Dollarization on El Dollarization on El SalvadorSalvador

Team MembersTeam Members

Nixon OrellanaNixon Orellana

Mike ScottMike Scott

IntroductionIntroduction

► 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 EL SALVADOR AT THE BEGINNING OF THE TWENTY-BEGINNING OF THE TWENTY-

FIRST CENTURYFIRST CENTURY►Since signing the Peace Accords in Since signing the Peace Accords in

1992 to end a 12-year civil war1992 to end a 12-year civil war

►El Salvador has moved steadily toward El Salvador has moved steadily toward the implementation of neoliberal the implementation of neoliberal economic policies by privatizing the economic policies by privatizing the banking system, telecommunications, banking system, telecommunications, public pensions, and electrical servicespublic pensions, and electrical services

EL SALVADOR AT THE EL SALVADOR AT THE BEGINNING OF THE TWENTY-BEGINNING OF THE TWENTY-

FIRST CENTURYFIRST CENTURY►Lowering import tariffs; eliminating Lowering import tariffs; eliminating

most price controls; and attempting to most price controls; and attempting to attract foreign investment through attract foreign investment through infrastructure improvements and infrastructure improvements and greater enforcement of intellectual greater enforcement of intellectual property rights (U.S. Department of property rights (U.S. Department of State 2002, 6-11).State 2002, 6-11).

EL SALVADOR AT THE EL SALVADOR AT THE BEGINNING OF THE TWENTY-BEGINNING OF THE TWENTY-

FIRST CENTURYFIRST CENTURY►On a macroeconomic scaleOn a macroeconomic scale

► Inflation has averaged only 5 percent Inflation has averaged only 5 percent since 1992 since 1992

►total external debt was manageable, total external debt was manageable, at about 23 percent of GDP in 2001at about 23 percent of GDP in 2001

EL SALVADOR AT THE EL SALVADOR AT THE BEGINNING OF THE TWENTY-BEGINNING OF THE TWENTY-

FIRST CENTURYFIRST CENTURY►1.5 million Salvadorans (immigrants)1.5 million Salvadorans (immigrants)

►$1.6 billion, or 60 percent, of El $1.6 billion, or 60 percent, of El Salvador's exports annually.Salvador's exports annually.

► imports from the United States are imports from the United States are about $2.1 billion, resulting in a rather about $2.1 billion, resulting in a rather large trade deficit large trade deficit

EL SALVADOR AT THE EL SALVADOR AT THE BEGINNING OF THE TWENTY-BEGINNING OF THE TWENTY-

FIRST CENTURYFIRST CENTURY

EL SALVADOR AT THE EL SALVADOR AT THE BEGINNING OF THE TWENTY-BEGINNING OF THE TWENTY-

FIRST CENTURYFIRST CENTURY

EconomicsEconomics

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

EconomicsEconomics

► The Salvadoran economy is dominated by The Salvadoran economy is dominated by the service sector, which amounts to 50 the service sector, which amounts to 50 percent of GDP, while the agricultural sector percent of GDP, while the agricultural sector produces 24 percent of GDP and the produces 24 percent of GDP and the industrial sector only 20 percent of GDP.industrial sector only 20 percent of GDP.

►Growth of real GDP has been slow but Growth of real GDP has been slow but steady during the decade, ranging from 2.1 steady during the decade, ranging from 2.1 to 4.2 percent annually (U.S. Department of to 4.2 percent annually (U.S. Department of State 2002, 6).State 2002, 6).

EconomicsEconomics

EconomicsEconomics

EconomicsEconomics

Politics and SocietyPolitics and Society

Politics and SocietyPolitics and Society

El Salvador At a GlanceEl Salvador At a Glance

• Smallest country (third largest Smallest country (third largest economy)economy)

• About the size of MassachusettsAbout the size of Massachusetts• Represents 1 of 7 independent nations Represents 1 of 7 independent nations

(officially dollarized)(officially dollarized)• 50% of population = poverty line50% of population = poverty line

Reasons for DollarizationReasons for Dollarization

(1)(1) Lower Interest RatesLower Interest Rates(2)(2) Decrease InflationDecrease Inflation(3)(3) Increase foreign investmentIncrease foreign investment

(other reasons):(other reasons):• Next logical step (colon pegged since Next logical step (colon pegged since

‘93)‘93)• Economy closely linked with U.S.Economy closely linked with U.S. (total exports & remittances)(total exports & remittances)

Real GDP GrowthReal GDP Growth

What happened to economic What happened to economic growth?growth?

El Salvador faced several shocks:El Salvador faced several shocks:• Two earthquakesTwo earthquakes• Declining international coffee pricesDeclining international coffee prices• Increasing oil pricesIncreasing oil prices• Slowdown of U.S. economySlowdown of U.S. economy

Result: Dampened economic growth &Result: Dampened economic growth & expected benefits from expected benefits from

dollarizationdollarization

Growth Indicators < Growth Indicators < expectedexpectedSince 2001:Since 2001:

• GDP < 2%GDP < 2%• Exports = 3% (versus 17.5% in 2000)Exports = 3% (versus 17.5% in 2000)• Foreign Direct Investment = slowForeign Direct Investment = slow

--> Fixed Capital Formation = 1%--> Fixed Capital Formation = 1%

Benefits of dollarizationBenefits of dollarization

• Lending interest rates decreasedLending interest rates decreased 11% (2000)11% (2000) 6.3% (2004)6.3% (2004)

• Remittance inflows increasedRemittance inflows increased = $2.55 billion (16% of GDP) in ‘04= $2.55 billion (16% of GDP) in ‘04

• Inflation decreasedInflation decreased 7.8% (1992-2000)7.8% (1992-2000) 3% Since 20013% Since 2001

Interest RatesInterest Rates

Interest RatesInterest Rates

Downside of dollarizationDownside of dollarization

• Forfeits control of money supplyForfeits control of money supply (can’t finance fiscal deficit with (can’t finance fiscal deficit with

“seigniorage”)“seigniorage”) --> limits Fiscal Policy’s ability to respond --> limits Fiscal Policy’s ability to respond to negative shocksto negative shocks

• Restricts Monetary Authority’s role asRestricts Monetary Authority’s role as “ “Lender of Last Resort”Lender of Last Resort”

Result: no safety net to stimulate growthResult: no safety net to stimulate growth

““Twin Challenges”Twin Challenges”

• Rising U.S. interest ratesRising U.S. interest rates

(-->decreases C & increases I)(-->decreases C & increases I)

• Greater competition from non-Greater competition from non-dollarized trading partnersdollarized trading partners

Recommendations & ChallengesRecommendations & Challenges

• Improve education/worker trainingImprove education/worker training• Provide more private investment in Provide more private investment in

basic infrastructure programs.basic infrastructure programs.

+ Raise productivity+ Raise productivity

+ Lower costs+ Lower costs