El Salvador’s economic shackles

A quarter of a century after its peace accord, El Salvador’s economy has come along tremendously, but rampant gang crime and a vast budget deficit continue to strangle the country’s true potential

 
MS-13 gang members languish in the Quezaltepeque police station in El Salvador 
Author: Elizabeth Matsangou
April 19, 2017

El Salvador is a small country with big problems. Just over a quarter of a century ago, it was engulfed in an intrastate war that mutilated both the nation’s economy and its infrastructure, all the while leaving deep social scars – the type that can take generations to heal. And yet, despite the atrocities carried out throughout the 12-year civil conflict – including the death of around 75,000 citizens, most of whom were non-combatants – El Salvador’s reconciliation process was exemplary. Its model has even been used by others since.

Efforts towards greater economic liberalisation have led to a remarkable increase in exports, which have now become El Salvador’s biggest economic driver

Yes, El Salvador has come a long way since its government and the left-wing guerrilla group Farabundo Martí National Liberation Front signed the Chapultepec Peace Accords on January 16, 1992. Notably, efforts towards greater economic liberalisation have led to a remarkable increase in exports, which have now become El Salvador’s biggest economic driver (see Fig 1). Daniel Lacalle, author, international advisor and professor of global economy, told World Finance: “The opening of the El Salvador economy has helped the country achieve impressive growth and increase GDP by more than 150 percent in the period.”

The economy progressed further still in 2001 as a result of the currency’s dollarisation, which helped to improve the country’s business climate with lower interest rates, reduced transaction costs and cheaper international financing. The agricultural industry too has remained crucial to the state, accounting for some 17.3 percent of total employment in 2015, while the banking sector has helped the inflow of foreign capital significantly, with the country’s five biggest banks now being foreign-owned entities.

Expediting exports
With the peace treaty in hand, the Salvadoran government was able to implement a series of reforms, which proved to be far more successful than previous attempts at tackling the economy’s once intractable imbalance. As well as structural reforms, improved legislation, better investment security and far more robust government support mechanisms all assisted in encouraging El Salvador’s export potential.

“A solid monetary policy that avoided constant inflationary pressures and devaluations helped to stabilise imports [and] improve productivity through efficiency and added-value”, said Osmel Manzano, Economics Principal Advisor at Inter-American Development Bank. “Exports multiplied from an all time low of $47.7m in November 1991 [just before the end of the Salvadoran Civil War] to almost 10 times higher at $400m in December 2016. In my personal opinion, the reasons for the economic miracle of El Salvador have been a successful set of reforms, control of monetary policy and impressive trade improvement.”

The consolidation of a vital export-led development plan, together with the opening up of the economy to foreign investment, has led to the noteworthy expansion of El Salvador’s biggest sectors: low added-value manufacturing, known locally as maquila; business process outsourcing, most notably in the form of call centres; and, of course, agriculture.

Before the civil war, around 55 percent of El Salvador’s population had lived in poverty, while some 110 family groups reigned over the economy. According to Manzano: “The civil war left a poor and undermanaged agricultural sector, where large parts of the land were left behind and unexploited.”

The peace accords, however, involved a redistribution of agricultural land to families that had been affected by the war. Manzano explained: “This improvement in the wealth distribution – added to a policy of avoiding the previous mistakes of constantly devaluing – has helped double GDP per capita. In this, the agricultural sector has been the biggest contributor to families’ improvement of prosperity.” Indeed, the reforms significantly reduced poverty in El Salvador to 26 percent, while also leading to a positive trade balance.

The country’s economic growth has been aided further by a significant shift towards tertiary services, including call centres, media and communications, and aeronautics. “The rise of industrial and service exports came hand in hand with FDI”, said Manzano. “The process of internationalisation of the economy reshaped the labour force, which became less agrarian and more industrial and services-oriented.”

It would be remiss to not mention the vast impact that foreign remittances have had on the Salvadoran economy since the 1990s: in 2016, they accounted for approximately 17 percent of El Salvador’s GDP, making them a key source of foreign currency.

“On the one hand, the steady increase in the value of remittances has fuelled a consumption boom that in turn feeds imports and fosters the growth of the economy’s non-tradable sector”, Manzano noted. “Therefore, a key policy challenge is to avoid remittances to promote a Dutch-disease-type process, leading to sustained real exchange rate overvaluation, inflating the non-tradable sector at the expense of the tradable sector. On the other hand, remittances have played a role in reducing poverty and income inequality, and have otherwise cushioned the economy from financial and trade shocks.”

Gang crime 
Despite such progress, prevalent gang violence across the country continues to stunt the potential and persistent development of the economy. In a population of around 6.5 million, it is estimated that as many as 60,000 citizens are involved in gang activity, wreaking havoc in some 247 out of 262 municipalities. According to a study by the Central Bank of El Salvador, gangs are responsible for around 49 murders per 100 citizens, while the cost they incurred to the economy in 2014 was approximately $4bn – equivalent to a whopping 16 percent of its GDP.

Consequently, the country exhibits an extraordinarily high rate of corporate extortion and theft. It is estimated that approximately 70 percent of businesses in El Salvador are subject to gang-related crime. According to Lacalle: “This problem is one of the reasons why industry and investment remain below the potential of the economy.”

75,000

Number of citizens killed in El Salvador’s 12-year civil war

17.3%

Share of total employment in 2015 attributable to the agriculture industry

$4bn

The cost gangs incurred to the country’s economy in 2014

The threat of gang violence is not only limited to businesses – it remains a titanic menace to the general population, with entire villages having been forced out of their homes in recent years. In fact, in September, a local government entity in the country’s western region created the first settlement camp for internally displaced citizens since the end of the civil war. “Worst of all, gang crime feeds on the more disadvantaged parts of the El Salvador economy”, Lacalle told World Finance.

This threat of violence and extortion, together with mushrooming costs to the state in terms of healthcare and security, have severely stunted the country’s economic progress in the 25 years since the end of the civil war.

Manzano agreed with this theory: “Rising crime and the deterioration of security conditions have clouded the investment climate. Aside from the obvious human cost of criminal activity, poor security conditions directly increase business costs, for example, as firms are forced to pay for private security services. Although firms of all sizes are being affected, smaller firms are hurt more than proportionately.”

Fiscal responsibility 
Last year, the Salvadoran economy faced even further peril as it teetered on the brink of collapse – a result of substantial pressure on the fiscal cash flow after years of overspending and slow growth. This could be largely attributed to the government’s failure to fully recognise the consequences of the global financial crisis, and specifically the endemic risk it faced as a result of plummeting export revenues.

“Exports fell from $500m to around $100m less very rapidly, at the same time as expenses increased”, Manzano told World Finance. “The government failed to adapt to an environment in which investment and capital inflow seen during the US quantitative easing period changed, and at the same time commodity and agricultural prices fell, while expenses did not.

“The cash crunch had multiple effects. On the one hand, government authorities started prioritising expenditures more carefully, and there is now a sense that they can continue running a leaner operation. On the other hand, the cash shortage in fact signalled the continuation of highly polarised political conditions, making the need for a dialogue and a national agreement more urgent.”

Despite the potential catastrophe of 2016, the state managed to avoid a complete shutdown and even continued debt servicing as usual. This was aided by the approval of the Fiscal Responsibility Law, which decreed an adjustment of three percent of El Salvador’s GDP.

Manzano explained: “There is a consensus that an adjustment of such magnitude would not only stabilise the public debt-to-GDP ratio, but would in time reduce the vulnerability of public accounts by reducing the debt ratio.

“To comply with the [Fiscal Responsibility Law], a balanced approach is recommended, encompassing both revenue and expenditure measures. Increasing revenues – particularly tax revenues – would require a combination of an adjustment in tax instruments and, of course, stronger tax administration.”

In terms of expenditure, the state must decelerate improvident spending, while also improving targeted subsidies. “Fiscal adjustment measures should be designed so that the burden of adjustment falls primarily on those able to shoulder it, while protecting the poor and vulnerable”, said Manzano.

Agriculture is among El Salvador’s largest sectors

Investing in security
Clearly, investment growth is of supreme importance in further developing the Salvadoran economy. Lacalle explained: “Increasing taxes is not a solution in a small economy that needs investment and inflow of capital. This, not interventionism, is what will help the economy strengthen, continue to reduce poverty and develop a successful middle class.” Yet in order to encourage a greater inflow of investment and capital, tackling the country’s rampant gang problem is absolutely crucial.

In the short to medium term, a more robust security system must be enforced to better protect businesses and in turn inspire greater confidence. As of late, the state has been cracking down on gang violence with some success. One method that has proved beneficial was cutting the communication between imprisoned members and their accomplices on the outside. Last year, the number of murders fell by 20 percent to 5,278, while street gang Barrio 18, having been weakened by the government’s increasingly vigorous offensive, offered to renounce extortion.

This offensive must continue. The impact of this will be twofold: giving businesses more breathing space, and encouraging greater confidence as a result of a demonstrable crackdown. Greater confidence, however, must start at home. Concerns about corruption within judicial systems, police and prisons not only remain rife, they appear to be worsening: in 2016, El Salvador fell 23 places, to 95 out of 176 countries, in Transparency International’s Corruption Perception Index.

El Salvador’s problems can be largely attributed to the government’s failure to fully recognise the consequences of the global financial crisis

Though the arrest of former President Antonio Saca for embezzlement last October was a clear check on power that bodes well for reducing state corruption, there has been a notable push back by the ruling party, which reportedly encouraged threats made by its supporters against constitutional judges.

In order to truly crackdown on the problems facing the country, the state itself must be strong and adhere wholly to the rule of law, penalising those who don’t do the same. Many argue that, for El Salvador to enter into a new stage, both as a country and as an economy, a new peace accord is needed.

Manzano agreed with this theory: “25 years ago, Salvadorans showed that they can sit together and get to an agreement that gives its economy and population a chance. Today is probably a good opportunity to revive the spirit of that agreement and rethink the next steps that El Salvador needs to take to further develop its economy.

“The key issue is to mobilise investment in the country. Investment is an essential ingredient of job creation, and productive jobs are in turn the best way to lift people from poverty on a sustainable basis.”

Better opportunities will also tackle a root cause of gang crime in El Salvador, for individuals often turn to such activities out of desperation and poverty, not because of some innate immorality that they possess. The cycle of repair will continue to feed into itself: with more investment, there will be less violence, and with less violence, there will be more investment.

El Salvador may face sizeable problems, but it is not a lost cause – far from it. With strong government efforts and increasing investment, this economy can be freed from its current shackles to advance into a new beacon of prosperity, which once again acts as a model for others, both in the region and beyond.