Economy

The Salvadorian economy has experienced mixed results from the recent government's commitment to free market initiatives and conservative fiscal management that include the privatisation of the banking system, telecommunications, public pensions, electrical distribution and some electrical generation; reduction of import duties; elimination of price controls and an improved enforcement of intellectual property rights. The GDP variable has been growing at a steady and moderate pace since the signing of peace accords in 1992, in an environment of macroeconomic stability.

A problem that the Salvadorian economy faces is the inequality in the distribution of income. In 1999, the richest fifth of the population received 45% of the country's income, while the poorest fifth received only 5.6%.

In recent years inflation has fallen to single digit levels, and total exports have grown substantially.

Dollarization

As of December 1999, net international reserves equalled US$1.8 billion or roughly five months of imports. Having this hard currency buffer to work with, the Salvadorian Government undertook a monetary integration plan beginning January 1, 2001 by which the US dollar became legal tender alongside the Salvadoran colón and all formal accounting was undertaken in US dollars. This way, the government has formally limited its possibility of implementing open market monetary policies to influence short term variables in the economy. Since 2004, the colón stopped circulating and is not now used in the country for any type of transaction; however some stores still have prices in both colónes and US dollars. In general, there was general discontent with the shift to the US dollar, primarily due to wage stagnation in relation to basic commodity pricing in the marketplace.

The change to the dollar also precipitated a trend toward lower interest rates in El Salvador, helping many to secure much needed credit for house or car purchases; over time, displeasure with the change has largely disappeared, though the issue resurfaces as a political tool when elections are on the horizon.

Diversification

A challenge in El Salvador has been developing new growth sectors for a more diversified economy. As many other former colonies, for many years El Salvador was considered a mono-exporter economy (an economy that depended heavily on one type of export). During colonial times, the Spanish decided that El Salvador would produce and export indigo, but after the invention of synthetic dyes in the 19th century, Salvadorian authorities and the newly created modern state turned to coffee as the main export of the economy. Since the cultivation of coffee required the highest lands in the country, many of these lands were expropriated from indigenous reserves and given or sold cheaply to those that could cultivate coffee. The government provided little or no compensation to the indigenous peoples. On occasions this compensation implied merely the right to work for seasons in the newly created coffee farms and to be allowed to grow their own food. Such actions provided the basis of conflicts that would shape the political landscape of El Salvador for the years to come.

For many decades, coffee was one of the only sources of foreign currency in the Salvadorian economy. The civil war in the 80's and the fall of international coffee prices in the 90's pressured the Salvadorian government to diversify the economy. ARENA governments have followed policies that intend to develop other exporting industries in the country as textiles and sea products. Tourism is another industry Salvadorian authorities regard as a possibility for the country. However, rampant crime rates, lack of infrastructure and inadequate social capital have prevented this resource from being properly exploited and is still under development.

The government is also developing ports and infrastructure in La Union in the east of the country, in order to use the area as a 'dry canal' for transporting goods from the Gulf of Fonseca on the Pacific Ocean to Honduras and the Atlantic Ocean in the north.

Free Trade Zones

Currently there are fifteen free trade zones in El Salvador. The largest beneficiary has been the maquila industry, which provides 88,700 jobs directly, and consists primarily of supplying labour for the cutting and assembling of clothes for export to the United States.

Trade Agreements

El Salvador signed the Central American Free Trade Agreement (CAFTA), negotiated by the five countries of Central America and the Dominican Republic, with the United States in 2004. In order to take advantage of CAFTA, the Salvadorian government is challenged to conduct policies that guarantee better conditions for entrepreneurs and workers to transfer from declining to growing sectors in the economy. El Salvador has already signed free trade agreements with Mexico, Chile, the Dominican Republic and Panama, and increased its exports to those countries. El Salvador, Guatemala, Honduras and Nicaragua also are negotiating a free trade agreement with Canada, and negotiations started in 2006 for a free trade agreement with Colombia.

Fiscal Policy

Fiscal policy has been the biggest challenge for the Salvadorian government. The 1992 peace accords committed the government to heavy expenditures for transition programs and social services. The Stability Adjustment Programs (PAE, for the initials in Spanish) initiated by President Cristiani's administration committed the government to the privatisation of banks, the pension system, electric and telephone companies. The total privatisation of the pension system has implied a serious burden for the public finance system, because the newly created private Pension Association Funds did not absorb coverage of retired pensioners covered under the old system. The government lost the revenues from contributors and absorbed completely the costs of coverage of retired pensioners. This has been the main source of fiscal imbalance. ARENA governments have financed this deficit with the emission of bonds, something the leftist party FMLN has opposed. Debates surrounding the emission of bonds have stalled the approval of the national budget for many months on several occasions, reason for which in 2006 the government will finance the deficit by reducing expenditure in other sectors. The emission of bonds and the approval of government loans need a qualified majority (3/4 of the votes) in the National Legislature. If the deficit is not financed through a loan it is enough with a simple majority to approve the budget (50% of the votes plus 1).

Despite such challenges to keep public finances in balance, El Salvador still has one of the lowest tax burdens in the American continent (around 11% of GDP), and maintains a very good credit rating. Many specialists claim that it is impossible to advance significant development programs with such a little public sector aid (the tax burden in the United States is around 25% of the GDP and in other developed countries of the EU it can reach around 50%, like in Sweden). The government has focused on improving the collection of its current revenues with a focus on indirect taxes. Leftist politicians criticise such a structure since indirect taxes (like the value added tax) affect everyone alike, whereas direct taxes can be weighed according to levels of income and are therefore fairer taxes. A 10% value-added tax (VAT), implemented in September 1992, was raised to 13% in July 1995. The VAT is the biggest source of revenue, accounting for about 52.3% of total tax revenues in 2004.

Foreign Income

Remittances from Salvadorians living and working in the United States, sent to family members in El Salvador, are a major source of foreign income and offset the substantial trade deficit of around $2.9 billion. Remittances have increased steadily in the last decade and reached an all-time high of $2.547 billion in 2005 (an increase of 21% over the previous year), and approximately 16.2% of gross domestic product (GDP).

As of September 2006, net international reserves stood at $2.02 billion.