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Country Report

Updated as of Oct 2014

Original Publication Date: April 2014

El Salvador

2014, The PRS Group, Inc.

ISSN: Printed in U.S.A.

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EL SALVADOR1054-5492

Political Risk Services 27-Oct-2014 Reproduction without written permission of The PRS Group is strictly prohibited.

Country Update 27-Oct-2014 Page U-1

El Salvador

Country Update MOST LIKELY REGIMES AND THEIR PROBABILITIES 18-Month: Divided Government 55% Five-Year: Divided Government 45% FORECASTS OF RISK TO INTERNATIONAL BUSINESS

Turmoil Financial Transfer

Direct Investment

Export Market

18-Month: Moderate B B+ B Five-Year: Moderate B- B B- ( ) Indicates change in rating. * Indicates forecast of a new regime. KEY ECONOMIC FORECASTS

Years

Real GDP Growth %

Inflation %

Current Account ($bn)

2009-2013(AVG) 0.8 1.9 -0.97 2014(F) 1.8 1.2 -1.40 2015-2019(F) 2.2 2.9 -1.10 Implications

Salvador Snchez Cern, a former guerrilla commander and the leader of the orthodox Marxist wing of the incumbent FMLN, assumed the presidency on June 1. When he reached the end of his first 100 days in office last month, Snchez Cerns approval rating stood at just 40%, compared to the 70%-plus levels recorded by his two most recent predecessors at the same point in their terms.

Although his opponents have warned that Snchez Cern is a radical leftist in the mold of Hugo Chavez, the architect of Venezuelas deeply troubled socialist system, the new presidents abbreviated honeymoon has less to do with the manner in which he is governing than with the lack of results. Polling data revealed that nearly two-thirds of respondents believe that the new government has done nothing useful to solve either the countrys worrisome security problem or address the weaknesses of the economy.

Political Risk Services El Salvador Country Update 27-Oct-2014 Reproduction without written permission of The PRS Group is strictly prohibited.

Page U-2 27-Oct-2014 Country Update

That assessment is not entirely fair; the administration has implemented policies in both areas, but the challenges are daunting, and it is too early to judge whether those efforts will bear fruit. Moreover, the scope for aggressive action is limited by the FMLNs minority status in the legislature.

The FMLN controls just 31 of 84 seats in the legislature, and, given the governing partys hostile relationship with the main opposition Arena, Snchez Cern will need to maintain friendly relations with the more centrist Gana if he hopes to accomplish much of anything in the coming months. However, that will become a bigger challenge going forward, as parties are preparing for legislative and municipal elections in March 2015.

Opinion polls suggest that the distribution of seats is unlikely to change significantly, as the FMLN and Arena are consistently polling within a few percentage points of one another (frequently within the margin of error), while Gana is maintaining its third-place status. Given the slump in Snchez Cerns popular support, and the dim prospects for improving the situation in the near future, it is highly doubtful that the FMLN will make significant gains at next years elections. In fact, it is doubtful that the party can avoid a loss of seats that will make it all the more dependent on the cooperation of Gana.

New President Already Encountering Headwinds

Salvador Snchez Cern, a former guerrilla commander and the leader of the orthodox Marxist wing of the incumbent Farabundo Mart National Liberation Front (FMLN), assumed the presidency on June 1. Snchez Cern served as vice president under Mauricio Funes, a non-affiliated journalist tapped by the FMLN as its presidential candidate in 2009 with the aim of putting a moderate face on the leftist party. In contrast, Snchez Cerns nomination this year was in keeping with a pledge by party leaders to back a truly red candidate in 2014. Many voters who backed Norman Quijano, the candidate of the conservative Nationalist Republican Alliance (Arena), did so because they view Snchez Cern as a radical leftist in the mold of the late Hugo Chvez, the former Venezuelan president whose heavily statist economic policies have damaged that countrys economy to an extent that even its oil wealth can no longer disguise. Arena did its level best to reinforce those concerns during the campaign, a factor that contributed to the FMLNs very narrow margin of victory.



Snchez Cern has attempted to soften his public image, claiming that he intends to govern more in the style of Uruguays Jos Mujica, another guerrilla-turned-president who has followed a moderate course over a five-year term that is nearing completion. The FMLNs campaign platform focused on the goals of boosting employment, enhancing security, and improving the quality of education, a fairly standard to-do list, and, upon taking office, the 69-year-old FMLN leader vowed to govern with honor, austerity, efficiency, and transparency. When he reached the end of his first 100 days in office last month, Snchez Cerns approval rating stood at just 40%, compared to the 70%-plus levels recorded by his two most recent predecessors at the same point in their terms. His abbreviated honeymoon has less to with the manner in which he is governing than with the lack of results. Polling data revealed that nearly two-thirds of respondents believe that the new government has done nothing useful to solve either the countrys worrisome security problem or address the weaknesses of the economy. Lack of Legislative Majority Will Continue to Be a Handicap

That assessment is not entirely fair, but the challenges are daunting, and it is too early to judge whether his efforts will bear fruit. On the security front, the president had the misfortune of taking office shortly after the collapse of a gang truce that had contributed to a 40% decline in homicides. In the month before Snchez Cern took office, the number of murders surged to 356, compared to 174 in May 2013. Snchez Cern has promised to personally take the lead in establishing a System of Citizen Security. In late August, leaders of the countrys largest gangs announced an agreement to cease attacks on members of the police and the military, a possible indication that the truce might be revived. Public opposition to the government cutting deals with the gangs made it politically unfeasible for Funes to formally endorse the previous truce, which proved to be a factor in its collapse. Snchez Cern will be in an even weaker position on that score. With regard to the economy, the president has managed to secure El Salvadors membership in the Petrocaribe alliance, whose participants are eligible to receive Venezuelan oil supplies on very generous financial terms. He also obtained a five-year, $277 million economic assistance package from the US,


Page U-4 27-Oct-2014 Country Update

through the Millennium Challenge Corporation, which Washington has conditioned in part on a tightening of anti-money laundering regulations. Snchez Cern has also followed through on plans to bolster the governments finances with a package of tax measures, a move that won praise from the IMF. In keeping with the FMLNs pledge of tax justice, the measures primarily affect those at the upper end of the income scale, and include a minimum tax aimed at closing loopholes, a 1% annual tax on company assets, and a 0.25% levy on financial transactions. Although the FMLN controls just 31 of 84 seats in the legislature, the support of lawmakers from the Grand Alliance of National Unity (Gana), a main source of backing for the Funes administration, ensured the majority required to tax reforms. However, Arena lawmakers staged a walkout before the vote, claiming that debate on the measures was wrongfully cut short, and were joined by members of smaller parties. The incident suggests that Snchez Cern will need to maintain friendly relations with Gana if he hopes to accomplish much of anything in the coming months. However, that will become a bigger challenge going forward, as parties are preparing for legislative and municipal elections in March 2015. Opinion polls suggest that the distribution of seats is unlikely to change significantly, as the FMLN and Arena are consistently polling within a few percentage points of one another (frequently within the margin of error), while Gana is maintaining its third-place status. Given the slump in Snchez Cerns popular support, and the dim prospects for improving the situation in the near future, it is highly doubtful that the FMLN will make significant gains at next years elections. In fact, it is doubtful that the party can avoid a loss of seats that will make it all the more dependent on the cooperation of Gana. Weak Growth, Low Inflation

Sales of coffee are the countrys main source of export revenue, but the crop has been decimated by the spread of the roya fungus. The National Coffee Council has estimated that the 2013/2014 harvest (which ended last month) was the lowest in a century. Not surprisingly, exports of coffee decreased by more than 55% (year-on-year) in the JanuaryAugust period, contributing to an overall decline in goods exports of more than 5% compared to the first eight months of last year. That the overall drop has not been larger is attributable to the beneficial effect of stronger demand in the US, which has boosted non-traditional exports, particularly textiles.



Increased remittances from Salvadorans working in the US, which are on track to top $4 billion in 2014, have not spurred stronger demand for imports, a fact that will compound the positive effect of a larger transfers surplus on the current account balance. However, the weakness of the agricultural sector will hold overall real GDP growth to less than 2% once again in 2014, and the current account shortfall will remain quite large, with a deficit of 5%6% of GDP forecast this year. Inflation averaged just 0.75% in the first half of the year, but bean shortages resulting from drought conditions have driven food prices higher in recent months, pushing the monthly inflation rate up to near 2% in the third quarter. Weaker oil prices will limit the risk of an inflationary spike in the last three months of the year, and the 12-month average is forecast to come in at just 1.2% in 2014.

Economic Forecasts for the Three Alternative Regimes

Divided Government Center-Left Coalition Centrist Coalition Growth

(%) Inflation

(%) CACC ($bn)

Growth (%)

Inflation (%)

CACC ($bn)

Growth (%)

Inflation (%)

CACC ($bn)

2014 1.8 1.2 -1.40 2.2 1.1 -1.55 0.8 1.0 -1.15 2015-2019 2.2 2.9 -1.10 2.4 3.6 -1.35 3.2 3.2 -0.80

2014, The PRS Group, Inc. ISSN: 1054-5492

El Salvador Table of Contents

Page Country Update .....................................................................................................................................................U-1 Country Forecast Map..................................................................................................................................................................... 2 Highlights .......................................................................................................................................................... 3 Current Data...................................................................................................................................................... 5 Comment & Analysis ..................................................................................................................................... 11 Forecast Scenarios Most Likely Five-Year Regime Scenario: Divided Government (45% Probability)....................... 15 Second Most Likely Five-Year Regime Scenario: Center-Left Coalition (40% Probability) ......... 24

Third Most Likely Five-Year Regime Scenario: Centrist Coalition (15% Probability) .................. 26 Forecast Summary.................................................................................................................................. 28 Political Framework Players To Watch.................................................................................................................................... 31 Country Conditions Climate for Investment & Trade Overview ................................................................................................................................................... 1 Tariff and Non-tariff Barriers ................................................................................................................. 3 Policies ....................................................................................................................................................... 4 Legal Framework...................................................................................................................................... 6 Infrastructure ............................................................................................................................................ 9 Corruption and other Bureaucratic Obstacles .................................................................................... 10 International Agreements...................................................................................................................... 10 Labor Conditions.................................................................................................................................... 12 Background Geography............................................................................................................................................... 13 Social Conditions.................................................................................................................................... 13 Government ............................................................................................................................................ 13

Map

Political Risk Services El Salvador Country ForecastReproduction without written permission of The PRS Group is strictly prohibited.

REV2003

El Salvador

Santa AnaAhuachapn

Sonsonate

Acajutla

Neuva San Salvador

La Libertad

Chalatenango

Sensuntepeque

San SalvadorCojutepeque

San Vicente

ZacatecolucaUsulutn

San Francisco(Gotera)

San Miguel

La Union

GuatemalaHonduras

North Pacific Ocean

Political Risk Services 30-Apr-2014 Reproduction without written permission of The PRS Group is strictly prohibited.

Highlights 30-Apr-2014 Page 3

El Salvador

Country Forecast Highlights

MOST LIKELY REGIMES AND THEIR PROBABILITIES 18-Month: Divided Government 55% (45%) Five-Year: Divided Government 45% (60%) FORECASTS OF RISK TO INTERNATIONAL BUSINESS

Turmoil Financial Transfer

Direct Investment

Export Market

18-Month: High (Moderate) B B+ B (B+) Five-Year: Moderate B B B (B+) ( ) Indicates change in rating. * Indicates forecast of a new regime. KEY ECONOMIC FORECASTS

Years

Real GDP Growth %

Inflation %

Current Account ($bn)

2009-2013(AVG) 0.9 1.8 -0.99 2014(F) 1.8 1.8 -1.40 2015-2019(F) 2.2 2.9 -1.10

Narrow Win Will Reinforce Polarization Key Points To Watch A challenge to the official results of the run-off presidential election held in March has been

dismissed by the Supreme Court, but the razor-thin margin by which the victor, Salvador Snchez Cern, won the second-round contest highlights a long-standing and persistent political divide and reflects the fear of a sizeable section of the electorate that Snchez Cern is either incapable of bridging that divide or will pursue policies that widen it

The president-elect came close to winning in the first round, taking 48.9% of the vote in a three-way race. However, an overwhelming majority of voters who initially backed the third-place finisher, former President Tony Saca, cast their ballots for Norman Quijano, the candidate of the center-right Arena, in the second round, as did a large majority of the nearly 300,000 voters who skipped the first round but turned out for the run-off contest

The fear of a radical shift in policy course under Snchez Cern that appears to have driven the surge in support for Quijano in the second round may be overblown. When he takes office in June, the new president will lack a reliable majority in the Legislative Assembly,

Political Risk Services El Salvador Country Forecast 30-Apr-2014 Reproduction without written permission of The PRS Group is strictly prohibited.

Page 4 30-Apr-2014 Highlights

where the FMLN holds just 31 of the 84 seats. And with legislative elections scheduled for March 2015, smaller parties may not be keen to tie themselves closely in the public mind to a polarizing president

Lack of Investment Will Weigh on Growth It is probably the case that Arenas attempts to paint Snchez Cern as a leftist ideologue

bent on asserting state control over the economy overstate the president-elects ambitions. At a party conference held in early September 2013, the FMLN produced a campaign platform that focused on three priority goals: boosting employment, enhancing security, and improving the quality of education, none of which is inherently incompatible with a generally market-based approach to economic management

Implementation will require money, which the FMLN has pledged will be raised in part through a program of tax justice that reduces the tax burden of the poor and increases that of the wealthy. However, Snchez Cern has indicated that he will attempt to accomplish that objective by closing loopholes, rather than increasing the tax rates for those at the higher end of the income ladder. Likewise, although mining companies will continue to confront administrative obstacles to moving forward on stalled investment projects, the moratorium on issuing mining-related permits represents the continuation of a policy initiated by the Arena administration under former President Tony Saca

In general, while El Salvador will remain a risky destination for foreign investmentthe collapse of a truce between the countrys deadly street gangs is an unwelcome development on that scorethe danger that the government will adopt a significantly more hostile posture toward foreign firms is not among the factors that should most concern potential investors, especially in the near term

With the murder statistics pointing to near-term setbacks on the security front, Snchez Cerns hopes of making a favorable early impression will most likely hinge on success at reinvigorating El Salvadors lethargic economy, which posted real GDP growth of just 1.7% in 2013, the weakest showing of any country in Central America. Unfortunately for the new president, there is not much cause for optimism on that score

Over the medium term, both the ideological bent of the incoming administration and the political obstacles arising from the governments lack of a reliable legislative majority will hamper efforts to address the main deterrents to foreign investment, contribute to difficult relations with multilateral lenders, and reduce the countrys ability to take full advantage of free-trade agreements to boost exports, resulting in persistent sluggish growth averaging just 2.2% per year through 2019.

Economic Forecasts for the Three Alternative Regimes

Divided Government Center-Left Coalition Centrist Coalition Growth

(%) Inflation

(%) CACC ($bn)

Growth (%)

Inflation (%)

CACC ($bn)

Growth (%)

Inflation (%)

CACC ($bn)

2014 1.8 1.8 -1.40 2.2 1.6 -1.55 0.8 2.1 -1.15 2015-2019 2.2 2.9 -1.10 2.4 3.6 -1.35 3.2 3.2 -0.80

Political Risk Services El Salvador Country Forecast 27-Oct-2014 Reproduction without written permission of The PRS Group is strictly prohibited.

Current Data 27-Oct-2014 Page 5

Political Fact Sheet

CAPITAL:

San Salvador CONSTITUTION:

December 20, 1983 ADMINISTRATIVE SUBDIVISIONS:

14 departments POPULATION:

2013: 6.34 million AREA:

21,393 sq. km. OFFICIAL LANGUAGE:

Spanish STATUS OF PRESS:

free SECTORS OF GOVERNMENT PARTICIPATION:

utilities, public works, agriculture, banking, broadcasting

CURRENCY EXCHANGE SYSTEM: US dollar adopted as the official currency in 2001

EXCHANGE RATE: 9/27/2014 $1=0.79 euros

ELECTIONS: Presidential elections are held every five years; last, February 2 and March 9, 2014; next, scheduled February 2019. Legislative elections are held every three years; last, March 11, 2012; next, scheduled March 2015.

HEAD OF STATE: President Salvador Snchez Cern (2014) HEAD OF GOVERNMENT: President Snchez (2014) OFFICIALS: Oscar Ortiz, Vice President Orestes Ortez, Agriculture Solomn Tharsis Lupez, Economy Carlos Canjura, Education Lina Pohl, Environment & Natural Resources Carlos Cceres, Finance Hugo Martnez, Foreign Affairs Ramn Valencia, Government Violeta Menjivar, Health Sandra Guevara, Labor & Social Welfare David Mungua Pays, National Defense Benito Lara Hernndez, Public Security & Justice Gerson Martnez, Public Works & Transport Jos Duarte Durn, Tourism LEGISLATURE: Unicameral; 84-member Legislative Assembly. Seat distribution: Nationalist Republican Alliance (Arena), 33; Farabundo Marti National Liberation Front (FMLN), 31; Grand Alliance of National Unity (Gana), 11; National Coalition (CN), 7; other, 2.

Political Risk Services 27-Oct-2014

El SalvadorDatabank

Reproduction without written permission ofThe PRS Group is strictly prohibited.

2004-2008 Average

2009-2013 Average 2004 2005 2006 2007 2008

Domestic Economic IndicatorsGDP (Nominal, $bn) 18.59 22.66 15.80 17.09 18.55 20.10 21.43Per Capita GDP ($) 3047 3618 2612 2815 3041 3284 3485Real GDP Growth Rate (%) 2.9 0.8 1.9 3.5 3.9 3.8 1.3Inflation Rate (%) 5.0 1.9 4.5 4.7 4.0 4.6 7.3Capital Investment ($bn) 2.93 3.20 2.47 2.61 3.01 3.28 3.26Capital Investment/GDP (%) 15.7 14.1 15.6 15.3 16.2 16.3 15.2Budget Revenues ($bn) 2.66 3.47 2.09 2.30 2.69 2.97 3.24Budget Revenues/GDP (%) 14.2 15.3 13.2 13.5 14.5 14.8 15.1Budget Expenditures ($bn) 2.79 4.01 2.27 2.48 2.82 3.01 3.37Budget Expenditures/GDP (%) 15.0 17.7 14.4 14.5 15.2 15.0 15.7Budget Balance ($bn) -0.13 -0.54 -0.18 -0.18 -0.13 -0.04 -0.13Budget Balance/GDP (%) -0.7 -2.4 -1.1 -1.1 -0.7 -0.2 -0.6Money Supply (M1, $bn) 1.50 2.36 1.21 1.29 1.49 1.73 1.76Change in Real Wages (%) -0.8 2.2 -0.1 0.8 0.6 -2.8 -2.4Unemployment Rate (%) 6.6 6.7 6.8 7.2 6.6 6.3 5.9International Economic IndicatorsForeign Direct Investment ($bn) 0.18 0.29 0.36 0.06 0.02 0.11 0.37Forex Reserves ($bn) 1.93 2.32 1.72 1.69 1.78 2.07 2.40Gross Reserves (ex gold, $bn) 1.97 2.58 1.75 1.72 1.81 2.11 2.44Gold Reserves ($bn) 0.10 0.28 0.14 0.11 0.08 0.09 0.10Gross reserves (inc gold, $bn) 2.07 2.86 1.89 1.83 1.89 2.20 2.54Total Foreign Debt ($bn) 10.03 12.43 8.87 9.42 10.59 10.13 11.14Total Foreign Debt/GDP (%) 54.1 54.8 56.1 55.1 57.1 50.4 52.0Debt Service ($bn) 0.91 1.07 1.13 1.23 0.75 0.64 0.80Debt Service/XGS (%) 11.1 11.1 15.7 16.0 8.8 6.8 8.2Current Account ($bn) -0.95 -0.97 -0.63 -0.62 -0.77 -1.22 -1.53Current Account/GDP (%) -5.0 -4.2 -4.0 -3.6 -4.2 -6.1 -7.1Current Account/XGS (%) -10.9 -9.7 -8.8 -8.1 -9.0 -13.0 -15.6Exports ($bn) 3.87 4.26 3.34 3.46 3.78 4.07 4.70Imports ($bn) 7.55 8.59 6.00 6.50 7.42 8.43 9.38Trade Balance ($bn) -3.68 -4.33 -2.66 -3.04 -3.64 -4.36 -4.68Exports of Services ($bn ) 1.05 1.48 1.09 0.95 1.01 1.13 1.06Income, credit ($bn) 0.21 0.07 0.14 0.17 0.23 0.31 0.18Transfers, credit ($bn) 3.39 3.87 2.62 3.11 3.55 3.84 3.85Exports G&S ($bn) 8.52 9.68 7.19 7.69 8.57 9.35 9.79Liabilities ($bn) 0.24 0.47 0.27 0.26 0.16 0.13 0.39Net Reserves ($bn) 1.83 2.39 1.62 1.57 1.73 2.07 2.15Liquidity (months import cover) 2.9 3.4 3.2 2.9 2.8 2.9 2.8Currency Exchange Rate* 1.317 1.346 1.243 1.246 1.256 1.371 1.471Currency Change (%)* -5.5 1.9 -9.9 -0.2 -0.8 -9.2 -7.3Social IndicatorsPopulation (million) 6.10 6.26 6.05 6.07 6.10 6.12 6.15Population Growth (%) 0.4 0.6 0.3 0.3 0.5 0.3 0.5Infant Deaths/1000 25 20 27 26 25 23 23Persons under Age 15 (%) 37 31 37 37 37 36 36Urban Population (%) 62 64 62 60 61 62 63Urban Growth (%) 1.4 1.3 3.6 -2.9 2.2 1.9 2.1Literacy % pop. 80 85 80 80 80 81 81Agricultural Work Force (%) 18 20 17 17 19 19 19Industry-Commerce Work Force (%) 21 22 17 17 23 23 23Services Work Force (%) 61 58 66 66 58 58 58Unionized Work Force (%) 5 5 5 5 5 5 5Energy - total consumption (1015 Btu) 0.12 0.13 0.12 0.12 0.12 0.12 0.13Energy - consumption/head (109 Btu) 0.02 0.02 0.02 0.02 0.02 0.02 0.02

Note: *value of local currency measured against the euro

Current Data 27-Oct-2014 ~ Page 6-7

Political Risk Services 27-Oct-2014

El SalvadorDatabank

Reproduction without written permission ofThe PRS Group is strictly prohibited.

2004-2008 Average

2009-2013 Average

Domestic Economic IndicatorsGDP (Nominal, $bn) 18.59 22.66Per Capita GDP ($) 3047 3618Real GDP Growth Rate (%) 2.9 0.8Inflation Rate (%) 5.0 1.9Capital Investment ($bn) 2.93 3.20Capital Investment/GDP (%) 15.7 14.1Budget Revenues ($bn) 2.66 3.47Budget Revenues/GDP (%) 14.2 15.3Budget Expenditures ($bn) 2.79 4.01Budget Expenditures/GDP (%) 15.0 17.7Budget Balance ($bn) -0.13 -0.54Budget Balance/GDP (%) -0.7 -2.4Money Supply (M1, $bn) 1.50 2.36Change in Real Wages (%) -0.8 2.2Unemployment Rate (%) 6.6 6.7International Economic IndicatorsForeign Direct Investment ($bn) 0.18 0.29Forex Reserves ($bn) 1.93 2.32Gross Reserves (ex gold, $bn) 1.97 2.58Gold Reserves ($bn) 0.10 0.28Gross reserves (inc gold, $bn) 2.07 2.86Total Foreign Debt ($bn) 10.03 12.43Total Foreign Debt/GDP (%) 54.1 54.8Debt Service ($bn) 0.91 1.07Debt Service/XGS (%) 11.1 11.1Current Account ($bn) -0.95 -0.97Current Account/GDP (%) -5.0 -4.2Current Account/XGS (%) -10.9 -9.7Exports ($bn) 3.87 4.26Imports ($bn) 7.55 8.59Trade Balance ($bn) -3.68 -4.33Exports of Services ($bn ) 1.05 1.48Income, credit ($bn) 0.21 0.07Transfers, credit ($bn) 3.39 3.87Exports G&S ($bn) 8.52 9.68Liabilities ($bn) 0.24 0.47Net Reserves ($bn) 1.83 2.39Liquidity (months import cover) 2.9 3.4Currency Exchange Rate* 1.317 1.346Currency Change (%)* -5.5 1.9Social IndicatorsPopulation (million) 6.10 6.26Population Growth (%) 0.4 0.6Infant Deaths/1000 25 20Persons under Age 15 (%) 37 31Urban Population (%) 62 64Urban Growth (%) 1.4 1.3Literacy % pop. 80 85Agricultural Work Force (%) 18 20Industry-Commerce Work Force (%) 21 22Services Work Force (%) 61 58Unionized Work Force (%) 5 5Energy - total consumption (1015 Btu) 0.12 0.13Energy - consumption/head (109 Btu) 0.02 0.02

2009 2010 2011 2012 2013

20.66 21.42 23.14 23.81 24.263343 3444 3696 3779 3826-3.1 1.4 2.2 1.8 1.70.6 1.2 5.1 1.8 0.8

2.78 2.85 3.32 3.37 3.6613.5 13.3 14.4 14.2 15.12.86 3.21 3.56 3.76 3.9613.8 15.0 15.4 15.8 16.33.63 3.79 4.08 4.17 4.4017.6 17.7 17.6 17.5 18.1

-0.77 -0.58 -0.52 -0.41 -0.44-3.7 -2.7 -2.3 -1.7 -1.81.98 2.39 2.39 2.49 2.57-0.6 -3.5 -3.3 4.1 14.47.3 7.1 6.6 6.1 6.2

0.23 0.25 0.31 0.47 0.202.61 2.32 1.90 2.55 2.222.87 2.57 2.15 2.81 2.480.12 0.31 0.35 0.37 0.272.99 2.88 2.50 3.18 2.75

11.31 11.40 11.98 13.36 14.0954.7 53.2 51.8 56.1 58.10.86 0.87 1.80 0.97 0.8610.2 9.4 18.4 9.4 8.1

-0.31 -0.57 -1.11 -1.29 -1.58-1.5 -2.7 -4.8 -5.4 -6.5-3.7 -6.1 -11.4 -12.5 -14.83.93 4.58 4.24 4.23 4.337.04 8.11 9.01 9.16 9.63

-3.11 -3.53 -4.77 -4.93 -5.300.86 0.98 1.64 1.86 2.070.08 0.06 0.06 0.07 0.073.56 3.67 3.83 4.12 4.188.43 9.29 9.77 10.28 10.650.49 0.43 0.42 0.44 0.572.50 2.45 2.08 2.74 2.184.3 3.6 2.8 3.6 2.7

1.395 1.327 1.393 1.286 1.3285.2 4.9 -5.0 7.7 -3.3

6.18 6.22 6.26 6.30 6.340.5 0.6 0.6 0.6 0.622 21 20 19 1935 32 31 30 2963 64 64 65 650.5 2.3 0.8 2.2 0.686 84 84 85 8519 19 19 21 2123 23 23 21 2158 58 58 58 585 5 5 5 5

0.12 0.12 0.13 0.13 0.130.02 0.02 0.02 0.02 0.02

Note: *value of local currency measured against the euro

Current Data 27-Oct-2014 ~ Page 6-7

El Salvador Country Forecast

30-Apr-2014 Comparison: El Salvador

Page 8 30-Apr-2014 Current Data

Reproduction without written permission of The PRS Group is strictly prohibited

Regional Real GDP Growth (2013): N&C America

0 1 2 3 4 5 6 7 8 9

Jamaica

Mexico

Trinidad & Tobago

Canada

United States

El Salvador

Honduras

Cuba

Costa Rica

Guatemala

Dominican Republic

Haiti

Nicaragua

Panama

(percent)

Regional Inflation Rates (2013): N&C America

0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0

El Salvador

Canada

United States

Mexico

Dominican Republic

Panama

Guatemala

Honduras

Costa Rica

Trinidad & Tobago

Cuba

Haiti

Nicaragua

Jamaica

(percent)

El Salvador Country Forecast

30-Apr-2014 Comparison: El Salvador

Current Data 30-Apr-2014 Page 9

Reproduction without written permission of The PRS Group is strictly prohibited

Regional Current Account/GDP (2013): N&C America

-15.0 -10.0 -5.0 0.0 5.0 10.0

Panama

Nicaragua

Jamaica

Haiti

Honduras

El Salvador

Costa Rica

Dominican Republic

Guatemala

Canada

United States

Mexico

Cuba

Trinidad & Tobago

(percent)

Economic Performance ProfileCountry's Ranking Relative to All Countries

Covered by Political Risk Services2009-2013

3615 0.9

1.8

6.7

13.9

-2.4

-4.3

6.7

1.9

BEST 25% NEXT 25% NEXT 25%

GDP Per Capita ($)

Real GDP Growth (%)

Inflation (%)

Unemployment (%)

Capital Investment (% of GDP)

Budget Balance (% of GDP)

Current Account (% of GDP)

Debt Service Ratio

Currency Change (%)

WORST 25%

Political Risk Services El Salvador Country Forecast 27-Oct-2014 Reproduction without written permission of The PRS Group is strictly prohibited.

Page 10 27-Oct-2014 Current Data

Social Indicators as of 2013

Primary Energy

Energy Consumption (1015 Btu): 0.13 Per Capita Consumption (109 Btu): 0.02

Population

Annual Growth 0.6% Infant Deaths per 1,000 19 Persons Under Age 15 29% Urban Population 65% Urban Growth 0.6% Literacy 85%

Work Force Distribution

Agriculture 21% Industry-Commerce 21% Services 58% Unions 5%

Ethnic Groups

Mestizo (86%), white (13%), Amerindian (1%)

Languages

Spanish, Nahuatl

Religions

Roman Catholic (57%), Protestant (21%), other (5%), none (17%)


Comment & Analysis 30-Apr-2014 Page 11

El Salvador

Country Forecast Comment & Analysis

Close Presidential Race Will Reinforce Polarization

A challenge to the official results of the run-off presidential election held in March has been dismissed by the Supreme Court. However, the razor-thin margin by which the victor, Salvador Snchez Cern, won the second-round contest highlights a long-standing and persistent political divide in El Salvador and reflects the fear of a sizeable section of the electorate that Snchez Cern is either incapable of bridging that divide or will pursue policies that widen it. The president-elect is a former guerrilla commander and the leader of the orthodox Marxist wing of the incumbent Farabundo Mart National Liberation Front (FMLN). He is also the sitting vice president, and his victory in the run-off election seemed assured after he won 48.9% of the vote in a three-way race in the first round of voting in early February, and polls conducted in the run-up to the March face-off showed him holding a double-digit leader over Norman Quijano, the candidate of the main opposition Nationalist Republican Alliance (Arena). However, the official tally showed Snchez Cern defeating Quijano by less than 6,400 votes, out of a total of nearly 3 million ballots submitted nationwide. Significantly, some 293,000 Salvadorans who skipped the first round came out to vote in the second round. In combination with the roughly 325,000 voters who cast their ballot for former President Antonio Saca, a former leader of Arena who mounted a third-party campaign, or one of the two other challengers from very minor parties, that put around 620,000 votes up for grabs in second round. By winning more than 70% of those votes, Quijano came very close to snatching victory from the jaws of defeat. Both the significant increase in turnout for the run-off contest and Quijanos impressive success in attracting the support of previously uncommitted voters no doubt reflect the success of Arenas campaign to paint Snchez Cern as a radical leftist in the mold of the late Hugo Chvez, the former Venezuelan president whose heavily statist economic policies have damaged that countrys economy to an extent that even Venezuelas oil wealth can no longer disguise. The fact that campaigning for the second-round vote took place against a backdrop of spreadingand increasingly deadlypolitical violence in Caracas can only have magnified the impact of Arenas warnings about Snchez Cern on


Page 12 30-Apr-2014 Comment & Analysis

the thinking of those not already ideologically disposed to dismissing them as campaign lies. Radical Policy Shift Unlikely

All of which could prove to be very significant as Snchez Cern begins his five-year term in June. When he first takes office, his administration will lack a reliable majority in the Legislative Assembly, where the FMLN holds just 31 of the 84 seats. And with legislative elections scheduled for March 2015, smaller parties may not be keen to tie themselves closely in the public mind to a polarizing president. But beyond the practical barriers to pursuing any radical policy departures, at least in the near term, it is probably the case that Arenas attempts to tar Snchez Cern with the brush of chavismo overstate the president-elects ambitions. At a party conference held in early September 2013, the FMLN produced a campaign platform that focused on three priority goals: boosting employment, enhancing security, and improving the quality of education, none of which is inherently incompatible with a generally market-based approach to economic management. In terms of job creation, key proposals include the creation of a public lender to ensure access to credit for small businesses and stronger support for industries with high growth and employment potential. The security and education initiatives are closely tied to one another, with proposals to increase spending on social support for school-age children framed as a means of preventing the drift of young Salvadorans into criminal gangs. Other security-related measures included proposals to invest in state-of-the-art anti-crime technology and drug rehabilitation centers, and alternatives to prisonincluding school-based rehabilitationfor youths convicted of minor offenses. Of course, implementation will require money, which the FMLN has pledged will be raised in part through a program of tax justice that reduces the tax burden of the poor and increases that of the wealthy. Moreover, mining companies will continue to confront administrative obstacles to moving forward on stalled investment projects, but the moratorium on issuing mining-related permits represents the continuation of a policy initiated by the Arena administration under Saca. Snchez Cerns candidacy has been framed by the FMLN as the partys abandonment of the pragmatic approach that resulted in its endorsement of the moderate leftist incumbent, Mauricio Funes, as its presidential candidate in 2009, in favor of a truly red agenda. However, the president-elect stated after his victory that strengthening relations with the US will be a priority for his administration, which suggests that pragmatism will not be jettisoned entirely. In general, while El Salvador will remain a risky destination for


Comment & Analysis 30-Apr-2014 Page 13

foreign investment, the possibility of the incoming governments adoption of a significantly more hostile posture toward foreign firms is not among the factors that should most concern potential investors. Collapse of Gang Truce Will Heighten Security Risks

El Salvador consistently ranks near the top among countries with the highest murder rates in the world; according to the most recent UN statistics, the per capita homicide rate of El Salvador is second only to that of Honduras among nations not currently at war. Much of the violence is attributable to El Salvadors role as a major shipping route for international drug-traffickers, which has reinforced the deadly rivalry between urban criminal gangs (maras). Warfare between Mara Salvatrucha (MS-13) and Barrio 18 helped to push the total number of homicides above 4,000 as recently as 2011. A truce between the maras brokered by church leaders reduced the total number of murders by as much as 1,000 annually in 20122013. But while Salvadorans viewed the reduction in homicides favorably, they opposed direct negotiations between the government and the gangs. For that reason, the Funes administration never formally endorsed the truce, and the public release of documents suggesting that the government had rewarded gang leaders for their part in reducing the number of homicides under an arrangement that smacked of capitulation to extortion all but ruled out any chance that Snchez Cern or Quijano might voice support for the truce during the campaign. Indeed, Quijano actually pledged to take aggressive action against the gangs if elected. Just one week prior to the run-off election, the head of the National Civilian Police (PNC) announced that the cease-fire between the gangs had collapsed, and officials affiliated with security-related agencies have since echoed that assertion, citing statistics that revealed the number of homicides increased by 44% (year-on-year) over the first three months of 2014. Assuming the truce cannot be salvaged, the trend will likely be confirmed (and may even accelerate) in the coming months. As in the past, most of the victims will be gang members, but perceptions of a generalized increase in the risk of violence will further undermine the already weak credibility of El Salvadors security apparatus, with negative connotations for the countrys attractiveness to foreign investors. In the World Economic Forums 20132014 Global Competitiveness Report, El Salvador ranked 101st overall out of 148 countries surveyed, but ranked 147th with regard to the influence of organized crime and 142nd in terms of the business costs associated with crime and violence.


Page 14 30-Apr-2014 Comment & Analysis

Weak Coffee Production Limits Potential for Economic Rebound

With the murder statistics pointing to near-term setbacks on the security front, Snchez Cerns hopes of making a favorable early impression will most likely hinge on success at reinvigorating El Salvadors lethargic economy, which posted real GDP growth of just 1.7% in 2013, the weakest showing of any country in Central America. Unfortunately for the new president, there is not much cause for optimism on that score. Sales of coffee are the countrys main source of export revenue, but the crop has been decimated by the spread of the roya fungus. The National Coffee Council is forecasting that the 2013/2014 harvest will result in a 36% decline in output compared to 2012/2013. Since October 2013, coffee export earnings have fallen by nearly 50%, resulting in a 16% year-on-year drop in overall exports over the same period, despite the beneficial effect of stronger demand in the US, which has boosted non-traditional exports, particularly textiles. Increased remittances from Salvadorans working in the US will contribute to stronger domestic demand, as well as a narrowing of the current account deficit. However, the weakness of the agricultural sector is forecast to hold overall real GDP growth below 2% once again in 2014, and the current account shortfall will remain quite large, with a deficit of 5%6% of GDP expected this year. El Salvadors use of the US dollar as its official currency will help to contain upward pressure on consumer prices in the near term, but dependence on imports for energy and food will leave the economy vulnerable to volatility in global prices. Russias use of its influence over European gas supplies for leverage in a brewing diplomatic battle with the US and the EU over Ukraine holds the potential to produce a price shock. However, given the fragility of the economic recovery in the west, a steep increase in global fuel prices is unlikely to be sustained for very long, as the negative effect on economic performance in the US and Europe would probably trigger a fairly rapid reversal of the trend. On balance, inflation is forecast to average less than 2% in 2014, and the risks to the forecast are weighted toward the down side.


Forecast Scenarios 30-Apr-2014 Page 15

El Salvador

Country Forecast Forecast Scenarios

SUMMARY OF 18-MONTH FORECAST

REGIMES & PROBABILITIES

Divided Government 55%

Center-Left Coalition 30%

Populist Coalition 15%

SUMMARY OF FIVE-YEAR FORECAST




Centrist Coalition 15%

Most Likely Regime Scenario 18-Month Forecast Period: Divided Government (55% Probability) Five-Year Forecast Period: Divided Government (45% Probability) The razor-thin margin by which Salvador Snchez Cern won the run-off presidential election in March 2014 highlights a long-standing and persistent political divide in El Salvador, and reflects the fear of a sizeable section of the electorate that Snchez Cerna former guerrilla and the leader of the orthodox Marxist faction of the incumbent Farabundo Mart National Liberation Front (FLMLN)is either not capable of bridging that divide or will pursue policies that widen it. Snchez Cern, who will be sworn into office for a five-year term on June 1, is the sitting vice president, and he appeared to be assured of an easy victory in the run-off election after he won 48.9% of the vote in a three-way race in the first round of voting in early February. Indeed, polls conducted in the run-up to the March face-off showed him holding a double-digit leader over Norman Quijano, the candidate of the conservative Nationalist Republican Alliance (Arena). However, the official tally showed Snchez Cern defeating Quijano by less than 6,400 votes, out of a total of nearly 3 million ballots submitted nationwide. By winning more than 70% of the votes cast by the roughly 625,000 Salvadorans who either sat out the

Divided Government

Growth (%)

Inflation (%)

CACC ($bn)

2014 1.8 1.8 -1.40 2015-2019 2.2 2.9 -1.10


Page 16 30-Apr-2014 Forecast Scenarios

first round of voting or voted for someone other than the two main candidates in the February election, Quijano came very close to pulling off a huge upset. His near comeback is a testament to the success of Arenas campaign to paint Snchez Cern as a radical leftist in the mold of the late Hugo Chvez, the former Venezuelan president whose heavily statist economic policies have damaged that countrys economy to an extent that even Venezuelas oil wealth can no longer disguise.

The fact that the FMLN candidate won anyway does not mean that most voters are comfortable with a Chvez-like ideologue (although some undoubtedly are), but rather that they accepted as sincere Snchez Cerns assurances that he would govern as a moderate, in the style of the current leader of Uruguay, Jos Mujica, another former guerrilla turned president. However, the fact that he only barely won means that a very large minority of the population remains skeptical on that point.

On that basis, a case can be made that it is in Snchez Cerns interest to adopt a moderate posture. The legislative arithmetic suggests that he may have little choice in the early going. The FMLN currently controls just 31 or the 84 seats in the Legislative Assembly, and with legislative elections scheduled for March 2015, smaller parties may not be keen to tie themselves closely in the public mind to a polarizing president.

Both Arena and the local business community, represented by National Private Enterprise Association (ANEP), have accepted the president-elects invitation to participate in a dialogue process aimed at smoothing the leadership transition. However, the new-found amity will probably not last long, as preparations for the legislative campaign will likely produce a reversion to form, with Arena seizing upon any missteps by the new administration and any scrap of negative news as confirmation of its prediction that Snchez Cerns election would spell disaster for El Salvador. On that score, the prospects for much in the way of good news about either the economy or the domestic security situation that might bolster the FMLNs electoral chances are dim.

In any case, Arenas fear-based electoral strategy is better suited to a legislative campaign than to a winner-take-all contest like a run-off presidential election. If Arena makes gains in March 2015, the FMLN administration will be in a weaker position to cobble together a majority coalition, even on an ad hoc basis, and the challenges in that regard will be all the greater in the probable event that seats picked up by Arena will come largely at the expense of its chief rival for the conservative vote, former President Tony Sacas Grand Alliance of National Unity (Gana).

Lack of Majority Will Limit Risk of Negative Policy Shifts

Beyond the practical barriers to pursuing any radical policy departures, at least in the near term, it is probably the case that Arenas attempts to tar Snchez Cern with the brush of chavismo overstate the president-elects ambitions. The actions taken by Snchez



Cern and Vice President-elect Oscar Ortiz are consistent with the signals from other FMLN leaders of an acknowledgment on their part that achieving the economic development required to produce jobs and ensure adequate funding for the new administrations social programs will require a constructive relationship with the private sector, one based on the type of cooperation and compromise that has been notably lacking under the incumbent administration of President Mauricio Funes. The same traits that convinced many Salvadoran voters to take a chance on Funes in 2009his lack of a guerrilla pedigree, his self-identification as a moderate leftist, and the fact that he was not even officially a member of the FMLNleft him poorly positioned to pull the FMLN toward the center, which will be absolutely essential if an FMLN administration hopes to have a constructive relationship with the business community. Snchez Cern will not be hampered by similar handicaps. At a party conference held in early September 2013, the FMLN produced a campaign platform that focused on three priority goals: boosting employment, enhancing security, and improving the quality of education, none of which is inherently incompatible with a generally market-based approach to economic management. In terms of job creation, key proposals include the creation of a public lender to ensure access to credit for small businesses and stronger support for industries with high growth and employment potential. The security and education initiatives are closely tied to one another, with proposals to increase spending on the current FMLN administrations social support for school-age children framed as a means of preventing the drift of young Salvadorans into criminal gangs. Other security-related measures included proposals to invest in state-of-the-art anti-crime technology and drug rehabilitation centers, and alternatives to prisonincluding school-based rehabilitationfor youths convicted of minor offenses. Of course, implementation will require money, which the FMLN has pledged will be raised in part through a program of tax justice that reduces the tax burden of the poor and increases that of the wealthy. However, Snchez Cern has indicated that the focus will be on closing loopholes currently exploited by wealthy taxpayers, rather than increases in the rates applied to the income of individuals or the profits of businesses. Likewise, although mining companies will continue to confront administrative obstacles to moving forward on stalled investment projects, the moratorium on issuing mining-related permits represents the continuation of a policy initiated by the Arena administration under Saca. In addition, the president-elect stated after his victory that strengthening relations with the US will be a high priority for his administration.



None of which is to say that Snchez Cern is not tailoring his rhetoric to fit his political situation, and would not adopt a more stridently leftist posture if such an approach enjoyed the backing of a legislative majority. Indeed, his candidacy was initially framed by the FMLN as the partys abandonment of the pragmatic approach that led to its endorsement of Funes as its presidential candidate in 2009 in favor of promoting a truly red agenda. But it appears that he his prepared to adjust his strategy to fit the circumstances, and will maintain a generally pragmatic approach if the FMLN fails to win control of the Legislative Assembly.

In short, while El Salvador will remain a risky destination for foreign investment, the possibility of the incoming governments adoption of a significantly more hostile posture toward foreign firms is not among the factors that should most concern potential investors.

In its most recent Doing Business report, the World Bank ranked El Salvador among the bottom 25% of countries surveyed in the areas of ease of starting a business, dealing with construction permits, investor protection, and paying taxes. In that vein, ANEP will lobby for measures aimed at reducing bureaucratic obstacles and simplifying the tax system, all of which would garner the support of enough opposition lawmakers to secure passage. However, an FMLN administration will be wary of pursuing reforms that threaten the interests of its core constituencies. Consequently, there is little chance that Snchez Cerns government will experiment with labor-market reforms or otherwise make an effort to reduce the wage-related costs for business, which, in any case, will remain low by global standards.

In terms of corruption, El Salvador trails only Costa Rica among the least corrupt Central American countries and is near the middle of the pack among nations in the Western Hemisphere according to Transparency Internationals most recent Corruption Perceptions Index. However, with a score of just 38 (with 100 representing a corruption-free climate), there is plenty of room for improvement. Any serious anti-corruption effort would undoubtedly focus on current and former members of Arena, which controlled the government throughout the post-civil war period until losing the presidency in 2009. That group includes the founding leaders of Gana, a party whose support is likely to be crucial to securing passage of the administrations legislative initiatives. As such, the FMLN government will have a political incentive to move cautiously, if at all, on the anti-corruption front.

El Salvador consistently ranks near the top among countries with the highest murder rates in the world; according to the most recent UN statistics, the per capita homicide rate of El Salvador is second only to that of Honduras among nations not currently at war.



Much of the violence is attributable to El Salvadors role as a major shipping route for international drug-traffickers, which has reinforced the deadly rivalry between urban criminal gangs (maras). Warfare between Mara Salvatrucha (MS-13) and Barrio 18 helped to push the total number of homicides above 4,000 as recently as 2011. A truce between the maras brokered by church leaders reduced the total number of murders by as much as 1,000 annually in 20122013. But while Salvadorans viewed the reduction in homicides favorably, they opposed direct negotiations between the government and the gangs. For that reason, the Funes administration never formally endorsed the truce, and the public release of documents suggesting that the government had rewarded gang leaders for their part in reducing the number of homicides under an arrangement that smacked of capitulation to extortion all but ruled out any chance that Snchez Cern or Quijano might voice support for the truce during the campaign. Indeed, Quijano actually pledged to take aggressive action against the gangs if elected. Just one week prior to the run-off election, the head of the National Civilian Police (PNC) announced that the cease-fire between the gangs had collapsed, and officials affiliated with security-related agencies have since echoed that assertion, citing statistics that revealed the number of homicides increased by 44% (year-on-year) over the first three months of 2014. Assuming the truce cannot be salvaged, the trend will likely be confirmed (and may even accelerate) in the coming months. As in the past, most of the victims will be gang members, but perceptions of a generalized increase in the risk of violence will further undermine the already weak credibility of El Salvadors security apparatus, with negative connotations for the countrys attractiveness to foreign investors. In the World Economic Forums 20132014 Global Competitiveness Report, El Salvador ranked 101st overall out of 148 countries surveyed, but ranked 147th with regard to the influence of organized crime and 142nd in terms of the business costs associated with crime and violence. Prior to the initiation of the truce with the gangs in 2012, the Salvadoran Chamber of Commerce and Industry put the cost of crime for businesses at about $1.2 billion per year (or about 6% of GDP), with some $600 million spent by businesses each year on security services, about $300 million lost to theft, and $300 million spent by the government on hospital and emergency costs associated with crime. In fact, the true cost is undoubtedly much higher, as even the Chamber conceded that its figures do not accurately measure the amount that businesses spend on protection payments to gangs, which business owners are reluctant to report owing to fear of retaliation by extortionists.



The new administration will inherit a long-running dispute with foreign companies that have been forced to halt their gold mining operations owing to the governments refusal to issue the necessary permits, apparently without legal justification. Although the gold mining projects hold the promise to produce rapid benefits in terms of investment and jobs, the associated environmental risks have produced a groundswell of popular opposition. In August 2012, the government approved a proposal to suspend all mining activity until such time as the structures are in place to address the environmental and social impacts of mining activity. On the one hand, the FMLN and anti-mining groups claim that the proposal does not go far enough and are demanding an outright ban. On the other hand, advocates of mining, including conservative opinion shapers in the US, have characterized the indefinite suspension as evidence of Funes hostility to foreign investment. In fact, the projects were initially halted by the Arena government headed by Saca. While Arena is ideologically disposed to promoting the development of the mining sector, the party is divided over the issue. Exploratory drilling for the controversial El Dorado project has allegedly resulted in the drying up of water supplies used by local ranchers and farmers in Cabaas, who are an important part of Arenas rural constituency, and have aligned themselves with anti-mining activists. Having survived the potentially fatal split that followed the 2009 elections, Arena is unlikely to risk opening an urban-rural fissure by reversing its position on the issue. Consequently, the FMLN government is unlikely to face heavy pressure from the opposition to reverse its position on the issue, and may even be able to achieve the necessary legislative backing to institute a permanent ban. Beyond the potential financial penalties El Salvador stands to incur in the event of a judgment in favor of mining companies that are pursuing international legal action, the dispute will do nothing to reassure other companies that are reluctant to take a chance on El Salvador owing to concerns about security and the reliability of the legal system. Reflecting the influence of Alexander Segovia, who served as Funes chief economic adviser during the 2009 campaign, and prior to that was an adviser to the Treasury in Sacas administration, the incumbent administration disavowed a number of the FMLNs traditional positions. Chief among these was the FMLNs long-standing pledge to discontinue the use of the US dollar as the local currency, a policy that has contributed to low inflation and increased macroeconomic stability since 2001, but has also restricted the flexibility of fiscal policy. An FMLN administration that lacks a reliable legislative majority is unlikely to chance course in this area.



Lacking recourse to expansion of the money supply, the government must finance any increases in spending through increased revenues, domestic borrowing, or the assumption of foreign debt. Competition between the government and the private sector for domestic loans would inevitably result in a counterproductive increase in commercial interest rates. But the assumption of foreign debt requires the approval of a super-majority in the Legislative Assembly, which may be difficult for Snchez Cerns government to muster unless it makes concessions to the opposition that limit the scope for promised increases in social spending. For that reason, Snchez Cern could be inclined to introduce tax increases, but he may have difficulty securing the backing of even a simple majority if he attempts to skew the burden of tax hikes too heavily toward the upper end of the income ladder. Salvadorans Souring on Free Trade

El Salvador has been a regional leader in pursuing trade initiatives, and the previous Arena administration banked heavily on DR-CAFTA, which was ratified in March 2006, to provide a significant boost to the economy. Officials predicted that the treaty would fuel consistent double-digit export growth, pushing total exports to $10 billion by 2015. When the early results proved disappointing, the Arena government responded by stepping up its efforts to diversify the countrys trade links, and Funes also assigned high priority to a free-trade agenda. However, spreading popular opposition to free trade, particularly among groups that represent key constituencies of the FMLN, will discourage aggressive pursuit of new deals under the incoming administration. El Salvador negotiates free-trade agreements (FTAs) in concert with other Central American countries, which as a group are pursuing trade deals with Canada and Peru, have initiated trade talks with Pacific Rim nations, and have concluded an FTA with Mexico and an association agreement with the EU that must be ratified by the legislatures of the individual countries before coming into force. Talks with Canada are unlikely to make much progress, as Prime Minister Stephen Harpers government focuses instead on much more significant trade deals with the EU and India. Moreover, the still unresolved legal battle between the government in San Salvador and Pacific Rim, a Canadian gold mining company, will remain a sore spot in bilateral relations. Despite strong opposition from social groups, El Salvador ratified the Central American association agreement with the EU in July 2013. Debate over the EU agreement revealed the degree to which popular perceptions of free trade have been shaped by assessments of the impact of DR-CAFTA, a pact that has its defenders, but has failed to deliver as



expected. There are numerous reasons whychief among them the global recession in 20082009but the fact remains that the treaty has not produced any measurable economic improvement. In fact, from the perspective of the Salvadoran population, the most significant result of DR-CAFTA has been a negative one, namely, the surrender of the governments authority to protect the countrys health and environment. The use of DR-CAFTA as the basis upon which mining companies are pursuing legal action against the government has reinforced popular doubts about the wisdom of signing trade agreements with countries that wield significantly greater economic and political heft than El Salvador. In general, tariffs will decline according to agreed reduction schedules. However, with 25% of the labor force employed in the agriculture sector, the government will be hesitant to remove the barriers to agricultural imports. Non-tariff barriers, especially on the import of poultry and other agricultural products, will be reduced very slowly, if at all. Customs procedures have already been streamlined. A computerized, satellite-based system to process customs forms and declarations is already in operation. Further reductions in bureaucratic obstacles will be more difficult. Given the potential for serious fiscal slippage that might create pressure on foreign reserves, the possibility of a substantial increase in payment delays cannot be ruled out. Legislative Weakness an Obstacle to Addressing Security Issues

Despite the countrys social inequities, political turmoil has been markedly reduced since the signing of the peace accords in 1992. Nevertheless, the political climate is highly polarized, and the temptation to exploit public anger for political ends will be strong on both sides of the ideological divide. The risk will become more pronounced if, as is likely, Arena recaptures the presidency in 2014. The Marxist leadership of the FMLN will not refrain from organizing street-level demonstrations designed to intimidate policy makers if an Arena administration proves resistant to more subtle means of discouraging policies perceived to benefit wealthier Salvadorans at the expense of the poor. The main threat to internal stability for the past decade has been an epidemic of violent crime stemming from the incorporation of flourishing youth gangs (maras) into international drug-smuggling networks. Successive administrations have sought to address the problem with various formulations of the Firm Hand (Mano Dura) approach first introduced by President Francisco Flores. In addition to the increased use of the military for domestic policing, anti-crime measures have included stiffer penalties for gang members convicted of crimes and the criminalization of mere membership in a gang.



The more recent sharp decline in the number of homicides has been attributed to a truce among the gangs brokered by leaders of the Catholic Church, but the government refused to formally endorse the plan, and law enforcement officials suggested that their efforts are the real reason for the improvement in security conditions. A plan to establish sanctuary cities in which the gangs agreed to refrain from open warfare was embraced by mayors from both Arena and the FMLN, but the national administration was reluctant to endorse any scheme that might be interpreted as turning a blind eye to criminal activity in exchange for assurances of peace. In any case, all evidence suggests that the truce has collapsed, creating a significant risk of a spike in violent crime going forward.

The drug trade that has fueled the murder epidemic is becoming more deeply entrenched throughout Central America, and even if the maras were to agree to end their participation in the trafficking business, it is very likely that someone else would be positioned to take their place. A lasting solution to the problem will require regional cooperation, which can only be accomplished with the active participation of the national administration. To the extent that a sustained improvement relies on substantive action on the policy front, a scenario of divided government will create an impediment to lasting progress.

Weak Investment Will Weigh on Growth

With the murder statistics pointing to near-term setbacks on the security front, Snchez Cerns hopes of making a favorable early impression will most likely hinge on success at reinvigorating El Salvadors lethargic economy, which posted real GDP growth of just 1.7% in 2013, the weakest showing of any country in Central America. Unfortunately for the new president, there is not much cause for optimism on that score.

Sales of coffee are the countrys main source of export revenue, but the crop has been decimated by the spread of the roya fungus. The National Coffee Council is forecasting that the 2013/2014 harvest will result in a 36% decline in output compared to 2012/2013. Since October 2013, coffee export earnings have fallen by nearly 50%, resulting in a 16% year-on-year drop in overall exports over the same period, despite the beneficial effect of stronger demand in the US, which has boosted non-traditional exports, particularly textiles.

Increased remittances from Salvadorans working in the US will contribute to stronger domestic demand, as well as a narrowing of the current account deficit. However, the weakness of the agricultural sector is forecast to hold overall real GDP growth below 2% once again in 2014, and the current account shortfall will remain quite large, with a deficit of 5%6% of GDP expected this year.



El Salvadors use of the US dollar as its official currency will help to contain upward pressure on consumer prices in the near term, but dependence on imports for energy and food will leave the economy vulnerable to volatility in global prices. Russias use of its influence over European gas supplies for leverage in a brewing diplomatic battle with the US and the EU over Ukraine holds the potential to produce a price shock. However, given the fragility of the economic recovery in the west, a steep increase in global fuel prices is unlikely to be sustained for very long, as the negative effect on economic performance in the US and Europe would probably trigger a fairly rapid reversal of the trend. On balance, inflation is forecast to average less than 2% in 2014, and the risks to the forecast are weighted toward the down side.

Over the medium term, both the ideological bent of the incoming administration and the political obstacles arising from the governments lack of a reliable legislative majority will hamper efforts to address the main deterrents to foreign investment, contribute to difficult relations with multilateral lenders, and reduce the countrys ability to take full advantage of free-trade agreements to boost exports, resulting in persistent sluggish growth averaging just 2.2% per year through 2019. Strengthening global demand will drive up prices for imported staples over the medium term, but currency stability will limit the risk of worrisome inflation, which is forecast to average a relatively benign 2.9% annually over the five-year period.

Low levels of investment and a lack of progress toward implementing key trade agreements will hamper development of the export sector over the medium term, a factor that in combination with higher prices for commodity imports will contribute to sizeable deficits averaging $1.1 billion per year through 2019. The government will need to remain on reasonably good terms with the US, the IMF, and other multilateral lenders if balance-of-payments difficulties are to be avoided, and the same factors weighing on the growth forecast will contribute to risks in that regard.

Second Most Likely Regime Scenario

18-Month Forecast Period: Center-Left Coalition (30% Probability) Five-Year Forecast Period: Center-Left Coalition (40% Probability)

Voters will head back to the polls in a little less than one year to elect the 84 members of the Legislative Assembly. Although not the most likely scenario, it is possible that the FMLN could win control of the legislative branch, or at least gain enough seats to facilitate the formation of a fairly stable majority coalition.

Center-Left Coalition

Growth (%)

Inflation (%)

CACC ($bn)

2014 2.2 1.6 -1.55 2015-2019 2.4 3.6 -1.35



Following its disappointing loss in the presidential election, Arena has been troubled by internal strife, with reformist faction pushing for a house cleaning. Corruption allegations against former President Francisco Flores during the run-up to the February election hurt Arena in the first round of voting. Flores, who served as an adviser to Quijano during the campaign, has been removed from any visible position of authority, and frustration with Quijanos campaign has fueled calls for significant changes in the way the party chooses it candidates.

Lacking a unifying figure capable of keeping the factional strife in check, it is possible that Arena could suffer another split. Short of that, internal battles could hamper the effectiveness of the partys legislative campaign. In addition, Quijanos post-election suggestion of a possible military coup instigated by what he claimed was widespread electoral fraud may have alienated Salvadorans who have painful memories of the 12-year civil war that ended in 1992. Taking such factors into consideration, it is hardly beyond the realm of possibility that the FMLN might score a decisive victory in March 2015.

Long term, it is possible that a FMLN-led government will not solve many of the countrys most persistent problems. Under this scenario, a centrist coalition could emerge that prioritizes a middle-of-the-road approach that has been successful in such neighbors as Costa Rica.

Moderate Tack to the Left

A government dominated by the FMLN would be more likely to pursue an overtly leftist policy course. During the presidential campaign, Quijano repeatedly warned that a government headed by Snchez Cern would use Venezuelas statist model as his guide. Given the record of the outgoing FMLN administration and Snchez Cerns own comments since winning the presidency, that dire prediction seems to be something of an overstatement.

However, it is very likely that an FMLN administration that enjoys the benefit of a solid legislative majority would pursue a more leftward policy course. At this point, moves to nationalize the mining sector would be largely symbolic, given the effective moratorium that has been in place for several years. Wealthy Salvadorans and private-sector businesses could expect to see their tax bills increase, the government would avoid the openly hostile approach of the leftist regimes in Venezuela and Ecuador, instead taking a more measured approach that involved negotiation and trade-offs with the aim of increasing revenues without driving away badly needed investment.

While noting that DR-CAFTA and dollarization have produced many negative consequences, FMLN leaders have acknowledged that the abandonment of either would cause more problems than would be solved. FMLN moderates acknowledge the benefits



of trade liberalization, and a government in which they played a role in shaping policy would support limited moves to reduce tariffs and pursue other forms of trade liberalization.

Little Change in Turmoil Risk

Regardless of who controls the government, security-related risks will be a fact of life in El Salvador. However, should the government fail to make progress on reducing poverty or shoring up the economic foundation, the sense of betrayal among the countrys poor could inject an added measure of hostility to anti-government protests that occurred, creating a somewhat higher risk of civil disturbances.

More Stable Political Climate Would Not Benefit Economy

Although the policies implemented under a center-left government would not contribute to a more attractive climate for investment, neither would they represent a dramatic break from the status quo. Consequently, the economy could be expected to muddle along as it has in recent years. Growth and inflation would reflect the impact of previously implemented measures, but few steps would be taken to build upon those measures in ways that might lead to a substantial economic improvement over the forecast period. Real GDP growth would average 2.4% annually through 2019, and inflation would be higher than under the most likely scenario, reflecting the impact of a more expansionary fiscal policy on domestic demand. Similarly, stronger demand for imports would produce larger current account deficits averaging $1.35 billion per year through 2019.

Third Most Likely Regime Scenario

18-Month Forecast Period: Populist Coalition (15% Probability) Five-Year Forecast Period: Centrist Coalition (15% Probability)

Although unlikely, it is possible that Snchez Cern might pull together a majority coalition willing to back a program that eschews fiscal discipline and embraces an unabashedly leftist policy agenda. The policies of a populist left regime would pose a threat to both social stability and the integrity of Salvadoran democracy, resulting in an even more highly polarized domestic climate and a deterioration of the countrys standing within the international community. Investors would steer clear of the country, and trade partners might seek to pressure the government by imposing trade restrictions. The US has threatened to suspend Nicaraguas participation in DR-CAFTA over its failure to meet democratic standards, and might be inclined to apply pressure on a populist Salvadoran government in the same way.

Centrist Coalition

Growth (%)

Inflation (%)

CACC ($bn)

2014 0.8 2.1 -1.15 2015-2019 3.2 3.2 -0.80



Looking further ahead, it is possible that conditions of divided government in the near term could become the basis for the election of a centrist presidential candidate in 2018, and the establishment of a majority coalition made up of the more moderate elements of both the FMLN and Arena.

A government that could claim a majority without the support of the hard-left faction of the FMLN or the most conservative elements within Arena would be more likely to implement meaningful economic reforms, but ideological differences within such a coalition would still be sufficiently large as to contribute to delays in approving legislation, and the risk of rupturing the alliance would encourage caution on the part of the president. Even so, some limited advances could be expected in the areas of privatization and business deregulation. A centrist coalition government would take steps to streamline the bureaucracy, but efforts to root out corruption would face resistance from vested interests, limiting the potential for any substantial reduction in informal obstacles faced by businesses.

The creation of a relatively stable centrist coalition that includes moderate factions from both the left and the right would facilitate efforts to secure passage of reform measures required to meet the conditions of lending agreements with the IMF, providing a firmer economic foundation on which to take steps to alleviate the poverty that has fueled polarization and contributed to social instability.

Medium-term Economic Outlook Somewhat Brighter

A centrist governments cautious approach to reform would probably not encourage a significant increase in levels of foreign investment. That said, assuming the governments policies received a favorable response from the IMF, even limited steps to enhance the climate for business could be expected to result in a somewhat better economic performance than would be the case under conditions of divided government. Growth and inflation would reflect the impact of previously implemented measures, but few steps would be taken to build upon those measures in ways that might lead to a substantial economic improvement over the forecast period. Real GDP growth would average 3.2% annually through 2019, and inflation would average 3.2% per year over the five-year forecast period. Improved export performance would offset the effect of more robust domestic demand on the external balances, and the current account deficit would average $800 million per year through 2019.



Forecast Summary

SUMMARY OF 18-MONTH FORECAST




Populist Coalition 15%

RISK FACTORS CURRENT Turmoil Moderate SLIGHTLY MORE SLIGHTLY MORE SLIGHTLY MORE Investment Equity Moderate Same SLIGHTLY MORE MORE Operations Moderate SLIGHTLY MORE Same SLIGHTLY MORE Taxation Moderate Same SLIGHTLY MORE MORE Repatriation Moderate Same Same Same Exchange Low Same Same SLIGHTLY MORE Trade Tariffs Moderate SLIGHTLY LESS SLIGHTLY LESS Same Other Barriers Moderate Same Same SLIGHTLY MORE Payment Delays Moderate Same Same SLIGHTLY MORE Economic Policy Expansion Moderate SLIGHTLY MORE SLIGHTLY MORE MORE Labor Costs Low Same SLIGHTLY MORE SLIGHTLY MORE Foreign Debt High Same SLIGHTLY MORE SLIGHTLY MORE

SUMMARY OF FIVE-YEAR FORECAST




Centrist Coalition 15%

RISK FACTORS BASE Turmoil Moderate Same Same Same Restrictions Investment Moderate Same Same SLIGHTLY LESS Trade Moderate SLIGHTLY LESS Same SLIGHTLY LESS Economic Problems Domestic High Same Same Same International Moderate Same SLIGHTLY MORE Same

* When present, indicates forecast of a new regime



El SalvadorReal GDP Growth Under Alternative Regimes

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

2009 2010 2011 2012 2013e 2014f 2015-2019f

(per

cent

)

Divided Government Center-Left Coalition Centrist Coalition

El SalvadorInflation Under Alternative Regimes

0

1

2

3

4

5

6

2009 2010 2011 2012 2013e 2014f 2015-2019f

(per

cent

)


El SalvadorCurrent Account Under Alternative Regimes

-1.8

-1.6

-1.4

-1.2

-1.0

-0.8

-0.6

-0.4

-0.2

2009 2010 2011 2012 2013e 2014f 2015-2019f

($bi

llions

)



Political Framework 30-Apr-2014 Page 31

El Salvador

Country Forecast Political Framework

Players To Watch

Salvador Snchez Cern: The former guerilla leader came close to wining an outright majority in the first round of presidential voting in February 2014, but only narrowly secured victory in the March run-off contest, defeating his center-right opponent, Norman Quijano, by a margin of less than 7,000 votes. The close call reflects widespread public fears that the FMLN leader will steer El Salvador down a socialist path, but Snchez Cern has offered assurances that he intends to govern as a moderate. In any case, his lack of a legislative majority will limit the scope for any significant changes in policy course until after the next round of legislative elections in March 2015. Since winning the election, Snchez Cern has reached out to both Arena and the local business community, represented by National Private Enterprise Association, and FMLN spokespeople have noted that the new president recognizes that achieving his administrations social policy goals will require the cooperation of private-sector investors. Although there is every reason to believe that Snchez Cern would tack somewhat to the left if he manages to secure a reliable legislative majority, sustaining that support will be difficult unless he manages to produce tangible economic improvements that are unlikely to materialize if he veers too far to the left. The increasingly questionable ability of Venezuela to subsidize hard-left regimes in the region is another factor that diminishes the risk of any radical policy departures by the new administration. Farabundo Marti National Liberation Front: The perennial leader of the opposition won the presidency for the first time in 2009, a result largely attributable to its nomination of a moderate leftist as its presidential candidate. The hard-left leaders of the governing party made no secret of their displeasure with the moderate course pursued by President Mauricio Funes, and the nomination of Snchez Cern, an orthodox Marxist, as the partys presidential candidate for 2014 pointed to the adoption of a more traditionally leftist posture. However, the partys campaign platform was largely uncontroversial, and Snchez Cern has signaled his intention to govern in the manner of the moderate leftist governments in Brazil and Uruguay. Unlike Funes, Snchez Cerns leftist credentials are impeccable, a fact that places him in a stronger position to pull his party to the center without triggering factional infighting.


Page 32 30-Apr-2014 Political Framework

Nationalist Republican Alliance: The countrys dominant party throughout the post-civil war period until it lost the presidency in 2009, Arena overcame the handicap created by the defection of more than a dozen of its lawmakers in the aftermath of its defeat by netting an additional 14 seats at the March 2012 legislative elections, making it the largest single party in the Legislative Assembly. The conservative party failed to recapture the presidency from the FMLN in 2014, and the defeat has triggered demands from within the party for changes, particularly with regard to h

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