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El Salvador: Central American Tiger?

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BY JUAN CARLOS HIDALGO


El Salvador
is becoming an economic success story in Central America. Since the end of the civil conflict in 1992, which left the country in ruins, El Salvador has transformed its economy by implementing a far-reaching liberalization process undertaken by democratic governments, which has included the privatization of state enterprises, deregulation, trade and financial liberalization, privatization of the pension system, and the adoption of the U.S. dollar as its official currency. According to the Fraser Institute’s Economic Freedom of the World Report, El Salvador ranks among the top 25 freest economies in the world.


The results of the market reforms are notable: between 1991 and 2007, the percentage of households below the poverty line fell from 60 percent to 34.6 percent. However, official figures point to mediocre average annual per capita growth during the period 1992–2007    only 1.9 percent  — which is very similar to Latin America’s average of 1.6 percent in the same period. But official figures grossly underestimate the performance of the economy because of flawed measurement. In fact, the economy is probably more than 30 percent larger than indicated by the official data. Accordingly, the average per capita growth rate since 1992 has been approximately 5.2 percent per year.

 

El Salvador still has much to do on its policy agenda. In particular, high crime rates constitute a major hindrance to further growth. This lack of security represents the greatest threat to sustained growth and liberal policies.


Nonetheless, the country is showing the rest of the region how economic freedom can pave the way for development and how globalization offers great opportunities for developing countries that are willing to implement a coherent set of mutually supportive market reforms. (…)

 

THE FIRST STEPS

 

The First Step: Financial Deregulation. The reprivatization of the banking sector, starting in 1990, launched the first round of economic reforms during the administration of President Alfredo Cristiani (1989–1994). (…)

 

Pension Privatization. El Salvador’s financial liberalization was consolidated by the privatization of the nation’s social security system, through the implementation of a private accounts system similar to that adopted in Chile in 1981. On April 14, 1998, a new pension system based on individual capitalization—part of the second round of economic reforms—replaced the old redistributionist public system. The public pension system was experiencing insolvency problems because of demographic changes and the economic instability engendered by the armed conflict. The strife of the 1980s resulted in an expansion of the informal sector and slashed the value of reserves as a result of high inflation. (…)

 

Integrating into the Global Economy: Trade Liberalization. At the same time as it liberalized its financial sector, and as part of the third generation of reforms, El Salvador began a process of trade liberalization that consisted of the reduction and elimination of tariff barriers and the implementation of bilateral trade agreements with other nations. (…)

 

A Dollarization Not Prompted by Crisis. El Salvador’s greater participation in the global economy paved the way for another important reform approved in 2000, this time in the realm of monetary policy. In November of that year, Salvadoran lawmakers passed the Monetary Integration Law, which substituted the Salvadoran colón with the U.S. dollar (at a fixed exchange rate of 8.75 colones per dollar). In addition, the law allowed people to enter into contractual agreements in any foreign currency in legal circulation. In contrast to other similar processes, El Salvador’s dollarization was not carried out in the midst of a crippling inflationary crisis, as was the case in Ecuador (…)

 

Liberalization and Privatization of Public Services. To truly appreciate the progress that El Salvador has made in privatizing and opening its markets in telecommunications, energy, and hydrocarbons, it is important to recognize that national infrastructure in these areas had yet to recover from years of insufficient investment because of the armed conflict. That situation made the participation of the private sector imperative in order to overcome this gap. (…)

 

TELECOM BOOM

 

In 1997, El Salvador’s new telecommunications law was approved. It opened the telecom sector to competition and established a regulatory framework for telephony and use of the electromagnetic spectrum. This statute, one of the most liberal in the world, instituted free competition in telecoms so that “prices and terms of service in telecommunications between operators shall be negotiated freely.”29 In addition, the law bars suppliers from segmenting the market among themselves, and also bars cross-subsidies of telecom companies that are in competition with one another. Finally, the statute introduced strong property rights protections over the electromagnetic spectrum, stipulating that every concession for use of the spectrum is a “private good, being transferable and open to fragmentation.”30 Salvadoran officials then went further that same year, when they privatized the National Telecommunications Administration, ANTEL, the state telephone company. (…)

 

In 1996 El Salvador liberalized and opened up the electricity market. The electricity reform also disaggregated the state energy company into various companies dedicated to generation, transmission, and distribution, some of which were sold to foreign investors. Private investment in electricity has allowed the rapid development of geothermal energy, which has enormous potential in El Salvador because of the country’s location in an area of high volcanic activity. (…)

 

With hydrocarbons, El Salvador went from a completely regulated market in 1992 to one in which the government limits itself to monitoring consumer prices on a weekly basis, with the aim of informing consumers about the best prices available at the country’s filling stations. The government does not import or refine fuels, and it does not regulate consumer prices in any way. Growing competition in recent years has allowed the emergence of independent service stations—thanks to the simplification in the licensing process for station operators— which has helped reduce the cost margins accumulated throughout the oil-supply chain. According to a 2005 study by the UN Economic Commission for Latin America, in the three years prior to the study those margins had come down in El Salvador from 40 U.S. cents to 34 U.S. cents per gallon, while other countries in the region that had highly regulated markets, such as Costa Rica and Honduras, had seen those margins rise.31 Thus, it should not be surprising that by November 2008, El Salvador had the lowest fuel prices in Central America. (…)

 

Fiscal Policy: Responsibility without Creativity. Despite an onslaught of natural disasters, including two earthquakes in 2001 and Hurricane Stan in 2005, El Salvador’s government has managed to maintain the fiscal discipline that has characterized its performance since the late 1980s. The national government reduced its fiscal deficit from 3.1 percent of GDP in 2002 to 0.5 percent of GDP in 2007, allowing El Salvador to enjoy, after Chile and Mexico, one of the best sovereign risk grades in Latin America by Moody’s and Standard and Poor’s rating agencies. Deficit reduction has been made possible by a small decline in government spending— which went from 15.6 percent of GDP in 2002 to 15.4 percent of GDP in 2007—and an increase in tax revenues, from12.5 percent of GDP in 2002 to 14.9 percent in 2007 (…)

 

THREAT OF VIOLENCE

 

Despite El Salvador’s favorable outlook resulting from its commitment to economic liberalization and integration into the world economy, there is another challenge that must be met if that country is to aspire to a good standard of living: citizens’ security. Ironically, the main catalyst for the climate of violence that currently besets the country is a problem that has been imported from the United States—juvenile gangs, known as maras. Today, El Salvador is the most violent country in the world. In 2007, there were 3,491 murders, and the country had a murder rate of 60.7 per 100,000 inhabitants.49 Gang violence is the main culprit behind these alarming figures. According to official figures, there are 10,000 gang members in El Salvador, and gangs are responsible for around 60 percent of all murders. This lack of basic security imposes enormous costs on the Salvadoran economy and scares away investment. According to a study by El Salvador’s National Public Security Council, the violence cost the country $2 billion in 2006—nearly 11 percent ofGDP. That is a tremendous loss for a country trying to take off both economically and in terms of social indicators (…)

 

PENDING REFORMS

 

The serious problem that civil violence represents in no way diminishes the important strides that El Salvador has made over the last decade and a half. (…)

 

Much remains to be done, especially at the micro level. One of the biggest failings of the reforms implemented during the 1990s throughout Latin America was to neglect the implementation of measures that could have allowed the majority of the populace to enjoy the benefits of an open economy. If, for a majority of the people, increased access to property is not realized, and access to the market economy is blocked through a web of regulations and restrictions, discontent will grow and will sooner or later be manifested at the ballot box. If globalization has helped exacerbate social inequality in Latin America, it has been largely because the states allow only a select group to participate in that process while the door remains closed to a much larger number. To increase opportunities for the poor, it is necessary to promote property titling among the most disadvantaged sectors of society and to eliminate regulations and restrictions that prevent the establishment of formal enterprises.


On that point, El Salvador still has a long way to go. According to the World Bank’s Doing Business 2009 report, starting a business in that country requires eight bureaucratic
transactions that take a total of approximately 17 days to complete. The cost of starting a business in El Salvador thus represents 49.6 percent of per capita income. By contrast, in Canada, starting a business requires only 1 procedure that takes 5 days, at a cost of 0.5 percent of per capita income. In El Salvador, fulfilling all permit and licensing requirements for a new building requires 34 transactions, takes 155 days, and costs 176 percent of per capita income. In New Zealand, a similar undertaking would require 7 transactions that take 65 days to complete, and costs 25.8 percent of per capita income.54 El Salvador has made significant strides in some of the areas measured in this World Bank index,55 but with such significant bureaucratic obstacles, it is not surprising that 40 percent of the economically active population works in the informal sector. For El Salvador’s reforms to reach a greater potential, it is imperative for Salvadoran officials to reduce the costs of doing business.

 

There are many challenges ahead, and it will be a long time before El Salvador will join the ranks of developed countries. Yet El Salvador is showing the world that, despite difficult conditions and a tumultuous past, the road to development and a better standard of living is opened by economic liberty and the opportunities created by globalization.

 

Juan Carlos Hidalgo is project coordinator for Latin America at the Cato Institute's Center for Global Liberty and Prosperity. Previously he was Latin America director of the International Policy Network and editor of elcato.org, the Cato Institute’s Spanish-language web site. This column is based on an excerpt from El Salvador. A Central American Tiger? (Cato Institute). Republished with permission from the author.

 

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