 Pragueo Jao Bnorobudur 20 Yeoexia H V dela Coslt, comer TeLFax (41)254763 URL htlptww daclrect.co5mau Tel (2) 24229433 PO. Box 18t Seou Valero St. SPAIN Fax: (2) 2422 1484 Jakarta 10320 TeH (2) 78S-163114 Makab, Metno Manita Mundi-Prensa Likos, S A UNITED KINGDOM AUSTRIA URL. itp/wwms.cz/ Tel. (21)380-4290 Far (2) 784-0315 Tel (2)817-9676 Castello37 Micronio Ltd Gerold and Co Fan. (21) 4214289 Fax: (2) 817-1741 28001 Madrd PO Box 3 Graben 31 DENMARK MALAYSIA Tel. (1) 431-3399 Alton, Hampshire GU34 2PG A 1011 Wien SamtundsLnrerahur 6tTAN University ol Malaya Cooperatove POLAND Fax: (1) 575-39W8 England Tel (1)533-50-14-0 Rosmenoems Ale II Kowkab Pube ers Booksnrp, Laned Inlernational Pubirshing Service hftp.hwv tsar eslmprensa Tel (1420)86848 Fan. (1)512 47-3129 DK-1l970FredenksbergC P.O. Box 1957S511 P.O. Box 1127 Ul Pektna31l37 Fax (1420)89889 Tel. (31)351942 Tehan Jalan Panti Bar 00-577 Warzawa Munb-Prensa Barcebna BANGLADESH Fax. (31)-357822 Tel: (21) 258-3723 59700 KueaLa Lwr Tel (2) 628-6089 Conse de Cent. 391 ZAMBIA Micro tndcuslnes Devetopment Far 98 (21) 258-3723 Tel: (3) 756-5000 Fax, (2) 621-7255 08009 Barcetna Urnversity ookshop Ass,stance Sooety (MIDAS) EGYPT, ARAB REPUBUC OF Far (3) 755-4424 Tel: (3) 488-3009 Great East Road Carripus House 5, Road 186 AlAam Kelab Sara Co. Prihers PORTUGAL Fan: (3)487-7659 PO. Box 32379 Dhanmondi FVArea Al Gataa Skeet Khaled EsYambi Ave.. MEXICO Lnaaria POugael Lusaka Dhaka 209 Carn 6rh Skeet INFOTEC Rua Do Carmo 70-74 SRI LANKA, THE MALDIVES Tel: (1)213221 Ea 482 Tel. (2) 326427 Tel: (2) 578-6083 Kuiehr Delatooz No 8 A,arlai Paslal 22-880 1200 Lisbon Lake Horse Bookshiop Fan. (2) 811188 Fax: (2)578-6833 Iehran 14060T la Tel: (1) 347-4982 PO. Boo 244 ZIMBABWE Tet 8717819or8716104 MetoD.F. Fan: (1)347-0264 100, Si ChiiamnpaLamA LorngmanZrmbabxwe(Ple)Ltd BELGIUM The lMe Eas4 Obsereer Far 8862479 Tet (5) 606r0011 Gadnier Maaloha Tourle Road, Anirerw Jean De Lannoy 41, Shefg Skreet Far (5) 606.0386 ROIANIA Comfflbo 2 PO. Box ST125 Av. du Ret 202 Cairo IRELANW Crpani De Libari Bucuars S Tel: (1) 32105 Southenon 1060 Brussels Tel: (2)393.9732 Gr3mrnrts upSliesAgency NEAERAINDS S9r Lpscarxnro. 26, sector 3 Far (1) 432164 Harare Tet (2) 538-5169 Far (2) 393-9732 oi(g anirSairak De Linlde rhOr-Pubtltabes Bucharesl Tel- (4)6216617 Fax (2) 538-848 4-5 Ha-rnu Reoad PO. Bot 202 Td: (1) 613 9645 SWEDEN Fax (4) 621670 FNLAND Dultrn 2 7480 AE Hakaberger Far (1) 312 4000 Frizes Cusaom Service BRAZIL Akaterne Kajaippa Tet (1) 461-3111 Tet (53)574-004 RegearlgaLon 12 Publxtcaces Tecricas tntemaornais PO. Box 23 Far (1) 475-2670 Fax (53) 572-9296 RUSSIAN FEDERAllON S-106 47 Stockhoks Ltda FIN-00371 Helsnb Isdaelstvo Tn: (8) 690 90 90 Rua Perxolo Goffrde, 209 Tel: (0)12141 SRAIEL NEW ZEALAICI 9a. Kdpadniy Pereulok Fax: (8) 21 47 77 01409 Sao Paulo, SP Fax: (0)121-4441 Yozr Lilerage Ltd. EBSCO NZ Lid Mosow 101831 Tel. (11) 259-6644 URL: NpAfkrokrrel.aultelt.iaka PO. Box 58055 Pnrrae Mael Bag 99914 Tel: (95)9178749 Wennergren-Wiiams AB Fax (11)258.6990 TeAviv61560 NevrUarkel Far (95)9179259 PO.Bot1305 FRANCE Tel: (3) 5285397 Asiranl S-171 25Sonia CANADA World Bank Pubklicaons Far (3)5285-397 Tel: (9)524-8119 SAUDI ARABIA, QATAR Tel (8) 795-97-50 Renoul Putlishtmg Co. Ud. 66, avenuedro ina Far (9)524-807 JanrBook Store Fan: (8) 27-071 1294 Atgorna Road 75116 Pans R.O.Y kteraonal PO. Box 3196 OGawa, Onlario KIB 3W8 Tel: (1) 40-69-30-5607 PO Box 13056 NIGERIA Rryadh 11471 SWffERLAND Tel 613 74134333 Fax: (1)40-69-3068 TelAviv 61130 Uneverry Press Lailed Tel. (1) 477-3140 Lrairie Payot Fax 613 741-5439 Tel: (3) 5461423 Tlhee Cruris Buibg Jericho Fan. (11477-2940 Service InsUtutionnel GERMANY Fax: (3) 5461442 Private Mal Bag 5095 Cotes de-Mnitberon 30 UNO-Vedag lbadan 1002 Lausanne PoppedsdorlerAllw 55 PalestinianrAuttAy/Mrle East Tel (22) 41-1356 Tel: (021(.34t-3229 53115 Bonn kidexriloriaeot Services Far: (22)41-2056 Fax: (021)-341-3235 Tel. (228) 212940 PO B. 19502 Jkersatem Fax: 228) 217492 Tel: (2) 271219 3 1 II Il I I * I l II 5S X- - [ I _ p _ I ; i Ir) - -.m-ili - -Cs7-" - _ t~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ !~~~~~~~~~~~~~~~~~~~~~~~~ 881370