Consultative Group for the Reconstruction and Transformation of Central America

"reconstruction must not be at the expense of transformation"

Central America After Hurricane Mitch
The Challenge of Turning a Disaster into an Opportunity

El Salvador

A. Summary

During 1998 and 1999 El Salvador has been able to maintain financial stability, with a balanced external sector, higher levels of consumption, a controlled inflation and a stable exchange rate. This has earned the country with positive investment grades from Moody’s and Standard and Poors. These positive indicators exist despite the negative effects of the international financial crisis and natural disasters such as hurricane Mitch and the adverse climatic effects of El Niño. It should be noted that the country has been successful in the process of modernizing the state through the privatization of public enterprises and promoting competitiveness.

Regarding recent political events, the country elected Mr. Francisco Flores as President and Mr. Carlos Quintanilla Smith as Vice-President, both from the ARENA party. The Political campaigns were basically centered on the following issues: (i) public safety, (ii) the reactivation of the agricultural sector, (iii) economic stability, (iv) transparency and (v) competitiveness.

Hurricane Mitch had its worst impact on the country’s eastern region, where the Lempa and Grande de San Miguel Rivers overflowed. The sectors with the most damages were agriculture (100,000 hectares affected by floods, with unfavorable effects on production), transportation, with serious damages in the highway infrastructure of the eastern region, and housing, with more than 10,000 homes affected.

Mitch-related Bank support has been through non-reimbursable technical cooperation for emergency assistance, assistance to the Ministry of Public Works in the damage evaluation process and through regional disaster prevention programs. The Bank has also assisted the Government in identifying portfolio operations with available resources that should be reoriented for reconstruction efforts. In this sense, the Bank’s Board of Directors approved reformulating projects in the amount of US$155.5 million and redirecting US$19.5 million of an energy sector loan for reconstruction of roads affected by the hurricane.

The Bank’s regular portfolio with the country mainly deals with supporting operations related with reconstruction efforts after the signing of the Peace Accords in 1992. These operations have dealt with Public Administration Modernization, physical and social infrastructure, and the strengthening of the financial sector

B. Country Analysis

B.1 The Economy
In 1998 GDP increased 3.4%, (4% in 1997). This slowdown was mainly due to production drops in agriculture (-0.9%). The construction and financial sectors also evidenced less dynamism. During 1998 the agricultural sector was significantly affected by the losses caused by El Niño and by Hurricane Mitch. Mitch affected the production of sugar cane, beans, corn, sorghum and rice and coffee. The dynamism observed in the manufacturing sector, which grew a satisfactory 7%, was due to a higher volume of industrial production and to the maquila industry.

In 1998, total demand, which maintained its rate of recovery after having decreased in 1996, was positively influenced by the growth of the economy, although with a lower increase than that of 1997.

Graph 1

Hurricane Mitch caused an increase in consumer prices in December 1998. In November 1998 4.2% (1.9% in December of 1997) food prices experienced a 5.4% monthly variation, the highest in years (0.4% for the same month in 1997). Mitch also increased El Salvador’s dependency on neighboring countries for the supply of basic grains.

Graph 2

Fiscal accounts in 1998 reflected growth in total revenues. This increase (15.6 % of GDP) was due to greater tax collections, which surpassed that of 1997, resulting from improvements in the administration of the VAT and the income tax. Capital revenues originated mostly from the sale of the national electricity distribution company which reached 50% of the increase in current revenues.

Government administration expenditures (14.4% of GDP) increased, mainly because of salary raises and capital expenditures increased 9%. This resulted in a fiscal deficit of 2.0% of GNP, slightly higher than 1997 (1.8%), but lower than estimated in the Monetary and Financial Program of 1998 (2.4%). This deficit was partially financed with resources coming from the sale of the electricity companies. On the other hand, monetary policy maintained restrictive characteristics with a tendency to decreasing pressure on prices, thereby inducing prices to stay at low levels.

Graph 3

The trade balance (including maquilas) continued to show a US$1.5 billion deficit, which is higher than preceding years. The slow increase in exports was mainly due to the slow growth in production of traditional goods, such a coffee. The maquila industry accounted for the highest export value, equivalent to 49% of total exports. Likewise, other traditional products, such as sugar and shrimp, also increased their sales. Non-traditional exports accounted for 34% of total exported goods. The increase in imports (US$4.0 billion) was due to the increase in demand of inputs for the maquilas. Imports coming from outside of Central America accounted for 81% of the total (excluding the maquila).

The negative balance of services account influenced the increase in the trade balance deficit, yielding a deficit on current account of US$83 million (the trade balance was positive in 1997). This deficit occurred in spite of the increase in family remittances that reached a level of US$1.3 billion (11.6% higher than in 1997).

The net balance on the capital account was favored by direct investment coming from the privatization of public enterprises (electricity and the telecommunications), resulting in a positive balance of payments (US$303 million surplus). This increased net international reserves at the end of the period to US$1.8 billion. In this context, the exchange rate was practically fixed, given that for the sixth year, it has been maintained at an average of 8.75 colones US$. External debt reached a level of US$2.6 billion. The relation between the debt and GDP was 22% while that of debt service to exports was at 23%.

Graph 4

Regarding policies linked to the modernization of the State, significant advances were made in the reform of the pension system, by creating and putting into operation five "pension fund administrators" (AFP). On the other hand, a series of initiatives to modernize the legislation of the financial system are currently under discussion in the National Assembly.

Regarding trade, a program for tariff deduction was implemented under the guidelines of the Central American Integration Treaty, and began to be applied to final and intermediary goods. Likewise, discussions with Guatemala and continued in an attempt to formulate a common strategy for a Free Trade Agreement with Mexico. On the other hand, El Salvador, along with Costa Rica and Guatemala, signed the last agreement in November, through which a Free Trade Agreement with the Dominican Republic would go into force. Regarding the signing of the same agreement with Chile, which the Central American countries have been negotiating as a bloc, there are indications that such an agreement will be signed in the near future.

B.2 Damages caused by Hurricane Mitch in El Salvador

As a result of Mitch, 240 people were killed, 19 are missing and approximately 59,000 were left homeless. Mitch entered El Salvador on October 30th 1998 through its eastern region, the most badly hit in the country. The storm initially affected the states of San Miguel, La Unión, Usulután and La Paz and then it went over the remaining territory including San Salvador. Damages were mainly caused by the overflow of Río Grande de San Miguel and the Lempa Rivers, which caused floods, mud slides and land slides, damaging roads and isolating the eastern portion of the country. The most seriously affected sectors are agriculture, the road system and housing. The disaster had its major impact in the rural areas, which also are the poorest in the country.

According to ECLAC, material losses were estimated at almost US$400 million, principally due to production losses (US$245 million). Of total losses, 45% were direct and 65% were indirect, affecting economic flows.

Agriculture had losses of about US$102 million, followed by industry (US$74 million) and livestock (US$52 million). The economic infrastructure suffered damages primarily to the highway system and communications (US$70 million), while the social sectors, housing, health and education, had estimated damages of US$12 million each.

Agriculture and livestock were affected by serious flooding of 100,000 hectares of pastureland and cropland. The hurricane affected the production of four basic crops--beans, corn, rice and sorghum--, especially the first two which lost 37% and 19% of their expected production. Additionally, there were losses in export products -coffee and especially sugar cane-, which lost 20% of the expected production. Also 10,000 cattle were lost in addition to other minor animals.

The industrial sector was indirectly affected due to the fact that important quantities of sugar, milk, corn and beans, among others, were lost locally and in neighboring countries affected by the hurricane, and thus could not be processed.

The transportation and communications infrastructure was affected with the destruction of two Bailey bridges and other secondary bridges, potholes on primary and secondary paved roads, and other damages, such as clogged drainage systems that damaged over 2,000 kilometers of unpaved roads.

In the social infrastructure, more than 10,000 homes were damaged, especially in the rural areas of Ahuachapán and the Bajo Lempa, due to flooding and landslides. Damages to homes in urban areas were limited to those located in the periphery, on inclined terrain. Regarding health and education there were losses in furnishings and equipment in 22 health units and 326 schools reported damage.

B.3  Medium term outlook

The Monetary and Financial Program for 1999 predicts a GDP growth of 4% (originally predicted at 4.5%). This should result from a decreased growth rate in sectors such as mining, manufacturing, transportation, warehousing and communications. Moderate growth (3.5%) has been assigned to the financial sector that traditionally has had high growth rates. This slow-down may be due to the possibility that it is subject to restrictive policies that impede its expansion. Nevertheless, recovery is expected in agriculture, construction and commerce, restaurants and hotels.

During 1998, exports were not affected by the hurricane because export production had been carried out before the storm. Exports are being affected during 1999 because of lower sugar production, and to a lesser extent, lower production of coffee. Although the demand of neighboring countries will be less, this should not have a serious impact on total exports because Honduran imports only amount to 6% of Salvadoran exports, and Nicaraguan imports only 3%.

One of the most affected areas was San Miguel, the province with the greatest number of residents living in the United States, and the highest volume of outside family support. Preliminary estimates indicate a 10% increase in the level of family remittances. The deficit of the balance on current account in 1998 (1.4% of GDP) was slightly higher than estimated. On the other hand, the country has a comfortable level of net international reserves that accounts for more than 4 months' worth of exports. The effect during 1999 will depend on how exports are affected.

In terms of fiscal policy, an increase in total revenues is estimated, induced principally by current revenues that ought to attain a level of 15.8% of GDP. Higher tax collections (VAT and income tax) are anticipated, in addition to higher revenues due to the surplus of public businesses. Current expenditures should reach a level of 14.7% of GDP, also higher than 1998. The higher increase of current revenues with respect to current expenditures should lead to a higher level of current savings, equal to 1.1% of GDP. Nevertheless, higher capital expenditures, induced by an increase in gross investment should lead to a fiscal deficit of 2.5% of GDP. Greater fiscal expenditures due to reconstruction needs, more donations and foreign loans, will increase liquidity, putting pressure on prices. Therefore, the Central Bank decided to gradually increase the bank reserve rates.

The trade balance is expected to close with a deficit of US$1.8 billion, 20% more than in 1998. Exports were affected by a significant decline in coffee. While the export value of other traditional goods declined, non-traditional ones and the maquila industry exports increased. The trade deficit will be partially compensated by net transfers of US$1.6 billion, of which US$1.4 billion will be from family remittances from the US, reducing the current account deficit to US$230 million. In this context, it is predicted that the exchange rate will remain the same.

C. Activities of the Bank

In 1998, the Bank approved loans to El Salvador for a total of US$208.5 million. Most of the existing portfolio is new, and it is coherent with the strategy agreed upon with the country to support reconstruction after the 1992 peace accords: 57% of the resources will be used for infrastructure, 26% for the reduction of poverty, 13% for the modernization of the state and productive projects, 1% for pre-investment, and 3% for the environment.

Likewise, the Bank approved non-refundable technical cooperation projects in the amount of US$3 million for El Salvador, in 1998.

Through the Multilateral Investment Fund (MIF), part of the IDB Group, operations for more than US$15 million have been financed. These include assistance in regulatory frameworks for energy, telecommunications, water and the financial system; support to small business; modernization of trade legislation; private sector human resources training; support to small financial institutions, and others. New operations are being considered US$6 million.

For 1999 three new loans for a total of US$52.8 million are being processed (Decontamination of Critical Areas, Modernization of the National Comptroller’s Office, and a Modernization Program for the Financial Sector). Three additional loans for approximately US$135 million are also in preparation (Modernization of Legislative Power, a Public Safety Program, and a Financial Sector modernization program).

El Salvador
Basic Data

Macroeconomic indicators 1994 1995 1996 1997 1998 1999*
GDP (growth rate) 6.1 6.4 1.8 4.0 3.4 3.5-4.5
Deficit Non-financial Public Sector (% of GNP) 0.6 0.1 2.4 1.8 2.0 2.6
Central Government tax Revenues (% of GNP) 10.9 12.0 11.2 11.0 11.1 11.4
End of year Inflation (percentage) 8.9 11.4 7.4 1.9 4.2 2.5-4.5
Balance of payments [Current Account (% of GNP)] -0.2 -2.8 -1.6 0.9 -0.7 -1.7
International Reserves (months of imports.) 3.7 3.6 4.4 5.0 5.7 5.5
Family Remittances(% of GNP) 12.3 12.4 11.2 11.0 11.2 11.2
Social expenditure (%of GNP) 7.3 7.2 8.2 8.6 8.7 n/a

Central America     Honduras    Nicaragua    El Salvador    Guatemala     Costa Rica


Nicaragua, May 2000   -   Honduras, February 2000   -   Stockholm, May 1999

Inter-American Development Bank