Document of The World Bank

FOR OFFICIAL USE ONLY

Report No. 31203-SV

INTERNATIONAL BANK FOR RECONSTRUCTION AND

DEVELOPMENT

PROGRAM DOCUMENT

FOR A

FIRST BROAD-BASED GROWTH

DEVELOPMENT POLICY LOAN

IN THE AMOUNT OF US$ 100 MILLION

TO

THE REPUBLIC OF EL SALVADOR

JANUARY 21, 2005

Central America Country Management Unit Latin America and the Caribbean Region International Bank for Reconstruction and Development

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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CURRENCY EQUIVALENTS Currency Unit = US$ 1

Fiscal Year: July 1,2004 - June 30,2005

BCR CACM CAFTA CAS CBI CEA CEM CFAA COFOG CONACYT CPAR DR-CAFTA

DPL DIGESTYC EDUCO FDI FOVIAL FSAP FTA FTAA GDP IADB ICA ICT IMF PSAS L A C LACAP MSME NAFTA NFPS OED ON1 PER PFM PROESA PSIA RED1 SAFI

ACRONYMS AND ABBREVIATIONS

Central Reserve Bank Central American Common Market Central America Free Trade Agreement Country Assistance Strategy Caribbean Basin Initiative Country Environmental Analysis Country Economic Memorandum Country Financial Accountability Assessment Classifications Consistent with International Standards National Council for Science and Technology Country Procurement Assessment Review Free Trade Agreement between the Dominican Republic, Central America and the United States of America Development Policy Lending National Directorate for Statistical and Census Community Education Program Foreign Direct Investment Road Maintenance Fund Financial Sector Assessment Program Free Trade Agreement Free Trade Agreement of the Americas Gross Domestic Product Inter-American Development Bank Investment Climate Assessment Information and Communication Technology International Monetary Fund International Accounting Standards Latin America and the Caribbean Law on Public Sector Procurement and Contracting Micro, Small and Medium Enterprise North America Free Trade Agreement Non-Financial Public Sector Operations and Evaluations Department National Investment Office Public Expenditure Report Public Financial Management Investment Promotion Agency Poverty and Social Impact Analysis Recent Economic Developments in Infrastructure Integrated financial management system

.. 11

FOR OFFICIAL USE ONLY

SIGET S IRH SMEs SSF TP U N A C

Superintendence o f Energy and Telecommunications Integrated System For Human Resource Management Small and Medium Enterprises Superintendence for the Financial System Trade Point Procurement Policy Office

Vice-president Pamela Cox Country Director Jane Armitage

Sector Director Emesto May Task Manager and I Lead Economist Carlos Feli e Jaramillo

ACKNOWLEDGEMENTS

The World Bank Group greatly appreciates the close collaboration with the Government of El Salvador in the preparation o f this Development Policy Loan (DPL).

The team would l ike to thank the entire country team for their contributions and give special thanks to several colleagues in the L A C Region including Todd Crawford, Jessica Poppele, Manuel Sevilla, Ana Lucia Armijos, Ricardo Tejada, Sonia C. Molina, Maria del Carmen Miiioso, Jesds Martinez, Mario Sangines, Aquiles Almansi, Manuel Vargas, Evelyn Villatoro as well as LEGLA and L O A G l .

This document has a restricted distribution and may be used by recipients only in the performance o f their official duties. I t s contents may no t be otherwise disclosed without World Bank authorization,

LOAN AND PROGRAM SUMMARY El Salvador

DEVELOPMENT POLICY LOAN FIRST PROGRAMMA TIC BROAD- BASED GR 0 WTH

Borrower

Implementing Agency

Amount

Terms

Commitment Fee

Front-End Fee

Tranching Objectives

Republic of El Salvador

MINISTRY OF FINANCE

US$lOO mill ion

Fixed-Spread Loan (FSL) in U S Dollars with level repayments of principal commitment-linked. Automatic Rate Fixing, based on cumulative disbursements o f USD$lOO,OOO,OOO. The Borrower also chose a grace period of 1 year and a total repayment term o f 21 years. Payment dates for interest and commitment charges due on each February 15 and August 15, with the following Amortization Schedule, during the l i fe of the Loan:

Payment Date February 15,2006 February 15,2008 February 15,2009 February 15,2010 February 15,2011 February 15,2012 February 15,2013 February 15,2014 February 15,2015 February 15,2016 February 15,2017 February 15,2018 February 15,2019 February 15,2020 February 15,2021 February 15,2022 February 15,2023 February 15,2024 February 15,2025 February 15,2026

Installment Share 2.50% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50% 2.50%

0.85% on undisbursed loan balances for f i r s t four years, standard charge of 0.75% on undisbursed loan balances thereafter, beginning 60 days after signing, less 0.5% waiver if loan i s signed on or before June 30,2005. 1% of the loan amount, less 0.5% waiver if loan i s signed on or before June 30.2005. Single tranche for the full amount o f the loan, minus the front-end fee. The proposed Programmatic Development Policy Loan i s part of a Drog.rammatic series o f four DPLs intended to sumort the Government's

i v

Description

Benefits

Risks

Operation ID Number

medium term development strategy to accelerate broad based and equitable economic growth and to contribute to the Government’s objectives o f (i) re-igniting growth, particularly through increased private investment and trade; (ii) reinforcing macroeconomic stability and strengthening fiscal sustainability; and (iii) increasing the efficiency and transparency o f public sector management. The first area includes policies to expand trade opportunities and improve the investment climate. The second area highlights measures related to expanding tax revenues, reducing the fiscal burden of pension reform and strengthening the financial sector. The third area supports public sector modernization efforts, with emphasis on the areas o f procurement, e-government and public financial management. Future DPL operations are expected to focus more intensively on the growth agenda (trade, business environment, publidprivate participation in infrastructure) while maintaining attention to transparency and efficiency in public spending. This f i r s t loan o f the program wi l l focus on the fiscal measures undertaken to meet the challenges o f stemming debt growth and preserving space for key growth and social investments. I t also devotes attention to the growth agenda, with special emphasis on measures related to widening trade opportunities, as well as to continuing public sector modernization efforts.

The key benefits expected from the program are: Meeting fiscal needs: Board approval o f this loan and i t s related disbursement in early 2005 would not only help the government to meet i t s objective o f diversifying financing sources but to secure financing on more favorable terms. This would support the government’s goal o f fiscal stabilization and efficient spending. Endorsement of sound policy and vehicle for dialogue: The DPL would secure overall continuity o f the Bank’s policy dialogue with El Salvador while strengthening the Bank’s reputation as a reliable development partner.

The most important r isks faced by the operation are: Fiscal: El Salvador’s current NFPS debt burden-nearly 40 percent of GDP-increases i t s vulnerability to potential shocks. Political: Despite the strong electoral mandate obtained by President Saca in April 2004, a divided Assembly could become an obstacle to important reforms, Extemal: Sustained high o i l prices or a possible international recession could negatively affect El Salvador’s economy and deteriorate debt dynamics. The end o f textile quotas in 2005 in the United States and other markets, i s intensifying competition from China and other Asian countries, which could potentially negatively impact the economy. Natural disaster: The country i s vulnerable to natural disasters (e.g., earthquakes and hurricanes) which could hurt the performance o f the economy in the short-term, thereby requiring significant unanticipated financing for emergency assistance and reconstruction.

PO93133

V

EL SALVADOR

DEVELOPMENT POLICY LOAN FIRST PROGRAMMATIC BROAD-BASED GROWTH

TABLE OF CONTENTS

I. INTRODUCTION AND STRATEGIC CONTEXT ...................................................... 1

11. THE ECONOMY .............................................................................................................. 3 A. GROWTH: RECENT EVOLUTION AND KEY CHALLENGES .......................................................... 3 B. FISCAL ISSUES 8 ......................................................... C.

THE GOVERNMENT’S PROGRAM: RESTORING BROAD-BASED MEDIUM-TERM MACRO-ECONOMIC PROSPECTS AND DEBT SUSTAINABILITY. ............... 1 1

111. GROWTH ........................................................................................................................ 11

B. RESTORING A SOUND FISCAL FRA C. PUBLIC SECTOR MODERNIZATION

THE PROPOSED LOAN .............................................................................................. 19 A. LINK TO CAS AND ANALYTICAL UNDERPINNINGS ........................................... 19 B. LESSONS LEARNED. ........................................................................................................................ 20 C. DESIGN OF DPL ........................

A. ACCELERATING BROAD-BASED GROWTH.

IV.

...................................... PACT ANALYSIS ...... MENT AND NATION

.................... 25 ............................................................................................................... 26

V. COORDINATION WITH DONORS AND STAKEHOLDERS ................................ 28

ANNEXES Annex 1: LETTER OF DEVELOPMENT POLICY ............................................................ 30 Annex 2: RESULTS FRAMEWORK - EL SALVADOR BROAD BASED DEVELOPMENT POLICY LN.. .... 38 Annex 3: PUBLIC FINANCIAL MANAGEMENT MILESTONES - EL SALVADOR BROAD-BASED

DEVELOPMENT POLICY Annex 4: DEBT SUSTAINABILITY ................................................................................................. 41 Annex 5: INTERNATIONAL MONE D RELATIONS NOTE? ....................... Annex 6: EL SALVADOR AT A GL

Figures Figure 1. Government Strategy 2004-2009 Safe Country ...................................................................... 12

Tables Table 1. Medium Term Macroeconomic Scenario ................................................................................... i o Table 2. Boxes BOX 1. BOX 2.

Expected Yield o f Tax Reforms in 2005 .................................................................................... 17

Actions to Maximize DR-CAFTA Opportunities for El Salvador ..................................... 24 CFAAand CPAR : Summary o f Findings and Recommendations ..................................... 26

EL S A L V A D O R

DEVELOPMENT POLICY L O A N FIRST PROGRAMMATIC BROAD-BASED GROWTH

I. INTRODUCTION A N D S T R A T E G I C CONTEXT

1. El Salvador i s a middle income country with a strong policy track record. Since the signing o f the Peace Accords in 1991, following a 12 year c iv i l war, El Salvador has made substantial progress in consolidating peace and democracy through three electoral cycles. On the economic front, progress has been rapid and wide ranging. Starting in the early 1990s, successive governments have tackled reforms in a host o f key areas including trade liberalization, tax reform, strengthening o f the financial sector, and promotion o f private participation in telecoms, energy, and pensions. More recently, a decision to dollarize the economy in 2001 has resulted in lower inflation and interest rates and reduced business uncertainty. Since the early 1990s, the country has also invested in schooling, health and other basic services, which, together with the economic reforms, have contributed to rising per capita incomes and a notable reduction in poverty. As a result o f these impressive sustained reform efforts, El Salvador stands out as a leader in reforms in LAC, along with Chile.

2. The re-establishment of peace and the country’s sustained economic reform efforts have yielded substantial gains for the population since the early 1990s. Economic growth in the 1990s rebounded to an average annual rate o f 4.9% --the second highest in Central America behind Costa Rica. Impressive progress was also made in social areas, including in basic education enrollment, infant and maternal mortality, access to reproductive health services and access to safe water. Overall poverty declined significantly (over 27 percentage points) between 1991 and 2002, while extreme poverty was halved in the same period. This impressive decline i s mainly due to the combined impact o f economic growth and human development improvements.

3. In recent years, external shocks impaired translation of policy performance into strong growth and instead led to rapid debt accumulation. Earthquakes, depressed coffee prices, international recession and, more recently, high o i l prices have led to l ow growth levels, which have barely kept up with population dynamics since 2000. L o w growth, substantial reconstruction outlays and growing transition costs f rom pension reform explain the An up in debt levels o f recent years.

4. The new government of president Tony Saca, elected in April 2004, i s aggressively addressing growth and fiscal issues with special emphasis on reaching the poor through a comprehensive development program as elaborated in section 111. The government’s program “Safe Country” i s based on three pillars: growth, equity and security. I t focuses on sound macro-fiscal management, foreign investment promotion, free trade, private sector-led development and a business environment free o f exchange rate risk. The government i s also placing greater emphasis on equitable growth and pro-poor policies, and plans to gradually increase social spending as a share o f GDP over the next f ive years, with a particular focus on improving the coverage and quality o f education. The vision o f a “Safe Country” encompasses a broad definition o f security, including improving physical safety through

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programs to combat and prevent crime and violence, increasing investor security through initiatives to combat corruption, increase transparency and impartial enforcement o f the law and building greater public confidence in public institutions, including the judiciary. The government i s also committed to reducing vulnerability, giving priority to enhanced social protection and safety net programs for the poorest and most vulnerable households.

5. This proposed single tranche development policy loan would lend support to the government’s impressive program in the amount of $100 million, at more reasonable financial cost than financing with external bonds. I t i s one o f the first under the new Bank guidelines approved in August 2004. The Bank’s Country Assistance Strategy (CAS) for El Salvador lays out a lending program in which the central component would be a series o f four programmatic Development Policy Loans (DPL) to support the new government’s medium term development strategy. This DPL and the three planned additional operations are intended to contribute to the Government’s objectives o f (i) reigniting growth, particularly through increased trade and investment, (ii) reinforcing macroeconomic stability and strengthening fiscal sustainability, and (iii) increasing the efficiency and transparency o f public sector management. The proposed DPL would support actions in each area. The first area would include policies to expand trade opportunities and improve the investment climate. The second area would highlight measures related to expanding tax revenues and reducing the fiscal burden o f pension reform. The third area supports public sector modernization efforts, wi th emphasis in the areas o f procurement, e-government and public financial management.

6. El Salvador is a prime candidate for development policy lending. I t boasts a strong track record o f sound macroeconomic management, policy and institutional reforms and marked improvements in social indicators. The new administration enjoys a significant mandate and has proposed a credible plan to accelerate broad-based and equitable economic growth.

7. The proposed loan presents opportunities and risks. For the Bank, rapid response to this request by the government presents a significant opportunity to be responsive and develop a closer relationship wi th a regional reform leader. Policy dialogue in El Salvador i s bound to enrich the Bank’s experience in dealing with an advanced reformer facing second generation issues, which should prove invaluable for upgrading i t s assistance to other countries. The DPL also provides a unique opportunity for El Salvador to lower i t s financing cost with respect to alternatives in international financial markets and to facilitate more rapid approval o f the budget and i t s financing plan in the Assembly. A programmatic series o f DPLs, synchronized with the government’s annual budget, may facilitate political negotiations by demonstrating broad support from the Bank as wel l as cost savings. If successful, this would break with the pattern o f lengthy approval delays that have become common for both the government’s budget and for the Bank’s investment projects in El Salvador. However, given a history o f political polarization, there are r isks that protracted political negotiations may affect the implementation o f pol icy reform and the DPL approval itself.

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11. THE ECONOMY

8. Despite impressive progress in structural reforms and sound macroeconomic management, El Salvador’s growth levels have been relatively low since the second half of the 1990s, and decelerated further in 2000-03 as a result of negative shocks. L o w growth, reconstruction needs after the earthquakes o f 2001 and the transition costs o f pension reform explain the rise o f about 10 percentage points o f GDP in public debt in the period 2000-2003. Given the r isks that may arise from further debt accumulation, the main challenge facing El Salvador in the current juncture i s to reignite growth and stem the fiscal imbalances o f recent years, while preserving fiscal space for much-needed social and growth investments.

9. The new government i s well aware of these challenges and has put forth a credible Plan to address them. President Saca, elected last March with a strong mandate, has proposed an economic plan that highlights among his key priorities, reigniting growth and addressing fiscal deterioration. The growth agenda i s based on actions to expand trade, improve the investment climate, provide critical infrastructure services, spur innovation and bolster educational levels. Actions to address fiscal challenges include improving fiscal revenues, reductions in pension expenditures and plans to address contingencies in the financial sector. The government expects that prompt ratification and implementation o f the free trade agreement recently negotiated with the U.S. (DR-CAFTA) along wi th complementary measures should lift growth rates and further improve the fiscal outlook.

A. GROWTH: RECENT EVOLUTION AND KEY CHALLENGES

10. The Salvadoran economy has weakened since 2000 due mainly to a series of exogenous shocks. The coffee crisis, the devastating 2001 earthquakes and the global recession explain to a large extent the sluggish growth o f the period 2000-2003 (1.9% annually). In 2003 real growth reached only 1.8% due to a decline in agricultural output, a decline in public sector reconstruction effort and private sector investment related to the uncertainty surrounding the 2004 presidential election. Growth in 2004 came in at a disappointing 2%, due to pre-election uncertainties (until April 2004), delays in government investment plans associated with the late approval o f the 2004 budget (June), high o i l prices and weakness in maquila exports. The latter i s due to an anticipation o f the scheduled end o f textile quotas by 2005 in the United States and other markets which i s expected to intensify competition from China and other Asian countries.

1 1. After a very successful period, progress in poverty reduction has slowed since 2000. El Salvador has made a number o f important socio-economic gains since the return to peace. Economic growth, coupled with reforms in some key sectors and increases in social sector spending in the second hal f o f the decade has contributed to substantial reductions in poverty and improvements in basic socio-economic indicators. Indeed, poverty declined from 64.4 % in 1991 to 37.2 in 2000. In the same period, extreme poverty declined from 31.2 % to 15.4 %; education levels have risen; access to basic services, such as safe water, has increased; and basic health outcomes, such as l i fe expectancy, infant and chi ld mortality, and chi ld nutrition have al l improved. With lower economic growth and external shocks, progress in social indicators has slowed down since 2000, as illustrated in the Bank’s recent Poverty Assessment. However, the study concludes that despite the 2001 earthquakes and other

shocks, figures f rom the 2002 surveys indicate that most o f the gains in poverty and other social indicators had been maintained.

12. The external current account deficit has increased since 2002 financed mainly by strong capital inflows, including FDI. Since most o f the increase can be explained by the need to finance greater fiscal deficits, the shortfall in the current account can be expected to narrow gradually as the new government carries out i t s fiscal plans. On the other hand, the large trade imbalance o f recent years that reached 15.8% o f GDP in 2004 i s l ikely to persist in the medium term financed by the significant f low o f remittances from Salvadorans l iv ing abroad. Remittances have increased from an average o f 2.6 9% o f GDP during the 1980s to 14.5 % in 2004, displaying remarkable stability despite the downturn in economic activity in the U.S. in 2001-02.

13. While growth prospects look brighter in 2005 and beyond, El Salvador needs to continue to press ahead with policy and institutional reforms. According to the Bank’s recent Country Economic Memorandum (CEM), which evaluated positively El Salvador’s reform agenda of recent years, key priority areas going forward include (i) further expanding international trade, (ii) improving the investment climate, (iii) addressing remaining bottlenecks in infrastructure, (iv) fostering innovation and adoption o f new technology and, (v) increasing the educational level o f the population. A summary o f challenges in each area i s presented below.

1) Trade

14. El Salvador, four other Central American countries and the Dominican Republic have negotiated a free trade agreement (DR-CAFTA) with the United States. I t s implementation i s expected to bolster trade and investment levels. The Bank’s recent analytical work in this area indicates that DR-CAFTA could add at least 0.5% per annum to El Salvador’s growth rate. The agreement would yield opportunities to turnaround the recent deceleration in export growth, which has been affected by greater competition f rom Asian textiles in external markets. I t i s also expected to improve significantly the investment climate in El Salvador, as i t contains rules and disciplines for investment relations, anti-corruption, as well as labor and environmental standards. Commitments in these areas are expected to yield improvement in key regulations, as wel l as a strengthening o f local institutions. Greater trade opportunities and a stronger investment climate are expected to boost investment levels, both from abroad and from internal sources, which i s the linchpin o f the government’s plan to reignite growth.

15. DR-CAFTA i s likely to enhance market access for some Salvadoran products, while making permanent the unilateral preferences offered in the past through the Caribbean Basin Initiative (CBI). Lit t le i f any trade diversion i s expected, since the U.S. has been traditionally the largest natural market for Salvadoran exports, as w e 1 as i t s largest source o f imports.

16. Complementary actions will be required to ensure that El Salvador takes full advantage of the opportunities offered by DR-CAFTA, and to obtain the anticipated boost in growth rates, as indicated in the Bank’s recent analytical work on this topic.

4

Actions w i l l be especially needed in improving the investment climate, addressing critical infrastructural bottlenecks, fostering innovation and raising the educational level o f the labor force. Complementary actions are also needed to ensure that the opportunities o f trade are accessible to small and medium size f i rms, which represent a significant percentage o f El Salvador’s economy. Further progress in deepening market access with other significant trading partners, including other Central American nations, the European Union and Canada, w i l l also bolster trade and growth opportunities.

17. Other issues that will need to be addressed to boost exports and investment are the need for a more active and consistent export and investment promotion policy and an improved quality certification system. On the first front, export and investment promotion efforts have improved in recent years with Bank assistance, but require further consolidation under a unified institutional structure. On the second front, recent surveys continue to indicate that Salvadoran f i r m s face difficulties in exporting, as their products do not always conform to international quality standards. The I C A found that only 6% o f Salvadoran f i r m s surveyed are ISO-certified, much less than other comparator countries f rom L A C and South East Asia. Improvements in this area are critical if local f i r m s can be recognized b y foreign countries as reliable partners.

2) Investment Climate

18. Remaining challenges in this area include addressing the poor functioning of some markets, insufficient competition in others, high costs of doing business and further development of capital markets, as described below.

0 Market pe~omzance and regulation of competition. One o f El Salvador’s key deficiencies in international competitiveness rankings i s the persistence o f perceptions of anti-competitive practices in some markets as well as the lack o f modern anti-trust and bankruptcy laws. The appropriate functioning o f some markets has been impaired by weak enforcement of current norms and the absence o f a modern Commercial Code. Market performance i s also affected by gaps in the overall regulatory framework and weaknesses in some regulatory agencies. Improvements in the effectiveness o f the judicial system i s also needed.

0 Costs of doing business. Recent reports by the Bank have highlighted the high costs o f doing business in El Salvador. In particular, local entrepreneurs s t i l l have to endure long and costly processes to establish a new business. Recently, the National Investment Office (ONI) reduced the time to register a foreign business form 8 months to 2 weeks. However the benefits o f administrative simplification for starting and operating a business need to be extended to local f i rms, including SMEs. According to the 2005 Cost o f Doing Business Report, El Salvador needs additional efforts in reducing the number o f days and the cost o f registering new firms.

0 Development of capital markets: El Salvador’s capital market has benefited f rom a regionally strong financial sector, generally effective legislation, banking consolidation, unrestricted capital flows and considerable integration o f micro-lending institutions to the formal banking sector. However, the banking sector’s ability to provide capital to al l types

5

o f productive activities i s constrained by i t s limited capacity to assume un-diversifiable risks, and by the need to permanently maintain high precautionary liquidity levels. The pension funds cannot fill the financing gap le f t b y the banks because the bulk o f their resources finance government needs, including the transitional costs o f the pension reform, as a result o f regulations that compel them to invest in safe domestic financial assets. Alternative financing instruments could develop through the securitization o f claims on selected investment projects, as banks, brokerage houses, and the Stock Exchange offer the infrastructure required to place those securities in their primary market, and to provide liquidity to them b y maintaining an active secondary market. Other areas that require further efforts to improve access to finance more broadly include improving credit analysis for micro lending institutions; introducing more flexible guarantees and more efficient registration o f related pledges and execution o f claims.

3) Infrastructure

19. Despite progress during the 1990s, and a major reconstruction effort after the 2001 earthquakes, El Salvador st i l l faces challenges in the coverage, quality, access and sustainability of infrastructure services. To move in this front, the country w i l l need to mobilize additional investment resources (public and private) and continue institutional and policy reforms. In particular, the country needs to improve the framework for efficient and equitable provision o f infrastructure services, strengthening the institutional capacity o f the “Superintendencia General de Electricidad y Telecomunicaciones” (SIGET) and issuing complementary legislation particularly in the energy, telecommunications, water and sanitation, and transport sectors. Key issues include:

1) In energy, an electricity sector reform program begun in 1996 unbundled the national utility and, in 1998, privatized distribution and generation assets. The privatization program led to investments of approximately US$SSO mi l l ion in the sector. This has significantly increased coverage and service quality, resulting in a decline in the production losses experienced b y Salvadoran firms as a result o f power interruptions, However, further regulatory and market structural reforms are needed to ensure competitive behavior and pricing as well as an investment program that keeps pace with demand.

2) In telecommunications, the situation has improved significantly over the past few years, as the liberalization o f the telecom market has led to impressive expansion o f coverage for telephony and a drop in rates. Nonetheless, El Salvador’s technological competitiveness i s impacted b y the l ow level o f reliance on information and communications technology illustrated b y an unusually l o w use o f the internet. This i s l ikely due to tariff structures that price internet usage out of the market for homes and small businesses. Regulatory and institutional strengthening in this area could help El Salvador to leverage i t s wide telephony coverage as a basis for more competitive ICT.

3 ) Water and sanitation. The sector presents a mixed picture in regulation and supervision, and the country i s lagging behind neighboring countries in the region, some o f them with much lower per capita income, in terms o f access to improved water sources. Many agencies from the public sector have jurisdiction over the water sector, resulting in

6

inefficiencies, poor accountability, and lack o f a comprehensive policy framework. The situation and performance o f the water and sanitation sector has impacts that not only affect public health but may be increasing the cost o f doing business and the capacity to attract investments in some areas of the country.

4) Roads. Through the creation o f the road fund (FOVIAL), El Salvador has made significant strides in rebuilding i t s primary and secondary road network since the 2001 earthquakes. However, i t s t i l l maintains the lowest level o f paved roads in Central America-26 %. Among those roads less than 60 % are in good or very good condition. In a survey conducted in 2002 as part o f the Investment Climate Assessment, approximately 40% o f f i r m s reported losses or damage o f goods in transport from plants to consumers. Inefficiencies in the transport and logistics chain generate losses equivalent to 1.8 % o f total sales. Going forward, the country needs to improve-through both public and private investments-critical roads for international and interregional commerce, including the East and North Corridors, as wel l as the unpaved rural road network that connects rural areas to the primary roads.

5) Air transport and ports. One out o f every three f i r m s in El Salvador found air transport to be a bottleneck for export competitiveness and FDI. Private investment and a modern management arrangement are also needed to improve cargo services at the Comalapa International Airport. In ports, the national seaport, Acajutla, remains a relatively inefficient public terminal with limited container capacity while most shippers seeks access through Honduras. While the government i s considering the development o f a new port facility with support from Japan, the port reform program has been highlighted in competitiveness studies as a priority for exporters and other shippers and consignees. In al l cases, i t i s clear that actions should go beyond physical infrastructure and deal with the entire logistics chain that increases cost and reduces the capacity to export and the attractiveness of El Salvador for private investment.

4) Innovation and technology

20. El Salvador i s trailing in the area of innovation and technology, as diagnosed in the Bank’s recent CEM. The country i s lagging in i t s efforts to develop an effective National Innovation System (NIS). B y international standards, El Salvador under performs in innovation outcomes (e.g., patents, scientific publications) as a result o f a very l o w level o f R&D investment in comparison to countries o f similar size and level o f development, despite evidence o f high potential rates o f return to this type o f investment. In addition, the efficiency o f the N IS system, measured as the productivity o f turning R&D investments into patents, i s low in comparison to similar countries. This inefficiency i s in great part due to the lack o f collaboration between the private sector and research organizations such as universities. El Salvador also performs poorly in international comparisons o f technology transfer through FDI.

21. Improving i t s NIS and levels innovation and technology transfer remains an important challenge in El Salvador going forward. The CEM suggested the fol lowing initiatives to improve El Salvador’s NIS: (i) improve the capacity o f El Salvador to fu l ly benefit from the available stock o f knowledge, by emphasizing imports o f capital goods and

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licensing; (ii) enhance the incentive-regime for private R&D to help technology absorption and support gradual technology adaptation; (iii) strengthen public-private partnerships particularly (although not only) in key areas o f the economy such as agriculture and teleservices; and (iv) improve coordination, policy-making and effectiveness o f public interventions.

5) Education

22. Continued progress in education i s critical to El Salvador’s economic growth and poverty reduction. El Salvador has been a pioneer in innovative and successful education reform measures, notably the EDUCO community-based school management model which has contributed to notable advances in coverage. Gross primary enrollment i s now over 100% while secondary i s 61%. El Salvador has also made great progress since the 1990s in raising primary graduation rates and in addressing disparities between urban and rural areas.

23. Nonetheless, challenges remain, particularly with respect to equity, quality, and efficiency. Low-income groups are s t i l l at a considerable disadvantage with respect to academic performance and secondary enrollment and completion rates. Learning outcomes are l ow when compared to predicted performance given El Salvador’s development indicators. This situation presents challenges for improving teacher performance, expanding students’ time in school, and gaining a greater understanding o f links between inputs and performance. Institutional challenges remain paramount in order to find strategies for raising efficiency, particularly wi th respect to increasing the cost-effectiveness o f key interventions, raising completion rates (under 80% for primary and 40% for secondary), and lowering repetition rates.

B. FISCAL ISSUES 24. Public sector debt has risen since 2000, a direct result of low growth and understandable expenditure pressures. Public debt levels have risen by about 10% o f GDP in the period 2000-2003, taking the overall NFPS debt level to 40.6% o f GDP by end 2003.’ Much o f this increase in public debt can be attributed to the unfortunate coincidence o f a l ow growth slump with the need for expenditures to respond to emergency earthquake reconstruction challenges and the financing o f the transition costs of the pension reform. Reconstruction costs have focused on infrastructure rehabilitation, including roads, bridges, schools and health facilities. Pension costs reflect the need to finance the obligations to pay out pensions to older generations which remain in the pay-as-you-go system.

25. I f recent expenditure and income trends are left unchecked, vulnerabilities could increase. The Bank’s recent Public Expenditure Review (PER) concludes that further growth in debt and associated interest payments could eventually be reflected in market spreads and affect El Salvador’s hard-earned creditworthiness. According to the analysis, a passive scenario in which expenditures and revenues would maintain recent growth trends would lead to increasing overall deficits, greater interest payments and a gradually rising public debt. With conservative macroeconomic assumptions, this scenario would lead to: (a) increasing

’ Total public sector debt i s estimated at 46.1 % o f GDP for 2003. The difference with NFPS figures i s accounted by outstanding net debt o f the Central Bank and other public banks.

8

overall deficit to an average o f 4.3% o f GDP by 2013; (b) interest payments o f nearly 3.7% o f GDP in 2013; and (c) total NFPS public debt close to 50% o f GDP by 2013, increasing at an even faster rate afterwards. These trends must be addressed, as El Salvador i s a country that requires an above average degree o f fiscal flexibility due to dollarization and the vulnerability o f the country to natural disasters.

26. One significant item that El Salvador will need to continue to accommodate in fiscal accounts over the medium term is the cost of pension reform. El Salvador adopted a pension reform in 1996 that replaced the existing pay-as-you-go system with a system o f individual retirement accounts. The reform was aimed at improving long-term fiscal sustainability by replacing a system that was projected to yield large and growing deficits in the future by a sustainable one, implying transitional costs as younger Salvadorans move to the private account system while the state keeps the obligation to pay out pensions to older generations. Facing mounting transition costs o f the pension reform, adoption o f further measures-such as raising retirement ages and the number o f years paid in order to have rights to a pension-remain a difficult political issue in El Salvador. Outlays required to finance the transition are expected to average about 2% o f GDP per year over the period 2005-2009.

27. A debt stabilization strategy that does not rely on raising public revenues would jeopardize critical expenditures. Bringing down recent fiscal imbalances to end further debt accumulation, would require a strong contraction in other areas o f spending. Given the comparatively small size o f El Salvador’s state, such a strategy would l ikely entail strong cutbacks in the overall wage bill (including education personnel), and a reduction in public investment in critical infrastructure including roads, schools and health facilities. These actions would clearly be detrimental to El Salvador’s growth prospects.

28. Given these constraints, the main challenge facing El Salvador in the current juncture i s to reignite growth and stem the fiscal imbalances of recent years, while preserving fiscal space for critical public investments in human capital and infrastructure needed for growth and social progress. The debt sustainability analysis presented in the recent PER, indicated that El Salvador would require an average primary surplus of 1.2% o f GDP between 2005 and 2009 in order to maintain a debt-to-GDP ratio below 40% o f GDP within the next 5 years (2005-2009) while simultaneously increasing public investments in human capital and infrastructure. The relatively small overall size o f public expenditures, their high efficiency levels in most areas, and the need to finance growing pension transition costs, indicate that the bulk of the adjustment would have to be made on the revenue front. A combination o f improved tax collection efforts, broadening o f tax bases, elimination o f loopholes and increased tax rates would be needed. On the expenditure side, some gains may s t i l l to be made f rom improved efficiency levels and from politically-difficult changes in parameters o f the pension system. However, over the medium term the emphasis wi l l need to be placed in boosting public investment levels in key human capital and infrastructure needs for growth and social progress.

29. Strengthening the financial sector i s also required to ensure consolidation of fiscal accounts. While El Salvador enjoys one o f the region’s stronger financial sectors, considerable scope exists for tightening prudential standards and reducing contingent

9

liabilities. As argued in the recent FSAP update, capital adequacy requirements need to be raised to meet international standards. In addition, direct contingent liabilities arise f rom the operation of three public banks. Two public retail banks (Banco de Foment0 Agropecuario and Banco Hipotecario) finance their lending to their target sectors wi th conventional bank deposits, and one wholesale bank (Fondo Social de l a Vivienda) sells long term debt to the private pension funds. The potential non performance of their assets implies a contingent l iabi l i ty for the National Treasury. Going forward, a new financing structure needs to be developed in which the fiscal cost of this public lending activity i s fully and transparently funded b y existing fiscal resources.

30. The new government i s responding to the economic and social challenges. The new Saca Administration has launched an economic medium-term plan intended to stem further debt accumulation while simultaneously protecting critical social and growth expenditures (see Section 111). The plan i s aimed at reducing the overall deficit to about 1.3% o f GDP and overall debt levels below 40% o f GDP b y the end of the presidential term (2009), while at the same time absorbing the growing costs of pension reform and creating space for gradually increasing public investment levels (see Table 1).

Table 1. M e d i u m T e r m Macroeconomic Scenario (as YG of GDP, unless otherwise indicated) -

2003 2004 2005 2006 2007 2008 2009 Macroeconomic Indicators GDP growth (“A change) 1.8 1.8 2.5 3.0 3.0 3.0 3.0 Inflation (end of period % change) 2.5 5.5 2.5 2.5 2.5 2.5 2.5 Gross reserves (months of imports) 3.3 4.5 4.3 4.3 4.3 4.3 4.3 Foreign direct investment 1.7 1.0 1.0 1.5 1.5 1.5 1.5

Public Sector Accounts Total NFPS revenues 16.8 16.8 17.1 17.0 17.4 17.9 18.4

Current Revenues 16.3 16.3 16.6 16.7 17.1 17.6 18.1 Tax revenues l2.1 12.2 13.3 13.6 14.1 14.6 15.2

Total NFPS expenditures 20.6 19.3 20.1 19.3 18.9 18.9 19.7 Current Expenditure (includes pensions) 16.9 16.7 16.8 16.3 15.8 15.4 15.0 Capital Expenditures 3.7 2.6 3.3 3.0 3.1 3.5 4.7

Overall NFPS balance -3.7 -2.5 -3.0 -2.3 -1.5 -1.0 -1.3

Total NFPS Debt 40.7 40.5 40.9 40.7 40.3 39.5 39.2

Balance of payments Current account balance

Exports of goods (f.0.b.) Imports of goods (f.0.b.)

-4.9 -4.4 -4.0 -4.2 -4.3 -4.3 -4.2 21.2 20.4 19.6 19.7 19.6 19.8 20.0

-36.4 -36.2 -35.6 -35.5 -35.6 -35.5 -35.6

Memorandum Items:

Gross Domestic Product ($ million) Overall NFPS balance (w/o pensions)

14,94015,697 16,47417,506 18,500 19,550 20,660 -2.1 -0.7 -0.9 -0.1 0.7 1.2 0.8

Source: Ministry of Finance estimates, base case scenario,

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c. MEDIUM-TERM MACRO-ECONOMIC PROSPECTS AND DEBT SUSTAINABILITY

31. Current short and medium term projections by the government and the IMF assume growth of only 3% annually from 2005 to 2009. While this rate i s an improvement over the average rate of the period 1996-2003 o f 2.5%, i t i s s t i l l l ow by historical and regional norms and below the potential rates projected b y the Bank’s C E M in the absence o f negative shocks. The l o w rate i s formally justified b y El Salvador’s continued vulnerability to shocks, and i s in keeping with El Salvador’s prudent macroeconomic planning. Even under this conservative scenario, macro and fiscal sustainability trends seem adequate. As confirmed by the recent IMF Article IV exercise, recent measures are consistent with the government’s current fiscal plan to raise revenues to 15.2% o f GDP b y 2009 and maintain NFPS debt below 40% by 2009 (Table 1) (see Annex 4).

32. El Salvador’s growth prospects should improve in 2005 and beyond. In particular, growth i s l ikely to be higher as the global economy translates into higher demand for Salvadoran exports, as the resolution o f recent fiscal trends improves confidence in the economy and as the ratification o f DR-CAFTA enhances the investment and trade outlook in the country. As illustrated in Annex 4, higher growth over the medium term would improve debt dynamics and provide opportunities for increasing public investments in key growth and social areas.

33. Factors affecting growth and fiscal prospects. Despite a positive outlook there are r isks to higher growth and the expected progress on the fiscal front. Natural disasters, a deterioration in the global economy or continued high o i l prices could dampen performance. Political gridlock in El Salvador could prevent passage o f fiscal measures. Export and employment growth may be affected by further weakness in maquila exports and investments in anticipation o f the scheduled end o f textile quotas in early 2005 in the United States and other markets. Whi le many o f the effects o f this well-known deadline has already prompted adjustments in this industry, a further intensification o f competition f rom China and other Asian countries could potentially prompt a further decline.

111. THE GOVERNMENT PROGRAM: R E S T O R I N G BROAD-BASED GROWTH

34. The new government has a strong mandate and a vision to tackle El Salvador’s current challenges. On March 2004, the 38-year-old entrepreneur, Antonio Saca, defeated his nearest r ival wi th a solid margin o f 57.7% to 35.7%. The new President has assumed office in June with considerable legitimacy, since he was elected with a record turnout o f around 60%. His Plan “Safe Country 2004 - 2009,” adopted during the campaign (summarized in Figure l), focuses on sound macro-fiscal management, foreign investment promotion, free trade, private sector-led development and a business environment free of exchange rate risk.

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Pillar I Accelerating Broad-Based

Equitable Growth and Increasing Employment

Pillar I1 Pillar I11 Improving Equity through Building Enhancing Security and Reducing

Human Capital and Expanding Access to Basic Infrastructure,

Assets and Markets

Ensuring sound macro- management and fiscal

Vulnerability

Modemizing education and building the knowledge society.

Making E l Salvador a safe country through control and reduction of

I

responsibility.

I Strengthening family assets by I Promoting social cohesion and stronger

Deepening insertion in world markets through regional integration and trade.

Increasing productivity and competitiveness through improving the investment climate and taking advantage of technology and connectivity.

Improving quality and universal coverage of health services.

Designing local and regional strategies- focused on expanding access to basic infrastructure, promoting agricultural diversification and facilitating private sector investment.

violence.

Ensuring social and economic rights of individuals and businesses by strengthening rule of law.

Modemizing public administration and services, in order to improve transparency and efficiency of resource use.

I Generating employment and opportunities by supporting SMEs.

Improving market regulation and supervision.

facilitating access to housing and expanding land administration and titling efforts.

families through a more effective social safety net and improving quality of l i fe at the local level.

Enhancing the interest of future generations by protecting the environment.

PROMOTING PARTICIPATION AND CONSENSUS BUILDING PARTNERSHIPS WITH SALVADORANS ABROAD

35. Policy progress in the growth agenda, fiscal consolidation, and public sector modernization, will underpin broader success. As recognized by the government, three areas o f policy and structural reform wil l underpin the broader success o f this comprehensive development plan. First, the government views reigniting broad-based growth as i t s ultimate challenge, as this holds the key to create jobs, raise incomes, generate government revenue, lower the debt burden and drive down poverty. Second, the government i s seeking to address recent fiscal disequilibria so as to stem growing debt levels while maintaining fiscal space to adequately finance i t s development agenda. Third, in l ine wi th this, the government i s also pushing ahead with modernization o f i t s public sector with an a im to using i t s l imited fiscal resources to greatest effect.

A. ACCELERATING BROAD-BASED GROWTH

36. The cornerstone of the new government’s growth agenda i s the implementation of DR-CAFTA and a complementary agenda o f policy and institutional reforms to ensure that El Salvador can obtain i ts full benefits. The Salvadoran Assembly approved the U S - Central America-Dominican Republic Free Trade Agreement (DR-CAFTA) in December 2004, making El Salvador the f i rs t country to ratify the agreement. Implementation on a bilateral basis w i l l fol low immediately after the treaty i s ratified by the U.S. Congress. Key

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complementary actions include measures to facilitate the expansion o f trade and investment levels, improvements in the investment climate, addressing infrastructure needs, promoting innovation and technology, and bolstering the educational level o f the labor force.

1) Trade

37. The government i s creating a consolidated export and investment promotion agency to capitalize on new trade and investment opportunities that will arise from DR- CAFTA and other free trade agreements. The new agency, led b y the Vice President o f El Salvador, i s built on the basis o f the Investment Promotion Agency (PROESA) that became fully operational in 2001. In addition to efforts to promote Salvadoran exports and attract investments from abroad, the new agency w i l l also provide specialized export-related information to small and medium enterprises through the Trade Point (TP) program. Government plans to move away from attracting only “maquila” related FDI, as shown b y recent successes in attracting more higher technology and value added investments: DELL Cal l Centers, an air transport maintenance facility, AEROMAN, a regional service hub for Philips Electronics. The government i s also establishing a partnership with the American Chamber o f Commerce and other private sector groups to improve the country’s image as a socially responsible platform for investments and exports, specially in areas o f labor and environmental standards. The government i s also planning actions to promote quality and the adoption o f norms and standards to support the expansion o f exports, including the implementation of a National Quality Program, encompassing the development and strengthening o f local quality certification capacity.

38. The strategy assigns a central role to ensuring that the benefits of new trade opportunities are accessible to SMEs, both directly through access to export markets and indirectly by developing strategic linkages with FDI and local exporting companies. The government plans to expand i t s programs to allow SMEs to gain access to market intelligence, establish export contacts, adopt and adapt technologies, and improve quality. New instruments w i l l be designed to disseminate information on requirements to access the U.S. market, and provide technical assistance to overcome technical barriers to trade and sanitary and phytosanitary standards. Some o f the most important programs contributing to these effort are: the Infocentros Network; the “BONOMYPE”, a training instrument; the funds for technical assistance support (“FAT and FOEX”); and programs to promote SME association.

39. The Government is also adopting plans to facilitate retraining programs and support for low income and economically displaced farmersflaborers to ensure a smooth transition to other areas with more growth potential. The government i s facilitating at least three private agreements that create financing facilities for technological upgrading and substitution activities for firms and sectors that could be negatively affected by the elimination o f tariffs wi th the U.S. In addition, to ensure that there i s a sufficient supply of qualified labor for f i r m s to take advantage o f new trade opportunities, the government i s also developing plans to strengthen technical labor training and tertiary education, with emphasis on responding to demands f rom the private sector.

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2) Investment Climate

40. In the area of market performance and regulation of competition, the government i s putting forward actions to improve the legal and institutional framework. Success in this area i s critical to make sustainable public opinion and political commitment to reforms and to stem frustration wi th market reforms in some areas. In December 2004, the government obtained approval o f a Competition Law which w i l l bolster efforts to improve the functioning o f some markets and reduce the incidence o f monopolistic practices. Going forward, the government also plans to modernize and streamline procedures in the area o f consumer protection through new legislation and strengthening o f the Consumer Protection Agency which would strengthen efforts to ensure that public services and others have in place proper channels to receive, process, respond to legitimate complaints, and in general ensure compliance wi th existing legislation. The government also plans to complete the process of modernization o f all public registries and o f the legal framework in various important areas (i.e., Investment Law, Commercial Code, Bankruptcy Law, e-Commerce, Movable Assets).

41. The government i s also committed to improve business registration procedures and reduce the time and cost of doing business in El Salvador, closing any existing gaps with regional leaders. Recent efforts to reform and harmonize the legal framework for business registration (including the creation o f the National Investment Office, ONI) wi l l be continued. These efforts are responsible for the sharp fal l in the number o f days that i t takes a foreign firm to start a business - from 3 to 6 months to only 7 to 10 days. Efforts w i l l also focus on extending the benefits o f ON1 to domestic firms, as they s t i l l face complex and costly procedures for registration and operating. Most significantly, the Government plans to open in 2005 a single registration windows for SMEs, in collaboration with the SME support agency (CONAMYPE). ON1 offices w i l l open in municipalities in the Eastern and Western regions o f the country.

42. To further develop capital markets, the government i s planning to present to the Assembly new legal frameworks for mutual funds and for securitization in early 2005. These laws should facilitate financing for new ventures b y providing a framework for standard contracts tradable in liquid secondary markets, as wel l as a regulatory and supervisory framework that provides predictable enforcement o f those contracts.

3) Infrastructure

43. In infrastructure, the government i s in the process of designing an ambitious agenda to address challenges and spur growth. The agenda i s expected to rely on further strengthening o f regulatory frameworks and institutions, as wel l as the adoption o f innovations in services delivery and administration arrangements. For this purpose, the government has asked for Bank assistance to address legal and regulatory needs and to design new modes o f infrastructure service delivery jo int ly wi th the private sector to cover areas such as to l l roads, port and airport facilities, electricity generation, urban transport services and water supply and wastewater treatment.

44. Some of the key priorities in the area of infrastructure development have already been identified by the government. In the area of ports, these include the modernization o f

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the port of Acajutla and cargo operations at Comalapa Airport, the development o f the new deep-sea port (Cutuco) and improvements in the sector’s legal and regulatory framework. In road transport services, the government intends to continue development and improvement o f the primary and secondary network under the Road Maintenance Fund (FOVIAL) program, address rural road maintenance shortfalls, and rationalize and improve urban public transportation services. In water, plans are underway for clarifying roles and responsibilities o f the many agencies involved in the sector and adopting new legislation to improve provision and establish a regulatory entity to oversee national water policy. In energy, the priority i s to strengthen the institutional capacity o f the Superintendence o f Energy and Telecommunications (SIGET), review the framework under which the system i s currently working to ensure competitive pricing and develop plans for expanding the regional inter- connection o f the Central American grid.

4) Innovation

45. The government plans to develop and formulate a new policy for innovation and technological development in close collaboration with the private sector. The government i s currently designing plans to (i) adopt a more clear policy framework; (ii) improve cooperation and coordination between public and private sector initiatives; (iii) clarify the role and strengthen the capacity o f the National Council for Science and Technology (Consejo Nacional de Ciencia y Tecnologia. CONACYT); and (iv) define and put in place more effective instruments to support innovation and technology adoption b y the private sector. The new pol icy wi l l include the establishment o f a National Innovation and Technology System. A fund to promote innovation and the adoption o f new technologies through matching funds i s under discussion. Other policies under evaluation include modification o f accounting rules to allow for capitalization and fast depreciation of R&D expenses. The public-private partnership program (“Descubriendo Potenciales Productivos”) plans to support the identification and testing o f new business activities through a venture capital facility and business incubators. As part o f the effort to promote innovation and technology adoption, a presidential program has been launched to promote I C T (“Agenda de Conectividad”) both in the public and private sectors. Special training programs are being designed for SME’s and programs to develop e-government and e-commerce are also being considered, taking advantage o f the infrastructure provided by the network o f INFOCENTROS.

5) Education

46. The new government i s responding decisively to the critical challenges in education that remain with respect to equity, quality and efficiency. Building on the substantial progress achieved in the past decade, the Government o f El Salvador i s preparing a new fifteen year Long Term Education Plan that sets specific targets for 2021 focused on key areas, including improving education quality, expanding access to secondary education, and strengthening secondary education through linkages to technology and productivity.

47. As the CAS explains, the Bank’s ongoing support in this area will be deepened under the new government through several complementary investment operations. The

15

new fifteen year plan w i l l be supported b y a Second Education Reform Project planned for FY06. This new project builds on an ongoing Secondary Education Project that is working to extend a participatory approach to secondary education, broadening i t s coverage in rural areas, financing school rehabilitation and maintenance, improving cost-effectiveness with an enhanced role for the private sector, and upgrading the content and relevance o f the curricula. The Bank i s also supporting an ongoing Education Reform Project that aims to ensure that at least 90 % o f children complete basic education wi th emphasis on the poorest rural and urban areas.

B. RESTORING A SOUND FISCAL FRAMEWORK

48. The need to stem the recent run up in debt levels i s a top priority of the new Saca administration as formulated in “Safe Country” and in the macroeconomic medium term plan. This plan includes measures designed to lower the fiscal deficit and reduce debt levels below 40% o f GDP b y the end o f the presidential term (2009), while at the same time protecting and eventually increasing critical social and growth expenditures. As a result o f the relatively small size o f overall expenditures and the need to accommodate the costs o f pension reform, the emphasis o f the government’s proposed fiscal adjustment relies on increasing tax revenues by 3% o f GDP b y 2009 from i t s 2004 level o f about 12% o f GDP. In addition, the plan includes measures to address contingent liabilities in the financial sector.

49. The government’s plan for fiscal consolidation relies in i t s first year in office on (1) a package of fiscal reforms, (2) expenditure discipline as reflected in the 2005 budget and (3) an adjustment to the pension regime that yields future expenditure relief. On the first item, the government obtained passage in late October o f a fiscal package o f laws that are expected to yield about 1.0 % o f GDP ($198 m) starting in 2005. The approved fiscal package includes reforms to twelve different laws in a broad range o f areas (e.g., tax code, penal code, financial sector, customs). Most significantly, the reforms include a significant broadening o f the tax base o f the value added and income tax, eliminating banking secrecy laws for the purposes o f tax audits and the introduction o f prison terms for tax evaders. In December 2004 the Assembly approved increases in excise taxes on cigarettes, alcoholic beverages, beer, guns, ammunitions and explosives. This additional reform i s expected to yield an additional 0.2% o f GDP starting in 2005. Revenues f rom this initiative w i l l formally fund the Health Sector Fund (Fondo Solidario para l a Salud) which w i l l help increase health coverage, specially in the poorest regions o f the country. Table 2 presents a breakdown o f the estimated fiscal yield for 2005 o f the fiscal reforms approved in 2004. The government has also announced it intends to monitor carefully tax revenues and i s committed to act wi th new revenue generating measures i f collections do not yield the desired targets. Recent efforts to improve the collection efficiency o f the tax administration, responsible for significant additional revenues in 2004, w i l l also be continued.

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Table 2 Expected Yield of Tax Reforms in 2005

Area Yield ($m) Of GDP Tax Code Reforms 51.1 0.3 1 Income Tax Law Reforms 15.2 0.09 Value Added Tax Reforms 31.7 0.20 Tax Administration efforts 57.7 0.35

Expected %

Fiscal Amnesty Excise Taxes

12.0 0.07 30.0 0.18

Total 197.7 1.20

50. On the expenditure front, the Saca administration has submitted a 2005 budget consistent with a fiscal def ic i t of 3 % of GDP. The budget includes a freeze on public sector wages, while protecting social and growth expenditure priorities.

51. In the pension front, the government acted promptly by obtaining legislative approval of the elimination of provisions that allow for early retirement. This change i s expected to reduce fiscal costs by about 1 % of GDP over the next five years (2005-2009). Going forward, the government expects to redesign the financing structure o f the pension system to contain i t s fiscal impact.

52. Several areas of action are envisioned to reduce contingent liabilities derived from financial institutions and to strengthen the sector more broadly. The government plans to present new legislation in early 2005 (a Financial Supervision Law) to strengthen supervisory power, including the regulation o f financial conglomerates. Supervisory power w i l l be strengthened by providing legal protection for the Superintendent and SSF staff, and by establishing their tenure and terms for removal. Financial regulators also plan to issue in 2005 new rules on loan classification and provisioning, and on credit risk administration, consistent with international best practices. In addition, the Government i s designing a strategy to transform public banks into vehicles o f an essentially fiduciary nature, with no access to third party funds.

C. PUBLIC SECTOR MODERNIZATION

53. Reforms in public sector modernization were started in El Salvador in 1994 and were strengthened in 1999 in order to improve service delivery, address the overextension and centralization of the State, as well as reform outdated and inadequate administrative infrastructures. Important accomplishments to date include: (i) the successful restructuring o f the Ministry o f Public Works, transforming i t into a pol icy ministry and spinning-off the maintenance activities to the private sector, wi th significant efficiency gains; (ii) development o f a human resources management system for the public sector including design o f tools for selection, evaluation, classification, remuneration and promotion o f government employees; (iii) issuance and implementation of modern financial management, procurement, tax, and customs legislation and the introduction o f integrated

17

financial management and tax information systems; and (iv) partial decentralization o f public services in water and health.

54. The new government i s committed to deepening these efforts in the overall public sector, as reflected in i ts plan “Safe Country.” This agenda aims to improve the efficiency o f public expenditures, strengthen governance and, ultimately, create an environment more conducive to investment and growth. During the next four years, the government intends to continue restructuring public sector institutions, improving human resource management, increasing the efficiency and transparency o f resources transferred to municipalities, modernize regulatory entities, and strengthen the judiciary. However, in the immediate future, the authorities plan on focusing on three elements that are at the core o f public sector reform in the context o f this program: Procurement reform, e-government, and financial management.

55. A major reform of government procurement processes was launched with approval of the L a w on Public Sector Procurement and Contracting (LACAP) in M a y 2000. The Procurement Policy Office (UNAC) was established by the Law within de Ministry o f Finance to exercise effective leadership in policy development and oversight o f the Public Procurement System. To this end, UNAC has recently obtained approval b y the Council o f Ministers o f the 2005 Procurement Policy for the Public Sector. Key challenges in ensuring a successful implementation o f the new legislation are outlined in the recently completed CPAR, carried out by the Bank and the IADB, and include (i) issuing regulations to the Procurement Law, which i s awaiting approval o f the Secretaria Juridica and expected to be obtained shortly, (ii) strengthening the capacity in al l government agencies and municipalities to carry out procurement, and (iii) strengthening o f UNAC with additional technical staff and resources so i t can exercise i t s effective leadership in pol icy development and oversight. The 2005 Policy l i s t s as one o f i t s specific objectives the implementation o f a module for dissemination o f information o f COMPRASAL, a component o f e-government, which wi l l constitute a technological tool which i s expected to improve competition and transparency in public procurement. I t i s envisioned that COMPRASAL in i t s more advanced stages w i l l allow for procurement transactions on line, which future DPLs w i l l support amongst other activities o f the reform.

56. Important initiatives in e-government have been launched to improve service delivery and availability of information for the public. An official e-government strategy has been approved and a number o f online services have begun operation, including 12 finance and customs services (including licenses, exporthmport declarations, and submission of statistical information), and the online payment o f taxes and customs duties. K e y challenges include the establishment o f a central payments portal for government services, the introduction o f e-procurement (initially through an information portal on government purchases), and the further expansion o f e-services to other areas.

57. The government is also well poised to push to deepen the public financial management (PFM) management reform process, building upon modern PFM legislation that has significantly improved the framework and processes of budget formulation, execution and reporting. Challenges in this area are spelled out in the recently

18

completed CFAA, carried out joint ly by the Bank and the IADB, and include (i) increased transparency o f budgetary documentation and development o f a medium term budget framework, (ii) upgrading o f the technological platform supporting the financial and payroll management systems, (iii) compilation, consolidation and analysis o f municipal budget data, (iv) improvements in content and external oversight o f government financial information, and (v) more effective internal controls and internal audits. A noteworthy step in this area has been the recent government adoption o f a framework for internal controls consistent wi th international standards.

IV. THE PROPOSED L O A N

A. LINKS TO CAS AND ANALYTICAL UNDERPINNINGS

58. Strategy that proposes a strategic program o f lending and non-lending services to support the three main pillars o f the government’s development plan “Safe Country 2004-2009: (i) to accelerate broad-based, equitable economic growth and increase employment; (ii) to improve equity through building human capital and expanding access to socioeconomic infrastructure, assets and markets; and (iii) to enhance security and reduce vulnerability.

The Bank Group’s assistance over FY05-08 i s elaborated in a new Country Assistance .

59. The central component of the Bank’s a proposed assistance strategy in El Salvador would be a programmatic series of Development Policy Loans (DPL) to support the Saca government’s medium-term development strategy to accelerate broad based and equitable economic growth as elaborated in this program document. As stated at the outset o f this document, the series o f DPLs would be intended to contribute to the Government’s objectives o f (i) reigniting growth, particularly through increased private investment and trade, (ii) reinforcing macroeconomic stability and strengthening fiscal sustainability, and (iii) increasing the efficiency and transparency o f public sector management. The design o f key prior actions, triggers and indicators (listed in Annex 2) are underpinned b y a substantial body o f analytic work carried out by the Bank in partnership with the government o f El Salvador over the last few years, including the f ive core diagnostic reports. This f i rst DPL operation focuses on the fiscal measures undertaken to meet the challenges o f stemming debt growth and preserving space for key growth and social investments, following recommendations presented in the PER. It also devotes attention to the early stages o f the growth agenda, with special emphasis on trade related mesures.

60. Future DPL operations are expected to shift gradually to focus on the international trade, business environment, capital markets and infrastructure areas. Focus on these areas w i l l draw on the Investment Climate Assessment, the REDI, technical assistance to enhance public-private participation in infrastructure, and a Country Environmental Analysis which w i l l review the policy and institutional framework and make recommendations, especially in relation to the environmental pol icy framework for infrastructure development and for the expansion o f trade and investment that i s expected under DR-CAFTA.

61. The entire DPL series will support gradual implementation of measures identified in the CFAA and CPAR to enhance governance, transparency and efficiency in public spending, as well as other government initiatives in public sector modernization.

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B. LESSONS LEARNED

62. The Bank has no recent experience with adjustment lending to El Salvador. The biggest obstacle to implementation of the lending programs envisioned in the last two Country Assistance Strategies for El Salvador (discussed at Board in Feb 1997 and Nov 2002) was the difficulty faced b y the Executive in obtaining Assembly support for ratification of external loans. The new government believes that the DPL series proposed in the context of the new CAS (FY05-09) w i l l help i t overcome this issue. B y incorporating DPLs within the budget presented to the Assembly, the Executive expects to have greater leverage as this would call attention to the lower cost of borrowing World Bank resources in contrast to alternatives.

63. lessons:

OED evaluations of Policy Reform Loans in the 1990s presented the following

(i) Multi-tranching contributes to slow implementation, particularly if it contributes to making the operation overly complex;

(ii) Classical ex-post conditionality weakens reform ownership; (iii) Rapidly changing policy environments are difficult to anticipate in loan design.

C. DESIGN OF DPL

64. The design of this new lending approach takes into account the lessons learned from past operations in Salvador and the latest thinking on Development Policy Lending for well performing middle income countries.* The underlying principles of this operation are the following:

(i) Upfront action instead of ex-post conditionality: This loan has been triggered by the new government’s commitment to build on the country’s strong record of policy performance record to consolidate fiscal accounts and restore broad- based growth; and by specific and significant policy actions toward those ends.

(ii) Support of reform program instead of specific conditionality. The DPL and the programmatic approach wi l l support a broad government reform program. Lack o f reform progress in a specific area can be compensated with actions in others if the overall reform program remains on track.

(iii) Aligning program loans with budgetary cycle. The proposed programmatic approach i s designed to become a predictable low cost source of financing for the government.

65. Starting with the second DPL in the program, loans would be presented to the Assembly for approval in the third quarter of the calendar year, so that they can be incorporated in the Budget before i t s formal presentation to the Assembly on September

World Bank 2004. Programmatic Adjustment lending retrospective, and World Bank 2004: Good Practice Note: Designing Development Policy Operations, http://intresources.worldbank.org/ INTCOUNTECONOMICSI Resources/Designingdevelopment90204.pdf

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30. This implies that there will be a relatively short turnaround time between the first and second DPLs in the series, as this f i rs t operation wil l come in late in the budget cycle, and i s currently expected to be submitted for legislative approval in the first quarter o f 2005. As explained below, a more thorough evaluation of progress in meeting the targets o f the D P L agenda (including the fiscal reforms o f 2004) w i l l take place in early 2006.

D. PROGRAMMATIC FRAMEWORK

66. The proposed DPL i s part of a programmatic approach that supports actions in three areas: (i) reigniting growth, (ii) macro stability and fiscal consolidation, and (iii) public sector modernization. I t i s expected that in the early DPLs, more emphasis would be placed on the second area (fiscal consolidation) and that the emphasis would shift gradually towards the first area o f structural measures to enhance growth in the latter loans. The entire program i s expected to support actions in public sector modernization. A policy framework i s included in Annex 2. The key measures highlighted as prior actions for this DPL are the following (see referred paragraphs for further details):

Reigniting Growth

1) 2) 3)

DR-CAFTA Treaty signed and dissemination program launched (p.14 and 36); Legislative approval o f new Competition Law (p.40); Reduction o f costs and time in business registration and operation for SMEs through creation of “Centro de Tramites Empresariales” (p.41);

Macroeconomic and Fiscal Consolidation 4)

5)

Approval of package o f fiscal reforms (corresponds to the modification o f 12 laws approved in October 2004) (p.49); Elimination o f early retirement provisions (p. 5 1);

Public Sector Modernization 6)

7 ) 8)

Issuance o f operational directives for procurement unit (UNAC) and four year program for the implementation o f the public procurement system (p.55); Launch of an e-government strategy (p.56); and, Progress in PFM improvement program as evidenced b y issuance o f a decree adopting public sector internal control norms consistent with international standards (p. 57).

E. M&E ARRANGEMENTS

67. The government and the Bank will take advantage of several important data sources to assess progress for the DPLs, including:

0 Central and Nonfinancial public sector budget monitoring f rom the Ministry o f Finance

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National Directorate for Statistical and Census (DIGESTYC) reports

Investment climate surveys

Central Bank o f El Salvador reports and analysis

Reviews and analyses o f laws and implementing regulations f rom the Bank and other stakeholders

Financial audits and fol low up o f CPAR and C F A A recommendations

Bank and IMF supervision missions and reports

Annual reports from the World Economic Forum

Annual reports f rom Transparency International.

68. The government of El Salvador and the Bank have agreed to monitor progress in the DPL program regularly, including at the annual reviews of CAS progress, when revisions to the scale and timing of the Bank’s lending program can be undertaken. Discussions w i l l be held with the Technical Secretariat o f the Presidency, the main counterpart agency for the loan, who w i l l be in charge o f M&E for the loan and for collecting f rom the appropriate sources the data necessary to assess implementation progress. Other agencies that w i l l play an important role in this process are the Central Bank (for financial sector issues), the Ministry o f Economics (for trade and investment climate issues) and the Ministry o f Finance.

69. Semi-annual reviews will take place between the Technical Secretariat and the Bank team aimed at identifying areas of strengths and weaknesses and possible assistance needed to maintain momentum toward the government’s planned medium- term outcomes and address possible downside risks. A mid-term review wil l be made in the first quarter o f 2006, when the government and the team w i l l joint ly evaluate progress in achieving the outcomes laid out for the program. Indicative targets for this medium term review include:

Non maquila exports (excluding coffee) as a share o f GDP at or above 8% o f GDP b y end 2005.

0 FDI flows at least 1.5% o f GDP in 2005.

0 “Centro de Trimites” created and cost o f registering local businesses reduced by at least 50%.

At least one infrastructure concession launched.

0 Tax revenues at or above 13% o f GDP by end 2005.

0 NFPS deficit wi th pensions at or below -3.0% o f GDP by end 2005.

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F. POVERTY AND SOCIAL IMPACT ANALYSIS

70. The task team considers that PSIA i s not needed prior to disbursement because most of the specific policy measures that are supported by this loan are not expected to have significant negative poverty or social impacts. O f the major components that are supported in the program, the implementation o f the DR-CAFTA agreement expected in 2005 w i l l be the subject of a PSIA, as i t may exert negative impacts on the incomes o f some segments o f Salvadoran society that have been hitherto protected. The task o f the PSIA would be to assess the impact o f DR-CAFTA on the poor and to identify potential effects on protected segments. This study would complement the regional ESW the that Bank has been conducting on the expected overall impact o f the DR-CAFTA agreement in the Central America region and the complementary measures required leverage i t s opportunities (scheduled for delivery in FY05). A draft o f the study was discussed at a regional conference in San Salvador in February 2004 and background papers sponsored b y the bank on this topic have been disseminated. Box 1 summarizes preliminary findings.

71. PSIA on the fiscal and pension measures undertaken under the program i s also planned to be conducted during 2005. While the bulk o f the fiscal reforms supported under this operation are not expected to have a significant impact on the poor, the study w i l l assess the distributive impact o f the Salvadoran tax code and o f further changes to the most significant taxes. In addition, a PSIA o f recent and potential future changes to the pension regime w i l l be undertaken. Results from these studies w i l l be presented to government and are expected to feed the policy dialogue for further DPLs.

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BOX 1: ACTIONS TO MAXIMIZE D R - C A F T A OPPORTUNITIES FOR EL SALVADOR

Education and knowledge absorption and generation: DR-CAFTA i s likely to bolster FDI and imports with the capacity to improve technology and productivity. However, to materialize the potential and enhance technological spillovers wil l require sufficient levels of human capital and an adequate knowledge and innovation system. In education, this means that E l Salvador needs to close i ts ‘gap in skil ls’, expanding coverage and quality of i t s primary and secondary schooling system. In the innovation front, i t wi l l need to boost the quality of i t s institutions of research, increase expenditures on R&D and develop links between public researchers and private sector users. There are important synergies to be exploited between a functioning innovation system and critical higher education initiatives. Institutional development and governance: El Salvador has achieved considerable progress in the institutional and govemance front over the past decade. However, serious deficiencies s t i l l exist, particularly in the rule of law and personal security front, as evidenced by corruption, violence and crime indicators. Weaknesses in rule of law are part o f the reason for the apparent low growth yield of reforms in E l Salvador in recent years. To reap the rewards of DR-CAFTA, continued improvement in institutions i s required, especially those aimed to improve the rule of law and fight corruption. T h i s wi l l require substantial local efforts, as such improvements have not been automatic byproducts of North-South free trade agreements. Infrastructure: While El Salvador has made great strides in modemizing i t s infrastructure (esp. airports and roads) in recent years, there are deficiencies that need to be addressed, particularly in road networks and ports. The experience o f Mexico has shown that the southem provinces have lagged behind the rest of the country in taking advantage o f the growth opportunities offered by NAFTA, principally because of low education levels, and weak transport and communications infrastructure. To allow all regions o f El Salvador to benefit from DR- CAFTA, strategic investments in infrastructure wi l l be required, with increased emphasis on lagging regions. Macroeconomic management: Investors should be attracted by El Salvador’s record of stable macroeconomic management of recent years. Potential fiscal losses associated with DR-CAFTA wi l l need to be compensated and macroeconomic management strengthened. Within the dollarization framework, the Central Bank’s role as lender o f last resort to the financial system needs to be bolstered and efforts must be redoubled to ensure compliance with strict prudential norms and regulations. Further fiscal consolidation wi l l also be required in order to pursue effective counter cyclical policies. Trade policy: In addition to strengthening institutions related to meeting DR-CAFTA commitments in the trade administration sphere, El Salvador i s likely to benefit from continuing to pursue i t s agenda of unilateral, bilateral and multilateral actions to expand trade and broader integration opportunities. Deepening trade and other links with regional neighbors through the CACM wi l l improve allocation of resources in the region and provide economies of scale needed to launch new viable export ventures. Further progress in reaching FTAs with Canada, the European Union and with other Latin American countries through FTAA wil l further broaden economic integration and minimize any possible trade diversion effects from existing FTAs. Broadening the benefits of CAFTA: Attention i s also required to ensure that benefits of DR-CAFTA are spread across all levels o f Salvadoran society. T h i s includes policies to foster development of financial services beyond large companies, so that MSMEs have access to finance. T h i s i s likely to require legal and institutional shortcomings regarding the protection of creditor and shareholder rights. Specially targeted programs for low income farmers/laborers may also be needed for those who are likely to be displaced from their current activities. to facilitate a smooth transition to other areas with more growth potential.

Source: The World Bank, El Salvador CEM, 2004.

G. ENVIRONMENTAL A N D NATURAL RESOURCES ASPECTS

72. Specific actions under the proposed first DPL are not expected to have any significant negative environmental impact. However, the Bank has begun to work wi th the government on preparation o f a Country Environmental Analysis (CEA) to be finalized in FY06, in an effort to support i t s capacity to assess and mitigate environmental consequences o f development policies. The CEA w i l l be timed so as to support implementation o f measures in future DPL which are expected to give more emphasis to structural growth actions, including investments in infrastructure. The CEA would develop a sound analytic

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understanding of the country and sector-wide institutional set-up and policy framework and provide guidance and advice to the government’s national environmental strategy and policy, currently under development. The Analysis w i l l be done in close coordination with the planned Recent Economic Developments in Infrastructure Report (REDI) diagnostic to provide the government wi th particular recommendations that would be relevant as i t pursues new policies to spur sustainable infrastructure development. It w i l l also pay special attention to needs that may arise out o f the expansion o f trade and investment that i s expected under DR-CAFTA and w i l l make recommendations on how to mitigate any possible adverse impacts o f this treaty.

H. FIDUCIARY ASPECTS

73. El Salvador’s fiduciary environment for DPLs is adequate. As part o f the government’s overall long-term focus on public sector modernization, significant improvements in the performance o f budget and procurement management institutions have been made over the past decade. T o document the current state o f public financial management in the country and propose priorities for action, the Wor ld Bank and the IADB carried out in 2004 a Country Financial Accountability Assessment (CFAA) and a Country Procurement Assessment (CPAR). The key findings and recommendations are summarized in Box 2. While overall findings indicate that the environment i s solid, the current government i s moving ahead to further strengthen i t s public fiduciary control framework, building on this foundation, as described in Section I11 o f this document. In connection to this, the Bank i s actively engaged in public financial management dialogue wi th the government to follow up on recommendations made through the CFANCPAR. Drawing f rom this ongoing work, certain key pol icy actions in the context o f the DPL program have been agreed (see Annex 2). In addition, the Bank plans to continue policy dialogue with the Government in public financial management (PFM) using selective milestones, which define specific elements o f the PFM improvement program to help track i t s progress (see Annex 3). The PFM milestones are focused on four areas that support the implementation o f internal control norms consistent wi th international standards: (i) quality o f budget formulation and reporting; (ii) coverage and technological platform o f integrated financial management (SAFI) and human resources (SIRH) systems; (iii) transparency o f municipal finances; and (iv) scope and coverage o f external audits.

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Box 2: CFAA and CPAR: Summary of Findings and Recommendations

The Country Financial Accountability Assessment Report (CFAA) and the Country Procurement Assessment Report (CPAR), prepared jointly with the IADB, analyze the performance and transparency of budget and procurement management institutions and systems in the public sector. The analysis and recommendations contained in these reports seek to identify areas where further improvements in public financial management could help to strengthen fiscal discipline, increase operational efficiency, and improve the country’s governance environment.

The analysis concludes that the Government has built strong foundations for well-functioning budget and procurement management systems, with a basis on modem legislation. Still, the widening public sector deficit and deteriorating governance indicators pose important challenges ahead. Accordingly, a detailed set of recommendations has been put forward to the Government - a brief summary follows:

I

I

Civil service. Further strengthening of the financial and procurement management institutions will benefit from the implementation of the government’s plans for a renovated legal and regulatory framework for human resource management and increased managerial accountability. Budget development. The sound methodologies used for budget formulation could serve as basis to improve disclosure of extra-budgetary funds, to aggregate and consolidate municipal budget data, to develop a medium term budget framework, to enhance information and indicators on the public investment program, and to bring the budget documentation up to international standards. Tax administration. The modem revenue administration systems could benefit from stronger coordination among the agencies involved, together with enhancements in the prosecution and sanctioning of tax and customs-related cases. Procurement management. The significant steps taken with the creation of a central regulatory body (UNAC) and decentralized procurement units (UACIs) can be better sustained through systematic staff training and technical assistance, issuance of regulations to the procurement law, and harmonization of bidding and contract documents. Budget execution. The integrated financial management system (SAFI) has significantly improved the procedures and information on government spending, but there i s s t i l l work ahead to develop or consolidate related administrative systems; most notably, the upgrading of the payroll management system, and the development of a comprehensive procurement information system (under the e-Government initiative), coupled with tools to monitor procurement performance. Debt. Active debt management will require the introduction of continuing programs for s k i l l s development in this highly specialized area - such programs to include the capacity to undertake systematic debt sustainability and risk analyses. Internal controls. Implementation of a more effective internal control and internal audit framework, based upon risk-based approaches, will be key to further guarantee efficiency and legality of public expenditures. Financial reporting and external oversight. The accounting function, which i s properly institutionalized and shows sophisticated advances, could serve as basis for further improvements in the content and accessibility of financial information. Comprehensive financial and procurement audits from the Court of Accounts, together with strengthened legislative oversight, would help fill current gaps in external fiscal control.

I. LOAN ADMINISTRATION

74. Borrower and Credit Amount. The borrower i s the Republic o f El Salvador and this operation i s a single-tranche loan o f US$ 100 mi l l ion equivalent that would be made available upon loan effectiveness.

75. Fundsflow arrangements. The Bank w i l l disburse the loan proceeds into an account o f the Central Reserve Bank (BCR) denominated in U S dollars which are legal tender in the c o ~ n t r y . ~ The BCR wil l immediately credit the disbursed amounts to the Ministry o f Finance’s Treasury Single Account (“Fond0 General”), thus becoming available to finance

The IMF’s most recent safeguards assessment o f the BCR (stage one) concluded that the safeguards in place appear generally adequate. The BCR subsequently made important progress in implementing the assessment’s recommendations, such as restructuring the Audit Committee, continuing its migration to international financial reporting standards, and disclosing better the financial information in the public realm.

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budgeted expenditures. Within a week o f this operation, the Ministry wi l l accordingly provide the Bank with a written confirmation. If, after deposit in the BCR, the proceeds o f the Loan are not used as determined above (including use for ineligible purposes as defined in the Loan Agreement), the Bank w i l l require the government to promptly refund the disallowed amount.

76. Given that there i s adequate knowledge about the soundness o f central bank control environment and the country’s public financial management system, as wel l as Government commitment to continue their strengthening, additional fiduciary arrangements (such as the use o f a dedicated deposit account) have not been deemed necessary in this case.

J. BENEFITS

77. policy reform, and the Bank’s relationship wi th El Salvador.

The proposed DPL i s an appropriate vehicle to simultaneously support fiscal needs,

78. Meeting fiscal needs. Board approval and disbursement early in calendar year 2005 o f this proposed loan would help meet the government’s objective o f diversifying financing sources, as wel l as provide financing on more favorable terms than alternatives for i t s 2005 budget. This, in turn, would support the government’s concurrent goals o f fiscal stabilization and addressing social needs through increased and more efficient spending.

79. reforms undertaken for this DPL were discussed with the Bank and were influenced b y the joint analytical work, including the PER, the CEM, the regional CAFTA analytic work, the C F A A and the CPAR. The proposed DPL would be a recognition o f the reform achievements thus far. Timely support b y the Bank would also be important in forming the basis for strong engagement with the new government on forward looking policy actions within the framework o f a new Country Assistance Strategy. The Letter o f Development Policy indicates the new administration’s commitments on a range o f issues where the Bank has either worked with the government to prepare analytical work or has plans to do so. The DPL instrument would provide a vehicle for continuity in pol icy dialogue on the range o f issues which wil l form the basis o f future DPLs. The DPL would also contribute to enhancing the Bank’s reputation as a reliable development partner.

Endorsement of sound policy and vehicle for dialogue. Most o f the

K. RISKS AND MITIGATION

80. partially addressed in the context o f this operation and the new Country Assistance Strategy.

The long-term success o f the proposed operation faces various r isks which can only be

81. Fiscal risk. El Salvador’s current NFPS debt burden, approaching 40 % o f GDP, increases i t s vulnerability to potential shocks. Such fiscal vulnerabilities are further compounded by El Salvador’s dollarized regime, which constrains potential macroeconomic responses in times o f stress. As rating agencies have increasingly voiced over the past year, a credible plan to address the fiscal area i s required to prevent a deterioration o f El Salvador’s hard earned creditworthiness. As discussed earlier in this document, the Saca administration

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i s aware o f the country’s fiscal vulnerabilities, and i s putting in practice a credible plan to address them.

82. Political risk. On the political front, a divided Assembly could become an obstacle to important reforms, despite the strong electoral mandate obtained b y President Saca. The inability to push through measures to increase tax revenues and control expenditures would l ikely raise public debt, which could adversely affect investor sentiment and the availability o f external finance. Likewise, failure to move on financial sector reform could lead to a weakening o f the sector’s soundness and eventual materialization o f contingent liabilities. T o date, the government’s approach to consensus building appears to be bearing fruit, but political obstacles to reform can not yet be fully ruled out. Potentially tense relations with the Assembly could also impede prompt ratification o f external loans, including this DPL, limiting access to funds for social development or forcing use o f higher cost financing. The government expects that concurrent submission o f the DPLs and the annual budget (or, in this case, soon after) to the Assembly w i l l give i t the leverage needed for prompt loan ratification.

83. External risk. Going forward, sustained high o i l prices or a new international recession could negatively affect El Salvador’s economy and worsen debt dynamics. A factor which i s bound to have a potentially negative impact i s the scheduled end o f textile quotas by 2005 in the United States and other markets, which i s expected to intensify competition from China and other Asian countries. While there i s s t i l l uncertainty about the precise impact on El Salvador’s export demand and growing indications that the U.S. i s l ikely to use safeguard measures to replace current import restraints f rom Asia, some plant closures and job losses over the past year suggest that much o f the adjustment to this announced regime change i s l ikely to have already taken place. In addition, given the increase in public debt o f recent years, an increase in international interest rates poses r isks o f unexpected additional financing costs. The government has expressed interest in using a Master Derivatives Agreement (MDA) and use o f the Bank’s financial products to help mitigate some o f these risks.

84. Natural disaster risk. Finally, the country remains vulnerable to natural disasters (e.g., earthquakes and hurricanes) which can hurt the performance o f the economy in the short-term and may require significant unanticipated expenditures for emergency assistance and reconstruction. The government’s focus on improving fiscal responsibility and restoring broad-based growth while building a stronger social safety net, position i t to better absorb such shocks in the future. However, near-term disaster could jeopardize medium-term reform targets .

V. COORDINATION WITH D O N O R S AND S T A K E H O L D E R S

85. Since the Saca administration took office, the Bank has worked closely with the Government, other donors, civil society, and the private sector to develop the Bank’s Country Assistance Strategy (CAS). The Bank’s CAS - where the framework for the proposed DPL was f i rs t presented - was widely discussed in several forums. Consultations were held in San Salvador in October, 2004. The consultations on the CAS centered on a one- day workshop attended by approximately 150 participants, including representatives o f the executive branch o f government, the judicial sector, members o f Salvadoran Assembly, local governments, academia and think-tanks, foundations, c iv i l society, the international donor

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community, the private sector and media. Participants discussed the findings and recommendations o f recent Bank analytical studies and provided input on proposed areas o f future Bank assistance including the proposed series o f DPL's. In addition, a series o f smaller meetings were held wi th specific stakeholder groups to solicit their views on how the Bank could best support El Salvador over the next four years. Annex D o f the CAS provides a summary o f the key points o f the discussions. Overall, responses and views were positive. Some stakeholders were concerned about the recent increase in the level and cost o f external debt in El Salvador and asked the Bank to help the Government to develop a debt management strategy. In this context, most participants welcomed the proposed Development Policy Lending approach as a way to lower the costs o f external financing. There was general support for DPLs as a appropriate way for the Bank to support the country's own development strategy and priorities, as long as efforts continued to strengthen the transparency and effectiveness o f budget expenditures.

86. The Bank has also worked closely with the IMF and other donors during the preparation of the DPL. The IMF and the Bank have coordinated during the CAS preparation process and the preparation o f the proposed DPL which has coincided with the regular preparation for the Article I V report. Teams from both institutions have shared their own debt sustainability analysis work. Major donors have been informed o f the Bank's work program and were consulted during the CAS preparation process. The European Community and the Inter-American Development Bank welcome the concept o f providing support to the Government's own development program and priorities through quick disbursing budget support. Indeed, the Inter-American Development Bank i s also supporting the new administration wi th a fast-disbursing budget support loan for competitiveness.

87. The DPL public information document has been made public. The Bank team plans to ensure continued engagement by multiple stakeholders in relation to the DPL objectives by holding workshops, roundtable discussions, and working groups to discuss progress on the specific reform benchmarks and advise on progress, impact, implementation capacity and timing.

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Annex 1: Letter of Development Policy

Presidency of the Republic of E l Salvador Secretary of Technical Affairs

San Salvador, January 21,2005

ST/CAPRES/MS/OlO

Mr. James D. Wolfensohn President World Bank Washington, D.C.

Dear Mr. Wolfensohn:

The Government o f President Elias Antonio Saca has requested f rom the Wor ld Bank a program o f Development Policy Loans (DPL), “Broad-Based Growth,” for U S $400 million. These resources w i l l be used for improvements in the country’s external indebtedness profile.

The Government Plan 2004-2009, “Safe Country,” has several ambitious goals and i s based on three axes o f action: Economic & Employment Growth, Equity, and Security. Below, you w i l l find the most important measures to be undertaken b y this administration to promote economic growth and the creation o f jobs - particularly those that wi l l use the support of the DPL program. A description o f future plans in the areas o f Equity and Security can be found in the Government Plan itself.

The Government recognizes that three areas are crucial to the success o f the Government Plan “Safe Country.” First, the Government i s working to establish the conditions to accelerate economic growth and create jobs, and, consequently, increase tax revenue and decrease poverty levels. Second, i t i s taking actions to strengthen public finances with the goals o f stabilizing the fiscal situation, decreasing debt levels, and increasing the budget allocated to expenditures in social arena and growth areas. Third, the Government w i l l continue i t s efforts to modernize the public sector, in order to achieve greater efficiency in the use o f fiscal resources.

. . . . . . .2/

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Page 2

Creation of Jobs and Economic Growth

Free Trade

Since the beginning o f the 1990s, El Salvador has been committed to leverage the great opportunities that result from free trade and globalization as an important tool to enabling a sustainable economic growth. Especially important in our agenda for trade openness, i s the recent signing, and subsequent ratification by the Legislative Assembly, o f the Free Trade Agreement wi th Dominican Republic, Central America and the United States o f America (DR-CAFTA), which provides great advantages for the Salvadoran economy. During the process o f negotiations and ratification o f the Treaty, there was significant participation f rom the various sectors, which gave way to a process o f diffusion o f information to the entire population.

In addition, we have free trade agreements with Chile, Panama, Mexico, and the Dominican Republic, and are advancing toward becoming integrated with other strategic trading partners - including the European Union and Canada. At the same time, we have made important progress and w i l l continue to work in our regional integration agenda with Central America countries, since the region i s the platform through which we want to become part o f the widest-reaching trade flows.

Leveraging DR-CAFTA

The globalization process and o f course the DR-CAFTA, in addition to creating opportunities, also presents us with great challenges we must face in order to leverage new opportunities. For this reason, our policies are focused on creating the necessary conditions to raise the level o f competitiveness o f our country and of our f i rms .

Especial relevance i s attributed to technological innovation and the promotion o f quality - essential elements to access the developed markets where we expect to sell our products and services in the future. For this reason, we w i l l define a technology development policy, to serve as the basis to create the National System for Technological Innovation. This System w i l l include some instruments as a Technology Research Fund and a statistical system to measure productivity. W e plan to strengthen co-investment funds for the innovation and adoption o f new technologies in companies. And we w i l l revise the organizational focus o f our National Council o f Science and Technology (CONACYT).

Additionally, we are working to promote a National Quality Program, focused on the public and private sectors, to streamline the use o f quality regulations, and strengthen our systems for certification and accreditation. Finally, we w i l l create an integrated agency for the promotion o f investments and exports.

. .3/

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Page 3

Support for Micro, Small and Medium Sized Enterprises

Micro, small and medium sized enterprises (MSMEs) are o f fundamental importance in the creation o f jobs and the battle against poverty, since they represent a significant portion o f the employed population. By using new free trade agreements, domestic businesses have a greater chance to merchandize their products and services in a much larger market -whether i t i s through direct exports, indirect exports through specialized channels, or by becoming providers o f raw materials, products and services for exporters.

For this reason, we w i l l adopt several measures to improve the competitiveness o f our MSMEs in this new environment. In collaboration wi th the private sector, we have already signed agreements to generate funds for the productive upgrading o f enterprises and sectors that wi l l be affected b y further liberalization o f trade. Additionally, we are developing a strategy for companies to have greater access to information and communication technologies. W e w i l l strengthen the elements they currently possess by providing them with access to training and technical support. And, finally, we w i l l promote alliances among private sector f i rms.

At the same time, we are working to the cut costs and the time it takes companies to register and begin operating in the country. For this purpose, we have created an Enterprise Transaction Center, which we w i l l later extend to locations outside of San Salvador. With this, we are looking to decrease costs to levels at or below regional averages, as measured by the World Bank’s Cost o f Doing Business Annual Report.

Market Performance

The modernization process of the public sector that propelled private participation in the provision o f key public services has been successful. I t has enabled greater coverage and accessibility. However, in some cases i t i s deemed that provision o f these services could be improved. Therefore, i t i s necessary to revise and strengthen the regulatory frameworks to ensure that prices are not hiding market or operator inefficiencies, which would be detrimental to households.

For this reason, the Government o f President Saca i s strengthening policies associated with market performance and consumer defense, and has already taking decisive actions in these areas.

. . . . . . .4/

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Page 4

Fol lowing twelve years o f failed attempts, on December 2004, the Legislative Assembly successfully approved a competition law, which seeks to remove the obstacles and anticompetitive practices among companies to prevent the entry o f new competitors, or to eliminate the barriers erected to prevent the expansion o f existing rivals. In addition, a Presidential Commissioner for Consumer Defense has been appointed who i s currently working on the creation of a new legal framework to strengthen the State actions to protect the consumer’s rights.

Investment Climate

The aforementioned policy measures w i l l improve the investment climate by increasing the returns and decreasing the r isks o f investing in El Salvador. In addition, we are working to improve the investment climate to promote investment, and we w i l l soon submit draft legislation to the assembly to develop the areas o f securization and mutual funds, since the existence o f regulated instruments to provide a wide spectrum o f riskheturn combinations i s a key issue to attract investments. W e are especially interested in improving the legal framework for economic activities, so we w i l l be working in draft legislation for bankruptcy proceedings, a Movable Assets Registry, Factoring, and reforms for the Code o f Commerce.

Infrastructure

In the area of infrastructure, the ports and airports sectors have been modernized through the approval o f the general laws and some o f the regulations for the operation o f the Maritime Port Authority and Civil Aviation Authority, which we expect to complete in the future. In January 2004, the Government initiated the mega development project o f the L a Uni6n Port which should substantially improve the distribution and storage services capacity in the country and which w i l l provide an alternative to the Panama Canal through the connection to a Honduran port in the Atlantic Ocean. Additionally, beginning on the first day o f this year, we have reduced tariffs for the Acajutla Port by 15%, and we are working on a request for bid proposals for a master concession contract o f the port.

With the support o f the World Bank, we have initiated a study on the obstacles that the current state o f infrastructure imposes on trade, growth, and the sustained reduction o f poverty. This study shed light over the most important actions to eliminate said obstacles. Given limitations in public financing, i t i s particularly important for the Government to promote alliances between the public and private sectors for infrastructure projects.

. . .SI

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Page 5

Macroeconomic Stability and Fiscal Consolidation

Public Finance

El Salvador enjoys macroeconomic stability, and i s one o f the few countries in Latin America with an investment grade. This stability i s a solid platform upon which we must build, since, even though i t i s not sufficient, i t i s an indispensable requirement to achieve economic development and growth. Thus, we have taken steps to consolidate public finances, as we are convinced that no Government i s able to ful ly meet i t s objectives without reliable assurance o f i t s fiscal effectiveness. For this reason, we have been conducting important reforms that w i l l enable us, until the year 2009, to increase tax revenues b y three percentage points, and decrease the fiscal deficit, while greater resources are allocated to social areas and other investments necessary to accelerate growth.

Aware o f the importance o f fiscal sustainability, the first measures taken by this Government focused on improving the state o f public finances. On October 2004, a fiscal reform was approved by the Legislative Assembly, consisting o f the reform o f 12 bodies o f law with which we are closing fiscal gaps, expanding the tax base, and combating evasion. More recently, legislation was approved to increase excise taxes, which w i l l serve to fund the health sector. Additionally, a plan has been launched to hire a significant number o f additional fiscal auditors in order to further decrease tax evasion. Finally, the Pension Savings System Law was reformed, eliminating the early retirement. In the medium term, we w i l l consider alternatives for the pension system’s financing structure, with the goal o f limiting the impact i t has on public finances.

The Government i s looking to optimize management o f the public debt portfolio and investments in management o f risks, including those arising from changes in exchange rates and/or interest rates, debt swaps, and financial investments, in order to cover from changes in long term liabilities. For such purpose, we have requested technical assistance from the World Bank, in order to develop and implement a strategy to manage our public debt.

Strengthening - the Financial System

W e are on our way to strengthening the financial sector through the adoption o f measures that wi l l enable optimum levels o f supervision, an improved financial position for banks, and the reduction o f contingent liabilities generated by this sector.

. . . . . . .6/

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Page 6

The current supervision scheme, which includes three independent entities, l i m i t s the capacity to monitor the financial conglomerates in a consolidated fashion. Therefore, i t i s necessary to define a new scheme and create a single entity, for which legislative changes are required. We are working to define the structure o f the new supervision entity and i t s relationship to the Central Bank. In addition, we are working on a program o f institutional strengthening, to identify the most critical weaknesses in financial supervision and determine concrete actions to address them.

W e are currently undergoing the process o f revising the policies used in loan classification and provisioning, as well as credit risk management, to be consistent wi th international best practices. The Superintendence for the Financial System plans to modify the policies associated with classification o f the risk assets portfolio, and the establishment o f appropriate corrective provisions in accordance with international best practices.

Aiming at having a strengthened financial system, we w i l l take the necessary steps to decrease fiscal contingencies derived from the intermediation activities o f public financial institutions (Banco de Foment0 Agropecuario, Banco Hipotecario and The Social Found for Housing) through the creation o f a new structure in which costs are financed transparently wi th fiscal resources.

Modernization of the State

Government Procurement

The Government i s also seeking to improve public finances through transparency and efficiency in public sector management. Currently, public institutions enjoy a modem law that contributes to the transparency o f their procurement activities. Draft regulations for this law w i l l be issued soon. We are also working to create manuals and instructions to facilitate compliance with said law.

Electronic Government

Modem practices in public sector management require o f use abundant information technology to increase efficiency, effectiveness, and transparency. For this reason, the Government launched an Electronic Government National Strategy. The implementation o f projects contemplated under this strategy has been recently initiated. The Payment Platform and the Informational Module (MODDIV) w i l l be operational in the near future.

. . . . . . .7/

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The Payment Platform i s a system that enables electronic payment o f transactions associated with the provision of government services. The main goal i s to build a technology platform to enable government institutions to provide this service online. For this purpose, the websites f rom governmental entities and financial institutions w i l l interact in real time to receive, validate and process payments, thus facilitating transactions, reducing costs, and procurement savings.

The MODDIV i s an interactive application that enables access to al l Government requests for bid proposals and direct purchases. The provider w i l l be able to register and request personal notifications each time a purchase i s open for bidding. This module represents the first phase o f Comprusal - the virtual environment to conduct purchasing and contracting transactions wi th the Government.

Internal Control Systems

The Government i s working to adopt and implement new regulations for internal control, so as to create a more efficient and effective public administration to achieve the Government Plan’s greater goals.

A strategic planning system i s being deployed, which requires the definition o f organizational structures, hierarchical levels, and control points for decision-making and system operability. This also requires well-defined operational manuals and good working knowledge o f them b y al l members o f the corresponding organization.

In addition, procurement plans are being created, l inked to the action plans o f institutions, guided by a national Procurement and Contracting policy. The budget i s also l inked to the action plans and compliance with goals.

T o accomplish the aforementioned objectives, operational manuals are being updated at the institutional. The goal i s for manuals to describe al l the points o f entry, decision-making, and output of processes involved in the decision or financial impact. These manuals should be consistent with international policies on internal control, which were recently enforced b y the Court o f Accounts o f the Republic - public body devoted to promoting the efficiency o f public administration.

. . . . . . .8/

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Conclusion

The Government o f El Salvador i s committed to taking the necessary steps to promote economic and employment growth, improve security, and progress in equality. The World Bank supports us in this effort through the DPL program and through funding for specific projects. Even though we have not explained in detail the social agenda o f this Government in this letter, we are committed to implement social programs, aimed at expanding access to markets and basic services, including the coverage and quality o f education and health care for the poor, and developing a social safety net for the poorest and most vulnerable Salvadorian families. W e are certain that the current administration wil l be able to reach the goals we have set forth to foster an El Salvador with more employment opportunities, enhanced security and improved equity.

Eduardo Zablah-Touch6 Technical Secretary for the Presidency and Governor before the World Bank

37

l-

o o

00 m

Annex 4: Debt Sustainability Analysis

El Salvador’s public sector debt has risen since 2000. Levels have risen b y about 10% o f GDP in the period 2000-2003, taking the NFPS debt level to 40.6% o f GDP by end 2003 reflecting earthquake reconstruction and pension reform costs.4 In 2004, NFPS debt declined slightly to 40.5% o f GDP due to a lower deficit and to the use o f proceeds from the sale o f the remaining shares in the telephone company.

The structure of public debt has improved substantially since 2000. Gross financing needs have declined, as El Salvador has substituted most of i ts short-term debt with long-term sovereign bonds in 2002. The average maturity of public debt has doubled to nearly 10 years, a reflection of increasingly prudent debt management practices.

Under the government’s planned policies, Bank projections indicate that NFPS debt would stabilize over the medium term at about 38-39% of GDP. Between 2005 and 2009, such a scenario assumes real GDP growth o f 3 per cent per year, real interest rates at 3.7% and a shift in the primary surplus f rom -0.7% to 1.1% o f GDP. The scenario i s broadly consistent with conclusions from the Bank’s recent Public Expenditure Review and the IMF’s debt sustainability analysis from i t s recent Article IV exercise, although the latter actually requires a smaller surplus to stabilize debt levels. The IMF notes that public finances would remain vulnerable to some shocks, despite relatively l ow gross financing needs (see Box A4.1).

Alternative Growth Scenario

As indicated in Section I1 of this program document, El Salvador’s growth prospects should improve in 2005 and beyond, possibly surpassing the government’s own conservative estimates. The recent Bank’s C E M indicates that in the absence of negative external shocks, El Salvador’s potential growth rates should improve to a range o f at least 3.5 to 4%, about 1% above the observed growth levels over 1996-2001. Higher growth levels would be explained f rom increased investment levels spurred b y the implementation o f DR- CAFTA and the complementary agenda described in Section 111, as wel l as f rom the phase out o f the negative effects o f the exogenous shocks o f recent years (e.g, earthquakes, low commodity prices, international recession, changes in world textile markets).

Higher growth levels would improve debt dynamics. While revenues would be expected to grow at the higher rates o f GDP expansion, debt servicing would become a proportionally smaller burden. Hence, greater growth would yield additional fiscal resources with respect to the base case, which would yield a faster debt reduction trajectory, i f government policies remain constant. Table A4.1 presents the results o f an Alternative Fiscal Scenario in which growth i s projected to increase to 3.5% in 2006 and 4.0% thereafter, while other parameters fol low the government’s medium-term plan as reflected by the base case presented in Section II. In such circumstances, the overall NFPS deficit would be slightly below the Base Case scenario, but total public debt would decline at a faster pace. NFPS debt would reach 36.7%

Total public sector debt i s estimated at 46.1% of GDP for 2003. The difference with NFPS figures i s accounted by outstanding net debt of the Central Bank and other public banks.

41

b y 2009. The materialization o f this scenario would allow El Salvador to resolve fiscal uncertainties sooner. Lower debt levels would mean that the country would enjoy greater fiscal reaction space for counter-cyclical macro management in a dollarized economy, and for responding to contingencies arising from future natural disasters. This scenario i s similar to one produced under the recent IMF Article IV exercise, which emphasized overall greater national saving to avoid vulnerabilities in the current account (see Box A4.1).

Given the need for El Salvador to continue to make key growth-inducing public investments in both the human capital and infrastructure areas, the new scenario would also provide opportunities for accelerating some investments. This would require prioritizing projects that require public financing and that could lead to a high growth payoff. However, sizeable increases in public investments would lead to a tradeoff with the speed o f debt reduction. Ultimately, a fine balance w i l l need to be struck between reducing debt to manageable levels and addressing public investment needs for growth and social progress.

Table A4.1: Alternative Fiscal Scenario Nonfinancial Public Sector Operations

(as percentage of GDP) ~

2003 2004 2005 2006 2007 2008 2009 8.4% 5.2%

Total Revenues (incl. Grants) 16.8% 16.8% 17.1% 17.0% 17.4% 17.9% Tax Revenue 12.2% 12.2% 13.3% 13.6% 14.1% 14.6%

Total Expenditures 20.6% 19.3% 20.1% 19.3% 18.8% 18.8% Current Expenditures 16.9% 16.7% 16.8% 16.3% 15.7% 15.3%

of which, Pensions 1.7% 1.8% 2.1% 2.2% 2.2% 2.1% Capital Expenditures 3.7% 2.6% 3.3% 3.0% 3.1% 3.5%

9.6% 5.0% 2.1% 4.7%

Overall NFPS Deficit -3.7% -2.5% -3.0% -2.3% -1.4% -0.9% -1.2%

Total Public Debt 40.7% 40.5% 40.7% 40.6% 39.4% 37.8% 36.7% Memo Items:

Real GDP Growth 1.8% 1.8% 3.0% 3.5% 4.0% 4.0% 4.0%

42

Box A4.1 The IMF and Debt Sustainability in El Salvador In i ts recent draft Article IV consultation report o f in January 2005, the IMF

conducted a public debt sustainability analysis for El Salvador, presenting three different scenarios. In i t s baseline scenario, the IMF projects that total public debt would stabilize at about 47% o f GDP (including financial public sector debt) over the medium term. This scenario assumes that the authorities’ planned policies wil l take place, resulting in a shift in the primary balance from a deficit o f 0.7% o f GDP per year in 2005-06 to a small surplus thereafter. The scenario also considers an increase in the real interest rate to 3.75% over the period, as well as GDP growth o f 3% per year, due to improved investment and productivity. Under this scenario, the IMF report concludes that public finances would remain vulnerable to shocks. While relatively low gross financing needs would provide some protection against adverse shocks, a shift in market sentiment could heighten funding costs and shorten average maturity over time.

Under a reinforced policy scenario, further fiscal consolidation and structural reforms would improve debt dynamics. This scenario assumes a recovery in growth to 4% per year and a primary surplus o f 1% o f GDP over the medium term, mainly a result o f further tax and expenditure reform. This would lead to a steady decline in the public debt to under 43% o f GDP by 2009, roughly equivalent to 37% o f GDP excluding current financial public sector debt.

A third and final adverse scenario i s also presented, which highlights the downside risks to the baseline scenario from fiscal slippages. Under such circumstances, public debt would rise to nearly 55% o f GDP by 2009. This scenario assumes that the primary fiscal deficit remains at 0.7 percent o f GDP over the period, and growth i s the same as in the baseline scenario.

43

Annex 5

January 19,2005

International Monetary Fund 700 19th Street, NW Washington, D.C. 20431 USA

El Salvador: Fund Relations Note

El Salvador maintains a close policy dialogue with the IMF, and does not plan to seek a formal arrangement. At the conclusion o f the 2003 Article IV consultation (July 18, 2003), the Executive Board praised El Salvador for i t s record o f fiscal prudence and impressive reforms since the early 1990s, even in the face o f the adverse shocks. However, Directors also noted a fiscal deterioration and sluggish growth in recent years, and encouraged the authorities’ to address these challenges. In particular, Directors urged the authorities to build on the credibility o f the dollarized regime b y strengthening fiscal and financial sector policies, and sustaining the structural reform effort.

During the 2004 Article IV consultation discussions (October 25-November 10, 2004), the staff encouraged the authorities’ongoing efforts to strengthen the fiscal position and pursue reforms with a view to improving growth prospects and fortifying the economy against shocks. The authorities explained that strengthening tax collections, securing early approval o f CAFTA, and deepening banking reforms were key policy priorities.

A Board meeting to conclude the 2004 Article IV consultation i s tentatively scheduled for January 3 1, 2005. Fol lowing the IMF Board meeting, the Bank’s Executive Directors wi l l be updated on the state o f El Salvador’s relations wi th the IMF.

44

Annex 6

2003

6.0

El Salvador at a dance

Growth of exports and Imports (%)

3 0 T I

9/15/04

0.5

POVERTY and SOCIAL

2003 Population, mid-year (millions) GNI per capita (Atlas method, US$) GNI (Atlas method, US$ billions)

Average annual growth, 1997-03

Population (%) Labor force (%)

Most recent estimate (latest year available, 1997-03) Poverty (% of population below national poverty line) Urban population (% of total population) Life expectancy at birth (years) infant mortality (per 1,000 live births) Child malnutrition (% of children under 5) Access to an improved water source (% of population) Illiteracy (% of population age 15+) Gross primary enrollment (% of school-age population)

Male Female

KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1983

GDP (US$ billions) 3.5 Gross domestic investment/GDP 12.1 Exports of goods and serviceslGDP 24.5 Gross domestic savingslGDP 6.6 Gross national savings/GDP 5.6

Current account balancdGDP -5.6 Interest paymentslGDP 2.0 Total debt/GDP 49.8 Total debt servicelexports 19.8 Present value of debt/GDP Present value of debtlexpork

1983-93 1993-03 (average annual growth) GDP 2.8 3.2 GDP per capita 1.3 1.3 Exports of goods and services 0.4 10.6

-Exports -+-Imports

El Salvador

6.5 2,200

14.4

1.7 2.9

59 70 33 12 77 20

112 114 109

1993

7.0 18.6 19.4 3.8

15.1

-7.5 1.7

29.2 13.9

2002

2.1 0.4 5.7

Latin America &Carib.

534 3,260 1,741

1.5 2.1

77 71 28

86 11

129 131 128

2002

14.3 16.4 26.7

1.9 13.7

-2.7 1.5

40.8 7.8

43.5 106.5

2003

2.0 0.2 3.4

Lower- middle- income

2,655 1,480 3,934

0.9 1.2

50 69 32 11 81 10

112 113 111

2003

14.4 16.6 27.6 0.8

13.0

-3.7 2.0

43.8 8.5

2003-07

3.9 1.8 5.0

Development diamond*

Life expectancy

I

Access to improved water source

-€l Salvador ___ Lower-middle-income group

Economic ratios'

I Trade

I T investment Domestic

savings

I

Indebtedness

- N Salvador - Lower-middle-income group

STRUCTURE of the ECONOMY

(% of GDP) Agriculture Industry

Services

Private consumption General government consumption Imports of goods and services

Manufacturing

(average annual growth) Agriculture Industry

Manufacturing Services

Private consumption General government consumption Gross dwnestic investment Imports of goods and services

1983 1993

31.2 14.0 22.3 28.2 16.6 22.4 46.5 57.8

77.5 87.6 15.8 8.6 29.9 34.1

1983-93 1993-03

0.7 0.9 3.0 4.8 3.2 4.9 3.3 3.0

5.2 3.6 -4.1 1.9 8.8 2.9 7.9 7.9

2002

8.7 30.3 23.5 61 .O

89.9 8.2

41.2

2002

-0.5 2.8 2.5 2.3

1.3 -7.2 -1.5 0.5

2003

9.4 31.8 24.5 58.7

87.9 11.3 43.4

Growth of investment and GDP (%)

% T

GDI *GDP -

Note: 2003 data are preliminary estimates. This table was produced from the Development Economics central database. * The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond will

be incomplete.

45

El Salvador

PRICES and GOVERNMENT FINANCE

Domestic prices (% change) Consumer prices Implicit GDP deflator

Government finance (% of GDP, includes current grants) Current revenue Current budget balance Overall SurDlusldeficit

TRADE

(US$ mi//ions) Total exports (fob)

Coffee conon Manufactures

Total imports (cif) Food Fuel and energy Capital goods

Export price index (1995=100) Import price index (1995=100) Terms of trade (1995=100)

BALANCE of PAYMENTS

(US$ millions) Exports of goods and services Imports of goods and services Resource balance

Net income Net current transfers

Current account balance

Financing items (net) Changes in net reserves

Memo: Reserves including gdd (US$ millions) Conversion rate (DEC, /ocal/US$)

EXTERNAL DEBT and RESOURCE FLOWS

(US$ millions) Total debt outstanding and disbursed

IBRD IDA

Total debt service IBRD IDA

Official grants Official creditors Private creditors Foreign direct investment POmolio equity

World Bank prcgram Commitments Disbursements Principal repayments Net flows Interest payments Net transfers

Composition of net resource flows

1983

13.3 10.6

1983

1983

91 2 1,085 -173

-131 108

-196

392 -195

2.8

1983

1,745 106 26

202 14 1

158 294 -19 28 0

0 7 6 1 8

-8

1993

18.6 12.8

1993

605 235

35 309

1,924 441 124 565

68 88 77

1993

1,273 2,487 -1,213

-129 823

-51 9

663 -1 44

645 8.7

1993

2,033 220 22

294 32

1

61 1 31 7

-3 16 0

93 51 18 33 15 18

2002

1.9 1.3

11.8 0.4

-3.9

2002

1,234 107 44

1,073 4,082 1,198

175 883

55 83 66

2002

3,810 5,887 -2,077

-287 1,980

-384

260 124

1,623 8.8

2002

5.829 37 1 15

453 46 1

107 164

1,211 208

0

143 63 28 35 19 17

2003

2.9 -1.2

12.4 0.6

-3.7

2003

1,357

1,080 3,926

906

55 84 66

2003

3,980 6,255

-2,275

-325 2,069

-531

550 -19

1,607 8.8

2003

6,305 372

14

514 54

1

78 310

0 38 38

0 17

-17

Inflation (%)

1 6 T

- GDPdeflator +CPI I

Export and import levels (US$ mill.)

5,OW T ‘“u 1,ow

I 97 98 99 W 01 02 03

Exports Imports

Current account balance to GDP (%)

L T

Composition of 2003 debt (US$ mill.)

A: 372 G: 991 B: 14

A - IBRD E - Bilateral B -IDA D - Other multilateral F - Private C - IMF G - Short-term

~~

Note: This table was produced from the Development Economics central database. 911 5/04

46