VZCZCXYZ0051
RR RUEHWEB

DE RUEHSN #1910/01 2141423
ZNR UUUUU ZZH
R 021423Z AUG 06
FM AMEMBASSY SAN SALVADOR
TO RUEHC/SECSTATE WASHDC 3275
INFO RUEHZA/WHA CENTRAL AMERICAN COLLECTIVE
RUCPDOC/USDOC WASHDC
RUEATRS/DEPT OF TREASURY WASHINGTON DC

UNCLAS SAN SALVADOR 001910 
 
SIPDIS 
 
SIPDIS 
STATE PASS AID/LAC AND OPIC 
USDOC FOR 4332/ITA/MAC/WH/MSIEGELMAN 
3134/ITA/USFCS/OIO/WH/PKESHISHIAN/BARTHUR 
 
E.O. 12958: N/A 
TAGS: ECON EINV ES
SUBJECT:  SALVADORAN ECONOMY GROWING, BUT STRUCTURAL PROBLEMS 
REMAIN 
 
REF: A. SAN SALVADOR 1719, B.  SAN SALVADOR 0353, C.  SAN SALVADOR 
 
0090 
 
Summary 
------- 
¶1.  Despite adherence to Washington-consensus policy 
recommendations, economic growth in El Salvador has been an 
unimpressive 2.5 percent over the last decade.  The economy is 
picking up, however, with Central Bank data showing 3.2 percent 
growth for the first quarter of 2006 and forecasted 3.5 percent for 
the year.  While natural disasters and weak rule of law are no doubt 
partly responsible for this poor economic performance, structural 
problems that limit El Salvador's export competitiveness may also be 
to blame for slow growth.  End summary. 
 
Economic Growth Picking Up 
-------------------------- 
¶2.  After a decade of GDP growth that averaged 2.5 percent, barely 
keeping up with population increases, the Salvadoran economy is 
showing signs of life again, registering 2.8 percent GDP growth in 
2005 and 3.2 percent for the first quarter of 2006.  The Central 
Bank estimated GDP growth for 2006 to average 3.5 percent for 2006; 
the bank's index of economic activity suggests that growth may be 
even higher. 
 
¶3.  FUSADES, a well-known Salvadoran think tank, agrees with the 
Central Bank estimate and is also forecasting 3.5 percent growth. 
In its most recent economic survey, FUSADES reported that sales were 
up for most business during the first quarter of 2006 and business 
confidence is high.  The firms surveyed were optimistic about the 
investment climate, identifying CAFTA-DR as the primary factor 
behind this positive outlook, and most said they would expand their 
businesses this year.  The number of participants in the Social 
Security health care system is another good indicator of positive 
economic trends in El Salvador--an increase suggests growth in 
formal sector employment.  From February 2005 to February 2006 the 
rolls increased by 3.9 percent, from 492,140 formal-sector jobs to 
511,504 jobs. 
 
¶4.  Growth so far in 2006 has been spread evenly among most sectors, 
with the construction and transportation sectors expanding most, 
showing 5.8 percent and 5.2 percent, respectively, according to the 
Central Bank. Growth in the construction sector, which averaged 3.4 
percent in 2006, is boosted by housing development and large 
infrastructure projects such as the port being built in La Union. 
Meanwhile, transportation services grew in large part due to 
increased business at the container port of Acajutla but also thanks 
to an overall up-tick in economic activity. 
 
¶5.  Real estate and services, aggregated in Central Bank data, 
showed 4.6 percent growth in the first quarter of 2006 while 
financial services grew 4.8 percent.  Despite dollarization, 
increases in international interest rates have not been completely 
transmitted to local interest rates.  The rate for loans up to a 
year increased from 6.95 in March of 2005 to 7.4 percent in March of 
2006, only a 0.5 percent increase.  Local interest rates remain low, 
thanks to excess liquidity caused by low local credit demand and 
strong competition among local and nonresident banks.  Meanwhile, 
Salvadoran banks continue to grow regionally and in the United 
States. 
 
¶6.  Agriculture, which grew by 5.8 percent in 2005 despite flooding 
caused by Hurricane Stan, posted 3.8 percent growth in the first 
quarter of 2006.  Favorable international prices for coffee and 
sugar, as well as new investments in poultry and cattle, contributed 
to these positive results.  Also important was the expansion of 
fruit and vegetable cultivation for domestic consumption, an 
investment supported by USAID.  Growth in the sector for 2006 is 
forecast at 6 percent, with the expectation that coffee and sugar 
prices will continue to increase and cotton cultivation will rebound 
from crop damages caused by Hurricane Stan in 2005. 
 
¶7.  Among the few sectors that lagged behind was manufacturing, 
which grew by only 1.5 percent in the first quarter, reflecting 
losses in the apparel (maquila) sector but growth in other light 
manufacturing.  For the maquila sector, staggered CAFTA 
implementation, with El Salvador coming on board with the United 
States March 1, and Honduras and Nicaragua a month later, proved to 
be a mixed blessing.  Salvadoran assembly operations saw their 
inputs from the latter two countries suddenly ineligible under 
CAFTA-DR rules of origin.  Many firms shifted production to Honduras 
and Nicaragua and stockpiled inputs from the United States.  There 
were as many as 4,000 job losses in March 2006, and garment exports 
contracted by 10 percent during the first quarter of 2006.  Contacts 
in the sector report that operations have recovered, and firms 
continue to focus on full-package production, a business model that 
has proven successful so far in competing with China and other 
 
low-cost producers. 
 
Inflation Stable Despite Oil Price Increases 
-------------------------------------------- 
¶8.  Despite increasing oil prices, inflation remains stable, at 
about 3.8 percent (annualized) for the first three months of 2006. 
Inflation for 2005 was only 4.3 percent, the lowest in the region. 
Price increases have hit the transportation sector hardest, and bus 
fares were recently increased to reflect higher operating costs. 
The Salvadoran Transportation Association now estimates that fuel 
costs are 60 percent of operating costs for truck owners.  Thermal 
plants generate about 50 percent of El Salvador's electricity, and 
high oil prices have prompted the government regulator to allow 
distributors to raise rates by 14 percent.  Meanwhile, generators 
and distributors are working with the government to implement 
regulations for purchasing power through long-term contracts, as 
well as selling power on the wholesale market using a cost-based 
model, to help stabilize energy costs and encourage new investment. 
 
 
Comment 
------- 
¶9.  After the civil war, El Salvador aggressively launched a 
Washington-consensus economic model that included trade 
liberalization, cuts in government spending, privatizations, pension 
reform, and dollarization.  While some Salvadorans are quickly 
taking advantage of CAFTA-DR business opportunities (Ref. A), 
President Saca has launched several other initiatives to kick start 
economic growth.  However, these efforts do not stray far from the 
laissez-fare course set by his ARENA predecessors. 
 
¶10.  Focusing on converting El Salvador into a logistics and 
transportation hub for Central America, the government is 
strengthening the Customs Administration's role as a trade 
facilitator rather that revenue collector.  There has also been 
progress in improving the country's trade infrastructure both at 
seaports and at the airport.  To promote tourism, a new Tourism Law 
established tax incentives for investment in tourism infrastructure 
(Ref. C).  Meanwhile, industrial policy has focused on improving 
competitiveness by streamlining the role of government and reducing 
transaction costs in addition to direct subsidies to promote the use 
of cutting-edge technology in industrial processes.  Initiatives to 
promote further growth in the financial sector, although delayed, 
have focused on streamlining the supervision of financial 
conglomerates and establishing improved legal frameworks for 
securitization, venture capital, or leasing. 
 
¶11.  Over the last decade, however, real economic growth has 
averaged only 2.5 percent, barely enough to keep up with population 
growth.  Over the last five years, foreign investment has averaged 
only 1.5 percent of GDP.  Meanwhile, the trade gap continues to grow 
and for the first half of 2006 was $1.9 billion, up from $1.6 
billion the year before.  There is no doubt that the back-to-back 
earthquakes in 2001, a fall in world prices for coffee and sugar, 
and an increase in violent crime have had a significant impact on 
growth here, but many Salvadorans are concerned it is the economic 
model--now pursued by four consecutive ARENA governments-- that is 
flawed.  That the economy grew by 3.5 percent is good news, but 
there is still plenty of room for improvement. 
 
¶12.  Restoring the rule of law to stem violent crime remains a 
prerequisite to getting the Salvadoran economy growing at its 
potential (Reftel. B).  However, there are two long-term issues may 
have throttled growth over the last decade, and may continue to have 
an impact for years to come.  One is that the underlying structure 
of the economy is still uncompetitive and businesses are unprepared 
to take advantage of the benefits of trade liberalization.  A 
handful of families continue to dominate the economy, especially in 
certain sectors: in 2002 the UNDP estimated that the richest 20 
percent of El Salvador controlled nearly 60 percent of the country's 
economy.  According to this explanation, economic concentration has 
led to a loss of competitiveness, and local businesses find 
themselves unable to either sell their products successfully 
overseas or compete with imports.  The new Competition 
Superintendency, created in January 2006, could have a strong role 
in promoting competition among local businesses.  However, early 
indications are that the Superintendency will avoid confrontation 
with the economic elite and instead focus on sectors dominated by 
foreigners.  CAFTA-DR, and the pressure of competition from U.S. 
goods, also has the potential to improve local competitiveness. 
 
¶13.  The second explanation suggests that remittances, which reached 
2.8 billion in 2005 and will likely exceed $3 billion in 2006, are 
undermining El Salvador's export competitiveness.  From 1992 to 2001 
(the last time it was calculated), El Salvador's real effective 
exchange rate appreciated 48 percent--since then, it has undoubtedly 
further appreciated.  This appreciation has made local goods 
 
expensive overseas and made imported goods cheaper, undermining El 
Salvador's trade-focused growth strategy just as the.   Mitigating 
this remittance-fueled worsening of El Salvador's terms of trade 
will be difficult.  Encouraging the use of remittances for 
investment instead of consumption, a task on which the Salvadoran 
Government and private sector are focused, would alleviate pressure 
on the terms of trade and help create jobs at home for potential 
migrants.  End comment. 
 
Butler