Finance-Led Development, or, Why People are Leaving El Salvador
Preliminary draft summary prepared for the Latin American Studies Association Congress
6 September 2001
Please do not quote without permission
John Schmitt William Stanley
Research Associate Political Science
Economic Policy Institute University of New Mexico
Washington, D.C. Albuquerque, NM
Summary of Economic Trends
El Salvador presents a paradox. Despite an average annual growth rate in real Gross Domestic Product from 1990 through 2000 of 8.9% (measured in US dollar terms, see Table 1), one encounters in El Salvador near despair regarding the country’s economic future. Public opinion polls show high public concern about employment and the economy overall, and anecdotal accounts from rural areas suggest that large numbers of young people in particular are giving up on El Salvador and heading for the United States. According to the conventional real GDP measures (in colons) issued by the Salvadoran Central Reserve Bank, growth clearly slowed during the final four years of the decade. Even by this measure, growth remained above the population growth rate for two of those four years – a mild recession, perhaps, but not a severe contraction. Overall poverty figures suggest gradual reductions in absolute and relative poverty, with the greatest improvements in the first part of the 1990s. Other factors such as a crime wave and the series of earthquakes in early 2001 have contributed to the public’s malaise, but economic disappointments appear to be central.
This paper explores the roots of this paradox by examining how major institutional changes in the post-war economy have affected the relative success of different sectors. The ARENA government undertook a series of profound changes, beginning in 1989 with the re-privatization of banks that had been nationalized in 1980. Other measures followed that were ostensibly designed to open the economy and reduce the extent of state interference with market forces. These included reprivatization of international trade in sugar and coffee, reduction in tariffs, modification of the tax system, privatization of pensions, privatization of some state-owned utilities, and creation of supervisory agencies to monitor the financial sector. The rhetoric of the government pointed to an intention to follow the export-led growth policies advocated by international financial institutions. In practice, the policies followed by the Central Reserve Bank (BCR) further accentuated El Salvador’s already over-valued exchange rate, with adverse effects on exports. From 1989 through early 1992, new foreign exchange laws allowed the colon to float, and it depreciated rapidly from 5 colons to the dollar to approximately 9 to the dollar. Rather than allowing the colon to continue to correct toward its historical real bilateral exchange rate with the dollar, the BCR intervened using open market operations to establish and maintain a still too high valuation of the colon (8.75 to the U.S. dollar) as a de facto fixed exchange rate. From 1993 onward, as the flow of dollar-denominated remittances from abroad increased dramatically, the BCR’s fixed exchange policy was faced with the opposite challenge, to prevent appreciation of the colon. The BCR’s response was heavy purchases of dollars, which in turn pumped large numbers of colons into the economy. To soak up (“sterilize”) the resulting excess liquidity in colons, the BCR sold bonds. To successfully market its bonds, the BCR set very high interest rates, which in turn propagated throughout the financial system.
The clearest positive result of these policies was a gradual decline in inflation from around 15% for the first half of the 1990s to a low of 0.5% in 1999. The negative consequences, however, included an inability to prevent further excessive appreciation of the colon (see tables 8 and 9), combined with very high real interest rates (see Table 7). Table 7 shows that nominal interest rates fell only five percentage points, from 19% in 1995 to 14% in 2000, while inflation fell from 10% in 1995 to 2% in 2000. The real interest rate peaked at 15% in 1999, before falling back to a still-high 12% in 2000. The magnitude of overvaluation revealed in Table 9 is impressive. Using 1980 as a benchmark, the colon had appreciated by 49% by 1990 and appreciated an additional 68% by 2000. To the extent that banks could borrow in dollars and lend in local currency, this progressive appreciation created an opportunity for dollar lending arbitrage yielding nearly 12% above the US discount rate (See Table 2).
The effects of these conditions are fairly predictable: the Salvadoran banking sector grew phenomenally, nearly quintupling its assets from 1990 to 2000, an annualized growth rate of 17.1% (Table 3). Earnings in the finance, insurance, and real estate sector more than doubled as a share of GDP from 1990 to 2000, from 8% to 16.1% (Table 5). Part of these gains were attributable to the BCR’s aggressive sterilization campaign, under which it offered high yield bonds that, because they were backed by the BCR itself, were quite low risk for the private banks. Other sectors that benefited included transportation, storage, communications, and construction, all of which nearly doubled their shares of GDP during the decade (Table 5). The maquila (assembly) sector, with most of its costs established outside El Salvador, expanded an incredible 2,724 % from 1992 through 1998, nearly ten times the maquila expansion rate of El Salvador’s neighbors (Table 6). Certain companies, such as Taca International Airlines, the Simán retailing group, and the Metro Centro commercial centers, have expanded aggressively into other Central American markets and beyond (Paniagua and Chávez Henríquez 2000).
The combination of greatly reduced tariffs and an overvalued exchange rate contributed to massive growth in imports and a widening trade deficit. Rivera Campos (2000, 78-95) describes the economic expansion of the early 1990s as a consumption bubble, driven by demand pent up during the war and financed through a combination of remittance income from family members abroad and rapidly expanding consumer credit. Low tariffs meant that much of the consumption was fed by imports. Exports grew, too, but at a slower rate, constrained by a lack of international competitiveness. El Salvador could sustain this deficit only because of substantial and growing remittances from Salvadorans abroad – remittances that more than compensated for falling international aid levels, and that were nearly sufficient in quantity to balance the current account (see Table 10).
The clear losers in this scenario were all elements of the economy that did not have extensive financial capital in hand, those that sought to export goods, and those forced to compete in domestic markets against inexpensive imports. All sectors other than FIRE (finance, insurance, and real estate) and manufacturing shrank from 1990 to 2000 as a share of GDP. Growth in manufacturing was confined largely to the maquila sector. Agriculture, already weak by 1990, shrank further and generated only 10.5% of GDP by 2000, substantially less than the share generated by the FIRE sector (16.1% -- see Table 5). In sectors that have generally done well within the liberalized economy, individual company success has often been linked to strong connections with the privatized banks; many failed companies’ market niches have been filled by firms owned by or closely linked to family-based entrepreneurial groups that control the key banks (Paniagua and Chávez Henríquez 2000). Not only were interest rates very high during this period, but banks were fairly selective in making business loans: most commercial lending went to some 300 individuals or firms.[1]
This redistribution of economic activity has adverse effects for employment. Agriculture employs 25.1% of the employed workforce, compared to 35.8% in 1990. Manufacturing, despite the maquila boom, employs roughly the same percentage as it did in 1990 (24.6% in 2000 versus 22.7% in 1990). FIRE, now 16.1% of GDP, generates only 3.7% of employment (Tables 3 and 4). Simply put, growth in El Salvador has been largely confined to two sectors, finance and maquila, that generate comparatively little employment. Moreover, none of the sectors that are performing well have extensive backward linkages to the rest of the economy. Maquilas draw on imported materials and capital equipment; the financial sector depends largely on imported technologies, and generates local demand for little beyond office construction, transportation, telecommunications, and advertising. The real, productive economy of El Salvador is, at best, stagnated. In some sectors such as agriculture it is shrinking.
Political Roots and Consequences
In Forging Democracy from Below, Elisabeth Wood argues that dramatic decline in the relative economic strength of agriculture, and the ascendance of commerce and other sectors, helped shift the interests of the Salvadoran elite away from support for the repressive political system that gave rise to the civil war in the first place (2000, 52-77). This shift in interests made possible a negotiated settlement under which a government representing the business elite agreed to largely eliminate the internal security role of the armed forces, and allow the political left full participation in a democratized political regime operated under liberal rules (Stanley 1996, 218-266; Peceny and Stanley 2001). Since the most dynamic and influential elements of the elite were no longer dependent on agriculture for capital accumulation, they no longer needed the services of the old repressive order.
According to Wood (2000), several forces drove the initial transformation of the economy. First, the powerful Farabundo Martí National Liberation Front (FMLN) insurgency made it too costly and hazardous for many coffee growers to continue their operations, particularly in the eastern half of the country. FMLN sabotage crippled other agricultural sectors, such as cotton. Civilian supporters of the FMLN seized de facto control over coffee lands and converted them to food production. The second major
factor was the departure of roughly twenty percent of the Salvadoran population in an exodus that was originally triggered by governmental repression but that subsequently developed into a mass migration in search of employment (Stanley 1987). The roughly one million Salvadorans abroad sent back substantial remittances, which, combined with substantial wartime aid flows from the United States, helped finance imports and buoy the commercial, construction, and (after 1989) emerging financial sectors. A third factor was the secular decline in coffee prices.
We argue that the same shift in elite composition and interests that helped make the peace negotiations successful has advanced further in the post-war environment, with increasingly damaging consequences. Post-war state economic policy has rapidly advanced the work begun by war-time conditions, killing off both export and domestic use agriculture, as well as some established industries, while creating opportunities for rapid capital accumulation in finance, commerce, real-estate speculation, and construction. Notwithstanding the pro-export rhetoric of three consecutive ARENA governments, their policies, as reflected in the actions of political appointees in charge of the BCR, have been adverse to exports and exceedingly friendly to financial capital. Neither the Superintendencia del Sector Financiero nor the BCR are genuinely independent, as their directors are political appointees whose terms match those of the president of the republic. There is currently no legislative oversight of either institution.[2]
Not surprisingly, elements of ARENA associated with the more traditional export agriculture sectors have left the party in favor of the National Conciliation Party (PCN), formerly the party of the military regime. ARENA’s pro-finance policy seems likely to perpetuate itself: the policy has been very advantageous to the economic sectors that now dominate the ARENA party, and very damaging to the economic bases of virtually all the other parties. While common interests in altering economic policy might give rise to a coordinated opposition sufficient to gain power and reverse the policy direction, the interests, preferences, and ideologies of the opposition parties are so diverse, and their resources so much weaker than those available to ARENA, that effective challenges will be difficult. Moreover, by dollarizing the economy in January 2001, the legislature has locked in the overvaluation of existing Salvadoran financial assets and made it extremely difficult for any subsequent government to use monetary or exchange policy at all. Indeed, part of the reason for dollarization in early 2001 was probably the growing political pressure for devaluation from representatives of export-oriented productive sectors.[3] Whatever the motives, it presents a tremendous windfall for the financial sector, which can now borrow more freely in dollars, while maintaining substantial portfolios of high interest loans originally denominated in colons.[4]
Fiscal Consequences
[Too be added. Main points: 1) Dollarization leaves fiscal policy as virtually the only policy tool remaining for the government to influence macroeconomic outcomes. The only monetary tool remaining is the BCR’s control over the legal reserve requirements for the banking community, known as encaje. 2) Fiscal policy is in disarray. The government expects substantial shortfalls in the near future, in part because of increased burdens imposed by the BCR’s outstanding bonds, as well as burdens associated with privatization of the pension system. Evasion remains very high, and the existing tax system is regressive. The simplest measure would be an increase in the IVA, since this tax is harder to evade, but it is inherently regressive. (See Moreno and Góchez Sevilla 2000)]
Central American Comparisons
We expected to find that El Salvador was exceptional within Central America in pursuing a finance-led accumulation strategy. No other country in the region has a comparable flow of remittances, so we did not expect to see signs of “Dutch disease” elsewhere. Yet we found that Guatemalan and Honduras have allowed significant, though somewhat lesser, degrees of overvaluation to set in. As already noted, El Salvador’s currency appreciated 68% from 1990 through 2000; Guatemala’s appreciated by 54.7% and Honduras’ by 17% during the same period. Even Costa Rica, after rapid devaluations in the 1980s, held nearly steady in the 1990s, with a 9.8% appreciation of its currency from 1990 through 2000 (Table 9). All three countries have sustained high real interest rates and as a result good opportunities for dollar lending arbitrage (Table 2). All three countries experienced rapid accumulation of bank assets (more than tripling for Guatemala and Costa Rica, more than doubling for Honduras) during the 1990s. We were unable to calculate the change in the financial sector’s contribution to GDP for the countries other than El Salvador; however, the growth in bank assets, the shrinkage of agriculture, and the overall stagnation of manufacturing in all of the countries suggests that finance has grown as a share of GDP in Costa Rica, Honduras, and Guatemala (see Table 5). We can’t even comment on Nicaragua because the data issued by the Nicaraguan central bank are so grossly inconsistent from year to year that we didn’t believe it appropriate to even attempt sectoral or real exchange rate analyses.