El Salvador - Current economic situation and prospects

RETUR T R E S T R I C T E D RETURN TO RSRCE REPORTS DESK Report No. WH-87a WITHIN FL CAp ONE WEEK This report was prepared for use within the Bank. In making it available to others, the Bank assumes no responsibility to them for the accuracy or completeness of the information contained herein. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT CURRENT ECONOMIC SITUATION AND PROSPECTS OF EL SALVADOR April 10, 1959 Department of Operations Western Hemisphere Prepared by: Fawzi Habib  CURRENCY EQUIVALENTS U.S. $1 _- ( 2.5 (colones) q' 1 - U.S.'40 cents (; 1 million - U.S. $400,000  TABLE OF CONTENTS Page No. SUNMARY i I. INTRODUCTION l II. ECONOMIC BACKGROUND. 1 III. RISE AND FALL OF EXPORT INCOME AND ITS IIMPACT ON PACE OF ECONOMIC GROW,ITH: 1957 AND 195d. 2 IV. STAGNANT EXPORTS AND ECONOMIC GROWTH: 1959 AND 1960. 4 V. FINANCIAL DEVaOPMENTS. 5 VI. EER.GENCE OF FISCAL PROBLEvi. 7 VII. LONGER RANGE POSPECTS AND CRFDIThORTHINESS. 11 APPENDIX I Balance of Payments Projection. 14 APP NDIX II Statistical Tables: 1-32 17  LIST OF TABLES Table No. External Public Debt 1 Sumnary of External Public Debt Outstanding 2 Service on External Public Debt: 1946-1972 Population Growth 3 Population Growth: 1950-1957 Production Trends and National Income 4 Estimates of GNP and Related Data: 1950-1957 5 Gross Domestic Product by Source: 1950-1957 6 Indices of Gross Domestic Product: 1950-1957 7 Share of the Different Sectors in GNP: 1952-1957 8 Agricultural Production - Export Crops: 1950-1957 9 Agricultural Production - Basic Food Crops: 1950-1957 10 Value of Industrial Production: 1951-1958 11 Gross Capital Formation by Type: 1950-1957 12 Public and Private Gross Capital Formation: 1950-1957 13 Investment in Industries Induced by Law of Development of IndastrLes: 1952-1958 14 Electric Power Producti4on: 1950-1958 15 Electric Power Consumption: 1950-1957 Trade and Payments Statistics 16 Indices of Volume, Value and Prices of Exports and Imports:1950-1958 17 Volume and Value of Principal Exports: 1950-1958 18 Coffee Exports and Related Data: 1951-1959 19 Average Spot Prices - Coffee and Cotton: 1953-1958 20 Imports by Category: 1953-1957 21 Balance of Payments Current Account: 1950-1966 22 Balance of Payments: 1954-1957 23 International Reserves: 1951-1958 Financial Developments 24 Factors of Expansion and Contraction of Money Supply: 1952-1958 25 Some Saving Indicators in the Private Sector: 1950-1958 26 Credit Ceilings Established by the Central Bank: 1957-1958 27 Credit Utilized by Commercial Banks: 1957-1958 28 Public Internal Debt: 1952-1958 29 Cost of Living Index: 1950-1958 30 Government Receipts by Source: 1954-1959 31 Government Expenditures by Purpose: 1954-1959 32 Government Ordinary Revenues, Expenditures and Sources of Financing Def:icits: 1954-1960  BASIC DATA Population in million, 1958 2.5 Per Capita GNP, 1958 $ 215 Gross Capital Formation, 1957 in million $ 83.2 16% As % of GNP 16%0 Exports, 1958 in million 115.9 of which coffee 87.8 or 77%": cotton 18.7 or 16% Total exports as % of GNP 25% Public Expenditures, 1958 in million 7n.3 as-- %of GNP 15% Net Gold and Foreign Exchange Reserves, 1958 in million $ 46.4 as % of imports 44% Public External Debt, October 1958 Principal in million. $ 25.6 1959 service, in million 3.6 As % of 1959 exports % As % of 1959 budget 5% 1967-1972 annual debt service on present debts, in million . 1.8  SUMI.ARY In spite of the substantial decline in coffee prices, the Salvadorean economy has been enjoying a relatively high rate of economic growth. In 1957, the increase in the volume of coffee and cotton exports was more than sufficient to offset the fall in prices. In 1958, a decline in the value of exports and the resulting loss in tax receipts have reduced the domestic re- sources available for investment and have slowed down the rate of economic growth. 2.. The expansion of government spending in 1958 vis-a-vis declining re- venues resulted in a small deficit financed by drawing down the Government's cash balances. The decline in cash balances, however, did not upset internal and external financial stability. No substantial rise in the price level took place. Gold and foreign exchange reserves increased at the end of 1958 above the past year's level, thanks to the Central Bank policy in curbing credit and to the tendency of the public to reduce imports. 3. The economy has shown an ability to absorb the drop of foreign ex- change earnings with little difficulty. The prospective decline of export income in 1959 and 1960 may reduce further the resources available for public and private investment, and econlomic growth wsill slow down if not halt al- together for a time. The government deficit mayr increase substantially and a decline in foreign exchange reserves will be hard to avoid. However, if the economy continues to adjust itself to the lower level of income easily and smoothly, economic stability will be maintained and the favorable longer range outlook delineated in the last economic report (1;3H-69a) will hold. 4. On the expectation that financial stability is maintained, the longer range outlook is not unfavorable. The opening of the Coastal Zone will pro- vide new land to raise wheat, sorghum, tobacco, sugar cane, livestock and other crops. This should lead to a saving of expenditures on food imports and.at the same time help to improve the diet of the rapidly increasing po- pulation. The tendency towards a more diversified economy, and the shift from less to more productive industries have placed the economy in a relati- vely good position in the medium term to offset part of the unfavorable im- pact of declining cotton and coffee prices. Over the long term, these tenden- cies may lea.d to an acceleration in exports of manufactured products. 5. Service of the present public debt constitutes 4% of 1959 export earnings and 5% of the budget. This low level of debt service and the longer term favorable economic outlook provide a margin for servicing additional external debt.  I. INTRODUCTION 1D The last economic report, (VIH-69a prepared in 1957), gave an account of the developments of the Salvadorean economy from 1950 to the spring of 1957. The report noted the rapid growth of the economy and stressed the significant role played by the export sector in accelerating the growth pro- cess. Since that time, the prices of coffee and cotton, E1 Salvador's leading exports, have declined at a much faster rate than expected, thus ad- versely affecting the country's financial position and its growth prospects. These adverse effects represent the core of the problem which the present report intends to examine. II. ECONOMviIC BACKGROUND 2. Over a decade ending in 1957, the Salvadorean economy enjoyed a period of economic prosperity, while at the same time it maintained financial stability. Higher revenues from coffee and cotton exports together with fa- vorable terms of trade resulted in higher levels of income and employment, and furnished the necessary finances for a broader public works program. In addition, the high export income provided the economy with rising capacity to increase its imports of capital goods, while at the same time gold and foreign exchange reserves increased. The favorable trend of economic pros- perity was strengthened by social and political stability and sound fiscal and monetary policies. 3. The Government, assisted by higher taxes on coffee and by higher re- venues from imports, was able to play an important role in accelerating the growth process. Power projects, roads and ports are examples of basic pro- jects initiated by the Government to stimulate private investment and to contribute directly to the existing stock of goods and services. Through promotion of education and vocational training, the Salvadorean Government has been seeking to increase the supply of skilled workers, to raise produc- tivity, narrow wage differentials and to improve the distribution of income. 1A. While the Government expanded its role in economic development, the private sector responded to the favorable situation created by the rise in coffee prices and the actions of the Government. Industrious and thrifty entrepreneurs channelled an increasing portion of their income into produc- tive uses in agriculture and industry. Some of the deposits held abroad were repatriated and invested locally, mostly in new lines of industries which produced commodities previously imported. In recent years, foreign private capital has also been showing an increasing interest in new lines of economic activities. On the whole, the role accredited to private invest- ment in terms of its share in GNP or in gross domestic investment was quite impressive over the years. The share of private real capital formation in total investment averaged 86% in 1954-1957 against 74% in 1950-1953. More- over, gross capital formation expanded at an annual rate of 12% over the years 1950-1957 and its share in GNP rose from 12% over 1950-1953 to 16% over 195h-1957. (Tables 1., 12 and 4).  - 2 - 5. Between 1953 and 1957, the years of most rapid expansion, investment in machinery and equiplent increased rapidly and the industrial output followed suit. (Tables 11 rsd 10). Hanufacturing was grow.Ting at much faster rate than agriculture. This pattern of economic growth has been helping establish some sort of balance between the different sectors - a balance that is apt to reduce, in due time, the strong dependence on agriculture as the major source of income and employment. (Table 7). Actually, this ten- dency has resulted in a shift of some laborers from agriculture to manufac- turing, from less to more productive industries. o. Looking back to 1950, the gro;th of the export sector has been quite impressive. Between 1950 and 1957, export income almost doubled, i.e. 14% per annum on the average. In the meantime, the gross domestic product in- creased in real terms by 45% or 5.4% per annum. This relati'vely rapid rate of growth of export earnings, attributable more to price than to volume in- creases, accentuated the importance of the export sector in the national economy, i.e. the ratio of exports to the gross domestic product rose from 20% in 1950 to 25% in 1957. III. RISE AND FALL OF EXPORT INCOM4E AYD ITS IMPACT ON PACE OF ECONOIiIC GIGOTh: 1957 AND 1958 7. In spite of the weakening of the coffee market in 1957, the economy moved ahead, with exports rising by 4%, and the gross domestic product in- creasing by 4*W8% above 1956.The country's established tradition of selling portions of its crops on futures made it possible for it to hedge against the full impact of the price deterioration prevailing in 1957. This together with the disposal of the entire 1956/57 bumper crop more than offset the price decline and coffee export earnings registered the highest level ever recorded. 8. The expansion of income generated by larger exports and favorable terms of trade explains the high and growing level of demand for imports which increased by 140% between 1950 and 1957, and by 10% between 1956 and 1957. The rise of imports was accompanied by noticeable change in their structure in favor of capital goods. The share of non-durable consumer goods (primarily food and beverages) in total imports declined while imports of machinery, equipment and other items principally required for industrial production (like chemicals and mineral lubricants) continued rising. In re- lative terms, imports of these comodities constituted 56% of total imports in 1957 against 50% in 1953. In the meantime, the share of food imports and live animals was reduced from 16% to 12.6% . These trends, noted already in the previous economic report, appear to have operated in 1957 with increased strength. (Table 20). 9. The very large increase in capital goods imports in 1957 was asso- ciated with an expansion of the productive capacity of the economy and higher levels of employment. New plants were erected, others expanded and the cons- truction industry continuted to boom. Electric power consumption rose by 23%.  Manufacturing increased by 11% (Table O). Agricultural production also re- gistered an increase of 10%, due more to the improvement of yields than the expansion of land area. WVhile land area under basic food crops remained un- changed in the 1956/57 season, output of these crops was 9% higher (Table 9). Also the export - crops area was increased by 3% while production rose by 15% (Table 8). The significant improvements in productivity are attributed to the intensive use of fertilizer, selected seeds and better agricultural organization, the fruits of which were noticeable in previous years on coffee fincas, corn and sugar fields. 10. The expansion of El Salvador's exports of coffee and cotton has not created, so far, a marketing proble V/. Even in 1957 and 1958 when exports were subject to limitations imposed by the Mexican and Washington Agreements, El Salvador disposed of the entire 1957/58 coffee crop at relatively good prices, and coffee retentions according to the Agreements have not created serious problems for her. Nevertheless, the weakening of the coffee market as reflected in coffee prices strongly affected export earnings in 1958. 11. Coffee export earnings from the 1957/58 crop were 2h% below the 1956/ 1957 peak. Part of this reduction however was offset by the rise in cotton exports. The 1957/58 cotton crop set a new record and more than half of it was sold before the weakening of the market. However, higher cotton earnings in 1958 were not large enough to offset the impact of declining coffee prices. 12. In view of the 9% decline in total exports in 1958, it was not pos- sible for the economy to maintain the preceding high rate of economic growth, and except for electric power production which continued to increase at a rapid rate, the pace of economic activities slowed down. The growth of in- dustrial output for the first 8 months of the year was estimated at a lower rate than for the corresponding period in 1957. Agricultural output of do- mestic food crops also increased at a slower rate. Wholesale and retail trade were off by about 10% . Stocks started piling up. Textile producers faced temporary difficulties and threatened to lay off more workers, thus obliging the Government to impose almost prohibitive duties on many imported textiles. Work on the Littoral Highwray was not active partly on account of bad weather conditions and partly due to the financial difficulties of cons- truction companies working on the project. A let down in the building boom was indicated by a sharp decrease in the number of building permits and a rise in unemployment.. 13. The unfavorable impact of these developments was partly offset by new economic activities that came into being. Increased building activity by oil companies which constructed 200 gas stations together with the ad- ditional low cost houses built by the Government's Instituto de la Vivienda Urbana (IVU) helped bolster the construction rate. The Listo soluble coffee plant was enlarged to tluheefold its original size. A four-ton electric arc oven plant, the only one in Central America, began pouring in October 1958; 2/ Between 1950 and 1957, El Salvador's coffee exports increased by 20% while cotton exports increased by eightfold.  - 4 - it melts scrap iron and steel for use in the plant's rod and bar mill and, with a present one shift pouring capacity of 9-12 metric tons daily should supply one-third of the national demand for iron and steel. The Instituto Salvadoreno de Fomento de la Produccion extended loans amounting to U.S. $ 800,000 to private concerns to produce powdered milk, textiles, mining and plastics.. Taking into account both favorable and unfavorable influences, the gross domestic product in 1958 may have expanded by about 4% above the preceding year's level. T'his was indeed a very good performance considering the impact of the decline in exports. IV. STAGNANT EXPORTS AND ECONOIIIC GROWTH: 1959 AND 1960 14. The dim outlook for coffee and cotton prices is likely to affect El Salvador's capacity to maintain the relatively high level of economic growth enjoyed from 1950 through 1958. While the rise in the volume of coffee ex- ports, at least since 1957, at a higher rate than anticipated at the time of the previous report, has made it possible for El Salvador to offset part of the impast of declining coffee prices, the prospective increase in output is limited :. Taking into account the number of the additional coffee trees planted in the boom years and their time of planting, exportable production in the 1958/59 and 1959/60 seasons is likely to rise (in the absence of un- favorable weather conditions) to a stable level of some 1.8 to 1.9 million quintals as against 1.7 million quint-als in 1956/57, and 1.5 million quintals in 1955/56. 15. El Salvador is not likely to face difficulties in disposing virtually of its entire 1959 and 1960 crops/. Given this possibility, coffee export earnings are likely to level off at some ,d 72 million in 1959 and $ 70 million in 1960 (provided that prices do not drop below 0.38 per pound). This is 20% lower than the past year's coffee returns, and more than one- third below the 1956/57 peak level. 16. Earnings from all other exports in 1959 are likely to offset part of the drop in coffee export receipts so that total exports will decline by no / Although there is some room for increasing productivity on small-size fincas, the margin of increase is insignificant; besides, there is no ad- ditional land suitable for new plantations. g According to the Washington Agreement, El Salvador has to retain until September 30, 1959, 5% of its first 300,000 bags of exportable production and 10% of the rest. Given a crop of 1.8 - 1.9 million bags (of one quintal each), El Salvador haa to withhold some 165,000 bags. Of. this amount, about 100,000 bags will be absorbed by the Listo soluble coffee plant. As of December 15, 1958, El Salvador had already disposed of one million quintals at an average price of U.S.;, 0.41 per pound.. This leaves some 600,000 bags to be disposed of between December 15, 1958 and October 1, 1959.  more than 8%. The problem will become more acute in 1960 as the production and exports of the country's second export crop, cotton, will be cut by some 20% and total export receipts will be reduced by another $ 4 million, i.e.20%. (See Annex on projection of balance of payments.) 17. Given the present cost-price structure, cotton production in El Sal- vador seems to have reached a critical point where a further price decline below 1958 levels will result in direct cut in production and exports. The record yields achieved in the past are hard to maintain since they noH re- quire incurring costs more than proportionate to prospective returns . Cotton production in El Salvador has been carried out for years on the same plots of land without crop rotation. As a result, some of the basic ingredi- ents of the soil were depleted and had to be compensated for by increasing amounts of fertilizer and other substances. This process while it has helped maintain productivity at its present high level is not likely to repeat it- self in the light of diminishing returns. At prices of $ 0.22 - 0.23 per pound, marginal producers will be breaking even and will be likely to shift to food production. 18. In summary, a decline in the cotton industry and a fall in coffee prices are likely to shape the prospects of economic growth in El Salvador during the next few years.. Ecport earnings from the two commodities are equivalent to over 22% of GNP, constitute 90% of the country's foreign earnings and contribute directly and indirectly about 60% of the Government's annual revenues.. Therefore, a weakening in the export sector will reduce real income and will have a depressing influence on effective demand. Given a price of coffee around $ 0.38 per pound in the 1959-1960 seasons, it seems unlikely that domestic output in 1959 and 1960 could expand by more than 3% per annum, somewhat less than the rate of population growth. 19. The dim outlook for income growth in 1959 and 1960 will set the frame- work within which fiscal and monetary policies have to move.. The low rate of growth foreseen for exxports and income while limiting government revenues and private savings will in turn make it difficult to finance public projects as well as private investrnent. And since bank credit could not be curtailed significantly without hampering productive investment, the Government will have to avoid inflationary financing if serious balance of payments problems are to be avoided and an environment conducive to the resumption of a more rapid rate of growth is to be maintained. V. FINANCIAL DEVELOPMENTS 20, It is to be recalled that since 1934, El Salvador has been maintaining This rules out putting the new land in the Coastal Zone area into cotton production upon completion of the highway and the feeder roads project in 1963/64.  - 6 - without control a stable rate of exchange, thanks to the prudent conduct of its finances. By balancing the budget and implementing sound monetary po- licies,. domestic inflation has been avoided, serious balance of payments problems did not emerge, and the country's international reserves have been maintained at satisfactory levels. 21. During the coffee boom, money supply and bank credit expanded at a rapid rate. This monetary expansion however did not endanger economic sta- bility - on the contrary, it was in line with the needs of the expanding economy. But, when the price of coffee started declining, the Central Bank started in April, 1957 to restrict credit slowly and gently. Through raising its rate of rediscount, exercising selective control and moral suasion, bank credit expanded less rapidly than before, i.e. claims on the private sector increased by 13% by the end of 1957 against 26% in the preceding year. 22. The monetary impact of credit expansion in the private sector in 1957 was partially counterbalanced by a noticeable improvement in the financial position of the Government. Government expenditures in 1957 were frozen at the preceding year's level of t 169 million while revenues mounted to an all time peak of ' 190 million. As a result, the Government continued to enjoy a fiscal surplus which was used to amortize its public debt and to increase its deposits with the Central Bank. These deposits increased from