US embassy cable - 05SANSALVADOR2541

UNCLAS SECTION 01 OF 03 SAN SALVADOR 002541 
 
SIPDIS 
 
STATE PASS AID/LAC 
USDOC FOR 3134/USFCS/OIO/WH/MKESHISHIAN/BARTHUR 
USDOC ALSO FOR ITA/MAC/MSIEGELMAN 
 
E.O. 12958: N/A 
TAGS: ECON, ETRD, EINV, ES, CAFTA 
SUBJECT: CAFTA BRINGS HOPE TO SLUGGISH SALVADORAN ECONOMY 
 
REFS: A) San Salvador 587, B) 2004 San Salvador 3181 
 
Summary 
------- 
1. GDP grew by a lackluster 1.6 percent during the first 
quarter of 2005. Official data have not been released yet 
for the second quarter, but a Central Bank indicator based 
on real production data suggests that the economy continued 
to perform poorly. High oil prices are taking a toll on 
economic activity, and the government lowered its forecast 
for 2005 GDP growth from 2-3 percent to 1.5-2.5 percent. 
CAFTA ratification has improved expectations for economic 
growth, but whether that promise is delivered depends on how 
well El Salvador takes advantage of not only CAFTA-DR's 
trade benefits but opportunities for institutional reform as 
well. End summary. 
 
Lackluster Economic Growth 
-------------------------- 
2. The Central Bank reports the economy grew at an annual 
rate of 1.6 percent during the first quarter of 2005, not 
much better than the 1.5 percent growth reported during the 
last quarter of 2004. For the second quarter of 2005, 
official data have not yet been released, but the Central 
Bank's Index of the Volume of Economic Activity (IVAE), 
based on real production data, suggests that the economy 
continued to perform poorly. Overall, the IVAE shows a 1.1 
percent fall in economic activity for May and 1.8 percent 
fall for April. Think-tank Foundation for Economic and 
Social Development (FUSADES) recently released its second 
quarter economic report, which also reported that growth was 
weak during the quarter. High oil prices are taking a toll 
on economic activity overall, and the Central Bank lowered 
its forecast for 2005 GDP growth from 2 to 3 percent to 1.5 
to 2.5 percent. 
 
3. Looking at the economy sector by sector, performance 
remains poorest in the construction sector, where the IVAE 
showed a 21.3 percent contraction. The retail sector was 
flat during the second quarter according to the Central Bank 
indicator--FUSADES' survey of businesses confirms this 
result. Meanwhile, the agricultural sector continued to post 
positive results, thanks to favorable international prices 
of the traditional crops, coffee and sugar. Other sectors 
showing expansion were financial services, transportation, 
and energy. 
 
4. As in previous FUSADES surveys, businesses blamed higher 
energy costs for the deceleration in economic activity. 
Crime has also become a significant factor according to 
survey respondents (septel). For the first time in more than 
a year, businesses surveyed by FUSADES have a negative 
perception of the investment climate, and consumer 
confidence is weak as well. The FUSADES survey was completed 
prior to the U.S. passage of CAFTA-DR, however, so these 
survey results may not reflect current sentiment. 
 
Formal Employment Growing Slowly 
-------------------------------- 
5. The FUSADES survey of local businesses shows that formal 
sector employment may have grown by as much as 2 percent 
during the second quarter of 2005. The number of maquila 
workers, about 16 percent of total social security 
contributors, fell by 8 percent, while the number of workers 
in other sectors increased by 5 percent, offsetting the 
maquila decline. What is unclear, however, is whether there 
were actually new jobs created during the period, or more 
previously informal employment is now covered under Social 
Security--either would be a welcome development. 
 
High Oil Prices Drive Inflation 
------------------------------- 
6. The inflation rate during the second quarter of 2005 
increased slightly over the first quarter of the year. 
Ministry of Economy data show a 2.1 percent rate for April 
and a 2.9 percent for May and June. Annual inflation for the 
period ending June 2005 reached 5.1 percent, well above the 
previous year's rate of 2.8 percent. Oil prices are the main 
factor behind price increases during the period. In response 
to U.S. Federal Reserve Bank rate increases, lending rates 
for short-term loans increased by 6.9 percent during the 
second quarter, but for loans over one year they only 
increased by 0.6 percent. Deposit rates have shown a more 
mixed behavior, with some increasing and some diminishing. 
Excess liquidity in the system and low levels of economic 
activity have helped to maintain these rates relatively 
stable. 
 
Trade Deficit Growing 
--------------------- 
7. The trade deficit grew by 11.5 percent between January 
and June of 2005, reaching $1,543.5 million. Total exports 
grew by 7.3 percent, while imports increased by 9.3 percent. 
The increase in exports was led by nontraditional goods such 
as ethnic foods, tuna and packaging materials, which 
increased by 10.4 percent to $700 million, and also by the 
recovery of traditional exports, which increased by 42.9 
million up to $156.6 million. Coffee exports grew by 37.7 
percent due to the recovery of coffee prices. Sugar exports 
also benefited from good international prices and a larger 
demand increasing by 28 percent. Maquila exports grew by 
only 1.1 percent to $883.8 million. 
 
Remittances Continue Steady Growth 
---------------------------------- 
8. Remittances have continued their steady growth, reaching 
$1,379.3 million by the end of June of 2005, 14.3 percent 
higher in relation to the same period of 2005. With the 
reduction of the Hispanic unemployment rate in the United 
States, remittance flows are expected to continue to perform 
well during the rest of the year and eventually surpass the 
$2.7 billion mark by December 2005. 
 
Tax Reforms Bolster Government Revenues 
--------------------------------------- 
9. Fiscal reforms implemented in January 2005 (Ref. B) have 
led to a substantial increase in tax revenues during the 
first half of 2005, up 16 percent in relation to the first 
half of 2004; revenues reached $1,145 million, $48 million 
higher than expected. VAT revenues grew by 13 percent, 
reaching $579.9 million. Income tax revenues increased by 
21.1 percent, up to $422.3 million. FUSADES projects that 
under certain assumptions tax collection could grow to 12.6 
percent of GDP by the end of 2005. 
 
10. FUSADES' quarterly report highlights the budget pressure 
created by pension costs and rising international interest 
rates. Although impressive, the increase in tax collection 
will not be enough to service existing debt for 2005. By 
June 2005, the fiscal deficit was an accumulated $53 
million, higher than the $23 of the previous year, and 
public debt as a percentage of GDP climbed to 44.3 percent 
of GDP. However, with municipal and legislative elections on 
the horizon, it is unlikely the government will either cut 
spending or increase taxes until Summer 2006. 
 
High Hopes for CAFTA-DR Trade Benefits 
-------------------------------------- 
11. Optimism--although tempered by rising oil prices--is the 
rule among government officials and the private sector now 
that CAFTA-DR is law in the United States. CAFTA-DR is 
viewed as the panacea for the sickly Salvadoran economy; it 
will boost exports, generate new employment, and attract 
foreign investment. Government officials, especially at the 
Ministry of Economy, are energized and actively working to 
assist exporters in taking advantage of CAFTA-DR trade 
benefits. The government is working toward implementation of 
CAFTA-DR in anticipation of the January 1, 2006 
implementation date. Long before CAFTA-DR ratification, the 
government had instituted a comprehensive trade capacity 
building program, with the aid of international donors, 
especially USAID. 
 
12. Federico Colorado, President of the National Association 
of Private Businesses (ANEP), which represents big business, 
said after passage that CAFTA-DR is what the country needed 
to push economic growth: "There were firms waiting for the 
signature of the agreement to invest in the country. This 
agreement will have an impact in many aspects--investment, 
employment generation, and wealth--in a very positive way." 
Ricardo Esmahan, President of agricultural sector 
organization CAMAGRO, is also looking at the bright side, 
and he recently said that CAFTA-DR is a valuable opportunity 
for the country, but the challenge is how to take advantage 
of it. Maximiliano Portillo, representative of a small 
business association, called on his members to be prepared 
to export to the U.S. market and take advantage of the 
opportunities offered. 
 
Comment: CAFTA-DR Institutional Reform also Essential 
--------------------------------------------- -------- 
13. Trade benefits under CAFTA-DR are the most tangible 
aspect of the agreement, so it is understandable that 
Salvadorans focus on them. In the long term, however, much 
of CAFTA-DR's promise for El Salvador lies in the 
institutional changes that it could bring about. Post is 
working to remind Salvadorans that CAFTA-DR's potential to 
transform the Salvadoran economy also requires faithful 
implementation of provisions related to telecommunications, 
banking, and electronic commerce, environmental and labor 
rights, intellectual property rights, investment, and 
dispute resolution. So far, we are encouraged by the 
commitment demonstrated by the government, especially in the 
Ministry of Economy. 
 
14. The United Nations Development Program (UNDP) recently 
released its human development report, which warns that 
pursuing export-led growth--without complementary measures 
to improve the competitiveness of the country--has produced 
poor economic results for El Salvador. UNDP argues that El 
Salvador's export-led growth strategy introduced in 1989, 
combined with dollarization and the immigration/remittances 
flow, eroded the country's export competitiveness by pushing 
up the real exchange rate. The lesson we hope the 
Salvadorans will take away from this report is not that they 
should abandon export-led growth, but that they should do so 
while also pushing forward with "second generation" economic 
reforms needed to make their private sector more 
competitive, especially in the financial sector to improve 
access to credit (Ref. A) and in the judiciary to resolve 
commercial disputes fairly and quickly. We hope CAFTA-DR 
implementation will give them the political cover they will 
need to undertake these difficult reforms. End comment. 
 
BARCLAY