Document of

The World Bank

FOR OFFICIAL USE ONLY

Report No. 50382-SV

INTERNATIONAL BANK FOR RECONSTRUCTION AND

DEVELOPMENT

PROGRAM DOCUMENT

FOR A

SUSTAINING SOCIAL GAINS FOR ECONOMIC RECOVERY

DEVELOPMENT POLICY LOAN

IN THE AMOUNT OF US$ 100.0 MILLION

TO THE

REPUBLIC OF EL SALVADOR

October 27,2009

Human Development Sector Central America Country Management Unit Latin America and Caribbean Region

This document has a restricted distribution and may be used by recipients only in the performance o f their official duties. I t s contents may not otherwise be disclosed without World Bank authorization.

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CURRENCY EQUIVALENTS

The U S Dollar i s the current currency in El Salvador

AAA AIN-C

ANDA

BMI CAS CCT CPS CONACYT

csu DDEs DPL DSA EDUCO EMH FDI FISDL FMLN GDP GOES IDB IMF INSAFORP

ISSS LACAP MAIS M&E MINED MSPASMOH MOF NPLs OPP PAT1 PEIS

FISCAL YEAR (FY)

JANUARY 1 - DECEMBER 31

ABBREVIATION AND ACRONYMS

Analytical and Advisory Activities Integrated Community Child Health Program (Atencidn Integral a la Nifiez en la Comunidad ) National Water and Sewage Company (Administracidn Nacional de Acueductos y Alcantarillados) Banco Multilateral de Inversiones Country Assistance Strategy Conditional Cash Transfer Country Partnership Strategy National Council for Science and Technology (Consejo Nacional de Ciencia y Tecnologia) Comunidades Solidarias Urbanas Departmental Directorates (Directores Departamentales de Educacidn) Development Policy Loan Debt Sustainability Analysis Community Schools Multipurpose Household Survey (Encuesta Multipropdsito de Hogares) Foreign Direct Investment Fondo de Inversidn Social para el Desarrollo Local Frente Farubundo Marti para la Liberacidn Nacional Gross Domestic Product Government of El Salvador Inter- American Development Bank International Monetary Fund Salvadoran Institute for Professional Formation (Instituto Salvadoreiio de Formacidn Profesional) Salvadoran Institute for Social Security (Instituto Salvadorefio de Seguridad Social) L.ey de Adquisiciones y Contrataciones de la Administracidn Pu'blica Modelo de Atencidn Integral de Salud Monitoring and Evaluation Ministry of Education Ministry of Health Ministry of Finance Non-Performing Loans Out-of-Pocket Payments Programa de Apoyo Temporal al Ingreso Extraordinary Budget for Social Investment (Proyecto de Decreto conteniendo las Reforms a1 Presupuesto Extraordinario de Inversidn Social)

FOR OFFICIAL USE ONLY PER RHESSA SBA SIEF SPSU SSGER STP UNDP WDR

Public Expenditure Review Hospital Reconstruction Project Standby Agreement Spanish Impact Evaluation Fund Universal System o f Social Protection (Sistemu de Proteccidn Social Universal) Sustaining Social Gains for Economic Recovery Techincal Secretariat of the President (Secretaria Tkcnica de la Presidencia) United Nations Development Program World Development Report

This document has a restricted distribution and may be used by recipients only in the performance o f their off icial duties. I t s contents may not be otherwise disclosed without Wor ld Bank authorization.

Vice President: Pamela Cox Country Director: Laura Frigenti

Task Team Leader: Sajitha Bashir Sector Manager: Chingboon Lee

EL SALVADOR

SUSTAINING SOCIAL GAINS FOR ECONOMIC RECOVERY

TABLE OF CONTENTS

LOAN AND PROGRAM SUMMARY ...................................................................................................................... i I . INTRODUCTION .................................................................................................................................................... 1 11 . COUNTRY CONTEXT ......................................................................................................................................... 3

A . POLITICAL CONTEXT AND IMPACTS OF THE ECONOMIC CRISIS ........................................................................ 3 B . MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY ............................................................................... 5

III . THE GOVERNMENT’S PROGRAM .............................................................................................................. 11 I V . BANK SUPPORT TO THE GOVERNMENT’S STRATEGY ....................................................................... 15

A . LINK TO THE COUNTRY PARTNERSHIP STRATEGY (CPS) .............................................................. 15 B . COLLABORATION WITH THE IMF AND OTHER DONORS .................................................................................. 15 c . RELATIONSHnr TO OTHER BANK OPERATIONS ................................................................................................ 15 D . LESSONS LEARNED ............................................................................................................................................ 17 E . ANALYTICAL UNDERPINNINGS .......................................................................................................................... 18

V . THE PROPOSED PROGRAM ........................................................................................................................... 21 A . OPERATION DESCRIPTION ................................................................................................................................. 21 B . KEY POLICY AREAS ..................................................................................................................................... 21

V I . OPERATION IMPLEMENTATION ................................................................................................................ 32 A . POVERTY AND SOCIAL IMPACTS ....................................................................................................................... 32 B . CONSULTATIONS .......................................................................................................................................... 32 c . ENVIRONMENTAL ASPECTS ............................................................................................................................... 32 D . IMPLEMENTATION. MONITORING AND EVALUATION ...................................................................................... 32 E . FIDUCIARY ASPECTS .......................................................................................................................................... 33 F . DISBURSEMENT AND AUDITING ......................................................................................................................... 33 G . RISKS AND RISK MITIGATION ........................................................................................................................... 33

ANNEXES

ANNEX 1: LETTER OF DEVELOPMENT POLICY ......................................................................................... 35

MATRIX .................................................................................................................................................................... 44 ANNEX 3: FUND RELATIONS NOTE .................................................................................................................. 48 ANNEX 4: DEBT SUSTAINABILITY ANALYSIS ............................................................................................... 50

ANNEX 6: COUNTRY AS A GLANCE ................................................................................................................. 54

ANNEX 2: EL SALVADOR . SUSTAINING SOCIAL GAINS FOR ECONOMIC RECOVERY . POLICY

ANNEX 5: EDUCATION AND HEALTH BUDGETS FOR 2008-2010 .............................................................. 53

MAP ............................................................................................................................................................................ 57

The Development Policy Loan was prepared by an IBRD team led by Sajitha Bashir (LCSHD) and included Ana Lucia Armijos (LCSPE). Sarah Berger (LCSHS). Tatiana Proskuryakova. Maria Colchao (LCSHE). Rafael Cortez (LCSHH). Michael Drabble (LCSHE). Alejandro AlcalA Gerez (LEGAL). Jania Ibarra (LCCSV). Andrea Kucey (LCC2C). Albert0 Leyton (LCCSV). Humberto Lopez (LCSPR). Fernando Montenegro (LSCHH). Edmundo Murmgarra (LSCHS). and Antonella Novali (LCSHE) . The team i s grateful for the close participation o f the Government of El Salvador during loan preparation . The peer reviewers were Roland Clarke (ECSP2) and Cem Mete (SASSP) .

LOAN AND PROGRAM S U M M A R Y

Sustaining Social Gains for Economic Recovery

Borrower

Implementing Agency

Financing Data

Operation Type Main Policy Areas

Key Outcome Indicators (by December 3 1,20 10)

Program Development Objective(s) and Contribution to CAS

Republic of El Salvador

MINISTRY OF FINANCE

ZBRD Loan Amount: USD 100 mil l ion Terms: Commitment linked loan with fixed spread, denominated in U S dollars, with level amortization o f principal payable in 30 years (including a 5-year grace period). The Borrower wishes to maintain al l risk management options embedded in the loan and has requested an Automatic Rate Fixing arrangement. The front end fee i s 0.25% o f the loan amount and wi l l be fmanced out o f the loan Droceeds. Single tranche DPL: USD 100 mil l ion The DPL i s constructed around three pillars, drawn from the most important elements o f the Government’s program and Anti- Crisis Plan. These pillars are: (i) protecting fiscal space for social expenditures; (ii) protecting income and consumption o f the vulnerable population and (iii) strengthening institutional capacity for policy formulation and implementation in the social sectors for economic recovery. Protectingfiscal space for social expenditures:

Reduction in transport subsidy by 38 percent from US$85 million; Non-personnel recurrent expenditure in education and health budgets for 2009 and 2010 are maintained at least at 2008 levels and critical investments in health are protected.

Protecting income and consumption of the vulnerable population: Coverage o f school feeding program expanded to 1.3 mill ion students in grades 1 through 9; Number o f hospital discharges in the public sector increased by 10 percent; The Temporary Income Support Program i s fully operational in 11 municipalities.

Strengthening institutional capacity for policy formulation and implementation in the social sectors for economic recovery:

A new curriculum for the teaching o f science and technology in upper secondary has been elaborated; Proportion o f individuals receiving health care attention in the 80 poorest municipalities rises to 80 percent; The Comunidades Solidarias Urbanas, one o f the components o f the Universal System o f Social Protection (Sistema de Proteccio’n Social Universal - SPSU), i s piloted in 2 municipalities.

The DPL w i l l support the Government’s Anti-Crisis Plan to protect the social gains made in the past decade and reinforce the framework for economic recovery. The SSGER DPL i s included in the proposed World Bank Group’s Country Partnership Strategy (CPS) 2009-2010 (Report No. 50642- SV), which i s being presented to the Board at the same time and

i

Risks and Risk Mitigation

Operation ID

complements other investment operations. While the SSGER DPL wi l l contribute to meeting the immediate financing needs o f the Government, i t wi l l also serve as a bridge between the ongoing DPL and a possible programmatic DPL series in FY 1 1 and FY 12. The operation i s subject to two signif icant risks:

Macroeconomic instability arising from fiscal pressures: Fiscal pressures are likely to emerge due to the sharp decline in current revenues associated with the economic slowdown, while expenditures w i l l grow in order to protect the poor from the effects o f the crisis. The fiscal deficit i s expected to reach 5.3% o f GDP in 2009. Even though the authorities have indicated their commitment to lower the fiscal deficit in 2010 this could prove difficult if the crisis i s longer than anticipated or the planned tax reform does not produce the expected results. Mitigation: The risk is partly mitigated through ensuring adherence to an acceptable macro-economic framework and continuous policy dialogue with the Government to ensure that incremental expenditures are targeted to protect the vulnerable population and services used by the poor. The Government has reached agreement on a new three-year Standby Arrangement with the IMF. Opposition to approval of Bank loans in Congress: The new administration does not have the required majority to approve Bank loans in Congress. In the past, lack o f Congressional approval led to cancellation o f several Bank loans. Mitigation: The Bank has made sustained efsorts to maintain dialogue on the Government’s program (including with opposition parties) and the SSGER DPL is being processed as part of a package, including the new CPS and two investment projects supporting the Government’s program.

P118036

.. 11

PROGRAM DOCUMENT

SUSTAINING SOCIAL GAINS FOR ECONOMIC RECOVERY

DEVELOPMENT POLICY LOAN

TO THE REPUBLIC OF EL SALVADOR

I. INTRODUCTION

1. El Salvador i s at a critical juncture in its development, after a historical political transition which took place in the midst of an unfolding economic crisis triggered by global financial turmoil and the U.S. recession. In March 2009, President Mauricio Funes, candidate o f the Frente Farabundo Martipara la Liberucio'n Nacional (FMLN), the party which had been in opposition for 20 years since the end o f the civi l war, won the Presidential elections. The FMLN also won the greatest number of seats in the Congress, although not enough to secure a majority. The Presidential candidate ran on an electoral platform with a clear social policy agenda, focusing on employment, job creation, provision of basic health and education services, and social protection for the poor. The new Government also promised improvements in the efficiency o f public spending and taxation in order to ensure the fiscal sustainability o f i t s ambitious medium term development strategy. The creation o f institutional mechanisms to promote the participatory development o f economic and social policy was also a cornerstone o f the electoral platform. The elections were held at a time when El Salvador was hit hard by the triple shock o f rising fuel and food prices, followed by the global financial crisis. The outcome o f the elections indicates a broad-based support for a reform program that touches on every aspect o f economic and social policy.

2. The impact of the global economic crisis on El Salvador has generated major economic and social risks and jeopardizes the ability of the new Government to implement its social policy agenda. By early 2009, tens of thousands o f Salvadoran households had been affected by the loss o f jobs, especially in the export sector, reduction in incomes and a sharp drop in remittances. The sharp downturn in the U.S. economy in the f i rs t half o f 2009 magnified these impacts, due to the close links between the two economies. These developments compound the problem o f a rapid rise in the poverty rate in 2008 caused by the increase in food prices. The new Government was also confronted with a rapidly deteriorating fiscal outlook, as tax revenues declined more than anticipated, constraining its efforts to deliver on i t s pro-poor social agenda. Within three weeks o f assuming power on June 1, 2009, President Funes presented the Government's Anti-Crisis Plan with priority initiatives and actions to protect the most vulnerable individuals o f the population, while preparing for economic recovery.' The Anti-Crisis Plan demonstrated the willingness o f the Government to tailor i t s agenda to the new fiscal realities.

3. The Government intends to address the challenges brought by the economic crisis while laying the ground for a social policy that i s sustainable and responds to the long-term development agenda. In December 2008, faced with adverse fiscal pressures and a threat to macroeconomic stability, the previous Government sought and secured a two-tranche Public Finance and Social Sector Development Policy Loan for US$450 mill ion from the Bank and a parallel US$ 500 mil l ion loan from the Inter-American Development Bank (IDB). The f i rst tranche o f US$200 o f the World Bank DPL was released in February 2009 and the program was designed to have a second tranche disbursing in FY 11. However, the fiscal deficit for 2009 i s projected at 5.3 percent of GDP

' Plan Global Anti-Crisis. Secretaria Tkcnica de la Presidencia. Presented at San Salvador, 19 June 2009.

1

against an init ial projection o f 2.8 percent o f GDP in the IMF Standby Arrangement (SBA) approved in early 2009. As a result, the Government has requested support from the multilateral institutions to finance the fiscal gap without having to curtail expenditures on social programs and public investment, which are required for the long term development o f the country.

4. The crisis calls for a combination of interventions to strengthen social safety nets and to build human capital to avoid reversing the important socio-economic gains of the recent period. El Salvador needs to improve i t s safety net program, which i s characterized by a large number o f small programs with low coverage which have limited impact on aggregate poverty. The most successful o f these has been the conditional cash transfer program for rural areas, Red Solidaria which, in 2008, covered 30 o f the country’s poorest 100 municipalities. Aside from traditional interventions to reactivate the economy, expanding the coverage o f safety nets, improving training programs, generating temporary jobs and increasing access to secondary education w i l l be critical to prepare the country for the economic recovery.

5. The Sustaining Social Gains for Economic Recovery (SSGER) DPL will assist the Government of El Salvador (GoES) to undertake immediate measures in the Anti-Crisis Plan to protect the poor, while supporting the process of economic recovery through the design of new initiatives and institutional strengthening in the social sectors. Apart from providing a part o f the financing for the Anti-Crisis Plan, the proposed DPL w i l l also enable the Bank to provide technical assistance in the area o f institutional strengthening and policy development to a new Government with limited experience in the executive branch. The SSGER DPL w i l l contribute to building a fiscally sustainable medium term development policy and serve as a platform for dialogue with the GoES, opposition parties and c iv i l society on the reform agenda.

6.

a.

b.

C.

7.

The proposed DPL i s structured around three pillars:

Protecting fiscal space for social expenditures. The DPL w i l l help to protect non-personnel recurrent spending and essential investments that are required to sustain the quality o f education and health services, while generating resources from the reduction o f the transport subsidy. Protecting income and consumption of the vulnerable populations. The DPL wi l l support the launch o f essential social programs including the protection and extension o f access to basic health and education services and the provision o f temporary income support to unemployed persons in poor municipalities. Strengthening institutional capacity for policy formulation and implementation in the social sectors for economic recovery. The DPL wi l l support specific actions to build the capacity o f the Ministries o f Education and Health, as well as the Technical Secretariat of the President (Secretaria Tknica de la Presidencia - STP), which i s in charge o f coordinating and monitoring the implementation o f social policy.

The SSGER DPL i s included in the new Country Partnership Strategy (CPS) and is designed as a single tranche DPL. This operation complements two investment projects that w i l l be submitted to the Board at the same time, as well as the ongoing two-tranche DPL approved by the Board in January 2009. The lending envelope for FYlO i s US$250 million, o f which US$lOO mill ion i s allocated for a social sector DPL. The indicative envelope for FY11 and FY12 i s US$400 million, subject to availability o f IBRD resources. Although no specific operations are included in the CPS as the lending envelope and program for outer years have not been finalized, a programmatic DPL series, which w i l l build on the progress under th is operation, i s envisaged to ensure continuity in the policy dialogue in human development. While this DPL wi l l contribute to meeting the immediate financial needs of the Government, i t i s also designed to serve as a bridge between the ongoing two-tranche DPL and the possible new programmatic DPL series starting in FY11.

2

11. COUNTRY CONTEXT

~~

A. POLITICAL CONTEXT AND IMPACTS OF THE ECONOMIC CRISIS

3

education remains low, while the net enrollment rate for high school i s much lower than that o f s imi lar middle income countries. As demonstrated by results from international and regional standardized testing scores (TIMSS 2008; SERCE 2008), the performance o f students in El Salvador i s low relative to other countries with a s imi lar Human Development Index. For example, sixth graders perform below the regional average in every subject area (mathematics, science, reading).

11. The need to create economic opportunities for the cohorts entering the labor market i s another major challenge for El Salvador, which has a relatively young population. About 34 per cent o f the Salvadoran population i s between 0 and 14 years old, compared to 23 percent for Uruguay, 27 percent for Brazil, and 30 percent for Mexico (only Guatemala and Honduras have a higher child population share in LAC). Moreover, half o f the Salvadoran population i s less than 30 years old. Limited access to high school education as well as to opportunities for quality employment has constrained youth development. While adult unemployment rates have remained constant or even decreased in recent years, the unemployment rate for youth (15-24 years old) i s nearly three times higher, around 11.5 percent. About 80 percent o f youth are confined to informal and low-paying jobs. Outmigration s t i l l seems to be the most economically rational decision for a large portion o f the youth population.

12. El Salvador’s relatively high dependence on remittances from the United States, which support the incomes of a significant proportion of poor households, also makes the country highly vulnerable to external shocks. In 2007, workers’ remittances (mainly from the U.S.) represented 18.1 percent of GDP. The extent o f dependence on remittances has increased rapidly between 2000 and 2007. More than 26 percent o f Salvadoran households received remittances in 2007, compared to 20 percent in 2000. The level o f dependence i s greater among rural households (29.2 percent) than in urban households (25.2 percent). Remittances contribute 42 percent o f the income o f recipient households. About 12 percent o f these households (nearly 150,000 households) receive more than 50 percent o f their income from remittances. Interestingly, remittances are relatively more important for households in the second, third and fourth quintiles than for the richest or poorest households.

13. In 2008, the poverty rate rose sharply, almost entirely wiping out the gains in poverty reduction of the decade and demonstrating El Salvador’s vulnerability to external economic shocks. The poverty rate rose to 42.3 percent, s imi lar to the rate in 2001 (43.6). The rural poverty rate shot up to 45.3 percent in 2008 from about 40 percent in 2007, reversing a decline from 52 percent to 35 percent between 2001 and 2006. In urban areas, the proportion o f poor was actually higher in 2008 than in 2001 (40.7 and 37.2 percent, respectively). This rise in the poverty rate was almost entirely due to the steep increase in the price o f food staples o f about 8 percent in 2007 and 17 percent in 2008, while income was almost stagnant.

14. The on-going economic crisis will increase unemployment and lower incomes, compounding the negative impacts of the food and fuel price increases of 2008. Unemployment i s expected to increase with job losses in the maquilas and other industries, as well as in the construction and service sectors. Migration, which has traditionally absorbed a significant share of new entrants to the labor force, has become relatively less attractive as the job opportunities in the U S have shrunk. These developments come on top o f a sharp increase o f 2.1 percentage points in the labor force participation rate in 2008, possibly reflecting an attempt by households to cope with the rise in the cost o f food. As a result, underemployment rose in 2008 to 32 percent, compared to 27 percent in 2007. These impacts may lead to stagnation or even an increase in poverty rates.

15. The projected reduction in remittances from the United States will also have a perceptible impact on incomes and poverty. Data from the Central Bank o f El Salvador show that there has been a reduction in remittances o f around 13-14 percent in real terms in the 12 months up to January 2009. Simulations done in the context o f the Bank’s on-going analytical work on the social sectors indicate that if remittances o f all households were reduced by 15 percent, the overall poverty headcount would

4

rise by 0.9 percentage points, -1.13 and 0.73 in rural and urban areas, respectively. These increases in the incidence o f poverty would push approximately 5 1,000 Salvadorans below the poverty line, eroding a substantial part o f the gains made in poverty reduction between 2000 and 2007. Moreover, beyond the macroeconomic and income poverty implications, there i s concern that lower remittance flows w i l l negatively affect social indicators such as school enrollment and child malnutrition, as households adjust spending to declining revenues.

16. Given these challenges, the GOES has prepared an Anti-Crisis Plan for the period of 2009- 2011 to mitigate the immediate economic and social impacts of the global economic crisis, while preparing the foundation for implementing its medium-term development agenda once global conditions improve. The Government recognizes that while enhanced social expenditures are required, maintaining fiscal and macroeconomic stability i s key to putting the country on a sustainable growth path which can support a permanent reduction in poverty and accumulation o f human capital. Hence, the authorities have focused on selective expansion o f the safety nets and access to education and health services, together with institutionalization o f the mechanisms for social policy formulation, coordination and implementation and improvement o f public expenditure management.

17. The following sections outline the recent economic and social developments, the medium-term outlook and the country’s strategies to meet both short and medium-term challenges in the context o f the proposed DPL.

B. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY

Recent Economic Developments

18. Until 2008, the growth performance of El Salvador was broadly positive, but the global crisis is having a significant effect on the country’s economy. Growth accelerated from 2.3 percent in 2003 to 4.2 percent in 2006 and 4.7 percent in 2007 (the fastest growth rate since 1995). The observed acceleration in economic growth was triggered to a large extent by rapid improvements in the external environment which resulted in cumulative export growth o f 26.2 percent between 2002 and 2007. In addition, the country’s traditional sound macroeconomic management facilitated the transmission o f the positive global developments. In 2008, however, El Salvador started feeling the effects o f the global crisis and, despite initial projections above 4 percent; GDP growth reached only 2.5 percent.

19. The growth slowdown has become even more marked in the first half of 2009. According to the monthly indicator o f economic activity in May, economic activity contracted more than 10 percent with respect to May 2008. The May decline was smaller than the contraction observed in April (1 1.7 percent) but it marked the eighth consecutive month o f declines in economic activity. The observed economic contraction i s broad based as nine o f the eleven sector categories underlying the index contracted over the same month o f 2008. The decline was particularly sharp in commerce, hotels, and restaurants. Current projections foresee a decline o f GDP by about 2.5 percent in 2009. This would be the first full-year GDP contraction in over two decades.

20. There are several elements behind the evolution of economic activity, including lower domestic investment, a dramatic deterioration in export performance, and a marked decline in workers’ remittances. On the investment front, gross domestic investment i s expected to decline from 16.1 percent o f GDP in 2007 to about 13.1 percent in 2009. This decline would be mainly driven by lower private investment which already declined from 14.1 percent o f GDP in 2007 to 12.8 percent o f GDP in 2008 and i s expected to further decline to 11.1 percent in 2009. At the same time, public investment has not been able to offset these changes as i t increased from 2 percent o f GDP in 2007 to just 2.1 percent in 2008 and 2009. On the export front, following the positive developments o f the past few years mentioned in paragraph 18, exports receipts declined over the f i rs t half o f 2009 by 16.5

5

percent with respect to the same period of 2008 on account o f both lower volume (-14 percent) and lower prices (-2.5 percent). For the year as a whole, export receipts are expected to decline by about 15.7 percent in 2009. Remittances, which in El Salvador represented 18.1 percent o f GDP in 2008, started to decrease in the second semester o f 2008 and abruptly dropped in the first quarter o f 2009. Indeed, over the f i rs t six months o f 2009 remittances reached US$1,740 million, in contrast with the flow over the f i r s t six months o f 2008 when remittances reached US$1,939 mill ion (Le. a decline o f more than 10 percent).

21. The economic contraction is having a negative impact on the country’s labor markets. The 2008 (formal) unemployment rate was 5.9 percent (the lowest in more than one decade) and even if El Salvador does not report periodical figures, the available information points to a significant increase in 2009. According to the Salvadoran Institute for Social Security (Institute Salvadorefio de Segun’dad Social -ISSS), which provides monthly figures on the evolution o f private sector workers contributing to social security, formal employment was falling at an annualized rate o f 3 percent in February 2009. Taking into account the existing correlation between national employment rates and social security contributions (0.78), the country’s unemployment could increase to about 9-10 percent by the end o f 2009 (the highest in more than one decade).

22. The crisis has resulted in an increasingly tight fiscal situation. El Salvador had been making continued improvements on the fiscal front over the past few years, with the non-financial public sector deficit falling to 1.9 percent o f GDP in 2007 from a peak o f 4.4 percent in 2001 and 2002. Notably, the primary balance showed a surplus o f 0.6 percent o f GDP in 2007 for the f i rs t time in more than a decade. The observed fiscal consolidation was largely due to strong revenue performance as the Government managed to increase tax revenues by nearly 1.0 percent o f GDP between 2005 and 2007. However, this trend did not persist in 2008 as public spending increased at faster rate than fiscal revenue (15 and 10 percent with respect to 2007, respectively). As a result, 2008 closed with a fiscal deficit o f 3.1 percent o f GDP.

23. The fiscal situation has continued to deteriorate during the first half of 2009 to a large extent because of the negative impact of the crisis on tax collection. As in many other countries, the economic slowdown has resulted in a significant decline in tax revenue. During the f i r s t half o f 2009 tax collection (which represents three quarters o f fiscal revenues) was 12 percent lower than during the same period o f the previous year and for the year as whole estimates o f Government revenue have been cut down from 17.2 percent o f GDP to 15.7 percent. On the spending side, the government has been showing restraint keeping spending levels below those envisaged in the IMF Standby program approved in early 2009. Yet, as a percentage o f GDP public spending i s expected to increase from an early estimate o f 20.1 percent to a current estimate if 20.8 percent. The combination o f these elements i s expected to result in a public sector fiscal deficit o f 5.3 percent o f GDP in 2009. This would be in contrast to a projection o f 2.8 percent o f GDP in the IMF Standby program. In order to finance the larger than anticipated fiscal deficit, the main political parties reached an agreement in June 2009 to use the proceeds of the IDB and World Bank budget support operations approved in late 2008 and early 2009. The Government had initially planned to use the proceeds o f these operations to pre-amortize the Eurobond series coming due in 201 1, when the country’s debt service i s expected to more than double reaching $1.4 bil l ion versus an average o f $650 mill ion during 2008-2010. As part o f the same agreement, the Government was also authorized to issue medium-term debt to cover the financing needs associated with the Eurobond. The Government has also sought multilateral support to cover the fiscal gap o f 2009 and th i s DPL i s a response to that request.

24. The mirror image of the evolution of the fiscal deficit i s the evolution of public debt levels. After declining from 42.1 percent o f GDP in 2003 to 39.1 percent of GDP in 2007, the stock o f total public debt increased to 41.2 percent o f GDP (of which 23.7 percent was external public debt) in 2008

6

and i s expected to further increase in 2009 to 47.7 percent o f GDP (of which 30 percent would be external public debt).

25. On the external front, the current account deficit is expected to improve in 2009. After averaging 3.5 percent o f GDP in 2005-2006, the current account deficit expanded to 5.5 percent o f GDP in 2007. This deficit was financed by large capital inflows (7.0 percent o f GDP), in part related to the sale o f three major domestic banks to foreign buyers in 2007. The current account deficit further deteriorated in 2008 to 7.2 percent as a result o f the high food and o i l prices. As with most countries in the region, imports have contracted more than exports in 2009. As a result, the current account deficit i s expected to fal l to 1.7 percent o f GDP as the trade balance improves.

26. Following the dramatic spike due to rising oil and food prices, inflation has moderated in 2009. During 2008, inflation accelerated drastically to levels not seen in more than a decade. In the first semester o f 2008, inflation rose to 9 percent. Most o f this increase i s explained by rising food and o i l prices. The current crisis followed this period o f high inflation that was strongly felt among the poorest households. Food inflation reached 16.4 percent, while inflation for the poor tripled to 11 percent (3.6 percent in 2007). Inflation was reduced to 5.5 percent in December 2008, and by June 2009 the country was approaching deflation as the annual headline inflation rate fel l to 0.2 percent. Despite the deflationary pressures the Central Bank s t i l l expects to end the year at about 1 percent (see Table 2).

Table 2. El Salvador - Key Economic Indicators 2005-2009 (percentage o f GDP, unless otherwise indicated)

Income and prices GDP growth (% change) 3.1 4.2 4.7 2.5 -2.5 Inflation (end of period % change) 4.3 4.9 4.9 5.5 1 .o

Investment and savings Gross domestic investment 15.7 16.1 16.1 15.0 13.1 Gross domestic savings 12.4 12.5 10.4 7.7 11.4

Consolidated public sector accounts Total revenues and grants 16.3 17.2 17.1 16.9 €5.5

Total tax revenues 12.5 13.3 13.4 13.0 12.0 Total expenditure 19.8 20.1 19.0 19.9 20.8 Primary balance -1.3 -0.5 0.6 -0.7 -2.9 Overall balance -3.5 -2.9 -1.9 -3.1 -5.3

Total debt 42.0 41.9 39.1 41.2 47.7

Current account balance -3.3 -3.6 -5.5 -7.2 -1.7 Trade balance -17.2 -18.9 -20.0 -19.9 -12.6

Public Sector Debt

Balance of payments

Exports (including maquila) 20.2 20.2 19.8 20.8 17.5

Foreign direct investment 2.3 1.3 7.0 3.3 0.4 Remittances 17.7 18.6 18.1 17.1 15.7

Nominal GDP (billions of US dollars) 17.1 18.7 20.4 22.1 22.1

Imports (including maquila) -37.4 - 39.1 -39.8 -40.7 -30.2

Memorandum item:

Source: Ministry of Finance, Central Bank, IMF, and World Bank staf f estimates

27. The banking sector in El Salvador has coped relatively well with both the global financial crisis and the change in administration. In addition to the challenges presented by global developments, during 2009 Salvadoran investors and bankers were concerned about the political r i sks

7

that they associated with a potential triumph o f the FMLN, the leftist party, in the January 2009 national assembly elections and the March 2009 presidential elections. Bankers and supervisors were afraid that such a triumph could prompt a run on the banks. To address th is concern, the Superintendence o f Banks had raised the liquidity requirements from 25 percent to 28 percent o f deposits, counting as liquid only assets deposited abroad in highly liquid instruments (managed by the Central Bank). As a result o f the raised requirements and o f their own concerns, banks raised their liquidity ratios to an average that, by May 2009, had reached 46 percent o f assets. Eventually, the FMLN won both the presidential and congressional elections (although i t fel l quite short o f commanding a majority in the Assembly), but the feared run did not take place.

28. Currently, capital adequacy ratios are at levels comparable to those observed before the current financial turmoil and well above the regulatory minimum of 12 percent. The system i s also relatively liquid with net liquid assets to short-term liabilities o f 34.4 percent. However, the combined effect o f the decline in growth and lower remittances i s leading to an increase in non-performing loans (NPLs) (see Figure 1). B y February 2009, NPLs had increased by 30 percent relative to the same month in 2008. While there are no data relative to sectors, it i s significant that the two banks with the higher exposure to consumer credit have the highest level o f NPLs as well as the highest rate o f growth o f these loans. B y February, four o f the five largest banks had provisioned between 100 percent and 122 percent of the NPLs, and only one o f them was marginally below 100 percent.

Bank profitability, however, i s declining. At this moment, the banks are primarily concerned with their declining profitability, which i s the result o f (a) low return assets associated with high levels o f liquidity and (b) growing levels o f provisions prompted by the increasing NPLs. Yet, even though the two-pronged erosion of the profitability o f the banks i s a source o f concern, the banks are s t i l l making profits.

29.

Figure 1. El Salvador: Evolution of main solvency indicators

NPLs, CAR and ROE

16% 14%

0 12%

9 8% w C 6% u

4% 2%

w

2 10%

4.0%

3.5%

3.0% 9 k 2.5%

2.0%

1.5%

CAR

*ROE

+NPL

-

SOURCE: Superintendence o f the Financial System, E l Salvador

CAR Capital Adequacy Ratio; ROE: Return on Equity; NPL: Non-performing loans

8

Macroeconomic Outlook

30. Recent indicators suggesting that economic activity i s starting to turn around in the United States are particularly relevant in the Salvadoran context. Forty-eight percent o f Salvadoran exports are directed to the United States. Furthermore, as mentioned previously, workers’ remittances (mainly from the United States) represent more than 15 percent o f GDP. Thus, to the extent that demand for Salvadoran products and remittances increase in parallel to a potential US recovery, the economic prospects o f the country w i l l also increase. Current estimates foresee a recovery in GDP growth rates to about 0.5 percent in 2010, 2 percent in 2011, and around 3 percent in 2012 and 4 percent in 2013 and 2014(see Table 3).

31. Inflation i s expected to remain under control in the medium term. The current medium term macroeconomic framework incorporates projections for the inflation rate that would be consistent with a moderate increase to 2.5 percent in 2010 and 2.8 percent in 2011 and beyond. These projections already incorporate the rebound in o i l prices observed since February 2009 (when the barrel o f West Texas Intermediate o i l reached US$39.1) to US$69.9 by midyear, and the recovery in food prices which, after having declined by 40 percent in the second half o f 2008, increased about 12 percent between January and June 2009.

32. In a similar vein, the current account deficit is expected to deteriorate in 2010 with respect to 2009, but the deficit is expected to be contained slightly below the levels of 2005 and 2006, before the food and oil crisis hit the country. These developments would be driven by a combination o f factors o f which the following are worth highlighting: the expected additional pressure on the import front as the prices o f commodities and food recover, and the relief provided from an expected recovery in remittances flows in parallel to the expected improvements in the U.S. labor market. On the financing front, foreign direct investment (FDI) i s also expected to recover from less than 1 percent o f GDP in 2009 to the levels observed before the crisis, which hovered around 2-3 percent, with the exception o f 2007 when FDI reached 7 percent in connection with the sale o f three banks.

33. The deterioration of the fiscal situation, however, has turned i t into the main source of macroeconomic concern, but the Government i s taking measures to maintain a disciplined stance. The 2010 fiscal deficit (projected at 4.3 percent o f GDP) i s expected to decline slightly with respect to the one in 2009 as the modest recovery projected for next year w i l l not likely result in dramatic improvements on the tax collection front. Similarly, the 2010 budget i s expected to include about US$355 mil l ion (1.5 percent o f GDP) in programs and projects from the Government’s US$560 mill ion Anti-Crisis Plan, pushing public spending to 21.4 percent o f GDP. In order to cover at least in part the additional financing needs emerging from the revised deficit for 2010 the Government i s relying on multilateral support and policy measures to keep expenditures under control and raise tax collections. Indeed, the Inter American Development Bank i s now preparing a US$200 mill ion budget support operation planned for 2010. Beyond 2010, permanent commitments associated with the Anti-Crisis Plan could add between US$200 and US$250 mil l ion (depending on how coverage o f the programs evolves) to public spending per year (0.8 percent to 1 percent o f GDP).

34. The Government is aware of the need to reduce the fiscal deficit to sustainable levels once the crisis is over. In this regard, with World Bank and IMF support, the administration i s working on the preparation o f legislation that w i l l include a reform of the tax administration. Measures under consideration include administrative actions to fight tax evasion, introduction o f new taxes (such as a new tax on vehicles) and adjustment o f some taxes (such as those on alcoholic beverages). On the spending side, the Government i s preparing a plan to rationalize (through better targeting and in some cases elimination or reduction) existing subsidies in the water, transport, and liquid petroleum gas sectors. This would be in addition to the actions already taken on the electricity front (supported by the

9

Bank’s Public Finance and Social Sector Development Policy Loan) to reduce the electricity subsidy for f i rms. As a result, the fiscal deficit i s expected to decline to less than 2 percent of GDP in 2014.

35. The medium term macroeconomic framework described above will be supported by a new three year SBA with the IMF. The authorities have requested to end the earlier SBA in 2009. That arrangement achieved i t s key objective o f helping the country weather the global crisis, maintaining macroeconomic and financial sector stability. In addition, following the IMF mission in late September 2009, the IMF and the authorities have agreed on a new 3 year SBA. The authorities intend to treat the SBA as precautionary.

Table 3. Medium Term Macroeconomic Scenario: Base Case (% o f GDP, unless otherwise indicated)

Income and prices

GDP growth (% change) Inflation (end o f period % change) Investment and savings Gross domestic investment Gross domestic savings Consolidated Public Sector Total revenues and grants

Total expenditures Primary balance Overall balance Public Debt Total debt Balance of Payments Current account balance Trade balance

Total tax revenue

Exports of goods (f.0.b) Imports o f goods (f.0.b.)

Foreign direct investment

0.5 2.5

13.7 11.1

17.1 13.1 21.3 -1.3 -4.3

48.8

-2.6 -14.2 17.2 31.4 0.8

2.0 2.8

15.0 12.3

17.7 13.9 21.0 -0.3 -3.3

50.1

-2.7 -14.4 17.7 32.1 0.8

3.0 2.8

16.0 13.4

18.3 14.6 21.0 0.3 -2.7

49.5

-2.6 -14.5 17.9 32.4 1.4

4.0 2.8

16.5 13.8

18.8 15.2 20.8 0.9 -2

48.3

-2.7 -14.8 18.0 32.7 1.9

4.0 2.8

16.5 13.8

18.9 15.3 20.7 1 .o

-1.8

46.2

-2.7 14.8 17.9 32.7 2.4

Remittances 15.5 15.7 16.1 16.2 16.2 Memorandum Item Nominal GDP (billions o f U S dollars) 23.0 24.0 25.4 27.3 29.2 Source: Ministry o f Finance, EIU forecasts and World Bank staff estimates.

Debt Sustainability

36. The recent deterioration in the medium term macroeconomic outlook of El Salvador i s also affecting the Debt Sustainability Analysis (DSA) presented in the Public Finance and Social Sector Development Policy Loan that was approved by the Board on January 22,2009. At that time, the DSA projected the country’s public debt level declining to below 33 percent o f GDP by 2013. Similarly, the DSA projected a total external debt (including both public and private) to GDP ratio o f about 40 percent in 2013. Clearly, the higher than initially envisaged fiscal deficits in 2009 and 2010 together with the lower growth projections have negatively affected the medium-term public debt trajectory. On the other hand, the total external debt DSA remains basically unchanged as the negative impact o f the lower growth and inflation projections i s offset by the lower than initially envisaged current account deficits.

10

37. The revised DSA indicates that the country’s public debt wil l not fall below 47 percent until 2014. Annex 4 indicates that public debt i s expected to increase to above 50 percent o f GDP in 201 1 to then start declining as the overall balance o f the public sector increase. As for the external debt, Annex 4 indicates that total external debt to GDP ratio w i l l decline to 40 percent o f GDP by 2014.

38. Even though the economy has entered a downturn and there are significant r isks to the short-term outlook associated with the difficult external environment, the macroeconomic policy framework i s adequate for the purposes of this development policy loan.

111. THE GOVERNMENT’S PROGRAM

39. The new Government’s electoral platform focuses on four areas: social reform, economic reform, environmental sustainability, and political reform. In the area o f social reform, the objectives are to substantially reduce poverty, raise the quality o f education and the educational attainment o f the population, reduce inequity and economic and social exclusion, and promote security. The program proposes measures to strengthen nutritional security, reform o f the health system to ensure universal coverage o f basic health services, reform of the education system to move towards creating a knowledge society, the development o f housing and urban areas, and initiating a system o f old age security to cover workers in the formal and informal sectors. In the area o f economic policy, the main objective laid out by the new Government i s to generate more and better quality employment, in particular for the youth, through promoting investment and reducing barriers for starting new businesses, raising the competitiveness o f agricultural production, improving access to credit, and creating a system o f national innovation, and scientific and technical development.

40. The Government’s program gives priority to developing policies and strategies to improve the coverage, equity and quality of social services, and the Anti-Crisis Plan, which was announced by the President within a few weeks of assuming power, focuses on key elements of this general program. Hence, there i s a large degree o f coherence between the Anti-Crisis Plan and the longer term vision o f the Government. Various sectoral Ministries are preparing draft medium-term strategies which are currently being discussed with key stakeholders. However, the expansion o f on-going programs and the introduction o f new programs, especially those involving large public expenditures, i s being done in a coordinated and phased manner, as part o f the Government’s Anti-Crisis Plan, which i s managed by the Technical Secretariat of the Presidency.

41. A crucial part of the Government’s agenda i s the creation of new institutional mechanisms for consultation and participatory processes to prepare a medium-term development agenda. The Government has instituted a “National Dialogue” for defining a national development plan, which concretely involves weekly consultations with the private sector and social organizations. Another i s the creation o f the Economic and Social Council (Consejo Econo’mico y Social) which w i l l take the lead in economic and social policy formulation. The composition, functions and powers of this Council are currently being drafted. A third prong o f this activity comprises the development o f sectoral strategies, especially in the areas o f education, health, environment, agriculture, and economy, by the respective sectoral Ministries through the creation o f mechanisms for conducting sectoral dialogue with relevant stakeholders and policy formulation. Many Ministries, including those for education and health, are carrying out internal re-organization to support policy development and implementation.

42. The Ministry of Education (MINED) has begun the process of developing an education strategy, focusing on quality improvement, decentralization, and institutional strengthening. A preliminary “Plan Social Educativo 2009-2014” has been produced with six strategic lines: (i) equality and access to education; (ii) relevant curriculum and improved learning; (iii) professional development and revised teachers’ career status; (iv) strengthening institutional and pedagogical management in

11

educational centers; (v) lifelong learning for youth and adult population; and (vi) integrating science and technology into education. In particular, MINED envisages a strong encouragement to the development o f science and technology, with a particular focus on improving science education from pre-school to the high school and training of science and technology professionals. The emphasis in curricular and pedagogical reform i s on encouraging creative thinking and the creation and application o f knowledge. Along with science and technology, the MINED’S policy includes the promotion o f arts and culture as a transversal theme in education reform.

43. In health, a new draft strategy has been prepared by the Ministry of Health (Ministerio de Salud Ptiblica y Atencidn Social - MSPAS) to achieve universal coverage, greater equity and enhanced quality through the creation of an integrated network of health care services. Over the past three months, the new Government has met with various key actors and stakeholders in the health sector to discuss and analyze how to overcome the existing fragmentation within the health sector. The MSPAS has proposed the creation o f an integrated network o f health care services which would unite al l the different service providers including the MSPAS, the ISSS, the military health facilities, the private sector and non-government organizations, which provide mostly primary health care and nutrition services.

The re-organization of the health sector is proposed along six strategic lines:

Reform of the structure, organization and functions within the health sector, focusing on the creation o f an integrated system o f primary care which prioritizes health promotion and disease prevention; the elaboration o f a mechanism for creating an integrated network o f public health services; strengthening the capacity for policy making and planning in the MSPAS; the regulation o f the health system, including the private sector, and promotion of community participation in health. Improving the coverage and quality of health services and their ability to cope with emergencies and natural disasters, including optimizing the network o f public health providers, creating a laboratory network to complement the health network and strengthen epidemiological surveillance, creating a regional network of public hospitals with division o f care between secondary and tertiary hospitals, administrative and financial restructuring o f the ISSS, and strengthening nutritional security. Development of human resources to include planning for current and future needs with a focus on providing primary health care in the poorest and most remote areas, developing the professional and occupational profile o f health workers, creating coordination mechanisms with the education and training institutions and developing community health workers, including a system o f training and accreditation. Formulation of a National Drug Policy to ensure the availability and access to essential drugs in the entire network public health services and the rationalization o f the prescription and dispensation o f medicines Coordination with water and sanitation sector to ensure the provision o f safe drinking water to the population and the safe disposal o f waste. Strengthening the financing and public expenditure management of the health sector to ensure accessibility for the poor by eliminating user charges; to improve public resource allocations to public institutions and regions in line with policy objectives and the health requirements o f the population; and to create mechanisms for social audit and control to promote transparency in the management o f the funds and combat corruption.

The Universal System of Social Protection i s also a priority initiative of the Government and builds on successful experiences in El Salvador and Lat in America. The creation o f the Universal System o f Social Protection (Sistema de Proteccidn Social Universal - SPSU) i s a medium- term objective that aims to provide a minimum standard of social services and economic opportunities

12

to al l Salvadorans. I t i s based on the principles o f citizen’s rights and local governance, among other things. The core o f the initiative w i l l be based on Comunidades Solidarias, a program which builds on the successful experience o f Red Solidaria, the conditional cash transfer (CCT) program for poor families in rural areas launched by the previous Government. The Comunidades Solidarias goes beyond the CCT program and has four areas o f intervention to strengthen local development: (i) human capital development; (ii) provision o f basic public services; (iii) income generation and productive development; and (iv) local governance. In rural areas, the Comunidades Solidarias Rurales focuses on the 100 poorest municipalities and wi l l increase the benefits o f the current CCT program, encourage investment in basic infrastructure (water and sanitation, electrification, schools, and health centers), provide basic pensions to the elderly who are more than 70 years old, coordinate the implementation o f the Programa de Vivienda Piso y Techo, and strengthen the governance capacity o f municipal authorities. The Comunidades Solidarias Urbanas (CSU) w i l l introduce CCTs for education in urban areas, activities for prevention o f youth violence and increasing security, improvement o f social infrastructure in the communities with high concentration o f poverty, worker training, micro-credit and a temporary income support program for unemployed persons.

The further development of the Government’s ambitious medium-term program into operational programs has inevitably been delayed by the economic crisis and the Government’s first priority was to elaborate an Anti-Crisis Plan, which has four major objectives and components. As stated earlier, the Anti-Crisis Plan and overall program o f the Government are broadly consistent. The objectives o f the Plan are to: (i) protect employment and generate new opportunities for work; (ii) protect the vulnerable population from the impacts o f the economic crisis; (iii) initiate the creation o f a Universal System of Social Protection and (iv) begin the construction o f economic and social policies in an inclusive manner. To this end, the program elaborates four components o f work:

46.

0

0

0

0

Support the production and generation o f income and employment Design and launch o f the Universal System o f Social Protection (SPSU) Strengthen Management o f Public Finances Improve the institutional framework for the medium-term development agenda

47. The component supporting productive activities envisages stimulation of small and medium enterprises, infrastructure development and employment generation. As part o f the recovery plan, the Government i s also planning to escalate public sector banking lending through two existing f i rs t tier institutions-Banco Hipotecario and Banco de Foment0 Agropecuario-and through a second-tier institution that would be turned into a f i rst tier bank -Banco Multilateral de Inversiones (BMI).’ However, this strategy w i l l require close monitoring to ensure the financial soundness o f these institutions.

48. This component of the Government Anti-Crisis Plan will also provide state guarantees to enable small and medium enterprises and enterprises in strategic economic sectors to increase access to bank credit. The Government proposes to import fertilizers and other agricultural inputs and distribute them at a reduced cost to small and medium agricultural producers. In 2009, 450,000 agricultural producers in 160 municipalities are expected to benefit, with the number o f beneficiaries increasing to 600,000 in 2010. The Government also plans to expand and improve public services and basic infrastructure, including in water and sanitation, electricity, schools and health centers, as well as infrastructure works to mitigate risks. Finally, the program includes the construction o f housing units for the poor through the extension o f bank credit and subsidies for the purchase o f land. A temporary

* BMI was created to provide medium and long-term resources to the banks. Since dollarization, the commercial banks’ demand for BMI funds declined sharply because they could mobilize long-term resources much cheaper than the cost o f BMI funds.

13

income support, employment and training program targeted at unemployed persons wil l be implemented in 100 o f the poorest municipalities.

49. As a prelude to developing the Universal System of Social Protection, the Anti-Crisis Plan focuses on immediate crisis alleviation measures to ensure that investment in human capital is maintained. These include the provision o f nutrition services in the basic package o f health care services in the 131 municipalities with high levels of malnutrition among children under 3 years o f age; the expansion o f the ongoing school meals program to urban areas, covering al l children from pre- school to grade 9; provision o f uniforms, shoes and school supplies to all children from pre-school to grade 9; the temporary extension o f health services for 6 months to workers in the formal sector who have lost their jobs and who had been previously covered by the ISSS; the elimination o f co-payments (cuotas voluntarias) for public health care services; and the supply o f essential medicines, vaccinations, laboratory supplies and strengthening o f the distribution and maintenance system.

50. The Anti-Crisis Plan also proposes important measures for strengthening public finance and transparency. An Executive Decree including various austerity measures was promulgated in June 2009. As noted earlier, an important element o f the Government’s strategy i s to increase tax collection and rationalize subsidies. These measures signal the interest o f the new Government to ensure continuity o f the country’s traditional sound fiscal policies. The Government has also proposed reforms to the law on procurement (Ley de Adquisiciones y Contrataciones de la Administracidn Pliblica - LACAP) and the establishment of a new law on access to information (Ley de Acceso a la Informacidn Pliblica).

51. The cost of the Anti-Crisis Plan is about US$560 million to be implemented over 2009 and 2010. The Government has already secured financing for about 60 percent o f the cost o f the plan and i s exploring options to finance the remainder. About US$205 mil l ion (1 percent of GDP3) i s expected to be spent in 2009, and if financing i s found for the whole program, the 2010 budget for the Anti-Crisis Plan wi l l amount to about US$355 million. The budget for the Anti-Crisis Plan w i l l be submitted to the Assembly in the form o f an Extraordinary Budget for Social Investment (Proyecto de Decreto conteniendo las Reformas a1 Presupuesto Extraordinario de Inversidn Social - PEIS).

52. The overwhelming share of the proposed expenditure i s on social programs and i s intended to cushion the impacts of the crisis on the poor, while preparing the framework for a system of social protection. A large share o f the spending goes towards the Comunidades Solidarias (including expenditure on vivienda social and basic pension) and another important component towards the provision o f uniforms, school supplies and school meals for children from pre-school level to grade 9. Another significant expenditure w i l l be for expanding health and nutrition services and reducing barriers to health services consumption, through the elimination o f the co-payments and the supply of essential medicines. Most o f the programs w i l l be included as part of the Universal System o f Social Protection, subject to the evaluation o f their costs and results, which the STP intends to conduct on a regular basis. For example, the Government intends to evaluate the expansion o f the school feeding program and the supply o f free uniforms to school children, as the costs o f both programs are substantial. The Temporary Income Support Program, on the other hand, w i l l be phased out after 18 to 24 months, when the most severe effects o f the crisis are expected to have passed.

Nominal GDP in 2009 i s estimated to be US$ 22.1 billion by IMF and MOF.

14

Iv. BANK SUPPORT TO THE GOVERNMENT’S STRATEGY

A. LINK TO THE COUNTRY PARTNERSHIP STRATEGY (CPS)

53. The CPS, presented in parallel with the SSGER DPL, covers the fiscal years 2010-2012 and comes at the beginning of a new political cycle for El Salvador. The CPS provides support to the Government’s program, including i t s Anti-Crisis Plan to address fiscal challenges, focus priority spending and set the stage for a strong recovery. The strategic guiding principle o f the CPS i s to balance the immediate response to the economic and social aspects o f the crisis, while also addressing the longer-tern development challenges - a principle that i s also being applied within this one-tranche SSGER DPL which has been an important entry point to establish a dialogue on medium-term policy actions. The strategic objectives o f the CPS are specifically to: (i) address macro and institutional vulnerabilities; (ii) mitigate the social impact o f the crisis and support the social sectors; and (iii) strengthen prospects for economic recovery. This one-tranche DPL, which i s included in the CPS, supports these objectives and specifically helps close the 2009 fiscal gap while protecting social expenditures and supporting policy actions in education, health and social protection sectors to protect the most vulnerable.

B. COLLABORATION WITH THE IMF AND OTHER DONORS

54. The Bank has been collaborating very closely with the IMF and the Inter-American Development Bank during the preparation of this operation. This collaboration began with the efforts to engage with the new administration. A workshop was organized jointly by the Bank and the IDB and IMF in May 2009, before the new government took office in order to discuss possible areas of support. These coordination efforts have continued since then. Consultation with the IMF has been particularly close in the context o f preparing the review o f macroeconomic development and in the update o f the Debt Sustainability Analysis. Moreover, the proposed DPL program i s consistent with IMF policy advice to the Government regarding how to address the fiscal imbalances that have emerged during 2009. The IDB and the Bank are coordinating their support for the Government’s program, through budget support and investment operations supporting the CSU program and the social protection agenda.

C. RELATIONSHIP TO OTHER BANK OPERATIONS

55. The proposed SSGER DPL i s accompanied by parallel and mutually reinforcing operations. In particular, i t builds on the ongoing Public Finance and Social Sector DPL (Ln.76350-SV), which supports the reduction and subsequent elimination o f the electricity subsidy, by focusing on one o f the largest remaining subsidies, public transport. The f i r s t tranche o f t h i s US$450 mil l ion operation was released on effectiveness in February 2009, and the Government i s on track to meet the second tranche conditions in early 201 1. The mtblic Finance and Social Sector DPL also supports improvements in the social protection and education sectors, in particular, expansion o f the Conditional Cash Transfer Program, Red Solidaria, and improving the coverage and quality o f secondary education. The proposed SSGER DPL complements these actions by protecting critical expenditures in the social sectors, expanding the school feeding program and laying the foundations for better institutional capacity in the social sector line ministries.

56. The Government has made significant progress with the conditions of the Public Finance and Social Sector Development Policy Loan and the Bank is working with the Government to ensure that problems are highlighted ahead of time and corrective actions implemented (Table 4). The only condition related to education i s being discussed with the new Government, given that i t i s in

15

the process o f reassessing the country's education strategy, including programs such as EDUCAME. To the extent that there are important sh i f t s in the country's strategy the fulfillment o f th is condition i s uncertain. However, the Government i s trying to secure the required resources for this action in the 201 0 budget.

Table 4. Public Finance and Social Sector DPL (Ln.76350-SV) Status of the Conditions for Second Tranche Release

The etectricity. subsidy for Ems has been completely

The gwesmnenf has: (a) futtk expanded Red SoMaria

In track

4el

)n track

h track

h track

hi track as 5gardS nphentation o f II: strategy

hder tli5mSsian

h e G ~ m m m ~ t is preparing a ccmprehensirip tax eform proposal that is expected to address the :omponents o f this caadition.

vas expected to reach 100 by September.

%e Goverrnnent if in the process o f secllring the quked resources in the 2010 budget, kmt the b v m e n t is reassessing the country's education trategy including tbe role o f prcigram &e DVC.ME.

57. In addition, the Government and the Bank are preparing a new investment operation, El Salvador Social Protection: Income Support and Employability Project (US$50 million - P117440), which will support the design and implementation of the temporary income program set up under the SSGER DPL. This new investment project w i l l also strengthen the institutional and policy capacity o f the Government to develop inclusive social policies especially on social protection

16

and employment dimensions. Finally, SSGER i s also closely linked to the upcoming US$20 mil l ion technical assistance project on Fiscal Management and Public Sector Performance (PO953 14), which w i l l support capacity development in line ministries, thus building on the institutional capacity pillar o f the proposed SSGER DPL.

D. LESSONS LEARNED

58. One of the key lessons reflected in the CAS Completion Report i s the importance of consensus-building efforts to ensure successful implementation of the program in a politically polarized environment. The process followed in the preparation of th is DPL builds on the successful experience o f the Public Finance and Social Sector DPL, which was discussed and agreed with the main political parties, as approval o f loans with a sovereign guarantee requires a two-thirds congressional majority. Moreover, during the consultation process with Government, legislature and other stakeholders, i t was suggested that presenting to Congress a package o f loans, rather than single loans, would facilitate the approval process. As a result, th is DPL would be accompanied by a CPS and other operations,

59. The CAS Completion Report also finds analytical work to be an extremely important tool to identify gaps in specific sectors, inform stakeholders, build consensus around important development issues and prepare the groundwork for future engagement in areas of mutual interest. Experience in El Salvador has shown that the Government greatly values the range o f global expertise the Bank can bring to complex development issues. The extensive analytical work o f the last 12 months to prepare Policy Notes on Education, Health and Social Protection sectors and an ongoing Public Expenditure Review underpins the proposed DPL.

60. Additional lessons from good practice have been elaborated in Box 1.

17

Box 1. Good Practice Principles for Conditionality

Principle 1: Reinforce Ownership. The operation supports the Government’s request to assist El Salvador during the financial turmoil and global economic slowdown. This operation supports specific programs and areas which are reflected in the Government’s Anti-Crisis Plan. The administration, although new has been working closely with both political parties to ensure support for this operation. The focus areas for the SSGER D P L were selected through sustained policy dialogue, based on extensive analytical work, which began with a two-day meeting (Encerrona ) in early M a y 2009 between the multilateral agencies and the transition team o f the new Government, before the new administration formally assumed power.

Principle 2: Agree up front with the Government and otherfinancialpartners on a coordinated accountability framework. The Bank’s support i s summarized in a brief and focused policy matrix, agreed with the Government, which provides the accountability framework for the operation. The DPL i s consistent with the IMF’s policy advice.

Principle 3: Customize the accountability framework and modalities of Bank support to country circumstances. The Ministry o f Finance has indicated that i t intends to fill i t s multilateral “budget support” needs through the proposed SSGER D P L operation, complementing the current DPL operation and the investment lending portfolio o f other donors and the Bank. The selected policy actions develop the ideas of the Government’s social agenda and the Anti-Crisis Plan and are based on the work being done in the technical line Ministries and agencies. Accordingly, the specific actions and intended outcomes enjoy technical and political support in their respective sectors. The relevance and soundness o f said actions have been assessed through the Bank’s analytical work and follow-up activities.

Principle 4: Choose only actions critical for achieving results as conditions for disbursement. The prior actions form part o f an agreed accountability framework that focuses on the Government’s critical actions for achieving the program objectives. The operation supports three complementary policy areas and the policy matrix has been limited to a number o f actions considered necessary to maintain coherence o f policy dialogue and benefit from complementarities toward the intended outcomes.

Principle 5: Conduct transparent progress reviews conducive to predictable and performance-based financial support. The approach and the timing o f the planned disbursement respond to the Government’s stated financial needs. The MOF wi l l exercise leadership in coordinating the monitoring and evaluation o f the arrangements.

E. ANALYTICAL UNDERPINNINGS

61. The actions supported by the DPL have been assessed through the analytical work of the Bank and the Inter-American Development Bank. In addition, prior work done by the Bank on education and health in Central America also highlights the main policy issues and provides recommendations. The substantial body o f work has provided the basis for an in-depth dialogue with the new administration and has supported the design o f the DPL. Table 5 shows the links between the prior actions in the DPL and the recommendations included in recent analytical work.

18

Table 5. Prior Actions and Related AAA work

Review (in progress; FY10)

Central America Education Strategy - An Agenda for Action (FY 2005)

I

Key Issues in Central America Health Reforms: Diagnosis and Implications ( ~ ~ 0 7 )

Education Strategy - An Agenda for Action (FY 2005) and Policy Note on Education in El Salvador: Striving for More Quality wi th Less Inequality (in progress ;FY09)

Key Issues in Central America Health Reforms: Diagnosis and Implications ( W 0 7 )

price subsidies on electricity, gas, water, and transport. Price subsidies have proven to be a burden on the Government’s budget and have adverse effects on the country’s fiscal position. In general, poor households in El Salvador have less access to services, consume less, and therefore benefit less from the existing subsidies. Reducing subsidies i s therefore likely to generate fiscal space for social expenditures without worsening the position o f the poor.

Most Central American countries, including El Salvador, spend less on education than other countries with similar per capita income. The vast majority goes to fund teachers’ salaries, leaving little for teacher training and classroom materials. In El Salvador, non-salary recurrent expenditures represent less than 15 percent o f the education budget (after excluding grants to community schools (EDUCO schools) which finance salaries o f community teachers. Improving budget allocations towards higher shares o f non-salary recurrent costs in order to procure teaching-learning materials w i l l help address the challenge o f ensuring universal primary completion.

About 70 percent o f M O H recurrent expenditures are personnel costs, the balance going to finance goods and services. In hospitals, about 40 percent o f the budget i s for non-personnel expenditure. These allocations finance medicines, medical and laboratory supplies that are critical for the provision o f services.

a key reason for children not completing primary education. A family in the lowest income quintile would have to spend over a third o f its annual income to keep two primary level children and one secondary level child in school. Broad supply-side interventions to eliminate school fees and provide free textbooks and uniforms for poor primary school students can offset some costs. Demand-side interventions should include subsidies for covering opportunity costs.

In El Salvador, about one-quarter o f the poor and one-third o f the extreme poor reported that they did not seek care from public health facilities due to out-of-pocket payments (OPP). Most o f these expenditures are on consultation fees, general hospitalization costs and medicines. Although an Executive Decree was issued in June 2002 to eliminate payments to public health centers, fees continued to be charged to supplement public resources. User fees need to be reformed to ensure that they exclude no one on the basis o f their ability to pay.

Links to DPL Prior Actions 1.a

1.b

1.b

2.a

2.b

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Policy Note on Youth Employability and Economic Opportunities in El Salvador (in progress; FYO9)

Policy Note on Income Vulnerabilities and Poverty in El Salvador (in progress; €9’09)

Republic of El Salvador Country Economic Memorandum (2003; Vols 1 and 2)

Health Policy Note (in progress; N 1 0 )

The increase in the younger population in El Salvador has raised the - _ _ importance of policies for youth development. Constraints in accessing secondary and higher education, however, have directly affected the labor market prospects for the youth. Introducing “new generation” temporary employment programs with training components (in occupations or l i fe sk i l ls ) will contribute to a higher skil led labor force.

Interventions to protect the incomes of the most vulnerable households in the context of a global and local economic slowdown, falling remittances, massive job cuts and reduced prospects of employment opportunities abroad for immigrants are necessary to protect the human welfare of vulnerable Salvadorans. Setting up other social safety nets including workfare programs, social funds, and training programs with a clear emphasis on urban areas i s important for protecting incomes.

2.c

2.c

engineering formation who have the sk i l l s for technological innovation and can create or adapt new technologies. The report recommends an

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V. THE PROPOSED PROGRAM

A. OPERATION DESCRIPTION

62. The SSGER DPL is designed as a single tranche operation to support the Government’s Anti-Crisis Plan and elaboration of its medium-term development agenda, and wil l serve as a bridge between the ongoing DPL and a possible programmatic DPL series in F Y l l and FY12. As described in paragraph 55, the proposed operation complements and builds upon the ongoing Public Finance and Social Sector DPL (Ln.76350-SV) by helping the Government to reduce or re-target main public subsidies. At the same time, the proposed SSGER would serve as a stepping stone towards a future programmatic DPL series which the Government has requested and, subject to the availability o f IBRD funds, the Bank intends to support. A single tranche operation i s an appropriate instrument to address the immediate needs o f the Government’s Plan while the new administration completes the preparation of i t s medium-term development strategy. The policy and institutional framework supported by the SSGER DPL wi l l also enable the Bank to provide the policy guidance and advice that the Government has sought.

63. The SSGER DPL i s constructed around three pillars, drawn from the most important elements of the Government’s general program and its Anti-Crisis Plan in particular, that will protect the social gains made in the past decade and reinforce the framework for economic recovery. These three pillars are: (i) protecting fiscal space for social expenditures; (ii) protecting income and consumption o f the vulnerable population; and (iii) strengthening the institutional capacity for policy formulation and implementation in the social sectors for economic recovery. While the Government’s Anti-Crisis Plan i s wide-ranging, the SSGER DPL selectiveIy supports specific and critical policy actions, focusing on those with the greatest immediate impact on the poor and vulnerable sections and institutional strengthening.

64. A negotiated policy matrix i s attached in Annex 2 and includes prior actions for the SSGER DPL. These actions and baseline as well as target values o f the expected outcome indicators were discussed and agreed during the preparation o f the operation with the Government, including the Ministry o f Finance and sectoral Ministries/agencies.

B. KEY POLICY AREAS

Pillar 1 - Protecting fiscal space for social expenditures.

65. In El Salvador, as in other countries, subsidies constitute an important part of social spending. The most important subsidies are for electricity, liquid petroleum gas, transport and water. In 2008, subsidies to basic services cost US$420 mil l ion (about 2 percent o f GDP), compared to spending in health in education, which was US$365 mill ion (1.65 percent o f GDP) and US$635 mil l ion (2.87 percent o f GDP), respectively. Although subsidies are not the best way to address equity issues, their complete elimination in the absence o f well-developed safety nets would have negative consequences for the welfare o f the poor. This i s all the more so in a situation o f economic crisis, when the poor face downward pressures on their incomes.

66. Nonetheless, the Government i s committed to reform the system of untargeted subsidies, continuing the program initiated under the Public Finance and Social Sector DPL (Ln.76350-SV) with the previous Government. Under this operation, as a prior action for the release o f the first tranche, the previous Government reduced electricity subsidy for f i rms. The elimination o f th i s subsidy for f i rms, which i s expected to yield savings of 0.4 percent o f GDP, i s a prior action for the release o f the second tranche. Prior to coming to power, the current Government agreed to these actions. This was later confirmed when the current administration included the reduction o f the cost o f subsidies as a critical element o f the Anti-Crisis Plan.

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67. The SSGER DPL extends the policy framework of the Public Finance and Social Sector DPL by supporting further actions to reduce the cost of another untargeted subsidy and releasing f iscal space for protecting critical expenditures in the social sectors. This operation focuses on the reduction o f the cost o f the transport subsidy. I t also contributes to the medium-term outcomes o f the Public Finance and Social Sector DPL, namely, the reduction o f untargeted public subsidies by 40 percent in 201 l(with respect to 2008).

Policy area la : Reduction of the public transportation subsidy

68. The current public subsidy to urban and inter-city passenger transport i s poorly targeted and costly. This subsidy was established in November 2007 to stabilize the price o f public transportation, which would have otherwise increased as a result o f the rising petrol prices. Since i t s implementation, the monthly lump-sum transfer paid to registered buses and microbuses, although not directly tied to changes in diesel prices, has increased with the increasing prices. For instance, in July 2008, after o i l prices rose sharply, the Government doubled the subsidy to US$800 for buses and US$400 for microbuses and it remained at this level even though diesel prices started declining from September 2008. Funding for this subsidy i s partly based on taxes o f US$O.lO per gallon o f diesel and gasoline. The current subsidy has an annual cost o f US$ 84 mil l i~n.~ However, because the subsidy i s so poorly targeted, the benefits rarely protect vulnerable households. The subsidy does not consider the number o f passengers being transported, the distance traveled, diesel consumed or access to transport, which i s actually less in urban areas than in rural areas.’

69. Prior action: The Government has reduced the Public Transportation Subsidy by means of a legislative decree, effective August 1, 2009. In July 2009, the Government originally proposed the elimination o f the transport subsidy; however, as a f i rs t step, the Government negotiated with the bus operators to lower the subsidy to US$500 a month for buses and US$250 a month for microbuses, which equates to around 38 percent from i t s current level o f US$84 mil l ion a year. The reduced tariff w i l l last 18 months, at which point the Government w i l l revisit the subsidy. The complete elimination could not be done th is year without raising ta r i f f s for consumers.

70. Over the medium term, the GOES intends to review and rationalize the transport subsidy, including the option of completely eliminating it and thereby saving an additional US$50 million every year. The administrative costs o f supervising the implementation o f the subsidy are high relative to the benefits. Regulations require that vehicles operate 25 days a month and make 7 daily trips, and it i s difficult to ensure compliance with over 12,000 buses and microbuses.

Policy area lb: Protect critical non-personnel recurrent expenditures in the social sectors and critical investments in the health sector

71. The quality of education and health services is likely to deteriorate unless expenditures on educational supplies, medicines, laboratory materials, and other equipment are maintained. Evidence from previous crises indicates that cutbacks in these expenditures,’ due to the rigidity o f personnel expenditures, has a long-term impact on educational quality and a more immediate impact on health outcomes (for instance, reduced vaccinations, preventive and curative services due to lack o f medicines or laboratory tests). In the case of education, non-personnel expenditures also include transfers to community schools (EDUCO) for paying teachers’ salaries. Protecting these expenditures therefore ensures the continuation o f education services to poor and rural areas where EDUCO operates.

Public Expenditure Review, El Salvador. 2009. “Draft Chapter 3: Subsidies in El Salvador and the Protection of the Poor” written by Luis Tejerina, IADB. World Bank Report (draft, in progress). Washington, D.C. Ibid.

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Further, i t i s necessary to protect investments in the health sector to ensure the availability o f medicines at hospitalsklinics in rural areas where the population continues to be without critical medical services.

72. Prior Action: The Government has: (a) maintained non-personnel recurrent expenditures in i t s education and health sectors for fiscal years 2009 and 2010, at least at fiscal year 2008 levels; (b) ensured that critical investment expenditure contemplated for hospitals in its Draft General Budget 2010 represents at least 39 percent of the investments budgeted for hospitals in its General Budget 2009; and (c) executed, by August 31,2009,48% of the 2009 investment budget for public hospitals. The execution rate o f the non-personnel recurrent and the investment budget as o f August 31, 2009 reflects the protection o f the budget in 2009. For 2010, the Government w i l l protect these resources through the draft Decree which reforms the Extraordinary Program o f Social Investments for 2009-2011 and the Draft General Budget for 2010 to be presented to the Legislative Assembly (See Annex 5).

73. While these short-term measures are appropriate in the current critical situation, the Government i s conscious of the need to incorporate medium-term planning and budgeting framework in the sectoral Ministries. While sector strategies have been prepared (or are under preparation), they do not present the costs broken down by investment and recurrent expenditure. The criteria for making the necessary trade-offs and prioritization have also to be developed. The proposed El Salvador Fiscal Management and Public Sector Performance Technical Assistance Loan, which i s also being concurrently presented to the Board, w i l l provide assistance to develop a multi-annual framework for the budget.

Pillar 2 - Protecting income and consumption of the vulnerable population

Policy area 2a: Expansion of School Feeding program to urban pre-schools and basic schools

74. School feeding programs have proven to be successful in increasing school attendance and the students' ability to concentrate in class. These are important and necessary to increase access to public education, particularly in times o f economic crisis. The private costs o f schooling are cited as an important reason for non-attendance and completion in El Salvador and the Government intends to provide free textbooks and uniforms, in addition to free school meals. In 2008, the GOES assumed the full responsibility o f the financing o f the school feeding program, originally financed by the World Food Programme. As o f June 2009, the school feeding program reached nearly 876,500 students from pre- school to the end o f basic education (end o f grade 9) in rural areas (all school centers with the adequate facilities for storage and preparing meals are eligible).

75. Prior Action: As of August 31, 2009, the Government has expanded the School Feeding Program to cover additional 764 public schools and 452,800 more students between preschool (ages 4-6 years) and the end of basic education (1S'-9th grade), compared to a baseline of 857,400 students as of 30 June 2009. The expansion o f the program began in August 2009 and the total coverage i s expected to reach 1.3 mill ion students, or an additional half a mil l ion students (the program w i l l continue to grow slightly in 2010 to include some schools in urban areas, which could not be included th i s year). The program with the expansion for the last third o f the school-year 2009 i s expected to cost US$27.9 mill ion in 2010.

76. Over the medium term, the Government wil l evaluate the benefits of continuing a universal School Feeding Program with significant budgetary costs. The STP, which i s in charge o f the Anti- Crisis Plan, intends to carry out th is evaluation at the end o f the two years.

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Policy area 2b: Ensuring access to health services for the poor

77. The system of co-payments (cuotas voluntarius) in public health institutions (medical centers and hospitals) was meant to provide them with additional funds to purchase essential medicines, supplies and maintenance in prompt and timely basis. Receipts from patients were retained by the centers and hospitals and did not accrue to the general revenues o f the Government. Although the revenue from this cost recovery has not been substantial relative to the total budget o f the MSPAS (approximately US$10.1 mil l ion for 2008, or less than 5 percent o f the Ministry’s budget), there i s strong evidence that the co-payments had a negative impact in the utilization o f health services by the poor due to the absence of a targeting scheme in the health centers. Even prior to the economic crisis, payments in public health facilities prevented about one-quarter o f the poor and one-third o f the extreme poor from seeking health care when they were sick. According to household survey data for 2007, households spent on average US$90 per capita during the year. Although these expenditures include those on private health clinics and medicines, co-payments constitute a significant proportion o f private expenditure. For a single episode requiring attention in a hospital, an individual could end up paying US$40 in public hospitals. In an economic downturn, these payments w i l l further lower the demand for health services by the poor.

78. The Ministry of Health abolished these co-payments in June 2009 through an instruction to the health establishments. Every hospital and health center prepared an action plan for the year and estimated the amount that would have been collected from voluntary co-payments. This information was utilized by the MSPAS to estimate the loss o f revenues o f those centers and to request additional budget from the Ministry o f Finance to maintain the quality o f services.

79. Prior action: The Government has eliminated existing co-payments for services offered by public health facilities and has provided supplemental funds to the MSPAS to compensate fully for the resulting loss of revenue. The Government w i l l issue: (i) a Decree to prohibit the levying o f these copayments by any type o f medical establishment under the MSPAS and (ii) a Decree modifying the Reglamento General de Hospitales del MSPAS, to forbid the copayments. To compensate for this loss o f revenue to the public health system, by August 31, 2009, the Ministry o f Finance has authorized to transfer around US$3.1 mil l ion to the MSPAS. For 2010, the M O F wi l l transfer about US$10 mill ion to the extraordinary budget o f the MSPAS, through a specific line item called “compensation to fees paid by patients.”

80. This measure will lower barriers to utilization of public health services by the poor and raise demand. The MSPAS anticipates a 30 percent rise in demand for public health services and a 10 percent increase in hospital discharges, which w i l l be partly met by the six new and rehabilitated rural hospitals funded by the Bank (Earthquake Emergency and Reconstruction and Health Services Extension Project (Ln.76350-SV) that w i l l become operational in 2010.

81. However, over the medium term, additional policy measures on financing are required to sustain quality and forestall the rise of informal, unregulated payments. Experience shows that unless a viable system o f financing i s put in place for hospitals and medical centers, the lack o f resources generates perverse incentives. Over the medium term, the MSPAS wil l need to generate additional resources through improving management efficiency and protecting budget o f essential expenditures such as medicines, medical supplies and maintenance o f medical equipment in hospital networks.

Policy area 2c: Protecting income of the poor

82. The economic crisis has hit the country in several ways. During the f i rs t f ive months o f 2009, exports shrank by 16 percent. A steep fall in remittances in 2008 and 2009 has increased income vulnerability due to the high level o f dependence on these transfers. Job losses have been substantial.

24

Between September 2008 and April 2009, more than 30,000 formal jobs were lost and this number may reach 90,000 by the end o f 2009.

83. This situation has affected the urban population disproportionately, in particular the youth, as well as women. In 2007, young people (between 15 and 24 years o f age) made up 20 percent of the overall population and 32 percent o f the working-age population (ages 15-65 years). Around 63 percent o f the youth l ive in urban areas (28 percent in San Salvador). However, less than 25 percent of youth between 20 and 30 years o f age had access to formal salaried employment. Unemployment incidence and duration remain greatest among those with less than basic education.6 In the context o f the crisis, the number of unemployed young people i s expected to increase by 2-3 percentage points, representing roughly 15,000 additional young people each year. The crisis has also generated unemployment among urban women who constituted most o f the workforce o f the export-oriented maquilas.

84. Rising youth unemployment i s likely to contribute to violence and risky behaviors, which are already having a profoundly negative impact on the society. El Salvador has the highest homicide rate among young people (176 cases per 100,000 young male population- data from 2005) in Latin America and the highest teenage pregnancy rates (around 14 percent o f Salvadoran females report an early birth- women aged 15-19 aged years- data from 2006).

85. In response, the Government has prepared a program of income support through temporary employment in the poorest urban communities, as part of the Comunidades Solidarias Urbanas. The Temporary Income Support Program (Program de Apoyo Temporal a1 Zngreso - PATI) i s a flagship program o f the Government, which was launched in 2 municipalities in September 2009. The program i s part o f the CSU, which aims to promote an integrated development o f extremely poor urban areas to improve the l iving conditions and create opportunities for growth o f individuals, families and communities (see paragraph 45). The main objectives o f the PATI are to: (i) provide income support to the poor and unemployed population, in particular youth and women (ii) augment human capital development through training; (iii) strengthen the role o f the municipalities in designing and delivering the program; and (iv) encourage participatory processes in selection o f beneficiaries and monitoring o f implementation. The criteria for selection give preference to new entrants into the labor market, those who have recently lost jobs, and women. Intended as a temporary program, it i s expected to last two years, up to early 2012.

86. The Temporary Income Support Program marks a departure from traditional social assistance and public works programs and involves the coordination of several institutional actors to meet program objectives. The design elements include appropriate targeting, criteria for selection of beneficiaries, capacity development o f municipalities and other actors, funds flow and monitoring and evaluation. The program design uses a two-stage targeting mechanism. At the f i rst stage, the poorest municipalities are selected based on a poverty map. At the second stage, the targeting o f eligible beneficiaries i s mainly through self-selection, by setting the wage at about the minimum wage level in rural areas. A minimum education qualification level o f 9 years o f schooling i s set in order not to create incentives for dropping out from school. Those who have not completed 9 years o f schooling w i l l need to go through the non-formal education called EDUCAME. Selected beneficiaries have to participate in community projects and training to receive income support. The design i s intended to deliver income support to the poor more rapidly than traditional public works program for creating infrastructure. A welcome feature o f the design i s the inclusion o f the training component which ensures that, unlike other simple emergency workfare programs, there i s medium and long-term investment in building human capital. Further, the training combines training in generic, transversal s k i l l s as well as job specific ski l ls . The program expects to cover about 40,000 beneficiaries in 43 municipalities, covering 35 percent o f those households l iving under extremely precarious conditions in those municipalities.

Policy Note on “Youth Employability and Economic Opportunities in El Salvador.” 2009. The World Bank Group

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(draft- in progress).

87. The delivery of the program, as part of the CSU, requires a legal framework to secure coordination across agencies and Ministries of the Government and with municipalities. The legal framework lays out the responsibilities o f the STP, as overall coordinator o f the program, the FISDL as the main implementing agency and the municipalities as partners.

Box 2 - The Temporary Income Support Program What the program jnances: Temporary income support (PATI) to the vulnerable population in urban areas, in exchange for their participation in training and community service activities. Types of activities: Social and community services such as childcare, sports and youth activities, improvement of public spaces; and specific training modules to enhance employability o f participants. Targeted municipalities: Large municipalities with high concentration o f urban poor communities (asentamientos). Selected using the criteria o f the urban poverty map o f UNDP and violence indicators. Eligible beneficiaries: Urban poor - particularly youth and women, especially female household heads that may be disproportionately affected by the economic slowdown. Amount of payment per benejciary: US$lOO per month, totaling US$600 at the end o f six months. This wage level w i l l promote self-selection o f the poor. Implementation mechanism: The program wi l l be executed by the Social Fund (Fond0 de Inversidn Social para el Desarrollo Local - FISDL) under the strategic coordination o f the STP. Municipalities from identified areas from the urban poverty map (UNDP, 2009) wi l l submit proposals for PATI activities supported, including nature of activities, duration, co-participation through material and tools, number o f participants, and type o f training. Design o f training packages would be required for al l eligible activity proposals. Most training activities would be carried out through the network o f training institutions certified b y INSAFORP, the public sector institution which regulates and accredits technical training. Payment to beneficiaries would be centralized b y F ISDL through field verifications from the municipalities, while the training providers would be paid by FISDL through INSAFORP. Monitoring and evaluation: The STP in coordination wi th FISDL w i l l monitor the program implementation and evaluate results in an articulated fashion with that M&E system being developed at the STP. An impact evaluation funded b y the Spanish Impact Evaluation Fund i s also planned. Participatory processes: All proposals to be prepared by Municipalities would respond to the demands from the community and the advice o f training experts. Municipalities, in coordination with local communities, w i l l decide on a l i s t o f eligible participants based on specific criteria for eligibility. Program phasing: The Government launched the program in two municipalities in September 2009, with expansion to 11-13 municipalities in March 2010 and 40 municipalities at the end o f 2 years.

88. Prior action: The Government has established the program Comunidades Solidarias, of which the Temporary Income Support Program is part of i ts urban intervention, and has set forth the legal and operational framework for i t s implementation. The program i s envisaged to come to an end in two years, but the lessons of the program w i l l serve to put in place income support mechanisms in the future. Over the medium term, municipalities are expected to have capacity to initiate local development and social protection programs.

Pillar 3 - Strengthening institutional capacity for policy formulation and implementation in the social sectors for economic recovery

Policy area 3a: Strengthening institutional capacity and policy-making in the Ministry of Education

89. Construction of policies for the long-term economic and social development of the country i s one of the Government’s top priorities. The Government has launched important initiatives, including the creation o f an Economic and Social Council, to initiate a national dialogue for the

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development o f a medium term strategy o f development. Consultations with business and civi l society have begun on a regular basis, led by the STP. Line Ministries are undertaking re-organizations to improve their ability to design and implement medium and long-term policies. The SSGER DPL wi l l focus on actions that are critical for strengthening institutional capacity in education, health, and social protection.

90. Education: The MINED’S new organizational structure supports its emphasis on improving quality, giving a prominent role to the development of science and technology education and research, and encouraging decentralization. In undertaking th is re-organization, the Ministry wi l l make maximum use o f existing capacity and knowledge o f the personnel and technical teams already in place, while re-assigning personnel where necessary in line with the new structure. Specifically, i t focuses on:

creating posts o f Vice-Minister for general education and Vice-Minister for science and technology (the latter has a transversal responsibility across levels of education), identifying areas under the direct responsibilities o f the Vice-Ministers, assigning corresponding units to each Vice-ministry according to the new academic, technological, and cultural emphasis supported by the GOES’S education policy;

strengthening and redefining the role o f the Central Directorates o f the Ministry in key areas essential to adequately inform and support decision-making and policy guidance such as: (i) planning (strategic planning, project and external cooperation, monitoring and evaluation and statistics); (ii) legal advice; (iii) internal audit and (iv) communication;

decentralizing to the Education Departmental Directorates (Directores Departamentales de Educacidn - DDEs) the functions related to pedagogical support, monitoring o f quality and student learning achievements, as well as regular administrative and management tasks

91. Prior Action: The Government has created a Vice-Ministry for Science and Technology within the Ministry of Education. The following six key strategic lines have been identified by the Vice-Ministry over the 2009-14 period to upgrade the quality o f science and technology education in line with international standards: (i) to update and increase the availability o f computers and access to internet in all education centers in the public sector; (ii) to strengthen the competencies and s k i l l s o f school directors and teachers alike in pedagogical use o f information and communication technologies; (iii) to develop and expand the equipping o f scientific laboratories in the education centers in the public sector; (iv) to strengthen and expand programs for the training o f talented youth to support the country’s scientific and technological developments; (v) to adapt the curriculum for technical education in upper secondary and higher education to develop professional competencies and ski l ls , to meet the needs o f the productive sectors and the future development o f El Salvador; and (vi) to promote and support scientific investigation in higher education to contribute to knowledge generation. The Government also proposes to create a Fund for Innovation and Technological Development, which wil l promote alliances between different stakeholders in the innovation and research system o f the country.

92. One significant expected outcome of this institutional strengthening i s an assessment of the relevance and quality of science and technology curriculum and teaching, specifically at the secondary education level, which i s a priority of the Vice-Ministry. Based on the findings and recommendations of t h i s assessment, new content for the teaching o f science and technology and pilot programs for the retraining o f teachers in science and technology w i l l be developed in 2010. The introduction o f other policy measures requires careful prioritization and further detailing o f the strategic plan in order to ensure that scarce resources are used efficiently. Over the medium term, the Government intends to launch the implementation o f the reform o f science curriculum in secondary schools.

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Policy area 3b: Strengthening institutional capacity and policy-making in the Ministry of Health

93. Health: Extending basic health care services to all sections of the population is a policy priority of the government. This has been done through the implementation o f various programs aimed at providing basic health care services to poor and isolated rural populations, especially women and children. Since 2005, the MSPAS embarked on an innovative approach using two different strategies o f extension o f coverage: (i) contracting o f NGOs to deliver the basic health and nutrition package in coordination with the MSPAS health units and (ii) public-public contracting, commonly known as institutional strengthening o f MSPAS health units, to deliver the basic health and nutrition package through mobile teams comprising public personnel. To date, over 650,000 people have benefitted under this program in the North and Oriental regions in 59 municipalities in the poorest areas o f El Salvador. The provision o f these services was financed under the Bank's project Earthquake Emergency and Reconstruction and Health Services Extension Project (Ln.70840-SV). Since 2009, the GOES has financed th is strategy with i t s own funds.

94. The MSPAS intends to continue these efforts to ensure coverage of this population through the creation of an integrated network of health care services, which will also address the fragmentation in the health sector, based on an Integrated Health Care Model. The MSPAS aims to form a network between the various service providers and various forms o f insurance mechanisms in order to extend coverage o f health services to all individuals. The MSPAS has acknowledged the effectiveness of the contracting o f NGOs to deliver health care services in a context of limited public networks in the rural and remote areas. However, i t also considers i t necessary to include both public health centers and NGOs to deliver services in rural and remote areas in order to promote efficiency at the health center level. The MSPAS proposes to consolidate all the experiences o f rural health services coverage through an Integrated Health Care Model (Modelo de atencio'n integral de salud, MAIS). The integrated health care model i s an approach to provide continuous health care to the population with special focus on the family health, and i s based on a collaborative care approach involving health services and community participation. I t consists o f the provision o f health care directed to the individual and family health, rather than to specific health intervention or illness.

95. Prior Action: The Government has created a Vice Ministry of Health Sector Policy and a Vice-Ministry of Health Care Services within the MSPAS. In particular, the Vice Ministry o f Health Sector Policy w i l l strengthen the design, implementation, and oversight o f health care policies, including the development and definition o f the Integrated Health Care Model. The Vice Ministry o f Health Care Services w i l l focus on improving the quality and access o f health care services through the creation o f the network o f integrated health care services including prevention, promotion and general health care.

96. One expected outcome of this institutional strengthening i s the expansion of the coverage of health services through the Integrated Health Care Model for poor people in the 80 poorest municipalities. This wil l require the MSPAS to continuously monitor the provision o f health services through the networks of public and non-government health providers.

Policy Area 3c: Strengthening institutional capacity for policy planning in social protection

97. Social Protection: The design of the Universal System of Social Protection i s a core policy objective of the Government. The SPSU envisages coordination in the provision o f a variety o f social services for an integral development o f families and communities through a partnership between the state, the municipal governments, the labor market, and the community. Specifically for the population l iving in extreme poverty and social exclusion, the Government proposes to create the program o f Comunidades Solidarias. In rural areas, the program wi l l build on the experience o f Red Solidaria, the Conditional Cash Transfer program. However, for urban areas, the program needs to be designed. Two key instruments in the design of the SPSU wi l l be the creation o f a Registry of Beneficiaries in order to

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coordinate social programs and optimize the use o f resources as well and a sound system o f monitoring and evaluation to assess the efficacy o f interventions.

98. Prior Action: The Government has re-organized the STP to coordinate social policies. The STP has been given the mandate for social policy planning for coordination across social sector Ministries. This w i l l be supported by the design o f technical instruments and capacity development o f staff responsible for designing, implementing, monitoring, and evaluating social policies. This capacity development w i l l be supported by the Bank’s El Salvador Social Protection: Income Support and Employability Project (P117440).

99. An expected outcome of th is is the piloting of the CSU in two municipalities. The implementation o f the pilot would reflect the ability o f the STP to conduct analysis of the factors leading to urban poverty and the design, implementation, monitoring, and evaluation o f coordinated multi-sectoral interventions.

100. The following table summarizes the links between policy actions supported by the SSGER DPL, their outcomes, the medium-term Government program and the CPS target outcomes (see Table 6).

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e I I s

vi

f

A

a E 0 0

I

8 x 8

2

VI. OPERATION IMPLEMENTATION

A. POVERTY AND SOCIAL IMPACTS

101. The proposed operation i s expected to have significant positive distributional effects by supporting the Government’s efforts to protect social spending levels with a special focus on the most vulnerable population. Pro-poor actions in the social sector, including protecting incomes o f the poor, eliminating health co-payments, and implementing school feeding programs, are specifically designed to promote poverty reduction or at the very least prevent deterioration during the crisis. Recent analytical work, including the ongoing PER and Policy Notes in Education, Health, and Social Protection suggest that the distributional impacts o f some o f the above actions supported by this DPL w i l l be positive. In addition, since the reduction o f the transport subsidy w i l l not lead to higher tariffs for consumers, this measure w i l l not have any immediate social effects. In the medium term, options for reforming the subsidy regime in the transport sector w i l l need to take into account possible distributional effects o f these changes and include a public communication campaign to ensure their political and social sustainability.

B. CONSULTATIONS

102. The Government’s program and the preparation of the SSGER DPL have been based on extensive consultations with political and civil society actors. Taking into account the political context, the background for Bank involvement, and the r isks associated with the design o f th is operation, the Government and the Bank have invested in a substantial consultation process with political actors, including the policy teams o f the FMLN and ARENA. In addition, discussions have been held with a wide range o f civi l society organizations including think tanks, and private sector representatives. These discussions have covered the Government’s Anti-Crisis Plan, the CPS, the proposed SSGER DPL, the proposed El Salvador Social Protection: Income Support and Employability Project, and the proposed El Salvador Fiscal Management and Public Sector Performance TA Project. Specific laws, institutional reforms, and programmatic actions supported by these operations w i l l be discussed with different groups including the Consejo Econdmico y Social, which i s made up o f delegates from c iv i l society, the private sector, representatives from the Government, and the academic community. The proposed SSGER DPL w i l l be discussed with members o f Congress from both major political parties. The Bank Country Office has also established permanent communication mechanisms with such stakeholders and political players in order to make sure all parties are properly informed o f the objective and scope o f the operation and thus facilitate i t s domestic discussion and dissemination.

C. ENVIRONMENTAL ASPECTS

103. The specific actions supported under the proposed DPL are not likely to have significant positive or negative effects on the country’s environment, forests, and other natural resources. In particular, measures to protect income and consumption o f the poor are not expected to have significant environmental effects, and since the reduction o f the transport subsidy w i l l be achieved without raising tariffs, i t i s not expected to have any environmental effects either.

D. IMPLEMENTATION, MONITORING AND EVALUATION

104. The Ministry o f Finance (MOF) i s responsible for the implementation o f the DPL as well as for coordinating actions among the concerned line ministries/agencies including, in particular, the Central Bank, Ministry o f Education, Ministry o f Health, the Vice Ministry o f Transportation and the Technical Secretariat o f the Presidency. Together with the Ministry o f Finance, these ministries/agencies wil l collect the necessary data to assess implementation progress and report i t to the Bank, taking into

32

account both process advances and service statistics, survey and other data that might be used to assess the achievement o f the program’s end outcomes.

E. FIDUCIARY ASPECTS

105. El Salvador’s fiduciary environment for DPLs is adequate. As part o f the Government’s overall long-term focus on public sector modernization, significant improvements in the performance o f budget and procurement management institutions have been made over the past one and a half decade. In April 2009, a PEFA assessment was completed with financing o f the European Commission and with participation o f the World Bank. The overall finding indicates that the general PFM environment i s solid, with a good performance in most o f the dimensions covered by the PEFA methodology, and the Government has completed successfully the PFM reform initiated ten years before. However, the report indicates that there are some shortcomings that affect the general efficiency o f the system and recommends a second generation of reforms for further strengthening o f the following areas: (i) the linkage between policy planning and budgeting and (ii) the auditing and external control mechanisms and credibility. In connection with this, and as part o f the El Salvador Public Finance and Social Sector DPL, the Bank i s engaged in public financial management dialogue with the Government to follow up on recommendations made through the CFAA and CPAR.

F. DISBURSEMENT AND AUDITING

106. The proposed loan will follow the Bank’s disbursement procedures for development policy loans. The untied finances w i l l be disbursed against satisfactory implementation o f the development policy program and not tied to any specific purchases. Once the loan credit i s approved by the Board and becomes effective, the proceeds o f the loan w i l l be deposited by IBRD in an account designated by the Borrower and acceptable to the Bank at the Central Reserve Bank o f El Salvador at the request of the Borrower. The Borrower shall ensure that upon the deposit o f the Loan into said account, an equivalent amount i s credited in the Borrower’s budget management system, in a manner acceptable to the Bank. The Borrower w i l l report to the Bank on the amounts deposited in the foreign currency account and credited to the budget management system. Amounts refunded to the Bank upon such request shall be cancelled. The administration o f this loan w i l l be the responsibility o f the Ministry o f Finance.

107. The Central Reserve Bank of El Salvador is the financial agent of the Government. At the conclusion o f writing this project document, the latest IMF Safeguards Assessment performed in 2009 i s not available. However, the Central Bank publishes i t s Annual Financial Statements with an audit opinion provided by the Banking System Oversight Office (Superintendencia del Sistema Financiero). The opinion provided was clean for the last two years. Based on a review o f external audit reports, nothing came to the attention o f the Bank that would indicate that the banking control environment into which the loan proceeds w i l l f low i s other than adequate.

G. RISKS AND RISK MITIGATION

108. The operation i s subject to two significant risks:

a) Macroeconomic instability arising from fiscal pressures: Fiscal pressures are l ikely to emerge due to the sharp decline in current revenues associated with the economic slowdown. Tax collection i s expected to decline from 13.0 percent o f GDP in 2008 to 12.0 percent o f GDP in 2009, and the fiscal deficit i s expected to reach 5.3 percent o f GDP in 2009 and 4.3 percent o f GDP in 2010. Even though the authorities have indicated their commitment to a lower fiscal deficit in 2010, th i s could prove difficult if the crisis i s longer than anticipated or if the planned tax reform does not produce the expected results. Mitigation: The risk is partly mitigated through ensuring adherence to an acceptable macro-economic framework and continued policy dialogue

33

with the Government to ensure that incremental expenditures are focused on the program’s objectives of protecting the vulnerable population in an economic crisis. The Government has also reached agreement on a new three-year Standby Arrangement with the IMF.

b) Opposition to approval of Bank loans in Congress: The operation supports specific programs and areas which are reflected in the Government’s program and Anti-Crisis Plan. Although the new administration has been working closely to ensure support for th is operation, the relationship could change with time. The administration does not have the required majority to approve Bank loans in the Congress. The approval process involves two votes by the Congress, requiring a simple majority in the f i rst vote and a two-thirds majority in the second vote to approve the loan. In the past, the Congress did not approve several Bank projects, including those in the social sectors, leading to their cancellation. Mitigation: To mitigate this risk, the Bank has made sustained efforts to maintain dialogue with all parties, including opposition parties, on all aspects of the Government’s program. The SSGER DPL is also being processed as part of a package including the new CPS and two investment projects supporting the Government’s program.

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ANNEX 1: LETTER OF DEVELOPMENT POLICY

Mr. Robert Zocllick President World Bank Washington, D.C.

Dear Mr. Zocllick:

San Salvador, October 1,2009

The Government o f President Carlos Mauricio Funes Caitagena i s requesting a US$lOO million Development Policy Loan (DPL) from the World Bank to “Sustain Social Gains and Establish the Foundations for Economic Recovery”. These resources are being requested in order to sustain the social gains made in the past and reinforce the Government’s framework for economic recovery.

This Policy Letter is structured in 5 sections with the objectives to: (i) provide a clear view o f El Salvador’s current economic and socio-economic situation; (ii) present the new Government’s policy agentla, refonns and Anti-Crisis Program; and (iii) the poiicy measures already taken in the first four months of the new Administration with the overall goal o f seeking funding to support thcsc initiatives during the current econoniic downturn.

Country Contest

Prior to the global financial crisis and economic recession, El Salvador’s macroeconomic fundamentals improved and several social indicators showed important advances. In addition, notable economic, financial, and tax reforms were accompanied by an institutional modernization process, which helped to position the country among the top countries in the Central American and Latin American region in many categories and international indices including the Index o f Global Competitiveness, the Doing Business Index, and the Index o f Economic Frecdom.

Since 2008, however, higher food prices as well as record and volatile o i l prices in the international inarket have severely impacted the Salvadoran economy. This price shock was exacerbated by the international financial turmoil and the global econoniic slowdown. As a result, El Salvador‘s fiindamentals weakened. In 2008, the economy slowed to a 2.5 percent real grow rate, clown from 4.7 percent in 2007, while the fiscal deficit rose from 1.9 percent o f GDP in 2007 to 3.1 percent o f GDP and total debt rose to 39.7 percent o f GDP compared to 38.7 percent ot‘GDI’ in 2007.

The continued negative effects o f the global economic recession are reflected in the loss o f more than 30,000 jobs, a 10 pcrcent drop in family remittances, a near 17 percent drop in exports, and over 28 pcrcent drop in imports. Fui-thermore, though June 2009, the 12-month moving average Index o f Economic Activity shows a contraction of 4.8 percent reflecting negative growth rates in the commerce, services, manufacturing and construction sectors, among others, The above

P 35

effects have impacted tax revenues, which are I 4 percent below target. I t i s estimated that by the end o f 2009, tax reveilties will fall short of the budget by nearly $500 million -equivalent to 2.3 percent of GDP, broadening the fiscal deficit. Given the negative performance during the first semester o f 2009, economic growth i s expected to decline 2.5 percent by year end.

The economic crisis i s also threatening the social gains achieved. In fact, according to the Multiple Purpose Household Survey, poverty levels rose from 34.5 percent in 2007 to 40.0 percent in 2008, while extreme poverty worsened, increasing from 10.8 percent to 12.4 percent. In addition, and despite increased allocations for education, El Salvador’s illiteracy rate for population 10 years and older increased to 14.1 percent from 13.9 percent in 2007.

Govenimcat’s Agentln

The 2009-201 4 Government’s Program i s concentrated in reducing poverty; the main priorities include: improving social conditions, especially for the poorest and most vulnerable sectors o f the population; regaining economic growth and fostering broad based and socially inclusive economic development; promoting environmentally sustainable growth; and strengthening democracy through an open and broad based dialogue to build consensus on political reforms.

In the social arca, the Government aims to tackle povcrty by increasing allocations to education and health programs. focusing on improving quality and access to such services. To date, coiisidcrable advanccs have been ntade on the development o f the Universal Social Protection System including the estension o f free education up to high school level, free health services, and a solidarity pension for the elderly in some o f the poorest municipalities in the country. In addition, the new Adminis!ration i s expanding thc former Rcd Solidaria Program, now called the Coniunidades liurnles Solidarias to include the Coniunidades Urbanas Solidarias.

111 terms o f the economy, the Government aims to regain economic growth, taking advantage o f the current global economic recession to promote equitable and socially inclusive growth. In, this regard, the Govcrnnient has begun to iinplement several initiatives to boost growth in agriculture and infrastiucture. Actions include a program to provide farmers with fertilizers to increase agricultural productivity, the housing programs known as “Piso y Techo” and “Vivienda para Todos”, and the expansion o f credit to the private sector. The Government expects that these programs will create an estimated 100,000 jobs over the nest three years, offsetting the jobs loss during the current economic contraction.

To address the economic crisis and protect the most vulnerable sectors of the population, the current Administration has developed an ambitious Anti-Crisis Program (ACP). The ACP’s objectives are: to protect employment and the most vulnerable population from the negative impacts o f thc crisis; to implement the Universal Social Protection System; to strengthen public finances; and to serve as a counter cyclical fiscal policy to regain economic growth and establish the basis for a broad based and inclusive economic devcloprnent process. The ACP i s the first major program announced by the new Administration and it builds on the Government’s strong social agenda.

The policies, programs and actions that will be supported by this $100 million DPL focus on expanding thc l iscal space through increased tax collections and enhanced expenditure

36

manageinent. I t i s important to take iiito account that this Program builds upon the ongoing $450 mil l ion “Public Finance and Social Development Policy Loan” granted by the World Bank as well as on thc parallel $25 mill ion “Strengthening Fiscal Management and Enhancing Public Sector Expenditure Performance” project currently under formulation with the Bank. Areas that will be supported by th is DPL prograni wi l l be explained in detail in sections 2, 3 and 4 o f this Policy Letter.

Justification for Finnncing

As previously indicated, the current Administration has piit together an Anti-Crisis Program designed to lessen the negative impacts o f thc economic crisis. This US$575.3 mill ion Program intends to protect the incomes o f the poorest and most vulnerable sectors of the population and serve as a counter cyclical fiscal policy to stimulate the economy and lay down the foundations for social inclusion policies which are at the core o f the new government‘s agenda. The ACP also considers ineastircs to strengthen the fiscal position and increase transparency and accountability as a i n e m s to generate fiscal space to finance new social programs fostering a more efficient use of public resources.

Even though the size o f the ACP should be proportionate to help offset the size o f impacts o f the global economic recession, given fiscal limitations which have been further constrained by the economic crisis, i ts total amount i s s t i l l important given the timeliness, temporality and the programs included. Nonethcless, as indicated, there are important fiscal restrictions; i t i s important to mention that as o f today, 60 percent o f the cost o f the ProgrRm i s already funded by internal efforts and reorientation o f existing external and internal resources,

Considering the urgency and importance o f the ACP, the government i s requesting the World Bank i t s financial support to help close the current financing gap and help meet the needs of the poorcst and most vulnerable sectors o f the population, thus helping sustain the social gains achieved during recent years.

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1. Recent Econoniic and Social Developmeiits

During the last four years (2005-08), the economy grew at an annual average rate o f 3.8 percent, much faster than in the previous four years (2000-04) when it grew at an annual rate o f 2.0 percent. This highcr expansion came in a period o f rapid global economic growth, and i t was supported by a rapid increase in family remittances which averaged 17.9 percent o f GDP. Furthermore, exports expanded at a 10.5 percent annual grow rate over the 2006-08. Growth was also supportcd by a 9.6 percent annual increase in domestic credit, which averaged 40.2 percent o f GDP. Inllation, however, jumped to a nearly 5.0 percent annual average reflecting higher petroleum priccs and the increase in basic foodstuffs.

The fiscal policy \vas also strengthened during this period as fiscal policy concentrated on increasing the tax burden and keeping current expenditures under relative control. In fact, as a result o f thc 2004 tax reform, El Salvador's tax intake increased from 12.0 percent o f GDP in 2003 to 14.0 perccnt oi' GDP in 2008; current expenditures, 011 the other hand, averaged 15.6 percent o f GDP over the 2005-08 period, but expanded in 2008 to 16.5 percent o f GDP reflecting the increasing costs ofuntargeted subsidies. The overall deficit in 2007 was cut to 1.9 percent o f GDP and the total debt to 38.7 percent o f GDP compared to 3.7 percent o f GDP and 40.4 percent of GDP, respectively in 2003.

As a result o f the global financial turmoil, record and volatile o i l prices, and the global recession that was originatccl in the advanced economies, E! Salvador's economic performance and the overall fiscal position weakened since 2008. For instance, economic growth slowed down from 4.7 percent in 2007 to 2.5 percent while the fiscal deficit rose from 1.9 percent o f GDP in 2007 to 3.1 percent o f ODD i n 2008, and total debt rose to 39.9 percent o f GDP vis-a-vis 38.7 percent of GDP in 2007.

In 2009, the wortd economic slowdown continues affecting adversely El Salvador's economy. This is reflected in a 10.3 percent decline i n family remittances, a 17.0 percent drop in exports, and a 28.3 pcrcent decline in imports, a sluggish behavior o f domestic credit, a drop in tourism revenues. Furtherinore, the Index o f Economic Activity Volume (IVAE) -a proxy for GDP growth, for the month o f Juiic shows, the economy contracted by 4.8 percent; in addition, more than 30,000 jobs haw been lost due to the contraction in exports and domestic demand cutting formal employment by 3.6 percent over the last 12 months ending in April 2009,

On the f isca l front, the deficit for the Non Financial Public Sector has widened and debt i s increasing. Tlic rcsults for the first seven months o f 2009 indicate that the fiscal deficit reached 2.7 percent ol' G1)P compared to 1 . 1 percent o f GDP in the same period o f last year, reflecting a 9.0 percent dccliiic in tax collections (on a gross basis). 'Tax collections could fall short o f the budget by nearl i $500 mill ion equivalent to 2.3 percent o f GDP thus widening the fiscal deficit and increasing thc total debt,

In the social area, despite the fact that the budgets for the Ministry o f Education and the Ministry o f Health have incrcasecl by 52 percent and 69 percent, respectively over the 2004-09 period, there i s still a greiit nccd to increase allocations to both institutions to deal with social lags. Even though both poverty and extreme poverty had been reduced f iom 38.8 percent and 16.1 percent

38

i n 2001 to 30.7 and 9.6 percent in 2006, respectively, according to the 2007 and 2008 Multiple Purpose Houscholtl Surveys, by 2007 both indicators havc reversed their gains. Extreme poverty jumped to 10.8 pcrccnt and total poverty to 34.6 percent with fiirther deterioration in 2008 when extreme poverly reached 12.4 percent and total poverty rose to 40.0 percent.

Considering the weakened fiscal position as evidenced by a growing fiscal deficit and total public debt and the increased social challenges poised by the current economic crisis, El Salvador’s goveriunent i s taking rapid and effective fiscal measures to bring the deficit down and maintain debt as perccntage o f GDP on a sustainable path. To create additional fiscal space and increase allocations to social programs, the Administration i s focusing in controlling expenditures and incrcasing internal revenues by implementing tax and administrative reforms, enhancing public expenditure management, and increasing transparency and accountability.

On the expenditure side, the first nieasure that the new Government approved i s the Public Sector Austerity Policy. I t a i m at controlling current expenditures, especially those related to goods and services, yielding a savings o f 0.2 percent o f GDP during the second semester o f 2009; in addition, the new Administration has reduced the subsidy on public sector transpoitation by 37.5 percent.

On the reveiioe side. tlic Government was able to attain Congress‘s approval to make permanent the $0.1 surcliarge on the consumption o f gasoline and diesel. This measure helps to fully finance the tmnsporta~ion subsidy that prior to the reform prcssured the Treasury to make up for the gap betwecn revenues and the transfer to the public sector transportation operators.

As a rcsult of the coinbination o f measures on both the revenue and the expenditure side, the deficit for the tion finruicial public sector will be reduccd in 2009 from an estimated 6.0 percent o f GDP to 5. I percent of GDP. To continue consolidating fiscal accounts and to accommodate the new socinl needs, the Gosernment has designed a tax reform packaged which include revisions of tas rates on cxcisc taxes, broadening the tax base o f VAT and Income Tax combined with measures to close Ioopholes and to tackle tax evasion and smuggling. It i s estimated that the reform package will be submitted for Congress’ approval during this month.

2. Tiic Govc~ntiient’s Program

The current Administration‘s mission is to establish peace with democracy, promoting economic growth and social development and the vision i s to become a robust growing and educated country, socially inclusive, with gender equality, improving justice and security.

To achievc those goals. thc Government’s Strategic Objectives, include: regaining economic growth for which the Global Anti-Crisis Program is the first policy under implementation; generating 1 1 w and bettcr employment by promoting productive investment, improving starting business procedures, and increasing credit to the private sector; reducing poverty and increasing social inclusion by ts(ablis1iing an Universal Social Protection System. In addition, the goveimment is interested to increase transparency and accountability for which i t intends to get Legislative approval to reform the Public Sector Procurement Law and approval for an Access to

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Public Infortnation Law. Finally, i t aims at consolidating democracy through an open dialogue to establish Public Policies and strengthen governance.

Government's priorities are to protect the most vulnerable and regain economic growth in a fiscally responsible approach. To advance in these areas, the Administration will give priority to policies and actions to increase investment in the agriculture and the construction sectors; in addition, i t will continue with the process to integrate El Salvador to the global economy, strengthening the Central American Integration Process. In the financial sector, the priority will be to strengthen integrated financial supervision and enhance public sector banks' activities in order to iiicrcasc credit to small and medium enterprises. In the fiscal sector, through the Ministry 01' Finance. the Government will focus on increasing the tax intake and will implement tax and adniinistrati\rc reforms aimed at tackling tax evasion and smuggling and closing loopholes. In addition, it wi l l improve public expenditure management through the application o f the Austerity Policy, reducing subsidies, and increasing transparency and accountability. In the social area. the niain priority i s to establish the Universal Social Protection System to reduce poverty, cspanding the quality and coverage o f public services including education, health, potable water, and electricity.

3. The Anti-Crisis Progrnm

As part o f the Economic and Social Development National Strategy, on June 19, 2009, the Government announced the implementation of an Anti-Crisis Program (ACP) to offset the negative impacts that the global ecotiomic slowdown is having on El Salvador's economy and sustain social gains achieved over the last years.

The main characteristics o f the ACP are: i ts total Dollar amount, the timeliness o f the implenientstion constitiiliiig i t as a countercyclical policy measure; the temporality as i t serves two main ob,jectives -regain economic growth and sustain social gains without compromising medium and long term fiscal sustainability, and its holistic approach as it includes education, health, basic pension coverage for the elderly in poor municipalities, investment in housing, agriculturc, incrcase production o f basic grains, among others.

The four main objectives o f the ACP includc: i ) protect existing and create new jobs; ii) protect the most vuli~erable population from the negative impacts of the crisis, especially the poorest and most excluded families; iii) design and iniplement the Universal Social Protection System; and iv) iniprovc the current institutional framework taking advantage o f the new opportunities created by the crisis to develop and implement socially inclusive public policies.

4. The Program Supported by the DPL

Even though not directly financed with, the programs that will be supported by the DPL operation include programs and projects that are included in the Anti-Crisis Program suck as the expansion o f the school fceding program. I t i s built around three main components: a) protecting social expenditure and improving targeting o f subsidies; b) protecting income and consumption o f vulnerable population; and c) strengthening institutional capacity for policy formulation and implementation in the social sector.

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A, Protecting social espcnditurcs and improve targeting o f subsidies

liationalization o f public transportation subsidy, In December 2007, the previous Administration introduced a $400 and $200 subsidy for buses and microbuses, respectively to maintain stable the cost o f public transportation 011 the face o f increasing costs to the system’s operators as a result o f increasing oi l prices, As the prices for fuels reached record levcls in 2008, the subsidy was doubled to $800 and $400, for buses and microbuses, respectively. Considering that this subsidy i s not well targeted and the need to protect social spending, the new Administration has already taken actions to reduce its cost and cut i t by nearly 40 percent. In the medium term, the government’s strategy wi l l focus on the modernization of th is sector as a means to further reduce the cost o f such subsidy.

Protecting cr i t i ca l non-personnel recurrent expenditures in the social sectors and crit ical investmeiits ill the healtli sector. The current Administration i s concerned that the negative i inpict from the crisis on the incomes o f the poors, might discourage them from accessing v i h l scrviccs such as cducation and health. To address this issue and to improve the quality mid coverage o f such services, the government is committed to maintain the allocations IO non-pcrsonncl recurrent expenditures, including those transfers for educational supplies and ineclicines, among others.

i.

ii.

D. Pratucting inconic and consuinption o f the vulnerable population

iii. Expanding the School Feeding Program to urban pre-schools mid pr imary schools. I t has been tlemonstrated that the school feeding program is a successful mechanism to increase both attentlance and students’ ability to concentrate in class. As o f June 2009, the MINED‘S school feeding program i s servicing nearly 600,000 students betwcen pre-school and end o f primary educalion. Similar to [lie protection o f non-personnel expenditure action, this approach riims at lessening the negative impact o f the crisis on the income o f poor families helping thcir children to remain in school atid avoiding an increase in the drop out rate.

Ensure ~ C C C S S to health services for the poors. Despite increasing allocations to the blinistry o f Heoltll over the last 10 years and the improvements in coverage and quality o f healtli scrvices, s t i l l an important sector o f the population did not benefit from them or had to makc “voluiitmy payments” to rcceive attention. To ensure free access to all sectors o f the population, especially to tlie poorest and most vdnerable, starting this semester the governincnt has climinated any voluntary payments and has declared illegal any socio economic evaluation to assess paynient capacity.

iv.

v. Protect inconies of the poors. As already mentioned, the global economic recession has so far led to the loss o f over 30,000 jobs and a 10 percent reduction in family remittances, thus hurting tlie incoiiic and the consumption capacity o f thousands o f poor families, women who worked at maquilas are among the most severely impacted. The government is working to develop r? Temporary Income Support Program to neet the demands o f the poorest and most vulnerable sectors of the popdation.

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i.

ii.

iii.

iv.

C. Strengtliening institutional capacity fo r policy fortnulation and implementation in the socii11 sectors for economic recovcry

Constructing polieies for thc long-term economic and social development. To this end, the goveri~iiicnt has created an Economic and Social Council in order to evaluate and establish national public: policies and build a broad based national strategy to promote social inclusion and higher economic growth. Fatherinore, i t i s strengthening the administration at the Ministry o f Health and the Ministry o f Education by creating new offices aimed at improving services and deal with structural lags such as deficiencies in science and technology i n education and coverage in health.

Raising qunlity o f school education, particularly in science and technology, and work sltills fo r young peoplc. As indicated in the previous point, the government i s undertaken institutional nieasures to improve the quality o f education, To achieve this goal, the MINED is developing and education strategy that w i l l integrate science and technology in the curriculum and will enhance technical skills to allow young people integration in the labor market on a coiiipetitiva basis. Furthermore, the MINE33 wi l l decentralize activities at the Departnicntal lcvrl in order to expeditc quality improvements in classrooins reducing bureaucratic procedurcs :it the Central level.

Extciitlirig coucwge under t h e clecentralized models o f basic health care service delivery. So far, the decentralization of services has proven to be successful in providing adequate health care in i*ciiiotc and deprcssed areas o f the country. To consolidate this model, Ihc Ministr) of I icalth wil l create a Community Health l in i t which will be in charge o f the oversight o f the “Estcasioii of Service Coverage Program” currently managed by the Planning IJnit .

Creation o f tlic Univrrsal Sgstcin o f Social Protection (SPSU), to protect vulnerable groups and to enable thc population to participate in economic recovery. The achieve this goal, thc Governmcnt is restructuring the administration to include the newly created Social Inclusion Secretariat and the Strategic Affairs Secretariat and has streamlined the Technical Sccretariat’s role on social policy coordination.

5. Rcquest t o Support tlic Program

This Policy 1,etter suinmariLes the niultiple challenges that El Salvador i s facing and the main policies and cspected outcomes that the new Administration envisages for the short and medium term. As esplained in sections 2, 3 and 4, the Government’s Social Agenda i s being threatened by the negativc impacts from the slowdown of the global economy. Thousands o f jobs have already been lost. the economic activity is declining, expoits and imports are dropping and there are expectations that this [ w i d wil l continuc in the near future with the economy contracting by 2.5 perccnt during 2009. povcrty lcvcls are widening, worsening the conditions o f l iving for the most vulnerable ones.

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Considering all the negative economic and social inipacts that the global recession is imposing on 131 Salvador, the technical and financial support from the World Banks is critical to help alleviate the most urgent needs of the poorest anti most vulnerable sectors of the population and to contribute to advance with the Social Agenda of President Mauricio Funes' government.

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m -

IA d

A 3 3

3 3

ANNEX 3: FUND RELATIONS NOTE

El Salvador-Assessment Letter for the World Bank October 7,2009

The latest assessment o f El Salvador by the IMF’s Executive Board i s contained in the press release of January 16,2009 (htt~://~~~.imf.0rg/external/np/~ec/pr/2009/pr09 1 O.htm), which summarizes the views Directors expressed at the approval o f the request for a 14-month Stand-By Arrangement (SBA) from the Fund for 300 percent o f quota (about US$800 million), which was to be treated as precautionary. The last Article IV Consultation discussion took place on November 12,2008 (see http://www.imf.ordexternal/n~/sec/~r1/2008/~nO8 15 1 .htm).

El Salvador has been severely impacted by the global crisis. The (former and current) authorities’ strong commitment to macroeconomic stability, supported by the Fund’s Stand-By Arrangement, contributed to maintaining investor confidence during the political transition, despite the severity of the global financial shock. Nonetheless, the Salvadoran economy has been adversely impacted by the slowdown in world economic growth, in particular through trade and remittance flow linkages with the U.S. economy. As a result, the Salvadoran economy i s now projected to contract by 2.5 percent in 2009 (versus 2.5 percent growth under the January program framework), while end-year 12-month inflation i s expected to fal l to around 1 percent.

The decline in trade and activity has led to a sharp decline in tax revenues, while overall spending has remained broadly in line with the budget (including the anti-crisis plan adopted by the government that took office on June 1). As a result, the deficit o f the nonfinancial public sector for 2009 i s projected to be well above original program levels at 5.1 percent o f GDP, and be financed mostly with external resources (including from multilateral development banks). This deviation from program targets, in the midst o f a political transition, prevented completion o f the reviews contemplated in the January arrangement .

The collapse in imports and trade i s projected to lower the external current account deficit to under 2 percent of GDP (from 7.2 percent in 2008). The real exchange rate appears to remain broadly in line with fundamentals, and several indicators suggest exports remain competitive. The banking system (mainly foreign-owned) has been resilient to the global financial turmoil and remains highly liquid, although nonperforming loans are increasing, and rising provisioning i s cutting into profitability.

In late September, Fund staff and the authorities reached agreement, ad referendum, on a three- year macroeconomic program that could be supported by a new Stand-By Arrangement (SBA). The authorities program i s anchored on maintaining the dollarization regime, improving public expenditure management, and ensuring fiscal sustainability and financial sector stability. The strategy envisages that output growth w i l l remain subdued in 2010 and that the recovery w i l l start taking hold in 201 1; inflation i s expected to remain stable at 2%-3 percent. The fiscal program envisages a steady but gradual improvement in the overall fiscal deficit, starting with a reduction in the deficit to 4.3 percent o f GDP in 2010 and further into the medium term consistent with an overall declining debt path. The program gives priority to improving the efficiency o f social protection programs, infrastructure investment and tax administration. The economic program envisages a moderate increase in the external current account deficit, financed mainly by FDI flows and official borrowing (mainly from multilaterals). The program w i l l continue to strengthen the financial system: the authorities have submitted legislation to bolster financial sector supervision (expected to be approved before year end) and plan to review the bank resolution framework, and strengthen the legal basis for investment funds. Fund s ta f f regards the authorities’ program as consistent with the goal o f preserving macroeconomic stability, though r isks remain, especially regarding the pace o f global recovery and continued political consensus. A board

48

meeting to discuss the 3-year SBA (for 300 percent o f quota, which the authorities intend to treat as precautionary) i s scheduled for November.

Table 1. El Salvador: Selected Economic and Social Indicators

2006 2007 2008 2009 201 0 EBS/09/6 Rev. Proj. EBS/09/6 Rev. Proj.

(Annual percent change, unless otherwise stated) Income and Prices Real GDP Consumer prices (end of period, e.0.p.) GDP deflator (period average) External Sector Exports of goods and services, volume Imports of goods and services, volume Terms of trade Real effective exchange rate (+ is appreciation) External sovereign bond (spread, basis points)

Money and Credit Credit to the private sector Broad money Interest rate (time deposits, percent) External Sector Current account balance Trade balance

Exports (f.0.b. including maquila) Imports (f.0.b. including maquila)

Services and income (net) Transfers (net) Public Finances Combined public sector balance Combined primaFy balance

Of which: tax revenue Total Public Debt

Of which: external public debt External public debt service

(percent of exports of goods and services) National Savings and Investment Gross domestic investment

Public sector Private sector

Of which: foreign direct investment Gross domestic saving

Public sector Private sector

Net Foreign Assets of the Financial System Millions of US. dollars Percent of deposits Memorandum Items: Net maquila exports Nominal GDP (billions of U.S. dollars)

4.2 4.9 4.9

10.1 11.2 -0.9 0.4

200

43.0 43.8

4.4

-3.6 -1 9.0 20.2

-39.1 -3.3 18.6

-2.9 -0.5 13.3

41.9 27.5

14.4

16.1 2.2

13.9 1.3

12.5 0.0

12.5

1,398 16.8

3.4 18.7

4.7 2.5 2.5 -2.5 2.5 4.9 5.5 3.8 1 .o 2.9 4.4 5.9 3.6 2.7 3.2

4.6 6.8 3.1 -13.1 3.0 7.9 4.8 -3.5 -1 9.3 2.6

-5.7 -10.2 6.0 12.5 -1.2 -0.5 0.5 ... ... ... 163 388 ... ... ...

(Percent of GDP, unless otherwise stated)

42.8 47.1

4.7

-5.5 -20.0 19.8

-39.8 -4.0 18.5

-1.9 0.5

13.4

39.1 24.3

11.5

16.1 2.0

14.1 7.0

10.4 0.5 9.9

2,134 22.5

2.8 20.4

41.3 43.9 4.2

-7.2 -19.9 20.8

-40.7 -4.7 17.3

-3.1 -0.7 13.0

41.2 23.7

8.9

15.0 2.1

12.8 3.3 7.7

-0.3 8.1

2,035 21.7

2.9 22.1

41.2 42.6

...

-2.7 -16.5 21.1

-37.6 -3.1 16.9

-2.8 -0.5 13.6

41.5 24.0

12.5

15.3 2.2

13.0 1.4

12.5 0.0

12.5

1,871 19.8

3.2 23.6

39.8 43.9

...

-1.9 -12.6 17.6

-30.2 -4.9 15.7

-5.1 -2.7 11.9

47.5 30.0

10.0

13.0 1.9

11.1 0.4

11.1 -2.8 13.9

2,673 28.4

2.6 22.1

41.1 42.4

...

-3.4 -16.8 20.8

-37.6 -3.1 16.5

-1.7 0.7

14.3

40.7 22.8

10.2

15.4 2.5

12.9 1.9

12.1 1.3

10.8

1,766 19.2

3.1 24.8

0.5 2.5 3.1

0.8 3.5

-3.5 ... ...

38.6 42.4

...

-2.9 -14.4 17.2

-31.6 -4.2 15.7

-4.3 -1.3 13.1

48.6 31.1

10.4

13.8 2.4

11.4 0.6

10.9 -1.7 12.6

2,530 27.4

2.4 22.9

Sources: Central Reserve Bank of El Salvador: Ministry of Finance; and Fund staff estimates.

49

ANNEX 4: DEBT SUSTAINABILITY ANALYSIS

1. The outlook on El Salvador’s medium-term macroeconomic prospects has deteriorated since the last DSA was prepared in the context o f the Public Finance and Social Sector Development Policy Loan. As a result debt dynamics have also changed. The revised debt sustainability analysis in this Program Document i s based on the macroeconomic framework developed by IMF sta f f for the Standby Program and Bank staf f projections.

2. The debt sustainability analysis (Table A.l) indicates that the public debt to GDP ratio i s expected to continue on an increasing path until 2011, when i t w i l l reach 50.1 percent o f GDP before starting to decline to reach 46.2 percent in 2014. This trajectory would be consistent with a primary fiscal balance deficit averaging 1.5 percent o f GDP over 2009-201 1, and a primary balance surplus averaging .7 percent o f GDP over 2012-2014. The fiscal improvement after 201 1 would be driven by both an expected better economic environment and the fiscal interventions o f the Government (tax reform and rationalization o f subsidies). As for the trajectory o f the total external debt, the revised macroeconomic framework assumes an average non interest current account balance surplus o f 0.4 percent o f GDP over 2009-2014 and i s consistent with stable debt dynamics until 2011 (at about 44 percent o f GDP) before declining to 40.5 percent o f GDP in 2014.

Table A.l. Debt Sustainability Analysis

Total External Debt (%of GDP) Public Debt (% of GDP)

Key Assumptions

Real GDP growth (%) Inflation (%, e-o-p)

Growth o f real primary spending (% o f GDP) Primary balance (% o f GDP)

Nominal interest rate on public debt (%)

Growth of exports (US dollar, %) Growth o f imports (US dollar, %)

Non-interest current account balance (% of GDP)

Projection Y

2

44.2 47.7

-2.5 1 .o

1.7 -2.9

5.9

-15.0 -23.0

1.2

44.4 48.8

0.5 2.5

0.5 -1.3

6.5

2.8 6.6

-0.2

44.3 50.1

2.0 2.8

2.0 -0.3

6.4

6.5 6.0

0.2

42.9 41.8 40.5 49.5 48.3 46.2

3.0 4.0 4.0 2.8 2.8 2.8

3.0 4.0 4.0 0.3 0.9 1.0

6.4 6.3 6.3

7.0 7.4 8.1 6.8 8.5 8.5

0.4 0.1 0.0

3. Thus, even though the higher public debt levels in the revised DSA imply an increase in the country’s vulnerabilities, in the absence o f a crisis scenario the medium-tern public and external positions of El Salvador remain sustainable.

50

4. There are, however, a number o f r isks to the medium-term outlook associated with the global situation, as well as with the ability o f the new administration to maintain macro stability and push structural reforms in a very volatile environment. Table A2 presents projected debt dynamics under more pessimistic alternative scenarios:

o Under less optimistic growth scenarios with growth .5 percentage points over 2009-2014 lower than the one in the baseline (3.5 percent over 2008-2013) -scenarios A1 and B l - the total external debt to GDP ratio would be about 1 percentage point o f GDP higher than under the baseline scenario, whereas the public debt would be 2.5 percentage points o f GDP higher than under the baseline scenario.

o Under tighter financial market conditions resulting in higher interest rates both for the external and the public debt o f around .5 percentage points over 2008-2013 -scenarios A2 and B2-, projected debt indicators for 2014 would be .5 higher than under the baseline scenarios for the external debt and 1.4 percent higher for the public debt.

o Under a more difficult external environment -scenario A3- resulting in a higher current account deficit (.8 percentage points o f GDP), the total external debt to GDP ratio would reach about 44.7 percent in 2014.

o Under a looser fiscal policy -scenario B3- with an average primary balance deficit o f .7 percent o f GDP over 2009-2014 rather than the assumed 0.4 percent o f GDP under the baseline scenario, the public debt to GDP ratio would be in 2014 about 2 percentage points o f GDP higher than under the baseline scenario.

o Scenarios projecting the impact o f contemporaneous shocks (albeit more moderate than those in Al-A3 and Bl-B3) -scenarios A4 and B4- would result in indicators for 2014 o f 43.3 percent o f GDP and 48.7 percent o f GDP for the external and public debt, respectively.

o Scenarios based on key variables fixed at 10 year historical levels -scenarios A5 and B5- would result in an external debt to GDP ratio 2014 projection that i s about 2.3 percentage points lower than under the baseline and in a 2014 public debt to GDP ratio that i s 1 percentage point higher than under the baseline.

51

o Table A2.3. Debt Sustainability Analysis: Alternative Scenarios

External Debt Sustainability Analysis

A1 . Real GDP growth i s baseline minus 1/2 sad. 44.2 44.6 44.7 43.5 42.6 41.5 A2. Interest rate on external debt i s baseline plus 1/2 s.d. 44.2 44.4 44.4 43.2 42.2 41.0 A3. Non-interest CAB i s baseline minus 1/2 s.d. 44.2 45.2 45.9 45.4 45.1 44.7 A4. Combination of Al-A3 using 1/4 s.d. shocks 44.2 44.9 45.4 44.6 44.1 43.3 A5. Key variables are at their 10 year historical averages 44.2 42.5 40.7 39.1 38.6 38.2

Public Debt Sustainability Analysis

Bl . Real GDP growth i s baseline minus 1/2 s.d. 47.7 49.2 51.8 50.8 50.2 48.7 B2. Interest rate on public debt i s baseline plus 1 s.d. 47.7 49.1 51.6 50.4 49.4 47.6 B3. Primary balance i s baseline minus 1/2 s.d. 47.7 49.3 51.9 50.8 50.0 48.2 B4. Combination of Bl-B3 using ?A s.d. shocks 47.7 49.3 52.1 51.1 50.4 48.7 B5. Key variables are at their 10 year historical averages 47.7 46.5 47.8 46.9 47.4 47.2

52

ANNEX 5: EDUCATION AND HEALTH BUDGETS FOR 2008-2010

Public Investment Support to cultural and educative institutions (24 Of which: Basic Education

Personnel Non-Personnel

Public Investment

Recurrent

Table 1: Education Budget (In Millions of USD)

68.88 11.83 50.09 51.32 3.50 25.08 1 1.94 11.70

79.68 53.91 81.29 85.88 58.76 74.09

322.86 208.68 314.27 378.35 257.58 405.42 322.86 208.68 314.27 378.35 257.58 405.42 231.38 153.65 237.44 270.58 178.83 283.93 91.48 55.03 76.83 107.77 78.75 121.49 0.00 0.00 0.00 0.00 0.00 0.00

*Approved budget ***Preliminary data 11 PEIS: Extraordinary Budget of Social Investment. Most of this budget i s expected to be executed until 2010. Source: Ley de Presupuesto General del Estado 2008 and 2009; Draft of Decree presented to the Congress containing the Reforms to the Extraordinary Budget for Social Investment 2009-201 1, and S A F I 21 Includes: Universidad de El Salvador, Caja Mutual de 10s Empleados del MINED, Instituto Salvadoreiio para e l Desarrollo Integral de la Niiiez y subsidios varios

Table 2: Health Budget (In Millions of USD)

53

ANNEX 6: COUNTRY AS A GLANCE

LOWf maw

Borne

3637 3 3 5 0

10 12

6.m lam 1.w

97 &6

69 11 25

93 85 m rn

88 54

b 91

ad7

3 8

247

T b is8

U U 1 7

1G w

5 1 18Ql

El Salvador

Ba lance o f Payments and Trade

(US$ millions) Total merchandise exports (fob) Total merchandise imports (cif) Net trade in goods andsewices

Workers’ remittances and compensation of employees (receipts)

Current account balance as a %of GDP

Reserves, including gold

Cen t ra l Government Finance

(soof GDP) Current revenue (including grants)

Current exqsnditure

Overall surplusideficit

Highest marginal tax rate (%)

Taxrevenue

Individual Corporate

External Deb t and Resource Flows

(US$ millions) Totaldebt outstanding and disbursed Total debt sewice Debt relief (HiPC, MDRI)

Totaldebt (%of GDP) Totaldebt sewice(%of exports)

Foreign direct investment (net inflows) Portfolio equity(net inflows)

2000

2,963 4,947 -1,975

1,765

-429 -3.3

2,033

2.1 102 11.8

-2.3

30 25

4,467 369 -

34 0 6.6

I73 0

2007

4,073 7,890 -3,817

3,776

-1,119 “5 5

2,198

11.4 21.4 ?d. 1

-2.3

25

9, W6 163 -

49.0 #. 1

204 0

Shan-tern 1230

IBRD. 417001, (IDA’’1.097 ,IMf, 0

1

Pnva1e.l 4847 574

us6 millions

P r i va te S e c t o r Development

Time required to start a business (days) Cost to start a business (%of GNI per capita) Time required to register property(days)

Rankedas a malor constraint to business (%of managers surveyed who agreed)

Crime Anticompetitive or informal practices

Stock market capitalization (?&of GDP) Bank capital to asset ratio (%)

2000 2008

I7 - 49.6 - 31

2000 2007

.. 49.0

.. 44.5

15.5 33.4 8.6 11.6

-

Governance indicators, 2OOOand 2007

VXR and xcountabMy

Political stability

Regulatory qudlly

Ruled law

Ccntrd of caruptim

0 25 50 75 1W

02007

02000 cwntry s percentile rank (5103)

higher w l u ~ ~ m # y b d l e r r a t n ~

Scune Kaulmann Kmay Maftwm Wodd Bank

Techno logy and Infrastructure

Paved roads (%of total) Fixed line and mobile phone

High technology exports subscribers (per 1,000 people)

(%of manufactured exports)

Env i ronmen t

Agricultural land (%of land area) Forest area (%of land area) Nationailyprotectedareas (%of land area)

Freshwater resources per capita (cu. meters) Freshwater withdrawal (%of internal resources)

C02 emissions per capita (mt)

GDP oerunitof eneravuse

2000

198

22

6 0

81 156

72

0 93

2007

105

2.8

82 11.4 19

2,669

0.94

<,

6 5 64

Energyuse percapita(kgof oil equivalent) 658 694

(2005 P PP $ per kg of oil equivalent)

Note Figures in italics are for years other than those specified 2007data are preiiminaly indicates data are not available -indicates observation is not applicable

Development Economics Development Data Group (DECDG)

55

9/24/08

Mi I I enn i um Deve I op me nt Goa I s El Salvador

With selected targets to achieve between 7990 and 2015 (estimate closesf to date sho wn, i/- 2 pars)

a l 1: halve the rates f o r extre Povertyheadcount ratio at$l25aday(PPP,%of population) Poverty headcount ratio at national poverty line (%of population) Share of income or consumption to the poorest qunitile (%) Prevalence of malnutrition (%of children under 5)

Goal 2: ensure that children are able t o complete primary school ing Primaryschool enrollment (net,%) Primarycompletion rate (%of relevant agegroup) Secondaryschool enrollment (gross.%) Youth literacyrate (%of people ages 15-24)

Goal 3: e l i y in educat ion and empower women Ratio of girls to boys in primaryand secondaryeducation (%) Women employed in the nonagricultural sector (%of nonagricultural employment) Proportion of seats held bywomen in national parliament (%)

Goal 4: reduce under-5 mortal i ty by two-thirds Under-5 mortality rate (per 1,000) Infant mortalityrate (per lo00 live births) Measles immunization (proportionof one-year olds immunized,%)

Goa l 5: reduce maternal mortal i ty by three-fourths Maternal mortality ratio (modeled estimate, per 100,000 live births) Births attended by skilled health staff (%of total) Contraceptive prevalence (%of women ages 15-49)

Goal 6 : halt and begin to reverse the spread o f HlV lA lDS and other m Prevalenceof HIV(%of population ages 15-49) Incidence of tuberculosis (per llO.000 people) Tuberculosis cases detected under DOTS (Oh)

Goal 7: halve the propor t ion o f people without sustainable access t o Access to an improved water source (%of population) Access to improved sanitation facilities (%of population) Forest area(%of totallandarea) Nationally protected areas (%of total land area) CO2 emissions (metric tons per capita) GDP per unit of energyuse (constant 2005 PPP $ per kg of oil equivalent)

Goal 8: develop a global partnership f o r development Telephone mainlines (per 100 people) Mobile phonesubscribers (per X)Opeople) Internet users (per 100 people) Personal computers (per MOpeople)

Education indicators(%)

2000 2002 2004 2006

rrO-. Pnmaiy net enmiimeni raso

Ratio of glds 10 boys in pnrnaiy & secondaiy Bducaiion

Measles immunization (%of 1-year olds) 100

75

50

25

0

1990 1995 20OC 2006

DEI Salvador DLaiin Amenca & the Canbbean

ICT indicators (per 1,000 people)

125 1 100

75

50

25

0

2000 2002 2 m ZOO€

OFixed +rnob i i~~~bscnbere OI"tBrnBf "*em

Note Figures initalics arefor years otherthan thosespecified . indicates dataare not available

Develop nomi ent Data Group (DECDG)

9124108

56

MAP SECTION

La Libertad

Acajutla

La Hachadura

Armenia

Chalchuapa

Metapán

Aguilares

Ilobasco

Olocuilta

San Luis

Tecoluca

Ciudad Barrios

La Herradura Jiquilisco

Intipuca

Santa Rosade Lima

NuevaEsparta

Osicala

Jocoaitique

Santiagode María

Suchitoto

NuevaConcepción

Tejutla

La Palma

Candelaria dela Frontera

Izalco

NuevaSan Salvador

Chalatenango

Sensuntepeque

Cojutepeque

San Vicente

Zacatecoluca

Usulután

San Miguel

San Francisco(Gotera)

La Unión

Sonsonate

Ahuachapán

SantaAna

SANSALVADOR

Paz

EmbalseCerrón Grande

Lago deIllepango

Laguna deOlomega

Lago deCoatepeque

Lago deGüija

Lempa

Lem

pa

Jiboa

Lempa

Torola

Goa

scor

án

Grande de San Miguel

L APA Z

S A NV I C E N T E

U S U L U T Á N

S A N M I G U E L L AU N I Ó N

M O R A Z Á N

C A B A Ñ A S

C H A L AT E N A N G O

S O N S O N AT E

SAN

TA A

NA

A

H U A C H A P Á N

CU

S CA

T L ÁN

SA

N S

ALV

AD

OR

L AL I B E R TA D

La Libertad

Acajutla

La Hachadura

Armenia

Chalchuapa

Metapán

Aguilares

Ilobasco

Olocuilta

San Luis

Tecoluca

Ciudad Barrios

La Herradura Jiquilisco

Intipuca

Santa Rosade Lima

NuevaEsparta

Osicala

Jocoaitique

Santiagode María

Suchitoto

NuevaConcepción

Tejutla

La Palma

Candelaria dela Frontera

Izalco

NuevaSan Salvador

Chalatenango

Sensuntepeque

Cojutepeque

San Vicente

Zacatecoluca

Usulután

San Miguel

San Francisco(Gotera)

La Unión

Sonsonate

Ahuachapán

SantaAna

SANSALVADOR

HONDURASGUATEMALA

L APA Z

S A NV I C E N T E

U S U L U T Á N

S A N M I G U E L L AU N I Ó N

M O R A Z Á N

C A B A Ñ A S

C H A L AT E N A N G O

S O N S O N AT E

SAN

TA A

NA

A

H U A C H A P Á N

CU

S CA

T L ÁN

SA

N S

ALV

AD

OR

L AL I B E R TA D

PACIFIC OCEAN

Golfo deFonseca

Bahía de

La Unión Bahía de Jiquilisco

Paz

EmbalseCerrón Grande

Lago deIllepango

Laguna deOlomega

Lago deCoatepeque

Lago deGüija

Lempa

Lem

pa

Jiboa

Lempa

Torola

Goa

scor

án

Grande de San Miguel

To Quezaltepeque

To Nueva

Ocotepeque

To Jutiapa

To Jalpatagua

To Taxisco

To Marcala

To Nacaome

To Ipala

Volcán deVicente

(2,182 m)

Volcán deSan Miguel(2,130 m)

CerroEl Pital

(2,730 m)

Volcán deSanta Ana(2,365 m)

90°W

90°W

89°W 88°W

89°W 88°W

13°N

14°N14°N

EL SALVADOR

0 10 20 30

0 2010 30 Miles

40 Kilometers IBRD 33401R

NO

VEM

BER 2006

E L SALVADORSELECTED CITIES AND TOWNS

DEPARTMENT CAPITALS

NATIONAL CAPITAL

RIVERS

MAIN ROADS

PAN AMERICAN HIGHWAY

RAILROADS

DEPARTMENT BOUNDARIES

INTERNATIONAL BOUNDARIES

This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other information shown on this map do not imply, on the part of The World Bank Group, any judgment on the legal status of any territory, o r any endo r s emen t o r a c c e p t a n c e o f s u c h boundaries.