Competitiveness and Growth in El Salvador

Luis Felipe ZegarraUniversidad de Piura, CIUP (Lima, Peru)

Martha RodríguezUniversidad del Pacifico, CIUP (Lima, Peru)

Carlos AcevedoUNDP (San Salvador, El Salvador)

Background

• El Salvador implemented pro-market structural reforms in early 1990s

• However, economic performance did not seem to respond: GDP´s growth rate has been low in the last 10 years

Stilized facts

• GDP growth rates high in early 1990s, but much lower in 1995-2005.

• Slow growth for Central American standards.

• Low savings and investment rates.• Slowdown of export sector.• Slowdown of all productive sectors,

especially agriculture and manufacture.

Annual growth rates (%) 1990-95 1995-2000 2000-05 Latin America 3.7 3.1 2.3 México 1.5 5.5 1.8 South America Argentina 5.7 2.5 2.0 Brazil 3.1 2.1 2.2 Chile 7.8 6.3 4.4 Peru 5.6 2.4 4.2 Others 3.9 1.3 3.0 Central America El Salvador 6.2 3.1 2.2 Others 4.6 4.8 3.4 Notes and sources: GDP is in constant prices. For El Salvador, the source is CEPAL (2006a). For the rest of countries, the sources are CEPAL (2003) for 1990-95 and 1995-2000, and CEPAL(2006a) for 2000-05.

Main questions

• Why has El Salvador grown so slowly?

• Why are investment rates so low?

General decision tree

Problem: Low growth rates of GDP Slow growth of capital Slow growth of labor Slow growth of land Slow growth of TFP Low returns to High cost of finance to investment

Decision tree for low investment rates

Problem: low investment rates

Low returns to economic activity High cost of finance Low social returns to Low appropriability investment Human Infrastructure Innovation External Tax Externalities Bad Bad capital conditions system local international finance finance Micro Macro risks risks

Binding constraint: migration

• Migration has affected GDP growth through:– Size of labor force

• Population• Reservation wage

– Competitiveness of trade sector• Quality of labor force (human capital)• Remittances and real exchange rate (aggravated by

inflexibility from dollarization)

• Also: unfavorable external factors• There is no much the government can do to

solve these problems. • Then, it is crucial to deal with other problems

Other constraints

• Cost of capital– For small firms

• Appropriability of returns– High crime rates– Fiscal sustainability

• Social returns to investment– *** Low human capital ***– Limitations in infrastructure– Lack of technological adaptation

Why does El Salvador grow slowly?

Problem: Low growth rates of GDP Slow growth of capital Slow growth of labor Slow growth of land Slow growth of TFP Low returns to High cost of finance to investment

Migration and labor force

• Migration has increased in recent years

• Significant impact on the size of labor force

Number of migrants (000)

-200

0

200

400

600

800

1000

1951-55 1956-60 1961-65 1966-70 1971-75 1976-80 1981-85 1986-90 1991-95 1996-2000 2000-05

Source: UNDP (2005)

Number of occupied workers (official)

500000

1000000

1500000

2000000

2500000

3000000

1950 1953 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004

Migration and labor force

• Preliminary estimates (2007 census) indicate that actual size of population is 1.3 million less than previous official figures.

• Assuming the same growth rate of population for labor force, we adjust the size of labor force.

Labor and GDP per-worker, 1990-2005

• Labor force grew by 0.47% per year (rather than 2.8%)

• GDP per worker grew by 3.29% per year (rather than 0.98%)

GDP(million Labor (thousands GDP per-worker Labor (thousands GDP per-worker

colons 1990) occupied workers) (million colons 1990) occupied workers) (million colons 1990)

1990 36,487 1,720 21,214 1,720 21,2142005 63,421 2,591 24,477 1,863 34,047

3.75 2.77 0.98 0.47 3.29

Official labor Adjusted labor

Annual growth rates (%), 1990-2005

Annual growth rate of GDP per-capita (%), 1990-2005

-0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5

Source: CEPAL* The actual growth rate of GDP per-capita is 1.8% per year in 1990-2005

Argentina

Bolivia

Brazil

Chile

Colombia

Costa Rica

Ecuador

El Salvador

Guatemala

Honduras

Mexico

Nicaragua

Panama

Paraguay

Peru

Uruguay

Venezuela

Annual growth rate of real wages (%), 1990-2003

-5 -4 -3 -2 -1 0 1 2 3 4

Source: ILO, ECLAC

Argentina

Bolivia

Brazil

Chile

Colombia

Costa Rica

Mexico

Nicaragua

Paraguay

Peru

Uruguay

Venezuela

El Salvador

Gross-capital formation (% GDP), 2005

• Investment rate in El Salvador is low

10

15

20

25

30

35

40

El Salvador Low-middle income Latin American andCaribbean

East Asia and Pacific South Asia

Source: World Bank

2000 2005

Harvested land (has)

• Harvested land has declined for more than 10 years

500000

550000

600000

650000

700000

750000

800000

850000

900000

1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003

Source: FAO

Decomposition of output

• What explains economic growth?– Production factors (capital, labor, land)?– Or total factor productivity (TFP)?

• Methodology:– Cobb-Douglass production function: Q=AKβL

αT1-α-β

– Kt=(1-δ)Kt-1+It– Assumptions: β=0.36,α=0.54, δ=2.5%,

r=15%.

Decomposition of GDP, 1990-2005

• Labor and land explain much of the evolution of GDP

• TFP grew by 1.7% per year (rather than 0.46%)– % TFP consistent with structural reforms

GDP Capital Labor Land TFP Capital Labor Land

Official labor 3.75 5.22 2.77 -0.77 0.46 1.88 1.50 -0.08Adjusted labor 3.75 5.22 0.47 -0.77 1.70 1.88 0.25 -0.08

Annual growth rates (%) Contribution to growth (%)

Why does El Salvador grow slowly?

• Slowdown of labor force (migration)• Low investment rates• Decline in land usage

Why is investment in ES low?

Problem: low investment rates

Low returns to economic activity High cost of finance Low social returns to Low appropriability investment Human Infrastructure Innovation External Tax Externalities Bad Bad capital conditions system local international finance finance Micro Macro risks risks

I) Is cost of capital high?

National savings rate (% GDP), 2004

• Savings rate is low in El Salvador

0 5 10 15 20 25 30 35Source: WDI, 2006

Mexico

Venezuela

Uruguay

Peru

Ecuador

Colombia

Chile

Brazil

Argentina

Panama

Nicaragua

Honduras

Guatemala

Costa Rica

El Salvador

Real interest rates (%), 2005

• If credit is a binding constraint, interest rate will be high. However, it is low for LAC standards.

-20

-10

0

10

20

30

40

50

Ven

ezuela

Arg

entina

Nicar

agua

Ecu

ador

El Salva

dor

Mex

ico

Guat

emala

Pan

ama

Hondura

s

Colo

mbia

LAC

Per

u

Bolivi

a

Uru

guay

Costa R

ica

Dom

inican

Rep

.

Par

aguay

Bra

zil

The World Bank, World Development Indicators

Credit access is limited for small and micro enterprises

Main sources of financing for SMEs in El Salvador

75.2%

9.7%

3.2%

11.9%

Retained earnings

Remittances

Credit from suppliers

Other

Cost of capital-Summary

• Domestic savings rate in El Salvador is low.

• However, El Salvador has a relatively easier access to credit than other countries.

• Credit is limited for small and micro enterprises. For SME credit may be a binding constraint

II) Is appropriability of returns low?

• Taxation• Institutions and micro risks• Macro risks• Externalities

Taxation

• Taxation system is not a binding constraint for investment– Taxes in El Salvador are low– Tax administration doesn´t seem to be

an obstacle to investment

Profit tax rate (% profit), 2005

0 10 20 30 40 50 60 70

Source: Doing Business, 2006

Venezuela

Uruguay

Peru

Paraguay

Ecuador

Colombia

Chile

Brazil

Bolivia

Argentina

Mexico

Panama

Nicaragua

Honduras

Guatemala

Costa Rica

El Salvador

Institutions

• Institutions are pro-investment• The main problem: crime

– Crime in El Salvador: one of the highest rates in the world

Murders per 100,000 persons, 2002

0 10 20 30 40 50 60 70

USA

Phillipines

Thailand

Uganda

Papua New Guinea

Latvia

Belarus

Estonia

Sri Lanka

Mexico

Kazakhstan

Russian Federation

Guatemala

El Salvador

Venezuela

Jamaica

South Africa

Colombia

Source: Crime and Development in Central America (2002)

Index of property rights (0 to 100)

• Greater value means better PR

20 30 40 50 60 70 80 90

Source: The Heritage Foundation, 2007

Venezuela

Uruguay

Peru

Paraguay

Ecuador

Colombia

Chile

Brazil

Bolivia

Argentina

Mexico

Panama

Nicaragua

Honduras

Guatemala

Costa Rica

El Salvador

Index of corruption, 2006

• Greater value means lower corruption2 3 4 5 6 7 8

Source: Transparency International, 2006

Venezuela

Uruguay

Peru

Paraguay

Ecuador

Colombia

Chile

Brazil

Bolivia

Argentina

Mexico

Panama

Nicaragua

Honduras

Guatemala

Costa Rica

El Salvador

Macro risks

• Inflation is low• Fiscal deficit is low• Vulnerabilities:

– Subject to external real shocks (dollarization)

– Fiscal sustainability is weak

Inflation rate (%), 2006

0 2 4 6 8 10 12 14

Source: ECLAC

Venezuela

Uruguay

Peru

Paraguay

Ecuador

Colombia

Chile

Brazil

Bolivia

Argentina

Mexico

Panama

Nicaragua

Honduras

Guatemala

Costa Rica

El Salvador

Fiscal sustainability

• Estimates on the primary balance required for public debt sustainability.

• Vergara (2003) estimates a fiscal adjustment of 2.5% of GDP of the trend primary balance

Externalities

• Externalities may have affected self-discovery

• But externalities exist everywhere• There is no strong evidence that

externalities are the binding constraint for growth

III) Are social returns to investment low?

• Human capital• Infrastructure• External conditions • Technological adaptation

A) Human capital

• Low education of labor force: third major problem.

• Low schooling rates

Illiteracy rate (%), 15 years and more, 2002

• Illiteracy in El Salvador is high

0 5 10 15 20 25

Source: The World Bank, World Development Indicators, 2006

Venezuela

Uruguay

Peru

Paraguay

Ecuador

Colombia

Chile

Brazil

Bolivia

Argentina

Mexico

Panama

Nicaragua

Honduras

Guatemala

Costa Rica

El Salvador

Migration and education

• Migrants are better educated than non-migrants.

• Outflow of talented people.

Distribution of Salvadorans (%)

No schooling or incomplete primary;

70.5%

Complete primary or incomplete secondary;

15.2%

Complete secondary; 3.7%

Tertiary education; 10.6%

Source: International Data on Educational Attainment (Barro and Lee, 2000)

Distribution of migrants (%)

No education or incomplete primary; 8.6%

Complete primary or incomplete secondary;

41.8%Complete secondary education; 27.9%

Tertiary education; 21.7%

Source: UNDP

High-skilled workers

• Low percentage of population with tertiary education

• Low availability of scientists and engineers

Population with tertiary education (%)

5 7 9 11 13 15 17 19 21 23

Source: International Data on Educational Attainment (Barro and Lee, 2000)

Venezuela

Uruguay

Peru

Paraguay

Ecuador

Colombia

Chile

Brazil

Bolivia

Argentina

Mexico

Panama

Nicaragua

Honduras

Guatemala

Costa Rica

El Salvador

Quality of education

• Quality of education in El Salvador is not high for Latin American standards:– Indicators of perception– Returns to schooling of migrants in U.S.

Index of quality of education (1 to 7)

1.5

2.0

2.5

3.0

3.5

4.0El

Salva

dor

Cos

ta R

ica

Gua

tem

ala

Hon

dura

s

Nicar

agua

Pana

ma

Mex

ico

Arg

entin

a

Boliv

ia

Braz

il

Chi

le

Col

ombi

a

Ecua

dor

Para

guay

Peru

Uru

guay

Ven

ezue

la

Public schoolsMath and science education

Note: The indexes measure the quality of public schools and math education. They range from 1 to 7, where a greater value indicates higher quality.Source: World Economic Forum, The Global Competitiveness Report, 2005-06

Returns to schooling in U.S.

0.010 0.015 0.020 0.025 0.030 0.035 0.040 0.045 0.050 0.055

Source: Bratsberg & Terrel (2002)

Uruguay

Peru

Ecuador

Colombia

Chile

Brazil

Argentina

Mexico

Panama

Honduras

Guatemala

Costa Rica

El Salvador

Is low schooling rate a binding constraint?

• Marginal returns– If low schooling is a binding constraint, then

marginal returns to schooling will be high– Hausmann, et al: schooling is not a binding

constraint; but they don´t control for quality– Our evidence: marginal returns to schooling

are not high, even after controlling for quality

• Survey data– Education is not binding

Returns to education and quality

Dominican Rep

Venezuela Uruguay

Ecuador

Colombia

Brazil

Bolivia

Argentina

MexicoChile

BoliviaNicaragua

Honduras

Costa Rica

El Salvador

Peru Paraguay

Panama

Guatemala

0.06

0.07

0.08

0.09

0.10

0.11

0.12

0.13

0.14

1.5 2.0 2.5 3.0 3.5 4.0 4.5

Quality of education

Ret

urns

to edu

catio

n

Sources: World Economic Forum, 2005-06; Hausmann et al (2005)

Does the education system meet the needs of a

competitive system? Index (1 to 7)

1.5 1.7 1.9 2.1 2.3 2.5 2.7 2.9 3.1 3.3 3.5

Venezuela

Uruguay

Peru

Paraguay

Ecuador

Colombia

Chile

Brazil

Bolivia

Argentina

Mexico

Panama

Nicaragua

Honduras

Guatemala

Costa Rica

El Salvador

Note: This index measures the quality of the educational system, which indicates whether the educational system meets the needs of a competitive economy. It ranges between 1 and 7, where a greater value indicates that the educational system meets the needs of a competitive economy better. Source: World Economic Forum, The Global Competitiveness Report, 2005-06

Human capital-summary

• El Salvador has low levels of human capital

• Low human capital represents a serious problem in order to upgrade its productive structure (to enhance productivity)– Low tertiary education– Lack of self-discovery

B) Infrastructure

• Roads, airports, ports, electricity• Average: among the best in the

region• Main problems: roads, electricity

Infrastructure gap: among the best Infrastructure Gap

0

2

4

6

8

Boliv

ia

Peru

Col

ombi

a

Ven

ezue

la

Braz

il

Gua

tem

ala

Uru

guay

Dom

inican

Rep

.

Arg

entin

a

Mex

ico

El S

alva

dor

Chi

le

Main problems: roads, electricity

0 5 10 15 20

BoliviaPeru

ColombiaVenezuela

BrazilGuatemala

UruguayDominicanArgentina

MexicoEl Salvador

Chile

Infrastructure gap by sector

Road InfrastructureGapPort InfrastructureGapAirportInfrastructure GapElectricityInfrastructure Gap

Infrastructure-summary

• El Salvador has good indicators of infrastructure for Latin American standards.

• However, higher economic growth will require greater investment in infrastructure.

C) External conditions

Decline in terms of trade in the last 10 years

Terms of trade (1990=100)

70

80

90

100

110

120

130

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Competition from China

• Chinese exports to the US has increased in the last 10 years

• Salvadorian maquila has been affected

External conditions-summary

• Unfavorable terms of trade• Increasing competition from Chinese

textiles

* Migration, remittances and RER *

• Migration has affected economic growth through:– Slowdown of labor force– Outflow of talented people

• Also: remittances and RER– Migrants send remittances to their relatives

in El Salvador– Inflow of remittances decreases real

exchange rate– Remittances have mostly funded

consumption rather than investment

Remittances (% GDP), 2005

0 5 10 15 20 25

Source: World Development Indicators, 2006

Argentina

Bolivia

Brazil

Colombia

Costa Rica

Ecuador

El Salvador

Guatemala

Honduras

Mexico

Nicaragua

Panama

Peru

Annual growth rate of RER (%), 1994-2006

-3 -2 -1 0 1 2 3 4 5 6 7

Source: ECLAC, Estudio Económico de América Latina y el Caribe, 2005-06; 2002-03

Argentina

Bolivia

Brasil

Chile

Colombia

Costa Rica

Ecuador

El Salvador

Guatemala

Honduras

Jamaica

México

Nicaragua

Panamá

Paraguay

Perú

Uruguay

Venezuela

Remittances and RER-summary

• Migration has increased remittances to El Salvador.

• The large flow of remittances has reduced the RER, which has affected competitiveness of Salvadoran trade sector.

• Remittances have mostly funded consumption (non-traded prices, deficit on trade balance).

D) Technological adaptation

• Lack of innovation• Lack of technological diffusion

– Low payments of royalties– Low share of capital imports (% GDP)– Low FDI (% GDP)

Classification by technological activityHigh Moderate Low InsignificantAustralia Argentina Bolivia BangladeshAustria Brazil China CameroonCanada Chile Colombia El SalvadorDenmark Costa Rica Ecuador MozambiqueFinland Czech Republic Guatemala NigeriaFrance Slovenia Honduras PakistanGermany Greece India ParaguayHolland Hungary Indonesia TanzaniaHong Kong Mexico NicaraguaIreland Poland PanamaIsrael Portugal PeruJapan South Africa PhilippinesNorway Spain Saudi ArabiaSingapore Uruguay ThailandSweden VenezuelaSwitzerlandUnited KingdomUSASource: Lall (2003), CAF (2006)

Royalties and license fees payments and receipts per-

capita (US$), 2004

0

2

4

6

8

10

12

14

16

18

Chile Costa Rica El Salvador Guatemala Nicaragua Honduras Latin America

Source: The World Bank, Knowledge for Development Program

Payments Receipts

Technological adaptation

• Innovation and technological diffusion in El Salvador are very limited

• Efforts of innovation are concentrated in large exporting firms

• Main constraints for innovation (Fusades´ survey):– Lack of technological information– Lack of technicians and skilled labor

* Product transformation and self-discovery*

• No diversification in the last 15 years• Decline in agricultural exports, but

no new products• Non-traditional exports have

increased, but remained concentrated in processors of raw-material and low-technology manufactures

Exports of El Salvador (US$ million)

0

500

1000

1500

2000

2500

3000

3500

4000

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Source: Banco Central de Reserva de El Salvador

TotalTraditionalNon-traditionalMaquila

EXPY (US$ 000)

• El Salvador: low EXPY

0

2000

4000

6000

8000

10000

12000

1975 1980 1985 1990 1995 2000 2004

Source: Hausmann & Klinger Data

Argentina Chile Colombia

El Salvador Guatemala Nicaragua

Product transformation

• Self-discovery is low in El Salvador• Why?

– Human capital– Distorting incentives– Externalities? (what about other

countries?)

• Some recent self-discovery: latest dynamism of some new non-traditional exports

Conclusions

• Migration is the main binding constraint. It has affected:– Size of labor force

• Population• Reservation wage

– Competitiveness of trade sector• Human capital• Remittances and RER

• Also: unfavorable external factors

Conclusions

• Important to deal with other conventional factors that affect competitiveness of Salvadoran trade sector:– Problems of access to credit to small firms – High crime rates– Unconsolidated fiscal sustainability – ***Low shooling rates*** – Limitations in infrastructure– Weak technological adaptation

Natural disasters

• Hurricane Mitchell (1998), two earthquakes (2001), volcano and tropical storm (2005)

• Effects of eruption of volcano Ilamatepec and tropical strom Stan (2005)– Overall: More than 60,000 Has. (9.1%

land size).– Coffee: 43,500 Has. (27% of land size)

Imports (US$ million)

0

500

1 000

1 500

2 000

2 500

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Consumption goods Intermediate goods Capital goods

Sectorial growth

1990-95 1995-2000 2000-05 Total GDP 6.2 3.1 2.2 Agriculture & livestock 1.4 1.0 1.4 Manufacture 5.7 4.8 2.3 Commerce 8.7 2.6 2.0 Construction 7.5 2.3 2.0 Others 7.8 3.7 2.1 Source: Central Bank of El Salvador, website. Data is in constant prices.