Report No. 32856-SV

EL SALVADOR PUBLIC EXPENDITURE REVIEW December 31, 2004 Central America Department Latin America and the Caribbean Region

Document of the World Bank ▬▬▬▬▬▬▬

Currency Equivalents

US$1 = 8.75 Colones

Fiscal Year January 1 – December 31

Main Acronyms and Abbreviations ACE EDUCO’s School Community Associations SIRH Human Resources Information System

AFI Law Organic Law of State Financial Management FDI Foreign Direct Investment

ANDA Water Company FESAL National Family Health Survey

(Encuesta Nacional de Salud Familiar)

ANDAR Asociación Nacional para la Defensa, Desarrollo y Distribución de Agua a Nivel Rural FIDSL Social Investment Fund and Local

Development

ANTEL Telecommunication Company FODES Fondo de Desarrollo de El Salvador

APRISA USAID’s Support to El Salvador Health Services Program FOVIAL Fondo de Conservación Vial

BCR Central Bank FUSADES Fundación Salvadoreña para el Desarollo Económico y Social

CABEI Central American Bank for Economic Integration GDP Gross Domestic Product

CAFTA Central America Free Trade Agreement GOES Government of El Salvador

CAESS El Salvador Electric Company IDB Inter.-American Development Bank

CASSA Compañía Azucarera Salvadoreña IMF International Monetary Fund

CDE Traditional School Councils INPEP Instituto Nacional Pensiones Empleados Públicos

CEL National Power Company ISDEM Salvadoran Institution of Municipalities

CG Central Government ISSS Salvadoran Social Security Institute

CEM Country Economic Memorandum LAC Latin America and the Caribbean

COMURES Corporación de Municipalidades de El Salvador LDC Less Development Countries

CONIP National Commission on Public Investment MDG Millennium Development Goals

CPI Consumer Price Index MINED Ministry of Education

CRA Development Center for Education Resources MOH Ministry of Health

DELSUR Distribuidora de Electricidad del Sur MOP Ministry of Public Works

DEUSEM Distributadora Eléctrica de Usulután Sociedad de Economía Mixta MRD Most Recent Data

DGCG Government Accounting Directorate NFPS Nonfinancial Public Sector

DGICP General Directorate for Public Investment and Credit NGO Non-Governmental Organization

DIGESTYC Dirección General de Estadísticas y Censos OMS Organización Mundial de la Salud

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ECLAC Economic Commission for Latin America and the Caribbean OPS Pan American Health Organization

EDUCO Community Based School Program PAE Annual School Plan

EHPM Encuestas de Hogares Propósitos Múltiples PAES Secondary Education Aptitude Test

FATEL ANTEL’s Privatization Fund PAHO Pan American Health Organization

PEI Institutional Education Project UNDP United Nations Development Program

PEIP Presupeusto Extraordinario de Inversión Publica USAID United States Agency for International Development

PEP Budget Execution Project VAT Value Added Tax

PLANSABAR Plan Nacional de Saneamiento Básico Rural WDI World Development Indicators

SAFI Integrated Financial Management System WHO World Health Organization

SIBASIS Basic Systems of Integral Health Attention WTO World Trade Organization

Vice President LCR: David de Ferranti Director LCC2C: Jane Armitage Director LCSPR: Ernesto May Sector Manager: Mauricio Carrizosa Lead Economist: C. Felipe Jaramillo Task Manager: Ana Lucia Armijos Research Analyst: Ricardo Tejada

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Table of Contents: EXECUTIVE SUMMARY .......................................................................................................x CHAPTER I: Macroeconomic Environment and Fiscal Sustainability.....................................1

I. Macroeconomic Trends.................................................................................................2 II. Fiscal Revenues and Expenditures................................................................................4 III. Fiscal Cost of Pension Reform................................................................................23 IV. Fiscal and Debt Sustainability.................................................................................26 V. Conclusions .................................................................................................................33

ANNEX I: Sensitivity Analysis To Changes In Main Macroeconomic Assumptions ............35 ANNEX II: The Fiscal Costs of Pensions ...............................................................................39 CHAPTER II: Public Expenditure Management....................................................................49

III. Institutional Framework..........................................................................................49 IV. Budget Formulation and Reliability........................................................................56 V. Budget Execution and Controls...................................................................................63 VI. Financial Reporting and External Oversight...........................................................71 VII. Conclusions and Recommendations .......................................................................76

ANNEX I: El Salvador CPAR.................................................................................................82 Main Weaknesses and Recommendations...........................................................................82

CHAPTER III: Education........................................................................................................84 I. Organization of the Sector...........................................................................................84 II. Strategic Objectives and Resource Allocation Processes ...........................................85 III. Expenditure Trends .................................................................................................87 IV. Expenditure Outcomes............................................................................................93 V. Conclusions and Recommendations..........................................................................107

CHAPTER IV: Health ...........................................................................................................111 I. Organization of the Sector.........................................................................................111 II. Strategic Objectives and Resource Allocation Process.............................................112 III. Expenditure Trends and Structure.........................................................................115 IV. Expenditure Outcomes..........................................................................................124 V. Conclusions and Recommendations..........................................................................132

CHAPTER V: Water Supply and Sanitation .........................................................................136 I. Sector Organization...................................................................................................136 II. Strategic Objectives and Resource Allocation Process.............................................137 III. Expenditure Trends and Structure.........................................................................140 IV. Expenditure Outcomes..........................................................................................144 V. Conclusions and Recommendations..........................................................................154

CHAPTER VI: Rural Roads..................................................................................................158 I. Sector Organization...................................................................................................158 II. Strategic Objectives and Resource Allocation Process.............................................159 III. Expenditures Structure and Trends .......................................................................161 IV. Expenditure Outcomes..........................................................................................165 V. Conclusions and Recommendations..........................................................................171

CHAPTER VII: Rural Electrification...................................................................................174 I. Sector Organization...................................................................................................174 II. Strategic Objectives and Resource Allocation Process.............................................176 III. Expenditure Outcomes..........................................................................................184 IV. Conclusions and Recommendations .....................................................................193

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Boxes: Box 1.1: Chile’s Fiscal Rule ............................................................................................. 32 Box 2.1: Public Sector Modernization Program............................................................... 50 Box 2. 2: Main Laws and Regulations Governing Public Financial Management........... 54 Box 2.3: Expenditure Budget Classifications ................................................................... 59 Box 2.4: Expenditure Budget Execution Process ............................................................. 64 Box 2.5: Court of Accounts – Selected Indicators............................................................ 73 Box 5.1: Water and Sanitation Sector Reform Efforts ................................................... 139 Box 6.1: Fund for Road Conservation ............................................................................ 164 Box 7.1: Principal Measures Implemented to Modernize the Electricity Sector............ 177 Box 7.2: Evolution of Electricity Subsidies.................................................................... 181 Box 7.3: Wholesale Electricity Market........................................................................... 187 Box 7.4: Quality Norms for the Distribution of Electricity ............................................ 188 Tables: Table 1.1: Non-Financial Public Sector and CG ($million) ............................................... 5 Table 1.2: Non-Financial Public Sector as Percent of GDP ............................................... 6 Table 1.3: Non-Financial Public Sector, as % of Total Revenues and Expenditures......... 7 Table 1.4: Non-Financial Public Sector (US$ m.) .............................................................. 8 Table 1.5: Government Allocations for FODES and FISDL (US$ m.)............................ 10 Table 1.6: Distribution of Expenditure by selected Countries, average 1996 – 2003 ...... 11 Table 1.7: CG revenues, expenditures and overall deficit (% of GDP)............................ 12 Table 1.8: CG Approved and Executed Budget by Management Area (% of total budget)

................................................................................................................................... 13 Table 1.9: CG Budget. Approved and Executed by Management Area (% of GDP)....... 13 Table 1.10: CG Budget: Executed as Percent of Approved by Management Area.......... 17 Table 1.11: Estimated Increase in Public Spending to Implement a National Social Policy

for Poverty Reduction ............................................................................................... 19 Table 1.12: CG revenues as percent of total revenues...................................................... 20 Table 1.13: CG Tax Revenues as % of Current Revenues and GDP .............................. 21 Table 1.14: CG Actual Revenues in US$ m. and as percent of Project Revenues ........... 22 Table 1.15: Central America Value Added Revenue Productivities ................................ 23 Table 1.16: Structure & Features of Pension Reforms in Latin America......................... 25 Table 1.17: Non Financial Public Sector Debt in US$ m. and as percent of GDP........... 27 Table 1.18: Main Macroeconomic Assumptions .............................................................. 28 Table 1.19: NFPS Primary Balance ** and Selected Macroeconomic Variables ............ 36 Table 1.20: NFPS Primary Balance ** and Selected Macroeconomic Variables ............ 36 Annex 1.A: Fiscal Performance Under the Passive Scenario .......................................... 37 Annex 1.B: Fiscal Performance Under the Fiscal Target Scenario ................................. 38 Table A.1: Basic Statistics of the Old Pension System .................................................... 39 Table A.2: Population Affiliated and Pensioners, by Social Security Institute ................ 41 Table A.2: Pension Debt, December 2003........................................................................ 43 Table A.3: Options to Reduce Pension Debt .................................................................... 45 Table A.4: Detailed Estimates of the Options to Reduce Pension Debt........................... 47 Table 2.1: Budget Transparency Perception Survey - Variables 2003............................. 53 Table 2.2: Budget Formulation Process........................................................................... 57

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Table 2.3: Aggregate Revenue Budget Execution – CG .................................................. 60 Table 2.4: Aggregate Expenditure Budget Execution – CG............................................. 60 Table 2.5: Average Deviation of Expenditure Budget Execution .................................... 61 Table 2.6: Budget Execution Volatility Over Time – CG ................................................ 61 Table 2.7: Short-term payables ......................................................................................... 65 Table 3.1: Student Population, by sector 2002 ................................................................. 84 Table 3.2 Education Vouchers, 1996-2003....................................................................... 87 Table 3.3: Public Education Expenditure per Student 1999 - 2002.................................. 88 Table 3.4: MINED Budget by Function 96-03 ................................................................. 90 Table 3.5: Trends in Monthly and Hourly Public and Private Teachers Real Wages ...... 91 Table 3.6: Pupil-Teacher Ratio in Primary, 1996, 2000/01.............................................. 91 Table 3.7 MINED’s Financing Sources, 1997-2003 ........................................................ 93 Table 3.8 Education Vouchers, by Source of Financing .................................................. 93 Table 3. 9 Trends in Gross Enrollments, 1996-2002, by Area Gross Enrollment Rate.... 94 Table 3.10 Gross and Net Enrollment Rates, 2002........................................................... 95 Table 3.11 Indicators of Educational Efficiency, by Area and Sector, 2002.................... 98 Table 3.12: Voucher Programs Under Execution ........................................................... 100 Table 3.13: Achievement Tests for Basic Education, Average Scores (1994-98).......... 101 Table 3.14: PAES’s Average Scores by Discipline, 1997 – 2001 a/ .............................. 102 Table 3.15: Reasons for not attending school, by area, 2002 ......................................... 104 Table 4.1: Total Health Expenditure Per capita, 1996 – 2000........................................ 116 Table 4.2: Public and Private Health Spending and Sources of Financing ................... 116 Table 4.3: MSPASE Expenditures, by Major Economic Category, 1996 – 2003 .......... 119 Table 4.4: Hospital Budgets by Type of Attention and Major Category, 2003.............. 119 Table 4.5: MSPAS and Public Hospitals Budget, by Category 1996 – 2003................. 120 Table 4.6: MSPAS’ Staff, 1999 - 2002........................................................................... 121 Table 4.7: MSPAS Spending, by Financing Source, 1997 - 2003.................................. 123 Table 4.8: External Financing for the Health Sector, 1994 - 2002 ................................. 123 Table 4.9: Key Health Indicators, 1990 – 2002 .............................................................. 124 Table 4.10: MSPAS Selected Indicators, 1996 – 2002................................................... 125 Table 4.11: Population Covered by Medical Insurance, 2002........................................ 128 Table 4.12: Establishment that Visited When Ill, 2002 .................................................. 128 Table 4.13: Motives for not visiting MSPAS establishments, 2002............................... 129 Table 4.14: Distribution of Persons Visiting Central Government MSPAS Facilities by

Income Group 2002 ................................................................................................ 130 Table 5.1: Water and Sanitation Coverage, by Institution, 2002.................................... 136 Table 5.2: Public expenditures on water supply and sanitation, 1990 – 2003................ 140 Table 5.3: ANDA Expenditures, by Major Economic Category, 1997 – 2003 .............. 142 Table 5.4: Public Investment Programs in Water and Sanitation, 1990 – 2003 ............. 142 Table 5.5: ANDA – Source of investment financing, 1990 - 2002 ................................ 144 Table 5.6: El Salvador Water Supply and Sanitation Coverage, 1990 – 2002 .............. 145 Table 5.7: Central America – Water Supply and Sanitation Coverage, 1999 ................ 146 Table 5.8: Central America Water Supply and Sanitation Coverage, 1999 ................... 146 Table 5.9: ANDA’s Water Losses, 1993 – 2002 ............................................................ 147 Table 5.10: Average Water Price in Greater San Salvador, 2002 .................................. 148 Table 5.11: Causes of Morbidity Related to Water Quality and Sanitation, 2002 ......... 151

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Table 5.12: Distribution of Water Sanitation Services, by department 1990 – 2002 ..... 153 Table 5.13: FISDL’s Distribution Water Sanitation Projects by Department 1991–2003

................................................................................................................................. 154 Table 6.1: El Salvador – Road Network, 2000 ............................................................... 158 Table 6.2: Damage Caused by the 2001 Earthquakes to the Road Network (US$ m.) .. 160 Table 6.3: FOVIAL’s Expected Benefits........................................................................ 161 Table 6.4: Public Expenditure in Road Network, 1990 – 2003 ...................................... 162 Table 6.5: Ministry of Public Works, Budget Execution, 1997 – 2002.......................... 162 Table 6.6; FOVIAL’s Expenditures, 2002 – 2004.......................................................... 163 Table 6.7: Financing of MOP-FOVIAL Investment in Road Network, 1998 – 2003 .... 164 Table 6.8: Participation of Rural Roads on Road Network, 1990 - 2002....................... 166 Table 6.9: Rural Household Access Indicators............................................................... 166 Table 6.10: Situation of the priority Road Network, 2002 ............................................. 168 Table 6.11: Situation of the Priority Road Network by Department, 2002 .................... 168 Table 6.12: Departmental Distributions of the Sustainable Rural Roads, 1999 – 2003 . 169 Table 6.13: FISDL Investment in Rural Road Improvement, by Department................ 170 Table 6.14: Evolution of the Access to Markets, by Poverty Level, 1995 – 2001 ......... 171 Table 7.1: CEL – Principal Projects Executed, 1990 – 2004.......................................... 179 Table 7.2: CEL’s Electricity Consumption Subsidies, January 1998 – March 2001 ..... 180 Table 7.3: FINET – Electricity Subsidies Granted, April 2001 – December 2003 ........ 182 Table 7.4: Implicit Subsidy on Rural Electricity Consumption, 1994............................ 182 Table 7.5: Public Resource Assigned for Rural Electrification and Subsidies............... 183 Table 7.6; Capital Investment by the Distribution Companies, 1998 – 2003 (US$ m.). 183 Table 7.7: Electricity Coverage in Central American Countries, 1990 – 2002 .............. 184 Table 7.8: El Salvador – Electricity Coverage, 1991 – 2002.......................................... 185 Table 7.9: El Salvador – Transmission & Distribution Electricity Losses (1990 – 2002)

................................................................................................................................. 185 Table 7.10: Central America – Transmission & Distribution Electricity Losses (1990 –

2002) ....................................................................................................................... 186 Table 7.11: El Salvador – Electricity Prices, 1998 – 2003 ............................................. 186 Table 7.12: Central America – Average Prices Residential Customers, 1998 – 2002 (US

cents/KWh) ............................................................................................................. 187 Table 7.13: El Salvador Energy Interruption and Not Delivered (EIND), 1990 – 2002 189 Table 7.14: Frequency of Deficit in Reserves, 2003 ...................................................... 190 Table 7.15: Power Supply and Demand, 1990 – 2003 ................................................... 190 Table 7.16: Electricity Companies – Indicators of Quality Services to Clients, 2003 ... 190 Table 7.17: FISDL’s Distribution Rural Electrification Projects, 1994 – 2003 ............. 192 Table 7.18: FINET – Geographic Distribution of Subsidy to Residential Consumption

(2001–2002)............................................................................................................ 192 Charts and Figures: Chart 1.1: Real GDP Growth Rates .................................................................................... 3 Chart 1.2: Non-Financial Public Sector Expenditure (% of GDP) ..................................... 9 Chart 1.3: CG Revenues, Expenditures and Overall Deficit ............................................ 12 Chart 1.4: Executed as % of Approved CG Budget, by Management Area..................... 17 Chart 1.5 CG Current Revenues and Total Expenditures as percent of GDP................... 20 Chart 1.6: Executed as % of Approved CG Budget by Management Area...................... 21

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Chart 1.7: Non Financial Public Sector Debt as percent of GDP ..................................... 26 Chart 1.8 Overall NFPS Deficit ........................................................................................ 31 Chart 1.9: NFPS Primary Balance .................................................................................... 31 Chart 1.10: NFPS Total Public Debt................................................................................. 31 Chart 1.11: NFPS Interest Payments ................................................................................ 31 Chart 2.1: Governance Indicators, 2002/2000/1998 and regional comparison 2002 ....... 52 Chart 3.1: Public Spending on Education ......................................................................... 88 Chart 3.2: Education Budget, 1996/03.............................................................................. 88 Chart 3.3: Dist. of MINED’s Recurrent Exp. by Level of Education 1996-2003 ............ 89 Chart 3.4: Gross Enrolments in Basic Education.............................................................. 95 Chart 3.5: Gross Enrolment Secondary Education National Level .................................. 95 Chart 3.6: Repetition Rates in Basic by Grades, 1996 - 2001 .......................................... 96 Chart 3.7 Dropout rates in primary urban areas, by grade 1996 –01................................ 96 Chart 3.8: Dropout rates in primary rural areas, by grade 1996 - 01................................ 96 Chart 3.9: Relationship Education Exp. and Net Enrollment on Primary Education....... 98 Chart 3.10: Relationship Public Spending and Net Enrolment on Secondary Education 98 Chart 3.11: Share of Public Education Expenditure by Quintile and Level, 2002 ......... 105 Chart 3.12; Net Enrolment in Basic Education Quintile................................................. 106 Chart 3.13: Average Years of Schooling for 15 Year Olds ........................................... 106 Chart 3.14: Pop. Income and MINED Spending in Basic Education by Department (2000)

................................................................................................................................. 107 Chart 4.1: Total Health Expenditures as percent of GDP, 2000..................................... 115 Chart 4.2: MSPAS Budget as percent of Total Budget and GDP 1996 - 2004 .............. 117 Chart 4.3: MSPAS Expenditures by Level of Attention & Administration (1996 – 2003)

................................................................................................................................. 118 Chart 4.4: Infant Mortality per Socio-Economic Group................................................. 126 Chart 4.5: Total health expenditure per Capita and life expectancy at birth. ................. 127 Chart 4.6: Total health exp. Per capita and infant........................................................... 127 Chart 4.7: MSPAS Hospital and Primary Health Care Spending by Quintile, 2002...... 131 Figure 4.8: Per capita income and MOH spending by Department (2000) .................... 132 Figure 4.9: Per capita income and primary health care spending by Department (2000)

................................................................................................................................. 132 Chart 5.1: ANDA Expenditures by Function, 1997 – 2003............................................ 141 Chart 5.2: ANDA Investment by Financing Source, 1990 - 2002.................................. 143 Chart 5.3: Nominal and Real Price of Water Service as Measured in CPI..................... 147 Chart 5.4: Per Capita Residential Consumption, 1990 – 2002 ....................................... 149 Chart 5.5 Water Qualtiy in ANDA’s Distribution Network, 2002................................. 151 Chart 5.6: Availability of Piped Water per Quintile, 1991 – 2002 ................................. 152 Chart 5.7: Availability of Sanitation per Quintile, 1991 – 2002..................................... 152 Chart 6.1: Priority Road Network................................................................................... 165 Chart 7.1; Areas of Influence of the Electricity Distribution Companies....................... 175 Chart 7.2: Access to Electricity by Quintile ................................................................... 191

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ACKNOWLEDGMENTS: This report was prepared by a team lead by Ana Lucia Armijos (LCSPE) and comprising Ricardo Tejada (LSCPE), Manuel Vargas (LCOAA), Jorge Camacho (LCC2C) and Jose S. Marques (Consultant). Document Processing Assistance was provided by Elizabeth Percesepe-Wallace (LCC2C). The team benefited from comments provided by World Bank staff and Government officials. We would like to especially thank our Peer Reviewers J. Humberto Lopez (PRMPR) and Jose R. Lopez Calix (LCSPE) who provided detailed inputs. The report also received comments from Jesus Maria Fernandez (LCSHH), Wladimir T. Jadrijev (LCOPR), Andrew D. Mason (LCSHD), Mario Sangines (LCSPR) and Manuel Sevilla (LCSFP). The report was written under the guidance and support of Jane Armitage (LCC2C Director), Felipe Jaramillo (LCC2C Lead Economist), Mauricio Carrizosa (LCSPE Sector Manager), and Helena Ribe (LCSHD Sector Manager). The team would like to express its gratitude for the cooperation received from Authorities throughout its elaboration, and particularly during the two missions to San Salvador. In particular, the team would like to thank Eduardo Zablah-Touche, Technical Secretary of the Presidency, Roberto F. Siman, Advisor-Technical Secretary of the Presidency, Guillermo Lopez Suarez, Minister of Finance, Carmen Regina de Arevalo, Viceminister of Finance, Anabella de Palomo, Undersecretary-Technical Secretary, and Manuel Rosales, Advisor Ministry of Finance, for their support. Many thanks also go to Mauricio Sosa de la Cruz, Guadalupe A. de Pacas, Jose A. Rivas, Dinora M. Cubias, Francisco Jose Rovira, Jorge A. Aguilar and Rene S. Garcia who provided timely inputs and responded to numerous requests.

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EXECUTIVE SUMMARY 1. El Salvador faces today two fiscal challenges that will greatly influence its economic performance over the coming years. The first is to regain a solid fiscal footing, by reversing partly some of the recent rapid growth in public debt. The second is the need to finance certain priority investments required to accelerate growth and meet pressing social needs.

2. This public expenditure review (PER) focuses on these fiscal challenges. It reviews overall trends in expenditures and revenues and lays out options for reducing debt gradually to levels that would grant greater flexibility to fiscal policy in the future, which is likely to be needed to respond to future shocks and contingencies and to aid in countercyclical economic management. In addition, the report provides in-depth attention to critical social expenditures, particularly those in health, education, water and sanitation, rural roads and electrification, which in aggregate represent over forty percent of the Central Government’s budget. It also reviews the public expenditure management framework and offers some recommendations to ensure that public funds are used productively and efficiently.

I. Recent Economic Trends 3. With a strong record of structural reforms in the 1990s, El Salvador has posted significant gains in economic growth and poverty reduction since the end of the civil war in 1992. However, starting in the late 1990s, growth levels have been disappointing, partly as a result of terms of trade shocks (esp., price of coffee), the international recession and disruptions caused by the earthquakes of 2001. The fiscal situation has deteriorated, as fiscal receipts have been affected by low economic growth, and expenditures have increased due to substantial reconstruction investments and the transition costs associated with pension reform. Due to El Salvador’s strong macro policies and its good standing as a sovereign debtor in international markets, much of the fiscal imbalance has been financed at moderate costs, although at the expense of a rapid increase in public debt since 2000.

4. The country has also made impressive progress in advancing in social areas since 1991, including basic education enrollments, infant and maternal mortality, access to reproductive health services and to safe water. Overall poverty declined significantly (over 27 percentage points) between 1991 and 2002, while extreme poverty was halved in the same period. While progress in poverty reduction has slowed in the 2000s, social indicators have not deteriorated, even in the face of the 2001 earthquakes, the regional coffee crisis, and slowdowns in domestic growth and the global economy. Broad gains in social indicators reflect not only the fruits of economic growth but increasing public sector attention in these areas since the mid-1990s which have been translated into some important reforms and greater budgetary allocations.

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II Fiscal Revenues and Expenditures 5. While fiscal performance has been broadly prudent since the 1990s, El Salvador’s non-financial public sector deficits rose during 2000-2003. The causes of this deterioration were the earthquakes of 2001, which called for a significant boost in expenditures for reconstruction, and the increasing transition cost of the 1996 pension reform. Recent deficits have been mainly financed by a growing public debt burden.

6. A successful public sector modernization effort, under implementation since 1994, is responsible for the streamlining and improved efficiency of key areas of the state, including a wage bill reduction of about one percentage point of GDP since 2000. In the same period, tax revenues increased by about 1 percentage point of GDP, in response to the introduction in 2002 of a new fuel tax to fund spending in road maintenance (FOVIAL), and to measures that broadened the tax base and improved tax administration and enforcement.

Composition of Expenditures

7. Since 2001, expenditure increases have been associated principally with a rise in: pension outlays following the pension reform that made the public pension system debt explicit, interest payments, and transfers to the municipalities. Capital expenditures of the central Government have been squeezed in this process, partly as a result of expenditure inflexibilities in about two thirds of the budget and difficulties in boosting revenues. Three types of expenditures -- which account for nearly 65 percent of non-financial public sector expenditures -- are particularly rigid: the public sector payroll, interest payments and transfers.

8. The level of total expenditures of the Central Government is still low in relation to other LAC countries. In the 1996-2003 period, current expenditures averaged 12.4 percent of GDP and capital expenditures 3.2 percent of GDP. The latter seems particularly low given the need to boost growth and meet a pressing social agenda.

Expenditure Priorities 9. Trends in public investment reveal a noteworthy increase in budget allocations in social sectors, a result of increased attention to the social development agenda in El Salvador. During the period 1996-2003, the budget allocation to Social Development increased from 4.7 percent of GDP to 7.3 percent of GDP. Within this allocation, education increased from 2.2 to 3.1 percent of GDP, and health from 1.4 to 1.5 percent of GDP; while transfers explain most of the increase as both, increasing from 0.1 to 2.4 percent of GDP. Other areas that feature prominently in the budget were Support for Economic Development (2.1 percent of GDP, on average) and Justice and Security (2.5 percent of GDP, on average). Past Performance and Prospects in Revenue Policies 10. Government revenues in El Salvador have increased very gradually in the past 8 years, with tax revenues explaining the bulk of the increase. Non-tax revenues decreased from 6.3 percent of GDP in 1996 to 4.2 percent of GDP in 2003. The tax structure relies fundamentally on revenues from the VAT and the income tax. Other revenues are derived

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from import duties and excise taxes on specific products. The former has been steadily declining as a source of government revenue since the early 1990s, as El Salvador has reduced sharply its average tariff levels. 11. According to a number of recent studies, there is ample room for El Salvador to continue improving tax revenues over the coming years. The area with most promise is the excise tax on specific products, in which El Salvador ranks low in international comparisons. Greater taxes on beverages and tobacco are a potential source of future revenues, particularly as El Salvador has lower rates than most Central American neighbors. Since El Salvador has developed a well structured VAT, with a broad base, a single rate and relatively high productivity, further revenues from this source would need to come from higher rates and the incorporation of a greater share of economic activity currently in the informal sector. III. Fiscal Cost of Pension Reform 12. El Salvador adopted a pension reform in 1996 that replaced the existing pay-as-you-go system with a system of individual capitalization. The reform was aimed at improving long-term fiscal sustainability by replacing a system that was projected to yield large and growing deficits in the future by a sustainable one, implying transitional costs as younger Salvadorans move to the private account system while the state keeps the obligation to pay out pensions to older generations. In addition the reform made the conditions for access to benefits more homogeneous among workers from the private, and public sectors, and aimed to gradually increase coverage and develop a private savings pool that could form the basis for long term investments. 13. As of December 2003, the size of the actuarial deficit was estimated at 72 percent of GDP. This includes the commitments to pay current and future pensioners, obligations to those who transferred to the private capitalization system, and payments of the complement for mandatory minimum pensions. Costs of the pension reform have been growing due to the increasing mismatch between contributing and beneficiary populations, the failure to raise further the retirement age, generous benefits compared to other social security systems, and the growth of administrative costs. Given recent fiscal trends, curbing the transition costs of the pension reform is an important challenge in El Salvador. IV. Fiscal and Debt Sustainability 14. Non financial public sector debt has accelerated rapidly in the last five years, to just above 40 percent of GDP. If left unaddressed, further growth in debt and associated interest payments could be eventually reflected in market spreads and potentially cause difficulties when tapping domestic and international capital markets. 15. Adjustments are clearly needed to address some of the underlying trends that have led to the rapid increase in the non-financial public sector debt. Much of this increase can be attributed to emergency earthquake reconstruction expenses and the growing transition costs of pension reform on the face of slow growing revenues. While reconstruction costs will wind down by 2005, the country will need to ramp up social and growth related

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expenditures. Hence, El Salvador’s greatest challenge over the coming years is how to regain a solid fiscal footing, while simultaneously financing the expenditures required to meet social and growth challenges. 16. If recent expenditure and income trends are left unchecked, the debt sustainability of El Salvador would be compromised. A passive scenario would lead to increasing overall deficits, greater interest payments and a gradually rising public debt. These trends indicate that serious attention is required in order to preserve the country’s credit rating and the cost of external borrowing. The investment-grade rating that El Salvador enjoys, which is responsible for its low interest rate spreads, is based on a solid track record of sound debt and fiscal management. 17. Returning to a non-financial public debt level that allows for fiscal flexibility -- to respond to shocks, contingencies or for cyclical economic management -- should be a priority in El Salvador. As an illustration of the type of adjustment, this report lays out a path to return to a debt level of about 35 percent of GDP over 5 years. This would require gradual increases in annual revenues of about 4.0 percent by 2009. About one and a half (1.5) percent of the total increase in revenues could be the result of greater efforts at revenue collection through administrative measures. The rest would likely require greater tax efforts. Additionally, some pension provisions should be amended to address overly generous benefits in the international context. V. Public Expenditure Management 18. The task of putting the economy on a sustainable and poverty reducing growth path has to be carried out with the support of a modern public expenditure management. Good budget institutions allow governments to balance the three interrelated objectives of budgetary performance: aggregate fiscal discipline, efficient allocation of resources according to the Government’s policy priorities, and operational efficiency in the use of resources. The financial management reform process, initiated in El Salvador in the 1990s under the umbrella of the public sector modernization program, has produced significant improvements in the performance of budget management institutions. The financial management law (Ley AFI) and other regulations provide a modern and functional framework of formal rules pertaining to each relevant area of budget management. While the basic foundations of a well-functioning public expenditure management system have been built, still important obstacles to operational efficiency remain. 19. Drawing from the Country Financial Accountability Assessment (CFAA) report, recommendations and priority actions are presented with respect to improving internal controls, comprehensiveness and quality of financial data, financial management reform, monitoring of public investment, cash management, civil service legal framework, and delineation of areas of intervention between central and local governments. Most significantly, the available aggregate targets and projections that guide fiscal policy should be the starting point to develop and formalize a medium-term budget framework that includes the projections, over a three-to-five year horizon, of fiscal indicators,

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expenditure estimates and forecasts of forward costs of the most significant investment projects. This could better inform the annual budget formulation and approval process, by increasing accuracy of the future fiscal impact of current policies and the prioritization of expenditures. VI. Accomplishments and Future Challenges in the Social Areas 20. Education. There has been a substantial increase in the amount of public resources allocated to education during the 1990s. Nevertheless, spending allocations in this area still falls short of regional averages. The allocation of resources has supported the implementation of the Education Development Plan 1995-2005, which contributed to major improvements in the sector. It is likely that the country will meet the 2015 Millennium Development Goals (MDG) on net primary education enrollment, share of students that complete the fifth grade, and the universal literacy target for youth. The targets related to gender in primary and secondary education as well as literacy rates have already been met. However, to reach the necessary coverage rates in the primary, basic and secondary cycles, it has been estimated that the education budget would need to increase in the next ten years by about 1.8 percent of GDP, with respect to 2003 levels. In addition, although there has been progress in recent years, there is still ample room to increase the efficiency of the education system. Overage, repetition, and drop out rates remain high, and programs directed at addressing these problems should continue to be supported, while an appropriate balance needs to be established between expenditures on wages and salaries, teacher training, didactic materials and other goods and services, and infrastructure. 21. Health. El Salvador’s health indicators have improved during the last several years but significant challenges remain. For instance, in relation to the MDGs it is highly likely that the country will be able to meet the 2015 targets on infant mortality rate, mortality rate in children under five, measles immunization, and tuberculosis incidence, but it is unlikely that it will meet the targets on maternal mortality, deliveries by trained staff, and HIV/AIDs. Since 2001, part of the resources allocated to the sector have financed the reconstruction of damaged infrastructure by the earthquakes. El Salvador’s overall budgetary allocation for health services as a share of GDP is low by regional standards as are total public outlays (including health programs of the Social Security Institute) on a per capita basis. The bulk of budgetary resources are currently allocated to hospital care and the primary healthcare. Going forward, efforts should focus on increasing the efficiency and equity of resource use, including increasing cost recovery from those that can afford it. There is a need to increase further primary health care through cost-effective, outreach programs since the coverage of the health system is still inadequate as less than 20 percent (6 percent of the poor) have access to medical insurance, and as much as 24 percent of the population still does not have access to health services or only has limited access. Providing access to a minimum package of healthcare/nutrition services to those who still lack regular health services would demand an additional 0.2-0.3 percent of GDP with respect to current levels. . 22. Water and Sanitation. Water supply and sanitation coverage has increased since the early 1990s, mainly in rural areas. The MDG in this area establishes the target of

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reducing the proportion of population not having sustained access to safe water and basic drainage to half by 2015. Recent data indicates that El Salvador has already surpassed the MDG target for urban water and sanitation and rural sanitation coverage and it is likely that by year 2015 the target for rural access to water will be met. Nevertheless, there are still significant challenges in the sector. To achieve universal coverage of water supply and sanitation by 2015, it would be necessary to increase annual investments in the sector by 0.1-0.3 percent. In addition, the quality of services needs to improve substantially and a new tariff policy should allow for recuperating operation and maintenance costs, financing expansion of water and sanitation systems, and promoting rational use of water. 23. Roads. Improved coverage and quality of rural roads during the 1990s has contributed to poverty reduction in rural areas, and has given household members access to markets, educational and health centers, water and security. Nevertheless, renewed efforts are required to obtain an adequate level of connection of districts and settlements in the country. One set of objectives consistent with the country’s goals to strengthen poverty reduction through infrastructure development would be: (i) to pave or rehabilitate an additional 1,000 kilometers of rural roads; and, (ii) to ensure annual maintenance of 3,000 kilometers of rural (secondary and tertiary) roads. Using recent average unit costs of road paving, rehabilitation, and maintenance as benchmarks, it is estimated that a 5-year program to pave and/or rehabilitate an additional 1,000 kilometers of rural roads implies additional investments of approximately 0.1 to 0.2 percent of GDP, above those dedicated in 2003.

24. Rural Electrification. Significant improvements have also been made in coverage and quality of electricity service since 1990, mainly in rural areas. The main sector challenge is to lower the cost of service through more efficient generation and distribution. In view of the importance of rural electrification for income generation, the study on the situation of El Salvador in relation to the MDGs, incorporates the goal of reaching a rural electrification rate of 85 percent by 2015, from 71 percent in 2002. Hence, raising by about one percentage point per year the rural electricity coverage would cost an estimated of about US$ 3 million a year. However, the sector’s resource allocation priorities need to be reviewed in order to allocate more resources for the benefit of low-income populations and rural areas lacking service. Less resources should be used for subsidies to those that already enjoy the service. Critical social and growth expenditures for the future 25. Given that some of the poorest segments of Salvadoran society have been unable to take advantage of recent economic growth, it is critical to put in place a coherent set of policies and investments to ensure that the poor can benefit from future economic progress. To build effectively on past achievements, it will thus be important to implement a social policy aimed at giving the poor better access to quality education and health care, and greater access to basic services, such as safe water and electricity. Given that the fiscal space for increased spending is limited, strategic choices among priority areas must be carefully made. This report puts forth a strategic package of investments oriented to ensure that the poorest have access to social services and to strengthen their

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position to benefit from future income earning opportunities. This package overlaps in some key areas (i.e., education and rural infrastructure) with the agenda of investments also required to promote overall growth. 26. Implementing the proposed package would imply increase in expenditures of 3.2 to 3.6 percent of GDP over current levels, that would need to be gradually phased in over ten years, due to the tight fiscal situation. The largest commitments of additional resources are associated with education and the social safety net. Improving education through achieving universal primary and basic education and increasing net enrollments in secondary schooling to 70 percent would require an additional 1.8 percent of GDP. Developing an adequate safety net would require spending of an additional 1 percentage point of GDP. 27. While this package of investments covers significant components of the growth agenda that El Salvador requires to boost economic performance over the coming years, it admittedly excludes some important investments that need to be included in such an agenda. Additional investments to promote growth will require commensurate additional fiscal efforts and creative methods to attract financing from the private sector. 28. In sum, El Salvador faces the difficult dual challenge of addressing recent fiscal trends while financing key investments required to accelerate growth and meet pressing social needs. Meeting both of these challenges simultaneously will require great skill, as there can be tradeoffs between them, especially in the short run. However, as the analysis in this report demonstrates, the level of new spending required should be manageable and can be reconciled with the goal of strengthening fiscal accounts. Ultimately, the expenditures recommended to ensure that the poor benefit from further economic progress are not only feasible but necessary to promote growth and poverty alleviation over the coming years.

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CHAPTER I: Macroeconomic Environment and Fiscal Sustainability Background 1.1 With a strong record of structural reforms in the 1990s, El Salvador has posted significant gains in economic growth and poverty reduction since the end of the civil war in 1992. However, starting in the late 1990s, growth levels have been disappointing, partly as a result of terms of trade shocks (esp., price of coffee), the international recession and disruptions caused by the earthquakes of 2001. The fiscal situation has deteriorated, as fiscal receipts have been affected by low economic growth, and expenditures have increased due to substantial reconstruction investments and the transition costs associated with pension reform. Due to El Salvador’s strong macro policies and its good standing as a sovereign debtor in international markets, much of the fiscal deficit has been financed at moderate costs, although the flip side has been a rapid increase in public debt since 2000. 1.2 As a new administration comes into office, El Salvador faces two fiscal challenges that will greatly influence its economic performance over the coming years. The first is to regain a solid fiscal footing, by reversing partly some of the recent growth in debt. The second is the need to finance certain priority investments required to accelerate growth and meet pressing social needs. Meeting both of these challenges simultaneously will require great skill, as there can be tradeoffs between them, especially in the short run. However, as the analysis in this report demonstrates, given improvements in the efficiency of public expenditures in recent years, the level of new spending required should be manageable and can be reconciled with the goal of strengthening fiscal accounts in a country where the tax burden is still relatively low by international standards. Ultimately, the selective expenditures recommended are not only feasible but necessary to promote growth and poverty alleviation over the coming years. 1.3 This public expenditure review (PER) focuses on the fiscal challenges described. It reviews overall trends in expenditures and revenues, with special emphasis on the key social expenditures that require the most attention, as well as on the public expenditure management framework required to ensure that public funds are used productively and efficiently. It also evaluates future trends in fiscal accounts and lays out options for reducing debt gradually to levels that would grant greater flexibility to fiscal policy in the future, which is likely to be needed to respond to future shocks and contingencies and to aid in countercyclical economic management. 1.4 This report focuses its in-depth analysis of expenditures on social investments, broadly understood, including rural infrastructure. Of these, social sector expenditure areas represented in 2003 approximately 43 percent of the Central Government budget. Areas that are not explicitly evaluated represented about a third of the 2003 budget.1

1 Areas that are not subject of in depth analysis in the report include general administration and defense (11 percent of the budget) and justice and security (13 percent), support for agriculture (1.3 percent), the urban

1.5 This chapter focuses on overall fiscal trends. It reviews recent macroeconomic developments, recent fiscal trends in both expenditures and revenues, summarizes key accomplishments and future challenges in each of the key social expenditure areas reviewed in more detail in Chapters III, IV, V, VI and VII. Moreover, it also evaluates the transition fiscal costs of the pension reform and presents recommendations on overall fiscal policies to 2009, based on a debt sustainability analysis.

I. Macroeconomic Trends 1.6 Over the past decade, El Salvador has distinguished itself by its record of sound macro management and consistent modernization efforts. Structural reforms undertaken in the 1990s included trade liberalization, financial sector strengthening, re-privatization of the financial sector and other state enterprises, comprehensive tax reform, pension reform and improvements in the competitiveness environment for private investment. As a result of these efforts, in 2000 the Heritage Foundation ranked El Salvador at the top of the Latin American free-market reforming countries and one of the freest in the world. In the social areas, reforms in the education sector have proven very successful in improving primary coverage, while achievements in health have been somewhat less impressive. 1.7 Structural reforms and sound macro management explain El Salvador’s solid economic performance since 1990, as illustrated by the achievement of the second highest growth rate in the 1990-2003 period in Central America, behind Costa Rica. However, this apparently stellar showing masks two contrasting phases of economic performance of the Salvadoran economy.2 Growth was high (6 percent, annually) over the 1990-95 period, and has been disappointing since (2.7 percent in the 1996-2003 period). The first phase clearly reflects the strong post war reactivation of public investment (reconstruction activities), private investment (especially real state), and consumption (especially of durable goods). The consumption boom was to some extent facilitated and reinforced by the massive inflow of workers remittances, which have been associated with an excessive expansion of the money supply, higher domestic credit and high inflation until 1995. The lower growth cycle started in 1996, as a result of a tightening of monetary policy to correct the growing macroeconomic imbalances. However, it has been extended by a number of negative exogenous shocks. A strong deterioration in the terms of trade occurred in the 1996-2000 period (about 4 percent per year on average), U.S. demand for Salvadoran exports declined in 2000-2001 (particularly those coming from the large maquila sector) and the real effects of the 2001 earthquakes rippled through the economy in 2001 and 2002. What is remarkable in this period is that despite continued low growth mainly for reasons beyond its control, El Salvador has been able to maintain sound macro management. (Chart 1.1)

component of the public works budget (6 percent) and the expenditures of the Ministry of the Economy (2.3 percent). 2 A detailed review of these growth phases is presented in Chapter 1 of the El Salvador CEM (2004).

2

Chart 1.1: Real GDP Growth Rates

Source: Central Bank of El Salvador

1.7

4.23.7 3.4

2.21.8

2.3 2.0

0.0

1.0

2.0

3.0

4.0

5.0

1996 1997 1998 1999 2000 2001 2002 2003

1.8 The country has also made impressive progress in advancing in social areas since the end of the civil war. In the 1990s, basic education enrollment rate increased from 74 percent to 85 percent, infant mortality was reduced from 46 per 1,000 live births to 31 per 1,000 live births; the maternal mortality rate was reduced from 148 per 100,000 to 120 per 100,000 live births. Access to reproductive health services increased from 40 percent to 60 percent; and population without access to safe water was reduced from 34 percent to 23 percent.3 Recent findings from the Bank’s Poverty Assessment reveal that poverty declined from 64.4 percent in 1991 to 37.2 in 2002. In the same period, extreme poverty declined from 31.2 percent to 15.4 percent. While progress in poverty reduction has slowed in the 2000s, what is truly remarkable is that it has not reversed, even in the face of the 2001 earthquakes, the regional coffee crisis, and slowdowns in domestic growth and the global economy. As will be explained in this report, broad gains in social indicators reflect not only the fruits of economic growth but increasing public sector attention in these areas since the mid-1990s which have been translated into some important reforms and greater budgetary allocations. 1.9 An important economic decision of recent years which has consequences for fiscal policy is the formal dollarization of the economy in January 2001 with the Monetary Integration Law.4 The decision was taken after several years of keeping an essentially fixed exchange rate, with a steady increase in net international reserves thanks in great part to the sustained inflow of worker’s remittances, which by 2000 was equivalent to more than 10 percent of GDP. The decision was taken in great part to diminish financing costs for the economy by eliminating country risk, as well as to reduce transaction costs and attract foreign investment. Since its implementation, El Salvador has enjoyed a substantial decline in interest rates (beyond what would be justified by international trends), as well as sustained low inflation rates. With this decision, El Salvador has effectively abandoned monetary policy and placed the burden of stabilization policies squarely on the fiscal side, for which it is critical to maintain sufficient flexibility to respond to negative shocks.

3 Progress of El Salvador towards achieving the MDGs is based on the WB Policy Notes for Poverty Reduction Report , May 2002 and WB Poverty Assessment report , June 2004. 4 Under the Monetary Integration Law of January 2001, the exchange rate was fixed at c 8.75:$1 and the US dollar became legal currency.

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1.10 Projecting future growth in El Salvador is particularly challenging at the time of this writing. On the plus side, the pickup in the world economy and particularly in the U.S. have brightened considerably the outlook for exports, as well as the signing of the Central American Free Trade Agreement (CAFTA) between the U.S. and five countries of Central America, expected to be approved by the legislatures by 2005, which seems to be already having an effect on FDI levels. On the negative side, high and uncertain future oil prices is a large cost for an oil importing country like El Salvador. In addition, the end of the world quota scheme for apparel and textiles, scheduled by the WTO at the end of 2004 poses significant challenges to the large “maquila” sector. With these uncertainties in mind, real growth in the range of 3 to 4 percent over the next 4 years would be a reasonable expectation, consistent with the 3.5 percent rate that has been recently quoted in government and IMF projections. Moreover, this range is consistent with calculations presented in the Bank’s own recent CEM (World Bank, 2004) about the average underlying growth rate for the 1996-2001 period of between 3.4 and 4.2 percent, using alternative filtering techniques.5

II. Fiscal Revenues and Expenditures 1. Policy Challenges 1.11 The central challenge for El Salvador is to restore fiscal discipline by bringing fiscal balances back to a sustainable path, while allowing for some additional public expenditures. As will be explained in detail in the following sections, to achieve medium-term public debt sustainability while accommodating additional expenditures for a social and growth agenda would require a gradual adjustment between 2005 and 2009 with a structural primary deficit starting at –1.0 percent of GDP in 2004 and turning into a surplus of 2.4 percent of GDP in its peak year (2009). This outcome would bring deficits down from 3.2 percent of GDP expected for 2004 to an average of only 1.4 percent of GDP over the 2005-09 period and would reduce the debt ratio to around 35 percent by the end of the period. 2. Fiscal Performance 1.12 El Salvador’s fiscal stance is under stress since 2001 due to a combination of adverse external shocks and growing cost of pensions. Led by an increasing primary deficit that reached 3 percent of GDP in 2001, the overall fiscal deficit significantly increased from 1.8 percent of GDP in 1997 to 4.4 percent of GDP in 2002, only to be reduced to 3.0 percent of GDP in 2003. The Nonfinancial Public Sector (NFPS) deficit averaged a low of 1.6 percent of GDP between 1990 and 1995. Such an outcome coincided with the important increase in growth of about 6 percent of GDP per year. However, the NFPS deficit increased to an average of 3 percent of GDP during 1996-2003 resulting basically from fiscal expansion. The main component of such deficit was the Central Government (CG) imbalance, which represented about 90 percent of the average NFPS deficit. CG fiscal deficits were the result of low tax revenue, volatile non-

5 Admittedly, the same report also presents projections using an international cross country framework that would forecast annual average growth of 5.6 percent for El Salvador under a “realistic” scenario, although it questions the reliability of such an optimistic estimate.

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tax revenue and the highly volatile behavior of current and capital expenditure (Table 1.1).

Table 1.1: Non-Financial Public Sector and CG ($million)

1996 1997 1998 1999 2000 2001 2002 2003 Overall NFPS deficit -253.8 -200.4 -312.2 -349 -394.1 -604.5 -625.2 -450

NFPS deficit as GDP -2.4 -1.8 -2.6 -2.8 -3.0 -4.4 -4.4 -3.0 Overall CG deficit -212.4 -126.1 -246.5 -269.1 -309.9 -595.2 -604.4 -595.1

CG deficit as GDP -2.0 -1.1 -2.1 -2.2 -2.4 -4.3 -4.2 -4.0 CG deficit/NFPS deficit 83.3 62.0 80.7 78.5 80.0 93.1 97.7 127.0

GDP 10,577.60 11,134.60 12,008.40 12,464.70 13,139.10 13,738.90 14,209.00 14,996.40Source: Ministry of Finance

1.13 While fiscal performance has been broadly prudent since the 1990s, El Salvador’s non-financial public sector6 deficits rose during 2000-2003, peaking at 4.4 percent of GDP in 2002. The causes of this deterioration were: (i) the earthquakes of 2001 which called for reconstruction expenditures totaling 1.5 percent, 2.2 percent and 1.6 percent of GDP in 2001, 2002 and 2003, respectively; (ii) the increasing transition cost of the 1996 pension reform, which rose from 0.7 percent in 2001 to 1.1 percent and 1.7 percent in 2002 and 2003, respectively; and (iii) the decrease of the surplus coming from public enterprises, that after reaching 2.2 percent of GDP in 1996, declined substantially in 1998 and 1999, reaching only 0.6 percent of GDP in 2003. Recent deficits have been mainly financed by public debt which climbed by 10 percentage points in the period 2000-2003, reaching 40.6 percent of GDP at end 2003. 1.14 The public sector modernization reform that started with the Government's development plan of 1994-1999, and was further extended by the economic plan of 1999-2004, created room for the wage bill to decline, from 8.4 percent of GDP in year 2000 to 7.4 percent in 2003. In the same period, tax revenues increased from 11.1 percent to 12.1 percent of GDP in response to the introduction in 2002 of a new fuel tax to fund spending in road maintenance (FOVIAL), measures that broadened the tax base and improved tax administration and enforcement. Notwithstanding this fact, the fiscal deficit increased from 2.8 percent of GDP in 1999 to 4.4 percent of GDP in 2002 and fell to 3.0 percent of GDP in 2003 due to cuts in the reconstruction program and some increases in tax revenues (See Table 1.2).

6 For fiscal reporting purposes, the non-financial public sector (NFPS) consists of 21 central government entities, including 12 ministries, 34 hospitals and other health entities, 47 decentralized institutions, including four state enterprises, and 262 local governments. Decentralized institutions have functional autonomy and Municipalities have financial, technical and administrative autonomy. The 262 municipalities account for around 5 percent of overall NFPS expenditures

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Table 1.2: Non-Financial Public Sector as Percent of GDP

1996 1997 1998 1999 2000 2001 2002 2003 I. Revenues and Grants 17.3 16.1 15.7 15.7 16.6 15.6 16.2 16.8

A. Current Revenues 17.1 15.8 15.6 15.4 15.7 15.1 15.4 16.3

1. Tax 10.9 10.9 10.9 10.9 11.1 11.1 11.9 12.1

2. Non tax 4.1 3.5 4.1 3.7 4.0 3.6 3.6 3.6

3. Public enterprise surplus 2.2 1.5 0.6 0.8 0.7 0.4 0.0 0.6

B. Capital Revenues 0.0 0.0 0.0 0.0 0.1 0.0 0.5 0.0

C. Grants 0.2 0.2 0.1 0.3 0.8 0.4 0.4 0.5

II. Expenditures and Net Lending 19.7 17.8 18.4 18.5 19.6 20.0 20.7 19.8

A. Current Expenditures 15.3 13.9 14.6 15.2 16.3 15.5 15.7 16.5

1. Consumption 10.8 10.1 10.4 11.2 11.4 11.0 10.7 10.8

of which: Wages & Salaries 7.3 7.0 7.8 8.3 8.4 7.8 7.4 7.4

2. Interests 1.7 1.6 1.5 1.4 1.5 1.5 1.7 2.0

3. Current Transfers 2.7 2.2 2.7 2.7 3.4 3.0 3.3 3.7

B. Capital Expenditures 4.4 4.0 3.8 3.2 3.3 4.5 5.0 3.3

1. Gross Investment 4.2 3.7 3.7 3.1 2.9 4.4 4.3 3.2

of which reconstruction 0.0 0.0 0.0 0.0 0.0 1.4 2.0 1.4

2. Capital Transfers 0.3 0.3 0.1 0.1 0.4 0.1 0.7 0.1

C. Net Lending 0.0 -0.1 0.0 0.0 0.0 0.0 0.0 0.0

III. Current Savings 1.8 1.9 1.0 0.2 -0.6 0.4 0.8 1.5

Reconstruction Expenditures 0.0 0.0 0.0 0.0 0.0 1.5 2.2 1.6

Pensions Expenditure 0.0 0.0 0.0 0.0 0.0 0.7 1.1 1.7

Primary Deficit -0.7 -0.2 -1.1 -1.4 -1.5 -3.0 -2.7 -1.0

Overall deficit with pensions -2.4 -1.8 -2.6 -2.8 -3.0 -4.4 -4.4 -3.0 Overall deficit without Pensions -2.4 -1.8 -2.6 -2.8 -3.0 -3.7 -3.3 -1.3

GDP 1.7 4.2 3.7 3.4 2.2 1.8 2.3 2.0 Source: Ministry of Finance

1.15 While it is too early to tell if the formal dollarization of 2001 has changed significantly the cyclical behavior of fiscal policy, the overall behavior of fiscal balances indicates broadly counter cyclical variations since at least 1996. The NFPS primary balance, which is a commonly used counter-cyclical indicator of fiscal policy, has been negative throughout the period 1996-2003 but has been positively related to the rate of growth. That is, lower deficits have tended to occur during years of higher growth, and in periods of lower growth (2001-2003) the reconstruction investments helped to stimulate the economy and generate employment, suggesting that fiscal policy has behaved counter cyclically. Moreover, recent fiscal performance shows a decline in public sector current savings. NFPS savings were substantial, nearly 2 percent of GDP in 1996-97, began to fall on a sustained basis in 1998, were negative in year 2000, and recuperated thereafter, giving signs of future higher economic growth. However, the higher infrastructure spending made by the government without an increase in public savings has given way to growing fiscal deficits, as Table 1.2 clearly shows. Public savings and public investment averaged 0.9 percent and 4.3 percent, respectively, in 2001-2003 and the overall deficit averaged 4 percent of GDP in the same period.

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3. Composition and Evolution of Expenditures a. Nonfinancial Public Sector 1.16 In terms of the economic classification of spending, the largest components of total expenditures in the period 1996-2003 were: current expenditures (80 percent), of which wages and salaries (40 percent of total expenditures), transfers to specific sectors, including pensions (15.2 percent of total) external and domestic interest payments (8.4 percent of total) and goods and services (16.3 percent of total expenditures). In the last three years (2001-2003) the expenditure increases have been associated principally with a rise in: pension outlays - following the pension reform that made the public pension system debt explicit- interest payments, and transfers to the municipalities. In 2003 current expenditures reached 83.5 percent of total expenditures in response to increases in consumption expenses, interest and pension payments, while capital expenditures were reduced to 16.6 percent of total expenditures, thus, reducing the overall deficit to 3 percent of GDP. The adjustments relied mostly on capital expenditure due to the rigidity in almost two thirds of the expenditure budget and the difficulty to increase revenue. Three types of expenditures are rigid: public sector payroll, representing 37 percent of total expenditures, interest payments, amounting to 10 percent of expenditures, and transfers to the municipalities, pensions and others, which represented 18 percent of total spending in 2003. These items amount to nearly 65 percent of NFPS expenditure, and over 100 percent of the tax revenues in 2003. (Table 1.3)

Table 1.3: Non-Financial Public Sector, as % of Total Revenues and Expenditures 1996 1997 1998 1999 2000 2001 2002 2003 Total Revenue 100 100 100 100 100 100 100 100 Tax Revenue 62.8 67.9 69.1 69.5 66.6 71.6 73.0 72.1 Non tax 23.5 21.5 26.1 23.8 23.9 23.2 22.0 21.3 Total Expenditure 100 100 100 100 100 100 100 100 Current Expenditures 77.5 78.0 79.4 82.5 83.1 77.4 76.0 83.4 Consumption 54.9 56.8 56.8 60.4 57.9 55.1 51.9 54.6 Wages & Salaries 37.0 39.3 42.4 45.1 42.9 39.1 35.9 37.2 Goods and Services 17.9 17.5 14.3 15.3 15.0 18.2 15.0 17.4 Interest payments 8.7 8.7 8.0 7.5 7.9 7.3 8.3 10.3 Transfers 13.8 12.5 14.5 14.5 17.3 15.0 15.7 18.5 Pensions 0.0 0.0 0.0 0.0 0.0 3.7 5.4 8.4 Capital Expenditures 22.5 22.3 20.7 17.5 16.9 22.6 24.01 16.5 of which reconstruction 0.0 0.0 0.0 0.0 0.0 7.09 9.6 7.1 Source: Ministry of Finance

1.17 NFPS current expenditure in El Salvador went from $1,616 m in 1996 to $2,474 m in 2003. As a percentage of GDP, current expenditures in the period 1996-1999 averaged 14.7 percent of GDP, and for the last four years it averaged 16.0 percent of GDP, displaying a growing trend despite the fact that wages and salaries in the period 1996-2000 amounted to an average of 7.8 percent of GDP, decreasing their share to 7.5 percent of GDP during the period 2001-2003, in response to civil service changes that

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make El Salvador’s public sector small by international standards. One of the main reasons for the change in current expenditure is the increase in transfers that besides pensions include transfers to the municipalities, which by legal mandate must receive 6 percent of total current revenue annually. During the period 1996-2003, NFPS transfers reached an average of 2.5 percent of GDP and in 2003 they accounted for 3.7 percent of GDP, of which 1.7 percent goes to pensions and 0.8 percent to the municipalities, respectively. (Table 1.4).

Table 1.4: Non-Financial Public Sector (US$ m.)

1996 1997 1998 1999 2000 2001 2002 2003 Total Revenue 1828.6 1790 1889.2 1954.8 2179.7 2137.2 2308.5 2512.6

Current Revenues 1808.1 1762.8 1871.4 1920.7 2062.1 2075.3 2193.6 2442.6

Tax Revenue 1148.5 1215.0 1304.8 1359.2 1452.1 1530.2 1685.0 1812.0

Total Expenditure 2085.7 1987.0 2204.2 2300.6 2577.9 2743.9 2940.7 2964.6

Current Expenditures 1616.2 1550.1 1749.6 1897.2 2141.9 2124.5 2234.8 2474.1 Consumption 1145.5 1128.9 1251.1 1390.6 1491.5 1512.9 1526.9 1617.9

Wages & Salaries 771.9 780.7 935.7 1038.0 1106.0 1074.0 1055.0 1103.0

Goods and Services 373.6 348.2 316.1 352.6 385.5 498.9 471.9 514.9

Interests 182.3 172.7 177.3 173.9 203.1 200.2 245.5 307.1

Transfers 288.4 248.4 321.1 332.7 447.3 411.4 462.3 549.0

Pensions 0 0 0 0 0 102.5 157.5 250.0

Capital Expenditures 470.7 443.9 455.6 403.8 436.2 619.6 706.2 491.2 Gross Investment 439.8 415.6 442.2 388.9 380.3 602.2 609.3 483.3

Of which reconstruction 0 0 0 0 0 194.5 282.0 209.6 Source: Ministry of Finance

1.18 In contrast to the growing current expenditure, non-financial public sector capital expenditure during the period 1996-2000 was pretty stable, fluctuating between $403 and $470m. However, after the earthquakes of 2001, capital investment increased considerably reaching $620 and $706m, in 2001 and 2002. As a percentage of GDP capital expenditures in the period 1996-2000 averaged 3.7 percent of GDP, and in the last three years it increased to 4.3 percent of GDP, of which reconstruction expenditures accounted for 1.6 percent of GDP, on average. 1.19 In the consolidated non-financial public sector statistics, expenditures are classified functionally into current and capital expenditures. Current expenditures include consumption (basically wages and good & services), interests, and transfers (pensions, judiciary and municipalities). During the last three years (2001-2003) consumption, interests and transfers accounted for 68, 12 and 20 percent of total current expenditures. Capital expenditures include gross investment, of which reconstruction investment has accounted for 40 percent of total investment between 2001 to 2003.

8

Chart 1.2: Non-Financial Public Sector Expenditure (% of GDP)

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

1996 1997 1998 1999 2000 2001 2002 2003

Period

Perc

enta

ge

Current Expenditures Capital Expenditures Total Expenditures

Source: Table 1.2 Interest Payments. As a percentage of GDP, interests increased together with the public debt and since inflation declined, the burden of interest increased more than what the table shows, which do not capture the effect of declining inflation on real interest rates. Wages. Following the Public Sector Modernization, wages as a percentage of GDP decreased from 8.4 percent in 2000 to 7.4 percent in 2003. A reduction of public employment has been one of the instruments through which El Salvador has sought to achieve fiscal balance and increase public sector efficiency. It has been a difficult instrument to apply due to institutional constraints. It is estimated that there are about 110,000 public sector employees that in 2003 received a total wage bill of $1103 million and accounted for about 20 percent of the economic population.. As a percentage of GDP, the public sector wage bill is about the same as other Central American countries. In Costa Rica, for instance, the wage bill reached 7.9 percent of GDP in 2003, while the average for Latin America in 2000 was 5-5.5 percent of GDP. Pensions. Together with interest payments, NFPS transfers, which include pensions, explain most of the recent increase in public sector expenditures, particularly since 2001. Transfers and interest payments alone account for 44 percent of the increase that total public expenditure experienced between 1996 and 2003. Of this increase, pensions more than doubled the rise in interests. The rapid growth of this item is explained by the transition costs of the pension reform approved in 1996 which created individual capitalization accounts and provides for the gradual phase out of the pay-as-you-go system. The fiscal costs of this reform are spelled out in more detail in Annex II of this report. Reconstruction. Capital expenditures increased importantly mainly in 2001 and 2002 due to the reconstruction after the earthquakes. Capital expenditures increased from 3.3

9

of year 2000 to 4.5 and to 5 percent of GDP, in 2001 and 2002 respectively. Of this increase, reconstruction accounts for more than 90 percent. Transfers to Local Governments. The Ministry of Finance (MH) includes in the NFPS statements data on the municipalities, on a sampling basis, due to the incomplete coverage available. Central government transfers to the municipalities are mandated by the Law of the Municipal Economic and Social Development Fund (FODES), which earmarks 6 percent of the current (net)7 central government revenues for this purpose. FODES funds are distributed among municipalities on the basis of a pre-established formula and its regulations stipulate that 80 percent must be used for investment and 20 percent for current expenditure by each municipality. In 2003, transfer flows amounted to $104.7 m, or 0.7 percent of GDP. Flows to the FODES will increase in 2005, since the National Assembly voted mid-June to raise the transfers to the municipalities to 7 percent of current government income. In 2003, a sample of about 50 municipalities was included in the NFPS statements. These municipalities reported revenues of $180 m of which 42 percent were obtained from local revenues and 58 percent from central government transfers. 1.19 The municipalities are also financed by transfers from the central government to the Investment Fund for Local Development (FISDL), which has traditionally been financed by external loans. While municipalities derive revenues from a number of fees and taxes there is no comprehensive data on them. Table 1.5 show the amount of total transfers to the municipalities through both funds (FODES and FISDL), which accounted for around 4.4 percent of total government expenditures. Pressures to increase transfers to municipalities are likely to continue in the future. To avoid repeating some of the problems seen in other decentralization experiences elsewhere in LAC, responsibilities should be matched with any further transfer. Moreover, municipalities need to strengthen the capacity to raise their own revenues to avoid relying excessively on transfers.

Table 1.5: Government Allocations for FODES and FISDL (US$ m.)

e/ estimate

Year FODES FISDL TotalShare of Cen

Gov exp.1998 63.2 4.7 67.9 3.31999 65.0 8.8 73.8 3.72000 62.7 10.0 72.7 3.32001 97.3 15.1 112.4 4.32002 99.7 28.1 127.8 3.62003 104.7 31.8 136.5 5.12004 112.5/e 50.0/e 162.5 7.2

Source: Ministry of Finance

7 Net central government revenues = current revenues – income tax devolutions and VAT tax drawbacks.

10

b. Central Government 1.20 Between 1996 and 2003, El Salvador’s Central Government total expenditures averaged 15.6 percent of GDP. Current expenditure totaled 12.4 percent of GDP and capital expenditures averaged 3.2 percent of GDP. Total expenditure is by and large the lowest in relation to other countries of the Central America Region, with the exception of Guatemala (12 percent). In the same period, current expenditure as a percentage of total expenditure, reached 80 percent, one of the highest in the region together with Costa Rica (83.4 percent); while capital expenditure shows a low participation in total expenditures with 20 percent. Even though cross-country comparisons can be misleading, El Salvador level of total spending and low tax revenue suggest that new sources of income are necessary or the level of public debt will raise over the 40 percent of GDP limit that the authorities have themselves established. Countries in the region sharing El Salvador high level of current expenditures as a share of total expenditures either spend less in capital expenditures (Costa Rica) or both, spend less and collect more revenue (Honduras). This highlights the need for El Salvador to reduce current expenditures while strengthening efforts to increase revenue (Table 1.6).

Table 1.6: Distribution of Expenditure by selected Countries, average 1996 – 2003

El Salvador Costa Rica Nicaragua Honduras Guatemala CA

Total Expenditure 15.6 20.1 30.5 21.3 12.0 19.9

Current Expenditure 12.4 16.8 19.7 16.0 7.9 14.6

Capital Expenditure 3.2 3.4 10.8 5.3 4.1 5.3

memo: tax revenue 10.6 14.2 19.4 16.6 9.4 14.0

(as percent of Total Expenditure)

El Salvador Costa Rica Nicaragua Honduras Guatemala CA

Total Expenditure 100 100 100 100 100 100

Current Expenditure 79.4 83.4 64.5 75.1 66.2 73.1

Capital Expenditure 20.6 16.6 35.5 24.9 33.8 26.9

Source: The World Bank

1.21 The overall deficit of the Central Government was in a worrisome ascending trend between 1997 and 2002 (Chart 1.3). In 1997 current revenues were 12.5 percent of GDP, current expenditures 11.3 percent of GDP, and capital expenditures 2.4 percent of GDP; by 2002 they were 13.2 percent of GDP, 13.1 percent of GDP, and 4.3 percent of GDP, respectively. The Central Government overall deficit increased from 1.1 percent of GDP in 1997 to 4.3 percent of GDP in 2002, mostly as a result of the reconstruction investment following the earthquakes and pension related payments. However, in 2003 the overall deficit decreased to 3.8 percent of GDP resulting from President Flores’ Decree formalizing the austerity program, the government efforts to contain non-essential current expenditures and the improvement in tax collections which in effect rose to 12.1 percent of GDP in 2003 from an average of 11 percent of the period 1996-2001. Current expenditures (excluding pension payments) have not increased due to cuts in wages and salaries and restricted capital expenditure. (Table 1.7)

11

0.0% 2.0% 4.0% 6.0% 8.0%

10.0% 12.0% 14.0% 16.0%

1996 1997 1998 1999 2000 2001

Rev

enue

s an

d

Expe

nditu

res

2002 2003-5.0%-4.5%-4.0%-3.5%-3.0%-2.5%-2.0%-1.5%-1.0%-0.5%0.0%

Overall

dfi

it

Revenues & grants Current Expenditures

Cap Expend & net lending Overall deficit (right side)

Overall deficit with pensions (right side)

Chart 1.3: CG Revenues, Expenditures and Overall Deficit

Table 1.7: CG revenues, expenditures and overall deficit (% of GDP)

Source: Ministry of Finance

1996 1997 1998 1999 2000 2001 2002 2003Total revenues and grants 13.2 12.5 12.5 12 12.9 12.6 13.2 13.7 Current revenues 13 12.3 12.4 11.7 12.1 12.2 12.8 13.3 Tax revenues 10.9 10.9 10.9 10.9 11.1 11.1 11.9 12.1Total expenditures 15.2 13.6 14.5 14.1 15.2 16.9 17.5 17.7 Current expenditures 12.1 11.3 11.6 11.8 12.6 12.9 13.1 14 Wages and Salaries 5.4 5.4 5.7 6.1 6 5.6 5.3 4.9 Pensions 0 0 0 0 0 0.7 1.1 1.7 Capital expenditure 3.1 2.4 3 2.4 2.7 4.1 4.3 3.7 Overall deficit (with pensions) -2 -1.1 -2.1 -2.2 -2.4 -4.3 -4.2 -4.0

4. Expenditure Priorities and allocation 1.22 Between the 1999-2003 period, the broad allocation of resources was initially guided by the Government’s Development Plan, which comprised the areas of Macroeconomic stability; support to sector policies (agriculture, micro enterprise, exports); public security and judicial security, and environment. The Government’s Plan contemplated detailed objectives and measures in each of these areas. The disruption caused by the 2001 earthquakes and consequent change in priorities put the Plan on hold, but since earthquake reconstruction progressed quite rapidly, the Government focused again on its original Plan in 2003 and 2004. The budget priorities were established by management areas, which are: social development, support to economic development, administration of justice and citizen security.

12

Table 1.8: CG Approved and Executed Budget by Management Area (% of total

budget)

Source: Ministry of Finance

App Exe App Exe App Exe App Exe App Exe App Exe App Exe App ExeAdministration 12.1 13.1 12.6 12.5 12.2 12.7 13.4 13.5 12.7 13.1 11.6 11.7 9.2 9.3 10.5 10.5Justice and Security 14.5 15 15 15 15 15.5 16.1 15.9 14.2 15 12.5 13.2 10 10.1 12.8 13.1Social Development 29.7 31.2 31.5 32.1 32.6 33.9 35.8 36.3 35.7 36 41.8 41.5 32.6 32.4 43.6 42.8Economic Dev. 16.7 13.9 17.1 14.4 17.8 14.9 12.3 11 14.2 13.2 14.2 12.3 11.8 10 10.7 10.3Public Debt 21.2 20.1 16.4 18 15.4 15.6 15.5 16.1 14.7 14.6 12.9 13.9 31.1 32.6 15.9 16.5State Obligations 5.8 6.6 7.4 8 6 6.5 6.6 6.8 7.5 8 5.1 5.6 5.3 5.5 5 5.2Public Enterprises 0 0 0 0 0.9 1 0.3 0.3 0.9 0.2 1.8 1.9 0 0 1.4 1.5Total Budget 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100

1996 1997 1998 1999 2000 2001 2002 2003

Table 1.8 shows the approved and executed budget allocation by management area. The executed budget for the social development area of management was lower than the approved during 2001-2003 mainly due to management issues in education and health, as discussed in detail in Chapters III and IV. Executed public debt service (18 percent of total budget) is higher every year than the amount originally approved, consistent with the persistent increase in public debt.

Table 1.9: CG Budget. Approved and Executed by Management Area (% of GDP)

1996 2000 2003 App Exe App Exe App Exe Administration 2.2 2.0 2.1 2.1 1.9 1.8 Justice and Security 2.6 2.2 2.4 2.4 2.3 2.2 Social Development 5.4 4.7 6.0 5.7 7.7 7.3 Presidency of the Republic 0.2 0.2 0.2 0.2 0.2 0.2 External Relations 1.0 0.6 0.0 0.0 0.0 0.0 Interior 0.2 0.2 0.1 0.1 0.0 0.0 Education 2.4 2.2 2.9 2.7 3.3 3.1 Health 1.4 1.4 1.6 1.6 1.6 1.5 Labor and Social Security 0.0 0.0 0.1 0.0 0.0 0.0 Housing and Urban Development 0.0 0.0 0.1 0.1 0.0 0.0 Transfers 0.1 0.1 1.0 0.9 2.5 2.4 Support to Economic Development 3.0 2.1 2.4 2.1 1.9 1.8 Public Debt 3.9 3.0 2.5 2.3 2.8 2.8 General Obligation of the State 1.0 1.0 1.3 1.3 1.2 1.2 Total 18.2 14.9 16.8 15.8 17.7 17.0

Source: Ministry of Finance

1.23 In recent years, El Salvador has made significant progress in social indicators due in part to increased attention to the social development agenda. During the period 1996-2003, the budget allocation to the Social Development area was the largest. In fact, the amount of resources allocated to this area increased from 4.7 percent of GDP to 7.3 percent of GDP. Within this allocation, education increased from 2.2 to 3.1 percent of GDP, and health from 1.4 to 1.5 percent of GDP; while transfers explain most of the increase as both, increasing from 0.1 to 2.4 percent of GDP. Other areas that feature prominently in the budget were Support for Economic Development (2.1 percent of GDP,

13

on average) and Justice and Security (2.5 percent of GDP, on average), both of which also contributed to the social and growth agenda. (Table 1.9). What follows is a brief summary of accomplishments and future challenges in each of the key social expenditure areas: education, health, water and sanitation, rural roads and rural electricity, which are reviewed in more detail in later chapters.

a. Education Sector 1.24 There has been a substantial increase in the amount of public resources allocated to education during the 1990s. Although spending has increased significantly to 3.3 percent of GDP in 2002, in the last two years it has declined to 3.1 percent in 2003 and in the proposed budget for 2004 it is at 3 percent of GDP, well below the 4.4 percent of GDP average for LAC. The allocation of resources were aimed at supporting the implementation of the Education Development Plan 1995-2005, which contributed to major improvements in the sector. The recent study on the situation of El Salvador in relation to the Millennium Development Goals (MDGs) concludes that it is likely that the country will meet the 2015 targets on net primary education enrollment, share of students that complete the fifth grade, and the universal literacy target for youth. The targets related to gender in primary and secondary education as well as literacy rates have already been met.8 However, to reach the necessary coverage rates in the basic cycle and secondary, it has been estimated that the education budget would need to increased by about two percentage points of GDP, or to 5 percent of GDP. And to increase the quality of education, an appropriate balance needs to be established between expenditures on wages and salaries, teacher training, didactic materials and other goods and services, and infrastructure. Resource use in El Salvador’s basic education sector has been broadly efficient but challenges remain in secondary education. b. Health Sector 1.25 El Salvador’s health indicators have improved during the last several years but significant challenges remain. For instance, in relation to the MDGs it is highly likely that the country meets the 2015 targets on infant mortality rate, mortality rate in children under five, measles immunization, and tuberculosis incidence, but it is unlikely that it meets the MDGs targets on maternal mortality, deliveries by trained staff, and HIV/AIDS Since 2001, part of the resources allocated to the sector have financed the reconstruction of the damaged infrastructure, and in the near future the health authorities should focus on increasing the efficiency and equity of resource use given the fiscal constraints. El Salvador is among the countries in Latin America that spends less (as a percentage of GDP) in health services. The allocation of budget resources to the sector reached 1.5 percent of GDP in 2002 and 2003, and the execution of the allocated budget has been deficient in the last three years. The bulk of resources has been allocated to hospital care and the primary healthcare share has tended to increase. Nonetheless, there is a need to increase further primary health care through cost-effective, outreach programs since the

8 “El Salvador: Informe de País Sobre el Avance de los Objetivos de Desarrollo del Milenio”, final draft, Presidential Commissioner for the Social Affairs, April, 2004

14

coverage of the health system is still inadequate as less than 20 percent (6 percent of the poor) have access to medical insurance, and as much as 24 percent of the population still does not have access to health services or only has limited access. c. Water and Sanitation 1.26 Water supply and sanitation indicators for 1996-2003 reveal an increase in coverage, mainly in rural areas. The MDG in this area establishes the target of reducing the proportion of population not having sustained access to safe water and basic drainage to half by 2015. Recent data indicates that El Salvador has already surpassed the MDG target for urban water and sanitation and rural sanitation coverage and it is likely that by year 2015 the target for rural access to water will be met. Nevertheless, there are still great challenges in the sector. Public spending during 1996-2003 has been equal to an annual average of 0.3 percent of GDP, of which 70 percent was destined to water systems and 30 percent to sanitation To achieve universal coverage of water supply and sanitation by 2015, it would be necessary to increase annual investments in the sector. However, given the uncertainty about the nature and timing of water and sanitation sector reforms and about the most cost-effective and appropriate service delivery models, estimating with precision the necessary increases in investments is difficult. Nonetheless, recent estimates suggest a possible range of costs using international calculations of efficiency prices and differentiating between the costs of investments in rural and urban areas, that would need an average annual investment of US$ 21 million between now and 2015, or about 0.14 percent of GDP per year9. Because these calculations use estimates of efficiency costs, rather than actual costs, they may be interpreted as lower-bound estimates. Following an analysis presented in the recent Human Development Report (2004), and using unit cost estimates that do not differentiate between the unit costs of rural and urban areas, it is estimated that the additional investment costs would range from US$ 45 to US$ 50 million or about 0.3 percent of GDP per year10 between now and 2015. d. Rural Roads 1.27 Improving rural roads during the 1990s has contributed to poverty reduction in rural areas, and has given household members access to markets, educational and health centers, water and security. However, great deal of effort is still required to obtain an adequate level of connection of districts and settlements in the country. One set of objectives consistent with the country’s goals to strengthen poverty reduction through infrastructure development would be: (i) to pave or rehabilitate an additional 1,000 kilometers of rural roads; and, (ii) to ensure annual maintenance of 3,000 kilometers of rural (secondary and tertiary) roads. The costs associated with a program to continue expansion and improvement of the rural road network, as well as to develop a

9 Yepes, Tito, 2004, "Infrastructure and Poverty Reduction in Rural El Salvador," draft, Poverty Reduction and Economic Management and Human Development Departments, Latin America and the Caribbean Region, World Bank. 10 In the absence of sector reforms and the identification of a cost-effective service delivery model for rural areas, the costs are likely to be closer to the upper- than the lower-bound estimate.

15

maintenance capacity for rural roads depends on the specific goals and the timeframe set for achieving them. Analysis of El Salvador’s road investments suggest that the unit costs of the road’s development is in line with international norms. Using recent average unit costs of road paving, rehabilitation, and maintenance as benchmarks, it is estimated that a 5-year program to pave and/or rehabilitate an additional 1,000 kilometers of rural roads would cost approximately an additional US $25 million per year over 2003 spending levels. This implies investments of approximately 1.4-1.5 percent of GDP per year, up from 1.3 percent of GDP in 2003. Hence the allocation of resources to the sector needs to be increased by about 0.1 to 0.2 percent of GDP. e. Rural Electrification 1.28 El Salvador’s electricity indicators for the period 1990-2003 reveal improvement in coverage and quality of service, mainly in rural areas, however the main sector challenge is to lower the cost of service through more efficient generation and distribution. In view of the importance of rural electrification for income generation, the study on the situation of El Salvador in relation to the MDGs,11 incorporates the goal of reaching a rural electrification rate of 85 percent by 2015 (from 71 percent in 2002. During 1991-2002, rural electricity coverage increased from 44 percent to 71 percent with an investment in rural electrification by public entities equivalent to 0.5 percent of GDP. Hence, raising by about one percentage point per year the rural electricity coverage would cost an estimated of about $ 3 million a year, but it is important that the sector’s resource allocation priorities be reviewed in order to allocate more resources to low-income population and rural areas lacking service; and less resources for subsidies to those that already enjoy the service.

Budget execution 1.29 Although there has been consistency between the Government’s priorities and the allocation of resources, the implementation record of different institutions within each management area has been mixed. Table 1.10 shows that total expenditures have had an execution of 92 percent of the approved budget during the 1996-2003 period. The management area with higher execution on average is Public Debt ( 95.2 percent); followed by Justice and Security (94.4 percent); General Administration (93.8 percent ) in the middle of the rank; Social Development (92.7 percent); and Support to Economic Development (80.7 percent) lagging behind. Chart 1.4 also illustrates that the execution of the total budget in the different areas of management has not been very efficient until 1999, but has since improved.

11 El Salvador: Avance de los Objetivos de Desarrollo del Milenio- Primer Informe de País, 2004.

16

Table 1.10: CG Budget: Executed as Percent of Approved by Management Area

1996 1997 1998 1999 2000 2001 2002 2003 Administration 89.1 89.1 95.9 94.8 96.1 92.7 96.6 96.0 Justice and Security 84.9 90.6 95.3 93.5 98.5 97.2 97.1 98.7 Social Development 86.2 92.3 95.8 95.6 94.4 91.6 94.9 94.4 Presidency of the Republic 94.2 96.0 96.3 95.7 98.0 90.9 99.2 100.0 External Relations 62.8 62.6 50.7 51.5 53.7 87.1 99.9 100.0 Interior 98.5 99.4 96.0 89.8 99.5 97.5 0.0 0.0 Education 90.1 96.4 96.8 95.7 92.7 91.0 94.6 93.9 Health 95.6 99.1 97.6 96.5 98.6 90.3 94.8 92.0 Labor and Social Security 85.2 85.7 82.2 71.4 93.8 93.8 97 99.5 Housing and Urban Development 93.1 98.8 98.8 93.2 94.3 98.2 0.0 0.0 Transfers 48.6 84.8 97.4 100 93.4 93.4 95.1 96.5 Support to Economic Development 68.3 75.9 77.2 84.7 86.6 79.6 80.9 92.7 Infrastructure 0.0 0.0 0.0 0.0 0.0 0.0 93.4 59.4 Public Debt 77.7 99.6 93.3 98.2 93.7 99.5 99.9 100.0 General Obligation of the State 94.3 97.5 98.9 97.6 99.7 100 99.9 100.0 Public Enterprises 0.0 0.0 100.0 100.0 21.5 98.3 0.0 99.9 Total 82.0 90.4 92.3 94.4 93.7 92.3 95.5 96.2 Source: Ministry of Finance

Chart 1.4: Executed as % of Approved CG Budget, by Management Area

Source: Table 1.9

50.0%

60.0%

70.0%

80.0%

90.0%

100.0%

110.0%

1996 1997 1998 1999 2000 2001 2002 2003

Period

Perc

enta

ge

Social Development Just ice and Security Support to Economic Development Administ ration Total

5. Critical social and growth expenditures for the future 1.30 The Country Economic Memorandum of El Salvador (2003) states that the experience of the 1990s suggests that economic growth has been a key feature of El Salvador’s accomplishments in reducing poverty and points to four broad areas to reinvigorate economic growth in the 2000s: (i) increase education levels of the

17

population, (ii) develop the country’s economic infrastructure, (iii) foster greater technology adoption and local innovation, and (iv) improve the investment climate, including efforts to reduce violence and increase the rule of law. Expansions in some needed infrastructure (i.e. ports or large trunk roads) need to be financed mainly through partnerships with the private sector, as El Salvador has simply too few public resources to dedicate to these tasks. While in recent years El Salvador has made important advances in this area, there remains considerable potential through such partnerships to enhance national development as a whole and poverty reduction in particular. 1.31 The recent Poverty Assessment concludes that the poorest segments of the most vulnerable Salvadorans have been unable to take advantage of recent economic growth and therefore it will be important for the incoming government to put in place a coherent set of policies and investments to ensure that the poor can benefit from future economic progress. To build effectively on past achievements, it will thus be important for El Salvador to implement a social policy aimed at giving the poor better access to quality education and health care, and greater access to basic services, such as safe water and electricity. The implementation of a social policy has potentially important gains in poverty reduction and increased economic participation of the poor. 1.32 Given that the fiscal space for increased spending is limited in El Salvador, it is necessary to be selective and make strategic choices among priority areas. Table 1.11 presents a strategic package of investments to meet key social targets in education, health, water and sanitation, rural roads and social protection. While this package is oriented to ensure that the poorest have access to social services and to strengthen their position to benefit from future income earning opportunities, it also overlaps in some areas (education and rural infrastructure) with the agenda of key investments spelled out in the Bank’s CEM to promote broad based growth. The total cost of implementing the proposed package implies an increase in annual expenditures between 3.2 and 3.6 percent of GDP that would need to be gradually phased in, due to the tight fiscal situation. The largest commitments of additional resources are associated with education and the social safety net. It is estimated that improving education through achieving universal primary and basic education and increasing to 70 percent net enrollments in secondary schooling would require an additional 1.8 percent of GDP until year 2015; developing an adequate safety net would require spending of an additional 1 percentage point of GDP over the next five years; ensuring access to safe water and sanitation among the poor who currently lack access would require an additional 0.1-0.3 percent of GDP until year 2015; providing access to a minimum package of healthcare/ nutrition services to those who still lack regular health services would demand additional 0.2-0.3 percent of GDP in the next ten years; and finally to rehabilitate an additional 1,000 kilometers of rural roads and give annual maintenance to 3,000 kilometers of rural, secondary and tertiary roads over the next five years, would require a minimum increase in spending.

18

Table 1.11: Estimated Increase in Public Spending to Implement a National Social

Policy for Poverty Reduction

Sector

Objective

Current Public

spending as percent of

GDP

Target Public

spending as

percent of GDP

Proposed increase as percent of GDP

100 percent completion of primary education (basic cycles 1 & 2) by 2015 (MDG2)

0.5

100 percent completion of basic education (3rd cycle); 70 percent net secondary school enrollments by 2015

1.3 Education

Total

3.2

5.0

1.8

Health Provide access to a minimum package of

healthcare/nutrition services to those who still lack regular health services

3.8

4.0-4.1

0.2-0.3

Water Ensure access to safe water and sanitation among the poor who currently lack access

0.8 2

0.9-1.1

0.1-0.3

Roads Rehabilitating an additional 1,000 kilometers of rural roads over 5 years; annual maintenance of 3,000 kilometers of rural (secondary and tertiary) roads

1.3

1.4-1.5

0.1-0.2

Safety Net Ensure access to basic service by the poorest, most vulnerable Salvadorans

0.5

1.5

1.0

Totals

9.6

12.8-13.2

3.2-3.6

Source: El Salvador Poverty Assessment (2004) and Chapters III, IV, V, VI and VII of this PER Notes: 2000-2003, unless otherwise noted. 2 1990-2002 average.

6. Revenue policies

a. Past Performance 1.33 Government revenues in El Salvador have increased very gradually in the past 10 years, with tax revenues explaining the bulk of the increase. Tax revenue in 2003 accounted for 88 percent of total revenue, while non-tax revenues have fallen from 16 percent of government revenues in the mid 1990s to 6 percent in 2003, mostly as a result of privatizations and the corresponding decrease in transfers from public enterprises to the central government. Revenue from tax sources in El Salvador has increased very gradually, from 10.9 percent in the mid 1990s to 12.1 percent in 2003.

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Table 1.12: CG revenues as percent of total revenues

1996 1997 1998 1999 2000 2001 2002 2003 Total Revenues and Grants 1398.2 1395.1 1497.2 1498.9 1692.6 1731.8 1883.3 2059.0 1. Current revenues 1373 1362.7 1487.1 1441.4 1555.7 1617.2 1804.4 1936.2 Tax revenues 1148.7 1215 1304.9 1359.3 1452 1530.2 1685.0 1812.4 Non tax revenue 224.3 147.7 182.2 82.1 103.7 87.0 119.4 123.8 2. Capital revenues 1.0 4.4 3.4 14.5 78.2 32.6 20.9 49.8 3. Grants 24.2 28.0 6.7 43.0 58.7 82.0 58.0 73.0 Total Revenues and Grants 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 1. Current revenues 98.2 97.7 99.3 96.2 91.9 93.4 95.8 94.0 Tax revenues 82.2 87.1 87.2 90.7 85.8 88.4 89.5 88.0 Non tax revenue 16.0 10.6 12.2 5.5 6.1 5.0 6.3 6.0 2. Capital revenues 0.1 0.3 0.2 1.0 4.6 1.9 1.1 2.4 3. Grants 1.7 2.0 0.4 2.9 3.5 4.7 3.1 3.5 Source: Ministry of Finance This proportion is still one of the lowest in all of LAC and in the Central American region as shown in the chart 1.5.

Chart 1.5 CG Current Revenues and Total Expenditures as percent of GDP

0.0% 5.0%

10.0% 15.0% 20.0% 25.0% 30.0%

Perc

enta

ge o

f GD

P

Total Expenditure Current R

Total Expenditure 17.7% 25.8% 21.9% Current Revenue 13.3% 21.7% 20.0%

El Salvador (2003) Costa Rica (2003) LAC (1998)

1.34 The tax structure depends basically on revenues from the VAT and the income tax, which generated jointly over 82 percent of the total in 2003. With a current rate of 13 percent, the VAT has been the most significant of the two, contributing with a little over half of tax revenues. The remainder is collected through import duties (9.8 percent in 2003) and excise taxes on specific products (3.4 percent). The former has been steadily declining as a source of government revenue since the 1990s, as El Salvador has reduced sharply its average tariff levels to around 5 percent, one of the lowest in LAC (Table 1.13)

20

Table 1.13: CG Tax Revenues as % of Current Revenues and GDP In $ millions 1996 1997 1998 1999 2000 2001 2002 2003 Current revenues 1373.0 1362.7 1487.1 1441.4 1555.7 1617.2 1804.4 1936.2 Tax revenues 1148.7 1215 1304.9 1359.3 1452.0 1530.2 1685.0 1812.4 Tax revenues as of current. Rev. 83.7 89.2 87.8 94.3 93.3 94.6 93.4 93.6 As percent of Tax Revenues Income tax 27.2 27.5 28.3 30.3 31.1 29.8 28.5 29.3 Import duties 14.2 11.2 11.2 10.9 9.7 9.6 9.2 9.8 VAT 52.6 54.7 55.8 54.0 55.1 56.6 53.6 53.0 Excise Tax 4.8 4.5 3.6 3.8 3.4 3.2 3.9 3.4 As percent of GDP Tax revenues 10.9 10.9 10.9 10.9 11.1 11.1 11.9 12.1 Income tax 3.0 3.0 3.1 3.3 3.4 3.3 3.4 3.5 Import Duties 1.5 1.3 1.2 1.2 1.1 1.1 1.1 1.2 VAT 5.7 5.9 6.1 5.9 6.1 6.3 6.4 6.4 Excise Tax 0.5 0.5 0.4 0.4 0.4 0.4 0.5 0.4 Source: Ministry of Finance

1.35 The record for projecting annual revenues for the purposes of fiscal policy in El Salvador has had mixed results. Actual current revenues and tax revenues have fallen short of projected values over the 1996-2000 period by about 10 percent. This resulted from consistently overestimating revenues from income taxes, value added taxes and specific taxes, while import duties were severely underestimated (Table 1.14). According to the Ministry of Finance, the underestimations of 1996 and 1999 resulted from delays in approving the tariff reform. In 2000 the overestimation resulted from the fact that the planned crackdown on contraband did not yield the revenues anticipated that year. In addition, 2001 projections were affected by the economy wide effects of the earthquakes.

Chart 1.6: Executed as % of Approved CG Budget by Management Area

Source: Table 1.14

50.0% 60.0% 70.0% 80.0% 90.0%

100.0% 110.0%

1996 1997 1998 1999 2000 2001 2002 2003 Period

Perc

enta

ge

Social Development Justice and Security Suppo rt to Economic Development Administration Total

21

Table 1.14: CG Actual Revenues in US$ m. and as percent of

Project Revenues

Actual 1996 1997 1998 1999 2000 2001 2002 2003 Tax revenues 1149 1215 1305 1359 1452 1530 1685 1812 Income tax 312 334.5 369.2 411.7 451.5 455.4 480.2 530.1 Import duties 163.2 145.9 145.8 148.1 140.5 146 154.8 177.6 VAT 603.7 665 727.8 733.9 799.7 866.3 903.9 960.3 Excise tax 55.6 55.2 47.3 51.5 48.6 49.2 66.5 61.7 Budgeted 1996 1997 1998 1999 2000 2001 2002 2003 Tax revenues 1358 1348 1373 1446 1578 1640 1702 1731 Income tax 354.6 381.7 391.4 438.6 473.3 532.4 495.7 509.2 Import duties 130 146.9 113.1 126.6 181.8 155.4 154.3 159.2 VAT 762.9 722.9 783.4 800.4 850.4 881.6 986.1 987.7 Excise tax 90.6 79.4 67.3 62.6 55 56.6 54.4 62 Actual / Budgeted 1996 1997 1998 1999 2000 2001 2002 2003 Tax revenues 84.6 90.1 95 94 92 93.3 99 104.7 Income tax 88 87.6 94.3 93.9 95.4 85.5 96.9 104.1 Import duties 125.5 99.3 128.9 117 77.3 94 100.3 111.6 VAT 79.1 92 92.9 91.7 94 98.3 91.7 97.2 Excise tax 61.4 69.5 70.3 82.3 88.4 86.9 122.2 99.5 Source: Ministry of Finance

b. Prospects 1.36 According to a number of recent studies, there is ample room for El Salvador to continue to improve tax revenues over the coming years.12 The area with most promise is the excise tax on specific products, in which El Salvador ranks low in international comparisons. Greater taxes on fuels, beverages and tobacco are a potential source of future revenues, particularly as El Salvador has lower rates than most Central American neighbors. VAT is an area in which the greatest challenge lies in continuing to incorporate the informal sector into the network. Moreover, El Salvador exhibits already a high yield from the 13 percent VAT rate (Table 1.15) 13. Since El Salvador has a well structured VAT, with a broad base and a single rate, further revenues from this source would likely require higher rates.

12 These studies include Stotsky and WoldeMariam (2002), Acevedo (2003), Acevedo and Gonzalez Orellana (2003) and Velasco and Rodriguez (2003). 13 The ratio for Latin America corresponds to the latest year for which the data is available. In effect, in 2003 VAT revenue productivity, defined as VAT revenue as a share of domestic consumption divided by the standard VAT rate, averaged 0.46 in Central America, higher than the ratio of 0.43 in Latin America.

22

Table 1.15: Central America Value Added Revenue Productivities

(CG data for 2003) Tax

Revenue as percent of

GDP

Tax Revenue as percent of

Total Revenues

VAT as percent of

Tax Revenue

VAT as percent of

Consumption

VAT Rate percent

VAT Productivity

Costa Rica 13.2 98.1 58.0 9.4 13.0 0.72 Dominican Rep. 14.6 76.3 25.8 4.7 12.0 0.39 El Salvador 12.1 89.5 53.0 6.4 13.0 0.49 Guatemala 10.3 93.0 45.8 5.1 12.0 0.42 Honduras 16.3 83.3 36.6 6.7 12.0 0.56 Nicaragua 16.0 97.0 16.1 2.8 15.0 0.19 Panama 8.8 54.7 17.7 2.1 5.0 0.42

Unweighted regionalaverage 13 84.6 36.2 5.3 0.1 0.46

Source: Ministry of Finance of each country (using IMF methodology) 1.37 A number of technical proposals have been made in recent years to improve collection and eliminate distortions in the personal and corporate income tax regimes. Some of these include eliminating the accelerated depreciation for investment, eliminating some deductions to personal and corporate income, and taxing interest income. Such changes could yield 0.4 percent of GDP from personal taxes and 0.6 percent in corporate taxes.14 By contrast, import duties are likely to deepen their secular decline in coming years, particularly as El Salvador implements the trade agreements with the United States and other Central American Countries. Recent estimates of the accumulated loss from CAFTA, once all tariff elimination commitments are phased in over a 10 to 20 year period, indicate that this is likely to reduce revenues by about 0.5 percent of GDP.

III. Fiscal Cost of Pension Reform 1.38 El Salvador adopted a pension reform in 1996 that replaced the existing pay-as-you-go system with a system of complete individual capitalization.15 The reform was aimed at homogenizing the conditions for access to benefits by workers from the private, public, and municipal sectors, increasing coverage of the system and laying out the groundwork for a deeper capital market. As was clear from the beginning, the adoption of such a reform would entail transition costs for a substantial period of time, stemming from the decline in government revenues from the shift of the younger population to the private account system, while preserving the obligation to pay pension benefits to retirees and the older cohorts who remained in the old defined benefit system.

14 ES Fiscal Performance, Prospects and Policy Options. Velasco & Rodríguez. 15 Decree 926 of December 19, 1996 also created the Superintendence of Pensions.

23

1.39 As of December 2003, the size of the actuarial deficit, estimated by the Superintendence of Pensions as equivalent to 72 percent of GDP, has several components: (i) the payment of pensions for the current pensioners; (ii) payments for future pensioners; (iii) the redemption of the transfer certificates and the complementary transfer certificates; and, (iv) payment of the complement for mandatory minimum pensions.16 In effect, the costs of the pension reform have been higher than first expected due to: unrealistic financial projections when the reform began, generous benefits compared to other social security systems, the growth of administrative spending and the negative yield of the technical reserves. In December 2001 legal provisions were approved to allow the government to amortize the transfers certificates over a period of 15 years instead of paying them in full when due, generating some fiscal relief. However, this was offset by the creation of a complementary transfer certificate aimed at equalizing benefits between the private account system and the public one. Given recent fiscal trends, curbing the transition costs of the pension reform represents an important challenge in El Salvador. 1.40 Most Latin American countries went through pension reforms since the 1980s. This process was lead by Chile in 1981 and followed in the 1990s by several other countries like Peru in 1993, Argentina and Colombia in 1994, Uruguay in 1996, Bolivia and Mexico in 1997 and most recently Costa Rica in 2001. El Salvador reformed its pension system in 1998 although some retirement benefits remained comparatively generous, both in terms of age and contribution limits. Retirement ages in countries such as Argentina, Chile, Mexico and Peru ranges between 60 to 65, differentiating by genders in some cases. The Salvadoran regime grants retirement benefits at age 55 for women and 60 for men, while countries like Costa Rica set the retirement age at 65 years for both men and women. Regarding early retirement, El Salvador pension system allows it after 30 years of contribution or with accounts that can finance pensions of at least 60 percent of the Basic Regulatory Salary. By contrast, in Chile, to be eligible for early retirement a person must have saved enough to finance a pension equal to 110 percent of guaranteed minimum pension, almost twice as much as in El Salvador. In Bolivia contributors must work until they are 65, both men and women, or account sufficient to finance a pension equal to 70 percent of the Basic Regulatory Salary. (Table 1.16).

16 The transfer certificate corresponds to the present value of the payment of the rights of acquisition for those persons who transferred to the system administered by Private Funds Administrators (AFPs in Spanish). The complementary transfer certificate is the actuarial value that it sufficient for a person to obtain a pension in the private Savings System for Pensions (SAP) equal to what the pensioner would obtain in the System of Public Pensions (SPP).

24

Table 1.16: Structure & Features of Pension Reforms in

Latin America

Source: ES Fiscal Performance, Prospects and Policy Options. Velasco & Rodríguez.

Model Country and date of

implementation

Eligibility

El Salvador, May 1998 M:60 F:55years, or contributed for at least 30 years, or account sufficient to finance a pension equal to 60% of the Basic Regulating Salary.

Chile, May 1981 M:65 F:60 years of account sufficient to finance a pension equal to 110% of guaranteed min. pension.

Bolivia, May 1997 M & F:65 years or account sufficient to finance a pension equal to 70% of the Basic Regulatory Salary.

Mexico, Sept 1997 At least 1250 contributed weeks and 65 years of age.

Peru, June 1993 M:65 F:60 years Colombia, Apr 1994 M:62 F:57 years

Argentina, July 1994 M:65 F:60 years, or contributed for at least 30 years.

Uruguay, Apr 1996 M & F:60 years, or 70 years with 15 contributed terms.

Costa Rica, May 2001 M & F:65 years, and at least 240 contributions.

Substitutive

Paralell

Mixed

1.41 Even though the benefits that El Salvador’s pension system offer are more generous than in most countries of the region, the total payroll tax rate is 13.5 percent, one of the lowest in LAC. In fact, the payroll tax rates in other countries of the region are 20 percent in Chile, 22 percent in Peru, 21.5 percent in Nicaragua, 24 percent in Bolivia, 26 percent in Costa Rica and Mexico, 34 percent in Colombia, 40 percent in Uruguay and 46 percent in Argentina. In El Salvador as well as in Costa Rica, Nicaragua, Mexico and Chile, the participation of new workers is mandatory, while in Peru, Colombia, Argentina and Uruguay the participation of new workers is voluntary. Finally, another important dimension along which reforms in Latin America vary is the degree of choice afforded to workers. In Chile, Mexico, Bolivia, and El Salvador, PAYG (pay-as-you-go) systems were closed and workers were forced to take up individual retirement accounts. In contrast, in Peru, Colombia and Argentina, workers that join the labor force are allowed to choose between the pay-as-you-go system and individual retirement accounts. 1.42 In El Salvador, options to deal with growing fiscal pressures include (i) raising the retirement age to 65 for men and 60 for women; (ii) increasing to 35 the number of years paid in order to obtain an old age pension, regardless of age; and (iii) eliminating the right to have an old age pension, regardless of age, after contributing 30 years. The fiscal

25

impact of these options are analyzed in detail in Annex II. The third alternative is the one that would yield most savings in relation to the base case, equivalent to almost 10 percent of the actuarial value. In this case, the maximum annual fiscal cost would be reduced from 2.3 percent of GDP to 1.8 percent of GDP.

IV. Fiscal and Debt Sustainability 1. Public Sector Debt Trends 1. 43 Public sector debt has accelerated rapidly in the last five years. In 1999, total public debt was close to $3.5 billion and by the end of 2003 it had reached $6.1 billion. As a percentage of GDP, public debt increased between 1999 and 2003 from 28.1 percent of GDP to 40.6 percent of GDP (Table 1.17). This rapid accumulation of debt comes after a decade of decline. El Salvador started the 1990s with a debt level at around 60 percent of GDP, which began to decline substantially after 1993, reaching a low of 28 percent in 1999. Between 1999 and 2003 the increase in debt led to higher interests payments, which went from 1.4 percent to 2.0 percent of GDP. This is a warning signal, as further growth in this indicator could be reflected in market spreads and could potentially cause difficulties when tapping domestic and international capital markets. As can be seen in Chart 1.7 the bulk of the increase of debt accumulated since 1999 has been contracted externally through Eurobond issues. This has been possible thanks to El Salvador’s investment grade rating, record of sound fiscal management and low initial debt levels. Chart 1.7: Non Financial Public Sector Debt as percent of GDP

0.0% 5.0%

10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0% 45.0%

1999 2000 2001 2002 2003

Period

% o

f GD

P

Total NFPS Debt External Debt Internal Debt Short term Debt

26

Table 1.17: Non Financial Public Sector Debt in US$ m. and as percent of

GDP

1999 2000 2001 2002 2003 Total NFPS Debt (1+2+3) 3,498.10 3,824.60 4,668.80 5,544.10 6,092.90 1. Long Term External Debt 2,482.30 2,471.90 2,772.00 3,851.10 4,292.70 Central Government 2,162.30 2,164.10 2,613.70 3,676.10 4,105.60 Non Financial Public Companies 319.7 307.5 158.3 173.5 183.3 Other Central Government (municipalities) 0.3 0.3 - 1.5 3.8 2. Long Term Internal Debt 785.8 871.8 1,211.20 1,693.00 1,710.20 Central Government 770 853.5 1,188.90 1,615.00 1,659.60 Non Financial Public Companies 6.1 8.8 14.9 66.4 40.7 Other Central Government (municipalities) 9.7 9.5 7.4 11.6 9.9 3. Short Term Central Government Debt 230 480.9 685.6 - 90

Percent of GDP Total NFPS Debt (1+2+3) 28.0 29.1 34.0 39.0 40.6 1. Long Term External Debt 19.9 18.8 20.2 27.1 28.6 Central Government 17.3 16.5 19 25.9 27.4 Non Financial Public Companies 2.6 2.3 1.2 1.2 1.2 Other Central Government (municipalities) 0.0 0.0 0.0 0.0 0.0 2. Long Term Internal Debt 6.3 6.6 8.8 11. 9 11.4 Central Government 6.2 6.5 8.7 11.4 11.1 Non Financial Public Companies 0.0 0.1 0.1 0.5 0.3 Other Central Government (municipalities) 0.1 0.1 0.1 0.1 0.1 3. Short Term Central Government Debt 1.8 3.7 5.0 0.0 0.6 Source: Ministry of Finance

2. Debt Sustainability 1.44 This section develops fiscal scenarios for El Salvador during the next 10 years in an attempt to quantify the adjustment needed to ensure fiscal sustainability. Adjustments are clearly needed to address some of the underlying trends that have led to the rapid increase in El Salvador’s total public debt. As explained in this chapter, much of this increase in public debt can be attributed to emergency earthquake reconstruction expenses (5.3 percent of GDP in the period) and the growing transition costs of pension reform (3.5 percent of GDP). While reconstruction costs will wind down by 2005, the country will need to ramp up social and growth related expenditures. Clearly, El Salvador’s greatest challenge over the coming years is how to lay out a path for debt sustainability while simultaneously financing the expenditures required to meet social and growth challenges. Furthermore, given the absence of monetary policy tools, all of the required adjustment will need to be addressed explicitly through fiscal policy levers. 1.45 The sustainability analysis has been prepared on the basis of expenditure and revenue patterns observed during the past five years, using conservative macroeconomic assumptions as a baseline and an accounting consistency framework that allows for time-varying GDP growth and interest rates (see Table 1.18 below). GDP is expected to grow by 2.5 percent in 2004 and then by an average 3.5 percent for the rest of the projected

27

scenario, consistent with growth prospects presented earlier in this chapter. As a dollarized economy, El Salvador is expected to enjoy low inflation (3 percent on average) and interest rates that closely follow US trends and current market rates for Salvadoran bonds. 1.46 Passive Scenario - No significant changes to current fiscal policy and tax structure. In this macroeconomic context, a path for NFPS revenues is estimated, assuming some increases in government revenues at the beginning of the period due to ongoing administrative measures to improve tax collection.17 The scenario also takes into account the expected reduction in tariff revenue (about 0.5 percent of GDP) that will gradually take place between 2005 and 2013 due to the implementation of CAFTA, while other revenue items are projected to continue growing at nominal GDP growth rates. 1.47 On the expenditure side, this scenario includes the fiscal impact of current pension liabilities as presented in the Base Scenario of Annex I-A. Also, public investment levels reflect the elimination of earthquake reconstruction expenditures by 2005, while other investments are projected at 3 percent of GDP from 2006 to 2013, consistent with recent historical trends. Wages and salaries of public servants grow at a rate equal to nominal GDP growth, as no significant further downsizing of government personnel is expected.

Table 1.18: Main Macroeconomic Assumptions

Actual OutcomeAssumptions

Average Average 2000-2003 2004 2005 2006 2007-2013 Real GDP growth (percent) 2.1 2.5 3.5 3.5 3.5 Average Inflation (percent) 2.8 3.1 3.0 3.0 3.0 Nominal interest rate on public debt* (percent) 5.2 6.0 6.6 6.7 7.5 Public external financing (as percent of GDP) 4.4 1.9 2.0 1.8 1.5 Average interest rate that applies to NFPS debt. New financing is obtained at current market rates for El Salvador (app. 8percent). The interest rate on old debt increases gradually following US LIBOR projections from the Global Development Finance 2004 report. 1.48 The results of the Passive Scenario are shown in charts 1.7 to 1.10 for four main fiscal indicators: the overall fiscal deficit, its underlying primary balance, total public debt and total interest payments (for details see Annex 1.A of this chapter). As can be seen from the charts, the Passive Scenario yields an unsustainable path for public debt as all major variables shift towards increasing levels of public deficits and indebtedness. The overall NFPS deficit increases from 3.2 percent of GDP in 2004 to 4.3 percent in 2013, as a result of a steady increase in total interest payments from 2.3 percent to 3.7 percent of GDP and an average primary deficit of 0.7 percent of GDP during the same period. Public sector debt increases from 40 percent of GDP in 2003 to 50 percent of GDP in 2013 (roughly equivalent to an annual increase of 1 percent of GDP), an admittedly much lower pace of debt accumulation than that observed between 2000 and

17 These measures include (i) strengthening of tax administration and enforcement; (ii) the implementation of electronic audits and (ii) the continued use of an electronic tax payment system.

28

2003. However, this pattern is unsustainable as debt indicators further deteriorate after 2013 at a much faster pace given the resulting debt dynamics. For example, total public debt could increase to 58 percent of GDP by 2018, only five years later. 1.49 While the Passive Scenario does not show a rapidly explosive debt situation, it should be noted that this is partly the result of some simplifying assumptions adopted for the projections. Perhaps the most salient is the assumption that all new financing will be obtained at a constant average nominal interest rate of 8 percent. More realistically, given the usual reaction of international financial markets to deteriorating fiscal and debt indicators, El Salvador could eventually loose its investment rating from Moody’s and the cost of its sovereign financing could increase to levels observed in other dollarized, but more indebted, economies. The scenario also assumes that there are no negative shocks (additional terms of trade declines, natural disasters or financial sector contingencies) in the 10 year period that may require additional significant expenditures. In addition, it does not include any of the additional expenditures included in the package presented on section II of this chapter to meet key social targets and improve growth prospects. 1.50 Fiscal Target Scenario – Lowering public debt to 35 percent of GDP and addressing critical social and growth expenditures. The Passive Scenario develops into further fiscal deterioration if no fiscal reforms are taken to turn the NFPS primary balance into a neutral, debt sustainable path. But how much fiscal adjustment is needed to achieve this? Which public sector debt level could be considered as sustainable and desirable over the long run? El Salvador’s current debt level is probably inconsistent with the fiscal flexibility that the country requires for the future. El Salvador’s fiscal policy needs to retain the capacity to respond rapidly to important contingencies in the future for several good reasons. One is the possibility of further natural disasters (e.g., earthquakes, hurricanes), which require emergency attendance and reconstruction, and which occur with some regularity in Central America. The second is the growing need to use fiscal policy in a counter cyclical manner, as it is the only significant policy tool left for this purpose since dollarization was implemented. The third reason is the need to respond to sudden, costly contingencies, such as those that can arise from the financial sector. These reasons, coupled with recent research,18 suggest that debt levels above 40 percent of GDP increase the likelihood of a debt crisis and can be harmful for growth. Therefore a reasonable goal for El Salvador would be to keep debt levels at no more than 35 percent of GDP. In addition, El Salvador should adopt a package of new investments as the one suggested in this report in order to meet social and growth needs. Such a package would require additional expenditures that would eventually reach a minimum 3.2 percent of GDP by 2012 - 2013. 1.51 Using the same baseline macroeconomic assumptions of the Passive Scenario, this report estimates the fiscal adjustment necessary to achieve a debt to GDP ratio of 35 percent within the next 5 years (2005 to 2009) and the phasing in of the additional expenditures. The level of the primary balance is derived from the requirement that the 18 For further details, see IMF (2002), Detragiache & Spilimbergo (2001) and Pattillo, Poirson, and Ricci (2002).

29

debt to GDP ratio needs to remain roughly stable for the rest of the projection period (until 2013). The results obtained for the same four variables discussed before are shown in charts 1.8 to 1.11. Further details are included in Annex 1.B. 1.52 A gradual primary adjustment path is projected between 2005-2009, with the primary deficit starting at –1.0 percent of GDP in 2004 and turning into a surplus of 2.4 percent by its peak year in 2009, when the debt ratio reaches 35.7 percent of GDP (Chart 1.10). The paths of the primary balance and public debt are also consistent with lower interest payments. Starting with interest payments equivalent to 2.3 percent of GDP in 2004, public debt interest payments would stabilize at around 2.6 percent of GDP by 2013 (Chart 1.11). If compared to the Passive Scenario, fiscal savings equivalent to 4.5 percent of GDP would accrue between 2005 and 2013 only due to the difference in interest payments between both scenarios. This would yield an average primary surplus of 1.2 percent of GDP between 2005 and 2009. Annex I presents the sensitivity analysis to changes in key assumptions. For instance, if growth were to be only 2.5 percent in the 2005-09 period, the total primary savings required would be 1.6 percent on average. Moreover, if the nominal interest rate turned out to be 9.5 percent, El Salvador would need to generate total primary savings of 1.8 percent on average.

30

Chart 1.8 Overall NFPS Deficit Chart 1.9: NFPS Primary Bala

Chart 1.8 Overall NFPS Deficit (as % of GDP)

-3.8-4.4

-1.5

-0.2-0.7

-1.5

-4.0-3.6-3.4

-3.3-3.0

-4.3

-4.2

-4.2

-3.1-3.2

-2.1 -2.0 -2.4

-2.0

-0.9

-5.0

-4.0

-3.0

-2.0

-1.0

0.0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Passive Target

Chart 1.9 NFPS Primary Balance (as % of GDP)

-0.6 -0.7 -0.8

0.20.6

1.11.7 1.7

1.00.5 0.4

-1.0 -1.0 -0.6 -0.7-0.6 -0.7 -0.8 -0.8

2.4

-2.7 -3.0 -2.0 -1.0 0.0 1.0 2.0 3.0

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Passive Target

Chart 1.10 NFPS Total Public Debt (as % of GDP)

38.8 40.6 41.1 41.7 42.4 43.2 44.1 45.1 46.3

47.748.9

50.2

38.8 40.6 41.1 41.0 40.4 39.4

37.935.7

34.2 33.6 33.5 33.6 30.0

35.0

40.0

45.0

50.0

55.0

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Passive Target

Chart 1.11 NFPS Interest Payments (as % of GDP)

1.7 2.0

2.3 2.5 2.6 2.7 2.8

3.03.2

3.5 3.53.7

1.7 2.0

2.3 2.6 2.6 2.6 2.6 2.6 2.5 2.6 2.5 2.6

1.0

2.0

3.0

4.0

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Passive Target

31

1.53 In order to achieve the required primary balance while at the same time increasing social and growth expenditures, there are several potential actions on the expenditure and revenue sides. Nevertheless, based on the analysis presented in this chapter, there is little room for action on expenditure cuts or substitution in El Salvador today, given the relatively small size of the state and the improved efficiency levels. The only potential area of expenditures in which some savings could be envisioned is in pensions. As pointed out earlier, despite the reform in 1996, pension benefits in El Salvador still remain overly generous by international comparison. While several potential changes are possible, eliminating the provision that allows Salvadorans to retire after 30 years of work, regardless of age would yield 2.3 percent of GDP in savings between 2005-2009 with respect to the Passive Scenario (Scenario 4 of Annex I-A). 1.54 Due to the limited space that El Salvador has on the expenditure side, it appears that the bulk of the adjustment would have to be made on revenue. There are two clear options in this regard. The first is improving revenues via administrative and operational improvements for which there still seems to be substantial room according to recent studies. Given recent trends and plans being implemented with the help of external cooperation, a reasonable assumption is to expect revenue gains of 0.3 percent of GDP annually for a total of 1.5 percent between 2005 and 2009. 1.55 The second options deals with changes in the tax code to widen the tax base, reduce exemptions or increase tax rates. Several studies have been recently conducted on the key areas that El Salvador needs to address. . Such research suggest that it is technically feasible to make changes that would yield the required increase of 2.5 percent of GDP in a reasonable time horizon to meet the 35 percent of GDP debt target before the end of the decade. However, it is difficult from the political point of view, as witnessed by the relatively small increase in tax revenues over the past eight years (from 10.9 in 1996 to 12.1 percent of GDP in 2003) and the bitter debate that any adjustment in the tax base, exemptions has generated in the past. For this to be feasible, it needs a consensus building process in which Salvadorans agree on the importance of financing a minimum social and growth agenda while maintaining sound public finances. 1.56 It should be noted that while the fiscal target scenario outlined above seems to be technically feasible, it assumes that there are no negative shocks (i.e., further terms of trade declines, natural disasters or financial sector contingencies) during the period covered in the projection. According to the IMF (2003), the most important contingent fiscal liabilities in El Salvador would come from private and public financial institutions, and would include non-performing loans, loans to coffee sector, repossessed collateral, and real estate exposure.19 Given the likelihood of these contingencies some leeway should be built into these plans. Box 1.1: Chile’s Fiscal Rule

19 The estimated fiscal implications of these contingent liabilities that could, under adverse circumstances, become an explicit part of public debt range from about 3 percent of GDP to 9 percent, with a middle scenario of 5.3 percent.

32

V. Conclusions 1.57 This chapter has delineated the major fiscal challenge that confronts El Salvador today: addressing the recent deterioration in the debt sustainability outlook while at the same time creating the fiscal space for certain priority investments required to meet pressing social needs and accelerate growth. As the analysis in the chapter indicates, the level of new spending required should be manageable and can be reconciled with the goal of strengthening fiscal accounts in a country where the tax burden is still relatively low by international standards. 1.58 El Salvador should consider funding a strategic package of investments to meet key social targets in education, health, water and sanitation, rural roads and social protection. This package is oriented to ensure that the poorest have access to social services and to strengthen their position to benefit from future income earning opportunities. The total cost of implementing this proposal implies an increase in annual expenditures of about 4.0 percent of GDP that would need to be gradually phased in over several years, due to the tight fiscal situation. While this package covers significant components of the growth agenda that El Salvador requires to boost economic performance over the coming years (i.e., education and rural infrastructure) as described in the recent Country Economic Memorandum (World Bank, 2004), it admittedly excludes some important investments that such an agenda requires (i.e., larger infrastructure investments, and competitiveness-type expenditures such as funds for R&D and labor training to complement private sector-led efforts). An in depth analysis of infrastructure investments, including public and private sources, will be conducted for El Salvador during Fiscal Year 2005, using a new diagnostic tool called "REDI" that would cover the energy (electricity and gas), telecommunications, transport (roads, rail, ports and airports), water and housing sectors. The REDI diagnostic will produce an integral assessment of El Salvador’s infrastructure sectors, explore the relationship between infrastructure and El Salvador’s development strategy, include benchmarks against regional and competitor economies; analyze the challenges of financing infrastructure requirements; and look at institutional and regulatory issues. The additional investments to promote growth not included in the proposed package, will require commensurate additional fiscal efforts and creative methods to attract financing from the private sector. 1.59 If recent expenditure and income trends are left unchecked, the debt sustainability of El Salvador would be compromised. A passive scenario would lead to: (a) increasing overall deficit to an average of 4.3 percent of GDP by 2013; (b) interest payments of nearly 3.7 percent of GDP in 2013 (one percentage point of GDP higher than in the Fiscal Target scenario); and (c) total public debt close to 50 percent of GDP by 2013, increasing at an even faster rate afterwards. These trends indicate that serious attention is required in order to preserve the country’s credit rating and the cost of external borrowing. The investment-grade rating that El Salvador has built and which is responsible for its low interest rate spreads is based on a solid track record of debt and fiscal management.

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1.60 Returning to a public debt level that allows for fiscal flexibility to respond to shocks, contingencies or cyclical economic management should be a priority in El Salvador. The chapter lays out a path to return to a debt level of 35 percent of GDP over 5 years which would require gradual increases in revenues which reach about 4.0 percent by 2009, of which 1.5 percent should be collected by administrative measures and the rest will require additional tax efforts. In addition, some pension provisions should be amended to remove benefits that are too generous in the international context and that can increase the degrees of freedom of fiscal policy. 1.61 El Salvador may benefit in the future from adopting more formally fiscal rules similar to those in force in other Latin American countries, in which a fiscal balance needs to be achieved on an annual basis, with some flexibility to allow for counter cyclical fiscal policy. The latter is important in the Salvadoran context, as formal dollarization leaves only fiscal instruments to stabilize the economic cycle. 1.62 The remainder of this report concentrates on two key aspects of the fiscal agenda facing El Salvador today. Chapter II presents an evaluation of the public expenditure management framework required to ensure that scarce public funds are used productively and efficiently. The remainder of the report presents detailed reviews and analyses of recent trends in expenditures in the most important areas for social advancement and to promote broad-based growth. Education, health, water and sanitation, rural roads, and electrification are the subjects of Chapters III, IV, V, VI and VII.

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ANNEX I: Sensitivity Analysis To Changes In Main Macroeconomic Assumptions

Both fiscal scenarios presented in Chapter 1 are based on strong assumptions about economic growth, interest rates and inflation that follow the corresponding paths summarized in Table 1.18. Changing any of these factors would have an important effect on the fiscal tightening needed to achieve a sustainable fiscal position. To determine how critical these assumptions are, sensitivity analysis was carried out on the average primary balance that, if maintained between 2005 and 2009, would allow the government to comply with the Fiscal Target of achieving a stable debt to GDP ratio of 35 percent of GDP by 2009 and maintained it thereafter. Table 1.19 can be interpreted as follows. The Fiscal Target scenario assumes that annual real GDP growth will stabilize at around 3.5 percent in the long-run (2005-2013). With this long-run growth rate, an average primary balance of 1.2 percent of GDP between 2005 and 2009 would result in a total public debt ratio close to 35 percent of GDP by 2009. If, however, growth turned out to be 2.5 percent annually, the average primary balance that would support a debt ratio of 35 percent by 2009 would be 1.6 percent of GDP. Note that the only assumption that changes is the GDP growth rate—everything else remains unchanged. As would be expected, higher growth would allow a more modest adjustment or the achievement of the 35 percent debt ratio in less than the proposed five years. Economic growth will depend on factors such as local infrastructure, stable export markets and terms of trade, and a competitive investment climate. A public sector debt perceived as unsustainable deters external financing and discourages private investment, thus hindering economic growth. A similar interpretation can be given to the sensitivity analysis around the interest rate. Under the Fiscal Target scenario, the nominal interest rate approaches 7.5 percent in the long-run, in which case the average primary balance that results in a debt ratio of 35 percent by 2009 is equivalent to 1.2 percent of GDP. If the nominal interest rate turned out to be closer to 9.5 percent, however, El Salvador would need to keep an average primary surplus equivalent to almost 2.0 percent of GDP between 2005-2009 to achieve a debt ratio of 35 percent of GDP by 2009.

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Table 1.19: NFPS Primary Balance ** and Selected Macroeconomic

Variables (Primary balance as % of GDP)

Real GDP Growth (2005-2013) 1.5 2.5 3.5* 4.5 5.5

NFPS Primary Balance** 2.0 1.6 1.2 0.8 0.5

Nominal Interest Rate (2005-2013) 5.5 6.5 7.5* 8.5 9.5

NFPS Primary Balance** 0.6 0.9 1.2 1.5 1.8 * Assumption use in the Passive and Fiscal Target scenarios. ** Average Primary balance that stabilizes the public debt-GDP ratio at 35 percent by 2009, if maintained between 2005 - 2009

As illustrated in Table 1.19, an increase in the interest rate would require higher savings to reach the desired debt target of 35 percent of GDP. Given that approximately 45 percent of El Salvador public debt is at variable interest rates, the authorities can hedge to some degree by issuing long-term debt in exchange for short-term debt, as they done recently in 2002. Of course, this would raise the average interest rate on the debt, but it would provide a safety cushion and reduce volatility. Using the same methodology, we could estimate the average primary surplus that will be necessary to stabilize the debt/GDP ratio at current levels (40 percent at end 2003). The results for different levels of GDP growth and nominal interest rates are shown in Table 1.20 below. In this case, under the base macroeconomic assumptions (3.5 percent growth and 7.5 percent nominal interest rate), the average primary surplus will have to be 0.5 percent of GDP between 2005 and 2009, for total savings of 2.4 percent during the period.

Table 1.20: NFPS Primary Balance ** and Selected Macroeconomic Variables

(primary balance as % of GDP)

Real GDP Growth (2005-2013) 1.5 2.5 3.5* 4.5 5.5

NFPS Primary Balance** 1.2 0.8 0.5 0 -0.4

Nominal Interest Rate (2005-2013) 5.5 6.5 7.5* 8.5 9.5

NFPS Primary Balance** -0.2 0.1 0.5 0.7 1.0 *Assumption use in the Passive and Fiscal Target scenarios. ** Average Primary balance that stabilizes the public debt-GDP ratio at 40% by 2009, if maintained between 2005-2009.

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Annex 1.A: Fiscal Performance Under the Passive Scenario

(NFPS as % of GDP)

2003* 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Total Revenues 16.8 16.1 16.0 16.0 16.0 15.9 15.8 15.7 15.7 15.6 15.5Tax Revenue 12.1 12.3 12.2 12.4 12.3 12.3 12.2 12.2 12.1 12.1 12.0 Direct Taxes 3.6 3.6 3.7 3.8 3.8 3.8 3.8 3.8 3.8 3.8 3.8 Indirect Taxes 8.5 8.7 8.5 8.6 8.5 8.5 8.4 8.4 8.3 8.3 8.2 On Trade 1.2 1.1 0.9 0.9 0.8 0.8 0.7 0.7 0.6 0.6 0.5 Other 7.3 7.5 7.6 7.7 7.7 7.7 7.7 7.7 7.7 7.7 7.7Non Tax Revenue** 4.2 3.3 3.3 3.2 3.2 3.2 3.2 3.2 3.2 3.2 3.2Capital Revenue 0.0 0.1 0.1 0.1 0.1 0.1 0.1 0.0 0.0 0.0 0.0Grants 0.5 0.5 0.4 0.4 0.4 0.4 0.3 0.3 0.3 0.3 0.3

Total Expenditures 19.8 19.4 19.2 19.3 19.4 19.5 19.6 19.7 19.9 19.8 19.9Current Expenditures 16.5 16.2 16.1 16.2 16.3 16.4 16.6 16.8 17.0 16.9 17.0 Consumption 10.8 10.6 10.5 10.5 10.5 10.4 10.4 10.4 10.3 10.3 10.3 Wages & Salaries 7.4 7.3 7.2 7.2 7.2 7.2 7.1 7.1 7.1 7.0 7.0 Good & Services 3.4 3.3 3.3 3.3 3.3 3.3 3.3 3.3 3.3 3.3 3.2 Interest Payments 2.0 2.3 2.5 2.6 2.7 2.8 3.0 3.2 3.5 3.5 3.7 Current transfers 3.7 3.4 3.0 3.1 3.2 3.2 3.3 3.2 3.2 3.1 3.1 Of which, Pensions 1.7 1.9 2.0 2.1 2.2 2.2 2.3 2.2 2.2 2.1 2.1Capital Expenditures 3.3 3. 2 3.1 3.1 3.0 3.0 3.0 2.9 2.9 2.9 2.9 On Reconstruction 1.4 0.6 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Other Investment 1.9 2.6 3.1 3.1 3.0 3.0 3.0 2.9 2.9 2.9 2.9

Overall Deficit (incl. grants)

- 3.0 - 3.2 -3.1 -3.3 -3.4 -3.6 -3.8 -4.0 - 4.2 - 4.2 -4.3

External Financing 2.9 1.9 2.0 1.8 1.7 1.5 1.4 1.5 1.5 1.5 1.5 Domestic Financing 0.1 1.3 1.2 1.5 1.7 2.1 2.4 2.5 2.7 2.7 2.8

Primary Balance (incl. grants)

- 1.0 - 1.0 -0.6 -0.6 -0.7 -0.7 -0.8 -0.8 - 0.8 - 0.7 -0.6

Total Public Debt 40.6 41.1 41.7 42.4 43.2 44.1 45.1 46.3 47.7 48.9 50.2

Memo Items: Overall Deficit w/o Reconstruction Exp.

- 1.4 - 2.3 -2.8 -3.0 -3.1 -3.3 -3.5 -3.7 - 3.9 - 3.9 -4.0

Primary Balance w/o Reconstruction Exp. 0.6 - 0.1 -0.3 -0.3 -0.4 -0.4 -0.5 -0.5 - 0.5 - 0.4 -0.3

* Preliminary figures. **Includes Public Enterprises operating surplus.

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Annex 1.B: Fiscal Performance Under the Fiscal Target Scenario (Nonfinancial Public Sector, as percent of GDP)

2003* 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Total Revenues 16.8 16.1 16.8 17.5 18.3 19.1 19.9 19.9 19.8 19.7 19.7

Tax Revenue 12.1 12.3 13.0 13.8 14.7 15.5 16.3 16.3 16.2 16.2 16.2

Direct Taxes 3.6 3.6 4.0 4.5 4.9 5.3 5.7 5.7 5.7 5.7 5.7

Indirect Taxes 8.5 8.7 8.9 9.4 9.8 10.2 10.7 10.6 10.6 10.5 10.5

On Trade 1.2 1.1 0.9 0.9 0.8 0.8 0.7 0.7 0.6 0.6 0.5

Other 7.3 7.5 8.0 8.5 9.0 9.5 9.9 9.9 9.9 9.9 9.9

Non Tax Revenue** 4.2 3.3 3.3 3.2 3.2 3.2 3.2 3.2 3.2 3.2 3.2

Capital Revenue 0.0 0.1 0.1 0.1 0.1 0.1 0.1 0.0 0.0 0.0 0.0

Grants 0.5 0.5 0.4 0.4 0.4 0.4 0.3 0.3 0.3 0.3 0.3

Total Expenditures 19.8 19.4 19.2 19.5 19.8 20.0 20.1 20.6 21.3 21.7 21.8

Current Expenditures 16.5 16.2 15.7 15.7 15.8 15.8 15.7 15.6 15.7 15.6 15.7

Consumption 10.8 10.6 10.5 10.5 10.5 10.4 10.4 10.4 10.3 10.3 10.3

Wages & Salaries 7.4 7.3 7.2 7.2 7.2 7.2 7.1 7.1 7.1 7.1 7.1

Good & Services 3.4 3.3 3.3 3.3 3.3 3.3 3.3 3.3 3.3 3.2 3.2

Interest Payments 2.0 2.3 2.6 2.6 2.6 2.6 2.6 2.5 2.6 2.5 2.6

Current transfers 3.7 3.4 2.6 2.7 2.7 2.7 2.8 2.8 2.8 2.8 2.8

Of which, Pensions 1.7 1.9 1.6 1.7 1.7 1.7 1.8 1.8 1.8 1.8 1.8

Capital Expenditures 3.3 3.2 3.1 3.1 3.0 3.0 3.0 3.0 3.0 2.9 2.9

On Reconstruction 1.4 0.6 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.0 0.0

Other Investment 1.9 2.6 3.0 3.0 2.9 2.9 2.9 2.9 2.9 2.9 2.9

Additional Social Spending 0.0 0.0 0.4 0.7 1.0 1.2 1.4 2.0 2.6 3.2 3.2

Overall Deficit (incl. grants) -3.0 -3.2 -2.4 -2.0 -1.5 -0.9 -0.2 -0.7 -1.5 -2.0 -2.1

External Financing 2.9 1.9 2.0 1.8 1.7 1.5 1.4 1.5 1.5 1.5 1.5

Domestic Financing 0.1 1.3 0.4 0.2 -0.2 -0.6 -1.3 -0.7 0.0 0.5 0.6

Primary Balance (incl. grants) -1.0 -1.0 0.2 0.6 1.1 1.7 2.4 1.7 1.0 0.5 0.4

Total Public Debt 40.6 41.1 41 40.4 39.4 37.9 35.7 34.2 33.6 33.5 33.6

Memo Items:

Overall Deficit w/o ReconstructionExp.

-1.4 -2.3 -2.0 -1.6 -1.1 -0.5 0.1 -0.4 -1.2 -1.8 -1.9

Primary Balance w/oReconstruction Exp.

0.6 -0.1 0.6 1.0 1.6 2.1 2.7 2.0 1.4 0.7 0.7

*Preliminary Figures. **Includes Public Enterprises Operating Surplus

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ANNEX II: The Fiscal Costs of Pensions Background

Prior to the 1996 reform, the problems of the existing system were: major disconnection between contribution and benefits, crossed subsidies between programs, heterogeneity of contributions, perverse incentives inside the benefit structure, low profitability of reserves. Ultimately, the problems lead to a lack of financial viability of the systems because of the increasing mismatch between contributing and beneficiary population (Table A.1). In this context, the following objectives for the reforms were put forward:

• Improve the benefits for workers by granting adequate and timely pensions. • Homogenize the conditions for workers’ access to the system. • Have the workers’ pension funds be administered securely and efficiently. • Create incentives for including new population groups in the system.

Table A.1: Basic Statistics of the Old Pension System

1980 1990 1996 Coverage ( percent of labor force) 21.3 20.5 24.2

Relation Active Contributors/ Pensioners 33.2 8.9 8.4

Administrative Expenditures ( percent contributory wage) 0.3 0.8 0.5

System employees x 1000 insured 10.1 10.2 11.5

Average pension in 1980 colones 1,704 1,091 1,083

No. Of pensioners 13,631 45,367 77,201

Reserves per member in 1980 colones 1,003 832 518

Source: Synthesis Consultores Internacionales “Opciones para enfrentar la deuda previsional” 1999.

With the objectives defined, the next step was to select the model appropriate for the economic and social conditions of El Salvador. After a thorough evaluation, it was decided to replace the existing pay-as-you-go system, the financing of which was based on the mechanism of the scaled average premium, with a system of complete individual capitalization. In 1996, the National Assembly approved the legislation that created the new system: the Law of the Savings System for Pensions and the law that create the Superintendence of Pensions.

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Organization of the Reform Pension Sector Legislative Decree 927 “Law for the Savings System for Pensions” of December 20, 1996 created the Savings System for Pensions (SAP) and the System for Public Pensions (SPP). The reform excluded the Social Insurance Institute of the Armed Forces. The Savings System for Pensions (SAP) is private in nature, administered by private firms given faculties by the State and called Pension Fund Administrators (AFPs). The AFP system began with five administrators, but with the merging of three of them in 2000, the market was left with only three. One of these AFP is under liquidation, therefore two AFPs remain. Those affiliated to this system are covered for the contingencies of disability and death by common risks, as well as old age. The SAP is based on complete capitalization from contributions to social insurance, from both employers and employees, in individual accounts owned by each worker affiliated. With the creation of this system, it was possible to homogenize the conditions for access to benefits by workers from the private, public, and municipal sectors. The legislation required that persons who on April 15, 1998 were less than 36 years old and were affiliated to the ISSS or the INPEP should join an AFP. It also established that persons on that same date who were between 36 and 50 for women and between 36 and 55 for men had the option of transferring to an AFP or staying with the old system. They had a year to make that decision and if they did not exercise the option during this period, the law obliged them to join an AFP. Lastly, any worker who started their first labor relation after April 15, 1990 was obliged to join an AFP, regardless of their age. The System of Public Pensions (SPP) comprises the programs for disability, old age, and death that are administered by the ISSS and INPEP. The Law gives the faculty to all those affiliated to the ISSS and INPEP who on April 15, 1998 were women 50 years or older or men 55 or older to remain in the SPP. With the reform, the conditions for access to benefits, the contributions, and the beneficiaries themselves were made homogenous in both Institutes. Further, in the ISSS, the health and pension programs were separated in terms of their administration and financing, with the Pensions Unit being created specifically for the organization, development, and execution of the program of coverage for disability, old age, and death. The SPP will continue being administered under the pay-as-you-go model of defined benefits until it disappears. Decree 926 of December 19, 1996 also created the Superintendence of Pensions as the institution responsible for overseeing, supervising, and controlling compliance with the legal dispositions applicable to the specific operation of the AFPs, the ISSS, and the INPEP. The highest authority in the institution is the Superintendent, who is appointed by the Council of Ministers from a proposal by the President of the Republic. Coverage of the System There were 547,470 people in 1997, or 24.6 percent of the Economically Active Population (labor force), affiliated to some program to protect them from the old age,

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disability, and death. As of 1998, the new system of AFPs began operations and the coverage of the integrated system rose to 39.8 percent of the labor force by 2001 and to 42.3 percent by 2003. If pensioners are added to the affiliates the coverage increases to 47.3 percent (Table A.2). There is low density of contributions, or the existing relation between effective contributors and the total number of affiliates. According to data from the Superintendence of Pensions this relation was 56.9 percent in 2001. In general in other countries, this relation is between 45 percent and 70 percent. Behind this relation are a number of difficulties that stem from the lack of stable employment and the existence of temporary jobs, the double accounting for the effects of transfers between AFPs, the arrears in paying into the system, and evasion of payment into the system. But the low density of contribution stems especially from a process of indiscriminate affiliation to the AFPs of people who are simply unemployed. The reason for this irrational affiliation was that the AFPs paid their recruiting agents a commission for each person enrolled. At present, the criteria have changed so that a commission is paid per person once the contributions for the following month of affiliation are received.

Table A.2: Population Affiliated and Pensioners, by Social Security Institute YEAR AFP ISSS INPEP IPSFA TOTAL Labor Force COVERAGE

1997 - 380,127 146,382 20,961 547,470 2,227,409 24.6 percent

2001 877,920 23,637 28,985 43,071 973,613 2,444,959 39.8 percent

Affiliates

2003 1,074,493 16,108 17,967 40,825 1,149,393 2,715,516 42.3 percent

1997 - 35,716 46,276 11,819 93,811 2,227,409 4.2 percent

2001 4,069 41,394 47,498 12,379 105,340 2,444,959 4.3 percent

Pensioners

2003 11,774 49,550 55,642 18,576 135,542 2,715,516 5.0 percent

1997 - 415,843 192,658 32,780 641,281 2,227,409 28.8 percent

2001 881,989 65,031 76,483 55,450 1,078,953 2,444,959 44.1 percent

Consolidated

2003 1,086,267 65,658 73,609 59,401 1,284,935 2,715,516 47.3 percent

Source: Synthesis Consultores Internacionales “Opciones para enfrentar la deuda previsional” 1999. Contributions and benefits Article 16 of the SAP Law stipulates that employers and workers will pay the contributions. The rate will be a maximum of 13 percent of the respective base income for contribution (IBC) and is distributed as follows: (i) 10 percent of the IBC will go to the individual account; of this total, 6.75 percent will be paid by the employer and 3.25 percent by the worker; (ii) a maximum commission of 3 percent of the IBC, charged to the worker, goes to contracting insurance for old age and survival and the payment of the administration of the individual accounts by the AFP. To reach these contribution ceilings for both the individual account and the commission, the Law foresaw a transition that would begin the year the new system started operations until the end of 2001. Starting in 2002, all affiliates to the new system, regardless of what sector they are from, will pay a maximum of 6.25 percent and the employer 6.75 percent, for a maximum total of 13 percent. If a person decides to increase their level of benefits, the system allows them to make voluntary contributions to be accumulated in the individual account. On the other hand, though it is true the commission has been fixed at a maximum of 3 percent of the base income, this was also affected by a transition, going

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from a maximum of 3.5 percent in 1998, to 3.25 percent in 1999 and 2000, and to 3 percent in 2001. In setting this commission, there is a certain flexibility so that the AFPs can compete through commissions, being able to set them under that percentage and in that way, reducing the total contribution of the worker. For those who stayed in the SPP, the total contribution rate was set at 14 percent of the IBC in equal portions from the employer and the worker. However, given the structure for contributions that there was before the reform, it was also necessary to have a transition so that it will reach 14 percent in 2003 for workers in the public administration sector and in 2002 for private sector workers. The workers in the public teaching sector contribute 14 percent since 2000. The criteria that gave rise to the difference in contributions between the new and old systems appear to have their roots in the incentive for transfer. Each affiliate or beneficiary with the right to a pension in the SAP is free to choose under some conditions between three modalities for pensions: scheduled income, lifetime income, and scheduled income with deferred lifetime income.20 Also in the SAP, unlike the SPP, the pensions have different sources of financing like the balance accumulated in the savings account for pensions, the Certificate of Transfer, the State Guarantee when it corresponds, and the Insurance for Disability and Survival contracted by the AFP with an insurance company.21 In the SAP, the amount of the old age pension may vary depending on the modality of pension chosen by the affiliate. On the other hand, in the SPP, the amount of the pension will depend on the average of the salaries deducted from in the last 10 years, that is, the basic regulator salary (SBR), and the total time over which contributions were made. In the SPP, the estimate for the pension starts with 30 percent of the SBR for the last three years of contributions plus 1.5 percent of the SBR for each additional year.22 Besides the benefits of disability and survival, the State grants a minimum pensions for old age, common disability, and survival. The amount of the minimum old age and total disability pensions is established annually by the Ministry of Finance in the Budget Law. The minimum survival pension is determined as a percentage of the minimum old age percentage in conformity with the percentages established for each beneficiary. On the other hand, the minimum pension for partial disability is equivalent to 70 percent of the minimum old age pension.

20 The pension by Scheduled Income consists in having the affiliate, at the moment of accessing a pension, maintain the balance of their account in an AFP so that it can give them a pension each month. Lifetime Income will be an insurance contract for persons with which the affiliate can sign a contract with a Personal Insurance Company of their choice, obliging it to pay the affiliate a monthly income as well as survival pensions in the event the affiliate passes away from the moment of signing the contract until it expires. The modality of Scheduled Income with Deferred Lifetime Income is a combination of the two previous ones. 21 For an affiliate of the SAP to enjoy insurance coverage for disability and survival, they must meet the following requirements: a) they are paying in and have contributed for at least six months during the twelve prior to the date of death or disability; or, b) they have been paying in during the period of twelve months prior to their date of death or the occurrence of the their disability according to the first ruling, having recorded six months of contributions in the year prior to the date when they stopped paying in. 22 It should be noted that the SAP law also sets rules that persons that were obliged to stay in the reformed public system will have the right to a calculation of a different pension, receiving 30 percent of the SBR for the first three years paid in, plus 1.75 percent for each additional year. Further, these persons have the option to choose the percentage benefit scales of the schemes of the old system, if they feel it suitable.

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With the SPP, pensions that are calculated based on the SBR and are less than the minimum pension in force are readjusted to the amount of this, subject to verification of the requirements. On the other hand, the minimum SAP pension operates when the balance of the individual account is exhausted in the event that the affiliate has opted for the pension by scheduled income or is in the phase of temporary scheduled income, as long as the requirements are met. At present, the amount of the minimum old age pension is $100, which is below the urban extreme poverty line of $127 and only slightly above the rural line of $93. A pensioner with a minimum pension would have to have an additional source of income in order not to fall into extreme poverty. Finally it should be noted that the Law allows one to obtain an old age pension after paying in for 30 years, regardless of age. Also, in the SAP, once the account balance is able to finance a pension of 60 percent of the SBR, which in turn is equal to or more than 160 percent of the minimum pension one may retire. Early retirement has a negative effect on savings since requiring resources before reaching the legal ages means putting an end to putting resources to other alternative uses, with the consequent impact on reduced savings. Actuarial Financial Deficit According to the Superintendence of Pensions, the size of the actuarial deficit of the SPP in December 2003 was $10,800.8 million, equivalent to 72 percent of GDP. The actuarial financial deficit is the result of the updating of the annual income flows from contributions minus the total expenditures for pensions and administration. In the case of El Salvador, this accumulated deficit has its roots in different problems that come from the initial design of the system. The old system had a heterogeneous structure for contributions and benefits; the contributions and the benefits were disconnected, creating the incentive to inflate the incomes for paying in from the last years in order to obtain a bigger pension; it had different institutions for attention to different population groups with heterogeneity in the retirement ages.

Table A.2: Pension Debt, December 2003 $ Millions percent Total (1+2) 10,800.80 100

1. Cost attributed to the Old Public System 9,912.40 90.8

i) Payment to Current & Future Pensioners 5,499.20 50.9

ii) Transfer Certificates (TC&CTC) a/ b/ 4,236.90 39.2

iii) Operational Deficit of Public System 69 0.6

2. Cost Attributed to the New System 995.7 9.2

a/ TC – Transfer Certificate b/ CTC – Complementary Transfer Certificate Source: Superintendence of Pensions.

The above difficulties, together with the low coverage of the system, the fall of the relation between assets and liabilities, the growth of administrative spending, and the negative yield of the technical reserves were determinant in having that system accumulate a high social security debt. The components of this deficit are: (i) the payment of pensions for the current pensioners; (ii) payments for future pensioners; (iii)

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the redemption of the transfer certificates and the complementary transfer certificates; and, (iv) payment of the complement for minimum pensions. Regardless of the reform, the first three components would have always had to be dealt with since they pertain to the implicit debt of the public system. The payment to current and future pensioners on the SPP is equivalent to $5,499.2 million. This represents 50.9 percent of the social security debt and corresponds to the commitment acquired by the State with about 105,192 affiliates who are currently pensioned with the ISSS and the INPEP.23 The redemption of the transfer certificates (regular and complementary) represents 39.2 percent of the social security debt ($4,236.9 million). The “regular” transfer certificate corresponds to the present value of the payment of the rights of acquisition for those persons who transferred to the private system administered by the AFPs. This right has the basic condition of having paid in for at least 12 months to the ISSS or the INPEP and is materialized in a value title that will earn annual interest equal to the inflation of the preceding year. Its redemption will be the responsibility of the State on the date the affiliate meets the requirements for accessing a pension.

The complementary transfer certificate is the actuarial value that it sufficient for a retiring person to obtain a pension in the SAP (AFP) equal to what the pensioner would obtain in the SPP. This is just for those that had the option of staying in the old system (between 36 and 50 for women and between 36 and 55 for men) but decide to joint the new system and now find out that their pension would be lower than in the old system. In December 2001, the Assembly of the Republic passed some modifications to the law that makes it possible for he government to amortize the transfers certificates over a period of 15 years instead of paying them in full when due as originally contemplated in the law. The operational deficit of public system is equivalent to $690 or 0.6 percent of the social security debt. This corresponds to the present value of the administration costs for the ISSS and the INPEP until its extinction and the payment of old age, disability, or survival pensions that these affiliates would generate minus the present value of the contributions that will be made by approximately 34,075 persons who opted to remain in the old system or who, because of age, were obliged to remain in it.24

The payment of complements in order to grant a minimum old age, common disability, and survival pension, which corresponds to 9.2 percent of the social security debt, is equivalent to $995.7 million. This component is the only one attributable, in part, to the reform. By law, the minimum pension will be established each year by the Ministry of Treasury based on the resources available to the Central Government. The actuarial pension deficit would be equivalent to 2 percent of the GDP for the period from 2003 to

23 To June 30, 1999. 24 Of which, 36,987 voluntarily opted to remain in the public pension system because of dispositions of Article 184 of the SAP Law, while 37,364 were obliged to remain in the public pension system because of their age because of dispositions of Article 186.

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2014, reaching a maximum of 2.3 percent of the GDP in 2009, and declining gradually to 1 percent until 2024, and then dropping to zero by 2067.25 Options to Reduce the Fiscal Cost of the Pension System There are a number of options for dealing with the social security debt. Three scenarios have been considered:26

1. Raise the retirement age in the SPP and SAP to 65 for men and 60 for women; 2. Increase to 35 the number of years paid in order to obtain an old age pension,

regardless of age; 3. Eliminate the right to have an old age pension, regardless of age, after

contributing 30 years in the SPP and SAP. Scenario 3 is the alternative that yields the largest savings in relation to the base case, equivalent of 9.9 percent less of the actuarial value. In this case, the fiscal cost would be reduced from 2.3 percent of GDP to 1.8 percent of GDP (see Table A.4, Figure A.1, and details of estimates at the end of the Annex).

Table A.3: Options to Reduce Pension Debt Pension Debt percent Reduction Maximum Fiscal Cost

($ millions) Respect Base Scenario ( percent GDP) a/

Base Scenario 10,800.80 - 2.3 b/

Scenario 1 10,694.70 -1 2.2 c/

Scenario 2 10,750.80 -0.5 2.2 b/

Scenario 3 9,918.90 -8.2 1.9 d/

Scenario 4 9,732.40 -9.9 1.8 e/

a/ Assuming average growth of 4 percent and inflation of 3 percent during 2003-2089. b/ 2009; c/ 2009-2011; d/ 2014; e/ 2009-2014 Source: Staff estimates on the base of Superintendence of Pension data

25 Assuming 4 percent GDP annual growth and 3 percent annual inflation rate during the 2003-2067 period. 26 Scenarios 1,2, and 3 would imply reforms to Articles 104 and 200 of the SAP Law.

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Figure A.1: Profiles of Pension Debt Reduction Scenarios

0.0

0.5

1.0

1.5

2.0

2.5

2003

2006

2009

2012

2015

2018

2021

2024

2027

2030

2033

2036

2039

2042

2045

2048

2051

2054

2057

2060

2063

2066

% o

f GD

P

Base Scenario Scenario I Scenario IIScenario III Scenario IV

Conclusions

The main causes that explain the enormous accumulated social security debt in

the old system are the constant decline of the relation between active and passive affiliates and the disconnection between the contributions received and the pensions granted by the SPP. Also influencing: low coverage, increased administrative costs, and investment of the technical reserve in operations that offered real negative profits in the 1980s (mainly Central Government bonds at a fixed rate in the most inflationary period in the economic history of El Salvador). The pension deficit would be equivalent to 2.0 percent of GDP for the period from 2003 to 2014, reaching a maximum of 2.3 percent of the GDP in 2009, and declining gradually to 1 percent until 2024, and then dropping to zero by 2076. A number of options to reduce the fiscal deficit have been explored , being the elimination of the right to pension regardless of age after 30 years of contributions, the option that yields most savings in relation to the base scenario (9.9 percent).

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Table A.4: Detailed Estimates of the Options to Reduce Pension Debt

(percent of GDP)

Year Base Scenario Scenario I Scenario II Scenario

III Scenario IV Nominal GDP $ mm

2003 1.78 1.73 1.72 1.64 1.61 14,996 2004 1.91 1.87 1.93 1.63 1.61 16,064 2005 2.02 1.98 2.05 1.62 1.61 17,207 2006 2.12 2.08 2.12 1.66 1.66 18,433 2007 2.15 2.11 2.10 1.71 1.72 19,745 2008 2.18 2.14 2.09 1.74 1.74 21,151 2009 2.25 2.22 2.16 1.78 1.78 22,657 2010 2.24 2.21 2.14 1.79 1.78 24,270 2011 2.21 2.18 2.13 1.84 1.79 25,998 2012 2.09 2.07 2.06 1.82 1.76 27,849 2013 2.05 2.03 2.03 1.83 1.76 29,832 2014 2.00 1.98 1.98 1.86 1.76 31,956 2015 1.89 1.87 1.89 1.83 1.73 34,231 2016 1.82 1.80 1.83 1.79 1.70 36,668 2017 1.79 1.78 1.80 1.72 1.69 39,279 2018 1.69 1.68 1.70 1.65 1.62 42,076 2019 1.55 1.53 1.55 1.55 1.53 45,072 2020 1.41 1.40 1.42 1.43 1.44 48,281 2021 1.29 1.28 1.29 1.33 1.33 51,718 2022 1.19 1.18 1.20 1.24 1.23 55,401 2023 1.09 1.08 1.10 1.15 1.14 59,345 2024 0.97 0.97 0.98 1.04 1.04 63,571 2025 0.90 0.89 0.91 0.97 0.95 68,097 2026 0.82 0.81 0.83 0.87 0.86 72,945 2027 0.75 0.75 0.77 0.81 0.80 78,139 2028 0.66 0.65 0.67 0.73 0.72 83,703 2029 0.58 0.58 0.59 0.62 0.62 89,662 2030 0.52 0.52 0.53 0.55 0.55 96,046 2031 0.46 0.45 0.46 0.47 0.47 102,885 2032 0.38 0.38 0.39 0.41 0.40 110,210 2033 0.33 0.33 0.34 0.36 0.35 118,057 2034 0.29 0.29 0.29 0.32 0.30 126,463 2035 0.25 0.25 0.25 0.28 0.26 135,467 2036 0.22 0.22 0.22 0.24 0.23 145,112

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Year Base Scenario Scenario I Scenario II Scenario

III Scenario IV Nominal GDP $ mm

2037 0.18 0.18 0.18 0.20 0.20 155,444

2038 0.17 0.17 0.16 0.17 0.17 166,512 2039 0.14 0.14 0.14 0.15 0.14 178,368 2040 0.12 0.12 0.12 0.12 0.12 191,067 2041 0.12 0.12 0.12 0.10 0.10 204,671 2042 0.11 0.11 0.11 0.08 0.08 219,244 2043 0.10 0.10 0.10 0.07 0.07 234,854 2044 0.11 0.11 0.11 0.06 0.06 251,576 2045 0.10 0.10 0.10 0.05 0.05 269,488 2046 0.09 0.09 0.09 0.05 0.05 288,675 2047 0.08 0.08 0.08 0.04 0.04 309,229 2048 0.08 0.08 0.08 0.03 0.03 331,246 2049 0.07 0.07 0.07 0.03 0.03 354,831 2050 0.06 0.06 0.06 0.03 0.03 380,095 2051 0.05 0.05 0.05 0.02 0.02 407,158 2052 0.05 0.05 0.05 0.02 0.02 436,147 2053 0.04 0.04 0.04 0.02 0.02 467,201 2054 0.04 0.04 0.04 0.02 0.01 500,466 2055 0.03 0.03 0.03 0.01 0.01 536,099 2056 0.03 0.03 0.03 0.01 0.01 574,269 2057 0.03 0.03 0.03 0.01 0.01 615,157 2058 0.02 0.02 0.02 0.01 0.01 658,956 2059 0.02 0.02 0.02 0.01 0.01 705,874 2060 0.02 0.02 0.02 0.01 0.01 756,132 2061 0.01 0.01 0.01 0.01 0.01 809,969 2062 0.01 0.01 0.01 0.00 0.01 867,638 2063 0.01 0.01 0.01 0.00 0.00 929,414 2064 0.01 0.01 0.01 0.00 0.00 995,588 2065 0.01 0.01 0.01 0.00 0.00 1,066,474 2066 0.01 0.01 0.01 0.00 0.00 1,142,407 2067 0.01 0.01 0.01 0.00 0.00 1,223,747

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CHAPTER II: Public Expenditure Management 2.1 Good budget institutions allow governments to balance the three interrelated objectives of budgetary performance: aggregate fiscal discipline, efficient allocation of resources according to the Government’s policy priorities, and operational efficiency in the use of resources (Schick, 1998). Institutions, understood as sets of formal and informal rules, influence behavior of public officials involved in the process of planning, allocating and spending public money aimed at implementing government policies and programs. 2.2 This chapter is drawn from the Country Financial Accountability Assessment (CFAA) report.27 It analyzes the performance and transparency of Salvadoran public expenditure management institutions and systems, with a focus on the central government, and provides recommendations that would in due course help to strengthen fiscal discipline and increase operational efficiency.28 Given the relatively small size of public expenditures in El Salvador, it is critical to strive for a framework that assures that public priorities are efficiently transformed into programs and projects that yield high social payoffs, while maintaining sound systems for financial and overall expenditure controls. The chapter is organized as follows: Part I describes the institutional framework for public expenditure; Part II looks into the process of budget formulation and its reliability; Part III examines the process of budget execution and related controls; and Part IV evaluates the arrangements for financial reporting and external oversight. Finally, the chapter draws some conclusions and suggests priorities for action.

III. Institutional Framework The Public Sector 2.3 Composition and size. Title VI of the Constitution regulates the attributions and competencies of the Government, which is defined broadly as the legislature, the executive, the judiciary, the Public Prosecutor, the Court of Accounts, and local governments. The non-financial public sector (NFPS) consists of 21 central government entities (including 12 ministries), 34 hospitals and other health entities, 47 decentralized institutions (including four state enterprises), and 262 local governments.29 Decentralized

27 World Bank and IDB, Draft of June, 2004. 28 Other processes that have a significant impact on the three levels of budgetary performance are analyzed in other Chapters of this PER (fiscal sustainability, quality of public expenditure planning and allocation) and in the CPAR (effect of contracting and procurement practices in operational efficiency). While this Chapter discusses some evident issues regarding availability (or lack) of information on municipal finances, the subject of local government expenditure management is not covered in this PER. 29 The Central Bank (BCR) consolidates data on municipal finances, on a sampling basis, into the NFPS statistics. The Ministry of Finance (MH) does not include municipal data in the state financial statements, which in turn do contain six entities from the financial public sector.

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institutions have legal status, their own regulations, and functional autonomy. Municipalities have financial, technical and administrative autonomy.

Box 2.1: Public Sector Modernization Program The ongoing public sector modernization reforms started with the Government's 1994-1999 plan for economic and social development, followed by the 1999-2004 alliance for an effective government. In the early 1990s, El Salvador's public sector was suffering from major structural weaknesses and deficiencies: (i) high functional inefficiencies caused by overextension and centralization of the State; (ii) low economy and efficiency caused by its organizational structure, its extremely weak financial and human resources management, and the low level of professionalization of its civil service; (iii) poor service delivery; and (iv) outdated and inadequate administrative infrastructure and equipment. The Public Sector Modernization Program has targeted these weaknesses under five major components Institutional Restructuring and De-bureaucratization. A major accomplishment has been the successful restructuring of the Ministry of Public Works (MOP), which has reduced that ministry's expenses by approximately 40 percent. Although less comprehensive, progress has also been made in the modernization of other ministries, showing a notable 12 percent reduction in the number of public employees. The main challenge ahead is to implement a strategy to consolidate and maintain the reform process and to replicate the successful experience of the MOP in other ministries. Human Resources Management. Major accomplishments include the development of an HR management system (SIRH), and the design of tools for selection, evaluation, classification, remuneration and promotion of government employes. The challenge ahead will be to update, pass and implement modern civil service legislation, and put the tools that have been developed into practice. Financial Management. The major accomplishments have been the issuance and implementation of modern financial management, procurement, tax, and customs legislation, and the introduction of integrated financial management and tax information systems (SAFI and SIIT, respectively). The main challenges ahead will be to increase coverage of SAFI, introduce performance monitoring, develop procurement information systems, and enhance judicial performance on tax and customs issues. Privatization and Private Sector Participation in the Provision of Public Services. Major accomplishments include the privatization of telecommunications, electricity distribution and thermal generation, the enactment and implementation of General Ports and Civil Aviation Laws, and the development of regulatory frameworks. Other important initiatives include the reform of the postal agency, railroad system concession, and the reform of the pensions system. The main challenge ahead will be the strengthening of regulatory agencies. Decentralization. Major accomplishments are the development of projects for decentralization of public services in water (13 systems) and health (28 basic health units “SIBASIS”). The main challenge ahead will be to clarify the functions of local governments. 2.4 By international standards, El Salvador’s public sector is small. According to the World Economic Forum’s Global Competitiveness Report 2002, El Salvador is 14th among 120 nations ranked according to government expenditure as percent of GDP. Moreover, after a decade of reforms, El Salvador’s public sector has made considerable progress in modernizing and refocusing its role. The modernization program (see Box 1) has lead to significant advances in reforms related to privatization, pensions, and deregulation. Relevant improvements have been made in financial management and decentralization, and some steps have been taken towards creating a professional civil

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service. As noted in Chapter I, a significant outcome of the modernization program has been the decline of the wage bill, from 8.4 percent of GDP in 2000 to 7.4 percent in 2003. 2.5 Civil service. The Civil Service Law of 1961 lays out the rules for a civil service career, both in the central and local governments; however, the law was never regulated despite various efforts to do so over the years. The outdated nature of the law and the lack of regulations have given way to multiple norms, creating ambiguity and contradictions in their application. There is no job classification system in the public sector; consequently, remunerations on similar posts differ from one entity to another; similarly, there is not an overreaching merit-based employment and promotion system. 2.6 Since 2002, as part of the public sector modernization program, the Technical Secretariat of the Presidency (SETEC) prepared a comprehensive program to modernize civil service. The program is based on the development of technical instruments for classification of positions, entering employment and promotion, remuneration, evaluation, and development. Executive training for senior staff and technical training to institutional human resources units (URHIs) have been provided to help introduce the techniques while legislation is being prepared. Governance Environment 2.7 Efforts to modernize the public sector have not led to changes in public perceptions of governance. In fact, the Worldwide Governance Research Indicators Dataset30 portrays a worrisome decline in all but one of the six indicators when compared with the 1998 results (Figure 1). When compared to the Latin America and the Caribbean average, El Salvador does well in preserving political stability, slightly less than average in terms of its regulatory framework and promotion of voice and accountability, but shows disappointing performance in rule of law, government effectiveness and control of corruption. 2.8 Public expenditure management performance can affect the perception of government effectiveness, which focuses on the inputs required for the Government to be able to produce and implement good policies and deliver public goods. Similarly, the perception of corruption, conventionally defined as the exercise of public power for private gain, can be affected by public expenditure transparency. In this case, the picture is not better.

30 The Governance Indicators, compiled by the World Bank Institute, reflect the statistical compilation of responses on the quality of governance given by a large number of enterprise, citizen and expert survey respondents in industrial and developing countries, as reported by a number of survey institutes, think tanks, non-governmental organizations, and international organizations.

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Chart 2.1: Governance Indicators, 2002/2000/1998 and regional comparison 2002

Note: Percentile rank indicates the percentage of countries worldwide that rate below El Salvador (subject to margin of error). The statistically likely range of the governance indicator is shown as a thin black line.

2.9 El Salvador ranked 9th among ten participating countries in the 2003 Latin American Index of Budget Transparency.31 As shown in Table 1, for none of the 14 variables surveyed did positive responses exceed 50 percent of total responses, with the most negatively qualified areas being the level of citizen participation in various stages of the budget process, the effectiveness and reliability of external controls, the timeliness of

31 The Index of Budget Transparency, part of the International Budget Project, was based on a perceptions survey on 14 variables of budget transparency, applied among experts and users of budget information (Probidad, 2003).

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publication of budget formulation, execution and audit information, the clarity of budget responsibilities between central and local governments, and the availability of indicators to evaluate budget implementation.

Table 2.1: Budget Transparency Perception Survey - Variables 2003

(in percent of positive responses) Citizen participation in the budget 5 Capacities of the institutions of external oversight 8 Timeliness of budget information 8 Responsibilities among government levels 13 Accountability 19 Control over public officials 21 Changes in the budget 23 Budget allocation 23 Information on national debt 31 Quality of information and statistics in general 32 Budget oversight 33 Information on macroeconomic criteria of the budget 33 Authority and participation of the legislature in the budget 45 Source: Probidad, 2003.

Formal Rules for Public Expenditure Management 2.10 The legal instruments for public expenditure management are contained in various laws and regulations listed in Box 2. The Financial Management Law of 1995 (Ley AFI) governs the formulation, approval, execution and monitoring of the national budget, the single treasury account, the government accounting system, and the investment and public credit functions. 2.11 Budgetary Attributes of Different Branches of Government. El Salvador’s Executive has powers of proposing and executing the budget that are similar to those in other Latin American countries, with the same tendency towards a strong executive role vis-à-vis the legislature, for the purpose of strengthening the Executive's capacity to control the overall fiscal balance. Still, the Legislative Assembly retains the power to authorize public debt, approve tax legislation and, of course, pass the annual Budget Law. The Assembly can reduce or reject budget credits requested by the Executive, but never increase them; in practice, it makes only marginal modifications to the budget.32 The President holds the right of veto on laws passed by the Assembly, which can be overturned by a two-thirds majority.

32 However, the 2004 Budget Law was approved only on ____, 2004 following a stand-off between the Executive and the majority opposition party in the Assembly over various issues, mainly the amount of transfers to local governments.

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Box 2. 2: Main Laws and Regulations Governing Public Financial Management

• Articles 223-234 of the 1983 Constitution regulate public finances, particularly the General State

Budget. Articles 195-199 regulate the fiscal control function of the Court of Accounts of the Republic. • The Financial Management Law (Decree 516 of 1995, as modified by Decree 716 of 1996 and Decree

172 of 1997) and its Regulations (Decree 82 of 1996) establish the integrated financial management system (composed of the budget, treasury, investment, public credit, and accounting functions) of the NFPS (excluding municipalities).

• The annual Law of the General Budget of the State and Special Budgets lays out the revenue and expenditure budgets and how the deficit is to be financed. It contains two main sections, one on central government and another on decentralized institutions. The Ministry of Finance (MH) has issued various manuals: Budget Formulation, Budget Execution Processes, Organization of Institutional Financial Units (UFIs), Classification of Public Sector Financial Transactions, Chart of Accounts, and Technical Aspects of the Integrated Financial Management System (SAFI).

• The Public Administration Procurement and Contracting Law (Decree 868 of 2000 and its amendments) regulates for public procurement.

• The regime for external audit is established in the Organic Law of the Court of Accounts (Decree 438 of 1995, as modified by Decree 998 of 2002 and Decree 1147 of 2003). That same law governs the “national system of control and audit in public management.” The Court of Accounts has issued Internal Control Technical Norms (Decree 15 of 2000).

• The Internal Regulations of the Executive Body (Decree 24 of 1999) dictates the organizational framework of the Executive Branch.

• The Municipal Code (Decree 247 of 1986) regulates municipal finances. 2.12 If by the start of the fiscal year the Budget Law has not been approved, the approved budget allocations from the previous year are put into effect; once the new Budget Law is approved, adjustments are made in accordance with actual execution. The authority to modify the budget during the fiscal year can be summarized as follows:

• Budget modifications resulting from an increase or reduction in the overall budget totals, as well as transfers of allocations between different sectors or administrative units, must be approved by the Assembly; however, certain transfer authorizations may be given upfront to the Ministry of Finance (MH) via the annual Budget Law.

• The MH can authorize transfers between allocations within a central government

sector or administrative unit, except those considered nontransferable; i.e., allocations for investments cannot be transferred to current expenses (excepting counterpart funds and taxes generated by investments, in which case authorization from the Council of Ministers is required), and allocations for debt service.

• Decentralized institutions (including non-financial public enterprises) can

authorize transfers between allocations within their budgets, unless these affect their current balance or investments, in which case authorization from the Council of Ministers is required.

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• Central government entities can only make transfers between lines of expenditure within the same object group. Transfers between different object groups require MH’s prior approval.

2.13 The MH is responsible for the direction and coordination of public finance. Each budget-executing entity maintains an institutional financial unit (UFI) responsible for budget, treasury and accounting functions. UFIs serve as the link with the Ministry of Finance’s central normative directorates for these functions. 2.14 The Constitution grants the Court of Accounts of the Republic the power to exercise fiscal oversight (fiscalización) of public finances and budget execution. Its Organic Law establishes, inter alia, the Court of Accounts’ responsibility for the external audit of all entities that manage state resources and its authority to set governmental policies and procedures on internal control, internal audits and external audits. The same law stipulates that every public sector entity must have an internal audit unit, which though reporting directly to the head of each entity, must submit its annual work plans and copies of each report to the Court of Accounts. 2.15 Non-financial public enterprises. The privatization reforms have reduced significantly the size of enterprises in the public sector (around 10 percent of the 2003 budget). Moreover, the four remaining enterprises, National Water and Sewerage Administration (ANDA), Hydroelectric Power Commission of the Lempa River (CEL), Autonomous Port Commission (CEPA) and the National Lottery, are subject to the provisions of the Ley AFI and the annual Budget Laws. 2.16 Local Governments. The 262 municipalities, which have financial and administrative autonomy as stipulated in the Constitution, account for around 5 percent of overall NFPS expenditures. A sample of 92 local governments showed that, in 2003, their expenditures were financed by local revenue (59 percent), debt and donations (5 percent), and central government transfers (36 percent). However, a separate study from the Corporation of Municipalities places at up to 68 percent the share of municipal expenses financed through central government transfers (COMURES, 2003). There are no legal limits on municipal borrowing; authorization is required only for the use of a central government guarantee. 2.17 Most central government transfers are funded under the Law of the Municipal Economic and Social Development Fund (FODES), which earmarks 6 percent of the current central government revenues for this purpose. The FODES is distributed among municipalities on the basis of a pre-established formula and its regulations stipulate that 80 percent must be used for investment expenditures by each municipality. Municipalities are only required to report budget execution of the use of transfers from central government. The Local Development Social Investment Fund (FISDL) implements certain investment projects (financed through external loans and grants) at the municipal level.

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Analysis 2.18 There is a comprehensive set of laws and regulations that cover each relevant area of budget management. The distribution of fiscal functions within the central government is clearly defined and functional, but as reflected in the Budget Transparency survey and a recent study from COMURES, the demarcation of functions of central and local governments is not clearly defined in practice.33 This, together with the lack of limitations on local government borrowing, can affect the quality of budget management. 2.19 By developing and promoting awareness of modern human resource management techniques, the Government is moving in the right direction. The effective implementation and sustainability of those techniques will depend, however, on a renovated and consolidated legal and regulatory framework.

IV. Budget Formulation and Reliability The Process of Budget Formulation 2.20 Revenues. An inter-institutional effort underlies the preparation of the revenue budget. A committee chaired by the Budget Directorate (DGP) of the MH and composed of representatives from the Directorates of Internal Revenue and Customs (DGII and DGRA), Treasury (DGT), the Macroeconomic and Fiscal Analysis Unit (UAMF), all of the MH, plus the Central Reserve Bank (BCR), is responsible for the analysis and monitoring of fiscal revenues. 2.21 The committee relies principally on a methodology combining statistical analysis of annual series for each revenue collection coefficient with simulation models built around macroeconomic projections and fiscal targets. Daily monitoring of collections is performed by the DGT, and monthly detailed reports on compliance with revenue targets are prepared by the DGII. The quarterly “economic conjucture” prepared by the UAMF summarizes quarterly revenue performance, and an annual “memoire of tax information” by the DGII documents annual performance. 2.22 Expenditures. In the absence of a formal medium-term budget framework, the budget formulation exercise focuses on the upcoming fiscal year. Ley AFI requires that an approved Budget Policy document (laying out the overall availability of resources and expenditure ceilings, priorities and variables for allocation, and norms for budget formulation) precede the preparation of the Budget Project, which in turn has to be presented to the Legislative Assembly no later than three months before the beginning of the fiscal year. The stages in the process, which are well documented, are summarized in Table 2.

33 The reports from COMURES and Probidad claim that 44% of central government transfers are invested in projects whose competency areas correspond to the central government or are not clearly delimited.

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Table 2.2: Budget Formulation Process

Dates Process Participants Feb. - March Estimates of tax and other revenues Inter-institutional committee Estimates of loan and grant receipts Executing entities, DGICP, DGP Debt service and estimated public investment program DGICP Estimates of expenditure ceilings DGP Approval of estimates Minister of Finance March - April Preparation of Budget Policy proposal DGP, Minister of Finance April Approval of Budget Policy Council of Ministers June Distribution of the guides for the annual budget

formulation and communication of ceilings DGP

June - July Formulation of draft institutional budgets Executing entities July - Aug. Analysis of draft institutional budgets DGP Aug. Preparation of Budget Project proposal DGP, Minister of Finance Aug. - Sep. Approval of Budget Project Council of Ministers Sep. Presentation of Budget Project to Assembly President Source: MH 2.23 Based on the Budget Policy and specific directives from the MH’s Budget Directorate, each executing entity formulates its draft institutional budget, which are discussed with the MH before their incorporation in the Budget Project. There is more room for discussion of options for capital than for recurrent spending, but the MH ultimately commands the decision-making process. Exceptions granted by Ley AFI are those related to the budgets of the legislature, judiciary, and Court of Accounts, which are incorporated into the Budget Project as proposed by the respective institutions. 2.24 The most prominent rigidities that affect flexibility in budget formulation, expressed as the share of allocations in the total budget for 2003, are: remunerations (29.7 percent), debt service (17.9 percent), pensions (9.2 percent), transfers to the judicial branch (4.5 percent), transfers to municipalities (4.3 percent), and the road-maintenance fund FOVIAL (2.9 percent). The constitutionally mandated transfers to the judiciary amount to 6 percent of current revenues.34 The tax on gasoline and diesel is earmarked to finance the FOVIAL. 2.25 Public investment program. Ley AFI requires that the public investment program be consistent with the Public Investment and Credit Policies, both approved by the National Commission of Public Investment (CONIP).35 Investment requests from the executing entities are reviewed by MH’s Investment and Public Credit Directorate. These requests are based on pre-investment studies, for which detailed guidelines have been prepared, and five-year investment programs. The quality of these documents is still perceived as limited and guided by a “wish list” approach. 2.26 Each executing entity is responsible for incorporating its approved institutional investment program into its draft institutional capital budget. A single project code in the 34 FUSADES has noted repeatedly that, as a percentage of GDP, transfers to the judiciary in El Salvador are large by international standards, e.g. larger than those in the U. S., Argentine and Spain. (FUSADES, 2001). 35 The CONIP consists of the Minister and Vice-Minister of Finance, the Ministers of Economy and Education, and the President of the Central Bank. No formal meetings of the CONIP were held in 2003.

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institutional public investment system (SIIP) and the integrated financial management software (SAFI) permits cross-checking of aggregates. However, SIIP does not have the same institutional coverage as SAFI. Coverage and Content of the Budget 2.27 Coverage. In accordance with Ley AFI, the NFPS budget comprises the general budget of the State, which includes 21 entities of the central government;36 the special budgets of decentralized institutions, which contain 63 entities (including 34 hospitals) and 4 public enterprises; and the extraordinary budgets. 2.28 The extraordinary budgets are envisaged in the Constitution for legislative authorizations to commit funds for special projects (“works of public or administrative interest”, or consolidation or conversion of public debt) that span multiple budgetary periods. These funds, which are not part of the annual budget law, in 2003 were composed of: the extraordinary public investment budget PEIP 2001-2003 (originally financed from privatization proceeds but later, after the earthquakes, incorporating local and external resources for specific investments); the extraordinary institutional resources (e.g., electricity infrastructure projects by CEL); the extraordinary economic recovery budget (PERE); and the extraordinary budgets for organization of elections. 2.29 Other major extra-budgetary activities are those financed by special activity funds. These funds are generated by the sale of goods and services by central government institutions and may be used by these entities for specific purposes with MH’s authorization. Finally, there are around 14 autonomous entities whose organic laws provide for their budgets to be approved by executive decrees or governing board accords. Together, extra-budgetary funds represent around 15 percent of NFPS expenditures. While excluded from the annual budget law, their operation is captured by the fiscal reports (see Part D). A marginal portion of donor funds may still escape the budgetary system. Aggregated information on municipal budgets is not systematically compiled. 2.30 Content. Ley AFI requires that the Budget Project approved by the Council of Ministers before submittal to the Assembly be composed of: an introduction (mensaje presupuestario) containing the macroeconomic and financial analysis upon which the budget is based; the Budget Project Law containing the general and special budgets; the Salaries Project Law; a summarized consolidation of the NFPS budget; norms for budget execution; and other annexes and summaries. 2.31 The introduction to the Budget Project contains summarized information on the macroeconomic environment (including growth and inflation projections for the year), the fiscal policy objectives (including targets for five aggregate variables over a three-year period), the overall budget policy, and aggregate data from the general and special budgets.

36 Central government includes the legislature, the judiciary, the national judicial council, 12 ministries, 3 entities of public prosecution (Ministerio Público), the Court of Accounts, and the electoral and civil service tribunals.

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2.32 Box 2.3 lists the five expenditure classifications used in the 2003 Budget Law. The summaries provide aggregate data by management areas (áreas de gestión), major economic groups (rubros de agrupación)37, and sources of funds. The same information is provided for each executing entity’s budget, which additionally disaggregates expenditures in accordance with “purposes” at two levels (“budgetary units” and “lines of work”), and provides summarized information on: (unquantified) policies, priorities, and objectives; a list of public investment projects; and remunerations classified by salary types and ranges. 2.33 The Budget Law and introduction to the Budget Project for recent years are posted on MH’s webpage (http://www.mh.gob.sv/mh_2003/presupuesto.htm). In addition, the MH prepares (ex-post) a Citizen’s Guide to the Budget, posted on the same page, that contains a summary of the budget introduction and major plans by sector. Budget Outcomes as Indicators of Budget Reliability

Box 2.3: Expenditure Budget Classifications Administrative classification ▪ 21 central government entities ▪ 63 decentralized entities (including 34 hospitals and health sector institutions) ▪ 4 public enterprises Functional classification (management areas - areas de gestión) 1. Administrative conduct 2. Justice administration and citizen security 3. Social development 4. Support to economic development 5. Public debt 6. General obligations of the State 7. Public entrepreneurial production Economic classification The detailed budget line items (cuentas and objetos específicos), which are not part of the budget law, are classified under these groups (rubros de agrupación): 51. Remunerations 54. Goods and services 55. Financial and other expenses 56. Current transfers 61. Investment in fixed assets 62. Capital transfers 63. Financial investments 71. Debt service 81. Transfers of special contributions 99. Outstanding allocations (asignaciones por aplicar) Sources of funds 1. General Fund 3. External loans 5. Donations Programmatic classification (propósitos) ▪ Budgetary unit (unidad presupuestaria) ▪ Line of work (línea de trabajo) 37 The MH’s Manual for Classification of Public Sector Financial Transactions further breaks down the economic groups into “accounts” and “specific objects”, and also provides for a geographical classification.

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2.34 A comparison of budgeted and actual revenue can provide an overall indication of the quality of revenue forecasting, a critical factor since budgeted expenditure allocations are based upon it. Since 1999, tax revenue outturn has been generally close to (though always below) the initial budget, reaching a 99 percent rate of execution in 2003 (Table 3). The low level of execution in 2001 can be explained by the effect of earthquakes, decrease in coffee prices, and other events that slowed down taxable economic activity. It is notable that in 2002, despite increased performance of the revenue administration agencies, the level of execution reached only 95 percent, a reflection of over-optimistic growth forecasts. Execution – C

Table 2.3: Aggregate Revenue Budget Execution – CG

(% of Budgeted) 1999 2000 2001 2002 2003 Modified Budget as percent of Initial Tax 100 100 100 100 102 Non Tax 104 157 153 161 157 Total 100 104 104 104 107 Executed Budget as percent of Modified Tax 94 90 88 95 98 Non Tax 81 92 86 106 91 Total 93 90 88 95 97 Executed Budget as percent of Initial Tax 94 90 88 95 99 Non Tax 84 145 132 171 104 Total 93 94 91 100 143 Source: WB database (based on budget laws and MH execution documents)

Table 2.4: Aggregate Expenditure Budget Execution – CG

(% of budgeted expenditure) 1999 2000 2001 2002 2003 Modified budget as % of initial budget Current expenditure 100 101 103 109 109 Capital expenditure 117 138 194 146 96 Total expenditure 103 107 118 116 107 Executed budget as % of modified budget Current expenditure 97 98 99 100 97 Capital expenditure 80 79 73 77 88 Total expenditure 94 94 92 94 96 Executed budget as % of initial budget Current expenditure 98 99 102 109 107 Capital expenditure 94 109 141 112 85 Total expenditure 97 100 108 109 103 Source: WB database (based on budget laws and MH execution documents).

2.35 The ratio of expenditure execution can shed light on the degree of realism in the budget document. The close execution shown in 1999 and 2000 went off-track in 2001 due to the extraordinary increase in capital spending for reconstruction efforts. Part of the over-execution in current expenditures during 2002 and 2003 shows unplanned spending

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in some entities, an effect partially off-set by sharp cuts in capital spending during 2003(Table 2.4). In all cases, actual spending was within the modified budget ceilings. 2.36 The credibility of the budget can be roughly indicated by the extent to which budget entities receive the resources initially indicated: where the composition of expenditure varies regularly from the original budget, the latter will not be a useful ex-ante statement of intent. After 1999, the inter-institutional variation of execution against the initial budget has deteriorated, but 2003 showed a significant improvement over the preceding year, with a 12 percent average variation across 22 budget entities (see Table 5). The rates of execution of the capital budget remained markedly more variable than those of the current budget.Table 2.5:

Table 2.5: Average Deviation of Expenditure Budget Execution Central Government

Source: WB database (based on budget laws and MH execution documents) Coverage: 22 entities from 2002-2003 and 25 entities from 1999-2001, including in each case a line covering “other obligations and transfers” from the central government. Interest on debt is excluded.38

(percentage of budgeted expenditure)

1999 2000 2001 2002 2003Variance in Modified Budget as percent of Initial BudgetTotal expenditure 8 21 18 22 14Variance in Executed Budget as percent of Modified BudgetTotal expenditure 8 6 9 6 5Variance in Executed Budget as percent of Initial BudgetCurrent expenditure 7 13 18 42 15Capital expenditure 38 58 55 60 28Total expenditure 8 18 16 18 12

2.37 A measure of budget execution volatility may be calculated using a simple methodology developed in Dorotinsky, Knack, Manning and Kugler (2001), which defines volatility as the median of year-to-year changes in percentage share of the budget, in each administrative and functional classification, over the preceding four years. The 0.13 median value of variability in expenditure execution for the period 2000-2003 for El Salvador (see Table 2.6) indicates that on average, entities executed 13 percent more or less in total expenditures than they did in the previous year. While volatility in execution has persisted in recent years, its level has been stable and not particularly high. Time – Central Government

Table 2.6: Budget Execution Volatility Over Time – CG

Source: WB database (based on budget laws and MH execution documents). Coverage: Administrative classification, 21 entities. Functional classification, six areas. In both cases, interest on debt is excluded. 39

1996-1999 1997-2000 1998-2001 1999-2002 2000-2003

Administrative 0.40 0.14 0.15 0.14 0.13 Functional 0.07 0.07 0.09 0.23 0.11

38 The table reflects, for any given year, the average absolute percentage change in allocations at the administrative level. For instance, while the total execution for 2003 was 3% higher than the initial budget , the average absolute deviation of the 22 entities from the initial budget was 12%. The entities with annual capital budget allocations of less than US$ 100,000 were excluded from the calculation of capital expenditure deviation.

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Analysis 2.38 The sound methodologies used by the inter-institutional committee for analysis and monitoring of revenues and the coordinated application of these methodologies have increased the credibility of the budget document. Still, tax revenue budgets have been under-executed as a result of over-estimation of GDP growth (FUSADES, 2002). 2.39 As in many Latin American countries, the expenditure budget formulation process is dominated by concern for aggregate fiscal discipline, with the MH exercising a strong role. While the process follows a comprehensive legal and procedural framework in an orderly and timely manner, over-execution in current spending and inter-institutional variations during 2002 and 2003 show that there is still room to increase the credibility of the initial expenditure budget. 2.40 Funds for current spending are allocated on a largely incremental basis, i.e. the previous budget is taken as the base for discussion, with some room for expenditure savings plans. The PIP allows more room for prioritization, and it is well integrated into the budget cycle. However, there is no systematic effort to calculate or take into account the current spending portion of investment projects or their implications in future current expenditures. Moreover, there is generally limited capacity in executing entities to produce quality medium-term investment programs and pre-investment studies, and it is uncertain how useful they are. 2.41 Most government spending is subject to annual legislative approval and extra-budgetary funds are included in the consolidated government financial statements (but not disclosed as attachments to the annual budget documentation). There is no consolidation of the general government budget, nor any aggregated information on municipal budgets. 2.42 The budget law documentation provides a large set of data on the planned uses of budgetary funds, but is still short of international standards. Good practices from the IMF’s Fiscal Transparency Code are not yet implemented, specifically the disclosure of:

• clearer identification of the overall balance supplemented by other fiscal

indicators; • comparable information for the outturns of the two preceding fiscal years and

aggregate forecasts for the two following years; • statements describing the nature and fiscal significance of contingent liabilities,

tax expenditures and quasi-fiscal activities;

39 Budget execution volatility over time is calculated as the median of the year-to-year changes in each of the 21 entities (and 6 management areas) over the preceding 4 years, where budget execution changes are defined as the absolute values of the difference in shares in total expenditure (for each entity and for each management area) from year n to year n+1, calculated as a proportion of the year n figure.

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• improved and more comprehensive information on the quantitative macroeconomic framework and fiscal policy, sustainability and rule;

• identification of major fiscal risks, including variations in economic assumptions. 2.43 There is a robust classification system in terms of administrative and economic items, but there is still room to improve the functional (broad “management areas”) and programmatic (“budgetary units” and “lines of work”) classifications, which are in large part aggregations and dissections, respectively, of the administrative classification. There is no specific identification of poverty related expenditures in the budget. Further levels of functional detail (e.g., the second- and third- level groups and classes contemplated in the United Nation’s Classification of Functions of Government) could provide a better framework for program (and, in due course, performance) budgeting and monitoring, analysis of inter-functional interventions of administrative units, and historical and policy analyses. 2.44 The Government took a significant leap towards enhanced public sector accountability with the introduction of a management-by-results system (SGPR)40. However, its roll-out was not supported by a clear conceptual and procedural framework linked to the budget formulation process. A set of public investment indicators has been developed, but these are either not reflected in budget documentation, too broad, or not particularly relevant for efficiency and effectiveness measurement. Interesting initial efforts for public service costing (e.g., at the Ministry of Health) have not yet had any impact on budget formulation. 2.45 Although the MH prepares aggregate fiscal targets and projections to orient fiscal policy, there is no formal medium-term budget framework that informs the annual budget formulation and approval process.

V. Budget Execution and Controls The process of Budget Execution 2.46 The Constitution establishes that public funds cannot be committed or paid in absence of a budgetary credit. Ley AFI and its Regulations delineate three overall stages of budget execution: (1) the credit (authorized allocation per the voted budget and subsequent modifications), (2) the commitment, and (3) the accrual, and establish the requirement for a DGP-approved execution program (PEP). MH’s Manual of Budget Execution Processes further details the execution procedures, summarized in Box 4. 2.47 Integrated financial management system (SAFI). The SAFI system, born in the mid-nineties as part of the public sector modernization program (see Box 2 above), has a clear legal base in Ley AFI. It integrates the budget, treasury, public investment and credit, and accounting systems through a common set of rules and procedures applicable

40 With the earthquakes of 2001, the SGPR was focused on the reconstruction efforts.

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to the NFPS (excluding municipalities). As such, SAFI is at the center of the budget execution process, under the premise of normative centralization (by MH) and operational decentralization (by executing entities, via legally mandated institutional financial units UFIs). But, as is clear in Box 5, the MH does maintain a critical operational role in the budget execution cycle, a reflection of concern for aggregate spending controls. 2.48 The system’s software for budget formulation and execution has been deconcentrated to the 21 central government entities, 34 hospitals and two public enterprises. In most (not all) of these entities, payrolls are prepared via the Integrated Human Resources System (SIRH, which combines nominal and payroll information), and downloaded to SAFI. Decentralized institutions, while not yet using SAFI for internal budget execution, do report to it using formats that allow incorporation by the MH into the government accounting records.

Box 2.4: Expenditure Budget Execution Process

Box 2.4. Expenditure Budget Execution Process

▪ Budget execution program (PEP). This annual document, prepared by the institutional financial units (UFIs) at each budget entity and approved by the Budget Directorate (DGP) of the Ministry of Finance (MH), distributes the approved budget over the twelve months of the fiscal year, thereby setting the monthly ceilings for commitments and the parameters for monthly execution reports. Public enterprises are exempt from the PEP.

▪ Budget commitment. Commitments, provided there is availability of resources in the PEP, are triggered by the issuance of purchase orders (goods or services), monthly payrolls (salaries), fund requirements (transfers to decentralized institutions), or bills (utilities). Expenses committed but not accrued by the end of the fiscal year are automatically transferred (credited) to the following year’s budget. Commitments can be reversed if they are legally rescinded.

▪ Expense accrual (devengado). Provided there is an open commitment, accruals are recorded against the legal documentation (invoices, payrolls) that sets the financial obligation to pay for goods and services received. Accruals are accumulated in the Accounts Payable Register.

▪ Funds requirement. The UFIs use this instrument to request transfers from MH’s Treasury Directorate (DGT) against accruals recorded in the Accounts Payable Register, in accordance with the Treasury’s payment schedules.

▪ Transfer receipt. The purpose of this document is to record the deposit of funds transferred from the DGT’S Account to the Subsidiary Institutional Account, which is managed by the UFI.

▪ Expense payment. Accrued expenses are paid from the Subsidiary Institutional Account via check or deposit issued by the UFI.

▪ Record keeping. All steps in the budget execution cycle are made through the integrated financial management system (SAFI). Supporting documentation of all expenses and payments is maintained by each UFI.

▪ Closing of accounts. The monthly and annual closings of accounts represent the UFI Accountant’s validation of accounting records for the respective financial reports.

▪ Bank reconciliations. These are prepared within eight working days after the end of each month. Source: Manual of Budget Execution Processes (2003)

2.49 Treasury operations. Ley AFI explicitly mandates the centralization of public revenues in a single fund, administered by MH’s Treasury Directorate (DGT), and the decentralization of payments to each budget executing entity. In line with this, the

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Treasury Single Account is composed of DGT’s principal accounts in the Central Bank (BCR)41 and a number of subsidiary accounts managed by executing entities. The latter are held in commercial banks (if authorized by the DGT and the BCR) that in theory work as zero-balance accounts, with monies being transferred to them only to cover approved accrued expenses.42 While the DGT has the power to recall idle funds in the subsidiary accounts, the same Ley AFI allows decentralized institutions to carryover end-of-year balances that are deducted from the next year’s transfers). 2.50 A treasury accounting unit within the DGT is in charge of bank reconciliations of the principal accounts it manages. These are performed and documented on a timely basis but do require a significant level of manual efforts. The executing entities are responsible for reconciliations of subsidiary accounts. 2.51 Overall control of the cash position is based on payment schedules and annual, monthly and daily cash flow programs that consider the PEP. The DGT can use two major legal instruments in case of temporary cash shortfalls: access of up to 90 percent of the funds in custody balance (composed of outstanding deposits, mostly judicial, from third parties); and issuance of short-term debt (LETES) under annual ceilings approved by the legislature in the annual budget law.43 In general, DGT’s cash management strategies have resulted in high predictability of flow of funds to executing entities. 2.52 Accumulation of arrears. The accounting system records expenditures on an accrual basis, but does not accumulate the share of total accounts payable that is in arrears. Arrears are not perceived as a problem in El Salvador because of the instruments available to the DGT to cover cash shortages. As shown in Table 7, the ratio of short-term payables at the end of the year to total annual expenditures has decreased since 2001.

Table 2.7: Short-term payables

Source: WB database (based on MH execution documents).

(percentage of executed 1999 2000 2001 2002 2003

Short-term debt issues 13 25 31 0 4 Accounts 8 7 7 5Other 9 10 14 30 43 52

1 13 8 18 13

2.53 Donor funds. Ley AFI allows the existence of bank accounts separate from the single treasury account when required by international agreements, but the same law assigns to the DGT the responsibility for managing those accounts. While executing entities maintain separate subsidiary accounts for loan and grant funds, the transfers from

41 The regulations grant exceptions in the cases of accounts linked to international agreements, revenues from state enterprises, and special activity funds. 42 In practice, though, there is the possibility of accumulation of idle funds when executing entities do not deliver the checks or these are not cashed. In light of this, the DGT is developing a system linked to the banks for control of subsidiary account balances. 43 The 2003 Budget Law placed the limit for issuance of LETES at 40 percent of current revenues.

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the DGT follow the same mechanism used for local funds; i.e., transfers against recorded accrued expenses. These procedures have allowed donor funding to be effectively captured by the budget management system.44 In terms of financial administration, the arrangements differ from entities where the UFI plays a major role (e.g, Education) to those where project administration units are set up (e.g., Health). Overall, donor funding is characterized by traditional individually negotiated investment projects, as opposed to sectoral aid. 2.54 Monitoring of budget execution. In accordance with Ley AFI, there are three levels of responsibility for monitoring and evaluation of execution: the UFI at operational level, the head of each budget entity at institutional level, and the DGP at the overall level. Moreover, it assigns the Directorate of Public Investment and Credit (DGICP) the responsibility to inform the DGP of the public investment program (PIP) execution. 2.55 Executing entities and the DGICP are required to report monthly to the DGP, which should consolidate that information and present periodic physical and financial execution reports to the MH. This is done by the DGP on monthly budget execution and PIP progress reports, and an annual report on central government budget outturns (of these, only very aggregated monthly financial execution data is published). In practice, the Presidential Commission for Monitoring of Public Investment (CPSIP) and the Technical Secretariat of the Presidency, which administers the management-by-results system (SGPR), also play a role in monitoring the PIP. 2.56 MH’s Financial Management Directorate (DINAFI) has developed a plan to create a data warehouse for managerial information (SIG), that would permit access to several databases (SAFI, treasury-SITEP, investment-SIIP, tax-SIIT, customs-SIDUNEA, and debt-SIGADE) for the production of customized data in friendly formats. In its initial phase, the SIG will be limited to budget execution data and be accessible through MH’s Intranet. Debt Records 2.57 Ley AFI stipulates that the MH is responsible for the formulation of public debt policy and the authorization of all NFPS debt and guarantees, which procedures are documented in the regulations. Debt management responsibilities, including maintenance of public debt records and debt service administration, are assigned to MH’s DGICP.45 The internal and external debt databases are maintained by the DGICP on UNCTAD’s Debt Management and Financial Analysis System (DMFAS/SIGADE). In practice, the BCR also registers public external debt, including that of the financial public sector. 2.58 Debt databases are the basis for debt service program data incorporated into the annual budget law, execution of debt service payments through the treasury single account, and incorporation of balances into government accounting records. In absence of automatic links between SIGADE and the SAFI software, however, debt-related 44 Small donations may still escape the system, but the effect is perceived as marginal. 45 This Chapter does not cover matters of debt management or sustainability.

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transactions are manually uploaded to SAFI. The DGICP prepares internal monthly reports on domestic and external debt service budgetary execution, and the BCR publishes monthly reports on the level and composition of public debt. Internal Control Framework 2.59 The Organic Law of the Court of Accounts establishes the “national system of control and audit in public management” and provides the Court with the power to issue Technical Internal Control Norms applicable to public sector entities. The current set of norms (2000) is divided into general, human resources, goods and services, financial, IT systems, and public investment norms. There are no quantified data to estimate the extent of their application, and in any case the various internal control systems in use by executing entities do not seem to be a product of specific plans to put the norms into practice. The norms are being restructured by the Court to conform to the COSO framework and introduce the concept of risk assessments and risk-based controls. 2.60 Internal audit. As part of the national system of control and audit, the internal audit function has its legal basis in the Organic Law of the Court of Accounts of the Republic, and this entity has the power to set policy and technical norms. Moreover, the Court receives internal audit plans and reports, and has the responsibility to evaluate internal auditors. In absence of internal audit standards, the Court’s (external audit-related) manuals are the technical point of reference for internal audit work. 2.61 Every public entity with an operational budget exceeding US$570,000 is obliged to have an internal audit unit, which is named by, and reports to, the head of the entity. Internal auditors are prevented from undertaking any administrative or prior control task. Most internal audit work is related to certain financial reviews (not financial statement audits) and unplanned special reviews. The Ministry of Education also has an audit committee – a rare occurrence among public entities. Analysis 2.62 Expenditure execution systems. The modern normative framework for expenditure execution, the standardization of procedures (with the exception of payroll controls), and the introduction of the SAFI software, have all contributed to the production of timely, reliable, and fairly complete information on government spending supported by audit trails. At the same time, the formal norms are progressively generating a healthy accountability and fiscal prudence culture in officials responsible for public expenditure. At the end of the day, SAFI has made a significant contribution to the MH’s capacity to control aggregate spending. Behind these achievements is the dedicated work of qualified professionals, particularly in MH’s central directorates (Financial Administration, Budget, Treasury, Accounting, and Public Investment and Credit). 2.63 While the basics are covered, there is room to enhance expenditure management performance. The streamlining of flows between executing entities and the MH has not been effectively replicated within the entities. There is still a certain degree of fragmentation, complication and duplication in internal administrative systems and

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procedures that ultimately affect efficiency in the use of public funds—the multiple operational manuals, action plans and software applications within institutions are probably a reflection of a more structural issue.46 There is room to upgrade the institutional SAFI software from its current budget accounting form towards the incorporation of certain administrative functions (most notably, procurement and management of fixed assets and inventories). 2.64 The payroll system (SIRH) is not used consistently among different entities and there are no standards for information to be captured; hence, there is no comprehensive public sector payroll database. In any case, SIRH’s platform is already obsolete and lacks security safeguards embedded in more modern applications. Finally, there are no provisions for the execution of routine payroll audits. 2.65 The lack of IT policies has encouraged the proliferation of different – and sometimes incompatible applications and databases, not only across different executing entities, but even within the MH.47 On the other hand, the sustainability of the current database management application for SAFI is uncertain and the provision of equipment is uneven and varies greatly from one entity to the next.48 2.66 Treasury. The DGT exercises good management and control of the Government’s cash position. This achievement flows from the operation of single treasury account system that captures, with documented exceptions, all government revenues; a financial programming function that has resulted in reliable cash flows; and from the use of effective legal instruments to deal with temporary cash shortages. The -legally instituted- deconcentration of payments, however, may be generating unquantified transaction costs and idle balances. 2.67 While the DGT transfers funds to executing entities only in accordance with recorded accruals, once funds reach the entities, these may exercise discretion in delivery of checks; such a system can produce arrears and idle funds at the executing entity level. The situation is aggravated in decentralized institutions that receive global transfers not linked to accruals. Furthermore, the disaggregation of government accounts makes it more difficult to enter cost-effective arrangements to substitute the current payment-by-check system to electronic deposits into accounts. 2.68 Donor funds. Through the provisions of Ley AFI and the implementation of SAFI, external financing has been effectively incorporated into, and makes good use of, the budget management system. Still, there has been limited use of potential economies

46 For example, within the Ministry of Education there are various systems, on top of SAFI and SIRH, that bear an effect on financial management: SMAEL (transfers to schools); SAP+ (investment projects); SIGAP (management information); “patrimonial accounting” (institutional accounting records); “fixed assets inventories”; and “budget formulation”. A similar situation can be found in the Ministry of Health. 47 In fact, different directorates within the MH have their own IT units. Just within the DGT, on top of SAFI there are systems for treasury (SITEP), programming, collection targets, tax information (SIIT), and the (new) control of bank accounts. 48 For example, in the largest public hospital, one computer was shared among various UFI officers.

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of scale in enhanced donor coordination and sectoral assistance, for which donors are partly responsible. 2.69 Execution monitoring systems. The SAFI software allows timely tracking of budget execution figures in each entity and at the MH, but the evaluation reports are not made public. The SGPR captures physical data on execution of the PIP, but the context and quality of indicators are subject to improvement. As regards the SIIP, there seems to be overlapping with both SAFI and SGPR. While still in the works and accessible initially only to the MH, the SIG can become a powerful tool to foster use of information for decision making. 2.70 Debt records. MH’s NFPS debt databases are rather complete and well used to introduce data into the budget formulation, execution and accounting systems, even though the information transfers are currently “manual”. Although debt management capacity was not covered by this PER, anecdotal evidence points to the need to introduce continuing programs for skills development in this highly specialized area, and to turn the DGICP into an active debt manager that undertakes systematic debt sustainability and risk analyses to minimize borrowing risks and costs.49 2.71 Internal controls and internal audit. There are no quantified aggregate data to estimate the extent of application of internal control norms, but the fact that roughly half of the individual financial audit reports issued by the Court of Accounts contain opinions other than “clean”, may point to the existence of serious problems in the effectiveness of the internal control framework (which is not risk-based). The new draft internal control norms based on the COSO framework are sound and modern, but their introduction in the absence of an evaluation of the practicality and application of current norms, and without a credible plan of implementation, would make little difference in the quality of government controls. A similar plan would be necessary for the release of the draft government audit norms that would introduce internal audit standards. 2.72 The legal mandate of the internal audit function provides a sound foundation to build its legitimacy and empowerment. However, internal audit units have in general been constituted on an ad hoc basis without technical studies or objective criteria to justify their size or budget.50 They usually lack sufficient numbers of professional and experienced staff, and do not have directly relevant training programs. There is general absence of risk-based approaches, and it seems that coordination with the Court of Accounts to prevent duplication of efforts is weak. Internal auditors do not produce statements on their overall assessment of the entities’ internal control system, and the

49 In the medium term, the DGICP could be organized into front, middle and back office organizational functions. The front office is responsible for executing transactions in financial markets and funding operations such as the management of auctions and negotiations for other types of borrowing; the middle office is responsible for analysis and advice on the debt management strategy as well as for the operational role of implementing risk controls, and the back office handles the settlement of transactions, the financial records and the debt database. 50 The proportional size of staff can vary significantly from one entity to another. For example, the Ministry of Education, with more than 42,000 employees and a budget of $485 million, has 16 auditors. The Supreme Court, with 8,500 employees and $112 million in budget, has 29 auditors.

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effectiveness of their work seems limited.51 Finally, there is no effective quality control system: while the Court is responsible for internal audit evaluations, these evaluations are not formally and systematically reported back to the internal auditors.

51 Adequate performance indicators are lacking, but it should be noted that in 2002 only 18 percent of presumed administrative liability (responsabilidad administrativa) resolutions, based on internal audit reports, have been ratified by the Court of Accounts.

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VI. Financial Reporting and External Oversight Financial Statements of the Government 2.73 The Ministry of Finance (MH) is required by the Constitution to submit to the Legislative Assembly, within three months after the end of the fiscal year (which coincides with the calendar year), the “general account of the latest budget, and the statement on the situation of public treasury and fiscal patrimony.” Ley AFI further institutes the figure of government accounting, applicable to the NFPS and the central government transfers to municipalities, as a unique model for budgetary and accounting transactions in accordance with “generally accepted accounting principles applicable to public sector.” The only requirement set by Ley AFI and its regulations to publish financial information is with regards to a summary of this annual document, within ten days after its submittal to the Assembly. 2.74 Ley AFI assigns to MH’s Government Accounting Directorate (DGCG) the responsibility to set accounting norms and consolidate financial information for the public sector. In line with this, each executing entity, while maintaining responsibility over its own accounting records, must also submit its monthly financial statements to the DGCG within ten days after the end of the month. Anecdotal evidence points to the fact that this requirement is not completely and regularly complied with, particularly in certain entities lacking the SAFI software. 2.75 Monthly reporting. A timely (though not always complete for the reasons noted above) monthly report on budget execution by the NFPS is distributed internally in the MH, and externally to the Office of the President, the Ministry of Economy, and the Legislative Assembly. A summary containing aggregate data is made public through MH’s website. Similar quarterly reports are also prepared. 2.76 Annual reporting. In order to fulfill its constitutional mandate, the MH prepares an annual State Financial Management Report within the timeframe stipulated in legislation. After submittal to the Assembly and the Court of Accounts, the report is made available on MH’s web-site (http://www.mh.gob.sv/mh_2003/informefinanciero.htm). The report consolidates budget execution, financial statements, and state of public debt of the central government, decentralized institutions and state enterprises (including six entities from the financial public sector), and special funds and extraordinary resources. Some aggregate data is presented on a comparative basis over a five-year period. No information on contingent liabilities is reported. 2.77 The financial statements are prepared on an accrual basis. The reasonableness of its application, however, has never been certified by the Court of Accounts, though “clean” audit opinions have been issued on the consolidation process.

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2.78 Municipalities. The government accounting software has been installed in 152 of the 262 municipalities. Of those, 92 municipalities reported their budget execution (31 more reported solely the use of FODES) to the DGCG in 2003. Due to the incomplete coverage, the DGCG has not included the municipal data in its financial reports. 2.79 Central Bank (BCR). The BCR has subscribed to the IMF’s Special Data Dissemination Standard (SDDS), and as such it makes monthly and annual public aggregate fiscal sector data available on a timely basis. The annual figures contain municipal data on a sample basis. 2.80 Public views. In terms of public perception, the Index of Budget Transparency (Probidad, 2003) noted the lack of performance and geographical indicators to complement financial data, and that these are too aggregated for in-depth reviews. The External Audit Function 2.81 The Constitution grants the Court of Accounts of the Republic the power to exercise fiscal oversight (fiscalización), in administrative and jurisdictional matters, of public finances in general, budget execution, and economic performance of public entities. Its Organic Law (1995) establishes its functional, administrative and budgetary independence from the Executive. 2.82 The Legislative Assembly elects the Court’s President and two Magistrates for a three-year period, may re-elect them and remove them, approves the Court’s annual budget and may audit it (but has never done so). The Court’s President must present an annual report of activities (informe de labores) and a report on the annual government accounts to the Assembly, but the Court is not in practice a branch of the Assembly. 2.83 In line with its constitutional mandates, the Court is organized into audit and jurisdictional functions. The audit divisions are organized by sectors: economic development and administration; justice and economy; social development and environment; municipalities; and external cooperation. Box 5 in the next page contains selected statistical data on the audit function. The jurisdictional tasks are in charge of the Chamber of First Instance, integrated by chamber judges, and Chamber of Second Instance, integrated by the President and two Magistrates. The Court bears authority to determine and sanction administrative and patrimonial responsibilities via account trials. 2.84 Annual reporting. The Court’s Organic Law makes reference to operational and financial audits, and establishes that the Court must issue an audit report on the government financial statements within four months after the Executive presents them to the Assembly. The audit report for 2002, however, contains an opinion solely on the reasonableness of the DGCG’s consolidation process, rather than on the financial statements themselves. 2.85 The Court can legally delegate audit functions to private sector external auditors whom it would supervise, but this option has not been operationalized. In practice, each

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decentralized public institution and the majority of external funds are currently subject to separate audits from audit firms and the Court. It should be noted, however, that USAID has authorized the Court’s External Cooperation Department to undertake audits, under USAID supervision, of its grants to the Government. Box 2.5: Court of Accounts – Selected Indicators

Box 2.5: Court of Accounts – Selected Indicators During 2002 and 2003, the following audit work was performed:

2.86 Public view. The Index of Budget Transparency (Probidad, 2003) points to two major challenges to the Court’s credibility: its perceived politization and lack of transparency. Apparently, over the last two decades the Court’s presidency has been granted to persons associated with one specific party, and public access to audit reports is

Quantity

Types of Audits Programmed

Un- programmed Total Concluded In Process

2002 Financial 141 6 147 114 33 Operational 167 1 168 137 31 Integral 2 0 2 2 0

Environment 1 0 1 0 1

“Special exams” 192 179 371 333 38

Total 503 186 689 586 103

2003

Financial 147 10 157 106 51

Operational 129 37 166 92 74

Integral 5 0 5 4 1

Environment 3 1 4 2 2

“Special exams” 102 86 188 120 68

Total 386 134 520 324 196

The data show that, in 2003 36% (54% in 2002) of the activities corresponded to “special exams”, of which 46% (48%) were not programmed. The 31% (24%) of total audit activities were operational, 30% (21%) were financial and the remaining 3% (1%) responded to other (incipient) types of audits. It should be noted that the nature of “operational audits” (mostly related to municipalities) is more of a special exam, given the lack of parameters to measure efficiency and effectiveness. Of the 114 financial audits concluded in 2002, 44% contained qualified audit opinions, 3% were adverse and there was one disclaimer. The presumed irregularities identified in audits and special exams amounted to US$197 million. These cases are subject to evaluation of administrative liability (responsabilidad administrativa), which could lead to fines, patrimonial liability, and criminal prosecution (if transferred to the public prosecutor). In 2002, of 2,753 reports in process of resolution of liability, 61% were processed and the remaining 39% were pending. Of resolutions issued, 62% were absolutions, 13% were subject to follow-up, and liability was found in 25% of the cases, for sentences amounting to US$3 million. The 106 financial audits performed in 2003 correspond to 89 entities. No other statistics were yet available for 2003. Source: Based on documents from, and interviews held in, the Court of Accounts of the Republic.

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generally restricted. There has been no known official response from the Court to the cited Probidad document. Legislative Oversight 2.87 While the Constitution mandates the MH to report on the annual government financial statements and the Court of Accounts to report on its audit, both to the Legislative Assembly, the Assembly’s process of scrutiny is neither regulated nor operationalized. There are no formal examinations of the documents it receives, nor hearings held about them. In fact, anecdotal evidence points to somewhat restricted access to audit reporting (other than the annual report). 2.88 It should be noted, however, that the Assembly’s Finance and Budget Commission has established a Unit of Analysis and Monitoring of the Budget (UASP), which staffed with only two professionals produces regular studies as requested by the Commission. The UASP, created as part of an USAID grant, is not sustained by legal basis. Analysis 2.89 Financial reporting. The accounting function has been effectively institutionalized and shows some sophisticated advances, most notably the accrual base of recording and the timely consolidation of monthly and annual financial statements for the public sector. While this information excludes municipal finances, commendable efforts are underway to provide the municipalities with accounting systems and to gradually approach full aggregation of local government data. The existent strong accounting foundations provide a good basis for enhancements in financial reporting standards and analysis; specific enhancements that could be made to the State Financial Management Report include: ▪ Budget execution statements could be presented in the same format as the budget

document. For example, the aggregation of entities could be consistent;52 the detailed statements could measure execution not only against the modified budget, but also against the initial voted budget; individual execution of entities could be presented as an annex to the same level of detail in the annual budget law (e.g., execution by budget units, lines of work, public investment programs, and classification of personnel expenditures).

▪ A distinction could be made between notes to the financial statements that include

narrative descriptions or more detailed schedules of figures from the financial

52 The annual budget law is organized in three parts covering the central government, NFPS decentralized institutions, and state enterprises. The budget execution information is shown in the annual financial management report in two parts, covering the central government, and an aggregation of decentralized institutions and state enterprises that includes some entities (e.g., from the financial public sector) not covered in the budget law. While these entities should be reported on, a better classification would allow comparisons of actual execution against initial budget allocations.

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statements, and additional information to assist users in assessing the Government’s performance, its stewardship of assets, and the allocation of resources. In both cases, there is considerable room for improvement.

▪ The arrears portion, if any, of the liabilities could be clearly identified. An effort

could be made to disclose contingent liabilities. ▪ Financial statements congruent with those published by the BCR on the fiscal

sector could be incorporated as an annex, complemented with a reconciliation of figures between the two sets of data.

▪ The aggregated data on special funds and extraordinary resources could be made

more transparent by adding an annex with detailed information by fund. 2.90 In terms of transparency, the MH has taken a good first step with the publication of the full contents of the State Financial Management Report, but there is still room for improvement. Specifically, the MH could disclose the detailed monthly reports on budget execution (not just the aggregate data) and execution of the public investment program. Following the precedent set with publication of the citizen guide to the budget, a similar document could be prepared with regards to budget execution and government financial statements. 2.91 Court of Accounts. The Court has taken two important steps toward its modernization: the preparation of a five-year strategic institutional plan and new sound government audit norms (currently in draft form). Moreover, it has recently introduced a citizen claims facility, its auditors are subject to a code of ethics (unique in the public sector), and it has been certified by USAID to carry out audits of grants. Current legislation provides the Court with adequate independence and room to exercise its external audit function, but there are two potential sources of conflict: the national internal control and internal audit system is regulated by the Court, which at the same time is responsible for the audit of internal controls; and the Court administers justice on the basis of audits it itself performs. 2.92 Two achievements of the Court of Accounts are that its 475 auditors have university degrees (although only 22 percent from the audit field), and that it has a continuing training plan (although only 12 percent of the training hours delivered in 2003 were directly related to audit techniques). The quality of current performance, however, is irregular: the fact that in 2002 only 25 percent of resolutions resulted in declaration of liability (responsabilidad) may reflect insufficient quality in the collection and analysis of audit evidence; moreover, for a sample of six entities, it took the Court an average of 14 months to issue the audit reports. 2.93 While an effort is underway to bring financial audits to date, the Court’s inability to opine on the state financial statements as a whole is related to the persistent backlog of individual entity financial audits. Important components, such as revenues, debt and pension costs have never been audited. While this partly reflects a lack of specific

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technical and technological capacity, the situation can be linked to the priority given to special exams and operational audits (which, in lack of methodology and parameters to measure efficiency and effectiveness, are far from international standards), and the limited use of its legal power to use work of private auditors (e.g., in decentralized public institutions). 2.94 Legislative oversight. As opposed to its clearly established role in the budget approval process, the Legislative Assembly’s ability to scrutinize budget execution, public finances, and audit reports is very constrained. A significant step to help reverse that situation has been the creation of a specialized unit for analysis and monitoring of the budget (UASP), which has made considerable efforts to undertake studies and produce regular reports. However, having only two professional staff and lacking a legal basis, its effectiveness is limited and its sustainability uncertain.

VII. Conclusions and Recommendations 2.95 The financial management reform process, initiated in the 1990s under the umbrella of the public sector modernization program, has produced significant improvements in the performance of budget management institutions. The Ley AFI and other regulations provide a generally modern, clear, complete, and functional framework of formal rules pertaining to each relevant area of budget management. The methodologies and processes of budget formulation and execution are well documented and normally followed. The Government is able to track spending under budgetary provisions, effective controls of its cash position are in place, and complete debt records are maintained. Both the annual budgets and financial reports provide considerable data on government finances. 2.96 There is an internal control framework, the internal audit function has a legal basis, and the external auditors are granted with independence and room to exercise their functions. In summary, the basic foundations of a well-functioning public expenditure management system have been built, the result of competent work from groups of committed public sector professionals. Still, important obstacles to operational efficiency and transparency remain. 2.97 First of all, the lack of an independent financial audit opinion on budget execution, let alone the state financial statements, prevents a basic external assurance on reasonableness of financial data and conformity with budgetary laws and regulations. The problem is compounded by the internal audit general lack of capacity to provide assurance that internal controls are effective. And while the implementation of a financial management system has introduced good budgetary controls, there is a significant portion of public resources managed out of the system. Finally, the information available for public scrutiny of use of funds, both budgetary and extra-budgetary, is subject to enhancements in its clarity, completeness, analysis, and dissemination.

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2.98 Given that some crucial financial controls are not yet in place, the capacity to measure and increase efficiency and cost-effectiveness cannot be better. The fact that the same systems that should be used to facilitate and monitor performance are inconsistently and uncoordinatedly used from one entity to the other – even within a single entity – is not a good sign. Other possible source of inefficient financial management is the proliferation of government bank accounts. Priorities for action 2.99 The analyses in the preceding parts of this Chapter lead to the conclusion that, building on the impressive achievements of the last decade, the budget management institutions can envision further enhancement of their performance to increase efficiency and effectiveness in the administration of public funds, and to positively influence the governance environment through improvements in transparency. This is of particular importance in light of country circumstances. As explained in the previous chapter, the earthquake reconstruction investments and the transitional costs derived from the pension reform have put strong pressure on public finances in recent years, while looking forward, there is a need to expand key investments in the social area that are also important for the growth agenda. All of this raises the need to increase revenues and efficiency in public spending. At the same time, perception surveys suggest that governance indicators have deteriorated and transparency is low. Should that trend continue, the Government’s capacity to enhance the country’s investment climate could deteriorate. 2.100 To contribute to the enhancement of performance and transparency of budget management institutions, the CFAA report presents a set of recommendations that various government entities could incorporate into their modernization plans. The following paragraphs, in turn, suggest the critical areas of action. 2.101 External oversight. The current lack of external audit reports on the content of government financial statements, and of legislative examination of financial and audit information, is a serious obstacle to transparency in public finances. 2.102 While capacity to perform operational audits is gradually being built, the Court of Accounts should concentrate its efforts on getting the basics right; i.e., producing a comprehensive financial audit on the reliability of government financial statements, regularity of transactions, and functioning of internal control systems. In the short term, this would require a policy shift, some technical assistance to help build risk-based approaches (including making wider, informed use of the work of private auditors and internal auditors), and training (to be followed in the medium term with a program of certification of government financial auditors). The Court could also take a policy stand to actively promote the legislature’s (and others’) prompt access to audit findings. 2.103 In the medium term, the Court’s credibility could be increased by a revision of the current form of appointment of the Court’s authorities; for instance, a transparent,

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independent, and technically based process for selection of short lists put forward for the Assembly’s vote could be introduced. 2.104 The Legislative Assembly should provide more appropriate resources (e.g., through available grants) and sustainability (issuance of regulation) to its own unit for analysis and monitoring of the budget (UASP). In the short to medium term, the function of legislative scrutiny of public finances and audits should be gradually institutionalized. 2.105 Internal controls. The low rate of “clean” reports from the Court of Accounts, together with the internal auditors’ inability to produce assessment statements on internal controls, may be symptoms of ineffectiveness of the current internal control system. 2.106 The Court’s planned introduction of the COSO framework for internal controls, and of government audit standards for the internal audit function (both of which should be closely interrelated, so that internal auditors can focus their scope of work on assessments of the internal control systems), should be preceded by evaluations of the current framework and by a comprehensive plan of training and gradual implementation to develop understanding and ownership. At the same time, objective criteria for the provision of internal audit resources (under a risk-based approach and connected to sound quality controls) should be developed. While indicative in the beginning, such criteria could be subject to certain enforcement measures in the medium term. 2.107 Comprehensiveness and quality of financial data. Incomplete information on municipal finances prevents the formation of an overall view and assessment of general government finances. Incomplete information on extra-budgetary funds at the time of preparation and approval of the annual budget prevents comprehensive analyses to support the budgetary fiscal and allocation decisions. Some financial documents could be publicly disclosed, and the information content of those currently available to the public could be further improved. 2.108 COMURES has shown its interest in increasing municipal transparency; a first natural policy step would be to make information on municipal budgets and their execution public. In the short term, ISDEM could help with the collection of information; in the short to medium term, the MH and COMURES should continue to expand the municipal coverage of the government accounting system. In the medium term, regulation on provision of information could be introduced. 2.109 The Executive could take short term decisions to disclose better extra-budgetary funds (extraordinary budgets, special activity funds and budgets of autonomous entities), as the subject of annexes to the annual budget documentation and of disaggregated schedules (e.g., by institution) to the consolidated government financial statements. In due course, the current exemption of certain NFPS funds and entities from inclusion in the annual budget law could be reexamined. 2.110 To further increase transparency, in the short term the MH could broaden the dissemination of interim reporting on detailed budget and investment program execution,

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and in the medium term it could make better use of information technology to enable customized queries from citizens (building upon the ongoing development of SIG). Finally, the content of information in both the annual budget law documentation and the annual state financial management report could be enhanced with relative ease in the short term by incorporating certain elements from international practice, under a plan to reach convergence in the medium to long term. 2.111 Financial management reform. While conceived under the overall public sector reform program, financial management interventions seem to run parallel to that reform program. The segmentation of organizational responsibilities—with the Technical Secretariat of the Presidency leading public sector reform and MH leading financial management efforts—may have fostered the perceived disconnect that is reflected, for example, in the proliferation of unconnected systems and procedures across and within entities, in SAFI’s lack of administrative (other than financial) tools, and the presence of separate skills development programs. 53 2.112 While the MH should continue to take the lead in financial management modernization, a greater awareness of financial management elements should be brought back into the public sector modernization program, and financial management efforts should be clearly coordinated with reforms on the civil service, procurement, and institutional restructuring fronts (in time, operational coordination measures ought to be developed, but they necessarily have to be preceded by a high level directive within the Executive). This framework should serve as basis for MH’s planned (and needed) technological upgrade of the financial management (SAFI) and human resources (SIRH) systems, their coverage extension to decentralized institutions and extra-budgetary funds, and the incorporation of certain administrative functions (most notably, procurement and management of fixed assets and inventories). 2.113 Public investment. Various entities and systems are involved in the monitoring of public investments, but the effect of these on the budget formulation process and the efficiency of expenditures is unclear, mostly because of the lack of quality indicators to measure performance. Moreover, there is generally limited capacity in executing entities to produce quality medium-term investment programs and pre-investment studies. 2.114 In the short term, administrative actions could be taken within the Executive to carefully revise, and simplify, the multiplicity of systems and responsibilities for public investment monitoring. Similarly, the criteria and decision process followed for selection (and rejection) of projects into the public investment plan, including related cost-benefit analyses, could be made transparent. As a step to integrate better capital and current budgeting, the MH could develop a methodology to calculate the recurrent cost implications of the public investment program and identify investment and current costs in capital projects. The successful experiences in practical SAFI-related training could be replicated for the development of a training program on planning and costing capital budgets under tight fiscal envelopes. 53 Development agencies may also bear some responsibility on the apparent disconnect.

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2.115 While performance-based budgeting54 is not advisable in the short term, the current framework and procedures for public investment programming and monitoring could benefit from the incorporation of certain measurement principles and techniques associated with performance budgeting (this would require technical assistance). Another area where international experience could be adopted in the short to medium term, is in the development of sectoral approaches to external development assistance. These could help reduce the transaction costs related to the administration of several investment projects.55 2.116 Cash management. The basic concept of normative centralization and operational decentralization applied to treasury operations has resulted in a proliferation of accounts (and possibly idle funds in the case of decentralized institutions funded by transfers) throughout the public sector. On a related issue, the lack of an objective system for sequencing release of payments in executing entities could encourage opacity in dealings with government providers. 2.117 With advances in technology, particularly in light of the need to upgrade the SAFI and SIRH software systems, the Government could consider in the medium term the introduction of payment centralization (while maintaining authorization to accrue expenses in the executing entities), and of a release-of-funds mechanism to non-entrepreneurial decentralized institutions based on accruals (as opposed to global transfers). Such actions would need to be preceded by further study and a change in legislation. In the meantime, better control mechanisms for subsidiary account balances and reconciliations could be implemented, and objective procedures for delivery of payments (e.g., adapted first-in first-out) could be issued. 2.118 Medium-term budget framework. The available aggregate fiscal targets and projections to orientate fiscal policy could be the starting point to develop and formalize a medium-term budget framework that includes the projection, over a three-to-five year horizon, of fiscal indicators, expenditure estimates by main aggregate classifications, and forecasts of forward costs of the most significant investment projects. This could better inform the annual budget formulation and approval process, by increasing transparency of the future fiscal impact of current policies and the prioritization of expenditures. 2.119 Human resources. Any effort to modernize budget management must be built upon a strong base of public sector financial management and audit professionals. Hence, there is a clear need for the Government to: prioritize the carrying out of SETEC’s plans to reform the civil service legal framework, create an administrative career based on merit-based employment, and upgrade related information systems; and ensure strong links between civil service and financial management reforms. In the meantime, the 54 As a result of the development of IT systems, instruments such as performance and cost measurement are regaining attention in OECD countries. In a few countries, “resource agreements” between the center (e.g. ministry of finance) and spending agencies may subject a certain portion of expenditures to performance agreements. (OECD, 2001) 55 Sector-wide approaches (SWAps) are emerging internationally as a means to strengthen government ownership and coordination of development assistance, and reduce transaction costs associated with multiple project, each with its own individual procedural requirements.

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ongoing program to help introduce modern human resource management techniques could continue under implementation with expanded coverage of government entities. 2.120 Municipal finances. While the scope of this PER does not encompass local government expenditure management, and granted that this is a politically sensitive issue, budget management policies for decentralization and related fiscal strategies would benefit enormously from a clear delineation of areas of intervention between central and local governments, and from regulation of municipal debt.

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ANNEX I: El Salvador CPAR Current Situation , Trends and Progress

The adoption in May 2002 of the Law on Public Sector Procurement and Contracting (LACAP) represented a significant improvement over the previous procurement legal framework as it promoted open and transparent competition and included many sound international procurement principles and practices. The LACAP established a comprehensive Public Administration Procurement and Contracting System (SIAC) to manage the public sector procurement function, and included the Procurement Regulatory Entity (UNAC), as a dependency of the Ministry of Finance, and the institutional procurement implementing units (UACI’s) in each government agency, including municipalities. The control and independent oversight of the procurement activities is performed by the Corte de Cuentas of the Republic and the office of the Attorney General.

Since the adoption of the procurement law, the government demonstrated its commitment to the procurement reform, the Technical Secretariat of the Presidency (STP) undertook various training and capacity building initiatives to disseminate the new law amongst the UACI’s and the private sector and to strengthen the overall new procurement system, and the Procurement Regulatory Entity (UNAC), provided technical assistance to government agencies on technical matters related to the application of the LACAP. However, despite all these efforts, the procurement processes established by the new law have not been fully implemented in all public agencies, the UNAC has not been able to efficiently discharge its functions mandated by law, many UACI’s still have difficulties in performing its procurement functions in an efficient manner, and the procurement public information system is still limited.

Main Weaknesses and Recommendations The main reasons for the delays to fully implement the new procurement system are the lack of: (i) the regulations of the law; (ii) a strong and effective regulatory entity; (iii) technical and institutional capacity at most of the procurement implementing agencies; and (iv) the availability of an electronic information system to increase efficiency and transparency. The recommendations of the CPAR to tackle above weaknesses are included in a action plan to be discussed with the Government. The main recommendations can be summarized as follows: (i) preparation and issuance of the regulations of the law as soon as possible; (ii) strengthening of the UNAC and the UACI’s through a comprehensive training and institutional strengthening program funded by the IDB and the World Bank (IDF grant and public sector modernization project); (iii) developing, installing and maintaining and e-procurement system, as part of the e-Government strategy, starting with an e-disclosure module and gradually moving to a comprehensive electronic bidding

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system. Implementation of these actions will require a strong leadership at the most highest level of Government and a well coordinated integral implementation plan, and be supplemented by other actions to increase efficiency through the usage of harmonized standard bidding documents, better structure and regulate in the civil service law the career of procurement professionals, to combat corruption in a more effective manner; and to further improve the procurement law to better meet international standards and procurement requirements of the Central American Free Trade Agreement.

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CHAPTER III: Education

3.1. The evaluation of education expenditures that follows focuses mostly on those incurred by the Ministry of Education (MINED). MINED has the responsibility for sector policy and for providing pre-primary, basic and secondary education to the Salvadorans that attend public schools. The Constitution of the Republic mandates that the first two levels of education are provided free of charge in public institutions. MINED also provides support to the tertiary level of education, including the autonomous University of El Salvador and several technical institutions. After reviewing the organization of the sector, the government’s sector objectives, and the process of allocation of public resources, public expenditures trends and sector outcomes are discussed. The chapter concludes with the identification of the sector’s key expenditure issues and recommendations.

I. Organization of the Sector 3.2. The public education system in El Salvador is organized in four levels: three years of pre-primary education usually for children age 4-6; nine years of basic education for children 7-15, which in turn is divided in three cycles of three years each; two or three years of secondary education depending of the modality: general studies two years and technical –vocational education three years; and the higher level of education which includes university and technological education. Most students attend public institutions up to and including the secondary level; the private sector has a preponderant presence in university education. In terms of enrollment, the public sector covers el 81 percent of pre-primary, 89 percent of basic, and 68 percent of secondary (Table 3.1). The National University of El Salvador, UES, enrolls 30 percent of a total university population of 100,000.

Table 3.1: Student Population, by sector 2002

Source: Ministry of Education

Establishments Pre - primary Basic Secondary Total

Public 183,691 1,148,044 106,651 1,438,386 Private 44,373 144,175 51,308 239,856 Total 228,064 1,292,219 157,959 1,678,242 Publ ic % 81 89 68 86 Private % 19 11 32 14

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3.3. During the 1990s, the administration of the public education system was substantially decentralized.56 In the early 1990s, MINED established EDUCO, a community-based school program managed through community associations, ACEs, which has been the instrument to expand pre-primary and basic education in rural areas.57 The ACEs have the responsibility for managing the school resources including the hiring and firing of teachers. In mid-1990s the authorities began transferring the positive experience with the ACEs to the traditional system where School Councils were created, CDE, with the responsibility for: i) planning and implementing the school activities; ii) manage the resources transferred to schools; and iii) raising additional funds to support school activities. Other instruments were developed at school level to empower the schools such as the Institutional Education Project (PEI) that sets forth the school medium term objectives and the associated Annual School Plan (PAE).

II. Strategic Objectives and Resource Allocation Processes 3.4 MINED’s strategic objectives and targets are set forth in the Government’s Ten Year Education Plan (1995-2005), which has received broad based support from the various sectors of the Salvadoran society. The Plan calls for: i) increasing coverage at all levels but with emphasis on the third cycle of basic education and secondary education, particularly in the rural and peri-urban areas; ii) creating and strengthening the different programs that facilitate the access to education and permanence in school of the poor; iii) improving the curriculum content and teaching-learning methods; iv) establishing learning evaluation systems as an instrument to improve continuously the quality of education; v) establishing monitoring, evaluation and incentive systems for teacher performance; and vi) strengthening school autonomy over resource management. 3.5 In 2000, the new MINED authorities revised the progress made with the implementation of the Plan and prepared their strategic program -- Education Challenges in the New Millennium, which details the challenges faced by education in each key area, the objectives to be accomplished, and the strategic guidelines. The program’s principal objectives are to increase education quality, strengthen community participation, facilitate access to education, and promote values and personal development. It details the programs, targets and financial requirements to achieve these objectives. 3.6 Until 1996, MINED resources were managed in a centralized manner. Departmental offices and traditional schools had virtually no decision-making capacity over any of the budgeted resources. Staffing and procurement decisions were taken at the center. For the EDUCO schools, resources were administered in a decentralized manner.

56 For a review of the sector reform effort during the 1990s see Marques, José Silvério and Ian Bannon. 2003. “Central America: Education Reform in a Post-Conflict Setting, Opportunities and Challeges”, World Bank, Conflict Prevention and Reconstruction Unit, Working Paper 4, April. 57 The number of EDUCO students in pre-primary and basic education increased from 10,721 and 42,851 in 1993 to 47,551 and 202,719 in 2002. Currently, EDUCO students represent about 16 percent of pre-primary and 18 percent of basic education students in public schools.

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ACES received transfers to pay for the teachers (who are hired under an annual contract) and for school materials. 3.7 In 1996 and consistent with its strategy of giving autonomy to the schools, MINED established a Education Quality voucher (or bono) that transfers resources to the schools (pre-primary, basic and secondary) to buy key goods and services to improve education quality. The voucher systems was accompanied by a series of other reforms that were gradually implemented, including: i) a teacher training/development program that is administered in a decentralized manner with strong school participation and the support of the Pedagogic Advisors, who replaced the previous school supervisors; ii) a decentralized system of administrative support to the schools; iii) incentives for teachers in rural areas; and iv) a performance-based incentive system for all teachers. At the same time MINED strengthened the capacity of its Departmental Offices to support the schools. 3.8 In 1999, the voucher system was used to transfers resources to repair the damage caused by Hurricane Mitch to the schools. In 2000, MINED established another seven types of vouchers as can be seen in Table 3.2. With the 2001earthquakes, MINED again used the voucher system to help finance the reconstruction of damaged infrastructure in a decentralized manner. In addition it created two other vouchers: to finance administrative assistance to the schools and to support the program Quality Models of Education. In 2002, it created a voucher to finance preventive maintenance in schools that had been reconstructed with IDB support. Table 3.2 shows the evolution of the vouchers and their increasing importance; in 2003 they represented 6.4 percent of MINED’s budget.

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Table 3.2 Education Vouchers, 1996-2003

Voucher Amount (US$000)

1996 1997 1998 1999 2000 2001 2002 2003 1.Education Quality 3,817 8,186 10,611 3,469 9,143 8,874 9,285 104022. Rehabilitation of Education Centers Damaged by Mitch 2,316 3. Rehabilitation of School Furniture 463 114 4. Education Quality for Accelerated Education 110

5. Vocation Training for Special Education centers 109 6. Development of Center for Education Resources –CRA 857 2,360 2240 2500 7. Quality Models 1,125 8. School lunches 1,371 4,732 5,103 8293

9. Professional Development Centers for Secondary Education 258 10. “Fondo Alegría” 655 857 300 11. Youth Fund for Open Schools 714 492 200 172 12. Teacher Professional Development Plans 1,830 1,803 2300

143 200 13. Youth Fund 14. Administrative Assistance 2,095 2640 2640

4,546 15. Provisional classrooms 5,842 16. Earthquake Reconstruction

17. Excellence 2,025 3000 1996 1997 1998 1999 2000 2001 2002 2003 18. Preventive Maintenance of Furniture and Infrastructure 886 1225

695 19. Paricipation Models of Managment

100 20. Summer camp Total 3,817 8,186 10,611 5,785 12,910 33,009 25,834 30,946

Memo: percent MINED’s budget 1/ 1.6 2.9 3.4 1.7 3.3 7.7 5.5 6.4 1/ For 1996-2000, executed budget; for 2002-3, approved budget. Source: Marques, José Silvério, “Costo Eficiencia de los Bonos Educativos”, Background paper prepared for the World Bank, processed, December 2002 and MINED,

III. Expenditure Trends 3.9 The public education budget has increased significantly in the last several years. As a share of GDP, it increased from 1.9 percent in 1992 to 3.2 percent in 2003 (Chart 3.1); as a share of the overall Central Government budget from 12.4 percent in 1996 to 19.5 percent in 2003 (Chart 3.2). Public education spending in El Salvador is, however, still below the average for Latin American and Caribbean (LAC) as well as below its neighbor Costa Rica. Moreover, in the last two years the education budget has declined as a share of GDP; the proposed 2004 MINED budget would drop to 3 percent of GDP and to 16.6 percent of the overall Central Government budget, certainly a worrisome development.

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Chart 3.1: Public Spending on Education Chart 3.2: Education Budget, 1996/03

0.0 1.0 2.0 3.0 4.0 5.0

% o

f GD

P

1992 1.9 3.3 3.1

MRD 3.2 4.4 4.4

El Salvador Costa Rica LAC

0

5

10

15

20

Perc

enta

ge

% of Total B d t

12.4 15.9 15.0 16.8 17.5 16.5 18.2 19.5 16.6

% of GDP 2.3 2.5 2.6 2.7 2.9 3.1 3.3 3.2 3

1996 1997 1998 199920002001200220032004

Note: MRD-most recent data: El Salvador (2003); Costa Rica (2000); Source: Ministry of Finance (1996/01executed budget; 2002/03 approved budget;

2004 proposed budget).

Latin America and Caribbean, LAC (2000). Includes total public spending on education including subsides to private education entities Source: World Bank, WDI

3.10 El Salvador also spends relatively too little on per student basis. Table 3.3 shows the World Bank latest comparable estimates of education expenditures per student as percentage of GDP per capita for El Salvador, Costa Rica and LAC. It can be observed, El Salvador spends 23 percent less than LAC on primary education students and 39 percent less than Costa Rica on secondary education students. Table 3.3: Public Education Expenditure per Student 1999 - 2002 Spending by Level and Function 3.11 Basic education absorbs the greatest share of MINED’s recurrent budget (Chart 3.3). During1996-2003, its share averaged 63 percent of the recurrent education budget; pre-primary and secondary education absorbed 8.2 percent and 6.9 percent, respectively (Chart 3.3). Allocations for higher education, which include the transfers to the University of El Salvador (UES), averaged 6.7 percent. Resources assigned to basic education increased during the period while for the other levels had an erratic trend. The item “other” includes administrative expenditure or overhead that cannot be assigned to any individual level. These other expenditures declined substantially during the period, from 19 percent of the overall recurrent budget in 1996 to 12.5 percent in 2003.

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Chart 3.3: Dist. of MINED’s Recurrent Exp. by Level of

Education 1996-2003

Chart 3.3 Distribution of MINED's Recurrent Expenditures by Level of Education, 1996-2003

-1020304050607080

% o

f Tot

al E

xpen

ditu

res

Pre-Primary Basic Secondary Higher Other

Pre-Primary 8.5 8.4 8.0 7.7 7.9 8.6 8.2 8.3

Basic 58.8 59.2 60.2 62.4 67.4 66.3 64.5 64.6

Secondary 7.0 6.2 6.5 6.6 7.2 7.2 7.3 7.2

Higher 7.1 6.3 6.8 6.6 6.3 6.3 7.1 7.4

Other 18.6 19.8 18.4 16.7 11.2 11.6 12.9 12.5

1996 1997 1998 1999 2000 2001 2002 2003

Source: MINED (Executed recurrent budget 1996-2001; approved recurrent budget 2002-23) 3.12 MINED’s expenditure on wages and salaries constitutes over one-half of its total budget but has been generally declining in importance, from 71 percent of the budget in 1996 to 57 percent in 2003 (Table 3.4). This relative decline has been continuously since 2000. In contrast, expenditures on goods and services, which include textbooks and other materials, have had an increasing trend form 12.4 percent in 1998 to 15.8 percent in 2003. Current transfers that includes the transfers to the UES (60 percent of current transfers in 2003) and to other educational and cultural institutions, have average 12 percent of total expenditures during the period. 3.13 Despite the decline in the share of wages and salaries in total expenditures, teachers’ salaries have been increasing. The relative reduction in wages and salaries results from an early retirement program implemented by MINED in 2001/02. A number of teachers elected to retire under that program and a new generation of teachers has entered the system, at lower average wages.

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Table 3.4: MINED Budget by Function 96-03

(% of total executed budget) Items 1996 1997 1998 1999 2000 2001 2002 2003

Wages and salaries 71.1 67.3 62.6 70.1 66.7 52.2 51.8 65.8 Goods and services a/ 14.2 15.2 12.4 12.5 13.1 13.4 18.8 15.8 Financial expenditures and other 0.0 0.0 0.0 0.1 0.1 0.0 0.1 0.1 Current transfers b/ 13.4 12.4 11.3 9.1 10.6 9.0 11.0 11.4 Physical investment and capital 1.2 5.1 13.7 8.3 9.5 25.4 18.2 15.5 Transfers c/ Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Memorandum items: Executed budget US$ mm 232.8 272.3 322.3 330.4 358.1 472.7 478.2 473.2 Approved Budget US$ mm 238.4 279.4 311.6 335.1 387.0 428.8 471.2 484.5 % Executed 97.6 97.5 103.4 98.6 92.5 110.2 101.5 97.7 a/ Includes purchase of goods and services financed by loans from the World Bank and IDB (including vouchers) b/ Includes transfers for the University of El Salvador and vouchers for EDUCO and other schools c/ Includes vouchers and other transfers for the purchase of capital goods financed by loans from the World Bank and IDB Source: Ministry of Finance, Executed budgets

3.14 The 1996 law that regulates public teachers pay (Ley de Carrera Docente) introduced a new salary scale and made teachers salaries a function of education background and experience rather than the level of teaching. Public teachers real hourly wage has increased by 37 percent between 1995 and 2002 and is very similar to the private teachers wage level (Table 3.5). Also, public teachers pay compares well with other professions. In 2002, the hourly wage of a public teachers with a non-university degree was US$ 3.83 compared to the hourly wage of US$ 3.2, US$ 2.48 and US$ 2.73 for public technicians, nurses and accountant with similar academic background, respectively. The latest public teachers wage increase was negotiated in early 2003 for about 5 percent. 3.15 In addition to the salary, teachers receive monetary incentives if they serve in rural areas (incentivo de ruralidad) or if they perform well (Reconocimiento a la Labor Educativa Institucional). In 2002, the former incentive was US$ 480 a year; it was given to 15,249 teachers (of a total of about 31,000 teachers) at a total cost of US$ 7.3 million for MINED. The incentive for working in rural areas has since been added to the teacher salary (sobresueldo). The performance incentive is equivalent to US$ 228 a year and is attributed to the school on the basis of an independent and standardized evaluation conducted by UES; it reviews the quality of the school’s institutional plan, school administration, quality of education, and teacher’s classroom management. For comparison, the minimum and maximum current monthly salaries for level 2 teachers (with three years of university education) are US$ 372.00 and US$ 537.15; for level 1 teacher (with a complete university degree), US$ 409.15 and US$ 592.00. Level 1 and 2 are both divided in six categories (escalafon).

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Table 3.5: Trends in Monthly and Hourly Public and Private Teachers Real Wages (1995 = 100)

Real Monthly Wage

Hours Worked per Week

Hourly Real Wage

Private Public Private Public Private Public 1995 100 100 100 100 100 100 2002 207 152 105 111 197 137 Memorandum 2002 Values a/ 2114 2267 24.6 27.5 21.5 20.6 a/ Wages in 1992 colones. Source: di Gropello, E., “El Salvador: Education Strategy Paper”, processed, WB 2004 3.16 The pupil-teacher ratio is of acceptable size. For primary education, it has declined from 33 to 26 between 1996 and 2000/01, below the average for LAC and close to that of Costa Rica. Pupil/teachers ratios in the departments of Sonsonate, Cuscatlan, Ahuachapan, La Libertad, Cabañas y La Paz are above the national average.58

3.17 El Salvador does not have a teacher supply problem as there are 15,000 teachers not working in the sector and, as discussed, salaries are quite attractive compared to other professions. Teacher distribution by department is closely related to the potential

demand for schooling, approximated by the distribution of school age children (4-18 years) by department. Rural areas have the bulk of public teachers while private teachers can be found mostly in urban areas. The department of San Salvador concentrates the larger share of teachers, though there is a relatively undersupply of public teachers that is more than compensated by the private sector.59

Table 3.6: Pupil-Teacher Ratio in Primary, 1996, 2000/01

1996 2000/01

El Salvador 32.8 25.6 Costa Rica 29.5 24.9 LAC 25.2 26.5 Source: World Bank, WDI

3.18 MINED’s capital expenditures have fluctuate widely in recent years. Since 2001, a large share of MINED capital budget was to reconstruct the infrastructure damaged by the 2001 earthquakes. Of the 2,647 existing educational centers, the earthquakes destroyed about 8 percent (232) and another 56 percent (1,530) was damaged. According to MINED, most of the damaged infrastructure had been reconstructed at a cost of about US$ 50 million. Notwithstanding, school infrastructure continues to be a challenge. A diagnostic of the state of school infrastructure conducted in late 1990s revealed that 50 percent of the buildings presented some physical deterioration. Many schools do not have basic facilities such as water or sanitation. 3.19 School infrastructure (classrooms) distribution in the country is closely related to the potential demand for schooling (i.e., distribution of school age children by deparment). Rural areas have the bulk of public school infrastructure. The department

58 See Marques, José Silvério “Policy Options to Increase Coverage in Upper Basic (3rd Cycle) and Secondary Education”, Background report prepared for the World Bank, August 2003 59 Ibid

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of San Salvador concentrates the larger share of the infrastructure, though there is a relatively undersupply of public infrastructure that is more than compensated by the private sector. The departments with highest pupil/classrooms ratios are: Sonsonate, La Libertad, San Salvador and Ahuachapan. 60

3.20 MINED does not have a permanent program to finance school maintenance. MINED has prepared a school maintenance manual which has been distributed to the schools. It has also authorized the schools to use part of the Education Quality voucher for infrastructure repairs. In 2002, with financing from the IDB, MINED established a new voucher to finance the maintenance of schools that had been reconstructed after the earthquakes with IDB support.61 The World Bank is also supporting school maintenance. Funding Sources 3.21 External resources have financed an important share of MINED’s spending in the last several years (Table 3.7). External loans and grants have increased from an average of 7 percent of the overall budget in 1996-99 to more than 17 percent in the last four years. The large increase in external finance in 2000 resulted from a large grant received from USAID to support basic education. The continued relatively high percentage of external finance since then is mostly related to the 2001 earthquakes. Comparing Table 3.7 and 3.4, it can be seen that in the last several years, external loans and grants have financed not only capital expenditures and capital transfers but also recurrent expenditures. 3.22 The vouchers are partly financed by external loans. They do not have a line item in the budget and are classified according to the destination of funds. If they are for the purchase of goods and services, they are included in current transfers; if they are to purchase capital goods they appear as capital transfers. The vouchers for Education Quality and school lunches are financed by local funds; all other vouchers are financed either by World Bank or IDB loans (Table 3.8). In 2003, of a total of US$ 31 million spent on the vouchers, the Government financed US$ 18 million (58 percent) and the World Bank and the IDB the remaining US$ 13 million (42 percent).

60 Ibid. 61 To determine the cost of maintenance, MINED did a pilot project and devise a formula that takes into account the type of construction, its age, and the number of students attended. The cost of an average classroom of 51.8 m2 (7.20mX7.20m) is US$ 15,000. The average cost of annual maintenance is US$ 200 or 1.3 percent of the cost of construction.

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Table 3.7 MINED’s Financing Sources, 1997-2003

( percent of total financing)

1996 1997 1998 1999 2000 2001 2002 2003 General Fund (Treasury) 99.5 91.9 86.6 93.1 81.1 79.5 87.5 83.2 External Loans 0.5 8.1 13.4 6.9 6.6 20.5 11.9 16.4 Grants 0.0 0.0 0.0 0.0 12.3 0.0 0.7 0.4 External Loans + Grants 0.5 8.1 13.4 6.9 18.9 20.5 12.6 16.8 Total 100 100 100 100 100 100 100 100 Source: Ministry of Finance

Table 3.8 Education Vouchers, by Source of Financing

Bono Financing Education Quality GOES/General Fund Development of Center for Education Resources –CRA World Bank School lunches FANTEL/GOES a/ “Fondo Alegría” World Bank Teacher Professional Development Plans World Bank Youth Fund World Bank Administrative Assistance World Bank Excellence (selected schools) World Bank Preventive Maintenance of Infrastructure World Bank/IDB a/ FANTEL is the fund that administers the proceeds of the privatization of the telecommunication Company FANTEL Source: Marques, José Silvério, “Costo Eficiencia de los Bonos Educativos”, Background paper prepared for the World Bank, processed, December 2002

IV. Expenditure Outcomes 3.23 Did the increase in MINED’s budget during the last several years resulted in higher enrolments? How has the decentralization of resources to the schools impact the efficiency of resource use? And how have the education systems perform in terms of quality? How have education expenditures impacted the different income groups? These and other related questions are discussed in the following paragraphs. Enrollments 3.24 Table 3.9 shows the evolution of gross enrollments for the 1996-2002 period. Gross enrollments compare the number of children enrolled in a specific level or grade with the school age population that correspond to it. Gross enrollments at national level have increased rapidly in the last several years. Enrollment in pre-primary education increased from 38 percent in 1996 and to 48 percent in 2002; for basic education, they increased from 95 percent in 1996 to 99.5 percent in 2002. Enrollments in rural areas have increased much more rapidly that in urban areas. This resulted from EDUCO, which focused on the most isolated, rural communities as well as from other MINED programs that gave priority to the rural areas where poverty was more pervasive and

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education enrollments were lower. For instance, the school lunch program focuses almost exclusively on rural areas. 3.25 Basic education gross enrollments in urban areas have declined continuously in recent years, from 96 percent in 1996 to 87 percent in 2001, though the absolute number of children in school has been increasing (Chart 3.4). This drop in the urban enrollment rate may result from a lack of supply of education facilities in fast growing peri-urban areas. For secondary education, gross enrollments at national level have increased from 34 percent to 40 percent between 1996 and 2002 (Table 3.9 and Chart 3.5). Most of the increase has been taking place in urban areas, as the supply of secondary education in rural areas is quite limited. Already in the 3rd cycle of basic education, gross enrollments in rural areas (59 percent) are much lower than in urban areas (about 90 percent), as many schools still do no offer this cycle. In recent years MINED has made a strong effort to extend the 3rd cycle to EDUCO schools, which is reflected in the significant increase in 3rd cycle coverage in rural areas (from 34 percent in 1996 to 59 percent in 2002), though enrollments still remains low by any standards.

Table 3. 9 Trends in Gross Enrollments, 1996-2002, by Area Gross Enrollment Rate

1996 1997 1998 1999 2000 2001 2002 National 70.5 73.4 72.1 73.3 73.7 75.2 77.6 Pre-primary 38.2 40.2 40.1 42.2 43.8 45.7 48.3 Basic 94.5 97.7 96.2 97 95.8 97.3 99.5 I and II Cycle 110.9 113.4 111.0 111.0 108.9 109.4 110 III Cycle 61.1 65.1 65.0 67.0 67.7 71.0 74.6 Secondary 34.3 37.0 34.5 35.3 38.3 38.1 40.2 Urban 77.1 77.9 74.8 75.1 74.4 73.6 N/a Pre-primary 40.8 41.3 40.2 41.8 42.7 43.0 44 Basic 96.1 96.0 92.8 92.1 88.8 87.4 N/a I and II Cycle 101.1 99.6 95.6 93.8 89.3 86.9 N/a III Cycle 80.2 88.8 87.0 88.5 87.7 88.8 N/a Secondary 61.6 66.0 61.2 63.1 67.7 65.9 N/a Rural 63.3 68.4 69.1 71.3 73.0 77.1 N/a Pre-primary 35.4 39.0 39.8 42.7 45.1 49.1 54 Basic 92.8 99.6 99.9 102.4 103.9 109.1 N/a I and II Cycle 121.0 127.9 127.6 130.9 132.0 137.6 N/a III Cycle 34.0 39.3 41.0 41.5 45.9 51.4 59 Secondary 3.2 3.8 3.9 3.1 4.1 5.4 7.0 Source: MINED

3.26 Increasing the enrollment in the 3rd cycle and secondary education is a major challenge facing the authorities. A recent study has estimated that to increase enrollment from 75 percent to 100 percent in the 3rd cycle and from 40 percent to 70 percent in secondary education, there was a need to increase the education budget by the equivalent of about two percentage points of GDP, or to 5 percent of GDP.62

62 See di Groppello, E. “El Salvador: Education Strategy Paper”, processed, World Bank, 2004.

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Chart 3.4: Gross Enrolments in Basic

Education Chart 3.5: Gross Enrolment Secondary

Education National Level

0 10 20 30 40 50 60 70 80

1996 1997 1998 1999 2000 2001 2002

Perc

enta

ge

Nati onal Urban Rural

70.0 75.0 80.0 85.0 90.0 95.0

100.0 105.0 110.0 115.0

1996 1997 1998 1999 2000 2001 2002

Perc

enta

ges

National Urban Rural

Source: Table 3.9

Table 3.10 Gross and Net Enrollment Rates, 2002

Gross Net Difference Total Urban Rural Total

Pre primary 48 44 54 Pre primary 48 I Cycle 126 89 176 I Cycle 126

II Cycle 93 79 110 II Cycle 93

III Cycle 75 89 59 III Cycle 75

Secondary 40 68 7 Secondary 40 Source: Enrollment Census (MINED)

Efficiency 3.27 The increase in retention of students in the system (or decline in dropout rates) indicate that the efficiency of the systems has improved in the last several years, though overage, repetition rates, and drop out rates remain high. Overage, that is children enrolled in grade for which the official age is lower, is a serious problem in El Salvador. It can be approximated by the difference between gross and net enrollment rates. As mentioned, gross enrollment rates are calculated by dividing the number of all students attending a particular level/grade by the number of children of the official age to attend that level/grade. Net enrollment rates consider in the numerator only the number of students with the official age to attend that particular level/grade. Thus, the difference between gross and net enrollment rates gives an estimate of the share of students in a particular level/grade that are under- or overaged. Table 3.10 shows that in the 1st cycle of basic education, 42 percent of the students have ages outside the official established range (7-9 years). It is reasonable to presume that most of these children are overaged and that the problem originates mainly in the rural areas given the registered high gross rates (176 percent). Overage may result from repetition or late entry in school. Children that are overaged in a particular grade take space and demand teacher time away from other children that could enter the system.

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Chart 3.6: Repetition Rates in Basic by Grades,

1996 - 2001

3.28 Repetition rates remain high in the first grade (about 16 percent) but decline rapidly for higher grades. For the 1996-2001 period, after a drop in 1999, repetition rates have increased for all grades of basic education (Chart 3.6). 3.29 Dropout rates remain a problem, particularly in the rural areas. Chart 3.7 and 3.8 shows dropout rates for primary education in urban and rural areas. It can be observed that these rates are still quite high for the first grade (about 17 percent and 9 percent in rural and urban areas,

respectively) and decline rapidly for grades 2 through 5. In rural areas, drop out rates increase again sharply for the 6th grade. Difficulties to pursue studies because of lack of facilities and/or demand constraints may explain this behavior. On the other hand, dropout rates have been declined since 1997 and at an accelerated pace for the 6th grade in rural areas. This may be a result of MINED effort to add the 3rd cycle to EDUCO schools and therefore giving rural students an opportunity to continue to pursue their studies near home.

0

5

10

15

20

1 2 3 4 5 6 Grades

Perc

enta

ges

1996 1997 1999 2000 2001

Source: Annual Census of Registration, MINED

Chart 3.7 Dropout rates in primary urban areas, by grade 1996 –01

Chart 3.8: Dropout rates in primary rural areas, by grade 1996 - 01

-

0 5

10 15 20 25 30 35

1 2 3 4 5 6 Grades

Perc

enta

ge

1996 1997 1999 2000 2001

0 5

10 15

1 2 3 4 5 6

Grades

Pere

cent

age

1996 1997 1999 2000 2001

Source: Annual Census of Registration, MINED

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3.30 Table 3.11 presents the result of an exercise to estimate the internal efficiency of the education system. It is based on the reconstructed analysis.63 It reveals that survival rates are only 65 percent at the end of primary education, 52 at the end of the third cycle, and 39 percent at the end of the second year of secondary. That is only about one-half of children that enter primary education completes the nine years of basic education. The estimates also indicate that the efficiency of the public and private sector are similar. The table shows that for completing primary, the public sector requires 7.6 and the private sector 7.7 years; for completing the 3rd cycle, the public sector requires 12.8 years and the private 12.2 years. It also indicates that on this measure, urban are more efficient than rural schools both in the case of public and private schools. 3.31 Several programs seek to reduce dropout, repetition and overage rates. Among these are the Healthy School program which provides healthcare in schools, a school lunch, and improved physical environmental in schools, with the objective of increasing student learning and retention rates and promote community participation in schools; Accelerated Education which seeks to reduce overage in basic schools by helping children with more than 2 years over the official age for the grade in which they are enrolled, to recuperate losses and get at par with the peers; and Alternative Classrooms which offers more than one grade in the same classroom in rural schools with low student population density; and scholarships for secondary and higher education, which encourages students to progress to higher levels of education (see paragraph 3.51). The World Bank supports the latter three programs. 3.32 How efficient is public education spending in general? As a first approximation, the expenditures and outcomes for similar education levels in El Salvador can be compared to other countries. Charts 3.9 and 3.10 relate per student spending on primary and secondary education (as percent of GDP per capita) and the net enrollment at these levels.64 The values are plotted for the most recent data available for a large sample of developing countries from the World Bank’s WDI database. Each Chart is divided in four segments determined by the average value of the sample. The segments identify countries with low spending and low outcomes (southwest); high spending and low outcomes (southeast); high spending and high outcomes (northeast); and low spending and high outcomes (northwest). The most cost efficient countries are those in the northeast segment; the worse cost efficient in the southwest segment. In the other two segments there is either low or high outcomes and spending. 3.33 In terms of primary education, El Salvador is situated in northwest segment which implies that with relatively low spending per student it gets a reasonable rate of net primary enrollment (more value for money). As for secondary education, El Salvador is in the southwest segment, which means that it spends too little per student but also has

63 A “school cohort” is defined as a group of pupils who join the first grade of a given cycle in the same school year, and subsequently experience the events of promotion, repetition, dropout or successful completion of the final grade. The reconstructed cohort method is used to analyze the internal efficiency of an education system. To apply this method, data on enrollment by grade for two consecutive years and on repeaters by grade from the first to second year are sufficient to enable the estimation of three main flow-rates: promotion, repetition and drop-out. 64 Notice that for El Salvador the data refers to basic education.

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low net enrollment. Therefore, El Salvador appears to be relatively efficient in terms of primary education while in secondary education, its situation does not reflect inefficiency but that this level has received low priority.

Table 3.11 Indicators of Educational Efficiency, by Area and Sector, 2002

Promotion Rate Repetition Rate Drop out Rate Survival Rate Years to Graduate

Primary 3rd Cycle 9th Primary 3rd Cycle 2sd Sec. Primary 3rd Cycle 9th 6th 9th 2sd Sec. Primary 3rd Cycle

Total 85.3 87.9 88.1 7.2 2.9 2.1 7.5 9.2 10.4 65.3 51.9 38.8 7.6 12.7

Urban Areas 91.2 97.1 114.5 6 3.2 2.1 2.8 -0.2 -16.2 76 73.1 70.9 7.1 10.5

Rural Areas 80.7 70.3 27.1 8.2 2.1 1.8 11.2 27.6 71.8 57.9 35.6 8.5 8.1 16.2

Public Sector 84.9 82.9 72.2 7.8 3 2.4 7.3 14.1 26.3 66 51.8 30.5 7.6 12.8

Public, Urban 91.7 91.6 98.2 7.2 3.3 2.4 1.2 5 0.1 81.2 80.3 64.8 6.9 10.1

Public, Rural 80.6 69.3 23.4 8.3 2.1 1.9 11.2 28.7 75.4 58 35.3 6.4 8.1 16.3

Private Sector 89.1 116.4 167.2 1.9 2.7 1.6 9.1 -19.1 -68.6 60.1 51.7 78.5 7.7 12.2

Private, Urban 89.6 117.8 172.3 1.7 2.8 1.7 8.7 -20.6 -73.7 60.7 52.4 80.4 7.7 12.1

Private, Rural 85.1 100.2 107.9 3.3 1.6 1.2 11.6 -1.7 -8.2 55 45.5 79.7 8.2 13.1 Note: Reconstructed Cohort analysis based on UNESCO framework and MINED data from the Enrollment Census, 2001 and 2002 Source: Marques, José Silvério “Policy Options to Increase Coverage in Upper Basic (3rd Cycle) and SecondaryEducation”, Background report prepared for the World Bank, August 2003

Chart 3.9 Relationship between Education Expenditures on Primary Education and Net Enrollments on

Primary Education

0

80

160

0 12 24Expenditure on primary educatrion per student as % GDP

percapita

Net

Prim

ary

Enro

lmen

t Rat

e

Chart 3.10 Relationship between Public Spending on Secondary Education and Net

Enrollment on Secondary Education

10

60

110

0 18 36Expenditures on secondary education per

GDP per

Net

Sec

onda

ry

Rat

e

El Salvador El Salvador

Chart 3.9: Relationship Education Exp. and Net Enrollment on Primary

Education

Chart 3.10: Relationship Public Spending and Net Enrolment on Secondary

Education Note: Most recent estimate circa 2000; Public expenditure peStudent (primary) is the public current spending on educadivided by the total number of students by level, as percenof GDP per capita; for El Salvador data corresponds to beducation. El Salvador coordinates: (9.9,84); Sample aver(12,80). WDI sample of 44 LDC countries. Source: Marques, José Silvério, El Salvador: Evaluation of Public Expenditure on Education and Health, processed, report prepared for the World Bank, June 2003, based on WDI

Note: Most recent estimate circa 2000; Public expenditure student (secondary) is the public current spending on educadivided by the total number of students by level, as percentage ofGDP per capita. El Salvador coordinates: (11.9,26); Sample avera(18, 60). WDI Sample of 37 LDC countries. Source: Marques, José S. ES: Evaluation of Public Expenditure on Education and Health, processed, report prepared for the WB, June 2003, based on WDI

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3.34 How cost-effective are the vouchers? Some vouchers seem to be cost-effective, though there are already too many vouchers. Currently, there are ten types of voucher being transferred to the schools. Nine are shown in Table 3.12. A new voucher created in 2004 (Gratuidad) will compensate the schools for the lost money given the decision of the National Assembly in late 2003 to prohibit the so-called “voluntary payments” or cuotas in public schools. All schools are eligible to receive the Professional Development (training) and Administrative Assistance vouchers. Basic education schools receive also the Fondo Alegria voucher and the secondary schools the Youth Fund voucher. These vouchers are to promote and finance extra curricular activities. In addition, rural schools receive a school lunch voucher. The CRA voucher is for secondary education to finance the purchase of technological-based teaching equipment. Finally the preventive maintenance voucher established in 2002 was only for a group of schools that were reconstructed/ rehabilitated with the support of IDB but in 2003 another group of schools also benefited from this voucher financed with funds from a World Bank loan. 3.35 An initial analysis of the cost-efficiency of the voucher system indicates that the voucher for Administrative Assistance to the schools and the voucher for Professional Development (teacher training) may be cost-efficient approaches.65 For several vouchers, it is not possible to determine their cost-efficiency because each voucher finances several activities, some of which are new activities. This applies for instance to the Quality of Education, CRA, Excellence, Youth and Alegria vouchers. The voucher for preventive maintenance could not be compared to previous expenditures made, since MINED did not allocate resources for this purpose and the little maintenance that took place was done by the school community for which records are not available. Nevertheless, the voucher for preventive maintenance is considered a sound investment, as it will prevent its premature reconstruction or replacement.66

3.36 The Professional Development (teacher training) voucher appears to be cost- efficient compared to the previous system of centralized teacher training. The cost per teacher is about one-third compared to the previous system and the number of teachers with access to training increased from one-half to the full teacher corp. While the quality under the two systems could not be evaluated, under the new system, schools and teachers with the support of a Pedagogic Advisor, decide what teacher training and therefore may be a better match between needs and the procurement of training.

65 See Marques, José Silvério “Costo Eficiencia de los Bonos Educativos”, processed, December 2002. 66 According to the World Bank (Western Java Education Project, Indonesia, Best Practices in Cost Benefit Analyses, World Bank, web page on Education) the expenditure on school maintenance should be equivalent to about 2 percent of the original cost of the facility. The existing maintenance voucher corresponds to about 1.2 percent of the cost of the facility.

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Table 3.12: Voucher Programs Under Execution

Secondary Education

Rural Urban Education Quality Education Quality Education Quality

Administrative Assistance Administrative Assistance Administrative Assistance Teacher Pr ofessional Development Plans

Teacher Professional Development Plans

Teacher Professional Development Plans

"Fondo Alegría" "Fondo Alegría" School lunches

Preventive Maintenance of Furniture and Infrastructure

Preventive Maintenance of Furniture and Infrastructure

Preventive Maintenance of Furniture and Infrastructure

Excellence (selected Excellence (selected Excellence (selected Gratuidad (2004) Gratuidad (2004) Gratuidad (2004)

Youth Fund Development o f Center for Education Resources - CRA

Basic Education

Source: Marques, Jose Silverio “Costo Eficiencia de los Bonos Educativos”, processed, December 2002 3.37 The Administrative Assistance voucher is also having a positive impact on the quality of school administration. Since the introduction of the voucher in 2001, the number of citations made by MINED’s Internal Auditor to the schools have declined significantly. 3.38 The administrative process of passing the voucher funds to the schools is cumbersome because of the large number of vouchers and the procedure to disburse the funds. Schools at the basic level receive at least 5 vouchers; if they are in rural areas, 6 vouchers. For each voucher each ACE/CDE director and treasurer must sign off a receipt before the funds are requested by the Departmental Office to the MINED-center; MINED-center in turn requests the Ministry of Finance the funds; when the funds are received, they are transferred to the Department Office and then to the school. It may take as much as three months for the schools to get the funds. Quality 3.39 The quality of the education system remains a major challenge. It can be assessed by the results of standard evaluation tests.67 MINED has conducted two types of tests: the achievement test for the 3rd, 4th, 6th and 9th graders of basic education, which was realized during 1994-1998 and the PAES that has been conducted to the secondary education leavers since 1997. The achievement test is conducted for a sample of schools and its results refer to the number of objectives met in each discipline of a total of 10 predetermined objectives per discipline. In contrast the PAES test is applied to the universe of students and its results are determined by reference to the group evaluated or

67 MINED does not realize any education tests that are comparable with other countries. This year, MINED plans to participate in a UNESCO’s regional education test-- the Latin American Education Evaluation Laboratory Program. The test will likely be conducted for the 6th graders.

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the so-called norm or curve (the highest score being 10 and the lowest 0). The results of both tests for the years they were conducted are shown in Tables 3.12 and 3.13.

Table 3.13: Achievement Tests for Basic Education, Average Scores (1994-98)

Discipline Grade 1994 1995 1996 1998 3° -- 3.8 3.9 5.4 4° -- -- 4 -- 6° -- -- 4.8 3.6 9° -- -- -- 2.9 3° -- 3.6 4 5.1 4° -- -- 2.2 -- 6° -- -- 3.6 3.5 9° -- -- -- 3.2 3° 1.9* 2.0* 1.9* 4.2 4° 1.7 -- 2.3 -- 6° -- -- 2.2 2.7 9° -- -- -- 2.4 3° 3.8 3.8 4 44° 2.5 -- 3.4 -- 6° -- -- 2.9 1.6 9° -- -- -- 1.1

Social Studies

Language

Mathematics

Science, Health

and Environment

Note: For each discipline 10 objectives were defined; scored indicate the number of objectives achieved--: Not evaluated; *: only nine objectives explored Source: MINED

3.40 Basic education test scores for the1994-98 period show a mix picture (Table 3.13). For 3rd graders there has been generally improvement in performance in all disciplines but for 6th graders, with exception of language, there has been deterioration. For the 4th and 9th graders, tests were conducted only in 1996 and 1998, respectively, so no trend can be derived from the data. 3.41 Secondary education test scores also show mixed results (Table 3.14). It can be observed that there is a marked break in the trend in 1999. There is an improvement in scores between 1997 and 1998 and some improvement in 2000 and 2001 relatively to 1999. There is no solid explanation for the break in 1999. Education authorities indicate that a drop of over one point in one year in average scores is not reasonable and that most likely the standards used in 1999 were different from those used in previous years and feel more confident in the consistency of the scores of the last three years. In terms of disciplines, social sciences had the highest score in 2001 with mathematics registering the greatest improvement since 1999.

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Table 3.14: PAES’s Average Scores by Discipline, 1997 – 2001 a/

199 199 199 200 200Overall National Average 6.2 6.4 5 5.1 5.2Social Sciences 6.6 6.6 5.7 5.2 5.3Language 6 6.6 4.5 5.2 5.2Mathematics 5.8 5.7 5 4.8 5.2Science, Health and Environment 6.1 6.6 5 5 5.2

a/ Score from a s ale of 0 to 10. cSource: MINED. 3.42 MINED changed the student evaluation system in 2001. The Basic Achievement tests for the 3rd, 6th, 9th graders and the PAES were integrated in a consistent system. Both tests are now based on minimum standards of achievement with pre-established criteria. Scores are based on a continuous scale, ranging from 300 points for the bottom of the third grade test to 1900 for the top secondary test. Tests for each grade are divided in three levels. For instance, for the 3rd grader, scores from 300 to 450 are considered “basic achievement”; from 451 to 600 “intermediate achievement”; and from 6001 to 700 “superior achievement”. The tests scores for 6th, 9th, and secondary school leavers are divided in a similar manner. 3.43 In 2001, MINED conducted the new test for the 3rd, 6th and 9th graders; in 2002 the PAES for the secondary school leavers. The results of the tests are not comparable to previous tests but convey similar messages. For basic education, the average score in all disciplines was within the “intermediate achievement” range; mathematics had the lowest score in the 6th and 9th grades; private schools performed better than public schools, and urban schools better than rural schools. As for the PAES, the results of the 2002 test shows also overall scores at the “intermediate achievement” level, with language rating the highest score. Private schools did better than public in all disciplines with mathematics ranking lower than other disciplines in both sectors. Boys ranked better than girls but not by much 3.44 To improve the quality of the education system a recent study suggests the need to: i) increase the investment in didactic material, labs, libraries; ii) improve school management; iii) improve teacher performance and teaching methods; iv) institutionalize and disseminate in a more effective wage the education achievement scores; v) give more emphasis to reading and writing in the curriculum of the first three grades; and v) re-orient EDUCO model towards high quality learning.68 Expenditure Incidence 3.45 How are public education expenditure distributed among income groups? Do public expenditures benefit the poor or the better off? How accessible and affordable is the public education system? Are there gender issues in the education system? These are some of the questions discussed below. 68 See di Gropello, E., “El Salvador: Education Strategy Paper”, processed, World Bank, 2004,

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Access and affordability 3.46 Education coverage is still low at the pre-primary and secondary levels. Even in basic education, a significant number of children do not attend school. Despite the rapid increase in enrollment, 52 percent of children of o pre-primary education age (4-6 years), 8 percent of children of primary education age (7-12), 20 percent of children of 3rd cycle education age ( 13-15 years), and 44 percent of young adults of secondary education age (16-18 years) are out of schools. Most of these children are from poor households. 69

3.47 A large share of Salvadoran youth does not attend school because they cannot afford. Basic education in public schools is in principle free of charge. In practice, students have not only implicit costs such as time that is not dedicate to work, but also direct costs with transportation, materials and contributions to the different school activities. Until recently, school directors frequently asked parents to contribute with a payment (cuotas) to help finance school spending. In some cases, parents even paid the salary of the teachers until MINED could assign teachers to the school. In other cases, parents would contribute to school maintenance, purchase of equipment or materials, or to finance extra-curricular activities. As mentioned, in late 2003, the National Assembly prohibited schools to ask parents for cuotas and MINED is transferring additional resources to schools (bono de gratuidad ) to compensate partly for this loss of financing. 3.48 As for public secondary schools, students are charged a monthly tuition that varies between US$1 to US$15. The amount of the tuition is determined by the School Councils. Low-income students may be totally or partially exempt. Students in the technical/vocational education track usually pay higher fees than those in the academic track. 3.49 When asked in the 2002 Household Survey why they did not attend school, 40 percent of the youth give as reasons either because it is too expensive, need to work, need to work at home, of family reasons which are directly or indirectly associated with affordability (Table 3.15). The percentage of youth giving these money-related reasons for not attending school increases very rapidly with the age of the cohorts: for those in upper basic and secondary education age group, they reach 48percent and 64percent, respectively. The magnitudes and pattern is similar between urban and rural areas.

69 See Marques, José Silvério, El Salvador: Evaluation of Public Expenditure on Education and Health, processed, report prepared for the World Bank, June 2003

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Table 3.15: Reasons for not attending school, by area, 2002 (% of school age children, 4-18 years)

Source: Household survey data.

Years Too Expensive

Needs to work

Domestic works

Family reasons Sum 1-4

No School nearby or no available Place

School damaged by earthquakes Sum 6-7

Parents do not want

Does not want; It is not interested Other Total

1 2 3 4 5 6 7 8 9 10 11 12 Total 20.5 9.8 3.7 4.2 38.2 2.9 0.1 3 10.8 17 31 100 4 - 6 13.6 0 0 0.6 14.3 2.9 0.3 3.2 19.8 2 60.7 100 7 - 12 36.9 1.8 0.6 4.7 44.1 6.3 0 6.3 12.5 20 17 100 13 - 15 25.4 12.5 5 5 48 2.4 0 2.5 3.9 34.7 10.9 100 16 - 18 19.7 25.7 9.6 8.5 63.5 1.4 0 1.4 0.9 27.4 6.8 100 Urban 20.1 10.8 3. 3 4.7 38.9 1.6 0.2 1.8 10.4 13.6 35.3 100 4 - 6 14.8 0 0 0.8 15.5 1.6 0.4 2.1 19.1 1.5 61.7 100 7 - 12 38.5 0.8 0.2 5.4 44.9 5.1 0.1 5.2 11.8 15.9 22.2 100 13 - 15 26.7 12.6 2 5.8 47.1 1.5 0 1.5 2 32.1 17.3 100 16 - 18 18.7 29.5 10 9.7 67.9 0.2 0 0.2 0.2 23.4 8.3 100 Rural 20.8 9.1 3.9 3.9 37.7 3.7 0.1 3.8 11.1 19 28.4 100 4 - 6 12.7 0.1 0 0.5 13.3 3.9 0.2 4.1 20.3 2.3 60 100 7 - 12 36.3 2.3 0.8 4.5 43.8 6.8 0 6.8 12.8 21. 8 14.8 100 13 - 15 24.9 12.5 6.3 4.6 48.3 2.9 0.1 2.9 4.8 35.8 8.1 100 16 - 18 20.3 23.2 9.4 7.8 60.7 2.2 0.1 2.3 1.3 30 5.7 100

3.50 School availability is not a major reason for not attending school: only 3 percent of the youth give as reason for not attending school that there is “no school nearby or no space available”, with the percentage being somewhat higher in rural areas compared to urban areas, as expected (3.8 percent versus 1.8 percent). The percentage of youth in the 3rd cycle and secondary education age giving this latter justification is lower than for primary age group. This is surprising in view of the apparent lack of public infrastructure at these levels, though it may be that other reasons such as cost overshadow the school availability factor. The unavailability of schools owing to the 2001 earthquakes is not anymore a significant reason for not attending school, which is consistent with the successful reconstruction effort mentioned earlier. 3.51 About one-third of children age 13-15 years (3rd cycle age group) give “lack of interest” as the reason for not attending school. Why so many youth have such little interest in studying? A recent study by the World Bank shed some light on this issue.70 It has estimated the private rate of return to one year of additional education for different levels. The estimates indicate the value of one additional year of schooling depends crucially upon the level of schooling. For primary education, the return is close to 7 percent while for the 3rd cycle is only 4.2 percent. In contrast, for secondary education the return increases to 11 percent and is even higher for higher education. The study concludes that without public intervention, progress is unlikely to be forthcoming rapidly in increasing coverage of 3rd cycle and secondary education.

70 World Bank, El Salvador Country Economic Memorandum, Report No.26238, 2003, Chapter VI, Volume II.

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3.52 Existing public programs to reduce the demand constraints facing the poor have a limited impact. There are three scholarships program: 1) the FATEL scholarships for higher education studies in El Salvador or abroad which are financed with resources from the privatization of the telecommunication company ANTEL; it awards about 200 scholarships a year; 2) the Rodriguez Porth scholarships for low income/ high achievers secondary graduates that finances about 80 scholarships a year;71 and 3) the secondary education scholarships financed with the support of a World Bank loan that awarded about 500 scholarships in 2003. Gender 3.53 Equity of gender does not seem to be a major issue anymore in the education sector. Household survey data indicate that though 22 percent of women had no schooling compared to 20 percent of men in 2001, for girls age 6-14 years, 31 percent had no schooling compared to 32 percent of boys of the same age. Also, the same proportion of man and women, 21.4 percent, had completed the first 6 grades of schooling in 2001. Distribution of Resources by Income Group 3.54 Public education spending is progressive for pre-primary and basic education. At these levels, MINED spends more on the poorest income groups (lower income quintiles) than on the richest income groups (Chart 3.11). At secondary and tertiary levels, spending favors the richest groups (upper income quintiles), given the low enrollment rates of the poor at these levels.

0 10 20 30 40 50 60

Pre - Primary Basic Secondary Tertiary Total

Perc

enta

ge

1st Q 2nd Q 3th Q 4th Q 5th Q

Chart 3.11: Share of Public Education Expenditure by Quintile and Level, 2002

Source: Household Survey and MINED

71 The Presidency of the Republic also gives Excellence Awards (US$ 114 per student) to the 500 most outstanding basic education students

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3.55 The progressively of spending at the basic level is reflected on education outcomes, both in enrollment and years of schooling. Household survey data shows that during the last several years, net basic education enrollments of the poorest quintiles has increased faster than for the richest quintiles, albeit from a lower based. Net enrollment in basic education for the first and second quintiles increased by 14 percentage points between 1991 and 2002, while for the 5th quintile it increase by 6 percentage points (Chart 3.12). Also, the average number of years of schooling increased significantly since 1995. For children 15 years in 2002 in the lowest quintiles the increase was over one year; for children in the highest quintiles the increase was visibly smaller (Chart 3.13).

Chart 3.12; Net Enrolment in Basic Education Quintile

64.5 69.2

86.1 70.8

76.4 87.8

75.2 81.6

90.8 78

83.1 92

50 60 70 80 90

100

1st Q 2nd Q 5th Q 1991 1995 2000 2002

Source: World Bank Staff estimates based on household surveys

Chart 3.13: Average Years of Schooling for 15 Year Olds

4

5

6

7

8

1 2 3 4 5

Income

Year

s of

sch

oolin

g

1995 2002

Source: Household survey

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Geographic distribution of resources 3.56 The analysis of the distribution of MINED resources by department indicate that there is not a bias towards the departments with higher per capita income. Chart 3.14 shows no relationship between public education spending per student enrolled in basic education and the per capita income of the departments. For secondary education, there seems to be a negative tendency, that is poorest department receive relatively higher allocations from MINED.72

Chart 3.14: Pop. Income and MINED Spending in Basic Education by Department (2000)

Note: Includes only recurrent spending. Coeficient of Correlation= –0.006; R2= 0.00004.

140 160 180 200 220 240 260

20 70 120 170 Percapita Departamental Income (US$/month)

Educ

atio

n Sp

endi

ng

per S

tude

nt E

nrol

led

(U

S$/y

ear)

Education Spending per student Logarítmica (Education Spending per student)

Source: Marques, José Silvério, El Salvador: Evaluation of Public Expenditure on Education and Health, processed, report prepared for the World Bank, June 2003, MINED and Household Survey

V. Conclusions and Recommendations 3.57 As a result of a broad-based consensus, there has been a substantial increase in the amount of public resources allocated to education during the 1990s, in support of the implementation of the Education Development Plan 1995-2005, which contributed to major improvements in the sector. The recent study on the situation of El Salvador in relation to the MDGs prepared under the direction of the Presidential Commissioner for Social Affairs with the participation of several sectors, concludes that it is likely that the country meets the MDGs 2015 targets on net primary education enrollment (100 percent) and the share of students that complete the firth grade (100 percent), and it is very likely that it meets the universal literacy target for youth (15-24 years). The targets related to 72 See Marques, José Silvério, El Salvador: Evaluation of Public Expenditure on Education and Health, processed, report prepared for the World Bank, June 2003

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gender in education (equal share of girls and boys in primary and secondary education and the male and female youth literacy rates) have already been met.73 3.58 The new President’s Government Plan —Safe Country, 2004-2009, calls for the development and implementation of a new National Education Plan for 2006-2021, which can also command a broad-based consensus and that will serve “as a renewed vision for sector development”. This plan may take into consideration the challenges identified in the previous analysis: low coverage at pre-primary, 3rd cycle of basic and secondary education; declining but still high rates of dropout, repetition, and overage in basic education; and general low academic achievement. Allocation of resources to the sector 3.59 The sector will need more resources to be able to increase enrollments and improve the quality of education. Public education spending has increased significantly during the 1990s to 3.3 percent of GDP in 2002. However, in the last two years it has declined, with the proposed budget for 2004 at only 3 percent of GDP, well below the 4.4 percent of GDP average for LAC. Spending per student is also much lower in El Salvador than in LAC or Costa Rica. 3.60 Enrollment in 3rd cycle and secondary education are still quite low and should increase. Many low-income students do not attend school at these levels. To reach coverage rates of 100 percent in the 3rd cycle and 70 percent in secondary, it has been estimated that the education budget would need to increase by about two percentage points of GDP, or to 5 percent of GDP. On the other hand, to achieve the required quality improvements at all levels, it will necessitate a comprehensive approach that includes increased investment in education resources and improved school management and teacher performance. Intra-sectoral allocation of resources 3.61 As suggested, incremental resources allocated to the sector should favor the 3rd cycle and secondary education. Primary education absorbs the bulk of the education budget and very little resources are assigned to secondary education. Additional resources assigned to the sector may preferably be allocated to increase enrollments at those levels but without disregarding the objectives of ensuring universal enrollment at primary level and gradually strengthening pre-primary education, as well as increasing the quality of education. Increasing coverage at cost of quality of education will be a disservice to all students. 3.62 The increase in the quality of education requires that an appropriate balance is established between expenditures on wages and salaries, teacher training, didactic materials and other goods and services, and infrastructure. The functional composition of the expenditures has improved in recent years: wages and salaries’ share of the education budget has declined as a result of a teacher early retirement plan, while expenditure of 73 “El Salvador: Avance de los Objetivos de Desarrollo del Milenio- Primer Informe de País”, 2004.

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goods and services has tended to increase. Teacher salaries are quite competitive, and there are incentives for teachers to move to rural areas and to improve performance. However, school infrastructure construction and maintenance continues to be a challenge. There is a need to strengthen the programs of school construction and rehabilitation, particularly where there appears to be undersupply (peri-urban areas) and develop public/private partnership to exploit private sector excess capacity in urban areas. Efficiency and equity of resource use 3.63 Although there has been progress in recent years, there is still ample room to increase the efficiency of the education system. Overage, repetition rates, and drop out rates remain high, and programs directed at addressing these problems should continue to be supported. Efficiency of spending appears to be adequate compared with other developing countries. El Salvador appears to be getting the value for the money in basic education but it spends too little in secondary education. 3.64 The decentralization of spending has empowered the schools and it should continue, though a more streamlined process of transferring resources to schools is needed. An initial analysis of the cost-efficiency of the voucher system indicates that the voucher for Administrative Assistance to the schools and the voucher for Professional Development (teacher training) may be cost-efficient approaches. Nevertheless, administrative process to transfer these resources to schools is cumbersome, in part because of the sheer number of vouchers involved and the controls established on them. In 2003 MINED introduced some simplification to the procedure to transfer the vouchers, but a more bold approach may be warranted, such as unifying the vouchers in a school budget that would support the implementation of the Proyecto Educacional Institucional, including school performance indicators. 3.65 Programs to remove demand side constrains need to be strengthened. In general, public education spending is progressive and the average number of years of schooling has increase significantly more for the lowest income groups since the mid-1990s. Nevertheless, many low-income children do not attend school because they cannot afford it and existing programs including scholarship programs have very limited impact. Recommendations: 3.66 The above conclusions suggests that there is a need to consider the following:

• Increase the budget resources assigned to the sector gradually to 5 percent of GDP over the next several years to finance the expansion of 3rd cycle and secondary education for lowest income students.

• Continue to pursue a composition of spending that favors the purchase of goods and services for the schools while ensuring the teacher salaries remain competitive and performance based.

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• Strengthen the programs of school construction and rehabilitation, particularly where there appears to be undersupply (peri-urban areas) and develop public/private partnership to exploit private sector excess capacity in urban areas.

• Consider unifying the vouchers in a school budget that would support the implementation of the Proyecto Educacional Institucional including school performance indicators.

• Invest in scholarships and other programs to reduce the demand constraints facing poor children and young adults.

• Improve the efficiency of spending by strengthening the programs to reduce overage, repetition and dropouts rates.

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CHAPTER IV: Health 4.1 The evaluation of health spending that follows focuses mostly on the Ministry of Public Health and Social Assistance (MSPAS). MSPAS has the responsibility for sector policy and for providing primary healthcare and hospital care in its network of health facilities, to those Salvadorans that are not covered by medical insurance, who are the majority of poor. After reviewing the organization of the sector, the government’s sector objectives, and the process of allocation of public resources, recent trends in public expenditures and sector outcomes are discussed. The chapter concludes with the identification of the sector’s key expenditure issues and recommendations.

I. Organization of the Sector 4.2 The health sector in El Salvador comprises the MSPAS, the Salvadoran Social Security Institute (ISSS), the military health facilities, the private sector and over 30 ONGs that provide mostly primary healthcare services. Total health spending has been distributed as follows: 22.1 percent MSPAS; 18.4 percent ISSS; 56 percent household out of pocket expenditures; 2.4 percent private insurance; and 0.2 percent ONGs.74 ISSS is financed by payroll taxes and caters to formal sector employees and their families covering about one million people (17 percent of total population); MSPAS is financed from government revenue and external loans and grants. 4.3 MSPAS has 30 hospitals (27 general hospitals and 3 specialized hospitals), 365 health centers, 168 health clinics (casas de salud), and 47 rural health and nutrition centers; the ISSS 16 hospitals, 70 health centers and 170 enterprise clinics; the military three hospitals; and the private sector, 36 hospitals. ISSS rents several MSPAS facilities including a full hospital (Hospital de Especialidades) in San Salvador.75 4.4 The public health infrastructure was severely damaged by the 2001 earthquakes. The first earthquake on January 13, left two MSPAS hospitals severely damaged and another six hospitals partially damaged, requiring full or partial evacuation. The most badly damaged hospitals continued to operate under provisional structures, while the rest reduced their operations. Altogether, about one-thirds of MSPAS health facilities were

74 Institutional Development Strategic Plan, MSPAS, October 2001 75 The Hospital de Especialidades (or Specialty Hospital) was built after the 1986 earthquakes with a grant from France. It was to replace the Rosales Hospital that was severely damaged by the earthquake. The authorities decided not to close the Rosales and since MSPAS had no resources to operate both hospitals, it decided to rent the Hospital de Especialidades to ISSS. The proceeds from the rent (US$ 2 million a year) go to the Treasury. Since the 2001 earthquakes, there has been reportedly negotiations to terminated this arrangement and return the hospital to the MSPAS.

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affected. The second quake on February 13, left more than 2,00076 hospital beds out of service, which compares to the 4,843 MSPAS hospital beds in 2000. The Government’s ongoing earthquake reconstruction program is supported by the IDB, the Central American Bank for Economic Integration (CABEI), Japan and the World Bank.77

II. Strategic Objectives and Resource Allocation Process 4.5 In contrast to the education sector, there has been no broad based consensus on the direction of the health sector reform, though in recent months there have been some positive development in this respect. During the 1990s, there were several proposals to reform the sector that did not prosper. In 2000, a Presidential Commission for the Health Sector Reform produce a diagnostic of the sector and some guidelines for sector reform78 but fail to reach agreement on key issues such as those related to sector financing. In September 2003, the President of the Republic appointed a Commission to Follow Up the Reform of the Health Sector, which has organized five “discussion” groups (financing, human resources, organization, social participation, and legal issues) that are currently working to reach a consensus on the direction of the reform. Reportedly some progress has been made in these discussions, which the new government is actively supporting. 4.6 Historically, hospitals in the major urban centers and particularly in the capital city of San Salvador absorbed the bulk of public health resources in detriment of primary healthcare and the rural areas, where most of the poor live. During the 1990s, MSPAS sought to improve healthcare services in rural areas by expanding infrastructure, hiring health promoters, and training midwives. While progress was made, especially in terms of infant mortality rates, problems remain: many families still do not have access to health services; the presence of a MSPAS promoters in the communities had little o no impact and the demand for health care by the poor; and MSPAS providers were considered of low quality, in part because of the low and irregular availability of and long waits for medication.79

4.7 MSPAS’ Institutional Development Strategic Plan of October 2001 seeks to address these problems by changing the organization and delivery of health services through: i) a community-based approach to primary care provision; ii) a functional planning approach that specifies the functions (such as the projected volume of

76 For estimates of the damage, Earthquake Emergency Reconstruction and Health Services Extension, Project Appraisal Report, World Bank, page 3; for number of existing hospital beds, Institutional Development Strategic Plan, MSPAS, October 2001. 77 On June 3, 2003 the National Assembly approved the World Bank loan to finance the “Earthquake Emergency Reconstruction and Health Services Extension Project” for US$ 142.6 million. 78 The agree principles are: Consolidate a National Health System; consolidate a attention model based on the promotion, prevention and primary health care; consolidate a mixed provision model (public and private); consolidate a model under the direction of the MSPAS; institutionalize social participation and decentralization as transversal systems; invest in human resources for health; strengthen intersectoral coordination; and guarantee basic services to all Salvadorans. 79 See Earthquake Emergency Reconstruction and Health Service Extension Project, Project Appraisal Document (Report NO. 22626-ES), October 31, 2001.

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procedures, equipment requirements, patient flows, service definition, numbers and categories of staff, and inter-hospital referrals) that will take place in the health facilities; and iii) closer ties between hospitals and primary care providers by decentralizing a subset of management functions, improving the referral system, and raising quality of care.80

4.8 The cornerstone of the Plan is the establishment of Basic Systems of Integral Health Attention (SIBASI) or health district units, which would replaced the Departmental management units, and the introduction of a new model of health service management in which the financing and the provision of services may be performed by different institutions. The SIBASI would be the basic operative structure of the reformed public health service. MSPAS will continue to have the responsibility for the financing but the provision of services may be done by NGO, the private sector, etc. In addition, the Strategic Plan calls for developing and implementing performance agreements and contracts and an incentive scheme to make health providers accountable to both the MSPAS and service users and introducing community participation in basic health and nutrition service delivery.81

4.9 MSPAS has established 28 SIBASI and has prepared the operational protocols. The purpose is to provide integral services to the population through the coordination of primary healthcare and general hospital care in the delimited geographic areas under the responsibility of each SIBASI. Within the SIBASI area, a network of health providers and a general hospital will work in a coordinated manner, avoiding duplicity of efforts, and referring cases to the three specialized hospitals in San Salvador, through a National Reference Center. The impact of the health providers’ work on the health status of the population under their responsibility will be monitored. The management functions related to planning of activities, provision of services and decisions concerning human, technological, and financial matters are being transferred to the SIBASI. Each SIBASI has a Managing Committee, which is advised by a Social Consultation Committee. The Managing Committee comprises representatives of the SIBASI’s health providers and the SIBASI manager. Technical, financial and administrative teams support the manager. The SIBASI health providers include ONGs, the ISSS, the MSPAS, the private sector and others. The organizational development of the 28 SIBASI varies. In some SIBASI there is already a strong NGO presence, in others the organization is still incipient. 4.10 USAID has been supporting the organization of seven SIBASI since 2002 covering about 20 percent of the total population of El Salvador and comprising 27 percent of all the health facilities in the country. These SIBASI are located in La Paz, Suchitoto, Cojutepeque, Usulután, San Miguel, San Vicente and Jiquilisco. According to USAID, the assistance provided is helping strengthen the decentralization process and reinforce the new managerial systems. 4.11 The World Bank’s Earthquake Emergency Reconstruction and Health Service Extension Project plans also to support ten SIBASI, seven covering 73 municipalities in 80 Ibid 81 “SIBASI: Marco Conceptual y Operacional”, version revisada, MSPAS, 2001.

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the northern part of the country where MASPA reach is limited and three other SIBASI in the central part of the country most affected by the 2001 earthquakes, where MASPS primary healthcare infrastructure will be strengthened. For the former seven SIBASI, the project will finance the contracting of NGOs by the SIBASI to delivery a basic healthcare package to between 8,000-10,000 people per NGOs; in the latter three SIBASI, the project will negotiate a performance agreement with each SIBASI which will receive financing to strengthen its primary health care activities. It is expected that after three years, MSPAS will gradually begin absorbing the costs of these operations. 4.12 Traditionally, the budgets of MSPAS and its hospitals have been prepared on the basis of historical (incremental) allocations. MSPAS’ hospitals have administrative and financial autonomy and manage their own budgets. MSPAS managed primary healthcare and other public health programs in a highly centralized manner. Departmental offices or health centers had virtually no decision-making capacity over any of the budgeted resources. Staffing and procurement decisions were taken at the center. The establishment of the SIBASI system involves profound changes in the resource allocation process. In 2003, the MSPAS began transferring the management of resources of primary healthcare to the SIBASI. Two major problems arose. First, the criteria to allocated resources to the SIBASI for the first level of attention (primary healthcare) were not clearly defined and the distribution of resources was made again on the basis of historical allocations. The allocation of resources based on an agreed performance contract has still not be established. 4.13 Secondly, since the SIBASI did not have legal status, MSPAS decided to use the general hospital budgets as the legal and administrative vehicle to make the transfers of funds to the SIBASI. The general hospitals created a new budget line for the resources assigned to primary healthcare in their SIBASI. This created a potential conflict between the SIBASI manager and the director of the general hospital because while the SIBASI manager is responsible for all health matters in his area including the care provided by the general hospital, the hospital directors is responsible to the Controller of the Republic (Cuerte de Cuentas) for the resources assigned to the hospital including those assigned for the SIBASI primary healthcare activities. To address this conflict MSPAS has appointed managers in many SIBASI that also accumulate the function of hospital director for administrative purposes; these hospitals have also retained a technical director. In some other SIBASI the hospital directors were appointed as SIBASI managers. This arrangement is unsatisfactory because the hospital should be another element of the SIBASI’s service network; having the financing going through the hospital and having the director of the hospital accumulating functions as director of the SIBASI may created conflicts in terms of allocation of funds and accountability. In this respect, concerns have been expressed over the possibility that funds assigned to the SIBASI for primary healthcare would be diverted to general hospital use, and that expenditures on health prevention would decline. Again, the disbursement of resources against agreed outcome could help overcome some of these problems.

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III. Expenditure Trends and Structure 4.14 El Salvador is among the countries in Latin America that spends more in health. World Bank (WDI) reports El Salvador’s total health spending at 8.8 percent of GDP in 2002 (3.8 percent public spending and 5 percent private spending), above Costa Rica (6.4 percent) and the average for Latin America and the Caribbean (LAC) (7 percent). While El Salvador’s public sector spends (as percent of GDP) less than Costa Rica’s, its private spending is more than twice Costa Rica’s. El Salvador’s public and private health spending are higher than the average for LAC.

Chart 4.1: Total Health Expenditures as

percent of GDP, 2000

0.0

5.0

10.0

% o

f GD

P

Private Public Total

Private 5.0 2.0 3.7 Public 3.8 4.4 3.3 Total 8.8 6.4 7.0

El Salvador Costa Rica Latin America &

Note: Total health expenditure is the sum of public and private health expenditures. It covers the provision of health services (preventive and curative), family planning activities, nutrition activities, and emergency aid designated for health but does not include provision of water and sanitation. Private expenditure includes out-of-pocket and private health insurance plans. Source: World Bank, WDI

4.15 Given El Salvador’s low GDP per capita, its total health spending per capita is much lower than Costa Rica or LAC, however.82 Table 4.1 shows that in 2000, Costa Rica and LAC spent 52 and 42 percent more on a per capita basis than El Salvador. Since public spending in El Salvador is much lower than Costa Rica, per capita public spending is just a fraction of that country, which impact on the coverage and quality of public health services, particularly of the poor.

82 In 2000, WDI shows total population of El Salvador and Costa Rica at 6.3 million and 3.8 millions, respectively; El Salvador GDP at US$ 11 billion and Costa Rica GDP at US$ 14 billion (in 1995 US$); and per capita GDP in El Salvador, Costa Rica and LAC at US$ 1,752, US$ 3,912 and US$ 3,856, respectively (all in 1995 US$)

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Table 4.1: Total Health Expenditure Per

capita, 1996 – 2000 (Current US$)

1996 1998 2000 El Salvador 135 164 184 Costa Rica 200 236 279 LAC 260 265 262 Note: See definition of total health expenditure in Chart 4.2 Source:World Bank, WDI

4.16 MSPAS estimates total health spending at 8 percent of GDP in 2001, a figure somewhat lower than the one reported by the World Bank for 2000. Of total health spending, 46 percent was financed by public sources, namely the treasury, 47.4 percent, the ISSS, 44.5 percent, external donors, 2 percent, and other sources for 6.1 percent (Table 4.2).

Table 4.2: Public and Private Health Spending and Sources of Financing

1996 1998 2001

Total Spending % GDP 7.6 8.3 8.0 Public Spending % of Total 41.0 42.5 46.4 Central Government Financing, % pubic spending 44.6 47.1 47.4 ISSS, % public spending 42.9 41.7 44.5 External resources, % public spending 11.9 6.8 2.0 Other, % public spending a/ 0.6 4.4 6.1 Private Spending % of Total 59.0 57.5 53.6 Private Insurance % private spending 2.0 3.3 2.6 Out-of- Pocket, % private spending b/ 97.7 96.7 97.4

a/ Includes mostly the "own resources" of the hospitals and other public facilities, paid by the patients or their institutions (i.e., Teachers Health Program).a/ Excludes co-payment in MSPAS facilities Source: Cuentas Nacionales en Salud, MSPAS, mayo 2003.

4.17 MSPAS budget in relation to GDP has remained relatively constant in recent years hovering around 1.6 percent; as a share of the Central Government budget it has increased from 7.8 percent in 1996 to 9.7 percent in 2003, or by about two percentage points (Chart 4.2). For 2004, the proposed MSPAS budget is equivalent to 1.6 percent of GDP and to 9 percent of the Central Government budget.83

83 The World Health Report (2002) shows that health expenditures by the General Government, which includes the Ministry of Health and other autonomous public institutions such as the social security, as a percentage of total General Government expenditures was much higher in El Salvador that other Central America Countries in 2002: El Salvador, 26.2 percent; Honduras, 18.3 percent; Costa Rica, 18.2 percent; and Guatemala, 16.4 percent.

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Chart 4.2: MSPAS Budget as percent of Total Budget and

GDP 1996 - 2004

0 2 4 6 8

10 Pe

rcen

tage

% of Total Budget 7.8 8.3 8.7 9.4 9.4 9.0 9.5 9.7 9.0 % of GDP 1.5 1.3 1.5 1.5 1.6 1.7 1.7 1.6 1.6

1996 1997 1998 1999 2000 2001 2002 2003 2004

Source: Ministry of Finance (1996-2001: executed budget; for 2002-2003, approved budgets; for 2004, proposed budget).

Spending by Level and Function 4.18 Traditionally, MSPAS has classified healthcare in three levels: Level I or primary healthcare; Level II or general hospital care; and Level III or specialized hospital care. Chart 4.3 presents the distribution of MSPAS approved budget for these levels of attention, for administration, and “other” expenditures that include transfers to other entities and investment expenditures. The bulk of MSPAS resources continued to be allocated to hospital care (57 percent on average during the 1996-2003 period), with the share going to hospitals declining marginally since 1997. In contrast, primary health care participation in MSPAS budget has declined from a peak of 34 percent in 2000 to 29.6 percent in 2003. Since the MSPAS budget as a share of the GDP has remained relatively constant, this implies that public primary healthcare spending as a proportion of GDP has decline in recent years, certainly a worrisome development. According to the MSPAS, the amount budgeted for administration has declined from 6.6 percent of total spending in 1996 to 4.7 percent in 2003. The item “other”, which includes investment related to the earthquake reconstruction, has doubled its share in the total budget from 6.6 percent in 1996 to 12.4 percent in 2003.

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Chart 4.3: MSPAS Expenditures by Level of Attention & Administration

(1996 – 2003)

0 5

10 15 20 25 30 35 40 45

% o

f Tot

al E

xpen

ditu

res

Primary healthcare General hospitals Specialized hospitals Administration Other

Primary healthcare 27.1 33.5 30.6 32.7 34.4 30.9 29.6 29.6 General hospitals 41.1 37.1 38.8 38.8 38.1 38.9 37.4 36.0 Specialized hospitals 19.4 18.9 19.6 18.9 18.1 18.8 18.1 17.2 Administration 6.6 6.0 5.5 5.4 5.2 5.1 4.7 4.7 Other 5.8 4.6 5.4 4.2 4.1 6.3 10.3 12.4

1996 1997 1998 1999 2000 2001 2002 2003

Note: Refers to approved budget. Primary healthcare includes level I (public health and primary care in health units); general hospital care includes level II; specialized hospitals includes level III. Administration spending refers only to that incurred by MSPAS-center. Other includes transfers to other entities and investment expenditures. Source: MSPAS

4.19 Table 4.3 shows MSPAS executed budget by major economic category for the 1996-2003 period. It reveals the impact of MSPAS transfers to the SIBASI. In 2003, 86 percent of the MSPAS budget was transferred to the specialized hospitals and to the SIBASI (for primary health care and general hospitals). MSPAS-center retained 14 percent of the total budget (about US$33 million) of which 3.4 percent were for wages and salaries and the remainder for goods and services, which still are procured centrally84, and for investment expenditures. In the near future, as MSPAS-center focuses on the functions of policy making and regulations and the SIBASI become responsible for procuring most goods and services, the budget of MSPAS-center should be further reduced.

84 This is for instance the case of fuel.

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Table 4.3: MSPASE Expenditures, by Major Economic Category, 1996 – 2003

Wages and salaries 29.0 25.9 24.2 25.4 25.4 25.0 24.9 3.4 Goods and services 14.1 8.8 7.4 9.1 10.5 7.6 8.9 4.2 Transfers 52.3 61.6 61.2 60.3 61.1 62.3 59.7 86.0 Financial expenditures 0.1 0.1 1.0 0.1 0.3 0.2 0.1 0.1 Investment & capital transfers 4.4 3.7 6.2 5.0 2.8 4.9 6.3 6.3 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Memo: Executed US$ mm 143.3 145.9 176.6 189.4 209.6 216.0 223.7 235.3 Budget US$ mm 150.6 150.6 151.6 188.3 205.9 222.4 232.0 240.6 % Executed 95.0 97.0 116.0 101.0 102.0 97.0 96.0 98.0 Source: Ministry of Finance (SAFI) 4.20 MSPAS has executed over 95 percent of its budget during 1996-2003 period. Table 4.3 shows that execution varied from 95 percent the 116 percent. This latter figure is a result of mid-year upward revision of the budget in 1998 related to a sharp increase in the salaries of nurses (US$ 18 million that year) and other emergency expenditures in the wake of Hurricane Mitch (US$ 13 million). 4.21 Hospitals spend about two-thirds of their budget in wages and salaries and one-third in goods and services. Table 4.4 shows the budget break down of the specialized hospital Bloom and of the general hospital La Union. By type of attention, over half of the budget of hospital La Union is now for primary health care of the SIBASI to which the hospital belongs. Administrative expenses absorb 5.6 and 6.6 percent of the La Union and Bloom budgets, respectively.

Table 4.4: Hospital Budgets by Type of Attention and Major Category, 2003

(% of total budget) Hospital Bloom Hospital La Union (specialized) (general) By Category Wage and Salaries 63 69 Goods and Services 36 31 By Type of Attention Ambulatory Services 7.4 12.8 Hospital Care 86 30.3 Primary health care N/a 51.3 Administration 6.6 5.6

Source: Ministry of Finance 4.22 The allocation of resources between general hospitals and specialized hospitals has been based on historical allocations and has had no explicit relationship with outcomes. A study published in 1999 showed that specialized hospitals in El Salvador received significantly larger budgets per patient than general hospitals apparently, owing to the believe that specialized hospitals treat persons with more difficult (and costly)

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illnesses.85 The study analyzes hospital expenditures over a 12-year period and, after controlling for patient morbidity, outputs and other characteristics, concludes that general hospitals are substantially under-funded relative to specialized hospitals. This issue deserves close attention by MSPAS authorities, particularly because under the new SIBASI financial arrangements the relatively under-funding of general hospitals may lead to diversion of resources from primary health care to hospital care, reducing even further the share of actual resources spent on primary healthcare. 4.23 The consolidated budget by spending category of MSPAS and the public hospitals indicates that during the 1996-2003 period, about two-thirds of the budget was to pay for wages and salaries; the remaining to pay for medicines, medical inputs, investment and other goods and services (Table 4.5). The purchase of medicines absorbed between 11 percent and 17 percent of total spending while medical inputs between 5 percent and 6 percent. The share of physical investment was below 3 percent of the budget until 2001, but it has since increased to almost 9 percent in 2003 as a result of the earthquakes.

Table 4.5: MSPAS and Public Hospitals Budget, by Category 1996 – 2003

Items 1996 1997 1998 1999 2000 2001 2002 2003 Wages and Salaries 59.2 63 64.1 75.8 73.7 72.3 68.6 65.1 Medicines 17.0 16.3 11.4 10.8 13 11.7 11.2 12.2 Medical Inputs 6.3 4.6 6.1 4.6 4.9 5.2 5.1 5.0 Physical Investment 2.7 1.5 1.8 0.1 0.1 2.2 6.4 8.8 Other a/ 14.8 14.6 16.6 8.7 8.4 8.6 8.7 8.8 Total 100 100 100 100 100 100 100 100 Note: Refers to approved budget a/ Includes other purchase of goods and services such as water, electricity, telephone, office materials, cleaning and taxes as well as transfers to other non-hospital institutions Source: MSPAS

4.24 The amount spent on wage and salaries have increased sharply during the 1996-2003 period, by 76 percent. What explains this trend? On the wage front, most of the increase took place in 1998 and 1999 owing to the adjustment to nurses’ wages following their strike in 1998. Also, from 1996 to 1999, MSPAS staff received an annual increase in wages that averaged 7 percent (escalafon). Since 2000, this increase has not been granted and the share of wages and salaries in total spending has declined. No analysis of MSPAS wages is available, but according to senior MSPAS officials, the salaries of the administrative staff compares well with their public and private sectors counterparts; at technical level salaries are reportedly lower than in the private sector. 4.25 The number of MSPAS staff from its web page is presented in Table 4.6.86 There are wide annual variations in the number of some staff; for instance, the number of doctors dropped sharply in 2000 but then increase back in 2001 to drop again in 2002. In the MSPAS, the number of positions (plazas) and the number of employed staff may 85 Fiedler, John L et. al. “Risk Adjustment and Hospital Cost-Based Resource Allocation, With an Application to El Salvador”, Social Science and Medicine, 48, 1999, 197-212. 86 MSPAS’s Division of Administration and Human Resources does not keep historic information on staff.

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differ substantially. In the case of doctors, one doctor may occupy more than one position, and in case of medical interns, more than one intern may occupy one position. Also, one position may refer to different daily hours of work. The information in the table seems to refer sometimes to the number of staff, other times to the number of positions. Notwithstanding these difficulties, the data indicates that the number of positions assigned in the budget to MSPAS has been declining since 2000, which would be consistent with a reduction in the share of wage and salaries in the MSPAS budget indicated above.87 Strengthening MSPAS human resource management systems is a priority.

Table 4.6: MSPAS’ Staff, 1999 - 2002

1999 2000 2001 2002 Doctors 3382 2759 3544 2723 Dentists 318 354 354 354 Nurses (graduated) 1800 1831 1943 1718 Auxiliary Nurse 3063 3186 3126 2906 Health Promoter 1781 1729 1593 1647 Lab 655 655 Paramedics 5411 4403 2331 3175 Sanitary Inspectors 356 356 Asministrative 4461 4897 5268 4859 Total No. of positions a/ 6451 6555 6392 6067 Trained mid-wives 3107 3200 3200 3200 a/ Budget Law Source: MSPAS (Web page) and Ministry of Finance (Budget documents)

4.26 The share of the budget spent on medicines has declined sharply until 1999 and has recuperated only slightly in recent years. In 2003, the share of medicines was 12 percent compared to 17 percent in 1996.88 This does not appear to be a result of a more efficient pharmaceutical procurement system. Indeed, a study by the Management Sciences for Health (MSH) found that for a sample of critically needed medicines, only 82 percent were available at MSPAS primary healthcare facilities and 62 percent at hospitals. Moreover, it discovered that El Salvador routinely purchases pharmaceutical products at prices higher than the international median. In addition, products of substandard quality were found in “50 percent of samples collected from public facilities (…) and 28.6 percent from private pharmacies”.89 In 2003, MSH proposed a new system to manage pharmaceutics, which involves joint procurement by the specialized hospitals and the SIBASI to obtain a better price and a single distributor to manage the purchase orders, storage and distribution; MSPAS would monitor the quality of pharmaceutical products ordered and purchased by the network facilities. During its first year of operation, the new system suffered logistic problems that MSPAS is seeking to overcome. 87 The number of positions approved by category is from the Wage Law (Ley de Salarios), which accompanies the annual Budget Law. 88 In dollar terms, US$ 9.5 million were spent in medicines in 1996; US$ 12 million in 2003. 89 Reported in the web page of Management Sciences for Health (www.msh.org/seam/3.1.2b.htm)

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4.27 Between 1996 and 2000, physical investment average less than 1.5 percent of the MSPAS budget. In 2003, the investment budget increased to 8.8 percent of the total budget as a result of the reconstruction of the infrastructure damaged by the earthquakes. MSPAS infrastructure is a combination of modern facilities and very old and obsolete ones. In some hospitals there are very old wings (over 75 years) side by side with more recently build ones. Weak anti-seismic construction specifications and lack of maintenance made the infrastructure more vulnerable to the natural disasters. Maintenance expenditures for infrastructure and equipment have been minimal. 4.28 MSPAS has developed a program to reconstruct/rehabilitate its facilities, including 23 of 30 national hospitals and 82 health centers. Existing IDB loans and CABEI funds, are being utilized to cover the costs of provisional structures and for the rehabilitation of the 15 less badly damaged hospitals. For the reconstruction of the eight hospitals with the greatest damage, the government has obtained the support of the World Bank and Japan.90 The World Bank Emergency Reconstruction project will support the strengthening and implementation of a comprehensive preventive maintenance program for the seven hospitals being reconstructed under the project. As mentioned, the project will also support the extension of basic services in remote areas and the strengthening of primary health care services and facilities in areas affected by the 2001 earthquakes Cost Recovery and External Funding Sources 4.29 To help finance hospital costs, patients usually pay a fee for the services, the so-called co-payments. In the early 1990s, with support from USAID’s APSISA program (Support to El Salvador’s Health Services program) MSPAS developed the different components of a cost recovery system for the hospitals: costing of services; socioeconomic evaluation of patients; administrative-financial management; and required legal changes. A pilot program was initiated but the system was never fully implemented or institutionalized, though hospitals continued to charge for some services. Reportedly, hospitals charge to all patients that use their facilities unless they claim that they cannot pay. The charges vary from hospital to hospital and past attempts to rationalize the systems have failed. Since the introduction of the SAFI, these resources colleted by the hospitals are treated as part of their budgets (own resources). If the hospitals recover more funds than those originally included in their budgets, they need to request the National Assembly authorization to spend the funds. Reportedly this is done routinely and does not constitute a major disincentive to cost recovery, though it may take up to three months to obtain the authorization from the National Assembly to use the funds. 4.30 The resources from co-payments are quite important for the hospitals. In 2003, income from the “sale of goods and services”, most of which are co-payments from patients, at Hospital Bloom represented 8.2 percent of its total budget of US$ 15.3

90 The World Bank loan will help rehabilitate and replace some equipment in three hospitals (San Juan de Dios in San Miguel, San Pedro in Usulutan, and Santa Teresa in Zacatecoluca) and replace four other hospitals (Maternidad in San Salvador, Santa Gertrudis in San Vicente, Cojutepeque in Cuscatlan, and San Rafael in La Libertad). Japan is expected to help reconstruct Hospital Rosales.

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million; the remaining being transfers from the treasury; for the general hospital La Union, the “sale of goods and services” corresponded in 2003 to 6.2 percent of its budget of US$ 3.6 million. As can be observed in Table 4.4, co-payments more than cover the administrative costs of these hospitals. 4.31 Until recently health centers also charged a fee for services, or the so-called

“voluntary quotas”. In June 2002, a Presidential Decree (Executive Decree 2002) abolished these quotas. Local governments are now working closely with communities to mobilize resources to finance some services in health centers that are not covered by MSPAS.

Table 4.7: MSPAS Spending, by Financing Source, 1997 - 2003

1997 1998 1999 2000 2001 2002 2003 Total Expenditure (US$ million) 145.2 177 180.9 204.9 209.8 217.8 226.1 External Financing (US$ million) 4.3 27.4 11.7 9.5 12.7 12.3 19.0 Grants 4.3 12.1 11.7 9.5 12.2 3.3 7.2 Loans 0.0 15.3 0.0 0.0 0.5 9.0 11.8 Ext. financing/ total expenditure (%) 3.0 15.5 6.5 4.6 6.1 5.6 8.4 Source: External Cooperation Unit, Directorate of Planning, MSPAS

Table 4.8: External Financing for the Health Sector, 1994 - 2002

Source: Ministry of Health

Financing Source Amount (US$000) Percent European Union 44,357 30.6USAID 26,748 18.5Spain 16,065 11.1PAHO 14,539 10Japan 13,493 9.3KFW 11,885 8.2Luxemburg 6,085 4.2UNICEF 4,429 3.1CABEI 4,325 3Other 2853 1.9Total 144,778 100

4.32 External sources have also provided an important support to the health sector. External support received by MSPAS should in principle be all accounted for in its budget. In practice, all loans are included in the ordinary or extraordinary budgets, while for the grants received the type of recording varies: grants that finance expenditures over a extended period of time such as those received from the European Community and Luxemburg, are included in the budget; grants received sporadically to buy goods or services or grants in kind often are not included in the budget. Table 4.7 presents the recorded loans and grants received by MSPAS. It shows that between 1997 and 2000, external sources financed on average 7.3 percent of MSPAS budget. This includes a large loan (valued at US$ 15.3 million) for hospital equipment and ambulances from Spain in 1998. With the earthquake in 2001, external financing increased to about over

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8.4 percent of MSPAS budget in 2003. In the last six years, about two-thirds of the financing came in the form of grants and one-third in the form of loans. The European Union, USAID, Spain, Pan American Health Organization (WHO), and Japan accounted for the bulk (80 percent) of external support to the sector since mid-1990s (Table 4.8).

IV. Expenditure Outcomes 4.33 There is no simple relationship between health spending and outcomes. Health outcomes are not only a function of the amount of public and private spending in the sector, but are also influenced by the efficiency and incidence of pubic spending as well as by other variables that are to a large extent outside the control of the sector such sanitary and education conditions. These considerations should be kept in mind as health indicators and the overall efficiency of health expenditures are discussed in the following paragraphs. Key health indicators 4.34 During the 1990s, El Salvador made progress in life expectancy and infant mortality rates but progress in reducing child malnutrition has lagged, while in immunization the coverage dropped. Table 4.9 shows key health indicators for El Salvador, Costa Rica, and LAC. El Salvador’s life expectancy and infant mortality rates improved during the 1990s and these indicators are now similar or better than LAC. Measles immunization in 2002 was 93 percent for children under 12 months, a drop from 98 percent in 1990, but still above LAC.91 On the other hand, malnutrition in children under five is still four times greater than Costa Rica.

Table 4.9: Key Health Indicators, 1990 – 2002

1990 2002 1993 2002 1993 2002 1990 2001 1990 2002El Salvador 65.6 70.1 41 25 11 10 98 99 98 93Costa Rica 75.4 77.6 13.7 9 2.8 N/a 90 82 95 88LAC 67.9 70.7 39.5 27.5 N/a N/a 76.7 91.1 70.7 88.6

DTP Immunization% of children under 12

months

Life expectancy at birth, total (years)

Mortality rate,

infant (per 1,000

live births)

Malnutrition in

children under

5(Percent) a/

Measles Immunization%

Children under 12 months

Note: Data is for the most near year available. a/ weight for age Source: National Family Health Survey (FESAL) conducted by the Salvadoran Demographic Association, “El Salvador: Informe de Pais Sobre el Avance de los Objectivos de Desarrollo del Milenio”, final draft, April, 2004, and World Bank, WDI

91 It should noted that according to MSPAS there has been no recorded case of measles since 1996 and in 2002, it introduced the multipurpose vaccination against six diseases including measles, and the triple viral vaccination (SPR).

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4.35 Despite the general progress in health indicators, substantial differences remain between the health outcomes for the different income groups. According the National Family Health Survey (FESAL) conducted by the Salvadoran Demographic Association, infant mortality is almost twice as high for low-income families than for higher income, though in recent years the gap has been closing (Chart 4.4). Also, 15.3 percent of children of low-income families suffer malnutrition (weight for age), only 3.7 percent of the better off children were found in this condition. Efficiency of Overall Spending

Table 4.10: MSPAS Selected Indicators, 1996 – 2002

Year Ambulatory Visits Major Surgeries

Institutional Deliveries Discharges No. Of Beds Population

1966 4,804,065 64,223 68,941 265,046 4,904 5,787,0931997 5,845,856 78,795 74,579 293,332 4,767 5,908,4601998 6,603,888 76,756 77,303 294,551 4,744 6,031,3261999 7,391,523 82,520 77,376 310,279 4,868 6,154,3112000 8,757,080 93,933 81,635 334,924 4,843 6,276,0372001 8,153,936 87,898 75,188 310,887 4,497 6,396,8902002 8,697,832 91,144 74,837 324,602 4,576 6,517,798

1997/96 21.7 22.7 8.2 10.7 -2.8 2.1 1998/97 13 -2.6 3.7 0.4 -0.5 2.1 1999/98 11.9 7.5 0.1 5.3 2.6 2 2000/99 18.5 13.8 5.5 7.9 -0.5 2 2001/00 -6.9 -6.4 -7.9 -7.2 -7.1 1.9 2002/01 6.7 3.7 -0.5 4.4 1.8 1.9

Percent Annual Change

Source: Ministry of Health 4.36 Table 4.10 shows recent MSPAS “production” indicators. It can be seen that

ambulatory visits, major surgeries, and hospital discharges have increased rapidly in recent years, with the exception of 2001 owing to the earthquakes. All the indicators recovered in 2002 with the exception of institutional deliveries.92 The fall in institutions delivery in 2002 may be associated at least in part with the damaged suffered by the Hospital de Maternidad in San Salvador during the 2001 earthquakes. Hospital utilization rates, averaging 86 percent since mid-1990s, have been at acceptable levels. For comparison, hospital occupation rates in Honduras during the same period average about 70 percent.93

92 Recall that this is one of the hospital to be replaced with the World Bank loan. 93 Honduras Public Expenditure Management for Poverty Reduction and Fiscal Sustainability, World Bank, June 2001, page53.

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Chart 4.4: Infant Mortality per Socio-Economic Group

0 10 20 30 40 50 60

Low Income Middle Income High Income

Per 1

,000

Liv

e bi

rths

FESAL 1993 FESAL 2002

Source: Ministry of Health

4.37 Notwithstanding these results, the report of the Presidential Commission for the Health Sector Reform published in December 2000, indicated that the poor quality and limited efficiency of public institutions were among the key debilities of the sector.94 The major determinant of poor quality of services in MSPAS facilities appears to be the lack of the proper number of trained staff in public facilities (most of them rely almost fully on different kinds of trainees) as well as the missfunction of doctors incentives and dedication at public institutions. Only half of the medical staff in public institutions is fully paid by MSPAS. Key clinical personnel spend approximately one-third to one-half of their time in non-clinical activities. 95 4.38 How cost-effective is El Salvador’s health sector compared to other countries? As a first approximation, health expenditures can be related to key health outcomes. Charts 4.5 and 4.6 plot total health spending per capita against life expectancy and infant mortality, respectively, for 27 Latin American countries from the World Bank’s WDI database. In terms of life expectancy, El Salvador is situated between the northeast and the southwest segments, which implies that it spends a reasonable amount of money and obtains a life expectancy that is also reasonably high compared to other countries in the sample. The most efficient countries in the sample are Cuba, Jamaica and Belize; the most inefficient Brazil.

94 The report indicated as other debilities the following: lack of equity and insufficient coverage; legal framework is not applied adequately; fragmentation and lack of coordination between institutions; sector institutions with centralized management styles; and incipient social participation. 95 Seiber, Eric. Baseline and Best Practices Assessment of seven SIBASI in El Salvador. PHRPlus. Dec 2002).

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Chart 4.5: Total health expenditure per Capita

and life expectancy at birth. Chart 4.6: Total health exp. Per capita and

infant.

0

26

52

0 171 342 Total Health Expenditure per capita (US$)

Infa

nt M

orta

lidy

rate

per

1,

000

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92

0 171 342 Total Health Expenditure per capita (US$)

Life

Exp

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El Salvador

El Salvador

Note: Most recent data (circa 2001); Total health expenditure is the sum of public and private health expenditures. It covers the provision of health services (preventive and curative), family planning activities, nutrition activities, and emergency aid designated for health but does not include provision of water and sanitation; El Salvador coordinates: (185,70); Sample average: (171,71) Source: WB’s WDI sample of 27 Latin American countries

Note: Most recent data (circa 2001); Total health expenditure is the sum of public and private health expenditures. It covers the provision of health services(preventive and curative), family planning activities, nutrition activities, and emergency aid designated for health but does not include provision of water and sanitation; El Salvador coordinates: (185,25); Sample average: (171,26) Source: WB’s WDI sample of 27 Latin American countries

4.38 As for infant mortality, El Salvador is also situated between the northeast and the southwest segments, which implies that it spends a reasonable amount of money and obtains a infant mortality rate that is not low compared to other countries in the sample (Note that to keep the interpretation of the Chart similar to that presented previously, the infant mortality scale is presented in the inverse form because higher spending should correspond to lower infant mortality). The most efficient countries in the sample are: Cuba and Jamaica; the most inefficient is again Brazil. In conclusion, El Salvador does not appear to be inefficient though it is not among the most efficient countries.

Expenditure Incidence 4.39 The following paragraphs discuss how public spending have impacted the access and affordability of health services to the poor, the possible existence of inequitable cross subsidies between ISSS and MSPAS in detriment of the latter, and the distribution of MSPAS expenditures by income groups and department. Access and Affordability 4.40 The coverage of the health system is still inadequate. Table 4.11 shows that less than 20 percent of the Salvadorans have access to medical insurance. The ISSS covers 17 percent of the population; private and institutional insurance another 1.8 percent; and the remaining 81.3 percent (97.3 percent for those in extreme poverty) has not insurance. MSPAS should cover the population without insurance, particularly the poor.

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Nevertheless, 24 percent of the population still does no have access to health services or only has limited access.96

Table 4.11: Population Covered by Medical Insurance, 2002 (% of total population)

Affiliate BeneficiaryTotal Population 81.3 11.4 5.6 1.7 0.1 Poverty 93.8 3.6 2.3 0.3 0 Extreme Poverty 97.3 1.7 0.8 0.2 0 Relative Poverty 90.9 5.1 3.6 0.4 - No Poor 71.9 17.2 8 2.8 0.1

ISSSPoverty Level

Without Insurance

Institutional Insurance

Private Insurance

Source: Household Survey, 2002 4.41 Substantial differences remain between the access of the poor and the better off to health services. Salvadorans in the highest quintiles are one-third more likely to receive medical care than those in the poorest quintiles.97 FESAL-1998 indicates that 32 percent of low income expecting mothers had no prenatal care visits compared to 9.7 percent of the better off; also while 80 percent of the better off mothers delivered in a hospital, only 41 percent of the low income mother had an institutional delivery. 14 percent of the poor go to private or NGO facilities rather than to MSPAS facilities (Table 4.12). One-quarter of the poor (30 percent in extreme poverty) do not seek MSPAS facilities because of lack of funds. (Table 4.13).98 In addition, one in each three poor persons that get ill, do not trust the public system and/or prefer to seek alternative cares.

Table 4.12: Establishment that Visited When Ill, 2002 (% of ill)

Poverty Level MSPAS ISSS Private NGO or Other Total 67.5 10.2 17.1 5.3 Poverty 81.3 4.5 9.6 4.6 Extreme Poverty 86.2 1.2 7.5 5.1 Relative Poverty 77.4 7.1 11.2 4.3 No Poor 56.5 14.7 23.1 5.7 Source: Household survey, 2002

96 Reported by the UNDP’s Human Development Report 2003 (Table 3.8) based on FUSADES estimates. FUSADES derives the lack of access to MSPAS services by calculating from the household survey the share of those that indicated than when ill they did not seek MSPAS facilities because of all the reasons asked in the survey minus that “it was not necessary” (Table G06 of the Household Survey) on the total number of those that got ill (Table G04 of the Household Survey). The reasons not to seek MSPAS include included in the survey are: there are no medicines, lack of attention, too expensive, there is no nearby heath center, does not believe/trust medical attention, bad attention, need to work, etc (see Table 4.13). The MSPAS acknowledges that about 20 percent of the population has not “regular” access to its services. 97 An Earthquake Emergency Reconstruction and Health Service Extension Project, Project Appraisal Document (Report NO. 22626-ES), October 31, 200. 98 Note: Executive Decree 2002 of June 2002, payments in health centers were eliminated. Future household surveys should indicate whether this impacted on visits to health centers. Nevertheless, the cost of accessing MSPAS facilities includes not only direct costs such as co-payments but also other costs such as transportation.

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4.42 The latest estimate of the annual cost of providing a minimum package of healthcare and nutrition services in El Salvador based on differentiated capitation is estimated at about $ 20 per person. The cost of the package of health and nutrition established by MSPAS (SESYN or Essential Heath and Nutrition Services) and based on universal capitation, which is the basis for providing basic health care in the IDB’s Support to the Modernization Health Program, is US$ 31 per person.99 Taking these two estimates as extremes, the annual cost of covering the 1.6 million people without regular health services could vary between $ 32 m and $ 50 m, equivalent to between 0.2 and 0.3 percent of GDP.100

Table 4.13: Motives for not visiting MSPAS establishments, 2002 (% of ill)

Poverty Level It was notnecessary

Lack ofmoney

Center too far,Center has nomedicines, lack ofattention

Does not trust, prefers to take domestic medicine, other

Total 43.8 15.6 23.3 17.3 Poverty 42.2 25.3 19.1 13.3 Extreme Poverty 36.2 30.1 18.8 14.9 Relative Poverty 47.7 20.8 19.4 12.1 No Poor 45.1 7.3 26.9 20.7

Source: Household Survey, 2002

Cross-subsidies 4.43 There is a major difference between ISSS and MSPAS notional spending per capita. ISSS is responsible for about 45 percent of total public spending but it serves only 17 percent of the population (6 percent of the poor population). In contrast, MSPAS with 55 percent of public spending must cover 80 percent of the population. ISSS spends about US$ 220 per beneficiary a year; while MSPAS’ annual budget corresponds to only US$ 50 per person it should cover. Only 6 percent of the poor have access to ISSS. 4.44 The renting of MSPAS facilities to ISSS further raises equity concerns. MSPAS may send patients to ISSS facilities, the cost of the treatment being deducted from the rent ISSS is required to pay to the treasury. Reportedly the number of patients sent to ISSS operated facilities (Hospital de Especialidades) is small, as referrals require formal

99 An Earthquake Emergency Reconstruction Project, PAD (Report 22626-ES), Oct. 2001, indicated a preliminary cost of $ 15 per person per year based on the Guatemala and Honduran experiences. Recent studies prepared for the WB project point out to higher costs of about $ 20. These studies are based on a differentiated capitation, where the cost of the package for children, adults, are different, while the IDB project uses an universal capitation.. 100 UNDP 2003 HD Report estimates the cost at $ 31 per person per year; with a annual cost of $ 50 million to reach 1.6 m. people or 0.3 % of GDP. To eliminate malnutrition in children under 5 years, UNDP estimates that it would cost an additional $ 23 m. a year, equivalent to 0.15 % of GDP. The estimate is based on the number of children with malnutrition in urban areas (29,655) and rural areas (49,841) and assuming the annual cost of eliminating malnutrition equivalent to the urban minimum basket ($ 385) and rural minimum basket ($ 240).

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authorization from the Minister of Health. ISSS’ members and beneficiaries also use MSPAS facilities. FESAL-1998 reports that 33 percent of ISSS’ members and beneficiaries had their delivery in MSPAS hospitals, while only 3.3 percent of those not related to ISSS had the delivery in ISSS’ hospitals.101 Aside from rents paid for the Hospital de Especialidades or other facilities, ISSS does not pay anything to MSPAS when its beneficiaries use MSPAS facilities. In April 2004, the MSPAS hospitals and the ISSS reached an agreement in which MSPAS hospitals will begin charging ISSS for emergency treatments to ISSS beneficiaries. In the near future, MSPAS authorities expect to reach a similar agreement with ambulatory treatments . Distribution of Resources 4.45 A large proportion of the better off uses MSPAS facilities. Household survey data shows that of those that visited MSPAS hospitals in 2002, the majority or 53 percent were no poor; 26 percent relative poor, and 21 percent extreme poor (4.14). Overall, 47 percent of the people that use MSPAS facilities are no poor.

Table 4.14: Distribution of Persons Visiting Central Government MSPAS Facilities by Income Group 2002

Hospitals Health Centers Health Units Total

National 100 100 100 100 Poor 47.5 55.6 73.5 53.3 Extreme poor 21.3 26.8 44 25.3 Relative poor 26.2 28.8 29.5 28 No poor 52.5 44.4 26.5 46.7 Source: Household Survey

4.46 Since 64 percent of the MSPAS budget is for the hospitals, the better off benefit disproportionably from MSPAS. Chart 4.7 shows the distribution of MSPAS resources by quintile for hospital and primary healthcare. In primary care, expenditure favor the poorest quintiles, while for hospital care, it favors the middle quintiles. This calls for strengthening the cost recovery policies in hospitals so that those that can afford to pay for the attention received do pay, and MSPAS may redirect resources to finance the delivery of basic health and nutrition services to the population currently underserved.

101 See FESAL-1998, Table 8.14, page 232.

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Chart 4.7: MSPAS Hospital and Primary Health Care

Spending by Quintile, 2002

Source: Staff estimates based on household survey and MSPAS data 4.47 On a geographic basis, MSPAS distribution of resources seems to be somewhat progressive. Charts 4.8 shows per capita income of each Department plotted against MSPAS total per capita spending. No clear relationship emerges which indicates that MSPAS resource distribution does not favor the better off Departments or the worse off.102 Given that hospital expenditures are concentrated in San Salvador where the three specialized hospitals are located, Chart 4.9 shows MSPAS spending on primary healthcare alone in relation to Departmental per capita income. It reveals a negative tendency between per capita income and per capita healthcare expenditure but the relationship is weak103 Therefore MSPAS distribution of primary healthcare expenditures by Department may be said to be somewhat pro-poor.

0 5

10 15 20 25 30 35

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enta

ge T

otal

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102 Correlation Coefficient=0.06; R2=0.003. 103 Coefficient of Correlation= –0.34; R2= 0.118.

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Figure 4.8: Per capita income and MOH

spending by Department (2000) Figure 4.9: Per capita income and primary health care spending by

Department (2000)

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20 40 60 80 100 120 140 160

Departmental PerCapita income (US$)

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Note: Per capita health expenditure excludes investment expenditure s.Source: Staff estimates based on household survey and MSPAS data

V. Conclusions and Recommendations 4.48 El Salvador’s health indicators have improved during the last several years. A recent study on the situation of El Salvador in relation to the MDGs prepared under the direction of the Presidential Commissioner for the Social Affairs, concludes that it is highly likely that the country meets the MDGs 2015 targets on infant mortality rate, mortality rate in children under five, measles immunization, and tuberculosis incidence, but it is unlikely that it meets the MDGs targets on maternal mortality, deliveries by trained staff, and HIV/AIDs. Relative to malnutrition, the study concludes that it is unlikely that the MDG target be met at national and rural levels, but highly likely at urban level.104 4.49 Thus, significant challenges remain. The MSPAS needs to recover the infrastructure that was severely damaged by the 2001 earthquakes and take benefit of this large investment in hospital infrastructure to build a rationalized, modern, and well-managed public hospital network. The outputs of this network needs to recover and surpass its level of production before the earthquakes, without substituting for care that should be done at earlier stages and less costly facilities. Public health expenditure for poor people will need to increase in the coming years since, on one hand, per capita expenditure is very low and, on the other hand, the government budget will need to absorb the expansion of services that the World Bank project is executing once the Bank's loan is finished. Allocation of resources within the sector needs also to be

104 “El Salvador: Avance de los Objetivos de Desarrollo del Milenio- Primer Informe de País”, 2004.

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carefully streamlined and enforced. Financial protection of the poor against health shocks needs to be better regulated and enforced, focalizing user fees in public institutions, expanding formal social security, and exploring other ways of community health insurance. Existing cross-subsidies between the ISSS and MSPAS need to be corrected and the cooperation between these two institutions harnessed. 4.49 The reform of the sector in such a direction will require a national consensus. In this respect, the new President’s Government Plan —Safe Country, 2004-2009, calls for the reform of the health sector in a “concerted manner which may lead to and efficient national health system, functioning in a decentralized manner, with universal coverage, and free of charge to all persons that can not afford.” Allocation of resources to the sector 4.50 Since most of the additional resources allocated to the sector will be needed to finance the reconstruction of the damaged infrastructure, MSPAS should focus on increasing the efficiency and equity of resource use in the sector, including increasing cost recovery from those that can afford it. El Salvador is among the countries in Latin America that spends more in health (as a percentage of GDP) because of large private spending. The public sector spends slightly above the average for Latin America, though on a per capita basis, El Salvador spends much less than Costa Rica or LAC. Given overall budgetary constraints, the heavy demands on the treasury that are being made by the reconstruction of health infrastructure, and other competing demands, it is unlikely that additional significant public resources will become available to the sector in the foreseeable future other than for the reconstruction of hospital and clinics, thus requiring MSPAS to focus on increase the efficiency of resource use. 4.51 In this context, it is important make a systematic evaluation about to what extent the decentralization program to the SIBASI has been implemented and, more importantly, how this reform is contributing to the overall performance of the sector. This assessment should focus in particularly on the efficiency and equity gains, managerial capabilities built in SIBASIS, changes in the quality services, balancing primary-hospital care and coordination of care, the role of management contracts to foster and reward better performance, the capacity of central MSPAS to perform its stewardship role and the strengthening of social participation. Intra-sectoral allocation of resources 4.52 MSPAS allocation of resources should favor primary healthcare. Hospital care continues to absorb a disproportionate share of the sector resources. The coverage of the health system is still inadequate as less than 20 percent (6 percent of the poor) have access to medical insurance, and as much as 24 percent of the population still does not have access to health services or only has limited access. The annual cost of providing a minimum package of healthcare and nutrition services to this population is estimated at between US$ 32 million and US$ 50 million (0.2 and 0.3 percent of GDP). MSPAS’s budget in recent years has been equivalent to 1.6 percent of GDP.

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4.53 The allocation of resources between general hospitals and specialized hospitals must be reviewed. The allocation of resources between general hospitals and specialized hospitals has had no explicit relationship with outcomes, and reportedly general hospitals are substantially under-funded, relative to specialized hospitals. In this context, there is a great concern about the current channeling of public funds for primary healthcare through hospital budgets and the important share of the public budget that is devoted to hospital care when hospital care is less pro-poor than primary health care. The establishment of performance contracts between MSPAS, the SIBASI, and the providers, such as those being supported under the World Bank financed project, and the implementation of a performance incentive system could help address such concerns. 4.54 Strengthening MSPAS human resource management systems is a priority. MSPAS expenditure on wage and salaries absorbs two-thirds of its budget. The lack of information on MSPAS staff is a clear indication that human resource management in MSPAS, which absorbs the bulk of the ministry’s budget, must be substantially improved to ensure an efficient use of resources. A new human resource policy is badly needed to address the long lasting bottlenecks: the lack of sufficient, well-trained and professionally balanced staff, operating under enforced labor rules and stimulating reward systems. 4.55 Establishing an efficient and cost effective pharmaceutics management system is another priority. There is some evidence that El Salvador purchases pharmaceutical products at prices higher than the international median. In addition, products of substandard quality were found in several public facilities. MSPAS needs to improve its management of pharmaceutics products, including cutting the cost of medicines procured. Efficiency and equity of resource use 4.56 There has been an effort to increase the efficiency of resource use in recent years and these efforts should be intensified. The number of ambulatory visits, major surgeries, and hospital discharges has increased rapidly in recent years and hospital utilization rates have been at acceptable levels. Also when comparing spending with outcomes, El Salvador’s is not among the most efficient countries in Latin America nor is it among the most inefficient. 4.57 There is a need to increase the outreach of the public healthcare services. Children in the poorest quintiles are three times more likely to be ill than are children in the highest quintile. One in each three poor persons that get ill, do not trust the public system and/or prefer to seek cure in alternative ways. Despite the progress in some health indicators, substantial differences remain between the health outcomes for the different income groups. Infant mortality is almost twice as high for low-income families as for higher income families, though in recent years the gap has been closing. 4.58 MSPAS should not subsidize ISSS. ISSS spends US$ 220 per beneficiary per annum, while MSPAS’ annual budget corresponds to only US$ 50 per person it should cover. Only 17 percent of the population and 6 percent of the poor are covered by ISSS.

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The renting of MSPAS facilities to ISSS, the use of MSPAS facilities by ISSS members and beneficiaries raises equity concerns and should be thoroughly examined to ensure that MSPAS does not subsidize ISSS. 4.59 Cost recovery policies should be rationalized and strengthened, and those that can afford it should pay for the hospital care they receive. A large proportion of the better off population use MSPAS facilities. While in primary care, MSPAS expenditures favor the poorest quintiles; in hospital care they favor the middle quintiles. This calls for strengthening the cost recovery policies in hospitals. Recommendations 4.60 In sum, the following recommendations may be considered:

• MSPAS allocation of resources should give priority to the delivery of cost-effective primary healthcare services to the poor communities that have not been reached by the health system.

• The functions and mission of each component of the SIBASI (hospital, health centers, health, clinics, and providers) should be clearly defined to strengthen the health network and referral system; performance agreements, contracts, and an incentive scheme should be implemented to make health providers accountable to both the MSPAS and the clients they serve.

• The allocation of resources between general hospitals and specialized hospitals should also be reviewed; particularly because under the new SIBASI financial arrangements, the relative under-funding of general hospitals may lead to diversion of resources from primary healthcare to hospital care.

• As the majority of those that use MSPAS hospitals are the better off, cost recovery policies in hospitals should be rationalized and strengthened so that those that can afford to pay for the attention received, do pay.

• The use of MSPAS facilities by ISSS members and beneficiaries and the renting of MSPAS facilities to ISSS should be thoroughly examined to ensure that MSPAS does not subsidize ISSS and that it recovers the expenses incurred with ISSS beneficiaries.

• MSPAS management of pharmaceutics products needs to improve to reduce the cost of medicines, which is high by international standards, and increase their availability.

• MSPAS human resource management systems should be strengthened.

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CHAPTER V: Water Supply and Sanitation 5.1. The analysis of public expenditure on the water supply and sanitation sector focuses on the National Administration of Water Supply and Sewage Systems, ANDA, the Social Investment Fund for Local Development, FISDL, and the Ministry of Public Health and Social Assistance, MSPAS. These institutions execute water and sanitation projects in urban and rural areas. The chapter contains a review of the sector organization and the analysis of the government’s strategic objectives and the process of resource allocation in the sector, the trend and structure of expenditures and sector outcomes. It concludes with the identification of the sector’s public expenditure principal challenges and recommendations.

I. Sector Organization 5.2. The water supply and sanitation sector in El Salvador comprises ANDA, self-supplied communities, municipalities, FISDL, MSPAS, non-governmental organizations, licensed water systems, and private water-bottling companies. ANDA was created in 1961 to provide—in a centralized manner—water supply and sanitation on a national level, having received through transfers the majority of systems managed by municipalities. Its roles comprise regulation, supervision, planning of the sector, finance, construction, operation, and maintenance of aqueducts and sewers systems; water-quality, supervision of waters served; and exploration of groundwater. By mid 1960s, it delegated management of rural water supply and sanitation of the entire country to the MSPAS’ Division of Rural Aqueducts. This function was taken up during the period 1981-1995 by the National Basic Rural Sanitation Plan, PLANSABAR. In 1995, ANDA created the Directorate of Rural Systems (GSR) to co-administer some 700 rural water systems, of which 315 were built by PLANSABAR. From 1999 onwards, ANDA began a decentralization process, signing several 5-year licensing agreements for operating water systems with private, not for profit entities, and municipalities.

Table 5.1: Water and Sanitation Coverage, by Institution, 2002

(% of population)

Institution Piped Waste a/ Sanitation b/ Urban Rural Urban Rural ANDA 92.6 43.6 73.7 2.4 ANDA Ex-PLANSABAR 0.2 56.4 22.2 97.6 Self-supplied communities 4.9 0.0 4.1 0.0 Municipalities 2.3 0.0 0 20.0 Total 100.0 100.0 100 100.0 a/ Includes domestic or public connections. b/ Includes domestic discharge in sewerage systems and latrines. Source: ANDA

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5.3. ANDA is the main water supplier. In 2002, it attended through its water supply systems 153 municipalities, 93 percent of the urban population and 100 percent of the rural population with these service (Table 5.1). Through its sanitation systems in 70 municipalities and latrines, it attended 96 percent of the urban population and 100 percent of the rural population with this service. 5.4. Self-supplied communities - by means of systems constructed by land developers - attended 4.9 percent and 4.1 percent of the urban population with access to piped-water supply and sanitation.105 Municipalities attended the remaining 2.3 percent of population with access to piped-water, by administering aqueducts in 72 municipalities. Municipalities receive technical, financial, and planning assistance from the Salvadoran Municipal Development Institute, ISDEM, and from the FISDL. From 1991, the FISDL support the expansion, rehabilitation and construction of small water and sewage systems, and latrines. Currently it is executing two programs: Water for Rural Schools in El Salvador (PRONAES), and Expansion of Drinking-Water Coverage to the Rural Area (PROAGUA). MSPAS is charged with the program for integrated attention for environmental health, which includes education in communal health, sanitary disposal of excrements and supervision of quality of water for human consumption. Not for profit organizations are also active in the sector.106 In 1998, the National Association for Defense, Development and Distribution of Rural Water (ANDAR) was created, integrating 28,491 associates organized through 102 water systems built by PLANSABAR in 62 municipalities in the country. These systems are administered by the communities, and receive subsidies from FINET for power supply for water pumping, and their tariffs are adjusted to recover costs, in accordance with the economic capacity of users. Finally, by the mid-1990s, private enterprises dedicated to bottling and distributing drinking water sprung up, with five major firms sharing this growing market.107

II. Strategic Objectives and Resource Allocation Process 5.5. At the beginning the 1990s, the sector faced major challenges: i) Fragmentation and lack of coordination of the entities involved within the sector; ii) Serious operational problems in ANDA, including lack of maintenance of equipment, leaks in old pipe lines and incomplete system cadastre and list of users, problems with measuring valves and large water losses (see paragraph 5.20); iii) Weak ANDA finances, because tariffs barely covered operational costs which caused payment arrears to suppliers amounting to US$27 million (CEL, CAESS, ISSS, Government and international financial organizations); iv) Major restrictions to availability of water resources for supplying drinking water, 105 Main communities are: Comunidad Las Margaritas in Soyapango, ADESCO ROMA in Colonia Roma, Urbanización Altos de San Antonio in Cuscatancingo and Urbanización Valle Verde IV in Apopa (San Salvador); Urbanización La Cima IV and Residencial Cumbres de Cuscatlán in Antiguo Cuscatlán, Comunidades Vista Hermosa, El Rasto and Urbanización Brisas de Zaragoza (La Libertad); as well as Comunidad Bosques de Perulapía (Cuscatlán). 106 The main non-governmental organizations building and operating the rural potable water supply and sanitation systems with participation of the communities are: Cooperativa Americana de Remesas al Exterior (CARE), Creative Associates International (CREA), Concern International Project (PCI) and Plan International. 107 Industrias La Constancia S.A. de C.V. (Agua Cristal), Inversiones Vida S.A. de C.V (Agua Alpina), Aquapura S.A. de C.V, Envasadora Aurora Limitada de C.V.( Agua Alaska, Agua Fresca and Agua Kasstle), Pure, Industrias Lácteas San José S.A. de C.V. (Agua Trópico).

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including high levels of contamination of underground water sources and conflicts with other uses (electricity, agricultural irrigation, ecological, etc.), and users (municipalities, enterprises, communities, etc.); v) Low coverage and low quality of water and sanitation systems, particularly in rural areas; and, vi) Inadequate institutional and legal sector framework. 5.6. Successive administrations sought to address these problems. The strategic objectives for the 1989-1994 period were108: i) To re-establish minimum order in ANDA; this included staff changes, strengthening of the Board of Directors to define up policies and coordinate the other operators in the sector, adjusting tariffs, paying overdue debts with suppliers, disconnecting service to clients with overdue bills, contracting private sector enterprises for reading water meters and for control of water quality; ii) To complete investment projects being carried out by ANDA, of which the most important was Phase I of AMSS water supply and sanitation system financed by IDB; and, iii) To raise the coverage in rural areas through higher community participation (by granting them planning, financing, building, and operating responsibilities in their water systems), with donations from USAID and UNICEF, as well as constructing small water and sanitation systems by the Social Investment Fund, with loans from IDB. 5.7. The armed conflict produced serious damages in the water and sanitation sector, estimated at US$58 million. Ninety percent of damages resulted from non-received income because of the constant interruption of water supply arising from power stoppages. This reduction in financial resources caused the postponement in the development of projects geared toward expanding water coverage and providing normal service, and finally caused a rise in ANDA tariffs. Damage to the water and sanitation infrastructure amounted to US$6 million. The National Reconstruction Plan (PRN) contemplated the execution of small water and sanitation systems rehabilitation projects in selected communities in an amount of US$6.1 million, though the actual investment turn out to be five-times the initial estimate. 5.8. Signing of the Peace Accords and execution of the PRN greatly influenced the strategic objectives for the 1994-1999 period, including:109 i) Rehabilitation of existent potable water and sewerage systems at the national level, within the framework of the National Reconstruction Plan, with loans from IDB for the eastern, western and central regions, and from Japan for the eastern region; ii) Increasing coverage and quality of potable water and sanitation service, focalizing on rural areas, with ANDA and FIS resources; iii) Improving San Salvador Metropolitan Areas (AMSS) water and sanitation systems with IDB and CABEI loans; and, iv) Starting the design for a reform of the sector with IDB support, which includes ANDA institutional modernization, establishment of a tariff policy, formulating a Law for Water and its regulatory entity, and designing proposals for decentralizing water and sanitation services (See Box 5.1).

108 Public Investment Priorities and Needs for Technical Assistance Needs, 1989-1994. Ministry of Planning and Coordination of Economic and Social Development. 109 “To Convert El Salvador into a Country of Opportunities: Government Plan for 1994-1999”. Government of the Republic of El Salvador, 1994.

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5.9. During the period 1999-2004, the strategic goals were110: i) To extend coverage of water supply and sanitation services to underserved rural and peri-urban areas with community participation; ii) To improve the quality of services; iii) To support the modernization of the sector’s legal and regulatory framework, including the allocation of water rights and concessions to the private sector under government supervision; iv) To restructure ANDA for operating in an open market; v) To begin a gradual process of decentralization of production and distribution of water and sanitation systems; and, vi) To promote rational use of natural resources.

Box 5.1: Water and Sanitation Sector Reform Efforts

The various diagnostics made of water and sanitation sector indicated that the key problems of the sector were: i) Absence of a rational regulatory framework; ii) Institutional weakness and dispersion; and iii) Lack of quantitative and qualitative information of water resources. El Salvador water legislation was found to be incoherent and contradictory. There is no single entity responsible for the integrated management of water resources, on the contrary, use is unsustainable and conflicts arise among heavy users (ANDA for human consumption, CEL for generating electric energy, and MAG for agricultural irrigation). In the absence of clear rules regarding rights and duties for the use of water, the private sector has no incentives for investments in the sector. Intents at reform of the sector date back to the 1970s. However, a more concerted effort began in the mid- 1990s. In 1995, a Coordinating Commission for Sector Reform of Water Resources was created (COSERHI) that in turn created the Coordinating Unit of ANDA Modernization, and prepared the Plan for Modernizing the Water Resources Sector. This plan proposed the creation of a governing institution—the National Commission for Water Resources—that would regulate the sub sector water and sanitation; an institution for the conservation of water resources and attention to the rural area; and, enterprises for operating and management of water and Sanitation systems. In 1998, the IDB approved a loan to support the reform of the sector. It included the establishing of a modern regulatory framework; reform of ANDA; studies of tariffs, subsidy policies, and updating technical norms; and designing the community administration model of rural water and sanitation systems. The loan was not approved by the National Assembly at that time and eventually was modified to support the sector reconstruction efforts after the 2001 earthquakes. Although ANDA has already prepared a proposals for: i) a new General Water Law that would establish as main mechanism for efficient water management, assigning rights for use of water for 50 years; ii) a Potable Water and Sanitation Law that would be created by the Superintendence of Water Resources as governing entity, and by the Superintendence of Potable Water and Sanitation as regulating entity; iii) a Potable Water and Sewerage Tariff Law; and iv) a Potable Water and Sewerage Subsidies Law, they still have not yet been presented to Congress for approval. In 1999, ANDA started a decentralizing pilot plan, signing 12 licensing agreements for 5-year operation of water systems. These included: 2 micro-regions (Tetralogía SEM in Usulután -Santiago de María, Alegría, Berlín, Tecapán, Mercedes Umaña and California- and Juayúa in Sonsonate -Juayúa, Salcoatitán, Nahuizalco and Santa Catarina Masahuat-); an industrial zone (20 enterprises grouped in Asociación de Empresarios y Vecinos de la Zona Industrial La Laguna –ASEVILLA- situated in Antiguo Cuscatlán); and an enterprise formed by ANDA employees to provide service to four rural aqueducts; and ten municipalities (San José Villanueva, San Juan Opico, San Matías, San Pablo Tacachico, Tacuba, Ataco, Apaneca, Suchitoto, San Isidro and Caluco). The results of these decentralization experiences are mixed. First evaluations of Tetralogía SEM (that receives subsidized electricity for pumping water), EMASA and ASEVILLA (See Table 5.2), yield positive results, whilst other municipalities have returned the aqueducts to ANDA because of the high cost of electricity for pumping water.

110 “The New Alliance, Government Plan for 1999-2004”. Government of the Republic of El Salvador, 1999.

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5.10. The earthquakes in year 2001 caused serious damage to water and sanitation systems. According to CEPAL, the damage amounted to US$23 million. In urban areas, damage consisted of cracks in water-storage and distribution tanks, damage to deep wells, instability of hillsides and localized landslides that caused ruptures of water conducting pipelines; in rural areas damage consisted in disconnection and rupture of pipelines, destruction of well walls, destruction of entire sections of conduction and distribution lines, as well as water collecting sites. The alternate network of Zona Norte project and the systems that served the para-central region of the country collapsed with the earthquake in February, bringing about generalized water scarcity. This forced the Central Government to redirect resources from loans that supported sector reform and the decontaminating of critical areas, toward rehabilitation of the infrastructure damaged by the earthquakes.

III. Expenditure Trends and Structure Overall trends and Structure 5.11. Total public expenditure (current and capital) for water supply and sanitation grew from 0.4 percent of GDP in 1990 to l percent of GDP in 2001, falling thereafter in 2003 to 1992-1995 levels (Table 5.3). Approximately 89 percent of total expenditure for period 1990-2003 belongs to ANDA, 6 percent to FISDL, and 5 percent to MSPAS. Investment grew by 0.1 percent of GDP in 1990 to a maximum of 0.4 percent of GOP in 2001, falling in 2003 to 1990 levels. Seventy percent of investment was used for rehabilitating, improving and building water systems (aqueducts and public water wells) and the remaining 29 percent for sanitation (sewerage, septic tanks, and latrines). The rise in total expenditure and investment in water and sanitation during the second half of the 1990s, is explained by the improved creditworthiness of public institutions after the adjustments carried out during 1991-1994.

Table 5.2: Public expenditures on water supply and sanitation, 1990 – 2003 (US$ m. and % of GDP)

1990 1995 1996 2000 2001 2002 2003 Total Expenditure 21.5 52.9 72.3 131.4 138.6 127.4 88.8 ANDA 20.0 43.8 66.9 119.5 126 114.9 85.6 FISDL 0.0 5.3 2.1 4.7 4.6 4.1 2.9 MSPAS a/ 1.5 3.8 3.3 7.1 7.9 8.3 0.3 Total Investment b/ 2.6 23.8 36.3 47.8 51.6 26.1 7.6 Water Supply 0.2 15.3 30.9 38.5 41.1 14.0 6.8 Sanitation 2.4 8.5 5.4 9.3 10.5 12.1 0.9 As % of GDP Total Expenditure 0.4 0.6 0.7 1.0 1.0 0.9 0.6 Total Investment 0.1 0.3 0.4 0.4 0.4 0.2 0.1 a/ For the 1990-1995 estimated as 3.1 percent of the budget as in 1996. For 2003 only includes expenditures by MSPAS-center, not by the SIBASI b/ Excludes US$ 12.3 million form the ANDA-FIS joint program to avoid duplication in the 1990-1996 period. Source: ANDA, FISDL and MOH

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. Expenditure by Economic Function and Category 5.12. A review of ANDA expenditures by function during the period 1997-2003 (Chart 5.1) indicates that: i) Activities related to production, physic-chemical treatment of water, and maintenance of distribution systems encompassed approximately 50 percent of total expenditure of the period, after falling to a minimum 32 percent of expenditures of 2000, and rising to 64 percent of expenditures of 2003; ii) Investments constitute the second-highest most important expenditure, having reached a maximum of 39 percent of expenditure in 2000 and then drastically falling to 5 percent of expenditure in 2003;111 iii) Administration represented an average 14 percent of expenditures for the period, participation for year 2003 being similar to 1996; iv) Resources destined for debt payment grew threefold between 1996 and 2003, reaching a maximum of 14 percent in 2000; and, v) Resources destined to preventive and corrective maintenance of water meters, mechanization of reading water meters, facilities granted for payment of water bills (ANDA’s collection centers and credit card and banking collection fees) and connecting water and sewerage, represented an average of 5 percent of total expenditure for the period.

Chart 5.1: ANDA Expenditures by Function, 1997 – 2003

0 10 20 30 40 50 60 70

% o

f Tot

al E

xpen

ditu

re

Administration 16.5 17.5 11.4 12.2 9.9 14.9 15.2 16.2 Debt Service 3.0 3.1 6.6 12.0 14.2 10.5 11.3 10.6 Billing&Collection 7.9 8.5 7.2 6.9 4.6 2.7 2.8 3.9 Production&Distribution 48.1 54.3 49.6 41.7 32.3 47.1 58.0 64.0 Investment 24.5 16.6 25.1 27.1 39.0 24.8 12.7 5.3

1996 1997 1998 1999 2000 2001 2002 2003

Source: ANDA and Ministry of Finance 5.13. A review of ANDA expenditure by economic category (Table 5.4) reveals that: i) Approximately 45 percent of resources for the period 1997-2003 were spent on the purchase of goods and services, of which the total for 2003 is lower than that of 1997; ii) Payment of wages and salaries averaged 17 percent of total expenditures during the period, with a decreasing trend up to year 2002; iii) 24 percent of resources for the period was allocated for purchase of assets, having reached a maximum share in 2001 of 33.5 percent, falling drastically thereafter to 4 percent in 2003 (see below); iv) Participation of

111 This decline is explained by discontinuation of projects affected by acts of corruption by the institutions’ ex president and ex- general manager, who are being prosecuted by the courts.

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financial expenditures increased six-fold between 1997 and 2003, from 3 percent to 19 percent; and, v) Current and capital transfers remained constant at 0.1 percent of expenditures for the period.

Table 5.3: ANDA Expenditures, by Major Economic Category, 1997 – 2003

(% of total executed budget)

1997 1998 1999 2000 2001 2002 2003 Wages and salaries 24.1 18.9 18.1 15.1 13.5 13.0 20.2 Goods and services 63.4 43.3 40.2 36.3 37.1 46.7 57.0 Transfers 0.0 0.1 0.3 0.1 0.1 0.1 0.1 Financial Expenditures 3.1 6.5 15.8 15.7 15.9 17.5 18.7 Asset Purchases 9.4 31.2 25.6 32.8 33.5 22.8 4.0 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Source: Ministry of Finance

Table 5.4: Public Investment Programs in Water and Sanitation, 1990 –

2003

US$ millions 1. San Salvador Metropolitan Area (AMSS) 80.6 Improvement in the water and sanitation systems of the (IDB) 23.2 Rehabilitation of the north zone water supply systems (France) 8.8 Rehabilitation of the north zone water supply systems (CABEI) 18.3 Expansion of treatment plants lempa river, phase II (Spain) 30.3 2. National Reconstruction Program (PRN) 31.2 Rehabilitation of water and sanitation systems (IDB) 19.9 Improvement in water and sanitation systems (Japan) 11.3 3. Rural Area 194.7

Water supply and basic rural sanitation in 15 municipalitites of the central region(KFW) 15

Water supply and sanitation in rural areas and urban marginal areas (Japan,USAID, CARE, PCI, Luxemburg, UNICEF, Korea) 39 Water and sanitation (FANTEL) 19.6 Water and sanitation , FISDL (IDB, CABEI) 63.2 Basic sanitation, MSPAS (USAID, UNICEF) 57.9 4. Counterpart resources ANDA Government a/ 69 5. Total 376.5 a/ Includes US$ 4.5 millions de ANDA in 2003 and excludes US$ 12.3 million of the ANDA-FIS join program to avoid duplication in 1990-1996. Source: ANDA, FISDL and MSPA

5.14. Investments in the water and sanitation sector for the period 1990-2003 amounted to US$377 million (Table 5.5), and were mainly geared toward: i) Increasing coverage of water and sanitation to rural areas and marginal urban areas through FISDL, MSPAS and ANDA, with donations, FANTEL resources, and BID and KFW loans (US$195 million, equivalent to 52 percent of investment of the sector); ii) Increasing production capacity and improving ANDA’s distribution network in the San Salvador Metropolitan Area, as well as improving served-water quality with financing by BID, BCIE, France and Spain

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(US$81 million, equivalent to 21 percent of resources); iii) Counterpart resources to the other programs with Central Government or own resources (US$69 million, equivalent to 18 percent of resources); and, iv) Rehabilitating or reconstructing water supply and sewerage systems in municipalities most affected by the armed conflict of the 1980s as part of the National Reconstruction Plan (US$31 million equivalent to 8 percent of resources). Finally, the sector benefited from an IDB’s loan to support the reform of the sector for US$ 44 million.

Chart 5.2: ANDA Investment by Financing Source, 1990 - 2002

0 5

10 15 20 25 30 35 40 45

(Mill

ions

of U

S$)

Total Investment 1.1 2.1 3.9 3.4 3.5 20.9 34.3 31.7 29.9 43.0 36.0 39.0 13.6 Foreign Loans 0.0 0.0 0.0 0.0 0.0 11.6 27.8 23.5 14.2 16.8 14.9 17.4 0.0 Donations 0.8 1.3 3.6 1.9 1.1 0.6 0.0 1.3 0.8 10.6 10.4 3.0 4.2 ANDA 0.3 0.7 0.3 0.1 0.9 2.5 3.2 4.6 12.5 13.9 9.6 5.6 1.3 Other Local 0.0 0.0 0.0 1.3 1.6 6.2 3.3 2.3 2.4 1.7 1.2 13.0 8.1

90 91 92 93 94 95 96 97 98 99 00 01 02

Source: ANDA and Ministry of Finance Source of Funds 5.15. ANDA investments in water and sanitation for the period 1990-2003 reached US$ 267 million, of which 93 percent were carried out in 1995-2002. Sub-periods with fewer investments were 2003 with US$4.5 million, and 1990-1994 with US$14.0 million (Table 5.6). Average counterpart financing of investment projects was 37 percent from ANDA own resources and transfers from public institutions. External resources for the period 1990-1994 came from USAID donations, because of overdue payments by ANDA with international agencies, while internal resources came from an ANDA-FIS agreement and the institutions own resources in equal amount. The main sources of external providers during 1995-2002, were: IDB, Spain, Japan, CABEI and Germany (54 percent of investment, and 85 percent of external resources); and own ANDA resources (21 percent of investment, and 58 percent of local resources). An average of 48 percent of ANDA investment for the period 1990-2002 (Chart 5.2) was financed by external loans. ANDA-own resources financed 21 percent of investment for the period, 15 percent with external donations; and, 16 percent with Central Government and FIS resources.

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Table 5.5: ANDA – Source of investment financing, 1990 - 2002

1990-1994 1995-2002 US$ million % US$ million Total Investment 14.0 100.0 Total Investment 14.0 Water supply 9.8 70.6 Water supply 9.8 Sanitation 4.2 29.4 Sanitation 4.2 Total financing 14.0 100.0 Total financing 14.0 External 8.7 62.7 External 8.7 BID a/ 0.0 0.0 BID a/ 0.0 Spain 0.0 0.0 Spain 0.0 Japan 0.0 0.0 Japan 0.0 CABEI 0.0 0.0 CABEI 0.0 KFW 0.0 0.0 KFW 0.0 France 0.0 0.0 France 0.0 Luxemburg 0.0 0.0 Luxemburg 0.0 USAID 8.7 62.7 USAID 8.7 Others b/ 0.0 0.0 Others b/ 0.0 Local Financing 5.2 37.3 Local Financing 5.2 ANDA 2.4 17.0 ANDA 2.4 FANTEL 0.0 0.0 FANTEL 0.0

Central Government 0.0 0.0 Central Government 0.0

FIS Agreement 2.8 20.4 FIS Agreement 2.8 a/ Only project lending b/ CARE, UNICEF, Korea, PCI and El Dorado Source: ANDA, FISDL and MOH

IV. Expenditure Outcomes 5.16. Investments carried out during the period 1990-2002 have improved coverage of water supply and sanitation systems, particularly in underserved rural areas and in the poorest communities. In spite of this, El Salvador still lags behind in terms of coverage with respect to its neighbors; and parasites and diarrhea continue to be the main causes of morbidity, in cases treated by MSPAS clinics. The following paragraphs analyze the sector’s coverage and the efficiency, the quality of water supply and sanitation services, and the incidence of public expenditures. Coverage 5.17. National coverage of piped-water service increased by 18 percentage points during 1990-2002: from 46 percent to 64 percent of total population (Table 5.7). This outcome is explained by having incorporated more than 300,000 new residential connections to ANDA’s distribution network. According to ANDA, coverage in rural areas increased by 19 percentage points during the same period, almost twice the increase in coverage of the urban area, through a similar expansion of residential connections and public connections (9.6 and 9.5 percentage points, respectively). In 2002, 96 percent of the urban population had access to water served by pipes, almost three times more than the rural coverage, mainly through residential service (90 percent, compared to 6 percent

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through public connections). Of 30 percent of rural population with access to piped water in 2002, 20 percent did so through residential connections, and 10 percent through public connections.

Table 5.6: El Salvador Water Supply and Sanitation Coverage, 1990 – 2002

(% of population)

1990 1994 1999 2002 Change 1990-2002 (%

points) Piped Water a/

National 46.1 50.0 59.2 63.7 17.6 Urban 86.0 80.8 92.4 96.0 10.0 Rural 11.0 18.0 25.3 30.1 19.1

Sanitation b/ National 60.8 55.8 68.4 70.9 10.1 Urban 86.6 80.7 85.9 90.0 3.4 Rural 38.1 58.5 50.3 51.0 12.9

Connections (#) Water 312,834 400,731 539,579 612,917 300,083

Sanitation 244,784 310,277 401,786 450,073 205,289 a/ Piped water to residential and public connections b/ Latrines and sewage Source: ANDA

5.18. Coverage of sanitation at the national level increased by 10.1 percentage points between 1990 and 2002, from 61 percent to 71 percent of total population, due mainly to incorporating more than 200,000 connections to ANDA sewerage networks. Expansion in the rural area was four times greater than that registered in the urban area (13 percentage points, versus 3.4 percentage points). In spite of this, coverage of sanitation in 2002 in the urban area was 1.8 times greater than in the rural area. Half the total population with access to sanitation in 2002 has residential connections to the sewerage networks and the other half has through latrines (35 percent and 36 percent respectively), with a relation of 3 to 1 connections-latrines in urban areas, while the rural areas are 100 percent latrines. Data for the household surveys show a similar trend to that reported by ANDA.112

112 Date for the household surveys show that the expansion in piped water coverage at the national level between 1991 and 2002 was 14.2 percentage points in terms of households. The increment in piped water to rural households was twice that registered for urban households, equal to Charts reported by ANDA in terms of population. Nevertheless, piped water coverage by EHPM in terms of households in 2002 is higher than ANDA Charts in terms of population (75.9 percent versus 63.7 percent). When considering households that have wells, water coverage in 2002 rises to 88.1 percent at the national level (versus 63.7 percent of population with access to piped water from ANDA), 96.5 percent for urban areas (similar to ANDA’s 96.0 percent) and 73.7 percent in rural areas (compared to ANDA’s 30.1 percent), and 97.5 percent in the San Salvador Metropolitan Area. As for sanitation, the expansion of drainage coverage at the national level between 1991 and 2002 according to EHPM was 14.9 percentage points in terms of households (higher than 10.1 percentage points in terms of ANDA’s Charts for population). The rise in coverage for rural regions was 9 times greater than in urban areas (compared to 4 times ANDA’s Charts). These differences can be explained because ANDA does not take into consideration latrines installed by NGOs operating in the sector. Coverage of drainage in 2002, according to EHPM, was 93.0 percent of homes at the national level (compared to 70.9 percent of population according to ANDA), 98.1 percent of

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Table 5.7: Central America – Water Supply and Sanitation Coverage, 1999

(% of population)

Costa Rica El Salvador Guatemala Honduras Nicaragua Panama Water Supply National 95.0 59.2 80.3 80.9 66.5 86.8 Residential Connection 89.2 51.9 61.7 75.2 54.0 82.0 Public Connection 5.8 7.3 18.6 5.7 12.5 4.8 Urban 99.6 92.4 98.7 93.8 95.0 87.7 Residential Connection 99.5 86.3 87.3 89.0 88.3 86.8 Public Connection 0.1 6.1 11.4 4.8 6.7 0.9 Rural 91.5 25.3 70.3 69.7 33.5 85.8 Residential Connection 81.4 16.7 47.9 63.2 14.4 76.1 Public Connection 10.1 8.6 22.4 6.5 19.1 9.7 Sanitation National 93.5 68.4 79.5 70.2 75.8 93.2 Residential Connection 21.0 32.5 42.2 25.7 17.3 35.5 Latrine 72.5 35.9 37.3 44.5 58.5 57.7 Urban 88.8 85.8 94.7 93.9 93.0 98.7 Residential Connection 47.3 64.1 92.7 55.2 32.3 64.1 Latrine 41.5 21.8 2.0 38.7 60.7 34.6 Rural 97.1 50.3 71.3 49.5 56 86.6 Residential Connection 1.1 0.0 15 0.0 0.0 0.3 Latrine 96.0 50.3 56.3 49.5 56.0 86.3 Population miles 3,341 6,157 11,088 5,989 4,690 2,762 Source: “Evaluation of the Water Supply and Sanitation Services in the Americas, 2000” , Pan American Center for Sanitation Engineering and Environmental Sciences,CEPIS/ WHO/PAHO

Table 5.8: Central America Water Supply and Sanitation Coverage, 1999 5.19. A comparison of the regional coverage carried out by WHO/PAHO in 1999 (Table 5.8), reveals that El Salvador registered the lower national coverage of water supply and sanitation. National coverage of water supply in El Salvador was 3/5 that of Costa Rica (59.2 percent of total population, versus 95.0 percent); and of sanitation approximately 3/4 (68 percent versus 94 percent). At the urban level, water supply coverage in El Salvador only exceeded Panama (92 percent versus 88 percent), while rural coverage in El Salvador was only 1/4 that of Costa Rica. Coverage of sanitation at national and urban level in El Salvador is 1.5 times higher than in Costa Rica. Efficiency 5.20. Efficiency of the water supply and sanitation systems can be evaluated through the losses in water distribution and the price of service. There is no public record of water losses in ANDA systems. However, there are indications that in the early-1990s, the losses were high but have subsequently diminished. For example, the survey of

urban homes (slightly higher to ANDA’s Charts 90.0 percent), 84.4 percent of rural homes (as against 51.0 percent) and 98.7 percent of homes in the San Salvador Metropolitan Area.

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hydraulic balance of the AMSS water supply system carried out in February 1993113 indicated that water losses were 39 percent; on the other hand. A WHO/PAHO evaluation indicated that in 1999 there were 21 percent water losses in AMSS.114 ANDA estimated at 17.4 percent potable water losses at the national level in 2002. Estimates of losses using ANDA systems reported production and consumption Charts at the national level for period 1993-2002 shown in Table 5.9, indicate that water losses (operational and commercial) rose from 16 percent in 1993 to a maximum 26 percent in 1996 and then diminished to 9.6 percent in 2002. In this context, it should be noted that the proportion of meters in operation declined from 72 percent in 1993 to 57 percent in 2002.

Table 5.9: ANDA’s Water Losses, 1993 – 2002

Year Production Consumption Water Losses Meters Functioning (Its/seg) (miles m3) (thousand m3) (percent) (percent) 1993 6972.1 219872.2 184235 16.2 71.8 1994 7634.1 240749.1 182116 24.4 73.6 1995 7567.1 238636.8 178999 25 62.5 1996 8060.1 254183.3 188125 26 67.2 1997 8317.1 262288.1 204058 22.2 67.1 1998 8344.2 263142.7 218135 17.1 67.6 1999 8475.1 267270.5 226970 15.1 64 2000 8713.6 274792.1 236934 13.8 61.6 2001 8844.4 278917.1 248964 10.7 57.6 2002 9706.7 306110.5 276762 9.6 56.7 Source: World Bank based on ANDA data

Chart 5.3: Nominal and Real Price of Water Service as Measured in CPI

0 25 50 75

100 125 150 175 200 225 250

Pric

e In

dex

(199

3=10

0)

Real 100 76 144 98 86 83 91 95 83 122 124 Nominal 100 100 173 173 173 173 173 173 173 247 247

93 94 95 96 97 98 99 00 01 02 03

Source: DIGESTYC

5.21. ANDA’s water tariff is approved by Congress, and includes a sewerage charge. This situation does not allow the establishment of a tariff structure for: i) Ensuring

113 “Analysis of the Potable Water and Sanitation Sector in El Salvador”, USAID, IDB, CARE, CONADE, WHO/PAHO. 1994 114 Evaluation of Potable Water and Sanitation Services in the Americas, 2000, WHO/PAHO.

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recovery of operational expenses, maintenance and service of current systems in use, an new systems for enhancing coverage; ii) Recovering collection costs, treatment, and final disposition of sewage; and, iii) Promoting rational use of water for human consumption and other household uses. During the period 1993-2003, the price of ANDA water service, measured by the Consumer Price Index has undergone two increments: in December 1994, when the last tariff adjustment was implemented, and in December 2001, when a 50 percent subsidy was eliminated for the first 20 m3 of water, irrespective of monthly consumption, remaining valid only for marginal communities and for users with monthly consumption up to 20 m3 (See Chart 5.3). These measures produced a 147 percent nominal increment in the price of the service between 1993 and 2003; and a real increment of 24 percent.

Table 5.10: Average Water Price in Greater San Salvador, 2002 (US$/m3)

Sector/ consumption range 0 - 20 m3 21 - 40 m3 41 m3 + Average Subsidy w.r.t. average price a/

Marginal Communities 0.08 0.1 0.1 0.1 330% Autonomous institutions 0.19 0.32 0.26 0.26 65% Residential 0.18 0.2 0.45 0.29 48% Municipal institutions 0.11 0.34 0.37 0.37 16% Government institutions 0.36 0.37 0.37 0.37 16% Commerce 0.49 0.47 0.47 0.47 -9% Industry 0.33 0.4 0.48 0.48 -10% Average price 0.3 43% Average cost 0.43 a/ (+)=subsidy in relation to the average price (-)=overprice relative to average price, which has been estimated dividing total collections by total water billed. Source: World Bank with ANDA data

5.22. In spite of the foregoing increments, the tariff structure in 2002 generated an average charge of US$0.30/m3 of water in the Greater San Salvador (GSS), 115 lower than US$0.43 which is the average cost for ANDA of 1 per 1 m3 billed (Table 5.10). This means that, in average, users in GSS still are being implicitly subsidized by the tariffs with 43 percent per 1 m3 of water consumed. Sectors that as an average do not receive implicit subsidies are the commercial sector, with a monthly consumption above 21 m3 and the industrial sector, with a monthly consumption above 41 m3. While the sectors that receive relatively greater implicit subsidies are the marginal communities (330 percent), the municipal institutions with monthly consumption of less than 23 m3 (291 percent), the residential area with a monthly consumption of less than 20 m3 (139 percent) and between 21 and 40 m3 (115 percent), the autonomous institutions with a monthly consumption lower than 20 m3 (126 percent) and greater than 41 m3 (65 percent). 5.24. The tariff privilege for GSS residential clients of ANDA becomes greater when compared to prices paid for provision of water through barrels (from US$2.86 to 115 The Greater San Salvador includes 16 municipalities while the Metropolitan Area of San Salvador includes 13 municipalities.

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US$4.57/m3 in 2000), or truckloads (US$3.66/m3 in 2000). In the first case, the implicit subsidy of ANDA tariff moves between 535 percent (when monthly consumption is greater than 41 m3 and 5 barrels are purchased, equivalent to 1m3 of water, at US$2.86), and 2,440 percent (when monthly consumption is lower than 23 and 1 m3 of water in barrels is purchased at US$4.57). While in the second instance, implicit subsidy in ANDA tariff moves between 713 percent (when monthly consumption exceeds 41 m3) and 1932 percent (when monthly consumption is lower than 20 m3). 5.25. Establishing tariffs that reflect the real degree of water scarcity is important, in

order to promote its rational use. Residential per capita consumption for homes connected to the network has increased by 20 percent between 1990 and 2002, with a drop in consumption when prices increased in 1994 and 2001 (See Chart 5.4). The per capita consumption level in 2002 (161.4 liters/habitant/day) was 35 percent greater than in Belgium, Germany, and Portugal (120 liters/habitant/day), countries with higher standard of living than El Salvador.

Chart 5.4: Per Capita Residential Consumption, 1990 – 2002

120

130

140

150

160

170

180

liter

s/pe

rson

/day

Consumption 134.2 159.0 162.3 155.7 176.8 136.7 138.3 143.3 142.3 149.1 150.8 145.8 161.4 90 91 92 93 94 95 96 97 98 99 00 01 02

Source: ANDA

Quality 5.26. Quality of water supply and sanitation service can be evaluated by: i) Continuity of water service, measured by the hours of average supply; ii) Quality of water supplied; and, iii) Degree of treatment of water discharges prior to final disposition. There are no official registers of the population that receives continuous water service (24 hours daily). Nevertheless, in 1994 ANDA’s Operations Management estimated that the average period of water supply for AMSS fluctuated between 16 to 18 hours daily, with critical

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sectors, such as Soyapango, Ilopango and San Marcos, with 8 hours daily. 116 WHO/PAHO estimates for 2000 indicated that 83 percent of 213 urban water supply systems analyzed, had intermittent service.117 The Diagnostic of the Water and Sanitation Network in El Salvador carried out in 2001, in 1,526 of 2,319 districts of the country, revealed that approximately 62 percent of households are supplied with water more than 4 hours daily.118 And the FESAL 2002 indicated that 18 percent of those polled in urban areas and 42 percent in the rural area declared they did not have water supply for at least 4 hours daily during the 7-day week.119 5.27. In view of the above service record, it should not come as a surprise that in 2002 ANDA was the most denounced institution in the Consumer Protection Directorate of the Ministry of Economy for making unlawful charges and the second most accused in 2003, directly behind the power distributor enterprises (19 percent and 14 percent of total complaints presented in 2002 and 2003, respectively). The most frequent complaint of users of ANDA is that bills always arrive on time although service is interrupted for long periods of time. 5.28. ANDA carries out quality control in water production sites and in distribution networks, by means of physic-chemical treatment required to guarantee that water supplied to the population is apt for human consumption. Of 1,370 physic-chemical analyses carried out in ANDA distribution networks at the national level, and 770 in the GSS during 2002, 68 percent and 63 percent, respectively, met standards established by MSPAS and WHO/PAHO (Chart 5.5). Of 5,760 bacteriological analyses carried out in the distribution networks at the national level and 3,160 in GSS, 47 percent and 87 percent, respectively, met these standards. Whilst, of 3,620 readings for chlorination in the GSS distribution network, 59 percent met the established standards. There is no information available on water quality in wells in the rural area. These results explain the proliferation of private enterprises selling bottled drinking water, mainly to medium and high income families, thought the cost of bottled water is 21 more expansive per m3 than the water supplied by ANDA.120

116 Analysis of the Potable Water and Sanitation Sector in El Salvador. USAID, BID, CARE, CONADE, OPS-OMS. 1994 117 Evaluation of Potable Water and Sanitation Services in the Americas, 2000. WHO/PAHO. 118 The Diagnosis of the Water and Sanitation Network in El Salvador. RAE-ES, September 2001. 119 Health survey carried out periodically by the Demographic Association of El Salvador with USAID support. 120 This Chart results from a comparison of the average price of the water supplied by ANDA to residential users—with consumption greater than 40 m3 (US$0.45/m3)—with the equivalent price for bottled water currently valid on the Salvadoran market, through purchase of 5 gallon containers (US$96.7/m3 = US$1.83 x 52.8 containers).

150

Chart 5.5 Water Qualtiy in ANDA’s Distribution Network, 2002

68%

47%

63%

87%

59%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

100%

Physic - chemical analyses Bacteriological analyses Chlorination readings

% o

f tes

t tha

t met

the

norm

Nationla Level GSS

Table 5.11: Causes of Morbidity Related to Water Quality and Sanitation, 2002

Age Intestinal Parasites Diarrhea and Gastroenteritis Infections Disease Ranking 1st time consultation % Disease Ranking 1st time consultation All 2 4.5 3 4.4 Less than 1 8 1.4 2 11.5 1 to 4 years 3 6.7 2 6.7 5 to 9 years 2 8.7 4 3 10 to 14 years 2 7.6 4 2.3 15 to 19 years 4 3.5 7 2.2 Source: MSPAS

5.29. In 1994, WHO/PAHO reported that there were 31 water discharge or sewage treatment plants in El Salvador with an approximate flow of 123 liters/second. In year 2000, WHO/PAHO estimated that only between 2 percent and 3 percent of total sewage was getting some type of treatment, while the remainder (over 95 percent) was being dumped into rivers or creek without treatment. The serious resulting environmental and health contamination is confirmed by MSPAS Charts on the most frequent causes of morbidity at the national level related to water quality and sanitation as shown in Table 5.11. Expenditure Incidence 5.30. Household survey data reveals that households located in the third income quintile experienced the highest increment in availability of water service between 1991 and 2002 (25 percentage points) (Chart 5.6). Second place went to households in the

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bottom quintile (23 percentage points), 1.7 greater than the increment reported for higher-income households in the 5th quintile (14 percentage points).

Chart 5.6: Availability of Piped Water per Quintile, 1991 – 2002

30

40 50 60 70 80 90

100

Quintile

% H

ouse

hold

s

1991 54.9 34.7 46.0 52.1 63.5 78.2 1995 58.7 35.8 47.8 58.9 67.5 83.6 2002 75.9 57.7 68.4 76.8 84.2 92.3

Total 1 2 3 4 5

5.31. On sanitation, household that registered a higher increment of service availability between 1991 and 2002 (Chart 5.7) were those in the poorest quintile (21 percentage points), 3.5 times the increment experienced by the households in the 5th quintile (6.5 percentage points).

Chart 5.7: Availability of Sanitation per Quintile, 1991 – 2002

55 60 65 70 75 80 85 90 95

100

Quintile

% H

ouse

h old

s

1991 78.1 60.4 72.8 79.1 85.4 92.7 1995 87.9 74.0 84.6 89.7 93.5 97.5 2002 93.0 81.5 92.1 94.6 97.8 99.2

Total 1 2 3 4 5

Source: Household Survey

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Table 5.12: Distribution of Water Sanitation Services, by department 1990 – 2002

Department Department Water Supply Sewage Per Capita Income New Connections New Connections Total country 300083 205289 Total Urban 97% 100% Ahuachapan 47.8 2.90% 2.20% Santa Ana 72.9 8.50% 6.20% Sonsonate 69.6 3.50% 2.80% Chalatenango 61 1.10% 0.80% La Libertad 125.3 9.60% 11.00% San Salvador 140.9 52.50% 63.30% Cuscatlan 79.3 2.10% 1.30% La Paz 68.1 2.90% 1.60% Cabañas 50.9 1.10% 0.80% San Vicente 66.2 1.40% 1.10% Usulutan 66 5.00% 2.80% San Miguel 80.1 4.40% 4.60% Morazan 56.5 0.30% 0.30% La Union 60.2 1.90% 1.20% Total Rural 3.00% 0.00% Correlation coefficient 0.81 0.81 Source: ANDA

5.32. Geographical distribution of new ANDA services for period 1990-2002, reveals that 62 percent of new aqueduct services and 74 percent of sanitation services were connected in the department of San Salvador and La Libertad (Table 5.12). The next-following department with greater proportion of newly connected services was Santa Ana. These results are congruent with ANDA policies of promoting a higher number of connections of service in those regions where there are already water supply and sanitation systems. Payment facilities for these connections are offered, so as to reap the benefits of the local economies—or their density—located in these infrastructures. In the case of sanitation service, the high correlation coefficient between department per capita income and new number of new connections reflects more so the fact that departments with higher incomes are also in possession of existing networks. 5.33. A geographical analysis of water supply and sanitation projects carried out by FISDL during 1991-2003, reveals that 60 percent of investments in water supply were done in the departments of San Salvador, Cuscatlán, Usulutan, La Libertad and Sonsonate; while 71 percent of investments in sanitation were done in the departments of San Salvador, San Miguel, Santa Ana, Sonsonate and La Paz (Table 5.13). In both cases, there is high correlation between investments carried out and departmental per capita incomes. Nonetheless, virtually all FISDL investments benefit low income communities within these departments.

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Table 5.13: FISDL’s Distribution Water Sanitation Projects by Department 1991–2003

Department Department Water Supply Sanitation

Per capita incomeInvestment ($million) Beneficiaries (#) Investment ($million) Beneficiaries (#)

Total (#) 31.87 736,096 16.56 185,390

Ahuachapan 47.8 5.10% 5.30% 7.30% 5.60%

Santa Ana 72.9 7.20% 6.00% 11.20% 6.60%

Sonsonate 69.6 9.10% 6.90% 9.70% 8.60%

Chalatenango 61 4.10% 3.50% 1.20% 0.80%

La Libertad 125.3 10.10% 15.50% 4.00% 3.30%

San Salvador 140.9 14.80% 20.80% 30.30% 31.00%

Cuscatlan 79.3 14.00% 7.80% 6.10% 12.90%

La Paz 68.1 4.80% 6.90% 8.40% 10.20%

Cabañas 50.9 2.10% 1.70% 0.70% 0.40%

San Vicente 66.2 2.10% 1.90% 4.30% 2.90%

Usulutan 66 11.40% 8.00% 3.50% 5.00%

San Miguel 80.1 6.30% 6.60% 11.70% 11.60%

Morazan 56.5 3.20% 4.00% 0.60% 0.20%

La Union 60.2 5.60% 5.10% 0.80% 0.80%

Correlation coefficient 0.7 0.94 0.7 0.7 Source: FISDL

V. Conclusions and Recommendations 5.34. Water supply and sanitation indicators for 1990-2003 reveal an increase in coverage, mainly in rural areas. The MDG-7 under the general objective of environmental sustainability establishes the target of reducing to half by 2015, the proportion of population not having sustained access to safe water and basic drainage in 1990. The recent study of the situation of El Salvador in relation with the MDGs indicates that El Salvador has already surpassed the MDG target for urban water and sanitation and rural sanitation coverage and it is likely that by year 2015 the target for rural access to water will be met.121 Nevertheless, there are still great challenges to be met in the sector. 5.35. Strengthening the water supply and sanitation sector is part of the new President’s Government Plan: Safe Country 2004-2009. It stresses the need to increase coverage of water supply services, particularly to the poor households, and improve basic sanitation with community participation; modernize the sector’s legal and institution framework; and promote water conservation. Consistent with these objectives, the previous analysis points out that the main sector challenge is to implement a reform that includes the establishment of a new legal framework that eliminates ANDA’s double role as regulator and operator, the creation of an independent regulatory entity, the restructuring of ANDA management to ensure the transparent use of resources, and the definition of water use

121 “El Salvador: Avance de los Objetivos de Desarrollo del Milenio- Primer Informe de País”, 2004.

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rights. In addition, there is a need to meet the following specific challenges: i) continue to raise water supply and sanitation coverage in the rural area; ii) reduce operational and commercial water losses; iii) improve the quality of water supplied; iv) improve service continuity (at least raising the number of days a year in which water is supplied to critical areas); and v) promote actions for the treatment of water discharges in the main cities of the country. Allocation of resources to the sector 5.36. The sector key challenge is to achieve universal coverage of water supply and sanitation by 2015. Coverage of water and sanitation services increased significantly in the last several years, particularly in rural areas. Nonetheless, El Salvador coverage through piped water networks and sanitation is still low compared to its neighbors. 122 Given the uncertainty about the nature and timing of water and sanitation sector reforms and about the most cost-effective and appropriate service delivery models, estimating with precision the necessary increases in investments is difficult. Nonetheless, recent estimates suggest a possible range of costs associated with attaining universal coverage in water and sanitation. Using international estimates of efficiency prices and differentiating between the costs of investments in rural and urban areas, Yepes (2004) estimates an average annual investment cost of US$ 21 million between now and 2015, or about 0.14 percent of GDP per year. Because these calculations use estimates of efficiency costs, rather than actual costs, they may be interpreted as lower-bound estimates. Following an analysis presented in the recent Human Development Report (2004), and using unit cost estimates provided by ANDA (although not differentiating between the unit costs of rural and urban areas), it is estimated that the additional investment costs of achieving universal water and sanitation coverage would range from US$ 45 to US$ 50 million between now and 2015, or as much as an additional about 0.3 percent of GDP per year.123

Intra-sectoral allocation of resources 5.37. New investment should not be in detriment of the need to maintaining the existing infrastructure and improving the quality of services. The qualitative aspects, such as improving water quality, continuity of service, and promoting adequate use of latrines built, are as important as increasing the coverage of the services. Thus, there is a need to balance the amount of resources dedicated to extend the coverage of service with the need to maintain and improve existing infrastructure and provide quality services. 5.38. The sector will benefit from more involvement from the municipalities, NGOs and communities, particularly in the execution of high-impact projects with low investment, to meet in the short term rural low-income household needs. These projects could include sanitary education, programs for building wells, water storage tanks, septic

122 When considering wells and latrines built by institutions operating in the sector, water coverage at the national level rises to 88 percent and drainage to 93 percent of households in 2002. 123 In the absence of sector reforms and the identification of a cost-effective service delivery model for rural areas, the costs are likely to be closer to the upper- than the lower-bound estimate.

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tanks and/or latrines, and campaigns for the treatment of water emanating from wells, rivers, creeks, and rainwater 5.39. ANDA needs to streamline further its operations and ensure that resources are used in an efficient and transparent manner. The recent corruption scandals call for a major restructuring of ANDA management policies and procedures. As mentioned ANDA’s mandate should be revised to eliminate its double role as regulator and operator with its conflicting incentives. In this context, there is also a need to establish a sustained model of decentralization of services in the sector. In the last several years, pilot projects have been initiated by ANDA with mixed results. In several instances, the administration of the systems was returned to ANDA because of the high cost of electricity for pumping water. In other cases, the service model appears to be working. Efficiency and equity of resource use 5.40. The quality of ANDA services needs to improve substantially. There is large disruption of ANDA water service, the quality of water at the national level is poor, and sewage is dumped into rivers, creeks, and lakes without treatment. As mentioned, 18 percent of those polled in urban areas and 42 percent of the rural area did not have water delivered at least during 4 hours daily. In 2002, only 68 percent of physic-chemical analysis and 47 percent of bacteriological analysis carried out at the national level on ANDA distribution networks met WHO/PAHO standards. On the other hand, less than 3 percent of total sewage gets treated before final disposition into superficial water sources. This means that the health benefits mainly to the urban population brought about by aqueducts and sewerage, in turn become environmental costs to the all population. 5.41. The pricing of water and sanitation services is inefficient and should be revised. Despite the tariff adjustments in 1994 and the elimination of subsidy for all consumers, except those that consume up to 20 m3 of water per month beginning January 2002, there remains an implicit subsidy in the water tariff of 43 percent. The cost for ANDA residential users is a fraction of the cost for low-income households that must buy water by the barrel or by truckloads. A new tariff policy should allow for: recuperating operation and maintenance costs; financing expansion of water and sanitation systems; and promoting rational use of water. This implies, eliminating excess privileges in the hands of current users of ANDA with high monthly consumption. Because of the sacrifice that will be demanded from consumers, tariff adjustments should be accompanied by specific commitments from ANDA to raising coverage, quality of service, operational and financial efficiency, and honesty and transparency of administration of resources. 5.42. FISDL spending on the sector has been pro-poor and it should continue to support low-income communities with cost-efficient water and sanitation systems. Between 1991 and 2002, lowest-income household (first three income quintiles), experienced an increment in piped-water availability 1.6 times greater than richest household (fifth quintile). This increase in water coverage in rural households was double the amount experienced by urban households. During the same period, households in the first quintile

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registered an increase in availability of sanitation 3.5 times higher than the households in the fifth quintile. Increases in sanitation coverage in rural areas between 1991 and 2002, was 9 times higher than for urban areas. Recommendations 5.43. In sum, consideration may be given to the following:

• Seek a broad consensus on the direction of sector reform that should include the approval of a new legal framework that eliminates ANDA’s double role as regulator and operator, the creation of an independent regulatory entity, the restructuring of ANDA management, and the definition of water use rights.

• Balance the amount of resources dedicated to extend the coverage of service with the need to maintain and improve existing infrastructure and increase service quality.

• Implement high-impact, low cost projects to meet in the short-term rural low-income household needs. These projects could include: i) sanitary education to promote adequate use and maintenance of the drainage infrastructure built, water conservation, final disposition of waste, habits of good hygiene, etc.; ii) programs for building wells, water storage tanks, septic tanks and/or latrines in households where it still is not socially worth expanding and/or building aqueduct and sewerage systems; and iii) campaigns for physic-chemical treatment of water emanating from wells, rivers, creeks, and rain-water.

• Evaluate the conditions necessary for reaching a sustainable decentralization of water supply and sanitation systems to municipalities and communities.

• Design and apply a tariff policy that allows for: i) recuperating operation and maintenance costs of current water supply and sanitation; ii) recuperating costs for collection, treatment, and final disposition of sewage; iii) financing expansion of systems, in order to raise coverage of services to population currently not being served; and iv) promoting rational use of water for human consumption and other household uses.

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CHAPTER VI: Rural Roads 6.1 The evaluation of public expenditure for rural roads focuses on the Ministry of Public Works (MOP), on the Fund for Road Conservation (FOVIAL), and on the FISDL. The chapter contains a review of the sector organization and the government strategic objectives and the process of resources allocation in the sector, an analysis of the public expenditure trends and structure and its outcome, and concludes with the identification of the sector’s principal public expenditure challenges and recommendations.

I. Sector Organization 6.2 Public institutions responsible for building and maintaining roads in El Salvador are: MOP, FOVIAL, FISDL, as well as the municipalities. During the 1990s, MOP administered the roads through the: i) General Administration of Road (DGC), that was in charge of planning, construction, roads signaling, and maintenance of national roads, including rural road; and ii) Administration of Urban Planning and Architecture (DUA), responsible for urban roads. Municipalities had the responsibility for the lowest traffic rural road (caminos vecinales). Since 1999, the FISDL has financed road improvement projects. Currently, it carries out the Technical Assistance Program for Preventive Maintenance of Municipal Road, in order to strengthen the municipal technical, organizational, financial capacities for preventive maintenance and repairs of their roads.

Table 6.1: El Salvador – Road Network, 2000 Kilometers PercentTotal Road Network 10,886 1001. Priority Road Network 5,086 46.7 a) Paved 2,177 20 -Special 133 1.2 -Primary 618 5.7 -Secondary 1,111 10.2 -Terciary Modified 191 1.8 -Rural Modified 122 1.1 b) Not Paved 2,908 26.7 -Terciary 1,323 12.2 -Rural "A" 775 7.1 -Rural "B" 809 7.42. Rest of Non paved road network 5,150 47.33. Urban road network 650 6Source: MOP

6.3 In 2000, MOP reclassified the roads network in the following manner: i) Priority roads, made up by 5,086 Kms of high-traffic inter-urban roads connecting urban centers

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in the country with the Central American countries,124 leading from municipality to municipality, municipalities to paved highways, and to high-production agricultural zones and tourist zones, (Table 6.1); ii) The remaining unpaved roadways, made up by 5,150 Kms of dirt-roads with very low traffic and, often not passable, and iii) Urban roads, made up by 650 Kms of city roads. MOP is in charge of road construction and maintenance (until the creation of FOVIAL, see below) of priority roads, while municipalities are in charge of maintenance of the remaining road network, unpaved and urban, which was previously under DUA’s responsibility. 6.4 FOVIAL was created in late 2000 to be an autonomous institution in charge of roads maintenance and signaling. However, in 2001, its seed capital was re-oriented to programs for removal of landslides and debris caused by the earthquakes of January and February. In October 2001, its founding-law was modified allowing it to obtain funding through a special tax (US$0.20 per gallon) extra or regular gasoline (excluding aviation gasoline) and diesel oil. On May 2002, FOVIAL began the periodic maintenance projects, and on June 2002, began all routine maintenance projects.

II. Strategic Objectives and Resource Allocation Process 6.5 Due to the condition of the road network in 1990—lack of maintenance over the 1980s—the government’s strategic objectives during the period 1989-1994125 was to give priority to maintenance and rehabilitation of the Central American corridors (alternative “A” and natural), as well as to rural roads, in order to support the export led development-strategy with greater territorial integration. The investment strategy did not contemplate any new road infrastructure. 6.6 Armed conflict produced damages in road infrastructure including the total or partial destruction of 63 bridges and building equipment. In 1991, it was estimated that the cost of rebuilding damaged roads and bridges would be US$285 million. The National Reconstruction Plan (PRN) considered only rehabilitating 310 Kms of rural roads and small municipal bridges, up to a total of US$28.5 million, as the country did not have the needed resources for rebuilding the bridges “Oro” and “Cuscatlan,” which constitute part of the Central American corridors (natural and alternative “A”) located on the Lempa river. 6.7 To avoid road infrastructure to become a bottleneck for economic development in peacetime, the Government established as strategic objectives and goals for the period 1994-1999126: i) Rehabilitating, re-building, and enhancing 135 Kms of major highways; ii) Paving 37,236 m2 of urban road national network and 130 Kms of regional roads; iii) Reconstructing the “Cuscatlán”, “Oro,” and 25 other bridges as well as repairing 33

124 Alternate corridor “A”or Pan-American highway (CA-1) and natural corridor or coastal highway (CA-2). 125 Public Investment Priorities and Needs for Technical Assistance 1989-1994. Ministry of Planning and Coordination of Economic and Social Development. 126 Converting El Salvador into a Land of Opportunities. Government Plan, 1994-1999.

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bridges; iii) Giving maintenance to 320 Kms of paved special highways—primary and secondary—at the national level, and to more than 100 Kms of tertiary roads and rural roads, at the national level; iv) Signalizing horizontally and vertically 1,150 Kms of special highways and main arteries in 27 cities; v) Rehabilitation of 790 Kms of rural roads and tertiary roads at the national level, and 310 Kms in PRN municipalities; and vi) Building five overpasses in the city of San Salvador. 6.8 The government strategic objectives for the 1999-2004 period were: i) Improving the road network to foment agricultural production and rural development, ii) Fostering rehabilitation and maintenance of rural sustainable roads, transferring resources to local administrations and sustained by the community; iii) Supporting strategic regional projects, such as the logistic Central American corridor, so as to advance in productive and commercial integration together with the Region; y iv) Vigorously foster construction, rehabilitation, and maintenance of physical supportive infrastructure for investment, production and export, in order to improve productivity and the economy, so as to create more and better jobs.127

6.9 Earthquakes in 2001 caused damage the road infrastructure amounting to US$150 million, according to ECLA’s estimates (Table 6.2). 45 percent were direct damages owing to total or partial destruction, mainly of components of primary roads including the freeway San Salvador-Comalapa; and in 14 secondary roads; and in lesser degree, in urban roads. The remaining 55 percent covered indirect causes, due to deviations of passenger and commercial national and international traffic to alternative routes, mainly at La Leona curve and Los Chorros.

Table 6.2: Damage Caused by the 2001 Earthquakes to the Road Network (US$ m.) Direct Indirect Total January Earthquake 63.4 82.5 145.9 Primary 43.2 78.5 121.7 Secondary 20.0 0.0 20.0 Urban 0.2 0.0 0.2 Emergency 0.0 4.0 4.0 February Earthquake 3.4 0.2 3.6 Total 66.8 82.7 149.5 Source: El Salvador: Evaluation of the January 13 and

February 13 Earthquakes Damage. UN’s ECLA

6.10 The prioritization of rehabilitation projects for FOVIAL is based on the Salvadoran Roads Management System (SIGESVIES), implemented at MOP with the support of an Israeli-Salvadoran consortium. The criteria used for prioritizing projects are the relation benefits/cost; given the available budget envelop, resources are assigned to those sections that bring the higher benefits to for users. Economic benefits of FOVIAL projects are threefold: i) Savings in cost of operating vehicles (COV); ii) Savings in travel time; and iii) Reduced traffic accidents. According to government estimates, FOVIAL

127 The New Alliance. Government Program 1999-2004.

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will reduce monthly small vehicle COV of US$38.09, and monthly heavy vehicle COV of US$181.71 (Table 6.3). Should 50 percent of total vehicles of this type circulate on FOVIAL-serviced roads, the country would save yearly COV of US$174 million. In addition, FOVIAL will bring about a decrease in small- and large-vehicle users’ travel time up to 40 percent; and up to a 65 percent decrease in traffic accidents.

Table 6.3: FOVIAL’s Expected Benefits

Type of Vehicle Transport/Heavy Passenger/Light Number of Vehicles 52,661 510,142Savings in monthly cost of operating 181.71 38.09Vehicles (COV) (US$/vehicle) 57,414,418 116,587,852Saving in annual COV (US$)a/ 174,002,270Saving in time of transportation Up to 40% Up to 40%Reduction in accidents Up to 65% Up to 65%a/ Assuming that 50percent of the vehicles circulate by roads thatreceive FOVIAL maintenance. Source: MOP Presentation of FOVIAL to the National Assembly,February.

III. Expenditures Structure and Trends Expenditure Trends 6.11 Public expenditure for execution of projects in construction, rehabilitation and maintenance of the road network (inter-urban and urban) for period 1997-2003 was US$1,256 million, of which 82 percent correspond to MOP, 11 percent to FOVIAL, and the remaining 7 percent to FISDL. Resources destined for roads peaked at 1.7 percent of GDP in 2002, and then fell to 1.3 percent in 2003. (Table 6.4). While public expenditure for rural roads for the period 1999-2003 rose to US$ 184 million, equivalent to 27 percent of total expenditures destined for road, during the same period. Fifty eighth percent of public expenditures on rural roads were for rural maintenance and for sustainable rural roads projects carried out by MOP, 37 percent for projects for improvement of roads executed by FISDL, and 5 percent for routine maintenance projects in unpaved roads, carried out by FOVIAL. MOP improved 779 kilometers of sustainable roads during 1999-2003, distributed throughout 58 percent of the central region, 30 percent of the eastern region, and 12 percent of the western region.

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Table 6.4: Public Expenditure in Road Network, 1990 – 2003

(US$ m. and % of GDP)

1997 1998 1999 2000 2001 2002 2003 Total road network a/ 177.5 186.8 120 139.7 195.1 247.6 189.5 MOP 163.6 186.8 116.1 123.9 179.7 183.1 79.8 FOVIAL b/ 0.0 0.0 0.0 0.0 0.0 47.4 93.5 FISDL 13.9 0 3.8 15.8 15.4 17.2 16.2 % of GDP 1.6 1.6 1.0 1.1 1.4 1.7 1.3 Rural Roads 0.0 0.0 23.6 45.7 42.1 28.8 44 MOP c/ 0.0 0.0 19.7 29.9 26.7 11.7 19 FOVIAL d/ 0.0 0.0 0.0 0.0 0.0 0.0 8.8 FISDL 13.9 0.0 3.8 15.8 15.4 17.2 16.2 % of GDP 0.0 0.0 0.2 0.3 0.3 0.2 0.3 a/ Inter-urban and urban b/ Periodic maintenance in paved and unpaved roads c/ Rural maintenance and Sustainable Rural Roads d/ Routine maintenance of unpaved roads e/ Rural (vecinal) road improvement Fuente: MOP, FOVIAL and FISDL

6.12 MOP expenditures that include public works, transport, housing, and urban development, rose from US$175 million in 1997 to US$240 million in 2002; equivalent to a growth of 37 percent (Table 6.5). Eighty six percent of expenditures during 1997-2002 correspond to investments made by the Vice-Ministry of Public Works and FOVIAL on the total road network, the remaining 14 percent was allocated to administration, geotechnical research, Vice-Ministry of Urban Housing and Development, Vice-Ministry of Transport, and support to related units, other than FOVIAL. Resources for rural roads represent 12.1 percent of expenditures made by MOP during 1999-2002; and 14.4 percent of resources for total road network in the same period.

Table 6.5: Ministry of Public Works, Budget Execution, 1997 – 2002 ($ million and %)

1997 1998 1999 2000 2001 2002 Total Total MOP a/ 175.0 203.7 134.7 148.4 201.8 240.2 1103.7 Housing and urban development 3.6 4.3 4.7 10.2 8.2 4.0 34.9 Public works and transport b/ 171.4 199.5 130.0 138.1 193.5 236.2 1068.8 % central government 10.8 10.6 7.2 7.2 8.4 7.2 8.3 Memorandum: % road network/ Total MOP c/ 93.5 91.7 86.2 83.5 89.1 76.2 86.4 % rural roads/ MOP 0.0 0.0 14.7 20.1 13.2 4.9 12.1 % rural roads/ road network 0.0 0.0 17.0 24.1 14.9 5.1 14.4 a/ Includes Vice Ministry of Public Works, Transport, Housing and Urban b/ Includes autonomous institutions (Railways, ANDA, FOVIAL, etc.) c/ Includes Vice Ministry of Public Works and FOVIAL Source: Ministry of Finance

6.13 During the first year of FOVIAL’s operations (2002), it carried out periodic maintenance of paved-road with MOP resources, amounting to US$46.4 million (Table

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6.6 and Box 6.1). In 2003, it carried out periodic maintenance to 250 kilometers of paved roads, amounting to US$62.1 million, and supplied routine maintenance on the main-roads (paved and unpaved) amounting to US$29.8 million, in both instances with own funds arising from the special tax on gasoline. For 2004, the forecast is to carry out periodic or routine management amounting to US$74.4 million.

Table 6.6; FOVIAL’s Expenditures, 2002 – 2004

($ million)

2002 2003 2004 a/ Administration 1.0 1.6 2.2 Periodic maintenance 46.4 62.1 30.9 Routine maintenance b/ 0.0 29.8 43.5 Total 47.4 93.5 76.6 a/ Programmed b/ In paved and unpaved roads Source: FOVIAL

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Box 6.1: Fund for Road Conservation

FOVIAL carries out three types of projects: i) Periodic maintenance; ii) Routine maintenance; and iii) Maintenance of bridges and signalization. Periodic maintenance consists in treatment and renewal of roll-surfaces and shoulders of the roadways. This is carried out every certain number of years, avoiding deterioration of the original conditions (good or regular) brought about by natural causes and use. Routine maintenance is carried out yearly on all elements and structures of paved roads, in order to maintain conditions of roadways and ensure their designed life-span. This implies, repairing roads, sealing fisures and cracks, leveling unpaved surfaces, cleaning longitudinal drainage (curbs), and transversal drainage (tubes), maintaining hillsides, cleaning shoulders and minor roadways, and focal repairs (retaining walls, boxes, etc.). Maintenance of bridges and signalization is carried out every number of years, in order to keep bridges and drainage sites in optimum functioning condition, and at maximum hydraulic capacity. This implies placing and/or replacing all vertical signalization elements (signs) and horizontal elements (division lines, night indicators, etc.), aimed at increasing driver and pedestrian security. FOVIAL activity on paved roadways, include: i) Overlaying roads in bad condition; ii) Repairing superficial and deep patches; iii) Applying seals for waterproofing roadways; iv) Cleaning minor roadways and drainages; and v) construction of drainage and protection sites. On unpaved networks, activities include: i) Re-conditioning roll-surfaces (conformation of road); ii) Substitution of selected material (ballast or gravel); and iii) Building drainages and protection sites. Activity on bridges and crossways, vertical and horizontal signalization, includes: i) Cleaning, repairing, and exchanging bridge elements or components, vaults and boxes; and ii) Placing and/or replacing roadway signalization. Source of Funds 6.14 Contrary to FOVIAL who finances road conservation programs with 100 percent local funds, MOP finances its road-investment programs with external loans (51 percent) and treasury funds (49 percent) (Table 6.7). The principal programs were: i) Multi-Phase for Rural Sustainable Roads (US$58 million—BID in Phase I and US$47 million in Phase II, and national counterpart resources of US$31.72 for both phases) approved in 2001; ii) Roadways Rehabilitation and Improvement Program approved in 1994 (BID US$225 million, OECF of Japan US$106, BCIE US$19 million, and US$116 local resources); iii) First Phase of San Salvador Beltway approved in 1998 (CABEI US$62.7 million, US$46.4 million local resources, and US$1.5 other sources); and iv) Expansion of National Paved Road Rehabilitation Program (CABEI US$32.9 million, and US$4.7 million local resources) approved in 1996.

Table 6.7: Financing of MOP-FOVIAL Investment in Road Network, 1998 – 2003

(US$ m.)

1998 1999 2000 2001 2002 2003 Total Total investment 191.0 120.8 134.1 187.9 234.5 179.6 1041.6 Financing (%) Local resources 33.7 50.9 49.8 52.7 45.0 64.7 48.7 External loans 66.3 49.1 50.2 47.1 50.2 33.5 50.2 Grants 0.0 0.0 0.0 0.2 4.8 1.8 1.1 Source: Ministry of Finance

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IV. Expenditure Outcomes 6.15 Investments in rural road have improved access of rural communities to markets, educational and health centers, water, and security, improving employment possibilities and the quality of life. In spite of the good progress realized in recent years, there is still much to do. The following paragraphs analyze the outcomes of coverage, efficiency and quality of the Salvadoran road network. Coverage 6.16 Between 1991 and 2002, El Salvador’s inter-urban road network grew 7.8 percent in length from 9,847 Kms to 10,618 Kms (Table 6.8 and Chart No 6.1). The proportion of rural roads (unpaved roads) decreased by 80 percent of total inter-urban road network in 1990, to 78.5 percent in 2002, as a result of carrying out of the Program for Rural Sustainable Roads. As from 2000, MOP selected 5,150 Kms of low-vehicular traffic and many impassable rural roads of the total inter-urban road network, converting these to priority roads. Rural roads represented 57 percent of the priority roadways administered by MOP and FOVIAL.

Chart 6.1: Priority Road Network

Source: MOP

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Table 6.8: Participation of Rural Roads on Road Network, 1990 - 2002

1991 1995 1999 2000 2002 Interurban road network (Km) a/ 9,847 9,925 10,177 10,235 10,618 % rural roads 80 79.9 79.2 78.7 78.5 Priority road network (Km) 0 0 0 5086 5555 % rural roads 0 0 0 57.2 56.5 Vehicular park X 100 inhabitants 4.1 5.7 8.2 8.6 9.4 X KM interurban road network 21.8 32.6 49.8 52.9 57.4 X Km priority road network 0 0 0 106.4 109.7 X KM paver road network 108.8 162.3 239.4 248.5 252.1 a/ Data for 2000 and 2002 include 5150 kms of non priority road network. Source: MOP

6.17 The total vehicular count rose from 214,243 units in 1991 (4.1 vehicles per 100 inhabitants) to 609,485 units in 2002 (9.4 vehicles per 100 inhabitants), which represents an increment of 184 percent. This means that demand for road infrastructure in El Salvador grew almost threefold between 1991 and 2002, from 21.8 vehicles per kilometer of total inter-urban road network to 57.4. When considering only the priority roads, vehicles per kilometer doubled in 2002 with respect to total inter-urban road network; and when considering only the paved network they grew fivefold with respect to total inter-urban road network.

Table 6.9: Rural Household Access Indicators

To: Distance (kms) Time (minutes) 1995 2001 Variation 1995 2001 Variation Paved road 5.5 3.5 -37% 35.7 a/ 25.4 -29% Bus stop 2.2 1.6 -25% 20.3 a/ 14.7 -27% Primary school 1.2 0.8 -28% 16.4 11.2 -31% Training center 8.6 6.9 -19% 44.3 36.5 -18% Health center 5.3 4.4 -18% 51.6 30.4 -41% Telephone 4.5 2.1 -52% 32.6 16 -51% a/ 1997. Source: Beneke de Sanfeliú, M. “Dinámica de Ingresos Rurales en El Salvador”. FUSADES, 2003

6.18 The investments carried out on rural roads have improved access of rural households to markets (paved road and bus stops), educational centers (primary schools and educational centers), health clinics and communication technology (closer to phones). The distance covered by rural household members to the closest phone was reduced by 52 percent between 1995 and 2001; to a paved road by 37 percent; to a bus stop by 25 percent; and to educational centers by 18-19 percent (Table 6.9). Travel times have also been considerably reduced.

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6.19 Studies based on FUSADES-Program Basis128, revealed that access of households to markets makes a positive impact on their income levels and, therefore, on their poverty condition. This is due to the fact that location of the household determines access to productive opportunities, which arise in dynamic markets. The closer the household is to urban centers, the greater its participation in the market and this increases household income. Efficiency 6.20 A recent World Bank study129 revealed that, in general, average cost of the Salvadoran road network rehabilitation carried out by various institutions (Sustainable Rural Roads –CRS-, MOP and FOVIAL) are consistent with international standards. Only rehabilitation carried out by MOP, at a cost of US$320 per kilometer, is above the average cost of a World Bank project basket (WBR), but lower than the average plus a standard deviation (See Chart 6.2)

Chart 6.2 Paved Road Works Cost per Kilometer in Thousands of Dollars

46

56

116

122

143

146

161

150

214

320

24

42

144

MOP Earthquake Overlay

WBR Funcional Overlays

CRS Overlay

MOP Overlay (Periodic)

MOP Overlay (Recarpeteo)

WBR Structural Overlays

FOVIAL Overlay (Periodic)

CRS Rehabilitation

WBR Rehabilitation

MOP Rehabilitation

Average

Std.Desv.

Source: WBR: “Road Works Cost per Km from World Bank Reports” Archondo, 2000. Earthquake – MOP, CRS, MOP y FOVIAL

128 Beneke de Sanfeliú, M “Dynamics of Rural Income in El Salvador”, FUSADES, 2003; Beneke de Sanfeliú, M. “Dyanics of Rural Family Income in El Salvador: Panel Study 1995-1997”, FUSADES, 2000; Lardé de Palomo, A. and Argüello de Morera “Integration to Markets of Rural Homes and Generation of Income”, FUSADES, 2000; and Briones, C. and Andrade-Eekhoff “Participation in Labor Markets of Rural Area Residents: Limitations and Challenges”, FUSADES, 2000. 129 Yepes, Tito “Infrastructure and Poverty Reduction in Rural El Salvador” Processed, World Bank, 2004.

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Quality 6.21 Quality of El Salvador’s road network is evaluated by their condition. In 2002, 35 percent of priority road network was in good condition, while 41 percent was in bad condition (Table 6.10). Paved roads were in equal proportion of good, bad condition (42 percent); while 70 percent of unpaved roads were in bad condition, compared with a mere 2 percent in good condition.

Table 6.10: Situation of the priority Road Network, 2002

Type of road Kms Good Regular Bad Paved 2418 42.60% 15.10% 42.40% Unpaved 3137 2.00% 28.00% 70.00% Total 5555 35.30% 23.50% 41.30% Source: MOP

6.22 Departments that in 2002 were in possession of a greater proportion of priority roads in good condition (Table 6.11), were: Cuscatlán (49 percent), Usulután and Cabañas (46 percent), San Miguel (44 percent), La Paz (43 percent), and La Libertad (39 percent). While departments with a greater proportion of priority roads in bad condition, were: La Unión (67 percent), Morazán (57 percent), Ahuachapan (51 percent), San Miguel (46 percent), Usulután (42 percent), San Salvador (41 percent), San Vicente (41 percent), and La Paz (41 percent).

Table 6.11: Situation of the Priority Road Network by Department, 2002

Departamento Kms Good Regular Bad Total Kms 5,555.10 1,959.40 1,304.10 2,291.60 Ahuachapan 372.3 29.40% 19.20% 51.40% Santa Ana 526.3 21.30% 39.50% 39.20% Sonsonete 376.4 23.10% 42.80% 34.10% Chalatenango 579.4 37.40% 34.00% 28.70% La Libertad 545.2 39.20% 28.20% 32.60% San Salvador 370.6 30.40% 28.30% 41.30% Cuscatlan 198.2 48.80% 22.70% 28.40% La Paz 381.5 42.50% 16.80% 40.70% Cabañas 271.5 46.40% 22.50% 31.10% San Vicente 326.5 36.40% 22.70% 40.90% Usulutan 439.2 46.40% 11.30% 42.30% San Miguel 490.8 44.10% 9.50% 46.40% Morazan 266.7 28.10% 14.70% 57.20% La Union 410.7 26.60% 6.80% 66.60% Total % 100.00% 35.30% 23.50% 41.30% Source: MOP

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Expenditure Incidence 6.23 The distribution of Rural Sustainable Roads investments made by MOP during 1999-2003 (Table 6.12) reveals that the main departments benefited were: La Libertad (21 percent of total kilometers built and 8 percent of total investment), Usulutan (13 percent and 9.8 percent), La Paz (10 percent and 8.6 percent), and La Unión (9 percent and 7.2 percent). This explains why La Libertad, Usulutan and La Paz rank among the first 6 departments with higher proportion of priority roads in good condition. While La Unión, in spite of efforts carried out, continues to be the department with the highest proportion of priority roads in bad condition.

Table 6.12: Departmental Distributions of the Sustainable Rural Roads, 1999 – 2003

Departamento Per capita income (US$) Investment ($ million) Length (Kms) Total 107.0 778.9 Ahuachapan 47.8 7.80% 5.30% Santa Ana 72.9 0.30% 0.30% Sonsonete 69.6 8.40% 6.60% Chalatenango 61.0 4.20% 7.20% La Libertad 125.3 21.80% 21.00% San Salvador 140.9 9.40% 7.20% Cuscatlan 79.3 7.00% 5.10% La Paz 68.1 8.60% 10.10% Cabañas 50.9 2.20% 3.00% San Vicente 66.2 5.00% 4.50% Usulutan 66.0 9.80% 13.10% San Miguel 80.1 0.50% 0.80% Morazan 56.5 7.80% 7.20% La Union 60.2 7.20% 8.60% Correlation Coefficient 0.5 0.4 Source: MOP

6.24 A geographical analysis of the projects for road improvement carried out by FISDL during 1997-2003 (Table 6.13), reveals that 63 percent of beneficiaries and 58 percent of total investment went to the departments of La Unión, La Libertad, San Salvador, San Miguel, Chalatenango and Usulutan. In spite of investments carried out, La Unión continues to be the department with highest proportion of roads in bad condition. While investments in La Libertad, San Miguel, and Usulutan contributed to place them as the leaders with higher proportion of roads in good condition.

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Table 6.13: FISDL Investment in Rural Road Improvement, by

Department 1997 – 2003

Departamento Per capita income (US$) Investment ($ million) Beneficiaries (No.and %)

Total 83.0 4,504,185 Ahuachapan 47.8 5.80% 3.00% Santa Ana 72.9 4.90% 6.60% Sonsonete 69.6 6.60% 3.50% Chalatenango 61.0 14.60% 9.30% La Libertad 125.3 8.00% 11.30% San Salvador 140.9 7.30% 10.40% Cuscatlan 79.3 3.70% 2.50% La Paz 68.1 7.10% 7.10% Cabañas 50.9 1.70% 1.10% San Vicente 66.2 4.30% 5.40% Usulutan 66.0 9.60% 7.80% San Miguel 80.1 8.80% 9.70% Morazan 56.5 8.10% 7.40% La Union 60.2 9.40% 14.90% Correlation Coefficient 0.1 0.4 Source: FISDL

6.25 Low correlation coefficients between investments carried out by MOP’s Program for Rural Sustainable Roads, and FISDL’s Improvement of Roads, with respect of per-capita income of each department (+0.5 and +0.1, respectively) and of kilometers improved (+0.4 in both instances), would indicate that departments did not receive benefits according to their income level. The selection of projects responded more to conditions of roads that would maximize reduction of general travel costs (operating cost of vehicles and travel time) and where there are areas with higher agricultural production and tourist attractions. 6.26 When analyzing the evolution of access of rural households to markets by poverty level, between 1995 and 2001, using as proxy variables the distance to a paved highway and bus stop, it can be seen in Table 6.14 that the mostly poor households and the no poor households have benefited from the different rural road programs, by reducing 48 percent and 38 percent, respectively, the distance to a paved highway. While no poor households and mostly poor households experienced the highest reductions in distance to a bus stop, 52 percent and 36 percent, respectively. Structural poor households have experienced lesser—but important—reductions in distance to a paved road (26 percent) and a bus stop (6 percent).

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Table 6.14: Evolution of the Access to Markets, by Poverty Level, 1995 –

2001

Distance (kms) To Paved Road To Bus Stop 1995 2001 Variation 1995 2001 Variation Total Rural Households 5.5 3.5 -37% 2.2 1.6 -25% Structural Pool 7.0 5.2 -26% 2.7 2.5 -6% Mostly Poor 5.4 2.8 -48% 2.2 1.4 -36% Mostly No Poor 5.0 3.1 -37% 2.0 1.5 -25% No Poor 4.4 2.7 -38% 1.5 0.7 -52% Source: Beneke de Sanfeliú, M. “Dinámica de Ingresos Rurales en El Salvador”. FUSADES, 2003

V. Conclusions and Recommendations 6.27 Improved rural roads during the 1990s has contributed to reducing poverty incidence in rural areas, inasmuch as it has given household members access to more dynamic markets, educational and health centers, water and security. However, the actual conditions of the road network reveal that a great deal of effort is still required to obtain an adequate level of connection of districts and settlements in the country. 6.28 The improvement in country’s road network is part of the new President Program. His Plan: Safe Country 2004-2009, establishes as priority the support to the Rural Sustainable Roads program that “will help fostering agricultural development and broadening the chain of value.” Consistent with these objectives, the previous analysis points out that the main challenges of the sector, are to: i) improve 70 percent of priority unpaved road network which in 2002 was in bad condition; and ii) mobilize resources to the municipalities in order to improve the state of 5,150 kilometers of rural roads that MOP does not consider priority and to maintain the 650 kms of urban roads previously under the responsibility of DUA-MOP. Allocation of resources to the sector 6.29 The importance of rural roads for enabling the poor to increase their human capital and take advantage of economic opportunities cannot be overstated. Indeed, El Salvador has understood the importance of improving rural roads, within the strategy of reducing poverty, and has incorporated them into the country’s “extended” MDGs.130 The costs associated with program to continue expansion and improvement of the rural road network, as well as to develop a maintenance capacity for rural roads depends on the specific goals and the timeframe set for achieving them. One possible set of objectives would be to consistent with the country’s goals to strengthen poverty reduction through

130 “El Salvador: Avance de los Objetivos de Desarrollo del Milenio- Primer Informe de País”, 2004

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infrastructure development would be: (i) to pave or rehabilitate an additional 1,000 kilometers of rural roads; and, (ii) to ensure annual maintenance of 3,000 kilometers of rural (secondary and tertiary) roads. Analysis of El Salvador’s road investments suggests that the unit costs of the country’s road development are in line with international norms (Yepes 2004). Using recent average unit costs of road paving, rehabilitation, and maintenance as benchmarks, it is estimated that a 5-year program to pave and/or rehabilitate an additional 1,000 kilometers of rural roads would cost approximately, and to initiate a rural road maintenance program would cost the Government of El Salvador roughly an additional US $25 million per year over average 2003 spending levels. This implies a spending level of approximately 1.4-1.5 percent of GDP per year, up from 1.3 percent of GDP in 2003 (and on average between 1999-2003). Intra-sectoral allocation of resources 6.30 There has been a strong improvement in sector management in recent years, and this progress should continue. Priorities for public expenditure in road network for the period 1990-2003, were to: i) transfer to municipal administrations, resources and responsibility for maintenance of urban roads; ii) create a modern self-financing mechanism, to preserve the road network (FOVIAL); iii) rebuild damaged roadway infrastructure (mainly bridges) caused by the armed conflict in the 1980s and earthquakes in year 2001; and iv) rehabilitate and give routine periodic maintenance to Central American corridors and rural roads, in order to support the development strategy based on an open markets and promotion of exports. 6.31 In the last few years, an increasing share of the sector’s resources was allocated to road maintenance and rural roads, and this better-balanced resource allocation should continue. FOVIAL began execution in 2002 spending US$ 47 million (19 percent of total investment in roads); in 2003 it spent US$ 94 million (49 percent of total investment in roads). In rural roads, investment increased from US$ 24 million in 1999 (20 percent of total investment in roads) to US$ 44 million in 2003 (23 percent of total investment in roads). A local and stable source of funds is financing road maintenance. FOVIAL road-conservation funding is 100 percent local, stemming from a special gasoline surcharge. The rural roads that benefit from improvements under the Sustainable Rural Roads program are maintained by the FOVIAL, which has the responsibility for maintaining the entire priority road network (paved and unpaved). The FISDL is supporting the municipalities to maintain/improve the 5,150 km of road network that are not classified by MOP as priority. Efficiency and equity of resource use 6.32 In general terms, the costs incurred with the road network rehabilitation through the Rural Sustainable Roads, MOP and FOVIAL programs, are similar to international standards. In other words, the sector is relatively efficient in the use of resources. On the other hand, the cost/benefit ratio of road projects has been high, because the criterion for project selection has been the state of road network for the purpose of maximizing benefits in terms of reducing general travel costs (cost of operation of vehicles and travel

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time) in those areas with greater agricultural production and tourist attraction, rather than level of department income. 6.33 The investment in rural roads has improved the equity of sector expenditure. MOP and FISDL investments on rural roads reduced between 1995 and 2001, the distance covered by rural households to the nearest phone by 52 percent, to a paved highway by 37 percent; to a bus stop by 25 percent, and to a school by 19 percent. Travel times are also shorter in similar proportion. Rural households most favored by rural roads programs, are among the poorest and no poor, by experiencing greater reductions in distances covered to reach a paved highway and a bus stop. Structurally poor households also received benefits from rural roads programs, though reductions in distances covered to a paved highway and a bus stop were lower. Recommendations 6.34 To continue to improve sector performance, consideration should be given to the following:

• Continue to support FOVIAL in order to count on a modern, self-sustaining mechanism for road maintenance, which in the medium-term will contribute to incrementing the proportion of roads network (paved and unpaved) in good condition. Ensure that FOVIAL resources are allocated to periodic and routine maintenance of the road network that has been classified as priority by MOP.

• Consistent with the country’s goals to strengthen poverty reduction through infrastructure development, continue the MOP’s Sustainable Rural Roads program.

Review municipal pavement rates in order to allow for timely urban road maintenance in all municipalities of El Salvador; and when considering municipal tax reform, design a mechanism, which will allow attending roads that do not form part of the priority roads network.

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CHAPTER VII: Rural Electrification 7.1 After the privatization of most of the electricity sector in 1996/98, rural electrification remains one of the main responsibilities of the State in the sector. The evaluation of public expenditures in the electricity sector that follows focuses on the three public institutions active in rural electrification, namely the Rio Lempa Hydroelectric Executive Commission (CEL), the FISDL, and the Electricity and Telecommunication Investment Fund (FINET). After a brief review of the sector’s current organization, the analysis focuses on the process of resource allocation, trends and structure in public expenditures, and sector outcomes. The chapter concludes with the identification the sector’s principal public expenditure challenges and recommendations.

I. Sector Organization 7.2 The restructuring that begun in 1996 has changed drastically the organization of the electricity sector. CEL lost its monopoly power, when the government decided to separate and privatize the generation, transmission, distribution, and electricity sales activities. CEL lost its regulatory and planning functions and retained only the administration of the hydroelectric plants on the Lempa river. It is also responsible for the construction of thermal generating plants and the power line of the regional interconnection system, or the SIEPAC project (Sistema de Interconexión Eléctica de los Países de América Central).” By 2003, the number of operators in the sector had increased to sixteen. 7.3 Five enterprises are responsible for wholesale generation: CEL (hydraulic); LAGEO—previously GESAL (geothermal); El Paso—previously Nejapa Power, Duke Energy International, Cemento de El Salvador – CESSA, and Compañía Azucarera Salvadoreña - CASSA (thermal). Installed capacity in 2003 was 1,105.5 MW, of which 46.5 percent correspond to thermal plants, 39 percent to hydroelectric plants, and 15 percent to geothermal plants. Net injection to the power system amounted to 4,402 Gwh, of which some 8 percent correspond to imports mainly from Guatemala, and the remaining 92 percent to local generation (33 percent CEL, 23 percent LAGEO, 18 percent El Paso, and 18 percent Duke Energy). 7.4 The Transmission Enterprise of El Salvador (ETESAL) is responsible for the maintenance of the national transmission grid since 1999 and controls its expansion since 2003. The grid consists of 36 transmission lines of 115 kV. and 2 interconnection lines of 230 kV. (Guatemala and Honduras), with a total length of 1,129 Kms, that link 23 power substations. 7.5 Distribution is the responsibility of five enterprises: Distribuidora de Electricidad del Sur (DELSUR), Compañía de Alumbrado Eléctrico de San Salvador (CAESS), Distribuidora Eléctrica de Usulután Sociedad de Economía Mixta (DEUSEM), Compañía de Luz Eléctrica de Santa Ana (CLESA), and Empresa Eléctrica de Oriente

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(EEO) (Chart 7.1). As a result of an international consolidating process, AES Corporation owns the last four distributors, and Pennsylvania Power and Light Global (PP&LG) owns DELSUR. Distribution is carried out by means of 33,755 Kms of low-tension and medium-tension lines (120 V, 23 kV, 34.5 kV, and 46 kV). In 2003, power sales recorded 3,770,221 MWh (37 percent to the residential sector) to 1,218,455 subscribers (92 percent residential). There are five independent power marketers.131

Chart 7.1; Areas of Influence of the Electricity Distribution Companies

EEO

DEUSE

DELSU

CLESA

CAESS

7.6 Rural electrification was initially in the hands of CEL, through the execution in 1962 of the Olocuilta Pilot Plan for Rural Electrification that linked 1,200 users. During the 1980s, a department of CEL (DISCEL) had the responsibility for rural electrification. In 1990, CEL together with National Rural Electric Cooperative Association (NRECA) implemented a rural electrification program financed by USAID grants. 7.7 The entities currently involved in rural electrification are: Directorate of Electricity (DEE) in the Ministry of Economy; the General Superintendence of Electricity and Telecommunications (SIGET); the Technical Secretariat of External Finances Secretariat (SETEFE), FISDL, FINET, the municipalities, and the distribution companies. DEE is responsible for policy making and planning the expansion of the rural electrification grid, as well as for the subsidies policies on rural electrification investment and electricity consumption. SIGET regulates the sector including the fees for use of transmission and distribution grid and tariffs to final consumers. SETEFE administers the remnants of the USAID donation to NRECA made after hurricane Mitch. FISDL provides the necessary resources to the local government and communities to carry out rural electrification projects.132 FINET subsidizes the rural electrification

131 Conexión Eléctrica de Centroamérica, Excelergy, Mercados Eléctricos, Comercializadora Eléctrica de Centroamérica, and Origem. 132 As of November 2002, FISDL executes the Rural Electrification Program for El Salvador (PROERES)

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infrastructure expansion and rehabilitation in low-income areas; electricity consumption by low income dwellers, schools and health units administered by local communities, as well as the use of electricity for water pumping and distribution. The municipalities also build distribution lines with their own funds. Finally, the distribution companies build rural lines, supplying the resources not covered by subsidies from FINET and the municipalities. Their building capacity is low, as they are not under contractual obligation to expand the rural distribution lines that are characterized by the low density of potential customers.133

II. Strategic Objectives and Resource Allocation Process 7.8 The armed conflict produced serious damage to the Salvadoran electricity system. According to CEL, there were close to 2,000 attacks on sub-stations and 3,800 attacks on transmission lines during the 12 years of conflict. Direct costs amounted to US$64 million and indirect costs to US$190 million. In 1992, the National Reconstruction Plan estimated the cost of rebuilding the national electricity system at US$310 million. 7.9 Rapid economic growth experienced after signing the Peace Accords, presented great challenges to the system: i) To increase the installed generating capacity to meet accelerated growth in electric power needs (an average of 9.7 percent annually between 1992-1995); ii) To rehabilitate the transmission system in order to reduce the frequency and the duration of power blackouts; iii) To increase power coverage – mainly in rural areas; and, iv) To improve quality of the electricity service in order to reduce the damage to end-users’ installations and equipment. 7.10 In order to meet these challenged, the Salvadoran authorities initiated a sector reform and modernization program, which main events are reviewed in Box 7.1. Most of the sector has been privatized but rural electrification remains as a State responsibility. The criteria used by DEE for deciding on rural electrification investments include several factors: i) efficiency, which implies investments in areas where benefits will be rapidly achieved for a large number of families; ii) technical evaluation indicating the feasibility of network expansion to determined areas maintaining rural power service quality within the criteria defined by SIGET; iii) synergy with other public expenditure such as rural roads, education, etc; iv) contribution of the Municipality, revealing the communities’ priorities for rural electrification; and v) support to donors investment in rural electrification as for instance was the case when the French Government made a donation for the benefit of municipalities severely hit by tropical storm “Mitch” and the year-2001 earthquakes.

133 At national level there are on average 88 clients per 2.51 Kms of line (typical network end-branch) and with less than 100 kWh/month of consumption.

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Box 7.1: Principal Measures Implemented to Modernize the Electricity Sector

▪ Approving a new legal framework (electricity law, LGE) and establishment the sector

superintendence, SIGET, in 1996; ▪ Restructuring CEL’s assets between 1996 and 1999; ▪ Re-privatizing electric power distribution between 1997 and 1998, through sale of CEL shares in

CLESA, CAESS-EEO and DELSUR to workers and strategic partners (US$589 million); ▪ Organizing the Wholesale Power Market (MME), and establishing the Transaction Unit (UT or

Unidad de Transacciones) in 1998, trusting it with the operation of the Transmission System, quality of power supply, and the administration of MME;

▪ Establishing FINET in 1998, trusting it with subsidies to the residential consumers and helping homeowners in low-income rural areas to obtain power supply;

▪ Selling shares of thermal plants to workers and strategic associates in 1999 (US$125 million); ▪ Establishing GESAL as a CEL subsidiary, in 1999, dedicated to exploration and commercial

development of geothermal resources; ▪ Establishing ETESAL, in 1999, entrusted with management of the national transmission grid

including the interconnecting lines with Guatemala and Honduras; ▪ Approving electricity sales on the retail markets and establishing the first independent power

marketers, in 2000, who would be in charge of introducing competition in electricity sales to end-users in industry, commercial establishments and residences;

▪ Establishing DEE of the Ministry of Economy, in 2001, entrusted with planning, formulating policies, and setting up the laws and regulations for the development of the electric power sector;

▪ Terminating the Power Purchase Agreement (PPA) between CEL and Coastal (currently El Paso Energy), by means of an international arbitrage, in March 2002, and an indemnity of US$90 million;

▪ Selection of a strategic partner (Enel Green Power Spa) of LAGEO –previously GESAL- in 2002, to launch the capitalization process (US$4.6 million in cash and US$13.7 under the modality of risk investment);

▪ Concluding the PPA between CEL and Duke Energy, in March 2003; ▪ Commencing a contract between UT and Duke Energy, in March 2003 in which Duke places at

the market disposition thermal units (125 Mw) to maintain the system’s parameters of security and stability. The cost is about US$ 700,000 a month plus the cost of used electricity;

▪ Approving reforms to the legal framework for amplifying SIGET’s faculties (fines, sanctions, service quality, market surveillance, and anti-trust), and ETESAL (expansion of system as well as of maintenance), in June 2003;

▪ Establishing a fund for price stabilization in the wholesale market, in June 2003; and ▪ Approving a loan from CABEI to CEL for US$48,5 million for building a thermal plant in Ateos,

2004. 7.11 Subsidies to construction and improvement of rural electricity infrastructure, are granted by FINET through “fund contests” every six months to municipalities and electricity distribution companies that offer the best matching counterpart. FINET is managed by FISDL and its resources come from: i) Government contributions; ii) 100 percent of SIGET resources obtained through concessions for the exploitation of hydraulic and geothermal resources for generating power; and iii) 100 percent of the resources obtained by SIGET from fines to operators in the electricity sector.

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Expenditures Trends and Structure 7.12 During the 1990-2004 period, CEL’s resources were assigned to: i) carrying out the second phase of the rural electrification project supported by USAID (1990-1997); ii) reconstructing and rehabilitating the transmission system (1993-2003); iii) building the interconnection line between El Salvador and Honduras; iv) ensuring availability of power and related energy through Power Purchase Agreements (PPA) with Coastal –currently El Paso- and Duke Energy (1995-2003); v) subsidizing power consumption for residential consumers (January 1998-March 2001); vi) installing two units in geothermal plant of Berlin (1997-2000); vii) Increasing power of the hydroelectric plants on the Lempa river (1999-2007); and viii) Building a thermal plant of 50 MW capacity in Ateos (2004) (Table 7.1). During this period, CEL also negotiated the approval of loans to build the transmission line of the project “Sistema de Interconexión Eléctrica de los Países de América Central” (SIEPAC). 7.13 Between 1990 and 1997, CEL and NRECA carried out the second phase of the rural electrification program with a US$12 million grant from USAID134, with which 1,020 Kms of power lines were built and 27000 users were connected. Maintenance was secured through a framework agreement between the (ex) Ministry of Planning, the FISDL, and CEL. 7.14 Cost of reconstruction and rehabilitation of the power network amounted to US$119 million and was carried out in two steps: i) the Emergency Transmission Program between 1993 and 1997 (US$45.2 million); and ii) the Rehabilitation and Expansion of the Power System Project between 1997 and 2003 (US$74.0 million), whose objective was to repair 961 transmission towers, 2,500 Kms of cable network, total reconstruction of two substations and expansion of 11 other substations. These projects were financed by JBIC within the framework of the II Electricity Development Program of the IDB. 7.15 The Interconnection El Salvador-Honduras was inaugurated on 21 August 2002. It cost US$18 million finance by the Central American Bank for Economic Integration (CABEI). The project consisted in building 93 Kms, of transmission lines of 230 kV, a substation 230/115/46 kV, expansion of the existing substation to 115/46 kV in the 15 September Plant and a microwave relaying station. This project would enable power interchange and related energy with Honduras, within the framework of the Regional Central American Power Market, which by promoting better use of existent resources would reduce energy production costs. 7.16 In order to meet increased post-war power demand, CEL in 1994, subscribed a Power Purchase Agreement (PPA) for 144 MW at 20 years with Coastal—currently El Paso—equivalent to 18 percent of the installed capacity, and in 2000, for 264 MW at 3 years with Duke Energy, equivalent to 26.5 percent of the installed capacity. Prices paid by CEL during the life of these contracts were above the wholesale market prices by 134 Estimated based on a cost for line of US$11.502 per Km, similar to the SETEFE’s cost for the period 1999-2001.

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US$255 million (US$142 million overpricing to Coastal, US$90 million as compensation to Coastal for termination of PPA ahead of deadline, and US$23 million overpricing to Duke).135 136

Table 7.1: CEL – Principal Projects Executed, 1990 – 2004

US$ million Rural electrification CEL - NRECA II 11.7 Transmission a/ 137.4 Emergency program 45.2 Rehabilitation and expansion project 74.0 Interconnection line El Salvador - Honduras 18.2 Power purchase agreements b/ 255.0 Over price coastal 142.0 Compensation for canceling coastal contract 90.0 Over price Duke energy 23.0 Energy consumption subsidy 174.4 Residential 150.6 ANDA 15.7 Non residential 8.1 Generation 213.9 Installation of 2 units in geothermic Berlin (56.2 MW) 113.0 Retrofitting of hydroelectric centrals (61MW) 42.4 Thermal central Ateos (50 MW) 58.5 Total selected priorities 792.4 Memorandum: Income from the privatization of generation and distribution c/ 718.1 a/ In 2003 there were approved the funds to build the SIEPAC line. b/ La Prensa Gráfica, February 23, 2002 and El Diario de Hoy, March 23, 2002c/ Only to strategic partners. Source: CEL

7.17 Between January 1998 and March 2001, CEL paid US$174 million in electricity subsidies for electricity consumption (Table 7.2): US$151 million to residential users that should have been paid by law by FINET; US$16 million to ANDA, so that increase in the water consumption tariffs could be avoided; and, US$8 million to non-residential consumers in 2000, in face of the sharp rises in the wholesale prices.

135 La Prensa Gráfica of February 23, 2003 and to El Diario de Hoy of March 23, 2003. 136 It must be noted that in order to determine if these contracts were onerous, it would be necessary to compare the price of the contracts with the price of the wholesale market in absence of this installed capacity and the losses in production due to possible rationing of power if there were any.

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Table 7.2: CEL’s Electricity Consumption Subsidies, January 1998 –

March 2001 1998 1999 2000 2001Jan-March Total Residential 43.8 45.6 54.0 7.1 150.6 Consumption 35.7 36.0 52.9 7.1 131.8 Value added tax 8.1 9.6 1.1 0.0 18.8 ANDA 5.7 5.2 4.8 0.0 15.7 Non residential 0.0 0.0 8.1 0.0 8.1 Total 49.5 50.8 66.9 7.1 174.4 Source: CEL

7.18 Construction of the Berlin Geothermal Plant, with a capacity of 55 MW (2 units each of 27.5 MW) was financed by IDB within the framework of the II Electricity Development Program. Investment amounted to US$113 million, having installed 45 MW in 1999, and 11.2 MW in 2002. The World Bank as a part of the Energy Sector Modernization Project financed the US$42.4 million-project of retrofitting hydroelectric plants. And, the construction of the Ateos 50 MW thermal plant should be concluded by the end of 2004 at a cost of US$58.5 million. It is being financed by a CABEI loan of US$48.5 million and the rest will be covered by CEL. The plant will have three generating units each of 16.6 MW. In this second phase, plant capacity will be increased by an additional 50 MW. With this project CEL returns to thermal generating, which it had interrupted in 1999, after the sale of the plants of Soyapango and San Miguel to Duke Energy. 7.19 CEL’s resource allocation implies that:

• It assigned for investment in generating, transmission and rural electrification 46 percent of resources spent on these projects, equivalent of 51 percent of the proceeds from the privatization;

• Overpricing for power paid through Power Purchase Agreements with Coastal and Duke was 19 percent more than the resources spent on increasing the hydroelectric, thermal and geothermal installed capacity and equivalent to 36 percent of the proceeds from the privatization.

• Subsides to residential users represent 22 percent of resources spent and near a quarter of the resources obtained from the privatization;

• Subsidies correspond to almost 15 times the amount of resources allocated for rural electrification.

7.20 FISDL and FINET resources were allocated toward: i) incrementing coverage of electricity service in rural areas; and ii) subsidizing energy consumption by residential users. FISDL executed during the period 1994-2003, a total of 1,375 electrification projects (620 Kms of rural power lines benefiting 905,992 people) valued at US$45 million (Table 7.3). The eastern part of the country received the largest number of projects and the higher amount invested. Nonetheless, because of their higher population density, the departments of San Salvador and La Libertad, had the highest number of beneficiaries.

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Box 7.2: Evolution of Electricity Subsidies

Up to December 1997, electricity consumers received an implicit subsidy by paying tariff rates below marginal costs (Table 7.5). This generated large costs for CEL, which were financed by transfers from the Central Government. This caused a (regressive) distribution of income from all Salvadorans paying taxes (including inflation taxes) to the large industrial, commercial and urban residential electricity consuming sectors, who were the main beneficiaries of these implicit subsidies. Parallel to the creation of FINET, direct subsidies were established: i) for electricity consumption of residential users and educational, health and water-supply projects (pumping and distribution) administered by the community; and ii) for construction and improvement of infrastructure for the supply of electricity to low-income rural areas. In January, 1998, residential users with monthly consumption below 500 kWh started receiving subsidies, as established by Art. 122 of the General Electricity Law and Art. 128 of its Regulations. The subsidy was equal to 100 percent of the positive spread (if any) between the tariffs for electricity consumption and the use of the network and billing and collection fees charged by the distribution companies and the maximum prices for electricity established by SIGET. In January 1999, subsidies were reduced to residential users with rates of consumption of less than 200 kWh. As of September 2000, only consumers within the monthly range of 1 to 99 kWh are being subsidized. In November 1999, subsidy decreased to 85 percent of the positive spread (if any) between full tariffs rates billed by distributors in respect of maximum prices established by SIGET (US$0.0640 for kWh for monthly consumption of 1 to 49 kWh and US$0.0671 for monthly consumption of 50 to 99 kWh). CEL covered the cost with the electricity subsidy since January 1998 to March 2001. From April 2001, these costs were directly absorbed by FINET, who is administered by the FISDL. From June 2003, the Government established an electricity price (PEN) of US$66.34 x MWh, whereas in the wholesale market the price from June to December 2003 was US$68.67. Electricity distributors purchase energy from PEN in the Wholesale Power Market and transfer these to their tariffs. Generating entities carrying out sales in the wholesale market perceive PEN, and the difference is accumulated in a price-compensation fund, which is administered by UT. According to Fitch de Central America, this fund accumulated a US$6 million deficit by year-end 2003, which constitutes an indirect subsidy from generating entities to all final users of electricity. DEE estimates that 60 percent of all residential users received subsidies in 2003. SIGET estimates that subsidies represent an average of 57 percent of billings, which consumers should pay when falling in the range of 0 to 49 kWh per month, and 43 percent of those users within the monthly range of 50 to 99 kWh, should subsidies not exist. Subsidizing energy used in water pumping and distribution systems administered by rural communities commenced in August 2000. This embraces 100 percent of the difference between the price for energy consumed and the price invoiced to ANDA on 31 December 1999. Subsidies to construction and improvement of rural electricity infrastructure, are granted through “fund contests” every six months to municipalities and electricity distribution and marketing companies that offer the best matching counterpart. They are disbursed at the conclusion of project works. The maximum FINET subsidy granted in these projects is that which enables obtaining a present net value of zero, considering a useful life of 20 years and a rate of real discount of 10 percent per annum. Earnings are derived from income from fixed and variable charges for use of the distribution network; whereas costs include the value of distribution losses, compensation for non-delivered electricity to final users, and the distribution network operational and maintenance costs.

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7.21 Subsidies directly paid by FINET between April 2001 and December 2003 amounted to $95 million, of which 93 percent correspond to subsidies to residential consumers (Box 7.2 and Table 7.4) In contrast, subsidies allocated for rural power infrastructure amounted to US$6.2 million (78 percent of total investment) and enabled the connection of 19,064 users.

Table 7.3: FINET – Electricity Subsidies Granted, April 2001 – December 2003 2001 2002 2003 Total Residential Consumption 26.2 28.3 30.9 85.4 Community Water pumping 1 1 1 3 Rural infrastructure a/ 2.5 1 2.7 6.2 Total 29.7 30.3 34.6 94.6 Memorandum: Number of connected users 3,589 2,629 12,846 19,064 Lines built (km) 211 136 400 747 Total Investment (US$ mm) 2.9 2.3 7.1 12.3 Infrastructure Subsidy granted (% of total investment) b/ 85.2 83.9 72.6 77.7 a/ Includes the grant from France of US$ 0.6 and US$ 1.2 millions in 2002 and 2003. b/ Includes FINET, France and municipalities Source: FINET

Table 7.4: Implicit Subsidy on Rural Electricity Consumption, 1994 Sector Average Rate Marginal Cost Implicit Annual Subsidy a/ (US$ cents/ kWh) (percent) Million US$ Residential 6.9 11.2 38.4 39.2 Commercial 9.1 10.6 14.2 6.4 Industrial 8.7 10.1 13.2 10.9 Government ad Municipalities 5.7 10.6 46.2 20.9 Public Lighting 5.7 10.6 46.2 2.3 Total 7.6 10.6 28.3 79.7

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Table 7.5: Public Resource Assigned for Rural Electrification and

Subsidies US$ million Expansion of rural electrification (1990 - 2003) 78.3 CEL - NRECA II 11.7 FISDL 44.9 FINET a/ 12.3 SETEFE b/ 9.4 Subsidy to electricity consumption (1998 - 2003) 268.8 FINET c/ 262.8 Compensation fund for wholesale prices d/ 6 Memorandum: Percent Rural distribution lines build (kms) e/ 4.207 Rural electrification/Subsidies to electricity consumption (%) 29.1 Rural electrification/Income from privatization (%) 10.9 Subsidies to electricity consumption/Income from privatization (%) 37.4 a/ Total investment includes support from France, municipalities and Distribution Companies.b/ Actual investment in 1999-2001; estimated investment in 2002-2003 c/ Includes payment by FINET on behave of CEL during January 1998-March 2001. d/ Risk classification report on CAESS, Fitch, December 2003. e/ 1,620 from FISDL; 1,020 from CEL-NRECA; 820 from SETEFE and 747 from FINET. Source: Tables 7.1, 7.2, 7.3 and 7.4

7.22 In sum, during the period 1990-2003, public institutions allocated US$78 million to expand rural electrification, and $269 million to subsidize electricity consumption (Table 7.6). This means that for each $1 used for subsidizing electricity consumers, $0.29 were used for providing electricity to the Salvadorans that did not have access to this service. Funds destined for rural electrification represented 11 percent of resources obtained from the privatization of the electricity sector. On their part, the private electricity companies (CAESS, DELSUR and EEO) made capital investments reaching $94 million during 1998-2003 (Table 7.7), to improve the distribution network.

Table 7.6; Capital Investment by the Distribution Companies, 1998 – 2003 (US$ m.)

1998 1999 2000 2001 2002 2003 Total CAESS 6.6 6.6 6.6 6 5.5 5.9 37.4 DELSUR 5.4 1.4 8.6 11.7 5.3 5.3 37.7 EEO 2.3 2.5 2.9 3.5 4.1 3.9 19.1 Total 14.3 10.5 18.1 21.3 14.9 15.1 94.3 Source: Fitch Central America

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III. Expenditure Outcomes 7.23 Public expenditure has marked effect on the results obtained in coverage, efficiency and quality of the sector during 1990-2003, inasmuch as it has created a scheme of incentives for new private operators in the sector; has provided the country with a greater rural electricity infrastructure; and has influenced the effective demand for electricity of low income rural households. These measures complemented investments carried out by private operators. Electricity Coverage 7.24 During 1990-2002, El Salvador experienced important advances in terms of electricity coverage. According to ECLA, the electricity coverage increased from 52 percent of population in 1990 to 78 percent in 2002 (Table 7.8). El Salvador registered the second-largest increment in electricity coverage in the Central American region (26 percent points), after Guatemala (48 percent points). Nonetheless, it continues to be in third-place in Central American, after Costa Rica (97 percent) and Guatemala (84 percent).

Table 7.7: Electricity Coverage in Central American Countries, 1990 – 2002(percent population with access to electricity)

1990 1995 1998 1999 2000 2001 2002 Change 1990-02 a/El Salvador 52.1 64.3 70.8 73.2 75.9 77.4 78.1 26.0 Guatemala 36.5 47.1 61.1 65.0 71.5 79.9 84.2 47.7 Honduras 39.1 47.9 54.3 56.0 58.0 61.9 62.5 23.4 Nicaragua 44.7 47.8 48.2 46.9 46.2 46.8 47.0 2.3 Costa Rica 0.0 0.0 0.0 0.0 97.0 95.0 97.0 0.0 Panama 53.4 58.6 63.8 66.2 69.3 71.6 75.4 22.0 Central America 53.0 60.0 65.0 67.0 69.0 72.0 74.0 21.0 a/ percentage points Source: UN’s Economic Commission for Latin America, ECLA.

7.25 This outcome is mainly explained by the increase in rural electrification. According to household survey (EHPM), the proportion of households in rural areas with electricity increased by 28 percentage points during 1991-2002 (Table 7.9), more than seven times the increment in service coverage in urban areas. In spite of this, in 2002, close to 29 percent of rural households still did not have electricity.

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Table 7.8: El Salvador – Electricity Coverage,

1991 – 2002 (% of households)

1991 1995 2002 1991-2002 National 69.6 76.8 87.5 17.9 Urban 93.6 94.9 97.3 3.7 Rural 43.5 51.2 71.1 27.5 AMSS a/ 98.1 98.2 98.7 0.6 a/ Metropolitan Area of San Salvador Source: Household Survey (EHPM)

Sector Efficiency 7.26 Efficiency in electricity services may be approximated by the losses in the transmission and distribution systems and by the price of electricity in the wholesale and retail markets. Total electricity losses have diminished by 5.4 percentage points between 1990 and 2003 (Table 7.10). This is explained by a reduction of transmission losses by an end to the sabotage after signing of the Peace Accords, and by rehabilitation and reconstruction activities carried out by CEL. Distribution losses (technical and non-technical) have stayed within a range of 10 percent during this period. 7.27 In spite of damage caused by the armed conflict to the infrastructure of the electric power system, electricity losses in El Salvador were lower than in Panama, Honduras and Nicaragua in 1990; and slightly higher than the Central American average (Table 7.11). During the period 1990-2002, El Salvador, was the country in the region that has been able to reduce to a larger extent electricity losses. El Salvador is now the second-placed country with less electricity losses in Central America.

Table 7.9: El Salvador – Transmission & Distribution Electricity Losses (1990 – 2002)

1990 1995 1998 1999 2000 2001 2002 2003 Totals 17.4 13.6 11.8 12.5 13.2 13.1 12.6 12 Transmission 1/ 6.9 3.5 2.4 2.8 3.5 2.7 2.2 2.1 Distribution 10.5 10.1 9.4 9.7 9.7 10.4 10.4 9.9 Technical 6.9 7.7 7.5 Non-technical 2.4 2.6 2.4 a/ During 1980-1989 was 7.5 percent on average with a maximum of 8.9 percent in 1987 Source: CEL, UT y SIGET

7.28 Electricity prices paid by consumers are influenced by the price in the electricity wholesale market (see Box 7.3), particularly by the System Regulator Market (MRS). During 1998-2003, prices in MRS rose by 24 percent in nominal terms and by 13 percent in real terms (Table 7.12). This is mainly explained by the increment in the price of fuel used in thermal generation in 2003 that up to 2002 had risen only by 6.2 percent in real terms with respect of 1998. Monthly volatility of prices has stayed within a range of +20 percent, with exception of 2000, when reportedly the abuse of market power by some

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operators led to fluctuation in the range of +60 percent and the real price, and an increase of 35 percent over the 1998 price.

Table 7.10: Central America – Transmission & Distribution Electricity Losses (1990 – 2002)

1990 1995 1998 1999 2000 2001 2002 Change 1990-2002 a/ El Salvador 17.4 13.6 11.8 12.5 13.2 13.1 12.6 -4.8 Guatemala 14.1 14.1 15.3 12.3 11.6 15 15.3 1.2 Honduras 23.2 27 22.6 20.9 18.1 19.8 20.6 -2.6 Nicaragua 17.6 29.6 29.1 30.1 31.9 31.3 32.5 14.9 Costa Rica 10.6 10.5 10.1 10.5 10 9.2 9.7 -0.9 Panama 24.5 20.5 22.7 19.8 19.6 19.7 19.8 -4.7 Central America 17 17.2 16.9 16 15.2 16.2 16.9 -0.1 a/ Percentage points Source: CEL-UT-SIGET (El Salvador) and ECLA (UN)

Table 7.11: El Salvador – Electricity Prices, 1998 – 2003

1998 1999 2000 2001 2002 2003 A. Wholesale market (US$/MWh) MRS nominal price a/ 58.2 64 80.4 66.7 66.2 71.9 Index of real price (1998=100) b/ 100.0 109.3 135.2 109.3 106.2 113.1 Monthly price volatility (percent) -18/+33 -15/+18 -57/+63 -22/+11 -23/+20 -14/+20 B. Retail market (US cents/KWh) Electricity prices in CPI (1998=100) c/ 100 100 126 177.1 169.8 175.3 Real price index (1998 = 100) d/ 100 99.5 123.3 168.8 158.6 160.4 a/ MRS- System Regulator Market or Mercado Regulador del Sistemar b/ Deflated by the Consumer price index (CPI) excluding electricity c/ Electricity service in the consumer price index (CPI) d/ Average price without subsidy charged by the distribution companies to their clients. Source: Transaction Unit (UT) and SIGET

7.29 The price of electricity in the retail market measured by the Consumer Price Index (CPI) experienced an increment of 75 percent in nominal terms between 1998 and 2003; and of 60 percent in real terms.137 The average electricity price paid by the Salvadoran residential users (without subsidy), has been higher than the price paid by users in Nicaragua (20 percent), Honduras (91 percent) and Costa Rica (118 percent) during the 2000-2002 period (Table 7.13). These differences can be explained through different subsidizing policies applied in the selected countries, differences in the participation of installed hydroelectric capacity (71 percent in Costa Rica, 43 percent in Honduras, 37 percent in El Salvador, and 16 percent in Nicaragua), etc.

137 These changes reflect the invoice variations of an average residential user who maintains the amount of electricity consumed after the elimination of subsidies, variations in energy prices, the distribution and authorized sale prices by SIGET to distribution companies, losses of energy, and fluctuations in price of energy in MRS or those regulated by Government.

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Table 7.12: Central America – Average Prices Residential Customers, 1998 – 2002 (US cents/KWh)

1995 1998 1999 2000 2001 2002 El Salvador a/ 7.6 0.0 0.0 12.8 13.4 13.3 Nicaragua 9.3 11.1 10.6 10.8 10.7 11.3 Honduras 5.9 6.8 6.5 6.9 6.8 7.0 Costa Rica 7.3 5.2 5.0 5.3 6.4 6.4 a/ Without subsidies. Price of 1995 corresponds to July 1994

7.30 These results lead to conclude that elimination of subsidies to residential users with monthly consumption higher than 100 kwh and variations in the related charges in the retail market explain to a great extent the increment in electricity price to final consumers in El Salvador between 1998 and 2002. Factors related to the wholesale market (reported abuse of market power, price rises for fuels for thermal generation, etc.) have been considerable in 2000 and 2003. This calls for increasing significantly the competition in generation and distribution as a mechanism of market discipline and for lowering electricity prices.

Box 7.3: Wholesale Electricity Market In the Wholesale Electricity Market buying and selling transactions take place by the generation, distribution, and power marketers and final users connected to the high-voltage grid (115 kV and 230 kV). There are two markets for electricity: the contract market (CM), and the System Regulator Market (MRS). In both of these markets, offers are submitted the day prior to delivery. In the contract market, participants negotiate freely prices and conditions for power and related energy; they inform la UT only the amounts of power to be interchanged at hourly intervals each day and the injection nodes and withdrawal of power. Transactions are dispatched in accordance with declarations made—unless UT determines that they affect quality and security conditions of the system. MRS is a power auction market in which bids for the delivery of energy the following day based on prices per MW at each hour of the day. Generation companies, who have power surpluses not under contract, are allowed to present their offers for sales, and buyers who have power demands not covered by contracts, can put in their purchase bids. Generation companies are also able to present bids for purchases in order to reduce their production and supply their contracts with lower-priced power obtainable through MRS; and buyers of power under contract can sell to MRS if prices are attractive. The equilibrium point between MRS offer and demand fixes the hourly market price paid to all suppliers and charged to all buyers, independently of prices stipulated in their offers. The retail market has participation of power marketers (independent or related to the distribution and generation companies) and final users connected to the distribution system for low- and medium-tension (120 V 23 kV, 34,5 kV and 46 kV). Although the law establishes free access to the distribution networks, independent power marketers have only been able to carry out few transactions with medium and large industrial and commercial users. Distribution companies continue to supply power to residential users and the great majority o of small-medium industrial and commercial users. Energy prices in MRS depend on the structure of the installed capacity (hydroelectric, thermal and geothermal, most expensive unit), the cost of inputs used in generation (water and bunkers, diesel oil, gas, etc.), on the consumption patterns of hourly and daily final users (typical load curve), on the climate (rainy or dry season, temperature variation), etc. The retail market price is subject to energy losses (transmission, distribution, and transformation), the MRS price or government-regulated price, competition among suppliers, etc.

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Service Quality 7.31 Among electricity service quality indicators are: frequency and duration of interruptions to energy supply; frequency of deficits in reserve; percentage of energy not supplied with respect to adjusted demand; quality of distribution network tension; flickering tension in the distribution grid; and indicators of quality of services (Box 7.4).

Box 7.4: Quality Norms for the Distribution of Electricity On March 30, 2000, through Agreement No 17-E-2000, SIGET approved the Manual of Quality of Distribution Service defining a group of quality indicators. In March 2002, through Agreement No 20–E-2002, SIGET approved one Quality Norms for the Power Distribution Systems, whose goal it is to regulate quality reference indicators and indexes for: i) Quality of supply or technical service delivered (interruptions in service); ii) Quality of the technical product supplied (level of tension, variations in the voltage wave-–flickering and disharmony tension—and user incidence in quality); and iii) client services (attention to clients, means attention to users, and precision of measuring equipment). The implementation process of these norms would be carried out in four stages: i) Preliminary stage (up to 20 September 2002), when each of the distribution companies should implement with SIGET, the measuring and control methodology for indicators of quality of the energy distribution system; ii) Probationary stage (October 2002 up to June 30, 2003), to obtain information and calculate total energy service distribution indicators to be controlled during the transition stage, in order to diagnose clearly the initial quality levels; iii) Transition stage (July 1–December 31, 2003), during which to control quality of distribution service supplied, by following up global and individual indicators, in order to demand compliance with fixed values of these norms; and, iv) Management stage, after which the distributor should have purchase and information management systems that enable SIGET to carry out controls foreseen by the norms. In March 2003, through Agreement No 53-E-2003, approval was given to the final users’ claims and complaints norms. In March 2004, SIGET approved the norms for compensation for damage to equipment, tools, or installations of final users through Agreement No 44-E-2004. 7.32 Interruptions in power supply due to failure of transmission lines and distribution circuits have decreased by 27 percent between 1998 and 2003 (Table 7.14). Investments carried out for rehabilitating and reconstructing the transmission system have reduced the power interruptions caused by ETESAL by 21 percent. Investments of distributing entities and the approval and setting in motion of quality norms for distribution service have reduced interruptions by 44 percent. This explains the 29 percent increment of interruptions due to grid maintenance. As a result, energy not served to final users fell abruptly by 8 percent of adjusted demand in 1989 to 0.2 percent in 2003. 7.33 During 2003, the Salvadoran power system registered a deficit in its reserve margin of 528 hours or 6 percent of power demand (Table 7.15).138 This reveals deterioration in quality and security of the power system with regard to required potency

138 The margin required for spinning reserve in El Salvador is 7 percent of power demand, which is the result of adding the amount of reserve for Primary Frequency Regulation of 3 percent (which allows instant balancing between generating and demand, following the normal deviations of flow and withdrawal), and the amount of reserve for Secondary Frequency Regulation under Automatic Control of Generation 4 percent (used for correcting the accumulated error of primary frequency regulation; and for maintaining interchange between interconnection with Guatemala and Honduras within the programmed values).

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for operation under normal conditions. This reflects a reduction in the margin between bulk available capacity and maximum power demand of 18 percent in December 2002 to 6.4 percent in December 2003 (Table 7.16), owing to removal of 88.4 MW of Duke’s plants in Soyapango and San Miguel for their re-conversion and the unavailability of 67.5 MW of the Cerrón Grande Unit 2 for adjustments in generating power. This is because maximum demand has grown at an average annual pace of 5.1 percent between 1990 and 2003, whilst installed capacity at a pace of 4.2 percent. Other technical aspects related to the quality of distribution also require improvement.139

Table 7.13: El Salvador Energy Interruption and Not Delivered (EIND), 1990 –

2002

1989 1995 1998 1999 2000 2001 2002 2003 # interruptions a/ 3,252 3,439 3,244 3,144 3,349 2,817 because of failures 2,462 2,722 2,463 2,352 2,430 1,799 because of maintenance 790 717 781 792 919 1,018 Responsible ETESAL 1,855 1,975 1,539 1,587 1,579 1,472 Distribution companies 1,086 1,014 901 770 903 605 Other b/ 311 450 804 787 867 743 IEND percent of demand 8.2% 0.5% 0.1% 0.2% 0.2% 0.3% 0.2% 0.2% a/ In transmission, lines, Guatemala and Honduras interconnection lines and distribution networks b/ Interconnections, Generators, Final users and UT Source: UT

7.34 Some indicators used by SIGET for measuring the quality of service to client by the distribution companies are: percentage of errors in invoicing residential users (IPE111); percentage of claims (PRUC); average response time for claims received (TPA); and average time for solving claims received (PRA). Year 2003 results (Table 7.17) indicate that all distributors reached required SIGET levels for IPE111; CAESS and DEUSEM did not comply with PRUC; CAESS and EEO did not comply with TPA; and only EEO did not comply with PRA.

139 SIGET measures tension quality in the distribution network through the equivalent frequency allowed for annual limits (+8 percent and +9 percent in low-tension lines <600 V in the urban and rural areas; and, +7 percent and +8 percent in medium-tension lines 600 V <V<115kV) or FEB per index, which must be equal to or more than 97 percent. Measurements taken in the transition stage yielded: DELSUR 96.51 percent, DEUSEM and EEO 94.55 percent, CLESA 92.02 percent, and CAESS 91.54 percent. This means that distributors must carry out investments in their networks in order to improve power quality in order to comply with SIGET requirements. SIGET also carries out campaigns geared to determine the presence of flickering and disharmony tension in the distribution networks. The flickering percentage registered beyond the tolerance levels in the second semester 2003 for distributors was: CAESS 0.8 percent, CLESA 0.87 percent, and DEUSEM 1.66 percent, EEO 2.60 percent and DELSUR 2.99 percent. Whilst the disharmony tension percentage registered beyond tolerance levels for the same period was: DELSUR 2.14 percent, CAESS 21.40 percent, CLESA28.87 percent, EEO 58.12 percent and DEUSEM 62.28 percent. This indicates that disturbances due to disharmony tension in the distribution networks are significant.

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Table 7.14: Frequency of Deficit in Reserves, 2003

Hours with Deficit Average Reserve January 15.5 5.3February 31.5 5.1March 14 5.6April 28.5 5.6May 33.5 5.5June 42.5 5.4July 47.5 5.6August 21.5 5.4September 99.5 5.3October 100 5.5November 58 5.5December 36 5.4Total 528a/ Samples have a duration of 30 minutes b/ The minimum reserve required is 7 percent of the power demanded Source: UT

Table 7.15: Power Supply and Demand, 1990 – 2003

1990 1995 1998 1999 2000 2002 2003 Wholesale installed capacity 650.4 908.5 943.4 988.4 1102.3 1044.2 1105.5 Available capacity a/ 560.0 782.2 812.3 876.6 936.0 867.9 1024.5 Maximum demand 412.3 591.7 694.3 718.0 758.0 752.0 785.0 percent of available capacity b/ 80.6 82.6 92.5 88.9 88.0 93.6 83.6 a/ Charts for 1990-1998 estimated on the basis of an availability factor of 86.1 percent b/ After considering a 7 percent margin for reserve Source: Own estimates on the basis of CEL and SIGET information.

Table 7.16: Electricity Companies – Indicators of Quality Services to Clients,

2003

Indicator SIGET criteria CAESS DELSUR CLESA DEUSEM EEO Billing errors (IPE111) < 4 % 0.27% 0.12% 0.24% 0.27% 0.42% Claims (PRUC) < 3 % 7.23% 0.50% 2.43% 7.33% 0.65% Response to claims (TPA) < 10 days 11.45% 1.6 0.47 1.81 12 Claims resolved (PRA) > 90 % 91.96% 93.69% 92.26% 90.91% 80.54% Note: IPE111- percentage of billing errors on residential consumers bills; PRUC- claims made be commercial clients of distribution companies as percentage of total number of clients: TPA- average time of response to the claims received: PRA- claims resolved as percentage of total claims received. Source: SIGET

Expenditure Incidence 7.35 Although a large part of the electricity sector is now privatized, the geographic distribution of FISDL and FINET rural electrification expenditures and the change in access of lower income households to electricity help to evaluate whether public expenditures in the sector have favor the poor. The household surveys indicate that between 1991 and 2002, the households in the poorest bottom quintiles saw their access to electricity increase by 21.4 percentage points against 8.8 percent points for the richest

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households. Households in the second quintile were the major beneficiaries (22.8 percent points) (Chart 7.2). 7.36 A geographic analysis of FISDL investments during 94-2003 indicates that the departments with the largest investment were Usulután, San Miguel and La Libertad (Table 7.18). The correlation analysis indicates that these investments were carried out independent of the per capita income of the department (+0.33 denotes a low positive correlation between variables). Thus it may be concluded that the allocation of resources did not favor the richest departments. However, most beneficiaries are concentrated in San Salvador and La Libertad, these being the o departments most densely populated in the country.

Chart 7.2: Access to Electricity by Quintile

40 50 60 70 80 90

100

Quintiles

Perc

enta

ge o

f Hou

seho

lds

Hog

ares

1991 69.6 45.0 62.3 69.7 80.9 90.2 1995 77.0 51.2 70.9 79.5 88.2 95.2 2002 87.6 66.4 85.1 91.4 95.8 99.0

Total 1 2 3 4 5

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Table 7.17: FISDL’s Distribution Rural Electrification Projects, 1994 – 2003

Department per capita income (US$/month) Investment ($ million) Beneficiaries (#)

Total 44.9 905,992 Ahuachapan 47.8 7% 6% Santa Ana 72.9 7% 7% Sonsonete 69.6 8% 4% Chalatenango 61 4% 4% La Libertad 125.3 10% 20% San Salvador 140.9 8% 16% Cuscatlan 79.3 7% 5% La Paz 68.1 5% 4% Cabañas 50.9 5% 4% San Vicente 66.2 5% 3% Usulutan 66 15% 13% San Miguel 80.1 11% 9% Morazan 56.5 4% 2% La Union 60.2 6% 3% Correlation Coefficient 0.33 0.82 Source: Staff estimates based on FISDL data

7.37 Geographic distribution of subsidies granted by FINET to residential users keeps the same proportion of subscribers to the distributing entities (Table 7.19 and Chart No. 7.1). This reveals a 60 percent concentration of users with monthly consumption below 100 kWh in the central region of the country.

Table 7.18: FINET – Geographic Distribution of Subsidy to Residential Consumption (2001–2002)

Region Clients as of Dic. 2002 Subsidies Granted Total #1162971 US$ 54.6 million Western a/ 21% 23% Central b/ 60% 56% Eastern c/ 19% 21% a/ CLESA; b/ CAESS y DELSUR; c/ DEUSEM y EEO Source: FINET

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IV. Conclusions and Recommendations 7.38 Electricity indicators for the period 1990-2003 reveal improvement in coverage and quality of service, mainly in rural areas. The main sector challenge is to lower the cost of service through greater generation with more efficient sources, and market competition in the segments of generation and distribution. 7.39 Strengthening the electricity sector is part of the new President Government Plan- Safe Country, 2004-2009. It calls for: “i) strengthening SIGET by giving it the technical capacity and the tools to maintain its supervision in accord with the electricity market developments and be on guard so that electricity prices do not depend on manipulation nor inefficiencies; ii) approving the Competition Law and the entity in charge of enforcing it; and iii) eliminating trade barriers to increment competition and thus stimulate reduction in prices of goods and services to consumers.” Consistent with these goals, the previous analysis indicate that the specific challenges facing the sector include: i) continue to increase coverage of power service in rural areas; ii) reduce electricity costs; and iii) continue to improve service quality, mainly at the distribution level. Allocation of resources to the sector 7.40 Although the MDGs do not include electricity coverage, in view of the importance of rural electrification for income generation, access to technology, and reduction of poverty, the recent study on the situation of El Salvador in relation to the MDGs,140 incorporates as a national commitment, the goal of reaching a rural electrification rate of 85 percent by 2015 (from 71 percent in 2002). This implies raising by about one percentage point per year the rural electricity coverage. It is estimated that this would cost (to public entities) about US$ 3 million a year or US$ 40 million for reaching the target in 2015.141 During 1991-2002, rural electricity coverage increased from 43.5 percent to 71.1 percent (Table 7.9) or by about 28 percentage points. The direct investment in rural electrification by public entities (CEL, FINET, FISDL, SETEFE) was about US$ 78 millions, or US$ 2.8 million for each percentage point increase.

140 “El Salvador: Avance de los Objetivos de Desarrollo del Milenio- Primer Informe de País”, 2004. 141 The report “ Analysis of the Cost to Meet the Requirements Established in the FINET Law” prepared by Hagler Baily for the FISDL/USAID in 1999, estimates that for meeting the needs of 15,000 new rural consumers annually (50 percent of total number of new users in rural areas) over the period 1999-2005 and increase rural coverage by 17.7 percentage points, there would be a need to invest US$ 45.3 million, assuming that there would be other contributions from the companies, municipalities, etc. This would be equivalent to a cost of US$ 2.6 million per percentage point increase in 1999 prices, or US$ 2.9 million in 2003 prices.

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Intra-sectoral allocation of resources 7.41 There is a need to promote greater generation with more efficient resources to lower the cost of service. Generation from renewable sources should be encouraged in order to reduce the dependency on thermal plants and imported fuels, which increase sharply the cost of electricity to consumers. At the same time, support should be given for the construction and operation of the SIEPAC line, so as to obtain cheaper power from Guatemala, Costa Rica and Panama, as well as to give greater stability and security to the national power system. 7.42 The sector’s resource allocation priorities should be reviewed in order to allocate more resources to rural low-income population lacking service; and less resources for subsidies to those that already enjoy the service. This requires addressing the price-regulation mechanism (PEN) current deficit; eliminating CEL subsidy to the water company, ANDA: focalizing subsidies more on residential power consumers; and facilitating the establishing of more power marketers. During 1990-2003, CEL allocated US$351 million to generation and transmission, equivalent to 49 percent of the proceeds from the sector’s privatizations. During this same period, CEL, FISDL, SETEFE and FINET allocated US$78 million to expand rural electrification coverage; and US$269 million for subsidizing residential power. This indicates that, for each US$1 used for subsidizing households already with the services, US$0.29 were allocated for increasing the coverage to those without the service. Resources destined for rural electrification represented 11 percent of the proceeds from the privatization, while resources for subsidies of electric consumption represent 26 percent. Efficiency and equity of resource use 7.43 The sector needs more competition in the segments of power generation and distribution to increase its efficiency and lower costs to consumers. Electricity prices in MRS increased by 13 percent in real terms between 1998-2003. Nevertheless, the total cost of power service to the average consumer, which includes cost of electricity, use of network, and billing and collection costs, increased by 60 percent in real terms. This indicates that the elimination of subsidies to residential users consuming more than 99 kwh and the increase in distribution charges (use of network and bill collection costs) explains to a great extent the rise in prices. However, reported abuse of market power and rises in fuel prices for thermal generating were important elements in price developments in 2000 and 2003, respectively. In this connection, there is a need to close the legal and operational gaps that do not allow power marketers to compete with distribution companies in supplying power to residential, commercial and industrial users. 7.44 The quality of service should continue to improve particularly at distribution level. Quality of service has improved inasmuch as: i) interruptions due to power failures in the transmission lines and power distribution circuits have decreased by 27 percent between 1998 and 2003; and ii) power not served to final users decreased from 8 percent

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of adjusted demand in 1989 to 0.2 percent in 2003. Nevertheless, in 2003, there was a decline in the system’s reserve margin. 7.45 The incidence analysis indicated that the access to electricity of the household in the bottom quintiles of the distribution of income increased faster than for the richest households. The geographic distribution of resources invested by the FISDL and FINET in the sector do no appear to benefit the department with higher per capita income. Recommendations 7.46 In sum, consideration should be given to the following:

• Evaluate the residential consumers' subsidy policy and the UT-managed price mechanism, so as to liberate resources for the support of rural electrification.

• Encourage renewable sources generation in order to reduce the dependency on thermal plants and imported fuels.

• Continue implementing the service quality norms for the distribution companies. • Mobilize internal support for the construction and operation of the SIEPAC line,

so as to obtain cheaper power from Guatemala, Costa Rica and Panama, as well as to give greater stability and security to the national power system.

• Introduce more competition in the segments of power generation and distribution, create the incentives for investments in new installed capacity, and close the legal and operational gaps that do not allow power marketers to compete with distribution companies in supplying power to residential, commercial and industrial users.

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