Economic Update from El Salvador

On Thursday, a day after he addressed the UN General Assembly, Salvadoran President Mauricio Funes announced a possible new agreement with IMF officials worth $800 million dollars to be paid out over three years. The new arrangement, which needs approval from the IMF management and Executive Board, will replace the 15-month stand-by agreement approved last January.

Economists forecast that El Salvador’s GDP will decrease 2.9% in 2009, due to the global economic crisis and its link to the US economy through remittances and common currency.  The new agreement is intended to promote fiscal and financial stability in the current climate by providing resources for private investors, increasing domestic demand and spending, and supporting the administration’s development plan for 2009-2014.

The administration says that the IMF agreement will benefit El Salvador’s most vulnerable communities by redirecting government spending to social areas.  In one example, the government plans to introduce a Universal Social Protection System that will administer programs such as a temporary employment program, a special public investment program concentrated on health, education, and infrastructure, and the expansion of the conditional cash transfer program (Comunidades Solidarias).

The IMF’s director of the Western Hemisphere department, Nicolás Eyzaguirre, said yesterday, “El Salvador was the first country in Latin America to seek financial assistance from the IMF to navigate the current global financial crisis. While this first program achieved its broad objectives, the effects of the crisis have been severe and challenges still remain. We are very happy that the administration of President Mauricio Funes has chosen to continue to rely on the Fund to support its economic program going forward.”

While Funes and the IMF were announcing their agreement, Moody’s Investors Services were placing El Salvador’s credit rating on watch for a possible downgrade into junk territory, citing the country’s worsening economy, its limited policy response, and restricted access to international capital markets.

Currently, El Salvador’s rating is Baa3, the lowest investment-grade level. Mauro Leos, Moody’s regional credit officer for Latin America, stated that “with no monetary or exchange-rate policy to speak of, and given the absence of a lender of last resort, economic-policy management has been hard pressed by current circumstances.” Moody’s also noted El Salvador’s dependence on the U.S. for exports and remittances from immigrants, as well as its adoption of the U.S. dollar as its official currency in 2001. When deciding whether to downgrade them further, Moody’s will consider El Salvador’s ability to respond to and survive economic and financial shocks.

Proponents of dollarization have always argued that adopting the dollar would facilitate trade with the U.S. and provide greater stability to El Salvador’s developing economy.  The majority of Salvadorans, rich and poor, urban and rural, have countered that the Colon was an important part of their identity and discarding it subjugated them to the U.S. financial system, which all but collapsed in 2008 and 2009.  Now El Salvador is in a bit of a pinch with limited control over their economy, dependent on U.S. exports and remittances, and turning to the IMF for a new $800 million loan.

While campaigning for the presidency, Funes stated that if elected he would not try to change the current monetary system. As chickens come home to roost, and the IMF and credit agencies recognize the downside of dollarization, perhaps the Funes Administration ought to reconsider its position.

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