Dollarization on El Salvador Team Members Nixon Orellana Mike Scott

Introduction ► ► In 2001 El Salvador engaged in full dollarization to enhance its economic reform process the set of previous structural reforms put in place to support economic stability and thus attract foreign investors ► ► The expected benefits of full dollarization include the elimination of exchange rate risk, contributing to the decline of the country risk premium and interest rates, as well as the reduction of the inflation rate and inflationary expectations. These outcomes are expected to encourage foreign investment and a stable capital flow.

EL SALVADOR AT THE BEGINNING OF THE TWENTY-FIRST CENTURY ► Since signing the Peace Accords in 1992 to end a 12-year civil war ► El Salvador has moved steadily toward the implementation of neoliberal economic policies by privatizing the banking system, telecommunications, public pensions, and electrical services

EL SALVADOR AT THE BEGINNING OF THE TWENTY-FIRST CENTURY ► Lowering import tariffs; eliminating most price controls; and attempting to attract foreign investment through infrastructure improvements and greater enforcement of intellectual property rights (U.S. Department of State 2002, 6-11).

EL SALVADOR AT THE BEGINNING OF THE TWENTY-FIRST CENTURY ► On a macroeconomic scale ► Inflation has averaged only 5 percent since 1992 ► total external debt was manageable, at about 23 percent of GDP in 2001

EL SALVADOR AT THE BEGINNING OF THE TWENTY-FIRST CENTURY ► 1.5 million Salvadorans (immigrants) ► $1.6 billion, or 60 percent, of El Salvador's exports annually. ► imports from the United States are about $2.1 billion, resulting in a rather large trade deficit

EL SALVADOR AT THE BEGINNING OF THE TWENTY-FIRST CENTURY

Economics ► GDP + Remitance reached the hefty sum of $1.9 billion in 2001 (U.S. Department of State 2002, 7). This is equivalent to almost 15 percent of GDP. This flow of dollars has spawned the popular expression in El Salvador, "our greatest export is our people."

Economics ► The Salvadoran economy is dominated by the service sector, which amounts to 50 percent of GDP, while the agricultural sector produces 24 percent of GDP and the industrial sector only 20 percent of GDP. ► Growth of real GDP has been slow but steady during the decade, ranging from 2.1 to 4.2 percent annually (U.S. Department of State 2002, 6).

Economics

Economics

Economics

Politics and Society

El Salvador At a Glance Smallest country (third largest economy) Smallest country (third largest economy) About the size of Massachusetts About the size of Massachusetts Represents 1 of 7 independent nations Represents 1 of 7 independent nations (officially dollarized) (officially dollarized) 50% of population = poverty line 50% of population = poverty line

Reasons for Dollarization (1) Lower Interest Rates (2) Decrease Inflation (3) Increase foreign investment (other reasons): Next logical step (colon pegged since ‘93) Next logical step (colon pegged since ‘93) Economy closely linked with U.S. Economy closely linked with U.S. (total exports & remittances) (total exports & remittances)

Real GDP Growth

What happened to economic growth? El Salvador faced several shocks: Two earthquakes Two earthquakes Declining international coffee prices Declining international coffee prices Increasing oil prices Increasing oil prices Slowdown of U.S. economy Slowdown of U.S. economy Result: Dampened economic growth & expected benefits from dollarization expected benefits from dollarization

Growth Indicators < expected Since 2001: GDP < 2% GDP < 2% Exports = 3% (versus 17.5% in 2000) Exports = 3% (versus 17.5% in 2000) Foreign Direct Investment = slow Foreign Direct Investment = slow --> Fixed Capital Formation = 1%

Benefits of dollarization Lending interest rates decreased Lending interest rates decreased 11% (2000) 11% (2000) 6.3% (2004) 6.3% (2004) Remittance inflows increased Remittance inflows increased = $2.55 billion (16% of GDP) in ‘04 = $2.55 billion (16% of GDP) in ‘04 Inflation decreased Inflation decreased 7.8% ( ) 7.8% ( ) 3% Since % Since 2001

Interest Rates

Downside of dollarization Forfeits control of money supply Forfeits control of money supply (can’t finance fiscal deficit with “seigniorage”) (can’t finance fiscal deficit with “seigniorage”) --> limits Fiscal Policy’s ability to respond --> limits Fiscal Policy’s ability to respond to negative shocks to negative shocks Restricts Monetary Authority’s role as Restricts Monetary Authority’s role as “Lender of Last Resort” “Lender of Last Resort” Result: no safety net to stimulate growth Result: no safety net to stimulate growth

“Twin Challenges” Rising U.S. interest rates Rising U.S. interest rates (-->decreases C & increases I) (-->decreases C & increases I) Greater competition from non-dollarized trading partners Greater competition from non-dollarized trading partners

Recommendations & Challenges Improve education/worker training Improve education/worker training Provide more private investment in basic infrastructure programs. Provide more private investment in basic infrastructure programs. + Raise productivity + Lower costs