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Dollarization on El Salvador

Dollarization on El Salvador. Team Members Nixon Orellana Mike Scott. Introduction. In 2001 El Salvador engaged in full dollarization to enhance its economic reform process the set of previous structural reforms put in place to support economic stability and thus attract foreign investors

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Dollarization on El Salvador

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  1. Dollarization on El Salvador Team Members Nixon Orellana Mike Scott

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

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

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

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

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

  7. EL SALVADOR AT THE BEGINNING OF THE TWENTY-FIRST CENTURY

  8. EL SALVADOR AT THE BEGINNING OF THE TWENTY-FIRST CENTURY

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

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

  11. Economics

  12. Economics

  13. Economics

  14. Politics and Society

  15. Politics and Society

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

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

  18. Real GDP Growth

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

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

  21. Benefits of dollarization • Lending interest rates decreased 11% (2000) 6.3% (2004) • Remittance inflows increased = $2.55 billion (16% of GDP) in ‘04 • Inflation decreased 7.8% (1992-2000) 3% Since 2001

  22. Interest Rates

  23. Interest Rates

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

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

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

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