Macroeconomic policy and the Salvadoran peace accords

Pergamon

Macroeconomic

World Development, Vol. 23, No. 12, pp. 2079-2099, 1995 Elsevier Science Ltd

Printed in Great Britain 0305-750x/95 $9.50 + 0.00

0305-750x(95)0010%6

Policy and the Salvadoran Peace

Accords

ELISABETH WOOD* Harvard University, Cambridge, Massachusetts

and New York University, U.S.A.

and

ALEXANDER SEGOVIA University of London, U.K.

Summary. - We analyze the relationship between macroeconomic policies and the implementation of the peace agreement that ended civil war in El Salvador. We review recent stabilization and adjustment policies and identify potential impediments to sustained growth. We observe that the agreement mandated thorough-going democratization of political institutions, but its socioeconomic reforms promised little more than excombatants’ reintegration into civilian life; the poverty and inequality impelling the war were not addressed. We analyze the political bargaining governing the agreement’s uneven implementation, and conclude that the macroeconomic policy environment of austerity, rather than resource constraints per se, impeded its timely implementation.

1. INTRODUCTION

In an influential contribution to the debate about postwar reconstruction and macroeconomic policy in El Salvador, de Soto and de1 Castillo decried the lack of coordination between the United Nations on the one hand, and the International Monetary Fund (IMF) and the World Bank on the other. They likened El Salvador to a patient lying “on the operating table with the left and right sides of his body separated by a cur- tain and unrelated surgery being performed on each side” (1994a, p. 74).

The metaphor is a dramatic depiction of the diff- cult challenge of achieving both the consolidation of peace and economic growth following civil war. If efforts at policy reform - economic and political alike - are not coordinated, either “operation” may undermine the other. Yet the surgical image, with its sole emphasis on the role of the international agencies, does not capture important aspects of the political dynamic of peace-building in El Salvador. Far from a passive individual patient undergoing surgery, El Salvador is made up of divergent groups whose evol- ving interests and shifting alliances not only fueled the war but continue actively to shape the peace.

The separation between economic policy and the peace process in El Salvador thus results from domestic political dynamics as well as inadequate coordination among international agencies. From the beginning of the peace negotiations, the Salvadoran government successfully insisted that the macroeconomic stabilization and adjustment policies begun in 1989 were not on the table for discussion. At the same time, the leadership of the Farabundo MartI National Liberation Front (FMLN) emphasized pressing military and political rather than socioeconomic issues in their negotiating agenda. As a result, economic issues were not discussed until the 11th hour of the peace negotiations, and even then the discussion centered on the narrow questions of devising channels for postwar reconstruction assistance which would not exclude the opposition and of creating conditions which would facilitate the reintegration of excombatants into civilian life.

*The authors would like to thank James Boyce, Colin Danby, Richard Fagen, Francesca Jessup, Terry Karl and Manuel Pastor, Jr. Elisabetb Wood would like to acknowl- edge the support of the Harvard Academy for International and Area Stndies.

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2080 WORLD DEVELOPMENT

Two broader issues were therefore neglected. The first is the short-run question of how to finance the implementation of the programs mandated by the Peace Accords signed in January 1992. The second, raised by the apparent tension between macroeconomic objectives of fiscal austerity and the expenditure requirements of peace-building, is the longer run question of how economic policy might be recast to undergird the consolidation of peace in postwar El Salvador.

This paper focuses primarily on the former question. The agenda of reforms, which included the founding of new institutions, the reconstruction of war-tom areas, and the development of reintegration programs including the transfer of land, required a substantial commitment of resources. The Salvadoran government called on international donors to finance the implementation of the peace agreement, arguing that its commitment to fiscal targets under agreements with the international financial institutions pre- cluded a significant change in the size or orientation of the national budget. While international donors did provide significant funding, programs essential to the peace agreement were delayed or scaled back.

In section 2, we review the macroeconomic policies pursued since 1989 and the bases for the significant expansion of the Salvadoran economy after the beginning of peace negotiations. Given the extraordinary inflow of remittances and the beneficial conse- quences of the resolution of the regional political crisis over this period, the causal contribution of the stabilization and adjustment policies to the resump- tion of economic growth can be easily exaggerated, and frequently is. We analyze three characteristics of the economy that may undermine both economic growth and political stability: vulnerability of foreign exchange earnings to changes in US immigration policy, the weakness of export performance resulting from the overvalued exchange rate, and continuing high rates of poverty inadequately addressed by social programs.

In section 3, we discuss the key elements of the peace agreements, particularly its core agenda of reform of the coercive institutions of the state and its meager agenda of socioeconomic reform (including some land transfer) limited primarily to facilitating the reintegration of excombatants into civilian life. We describe the postagreement bargaining that defined reconstruction and reintegration policies, as well as their costs. In section 4, we describe how the macroeconomic policy environment with its emphasis on fiscal austerity resulted in delays in needed public investment and legitimated deferral of expenditures essential to the peace agenda. We suggest that the international financial institutions might have contributed more to postwar reconstruction had their discussions of conditionality given as much attention to

the implementation of the peace agreement as they did to the implementation of economic reform. In section 5, we analyze the uneven implementation of the peace agreement to date, and the social costs of deferral of the peace agenda. Some concluding remarks are offered in section 6.

2. MACROECONOMIC POLICY SINCE 1989

In 1989, the newly elected government of Alfred0 Cristiani embarked on a new set of stabilization and adjustment policies. The government’s program, which included a major reform in the trade and tax regimes as well as a general thrust toward privatization and liberalization, was backed by all the relevant international institutions. The World Bank played a particularly key role, substituting for the role USAID had previously played in directing and supervising the Salvadoran economy in the 1980s (Rosa, 1993). The program was, moreover, generally supported by the private sector, easing the tense business-government relations that had characterized the previous presi- dency.

During the period of the adjustment program’s implementation, the economy has experienced relatively high rates of growth (reaching 5% or more in recent years) and the rate of open unemployment has diminished, albeit marginally. While poverty indexes have remained high, they do not appear to have grown worse; and inflation has been controlled. International institutions have thus judged the program as both highly successful on its own terms, and important as a supportive economic basis for the peace process (USAID, 1994b, p. 3).

This period of macro-management has, however, not been an unqualified success. Stability and growth have depended heavily on a very large and increasing influx of remittances from Salvadorans residing over- seas. This influx has financed - and indeed can be regarded as the principal cause of - a large and widening trade deficit. Growth in nontraditional exports to countries outside the Central American Common Market (CACM) has been quite sluggish, in part due to the appreciation of the real exchange rate driven by remittances.

At the same time, remittances have mitigated tbe social costs of adjustment, not only by sustaining growth and checking inflation, but also by directly augmenting the incomes of poor and middle-class households. The fact that poverty has remained so high despite these inflows is therefore quite troubling. Moreover, the long-term future of the flows is uncer- tain, particularly given recent changes in US immigration policy. The policy “space” provided by the current foreign exchange bonanza could have been used to develop the infrastructure for competitive exports and to repair the poor distribution of assets and

MACROECONOMIC POLICY AND THE SALVADORAN PEACE ACCORDS 2081

income that was a fundamental factor in causing the war. Instead, the government chose to push a neoliberal model of economic adjustment that may eventually worsen equity and increase macroeconomic fragility.

The new government which took power in June 1994 has chosen to deepen this neoliberal restructuring and has recently announced a new program aimed at turning El Salvador into a large free-trade zone. The program, which has as its central pillar a fixed exchange rate and convertibility of the col6n (along with further market liberalization), has generated much debate in El Salvador and in Central America. In contrast to the previous reforms, this new proposal has neither the unconditional backing of the private sector nor the formal approval of the international financial institutions.

(a) General context of the reform program

Macroeconomic policies are never implemented in a vacuum. Negative trends and external factors can often make a coherent adjustment fail while positive trends can give flawed approaches the aura of success. In our view, at least three background factors are key to evaluating the adjustment program initiated in 1989. The first is the reduction in regional and internal political and military tensions, a trend which enhanced social stability and raised private investment because of the attendant reduction in risk. The second factor was the restoration of the alliance between the government and the private sector, a phe- nomenon which also aided the process of private capital formation. The final factor was the massive increase in the flow of foreign exchange coming from remittances, a trend which produced a more favorable growth-inflation tradeoff.

(i) The amelioration of the politico-military crisis After the guerrilla offensive of November 1989, El

Salvador entered a period of relative socio-political stability. Peace negotiations began in 1990 and culmin- ated in the signing of the Chapultepec Accords in January 1992. The signing of the Peace Accords lifted a principal obstacle to economic management of the country - that is, the war - and the relative (and growing) tranquility improved the investment climate and helped to reactivate some sectors and activities that were depressed during the conflict.

The end of the war and the subsequent reconstruction phase also had a favorable direct impact on the economy. The peace effort has some required expansion in public spending; while we would argue that even more “investment” in consolidating the peace would have been desirable, large sums have indeed been expended and this has had the usual multiplier

impacts. Moreover, the end of the war permitted the government, particularly after 1992, to redirect resources that were dedicated to the war effort toward social sectors. Again, more could have been done, but this spending shift toward nontradable services also helped domestic employment and income.

The positive economic effects of this domestic peace process were reinforced by successful peace negotiations in other areas of Central America. In Nicaragua, for example, the electoral defeat of the Sandinistas helped to usher in an era of detente in the region and of slow but sustained recovery of the regional market. El Salvador has particularly benefited from this and demand from the Central American Common Market (CACM) has been one of the principal sources of growth in recent years. Thus, the resolution of both the domestic and regional crises had positive externalities which helped the post-1989 Salvadoran reform program to achieve better economic results.

(ii) Reestablishment of the private sector-government alliance

The coming to power of the ARENA party in June 1989 also brought a warming of business-government relations, in contrast to the various tensions that had characterized the decade of the 1980s. In a country in which the private sector has the power to make any economic strategy unviable, its almost unconditional support for the government was decisive in implementing the adjustment program, which by its nature involved changing the existing economic rules of the game with sometimes negative effects - at least in the short term - for certain sectors (particularly agriculture and certain manufacturing firms). That business was willing to go along with such short-term sec- toral pain suggested the depth of the new alliance.

While private sector support for the government and its program was partly driven by ideological considerations, it also reflected the impact of US efforts to “modernize” the business community. US efforts over the 1980s had created a social base for support of the export model, much of it centered in the new business institutions such as the Foundation for Economic and Social Development (FUSADES). Indeed, FUSADES played a leading role in the design and promotion of the adjustment program and at least 17 business leaders and others linked with that institution became part of the new government. Other factors that contributed to business modernization and support for the new government were: the crisis of traditional export agriculture, which forced many business people to explore new opportunities in other areas and economic sectors; the internal political crisis which had spurred an emer- gent process of internationalization of Salvadoran cap ital; and generational change in some of the most important economic groups in the country (Johnson, 1993; Segovia, 1994a; Wood, 1995).


(iii) The massive growth in theflow of remittances During most of the 198Os, remittances bypassed

official channels. After the post-1989 government opened currency exchange shops and established a single exchange rate, a move intended to eliminate the black market, recorded remittances soon took the place of official transfers as the largest single source of foreign exchange, increasing from 3.5% of GDP in 1988-89 to more than 8% in 1992, exceeding for the first time the total earnings from exports (see Table l).’ By 1993, remittance inflows were double the volume of official external assistance, and in 1995 they may surpass 10% of GDP.

Perhaps the most important impact of remittances was that they allowed the government to focus on economic restructuring and not simply stabilization.2 Remittances allow the country to live “beyond its means,” importing more than it exports (that is, aside from labor). The large volume of remittances provide sufficient foreign exchange to finance the trade gap and maintain a stable exchange rate, making it easier to maintain growth and control inflation. Remittances have been the key factor preventing the adjustment process from producing recession, as internal investment as well as domestic consumption have been financed with external savings (ANEP, 1992, p. 52).

With the problem of short-run stabilization more or less solved, the government concentrated its attention on the task of structural adjustment, understood as a general process of economic liberalization. Indeed, the greatest achievements of the adjustment program from the point of view of its designers and backers, were advances in installing in the country an economic system based increasingly on market forces.

The problem, as we will note below, is that the inflow of remittances has resulted in an overvaluation of the Salvadoran currency, which strongly militates against the success of the government’s export- oriented growth model3

Remittances also played a fundamental role in cushioning the social costs of adjustment and stabilization. As several studies point out (Montes, 1987; CEPAL, 1993; USAID, 1993), remittances have had a strong redistributive effect, as they often represent a direct transfer to the poor sectors of the society. Montes (1987) estimated that one-third of Salvadoran families have at least one relative in the United States, and that the remittances received by each family represent on average 47% of their income; USAID (1993, p. 31) cites studies showing that remittances increase the income of poor urban and rural families by one- third. Thus for many poor families remittances play a crucial role in subsistence.4 Given the close relationship between worsening income distribution and rising social tensions, remittances have played a crucial, albeit not consciously orchestrated, role in the Salvadoran peace process, and certainly helped to reduce political opposition to the post-1989 economic restructuring.

In addition to direct effects, remittances indirectly affect the income distribution in several ways. Most obviously, emigration reduces the supply of labor, putting some upward pressure on employment and/or wage rates within the country. A substantial fraction of remittance income undoubtedly translates into demand for food, helping to boost basic grain prices, thereby benefiting net sellers of grain, some of whom are poor. Some remittance income also provides working capital for small businesses (Lopez and

Table 1. Macroeconomic significance offamily remittances, 1979-94

Year

Remittances Remittances Remittances Remittances (millions as a % of as a % of as a % of of us $) Exports Net Transfers GDP

1979 49.2 4.4 95.7 1.4 1980 59.6 5.5 86.5 1.7 1981 74.7 9.5 92.4 2.2 1982 87.3 12.5 42.0 2.4 1983 97.0 12.8 35.7 2.4 1984 121.0 16.7 38.4 2.6 1985 101.9 14.7 31.9 1.8 1986 134.5 17.8 35.0 3.4 1987 168.7 28.5 29.4 3.6 1988 194.0 31.9 38.1 3.5 1989 203.7 41.0 39.2 3.5 1990 322.1 55.4 56.6 5.9 1991 518.0 88.1 94.6 6.8 1992 686.0 114.7 91.7 8.1 1993 789.0 107.8 89.4 8.1 1994 870.0 104.7 NA 9.7

Sources: PUSADES; BCR.


Seligson, 1989).5 Despite these ameliorative effects, poverty rates in El Salvador remain extremely high, as we shall see below.

(b) Logic and content of the post-1989 adjustment program

While the adjustment program initiated in 1989 had the usual goals of inflation reduction and macro stability, its more fundamental objective was to install an economic model based on private enterprise. This implied eliminating all restrictions and controls on markets (i.e., liberalization) as well as opening the greatest possible space for accumulation of capital by business sectors, principally through privatization and reducing the size of the state. It was assumed that the external sector would be the new axis of accumulation, with exports providing the foreign exchange necessary to maintain short-run financial and exchange rate stability. In contrast with the long-standing agroexport model, where the bulk of exports consisted of a few primary commodities facing unstable prices on the world market, the new model was to rely on nontraditional agricultural and industrial exports to markets outside the region.

The government moved quickly to implement the program. In mid- 1990 the single rate of exchange was established and a “dirty float” system was put in place to promote exports while maintaining a flexible and realistic exchange rate. profound tariff reductions were carried out in little more than two years, with a

significant impact on the real level of protection.6 Interest rate restrictions were relaxed and price controls were eliminated on approximately 200 products. An accompanying fiscal reform eliminated export duties, reduced and simplified direct taxes, and introduced a value-added tax (VAT). Partly to reduce pressure on the spending side, steps were taken to restruc- ture the public sector, particularly the education and health ministries. In addition, a privatization program was designed which included the sale of some state property, the privatization of public services, and the privatization of the financial system which had been nationalized in the 1980s.’

The adjustment program did not undergo substantial changes as a result of the signing of the peace agreements, as we shall see below, despite the need to dramatically increase expenditures to implement the agenda of reform and reconstruction.

(c) Progress in stabilization

One of the successes of the program is the progress achieved in stabilizing the Salvadoran economy. Annual inflation slowed to 15% in 1990-93, versus 25% in the preceding five years. In our view, this is due principally to the availability of foreign exchange from remittances and international aid.8 Moreover, this inflation success has been “purchased” with an increasingly overvalued exchange rate, as the Central Bank has sought to essentially fix the nominal exchange rate in the face of modest price increases

Table 2. Basic economic indicators, 1990-94

Average Average 1990 1991 1992 1993 1994* 1985-89 1990-94

Real growth of GDP (%) Real GDP per capita6 (1962 colones)

Gross Domestic Investment (% of GDP) Private investment (% of GDP) Public investment (% of GDP) Deficit in non-financial public sector (% of GDP)

Deficit of central government (% of GDP) Public saving of non-financial public sector (% of GDP)

Exports (millions of US$) Non-traditional Exports Imports (millions of US$) Trade deficit Deficit in current account (millions of US$) Net international reserves (millions of US$)

3.4 3.5 5.3 635 644 663

11.9 14.0 16.9 8.9 10.3 11.5 2.9 3.2 4.6

2.5 4.5 6.3 4 3.4 3.6 4.1 3.2 4.5 4.8 3 n.a. 3.7 3.9

-0.3 -0.1 0.2 0.8 n.a. 0.6 0.0

582 588 285 316

1262 1406 680 818 330 292 463 471

597 380

1101 338 587

122 797 629 658 450 540 199 394

1900 2067 1012 1667 1177 1270 382 1009 266 306 714 ;;“d

234 252 605

5.1 5.5 672 n.a.t

17.1 18.5 12.4 13.5 4.6 4.6

1.6 4.6 624 654

13.3 15.7 9.4 11.3 3.8 4.0

*Estimates. tn.a. = not available. Sources: FUSADES, BCR, IMF, USAID.


ao’l”““““““““““’ 70 72 74 76 76 90 82 04 96 86 SO 92

Figure 1. Real exchange rate, 1970-93. Index 1980 = 100 (n’se corresponds to depreciation). Calculated from Salvadoran consumer prices and U.S. Wholesale prices.

Source: IhfF, International Financial Statistics.

(see Figure 1). The col6n rose in price by 31% between the end of 1990 and May 1994. The result has been a dramatically widening trade deficit, notwith- standing strong growth in exports to the CACM, raising worries for a model supposedly built on export growth and a “realistic” exchange rate policy (see Table 2).

How best to resolve the contradiction between a highly valued currency and an export-oriented accumulation model remains a topic of ongoing debate. Both Harberger (1993) and Hinds (1994) suggest that remittances will continue in the long run and that the current real exchange rate is therefore market-appropriate; in this view, nominal devaluation would simply translate quickly into inflation. Other authors, including Gonzalez Orellana (1994), argue that appreciation of the real exchange rate has come at the cost of a severe deterioration in export competitiveness, and that a real devaluation is needed to promote competitiveness. Forcing a real devaluation is sensible only if remittances are viewed as a short-run phenom- enon, as the devaluation would simply adjust the exchange rate to where the market itself will be in few short years, thereby sending the right signal to investors.

Ultimately, what exchange rate policies should be adopted thus depends on the permanence of the current remittance flows. An IMF official interviewed for this study took an optimistic view, suggesting that in future years remittances are likely to grow at the same rate as host-country (that is, US) GDP. While this would represent a somewhat lower rate of increase than in previous years, it would imply that current levels would be maintained for the foreseeable future.9 In a less optimistic scenario, a “soft landing” predicted by some observers, remittance inflows will gradually decline in coming years as the ties between emigre Salvadorans and their homeland grow weaker.

A more alarming possibility, a “hard landing,” would be a sudden drop in remittances, perhaps pre- cipitated by a change in US immigration policy.

Officials at international financial institutions interviewed in November 1994 tended to discount this possibility, but later that month the US announced plans to terminate the Deferred Enforced Departure program under which some 180,000 Salvadorans lived in the U.S. without immigrant visas.‘O Although the affected persons will be able to delay their depar- tures, the termination of the program could affect large numbers of Salvadorans in the next few years. Other anti-immigration measures in the US could also lead to repatriation of Salvadorans residing there ille- gal1y.l’ Repatriation in large numbers could lead to a sharp contraction in remittances, and thus to shortages of foreign exchange, severe income losses for remittance recipients, and great pressure on labor markets. In such a case, the stabilization success since 1989 would be exposed as resting on fragile pillars, a result foreshadowed by the recent Mexican collapse.

(d) Progress in structural adjustment

If structural adjustment is understood simply as the process of installing a neoliberal economic model, then El Salvador’s post-1989 experience may be considered a great success. ‘* The Salvadoran economy is now less protected externally and more reliant on market mechanisms and the role of the private sector has been expanded through privatization and the reduction in the size of the state. In addition to consolidating the support of international financial institutions, this structural change has generally reinforced the confidence of the private sector, reflected in the modest but sustained recovery of private investment.

This process of “modernizing” the market economy has not, however, been free from difficulties and problems. Some of these clearly contradict the overall goal of a competitive economy. For example, irregu- larities in the privatization of banking have produced oligopolization in the financial sector, hindering fair competition and raising real interest rates (including commissions) to borrowers. As a result, the banks have become the defacto financial arms of major economic groups, reflecting and reinforcing the concentration of wealth with negative effects on the prospects for sustainable economic growth and the strengthening of new economic actors.13

Perhaps the biggest conflict, however, is the afore- mentioned contradiction between the use of the exchange rate as an inflation-fighting tool and the objective of creating a strong and diversified export sector. Despite the export-promoting policies described above, nontraditional exports outside the region remain weak. The only nontraditional exports that have shown dynamic growth in recent years are those goods directed to the CACM, and assembly services, a category which generated more than 40,000 jobs in 1985-93 (Paus, 1995). Impressive performance


in the assembly industry is not, however, likely to make up for generally slack growth: local value-added represents only about 30% of gross value, and the pos- sibilities for future growth have been reduced after the US Congress blocked financing for free-trade zones (GAO, 1993). Nor is it likely that the CACM will fuel ongoing high growth of Salvadoran exports.

While a key barrier to a new dynamic pattern of export growth is the appreciated colbn, Hinds (1994) and the National Association of Private Enterprise (ANEP, 1993) have also stressed the lack of productive investment. Hinds (1994) attributes this to high interest rates, high operating costs (due to deficient infrastructure, taxes on inputs and capital goods, etc.), the low national savings rate, and the mentality of many business enterpreneurs, who expect high returns without large risks. I4 ANBP (1992, 1993) has repeatedly argued that the weak showing of exports is due not only to exchange rate overvaluation but also to economic incentives which encourage speculative investment and investment in the commercial and service sectors, rather than in the production of tradable goods.

There indeed has been an increasing orientation of the economy toward the tertiary or service sector: the share of agriculture in GDP has declined dramatically in recent years, while the share of commerce and services has increased considerably.i5 This shift is not surprising, however, given the real exchange rate appreciation and the direct boost to consumption due to remittances. In short, the exchange rate policy and the lack of productive private investment are closely linked. A successful macroeconomic alternative would have to both depreciate the currency in real terms and increase investment.

Finally, the adjustment of 1989-94 was not able to decrease poverty significantly (nor did this goal figure prominently in its intentions). Indeed, urban surveys conducted by the Ministry of Planning indicate that the number of people living in “extreme poverty” rose from 23.3% of the urban population in 1988-89 to 29.6% in 1992-93. That the increase was not greater was due to governmental compensatory programs - mostly financed with external resources - as well as economic growth and the redistributive effect of remittances. The positive impact of remittances, probably the main factor in limiting poverty and ameliorat- ing distributional inequities, can hardly be viewed as a deliberate result of government policy, except to the extent that the government helped to persuade the US government to allow emigres to stay in that country after the negotiated conclusion to the conflict. Both real wages and basic grain prices have fallen sharply in recent years, demonstrating that whatever their favorable effects, emigration and remittances have been insufficient to counter unfavorable trends in the current macroeconomic environment. The continuing high level of poverty in El Salvador is widely recog-

nized as the most serious threat to the consolidation of peace (see, for example, USAID 1994b and World Bank, 1994).

The lack of major progress in the social sector - not withstanding the positive impacts of the large inflows of remittances - is related to two factors. First, the government placed a much higher priority on structural adjustment than on social policy (Belt and Lard& 1994). The trickle-down vision underlying the program accepted the old premise that growth and distribution are incompatible in the short term, and therefore emphasized growth first and redistribution of the fruits of growth later. I6 This is hardly an auspicious framework for making significant dents in poverty rates.

A second reason for slow progress on poverty and inequality was the institutional and financial weaken- ing of the state as a result of the war, economic crisis, and fiscal adjustment. On the administrative side, many social policies were impeded by the lack of qualified personnel and institutional resources; those policies that were implemented often lacked adequate control mechanisms. This institutional weakness has been exacerbated by the emphasis on privatization and decentralization, which accorded with the US-supported strategy of building up institutions that were parallel to the state. On the fiscal side, revenues have increased only moderately (see section 4). As a result, social programs were heavily reliant on external funding, suggesting a lack of a deep governmental commitment to building appropriate social safety nets.

In sum, the Salvadoran economy has been substantially restructured-the market plays a larger role, the state has less power, the private sector has more property, and agricultural exports play a much smaller role. But progress toward a diversified export strategy and sustainable growth has been frustrated by an overvalued exchange rate and the lack of productive investment. Progress on the social front meanwhile has been very slow and largely inadequate to the task of meeting the demands of a deeply frustrated society. These shortcomings point to the need for a new strategy - one which would consciously depreciate the real exchange rate to foster a shift to tradables, encourage more productive private investment (in part through enhancing public investment), and pay far greater attention to the lot of the poor.

(e) The reform program announced by the new government

In early 1995, the government which took office in June 1994 announced its intention to carry out a new economic reform program whose underlying goal appears to be a total dollarization of the economy. The centerpiece of the program is the proposal to fix the exchange rate at a level of 8.75 colones to one dollar,


with total convertibility. This would entail the creation of a Currency Board, which would eventually take the place of the Central Bank, as exchange rate policy would disappear and credit policy would effectively be ceded to Washington. The designers of the program anticipate that this policy would have a series of short-term benefits for the country. First, it would increase the confidence of national and foreign investors due to the final elimination of the exchange rate risks associated with devaluation. Second, fixing the exchange rate and forcing the dollarization of the economy would hold inflation to levels prevailing in the United States and reduce the quasi-fiscal deficit which arises due to the exchange rate losses of the Central Bank. This, it is argued, would increase El Salvador’s competitiveness, promote saving, and contribute to raising real wage levels. Third, the new exchange rate policy would cause interest rates to drop substantially, hopefully close to international rates, which would aid in increasing levels of productive investment.

Accompanying this fixed exchange rate policy would be a dramatic reduction (over five years) in tariff rates, cutting the current ceiling from 20 to 6% and the new floor from 5 to l%.*’ As fiscal revenues would decline, the government proposes to increase the value-added tax, to step up measures to combat tax evasion, to accelerate privatization, reduce public employment, and to reform pension schemes. The immediate impact on income distribution, particularly on the tax side, is likely to be regressive.

Announcement of the program set off intense debate in El Salvador and in Central America. As of this writing, the principal business organizations have given it conditional support (expressing concerns about higher taxes and the fixed exchange-rate), while the opposition parties and the trade unions have declared their opposition to the proposals. Other Central American countries have reacted cautiously, partly because the plan would reorient El Salvador away from the Central American market toward the larger world economy and because the proposed tariff changes would violate current subregional agreements. El Salvador has formal commitments to the CACM which it cannot abandon lightly. Nor should it do so, for intraregional trade is currently the most dynamic component of the country’s export sector. In light of these reactions, the specifics of the plan remain highly tentative.

Regardless of its final content, the proposal represents a unique opportunity to open a serious debate about what kind of economy is most desirable for El Salvador. This is particularly the case because the program seeks to respond honestly to three fundamental problems. First, it attempts to respond to the deli- ciency of productive investment, by reducing risk and thereby, it is argued, attracting foreign and increasing domestic investment. Second, it attempts to discipline

a domestic business class accustomed to extraordinarily high rates of profit by tightening competition and financial oversight. Finally, it recognizes the need to incorporate the Salvadoran economy into the world economy in a different way, recognizing that present demand originating in the internal and regional markets will not sustain high growth rates and reorienting the economy toward the world market, particularly the North American market.

But while the new program is a welcome opening for debate, it offers the wrong policies at the wrong time. One key premise of the program is that remittances from Salvadoran labor are akin to having an assembly zone located in the United States: these earnings will continue in the medium-term and thus attempts to lower the real exchange rate will only generate exchange losses and reduce the real credit available to the private sector.

But declaring defeat in the face of the “Dutch disease” may prove to be a recipe for long-run disaster, if remittances decline, particularly if this were to occur quickly as in the “hard-landing” scenario.18 Sooner or later, El Salvador will have to fall back on exports - and the export infrastructure will only be there if the government combines the right policies (i.e., public investment) with the right prices (i.e., a less highly valued colon). Freezing the exchange rate now against the dollar would instead lay the groundwork for a financial explosion h la Chile in 1982 or Mexico in 1994: bad news or external shocks could then trigger an economic meltdown.

The key shortcoming in this new program is its failure to incorporate a serious effort to reduce poverty directly and to redistribute assets, opportunities, and income. Poverty reduction is crucial as an end in itself. But the evidence clearly shows also that market economies work best when they start from a precondi- tion of relative equality. Among other benefits, greater equality reduces rent-seeking and induces a willingness to share burdens, both of which makes it easier to achieve stabilization and adjustment. For El Salvador’s new market-oriented strategy to work, it must now (and not later) launch a committed redistri- butional and anti-poverty program.

This is particularly important in a country trying to fulfill the obligations of a peace accord. The success of any economic program depends on creating a climate of stability which gives confidence to national and foreign investors. In El Salvador this presumes the consolidation of democracy and the full implementation of the Peace Accords: the country cannot subordinate peace to economic restructuring. Moving ahead with both processes simultaneously is the only viable option for attaining the goals of development and democracy. The best way to insure such compatibility is to make the more general guarantor of social peace-distributional improvement and the elimination of poverty -the centerpiece of a new economic strategy.


3. THE PEACE ACCORDS AND POSTWAR RECONSTRUCTION

On January 16, 1992, the Salvadoran government and the FMLN signed a peace agreement that ended more than a decade of civil war. In essence, the agreement laid out a political compromise in which the left agreed to a democratic political regime and a capital- ist economy with only very limited socioeconomic reform, and the right agreed to participation by the left in a democratic political regime with some degree of socioeconomic reform. The Peace Accords enshrine a democratic bargain: the two sides agreed to resolve their future differences through a democratic political process (Karl, 1992; Vickers, 1992; Munck, 1993). If fully implemented and consolidated, the Peace Accords will lay the institutional foundations of political democracy in the postwar period.

The principal impediments to full implementation of the peace agreement have been domestic political obstacles, not economic constraints. To the extent that a lack of economic resources constrained some aspects of the peace process, the shortfall itself reflected a lack of political commitment. International actors, although they contributed significant financial resources and political pressure at key moments, did not compensate fully for inadequate political commitment by Salvadoran actors, particularly the Salvadoran government.

(a) Political reforms

The core of the peace agreement-the axis around which its democratic promise revolved - was the agenda of extensive reforms of the coercive apparatus of the state. The agreement reaffirmed previously negotiated agreements institutionalized in the April 1991 reforms to the Constitution, particularly the nar- rowing of the Armed Forces’ role of defense (not public security, except under particular emergency conditions). A commission of civilians, the “Ad Hoc Commission,” would review the human rights records of the officers of the Armed Forces and issue recommendations, and a Truth Commission would investi- gate a range of human rights violations by both sides. The Accords mandated a set of key institutional reforms to reduce the military’s historical control over rural areas, including the dissolution of the civil defense patrols, the Treasury Police and the National Guard, the institutional separation of intelligence services from the Ministry of Defense, and the suspen- sion of forced conscription.i9

The Peace Accords provided for the founding of a new National Civilian Police (PNC) under the Ministry of the Interior, separate from the Armed Forces chain of command, and a new National Academy of Public Security (ANSP) for its training.

Both exguerrillas and ex-National Policemen would participate in the new force (not to exceed 20% of the new force in either case) after attendance at the Academy.

The Peace Accords also reaffirmed earlier agreements on judicial and electoral reform. Most important of these was the founding of a new investigative and prosecutorial body, the National Counsel for the Defense of Human Rights (Procuradurfa de Derechos Humanos). Earlier reform of the Constitution had changed procedures for the selection of Supreme Court magistrates, a step toward breaking the traditional dominance of the judicial system by the ruling political party. *O The Accords also included provisions to strengthen the independence of the National Judicial Council and founded a new institution for the training of judges and other judicial personnel. The Peace Accords also extended earlier reforms to broaden political party representation in the supervi- sion of elections. The agreement mandated the legal- ization of the FMLN as a political party, recognizing its right to meet, to mobilize, to publish and to hold licenses for communication (to legalize the FMLN’s two clandestine radio stations).

(b) Socioeconomic reforms

The section of the Peace Accords concerning socioeconomic reform was in places both vague and ambiguous - in sharp contrast to the detailed agreements on military reform and public security. While the Accords explicitly declared any consideration of the “philosophy and general orientation” of the government’s economic policy as beyond the scope of the agreement, the government agreed that postwar stability depended on the transfer of some resources to former guerrillas and their supporters. Principal elements of the agreement’s limited agenda of socioeconomic reform were limited land transfer to excombatants and civilian supporters of the FMLN, channels for the flow of external aid to communities in the former conflicted zones, the founding of a forum of labor, business and government for further negotiations, and a National Reconstruction Plan targeted on the excon- flitted zones with programs to facilitate the reincorporation of excombatants of both sides into civilian life.2’

The peace agreement thus did not include a redistributive agenda, a troubling omission in view of the sustained fall in real wages during the war and the contribution of social and economic inequality to the emergence of civil war. No agreements on wage increases or even the right of unions to organize were included. Notably absent was any significant extension of existing agrarian reform legislation; indeed, the agreement indirectly affirmed the existing consti- tutional ceiling on landholding (245 hectares). Nor


was poverty directly addressed outside the areas targeted by the PRN except in the vaguest of terms (Vickers, 1992).

Redistribution was thus limited to the transfer - more precisely, the purchase - of land to excombatants and supporters of the PMLN as part of the reincorporation measures. There are perhaps two principal reasons (Wood, 1995). Fist, as described above, the government’s economic policy emphasized diver- sification away from a narrow dependence on agricultural production and integration into regional and international markets - a policy that would be more threatened by wage and labor policies favorable to workers than by the limited transfer of land. That is, for ARENA modernizers, the price to be paid in land for peace did not look steep-if it could be limited to the conflicted zones and did not threaten the political and economic base of the party in the western coffee areas. Second, land transfer was critical for the FMLN’s internal political cohesion: given the peasant origins of most of its combatants, to negotiate an end to the war without some transfer of land would have led to traumatic internal difficultiesz2

The agreement defined the categories of land to be transferred, including some state properties and private properties in the “conflicted zones” subject to the landlord’s agreement, but contained few details and many ambiguities. There was no attempt to estimate how much land would fall into any category, and initial estimates varied widely. Nor did the Accords define the boundaries of the “conflicted zones,” despite several references to programs particular to those areas. Within 30 days of the signing, the FMLN was to present an inventory of properties claimed in the conflicted zones; the government was to legalize tenure definitively within six months and extend credit for land purchase on the terms of the 1980 agrarian reform. The agreement stated explicitly that the current landholders (tenedores) would not be evicted, but would eventually be resettled if the landlord chose not to sellz3 Landlords were to be paid market prices, but what that would mean in areas where the civil war had raged was not spelled out. Nor did the agreement clearly define a process by which these issues would be resolved and the transfer implemented.

The Accords stated that the government would present a draft of the National Reconstruction Plan (PRN) to the FMLN within a month of the signing of the agreement. While the FMLN’s recommendations and requests would be “taken into account,” its role was clearly secondary; there was no provision for the participation of the beneficiaries in the development of the PRN (except in the case of credit policy). The principal goals of the plan were the integrated development of “areas affected by the war,” attention to basic needs of the population most affected by the war and the excombatants of both sides, and the recon-

struction of damaged infrastructure. Policies facilitating the reincorporation of the Fh4LN were to include programs such as scholarships, jobs and pensions, housing projects and business promotion. Appealing to the international community for support, the Accords assigned to the United Nations Development Programme (UNDP) the role of consultant in fundraising, project design, and coordination with nongovernmental organizations.

While the balance of political forces in the country had been sufficient for the reaching of the commitments enshrined in the Peace Accords, at the war’s end it remained an open question whether the evolv- ing balance of power in the postwar period would be sufficient for their realization. The calendar of implementation of the socioeconomic agenda was defined by the political logic of the peace process, not by an analysis of its feasibility, an aspect of the agreement that would complicate its implementation.

As the two armies separated to their designated “points of concentration” after the signing of the Peace Accords on January 16, 1992, both domestic and political actors became increasingly aware of the challenge of peace-building after more than a decade of civil war. Beyond the immediate issue of the effec- tiveness of the monitoring of the cease-fire by the United Nations Observer Mission (ONUSAL), loomed two key issues. First, would the calendar of staggered implementation of the Accords together with the attention of the international community provide mutual confidence sufficient to engender ongoing compliance? Second, who would pay the costs of peace, given the significant resources required for the implementation of the peace agreement? These two issues were inextricably related: the political implications of the amount and modalities of funding could either reinforce or undermine the political will and capacity of one or both parties to carry out the terms of the peace agreement.

The fundamental challenge was to translate the political commitments of the Peace Accords into adequately-funded programs and policies that would institutionalize the democratic bargain that resolved the war. At the time of the signing of the Accords, no overall assessment of the cost of the implementation of the agreement existed; only initial estimates for reconstruction based on a preliminary version of the PRN existed.24

Planning for postwar reconstruction began in mid- 1991, half a year before the signing of the Peace Accords, with an initial Consultative Group (CG) meeting of donors and government representatives (MIPLAN, 1991d).= Between that meeting and the second CG meeting in March 1992, the Ministry of


Planning and Coordination of Economic and Social Development (MIPLAN) issued a series of increasingly detailed documents describing what was to become the National Reconstruction Plan (PRN) (MIPLAN, 1991a, 1991b, 1991~). Asaresultofcrit- icism and debate, some changes were made but the broad outlines of the plan remained essentially the same. At the March 1992 CG meeting, the govem- ment presented three documents outlining programs and budgets for the PRN, the strengthening of democratic institutions, and technical assistance (MIPLAN 1992c, 1992b, and 1992a, respectively). The PRN was to cover approximately 40% of the country, including the 20% of the population most affected by the war. Investments and current expenditures within the scope of the plan was to vary between $1,200 and $1,600 million over a five-year period. The average expenditure in each of these years was equivalent to between 4 and 5% of GDP (IDB, 1993, pp. 3-4).

The government appealed for international assistance, arguing that it faced very serious fiscal constraints as a result of its commitments under the stabilization and adjustment programs and the absence of a peace dividend given the degree of external financing of the war (MIPLAN, 1992a). The intema- tional community pledged some $600 million in response ($800 million if previous commitments are included).

In the months after the CG meeting, two issues dominated debate on reconstruction: the reintegration of excombatants in general, and the transfer of land in particular. Negotiations between the government and the FMLN collapsed in mid- 1992 over the amount of land to be transferred, the number of beneficiaries, and the application of “market prices.” Nor were the promised training and credit programs - the necessary complements to land transfer - in place.

The impasse threatened the peace process itself as the FMLN suspended its demobilization process and political tensions increased. In an extraordinary instance of its “good offices” mandate, the UN sent a team of agrarian specialists to evaluate the situation and then offered the two parties a take-it-or-leave-it settlement. The proposal, subsequently considered by the UN as an addendum to the Peace Accords, defined the scope of the transfer in terms of both the number of beneficiaries - 7,500 excombatants of the FMLN, 15,000 excombatants of the Armed Forces, and 25,000 tenedores - and the amount of land per bene- ficiary. If the agreement had been fully funded and fully implemented, the transfer of land would have amounted to 12% of Salvadoran farmland (a bit over half of the amount distributed under the 1980 agrarian reform). Subsequent agreements, however, pared down the amount to be transferred.

Development of other reinsertion programs trailed the negotiations over land. Representatives of the

FMLN and the government began negotiations over other reinsertion programs for excombatants by mid- 1992, with the UNDP acting as an observer.26 After a series of discussions, facilitated and coordinated by the UNDP, three tracks for reinsertion were defined (in addition to the PNC track for those excombatants who joined the new police force). For those pursuing agriculture, training programs by nongovernmental organizations were to begin immediately; once in pos- session of land through the land transfer program, agricultural credit, including a five-year loan to capitalize the farms, was to follow (UNDP, 1993). Excombatants who preferred a nonagricultural future would have access to credit for the founding of “microenterprises” after technical-vocational training; university scholarships were also available if appropriate. The approximately 600 mandos medios y Zideres (mid-level commanders and leaders) of the FMLN would participate in a program of business training and credit to start their own enterprises or to join existing ones with adequate technical and administrative skills. Under UNDP coordination, three sub- tracks of this last track were developed: technical- vocational training (33% of the participants), business administration (58%), and executive training (9%) (UNDP, 1994).

Throughout the negotiations, the government maintained that the programs should be equally available to excombatants of both sides. Parallel programs for excombatants of the Armed Forces were developed for the agricultural and technical-vocational tracks (but not for the mandos medios program, for which there was no parallel group). In both their design process and implementation the programs were quite separate although the opportunities were roughly similar.

In April 1993, a third Consultative Group meeting of international donors was convened by the World Bank. The government presented a revised proposal that emphasized the reinsertion programs and poverty alleviation, with updated figures of estimated needs, existing government and donor commitments, and a substantial “funding gap” of still unfinanced programs (summarized in Table 3).

Troubling to many observers was the continuing inadequate funding of many programs judged essential to the consolidation of the peace process - particularly the new public security institutions and the reintegration programs. The discrepancy intensified the debate about the relationship between economic and political reform (de Soto and de1 Castillo, 1994a; Segovia, 1994b). Moreover, progressive lack of confidence by donors in the National Reconstruction Secretariat resulted in its programs being almost exclusively funded by USAID, with other donors opt- ing to channel bilateral assistance through other ministries and through the UNDP (Boyce, 1995; Murray Coletti and Spence, 1994).


Table 3. Funding priorities and shorrfalls, 1993-96: 1993 Consultative Group budget (millions of US dollars)*

GOES Expected international Shortfall, Shortfall commitment contribution, (April 1993 (January 1994

PrOgKilllS Requirements (April 1993) (April 1993) est.) est.)

Priority Programs National Civilian Police 173.0 35.4 6.0 131.6 Public Security Academy 104.7 28.0 9.9 66.8 182.0

Judicial Reform 219.8 162.3 15.0 42.5 Human Rights Ombudsman 16.8 6.4 1.1 9.3 66.6 Elections Tribunal 20.0 0.6 4.0 15.4 Reintegration (PRN) 316.8 26.6 80.0 210.2 177.8

Pensions for disabled 8.2 0.7 0.0 7.5 Land transfer 142.5 23.3 47.5 71.7 62.7 Housing 77.1 2.6 12.5 62.0 Agricultural credit 62.0 0.0 10.0 52.0 Microenterprise credit 27.0 0.0 10.0 17.0

Poverty alleviation (PRN) 310.2 57.2 147.7 105.3 93.7 Subtotal Ll61.3 316.5 263.7 581.1 520.1

Other Programs (PRN) Social and productive sector 120.0 10.9 55.6 53.5 -14.6 Infrastructure 530.1 78.3 281.3 170.5 161.0 Environmental sector 17.5 1.9 0.0 15.6 15.4

Total 1,828.9 407.6 600.6 820.7 681.9

Sources: MIPLAN 1993a. GAO 1994. *For further details, see Boyce (1995), Table 2. A negative shortfall indicates a surplus. The report to the 1993 CG meeting also included a priority request for poverty alleviation funds for non-PRN areas ($372.32 million). As these figures are not included in other documents, they are here ignored as well. In addition, a separate document requesting $20.4 million for technical assistance (MIPLAN, 1993b) accompanied the principal document; this request is treated in the text but is not included

in the table.

4. DOMESTIC RESOURCE MOBILIZATION

With the signing of the peace agreement, the need to mobilize domestic resources has grown. While international agencies and foreign governments wel- comed the end of the war, external aid has, nonetheless, fallen. Domestic savings remain low, as does government revenue. Given the rigidity of public spending, there has been a constant potential conflict between the need to fulfill the commitments contained in the peace agreements and the need to maintain and strengthen macroeconomic stability. The threat that the “adjusting variable” would be peace expenditures has been raised in requests for external assistance. Indeed, key programs were delayed or scaled down as a result of funding constraints, as we shall see. below. Yet it is by no means clear that the scope for the mobilization of domestic resources for peace through expenditure shifting and increased tax revenues has been exhausted.

While the foreign exchange gap has been filled by remittances from Salvadoran emigrants as noted above, it cannot be assumed that this windfall will be permanent. In this context, a crucial task for Salvadoran policy makers is to devise mechanisms that will allow the economy increasingly to use domestic resources to finance the costs of peace and to

achieve economic growth with social justice. The government’s tax reform initiative (Gallagher, 1993) has produced some favorable results in terms of simplification and improved efficiency of the tax system, but has not fully yielded the expected increase in fiscal receipts.

(a) The principal features and results of the tax reform

Recognizing the need to both enhance and stabilize tax revenue, the adjustment program implemented in 1989 attempted to establish a more modem tax system and to reduce the state’s reliance on volatile export income.27 Among the most important measures implemented were: (i) a total overhaul of the tax system, including the elimination of all taxes on exports, of the tax on net worth, and of the majority of tax exemp- tions; simplification of personal and corporate income taxes; reduction of the top income tax rate from 60% to 25%; and replacement of revenue stamps by a value-added tax (VAT); (ii) a variety of policies to end widespread tax evasion28; and (iii) the simplification and reduction of taxes on imports.

This reform in the structure and composition of tax revenues has had a profound impact. First, the elimi-


g ;r;;;ltand propertvtrenefers

R Domestic transactions

0 1985 1987 1989 1991 1993 prel 1986 1988 1990 1992 1994 est

Figure 2. Composition of tax revenue, 1985-94. Source: USAID,from BCR.

nation of export taxes - which had traditionally been the most significant source of government revenues - and the introduction of the VAT has indeed made the tax system more stable (see Figure 2). Second, the bulk of state revenues now come from three taxes: the VAT, the income tax, and the tax on imports. The tax system is now much easier to administer and control, particularly because of the tremendous enhancement in computer, auditing, and control systems.29

Despite the merits and achievements of the reform there are problems. First, the new system, by reducing direct taxes and increasing reliance on indirect taxes, has made the overall taxation structure more regres-

sive, worsening the already severe inequality of incomes. Second, the reform has not had the expected results in terms of increasing revenues, partly because of an extraordinarily high degree of tax evasion.30 While the tax ratio (ratio of tax revenues to GDP) did increase by two percentage points during 1989-93, rising from 7.6% of GDP in 1989 to 9.7% in 1994, it continues to be very low in comparison to that of other underdeveloped countries,31 and low even in comparison to prewar levels (see Figure 3).

The low level of tax revenues has been largely responsible for the government’s failure to achieve its original goal of eliminating the fiscal deficit by 1994 (BCR, 1989,p.20).Infact,thedeficitduring 1989-94 was higher on average than during the preceding five years. Partly as a result, the state has become increasingly reliant on external resources to finance social spending, especially for programs related to poverty alleviation and investment in human resources. This is particularly worrisome as external assistance is expected to decline in coming years.

Rivera Campos (1994, p. 11) suggests that “official transfers [of foreign savings] are allowing a lower tax burden.” In other words, while the formal conditionalities and less formal policy dialogue of the international donors have sought to encourage an increased tax effort, the financial resources they provide may, in and of themselves, have had the opposite effect. In such a context, the strength with which conditionality is exercised becomes critical (see Boyce, 1995).

7970 1972 1974 1976 1978 1960 1982 1984 1986 1968 1990 1992 1971 1973 1975 1977 1979 1981 1983 1985 1987 1969 1991 1993

Figure 3 Tax coeficient 197693. Source: IMF, International Financial Statistics and Government Finance Statistics; 1993 tax revenue drawnfrom USAID.


(b) Fiscal targets and the Peace Accords

Public finances were in a precarious state in 1992, when the peace agreements were finalized and sigmd3* The fiscal deficit of the nonfinancial public sector (NFPS) had climbed to 4.4% of GDP in 199 l- much higher than the figure for 1990 (2.5%) and the 1991 target of 2.6%. The central government’s fiscal deficit had risen from 3.2% in 1990 to 5.1% in 1991, again above the targeted goal of 2.5%.33 Alarmed by the fiscal imbalances, the IMF insisted on greater fiscal stringency, including a reduction in the general NFPS deficit by over 2% of GDP.34 The central government itself was to adjust revenue and expenditure by close to 1% of the GDP, with expenditure reductions leading the way.35

The spending projections were discussed by the IMF’s Executive Board on January 6.1992 - a week after the initial signing of the peace agreement and two weeks before the signing of the formal agreement. Although the Fund recognized that expenditures on demobilization, reintegration and reconstruction would far exceed the amounts that could be reassigned from the existing 1992 budget (IMF, 1991b, pp. l&19), the projections made no allowance for the financial implications of peace. Additional outlays beyond the redi- recting of existing expenditures would have to be financed entirely by foreign resources “in order to pre- serve the price and balance of payments objectives of the program for 1992” (IMF, 199 1 a, Attachment III, pp. 59-60). Evidently the assumption was that the expenses associated with the peace agreements and national reconstruction would be financed entirely through foreign resources, in addition to some transitory financing from the Central Bank (see also USAID, 1993, p. 25).36

When peace did come, the failure to account fully for its financial implications produced a worsening of the country’s fiscal situation. The NFPS fiscal deficit rose from 4.4% of GDP in 1991 to 5.9% in 1992 (as contrasted with the target of 2.3%). The central government also failed to meet its targets for current savings and expenditures.

In mid-1992, the World Bank recommended that “the authorities should formally incorporate the ‘peace’ impact into [the] monetary program without

further delay” (World Bank, 1992, pp. i, 1.) The IMF, however, continued to insist that tight fiscal and monetary targets were still achievable. A July 1992 mission held to the original objectives for the overall public sector and central government deficits, even though the mission foresaw a significant increase in peace-related expenditures during the second half of the year, 45% of which could not be covered by foreign resources. The mission suggested that the government adopt a series of fiscal measures aimed at raising an additional 1% of the GDP.37 Many of the Fund’s suggested revenue enhancements were never, however, implemented and others were not put into effect until September 1992 (introduction of the VAT and increase in electricity rates). As a result, the fiscal goals for the year were not attained.

Thus the Salvadoran government and the intema- tional financial institutions did not really “plan for peace.” Even as rising peace-related expenditures derailed fiscal targets, the &IF’s macroeconomic priorities remained firm. While economic stability and inflation reduction were worthy and shared goals, unrealistic assessments which failed to incorporate the costs of peace threatened to make peace the adjusting variable. The international financial institutions did not themselves fund high-priority programs mandated by the peace accords, nor did they condition agreements and loans to encourage the government to increase further its domestic resource mobilization for peace-related needs. The peace process thus remained largely tangential to fiscal policy, rather than becom- ing integral to it.

The failure to make fulfillment of the accords a primary economic as well as social objective was com- pounded by a tendency to achieve fiscal balance through short-sighted reductions in public investment. While the 1993 tax-to-GDP ratio rose to 9.3%, and the NFPS and central government deficits were reduced, these levels were largely achieved because capital spending - particularly that associated with the National Reconstruction Program - was lower than planned.38 As can be seen from Table 4, public sector investment was substantially below projected levels in 1993, a trend which continued in 1994. The principal mechanisms for public investment cutbacks were:

Table 4. Planned and actual capital expenditure by the nonfinancial public sector, 1992-94

Planned expenditure Actual expenditure

Millions of Percentage of Millions of Percentage of colons GDP colones GDP

Percent of planned expenditure

realized

1992 2,214 4.1 2,856 5.7 129 1993 4,145 6.2 2,767 4.6 67 1994 4,013 5.3 2,844 4.0 71

Source: BCR.


execution of programs on a smaller scale than planned, and deferral of program execution until sufficient funds from the international community were available. Among the programs affected were some central to the peace process.

International financing agencies accepted the con- ditioning of capital spending on the availability of foreign funds in the interest of maintaining macroeconomic stability. Yet even the IMF’s Executive Board has recognized that cutbacks in public investment may have jeopardized the achievement of long-term development objectives at a time when the country is in the midst of rebuilding (IMF, 1994a, 1994b). As with the failure to take account of peace-related current expenditures, this acceptance of delays in public investment may ultimately harm macroeconomic stability itself, by undermining growth, improved income distribution, and the consolidation of peace.39

5. THE UNEVEN IMPLEMENTATION OF THE PEACE ACCORDS

In the three years since the signing in Mexico City, remarkable progress has been made in some aspects of the Peace Accords. The FMLN participated in the general elections of March 1994, making a respectable showing at the presidential and legislative levels. The military has been restructured, purged and reduced in size; the new civilian police force has been deployed throughout the country. Various reconstmc- tion programs have been designed and implemented. Implementation of the peace agreement, however, has been incomplete and uneven in several areas, a number of which remain essential to the consolidation of peace in El Salvador.

The founding of the new civilian police force (PNC) has been one of the most problematic aspects of the peace process. The decision to start a new force made a new “organizational culture and adequate guarantees for civilian rights” more likely, yet posed significant obstacles as well (Stanley, 1995, p. 8). Among those obstacles were the financial challenge of building a new institution from scratch, the reluctance of the National Police (PN) to cooperate with the PNC in the transition period, and the crime wave fueled in part by delays in the reinsertion programs (Stanley, 1993, 1995; UN Security Council, 1994a, 1994~).

As a result of these difficulties, the training and deployment of the PNC were subject to very serious delays and problems. One factor was the lack of adequate initial funding.@ Facilities and equipment belonging to the former security forces were retained by the Armed Forces and the PN, forcing costly delays as the PNC was built from scratch. While the UNDP, Spain and the United States participated in the development of curriculum and organizational plans, adequate international funding was not forthcoming.

Stanley (1995) suggests two reasons to account for the reluctance to fund an institution so obviously key to the peace process: the lack of international interest in funding police in general, and the reluctance in particular to fund an institution to which the government seemed inadequately committed.

One reason for donor skepticism about the govem- ment’s commitment to the new force was its reluctance or inability to end ongoing efforts by the former security forces to undermine the PNC’s autonomy, efforts that outlasted frequent ONUSAL attempts to enforce the letter and spirit of the Accords.41 For example, two units of the National Police were transferred in their entirety into the PNC in 1993 with neither the evaluation nor the retraining specified in a previous agreement. Nor were they integrated into the new civilian line of command (Washington Office on Latin America, 1994). Moreover, the training center for the National Police continued to produce new recruits well after the opening of the ANSP, a clear violation of the spirit if not the letter of the Accords. In late 1994, the newly elected President Calderon Sol decided to dissolve the PN by the end of the year, a move that some observers attributed to involvement of high-level PN officers in organized crime, and announced increase funding for the PNC.42

To date the investigative capacity of the National Civilian Police remains inadequate, contributing to the general insecurity and rising crime. The judicial system, including the new National Counsel for Human Rights, remains extremely weak, although reform programs are now in place (Popkin, 1994). As a result, the authorities have been unable to curb the activities of organized crime with increasing insecurity the result (Spence, Vickers and Dye, 1995).

Ongoing and to date unresolvable delays in the transfer of land - an essential aspect of reintegration of excombatants into civilian life - continue to present serious threats to the consolidation of the peace process. The key problem has not been lack of funding for the implementing agency, the Land Bank, but rather lack of political will. The Land Bank has had adequate interim funding from USAID; the bottle- neck from month to month in the transfer of land has not been a shortage of cash (interview with senior USAID official).

Rather, the recurrent delays are due principally to two factors (Wood, 1995). First, the titling process remains remarkably cumbersome, despite repeated agreements to streamline it (which could have been readily accomplished by Presidential decree). The government has taken a bureaucratic approach to the process, originally insisting that only those on initial lists would receive land and refusing to extend credit until legal title was transferred. Second, the FMLN and its allied peasant organizations have found it extremely difficult to construct a stable list of beneficiaries for each property to be transferred. In part this


reflects the substantial mobility in the countryside in the aftermath of the war and in part the FMLN’s inadequate organizational resources. The instability in the lists of beneficiaries was reinforced by the delays in titling, leading to a vicious circle fueled by insecurity as some beneficiaries decided the delays and terms of transfer were too hard a bargain.

As a result of the ongoing delays and problems, representatives of the government and the FMLN agreed in mid- 1994 to scale back the number of beneficiaries of the land transfer from 47,500 to just over 40,000. In May 1994, the government introduced a number of measures intended to streamline the process and announced that adequate funding for the scaled-down program had been secured (UN Security Council, 1994b). But as yet little acceleration of titling has resulted; as of March 16, 1995, less than 50% of the reduced number of beneficiaries have received land.

Reinsertion benefits remain a hotly contested issue as excombatants and demobilized members of the National Police, security forces, civil defense patrols have paralyzed government on a number of occasions, most recently in January and February 1995 when thousands of protestors occupied governments build- ings demanding land and indemnity payments. Many of the demands clearly exceed the provisions of the Peace Accords (in particular, civil defense patrol members were never considered eligible for reinsertion benefits). Under the mediation of ONUSAL, the government agreed to a compromise set of programs to be implemented in early 1995.43 The specter of ongoing unrest caused by excombatants of both sides in neighboring Nicaragua offers a cautionary lesson to Salvadoran observers, many of whom associate the increasing crime rate with the inadequacy of the reinsertion programs.”

While the completion of these programs is necessary, it will not be sufficient for successful reintegration, as the sustainability of the excombatants reinsertion into civilian life remains precarious (see for example, UNGA, 1994, p. 6). As international donors turn their attention increasingly to other postconflict- ual situations, the funding for reintegration and reconstruction in El Salvador will have to come increasingly from domestic resource mobilization. While there is significant scope for such mobilization, as we saw above, present policies are undermining the conditions for stable and equitable economic growth.

6. CONCLUSION

El Salvador’s stabilization and adjustment program begun in 1989 was undertaken in a highly favorable context - its implementation coincided with the beginnings of peace, the growing closeness of business and government, and the increasing flow of

remittances. These advantageous conditions may not endure: the domestic costs of implementing the peace are growing, business may be less enthusiastic as the government attempts more direct measures to improve the private sector’s tepid response to market incentives for productive investment, and, most importantly, the flow of remittances may taper off. In this sense, the adjustment process is entering a new and more difficult stage.

So too is the peace process, following the departure of the UN Observer Mission in April 1995. While significant reform of key institutions has been achieved, the implementation of some aspects of the peace agreement remains incomplete and in some cases precarious. We have argued that the fundamental problem has not been funding constraints but rather a lack of commitment on the part of the government at crucial stages of the peace process. Thus, as we have seen, a lack of political commitment, not financial shortfalls, resulted in ongoing delays in the transfer of land to excombatants and consequently in other reintegration programs as well. Further, the government’s apparent tolerance of repeated efforts by the super- seded security forces to undermine the new public security institutions signalled a lack of commitment to key aspects of the peace agreement. The govem- ment’s at-best lukewarm support-both political and financial - also discouraged international financial support. The delays affecting the new police force and the land transfer program appear particularly threaten- ing to the peace-building: according to de Soto and de1 Castillo (1994b), “on their success rests the entire peace process” - and its sustainability in the long run.

The rhetoric of austerity stemming from the macroeconomic policy environment, not domestic resource mobilization constraints per se, apparently legitimated delays and the scaling down of these and other programs. A greater interest on the part of the international financial institutions in the implementation of the Peace Accords rather than a dominant emphasis on economic reform might have contributed to the reconciliation of the apparently conflicting priorities of macroeconomic stabilization and peace- building.

With the declining presence of the international institutions, the implementation of the remaining agenda of the Peace Accords depends primarily on the willingness of the government to shoulder the costs of peace. Scope for significant increase in the mobilization of such resources exists.45 Tax reform has produced rising and more stable revenues and advances have been made in improving the auditing capability of the relevant ministries. Nonetheless, the tax-to- GDP ratio remains very low by both historical and comparative standards, the tax structure is quite regressive, and the government faces a significant problem of tax evasion. Most domestic actors recog-

nize the latter problem, and there is a broad consensus in the country on the need to raise revenue.46

Macroeconomic stability and growth will prove short-lived in the presence of political turmoil. Given the potential for further unrest on the part of excombatants and others and the continuing high rates of poverty, political stability considerations strongly support a transfer of fiscal resources from military spending (as yet well above prewar levels) to reintegration and poverty alleviation programs. This implies the need to continue to reduce military expenditures and a need for

active “peace conditionality” on the part of intema-

tional lenders. Further substantial reductions would

allow both social spending and public investment to

rise, even if tax revenues lag, thus contributing to both

the country’s peace and its economic future. Hence the Peace accords should no longer be

treated as an afterthought or a “remainder”; instead, macroeconomic strategy must be designed to support the goal of consolidating the peace. Moreover, the importance of the political reforms mandated by the Accords goes well beyond the desirability of democratic objectives and ending the civil warper se. While the peace agreement did not directly address the profound economic and social inequalities that fueled the civil war, the consolidation of the political reforms is both necessary and urgent if a future process of political bargaining is to define a more equitable model of economic development and a durable peace in El Salvador.


NOTES

1. Orellana Merlos (1992, pp. 5-7) reviews official estimates for 1979-91 and their problems. He estimates the remittance inflow in 1987 at $504 million, compared to the official estimate of $169 million and Montes’s (1987) estimate of $1.3 billion. Table 4.3 reports the official estimates which seem to be relatively accurate in the most recent years.

2. Moreover, the government’s latitude for defining policies was augmented considerably once it had access to these remittances precisely because they were autonomous - and as such not subject to the usual conditionalities attached to foreign aid and international assistance. For example, the government did not have to rely on funds from the IMF, despite having signed four Stand-By Agreements (these Agreements were considered precautionary).

3 _ While appreciation of the real exchange rate does not have strong adverse impacts on traditional exports or on exports to the CACM, it is of major importance for the competitiveness of nontraditional exports outside the region.

4. A national household survey, conducted by the Ministry of Planning in 1991-92, found that 7.1% of “extremely poor” and 12.4% of poor households received remittances, on average $36 per month and $61 per month, respectively. Remittance income is greatly understated in the survey, however: total remittances extrapolated from the survey were only $149 million/year, compared to the officially registered inflow of $690 million for 1992. Siri and Abelardo Delgado (1995, p. 6) note that understatement is likely to be especially significant for poor households.

5. On the other hand, emigration that has produced remittances has also had some negative distributional conse- quences. Survey data indicate that emigrants tend to have “above-average labor force characteristics” (Funkhouser, 1990, p. 23) and the country is now deprived of their human capital. The positive income effects of emigration must also be weighed against the social costs of the disruption of families and communities. Perhaps most troubling, El Salvador’s heavy dependence on remittances renders the economy in general, and the poor in particular, vulnerable to an adverse

shock from their sudden contraction, a topic to which we return below.

6. The reforms reduced tariffs from a range of O-290% to a range of 5-20%. There was much “water” in the earlier tariffs, thanks in part to competition within the CACM; hence the lowering of tariffs did not result in a wave of bankrupt- cies.

7. For a detailed analysis of the process of privatization in El Salvador, see Segovia (1994~).

8. In fact, the only times when the government had problems in controlling inflation were precisely those in which the exchange rate underwent strong fluctuations (as happened at the end of 1989 and beginning of 1990 due to the November guerrilla offensive) or when measures were applied that impacted directly on costs and inflationary expectations, as was the case in 1992, when the introduction of VAT and other fiscal measures led to significant price increases. The inflationary spiral of 1992 was particularly serious because the introduction of the VAT coincided with a serious shortage of basic grains (beans) due to the drought that afflicted the country that year.

9. Similarly, Harberger (1993, p. 17) predicts that the influx of remittances will continue “as long as more than a million Salvadorans live abroad,” and that they will probably grow over time, “particularly if those Salvadorans share in the economic growth which is occurring in the United States.”

10. The DED program was established to provide tempo- rary protected status in 1990, and was extended on three occasions “based largely on Salvadoran government con- tentions that the country was not able to assimilate large numbers of its citizens now living in the United States.” In decid- ing to terminate the program, the Clinton administration ignored “strenuous appeals by Salvadoran authorities” (Associated Press, 1994).


11. For example, California’s Proposition 187, passed by voters in November 1994, seeks to deny public education and health care to illegal immigrants, and requires teachers and health-care providers to report illegal immigrants to immigration authorities.

12. These advances have been highlighted by international institutions as one of the most important achievements of the adjustment program. See USAID (1994b, p. 3) and World Bank (1993, p. 2).

14. For a critical analysis of the process of privatization in banking, see Sort0 and Segovia (1992) and Sort0 (1995).

14. Harberger (1993, p. 16) reports that, with the important exception of agriculture, real profit rates in El Salvador are very high, in the neighborhood of 2630% per annum.

15. Changes in relative prices have played the major role in this shift (Acevedo, Barry, and Rosa, 1995).

16. For example, FUSADES (1993) suggests that: “Experience shows that the sequence which eventually makes it possible for a country to eliminate extreme poverty, while at the same time attaining a condition of solvency (i.e., without significant macroeconomic disequilibrium), consists of sustained growth first in order to distribute the fruits of growth later” [emphasis in the original].

17. With the goal of giving businesses time to adjust, the government is considering reducing tariffs by stages (rather than a full and immediate cut) and allowing the pace of tariff reduction to differ by sector; agricultural and animal hus- bandry sectors, for example, would receive special treat- ment.

18. The “Dutch disease” refers to the adverse impact of a foreign exchange bonanza on the competitiveness of other industries in the tradable goods sector (Corden, 1984).

19. Irregular Batallions were to be reabsorbed into the army and civilians would participate in curriculum development in the military academy.

20. Magistrates are now selected by a two-thirds majority of the National Assembly and serve staggered nine year terms (Popkin, 1994).

21. Other elements included but never adequately implemented were the extension of credit for agriculture and for small business and measures to alleviate the costs of structural adjustment.

22. One indication of the depth of conviction on this issue is that FMLN field commanders in Usuluti - many of them of peasant origins - repeatedly conditioned the concentration and demobilization of their forces on progress in the transfer of land, at times without authorization from their central command (Wood, 1995).

23. Because tenedores thus did not necessarily occupy property, we use the Spanish term rather than the lit- eral translation “holders.”

24. During the negotiation of the Accords, no attempt was made to estimate its financial implications, a process which would probably have impeded reaching an agreement by the endof 1991.

25. USAID contributed importantly to initial aspects of the government’s reconstruction planning. Two teams of consultants to USAID carried out assessments of two aspects of the reconstruction, defining possible priorities and estimated costs for programs of physical infrastructure (Jones and Taylor, 1991a, 199lb) and reintegration of excombatants (Creative Associates, 1991).

26. In order to address the immediate needs of the FMLN combatants confined to certain areas during the cease-fire, the UNDP coordinated an emergency appeal to international donors for resources (Weiss Fagen, 1995).

27. The most important measures included under this reform were instituted over a period of slightly more than two years, making El Salvador one of few countries in the world to have executed such extensive tax reform so quickly (Gallagher, 1993).

28. Policies to rein in tax fraud included the enactment of a new law on tax fraud, creation of a new unit to focus on col- lection of taxes from large taxpayers, improvement of the computer, auditing, and control systems.

29. Under the joint sponsorship of USAID, the IMF, and the IDB, a tax system modernization project, known as MOST, was implemented in 1991. According to USAID (1994b), the Ministry of the Treasury now has “a state-of- the-art tax information system and enhanced administrative capabilities.”

30. CENITEC (1993) and Mtndez and Abrego (1994) report that tax evasion may be as high as 50%, with evasion of the VAT running near 57%.

31. The World Bank (1994, p. 39) observes that El Salvador’s tax-to-GDP ratio “remains one of the lowest in the world.”

32. In part this reflects increased costs to the hydroelectric authority during the 1991 drought. In addition, consolidation of the internal public debt in 1989 and 1990 provoked a substantial increase in interest payments in 1991. The situation was further aggravated by the increase in interest payments on the external debt that resulted from the finalization of the debt restructuring period provided for under the Paris agreement of 1990.

33. In September the government, in conjunction with the IMF, revised the original goals, raising the target fiscal deficit for the nonfinancial public sector from 2.6% to 3.4% and that of the central government from 2.5% to 3.8%. The final results proved that these targets were too ambitious.

34. The government was also supposed to reduce the total public sector deficit (including BCR losses) from 4.3% of GDP in 1991 to 3.0% in 1992, and generate positive savings of 1.5% of GDP in the current account of the NFPS. For


details see “Memorandum on the economic policies of El Salvador” (IMF, 199lb. Attachment III).

35. The program also envisioned a shift in the composition of spending, with military spending declining and spending on education and health rising.

36. The economic program of 1992 assumed that the country would receive US$ 160 million in gross loan disburse- ments from multilateral institutions and US$ 320 million in loans and grants from bilateral sources (IMF, 199lb, p. 42, Appendix VI).

37. The mission offered a positive assessment of the macroeconomy and attributing fiscal shortfalls to the government’s delay in implementing planned measures (the VAT, an increase in electricity rates, and the establishment of the large taxpayers unit), as well as to the effect of the drought on the electric company’s deficit and the impact of the drop in coffee prices on fiscal revenues.

38. In 1993. the Salvadoran government achieved the majority of fiscal targets specified in yet another stand-by arrangement with the IMF, this one also supported by the World Bank and USAID. The tax-to-GDP ratio, for example, rose to 9.3%. the highest achieved during the government’s term in office. The NFPS and central government deficits were reduced to 3.9% and 1.4% of GDP, respectively, and NFPS current savings improved compared to 1992.

39. Although the “peace dividend” has yet to materialize fully, there has been a notable shift in the composition of government expenditures. Since 1991 the defense budget has declined in real terms and as a proportion of GDP; since 1993 the defense budget has been frozen in nominal terms at 866.5 million colones (roughly $100 million). This has been accompanied by an increase in allocations for the social sectors and for activities related to the strengthening of democratic institutions. Further progress in these directions is critical for the consolidation of the peace.

40. A US State Department official argues that the early deployment of the PNC, despite inadequate training and equipment, was important to capitalize on the euphoria of the signing of the Accords (interview, December 1994).

41. The issue was complicated by high and rising levels of crime, attributed by many to excombatants of both sides, which led to an agreement in December 1992 to increase

the number of PN agents admitted to the PNC provided they were evaluated and attended the Academy (UN Security Council, 1994b; Spence, Vickers and Dye, 1995, p. 7). The number of former National Policemen to have joined the new force may well have exceeded those agreed levels; the government’s long-standing refusal to supply ONUSAL with lists of former combatants has made enforcement of the agreements extremely difficult. An attempt to implement ONUSAL’s recommendation that all those transferred in excess of the December 1992 agreement be dis- missed led to a month-long strike by one of the units in early 1995. The situation was eventually resolved: over 150 members of the unit will retire with a year’s severance pay (Spence, Vickers and Dye, 1995, p. 7; El Salvador Information Project, 1995).

42. In June 1994, the lieutenant in charge of the criminal investigations division of the PN was identified on a video- tape of a bank robbery in San Salvador (Popkin, 1994). The PN was disbanded on December 31, 1994 and its facilities turned over to the PNC in mid-January 1995.

43. Proceso (El Salvador), February 1, 1995.

44. See Collier (1994) for evidence linking rising crime rates in some districts of post-civil war Uganda with land- lessness of excombatants.

45. Various studies have concluded that given the prospects for economic growth over the next few years and the changes in the tax system, it is feasible to raise tax revenues as a fraction of GDP by between 0.5% and 1% each year for the remainder of the century, resulting in a tax ratio of 14% by the year 1999. Yet the government and FUSADES have projected a tax ratio of only 10 to 11%. In addition to vigorous implementation of existing tax reforms, the tax ratio could be raised by further taxes on the nonproductive transactions of high-income individuals, such as purchases of luxury goods and high-value property transfers, which would also improve the distributional incidence of the tax system.

46. Indeed during the 1994 electoral campaign all the presidential candidates - including Dr Armando Calder6n Sol, who won the election - signed a document drawn up by UNICEF in which they agreed to raise the tax ratio to around 15% during 1994-99 in order to be able to increase social spending.

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Documents

Macroeconomic policy and the Salvadoran peace accords