3. El Salvador needs a productive transformation to overcome its development challenges

Abstract

To accelerate development, El Salvador needs a productive transformation. This chapter examines productivity growth and the potential of structural transformation to accelerate development in El Salvador. It examines productivity differentials across firms and sectors and analyses key factors that can drive productivity growth at the sector level and at the firm level, including international trade, foreign direct investment, participation in global and regional value chains, and informality. The analysis also identifies opportunities to increase value added in key sectors in the economy. While a number of high value-added sectors are thriving, El Salvador’s exports remain concentrated in goods with moderate levels of economic complexity and of skill and technological intensity, and FDI is not primarily directed to the most innovative technology-intensive sectors, suggesting that there remains unexploited potential to increase productivity growth in the economy.

The Government of El Salvador has set out a vision for a prosperous, dynamic and modern economy, which is able to create opportunities for personal and community development for all. As well as being at the core of the country’s economic development strategy, the creation of economic opportunities also has a critical role to play as El Salvador seeks to tackle other key challenges, most notably with regard to insecurity and social inclusion.

To accelerate development in El Salvador, it is necessary to increase economic growth and to make the pattern of economic growth more inclusive. Even before the COVID-19 crisis, economic growth in El Salvador stood at 2.4% between 2015 and 2018, while neighbouring countries with comparable levels of GDP per capita were growing at rates between 3.5% and 4%.1 One feature of growth over the past decade has been a decline in total factor productivity growth, and this highlights the importance of going beyond the necessary increases in investment in order to accelerate growth.

In order to make growth more inclusive, it is also necessary to create good quality jobs in productive sectors. Since 2010, the working-age population increased by over 92 000 a year, but the economy created only just over 15 000 formal jobs per year. Manufacturing sectors have played an important role in sustaining quality employment since 2010, recovering jobs lost during the global financial crisis. However, most new jobs created between 2010 and 2018 were in low value-added service sectors such as hospitality and restauration, in which 80% of new jobs are informal. On the other hand, service sectors with a high amount of value added have generated an important number of formal jobs and offer great prospects for future growth if they can find the space and resources to grow sustainably.

This chapter explains why El Salvador needs to foster a structural transformation of its productive sector. It analyses aggregate and sectoral performance, highlighting the scope that there is for increasing productivity through a structural transformation. El Salvador can build on the strength of a diversified economy and industrial base. These strengths should be a platform for fostering the emergence and growth of sectors that can generate domestic value chains and integrate regional and global value chains, generating productivity increasing dynamism. The chapter includes an analysis of productivity growth in El Salvador, of structural transformation in the Salvadoran economy, of export performance and foreign direct investment (FDI) in El Salvador, of the country’s participation in regional and global value chains, and of productivity levels in Salvadoran firms.

Low productivity growth in El Salvador limits improvements in living standards and competitiveness

When compared with the trend in most middle-income countries, productivity growth in El Salvador since 1990 has been too slow. Growth in labour productivity in El Salvador was relatively high (1%) from 1992 to 1995, following the signature of the Chapultepec Peace Accords. It slowed down to 0.1% between 1995 and 2000, and then accelerated again to an average of 1.1% between 2000 and 2008. However, as a consequence of the 2008-09 economic and financial crisis, which hit El Salvador hard, labour productivity declined by 1% on average between 2008 and 2010. The growth in labour productivity has been slow since then, amounting to only 0.1% between 2010 and 2019. This latter period coincided with a slowdown in global productivity growth, which fell from close to 2% in OECD countries to below 1% after 2010 (see Chapter 1). El Salvador’s performance in terms of labour productivity has not put the country on a convergence path with advanced economies, instead mirroring the average rate for Latin American countries (Figure 3.1, Panel A), and indeed underperforming relative to the average for Central American countries. Within the Central American region, Costa Rica and the Dominican Republic have seen their labour productivity converge towards levels in the United States. Meanwhile, Guatemala and El Salvador’s relative labour productivity fell during most of the 1990s and 2000s, but started increasing slightly in the past few years. The relative labour productivity of Honduras and Nicaragua has been declining steadily since the 1990s (Figure 3.1, Panel B).

Figure 3.1. Labour productivity is not on a convergence path with developed economies

El Salvador has room to expand capital formation and employment. Gross fixed capital formation amounted to 17.8% of El Salvador’s GDP in 2019. This was in line with the Latin American average (17.8% in 2019). However, it was considerably lower than in OECD member countries, for which the average level was 21.4% of GDP in 2019. This is also too low a level to raise El Salvador’s annual GDP growth to 3.5%, which is the government’s objective. El Salvador’s employment-to-population ratio (for the population aged 15 and over) was 58.2% in 2019. This was in line with the average level for Latin American countries, which was also 58.2% in 2019, but El Salvador’s employment-to-population ratio was much lower for women (44.3% in 2019) (ILO, 2022[2]; World Bank, 2022[1]). Thus, there is scope to increase labour input significantly by increasing women’s labour force participation and employment. Furthermore, even though employment growth has kept pace with the expansion in the working-age population, the absolute number of people aged 16 and over who are not in employment increased from 1.66 million in 2000 to 2.09 million in 2019 (DIGESTYC/MINEC, 2020[3]). In addition, the apparent similarity of El Salvador’s employment-to-population ratio and that of the Latin American region as a whole does not account for underemployment, which affected 32% of the urban active labour force, and as much as 53% of the rural active labour force, in 2019 2 (DIGESTYC/MINEC, 2020[3]). There is thus scope to increase labour input on the intensive margin, thereby increasing output per worker.

El Salvador’s economy has experienced low average total factor productivity (TFP) growth over the last decade. Total factor productivity growth in El Salvador averaged 2.4% in the 1990s following reforms that liberalised the country’s economy and its participation in international trade after the 1992 Chapultepec Peace Accords. These reforms led to the development of a maquila industry in El Salvador (export-oriented, light manufacturing).3 However, total factor productivity growth started to decline in the 2000s, when El Salvador’s economy became less competitive and investment opportunities declined. This was due to increased international competition in light manufacturing sectors such as apparel and textiles, and to high business costs. Productivity growth declined even further as a consequence of the economic and financial crisis of 2008-09, averaging only 0.3% between 2010 and 2018 (see Chapter 1).

The fall in productivity growth at the aggregate level calls for action in terms of public policy. Slowdowns in growth led by falls in TFP growth are symptomatic of the so-called “middle income trap”, especially in Latin America (Agénor, 2017[4]; Eichengreen and Shin, 2012[5]; Aiyar et al., 2018[6]). While economic growth in El Salvador recovered somewhat after 2010, this trend was largely led by a recovery in factor accumulation. Investment added 1 percentage point to GDP growth in 2010-18 compared to the previous decade, while employment added 0.45 percentage points. However, the contribution of TFP fell even further, from 0.8% to 0.3%. At the aggregate level, TFP growth captures not only technological sophistication, but also institutional factors that allow firms and industries to use factors of production more efficiently, and to make the most of existing opportunities, including FDI. FDI, regulatory quality, stable macroeconomic environments, and a skilled workforce are among the factors that have correlated with TFP convergence differentials across countries in Latin America (Daude, 2010[7]).

Structural transformation can help to accelerate productivity growth

Labour productivity exhibits large disparities across sectors in El Salvador, highlighting the potential for structural transformation to increase productivity growth (Figure 3.2). Employment in the country is concentrated in sectors with low levels of value added per worker. Almost 60% of El Salvador’s labour force works in sectors in which value added per worker is less than 60% of the country’s average level (USD 7 948 in 2018). Most importantly, these sectors include wholesale and retail trade and vehicle repair (which together account for 23.7% of total employment), and agriculture (17% of total employment). Labour productivity in trade and vehicle repair is only 54.3% of the average for the whole economy, and labour productivity in agriculture is only 33.3% of the economy-wide average (BCR, 2020[8]). In some of these sectors, labour utilisation is a significant issue. Visible or time-related underemployment (which occurs when a worker involuntarily works fewer than 40 hours a week) concern 12% of workers in agriculture, forestry, and fisheries, compared to 8% in the economy as a whole.

El Salvador’s services sector operates at two speeds. On the one hand, there are highly productive international services industries (largely export-oriented services). More than 40% of employment in services is in industries with a level of value added per worker that exceeds the average for the whole economy (BCR, 2020[8]). Service industries that have a high level of value added per worker include real estate, financial and insurance services, telecommunication and information services, business, personal and social services, utilities, transport, and aircraft maintenance. Some of these highly productive, mainly international, service industries concentrate large amounts of FDI. Financial and insurance services account for 33.8% of El Salvador’s FDI stock, and the sector’s labour productivity as measured by value added per worker is six times the economy’s average. Information and communication services concentrate 13% of El Salvador’s FDI stock, and value added per worker in this sector is more than seven times the average for the whole economy (BCR, 2020[8]; Sierra, 2019[9]) (see Chapter 1). On the other hand, however, El Salvador also has a large non-tradable services industry with low levels of labour productivity. Over half of employment in services remains concentrated in services with a value added per worker of less than 60% of the economy’s average. Most importantly, this is in wholesale and retail trade and vehicle repair, food and beverages, and domestic personnel (BCR, 2020[8]).

El Salvador’s manufacturing sector is largely composed of industries with relatively low levels of productivity – mainly export-oriented light manufacturing. In some of El Salvador’s manufacturing industries, such as beverages, chemicals, rubber and plastics, textiles, and pharmaceuticals, labour productivity as measured by value added per worker is high relative to the country-wide average. Labour productivity in the beverages sector is 4.8 times the average for the economy as a whole. In chemicals and textiles, it is 2.3 times the economy-wide average. In the plastics and rubber sector, it is double the average for the whole of the economy. In pharmaceuticals, it is 1.9 times the economy-wide average. However, close to 70% of El Salvador’s employment in the manufacturing sector remains concentrated in industries with value added per worker that is below the economy’s average. This is the case most importantly in the largest subsectors of the food industry (which, as a whole, represents 40.7% of manufacturing employment in El Salvador), and in the clothing subsector (19.8% of manufacturing employment in El Salvador) (BCR, 2020[8]). Both sectors consist mainly of export-oriented, low-tech, light manufacturing. They largely employ low-skilled workers, and they account for a large share of El Salvador’s exports.

Figure 3.2. Employment in El Salvador is concentrated in sectors with low value added per worker

El Salvador has experienced a structural transformation away from agriculture and towards services. Since the 1990s, the share of El Salvador’s services sector in GDP (excluding commerce and vehicle repair) has expanded, rising from 44.2% in 1990 to 57.5% in 2018 (Figure 3.3) (BCR, 2020[10]). At the same time, the shares that agriculture and commerce and vehicle repair represent of El Salvador’s overall GDP have fallen. The decline of El Salvador’s coffee industry since the 1980s has contributed to the decrease of agriculture’s share in the country’s GDP.

The expansion of El Salvador’s services sector has been fuelled by two trends. The first of these has been the large inflows of remittances that sustain the consumption of final goods and non-tradable services by households in El Salvador. Between 2005 and 2016, this resulted in the expansion of several low-productivity sectors such as accommodation and food and drink (Figure 3.4). Given these sectors’ larger size, they represent a sizeable proportion of net employment creation in absolute terms. However, while these largely non-tradable services generate jobs, they tend to employ low-skilled workers, and both wages and labour productivity tend to be low. Secondly, global trends such as falling international transport costs, declining tariff barriers, and digitalisation, have led to an increase in the share of services in international trade worldwide, and have contributed to the development of an international services industry in El Salvador (see Chapter 1). Globally, trade in services increased more rapidly (5.4% per annum) than trade in goods (4.6% per annum) between 2005 and 2017, and the share of developing countries in global services exports increased from 14.7% in 2005 to 25.2% in 2017. Distribution services (19.9% of global trade in services), financial services (18.6%), telecommunications, ICT and audio-visual services (13.2%), and transport (11.8%), make up the bulk of the global trade in services (WTO, 2019[11]). As a consequence, high-productivity international services such as telecommunications, information services, and financial services have seen rapid employment growth (of 1% and 2.3% per annum respectively, compared with aggregate employment growth of 1.5% per annum between 2005 and 2018) (Figure 3.4).

Figure 3.3. El Salvador has experienced a structural transformation from agriculture to services since the 1990s

El Salvador has managed to preserve a significant manufacturing base despite a decline in international competitiveness and liberalising reforms. Following the peace accords, and in combination with low wages and tax incentives, export-oriented light manufacturing industries – which constitute a large part of El Salvador’s manufacturing base – experienced significant growth in the 1990s. After reaching 20.5% of GDP in 1993, manufacturing’s share of GDP declined gradually to 16.6% in 2005, and it has remained stable over the past 15 years (Figure 3.3). Due to increased international competition, El Salvador’s light manufacturing sector started to become less competitive in the early 2000s. The most important reasons for this decline in competitiveness were China’s accession to the World Trade Organization (WTO) in 2001, and high business costs in El Salvador itself. The country’s competitiveness in light manufacturing has declined even more in the light of increasing real wages. Since 2014, nominal wages in El Salvador have been growing faster than GDP and labour productivity, in large part due to significant increases in minimum wages. In the 1990s and 2000s, furthermore, El Salvador underwent a set of liberal reforms to open up the economy to trade by lowering tariff barriers, and by signing several trade agreements, most importantly the Dominican Republic-Central America-United States Free Trade Agreement (DR-CAFTA) in 2006 (see Chapter 1). That the manufacturing sector has maintained its share of GDP despite El Salvador’s openness and declining international competitiveness is a testament to the opportunities that it offers for the country. According to the United Nations Industrial Development Organization’s (UNIDO) Competitive Industrial Performance (CPI) database, El Salvador ranks as the tenth-placed country with regard to the share of manufacturing products in its export basket, and in 38^th place when it comes to manufacturing’s share of value added (out of 152 countries covered) (UNIDO, 2021[12]).

Within El Salvador’s manufacturing sector, a shift has occurred from garments and apparel towards the more productive textile sector. Value added in wearable apparel fell between 2005 and 2018 in both absolute and relative terms (from 12% of total value added in manufacturing in 2005, to 3.3% in 2018), while the share of overall value added in manufacturing that comes from the more productive textile industry expanded (from 3.5% of total value added in manufacturing in 2005, to 7.6% in 2018) (BCR, 2020[8]).

Aside from the shift towards textiles, however, the composition of El Salvador’s manufacturing sector has not generally shifted to more productive sub-sectors of manufacturing since 2005. Other manufacturing industries that expanded by more than 1% annually in terms of value added as a share of GDP between 2005 and 2018 include sugar processing, beverages, the maintenance and repair of machinery, rubber and plastics, the manufacturing of clothing, oils, vegetable and animal fats, and meat processing. The performance of these sectors in terms of labour productivity is mixed (BCR, 2020[8]). Figure 3.4 shows that both dynamic manufacturing industries and sectors with low value added per worker experienced significant employment growth between 2005 and 2018.

Since the mid-1990s, structural transformation through labour reallocation has not contributed significantly to the growth of labour productivity in El Salvador. Figure 3.5 breaks down growth in labour productivity into growth within individual sectors, on the one hand, and the contribution of shifts in the composition of employment on the other. It shows that the reallocation of labour from less productive to more productive sectors made a sizeable contribution to productivity growth during the 1990s. The shift from very low-productivity agricultural employment (which went from 36% of total employment in 1992 to 27% in 1995, and to 22% by 2000) to manufacturing and services sustained relatively rapid productivity growth. However, the contribution that labour reallocation made to productivity growth was very low (0.2%) prior to the 2008-09 economic and financial crisis, and was negative (-1%) during the crisis, mainly due to the destruction of jobs in manufacturing industries. The contribution of labour reallocation to productivity growth has increased somewhat to 0.5% over the last decade, most importantly due to a positive labour reallocation effect towards higher-value service industries.

Figure 3.4. Employment in El Salvador has been expanding in some sectors with high value added

Figure 3.5. Labour reallocation has not contributed significantly to productivity growth in El Salvador since 2000

El Salvador’s exports are concentrated in goods with moderate levels of economic complexity, skills and technology intensities

El Salvador is already a rather open economy. In the context of the reforms that opened up El Salvador’s economy in the 1990s and 2000s, average tariffs applied (weighted by trade flows) fell from 9.15% in 1995 to 3.93% in 2006, and to 1.94% in 2018 (World Bank, 2022[14]). Trade amounted to 77.2 % of El Salvador’s GDP in 2019, which is above the Latin American and Caribbean average (45.8% of GDP in 2019), but less than in highly open economies in Asia (210.2 % of GDP in Viet Nam) and Europe (141.2% of GDP in Estonia) (World Bank, 2022[1]). It was estimated that the export sector created 19% of employment in El Salvador in 2014, and that this sector accounted for 32.2% of newly created jobs between 2005 and 2014 (Aquino Cardona, 2019[15]).

Figure 3.6. El Salvador’s exports are dominated by textiles, services and agricultural products

El Salvador’s exports are diversified, and are composed largely of services, textiles and agricultural and food products (Figure 3.6). In 2020, textiles (including apparel) represented 28.4% of El Salvador’s total exports, whereas services represented 28.8% of exports and agricultural products 19.3% (Harvard University Growth Lab, 2020[16]). Manufactured goods accounted for 75.6% of El Salvador’s merchandise exports in 2019, prior to the COVID-19 pandemic (World Bank, 2022[1]). Since the 1990s, El Salvador has transitioned from exporting mainly agricultural goods to exporting services and light manufacturing, mainly textiles (Figure 3.6, Panel B). Coffee was El Salvador’s main export good for much of the 20^th century, but the country’s coffee exports fell from 87.5% of total exports in the early 1950s (see Chapter 1) to 32.5% in 1994, and to less than 2% in 2019 (UN, 2022[17]).4 El Salvador’s services and textile exports have expanded since the 1990s, but have grown only slowly since 2013 (Figure 3.6).

Figure 3.7. El Salvador’s level of economic complexity has grown slowly

El Salvador’s exports are characterised by moderate levels of economic complexity. The complexity of an economy depends on the amount of productive knowledge embedded in it, and can be measured by the composition of a country’s productive output (as approximated by the country’s exports) (Hausmann et al., 2011[18]). The Economic Complexity Index (ECI) measures the degree of complexity of a country’s export basket on the basis of how many other countries are competitive exporters of the same product. Therefore, improvements in the ECI are secured by adding more complex products to the export basket. El Salvador’s level of economic complexity as measured by the ECI has stagnated since 2011, and it progressed only at a very slow pace prior to that (Figure 3.7). El Salvador ranked 53^th out of 133 countries in the Atlas of Economic Complexity in 2018, as compared to 56^th in 2011 (Harvard University Growth Lab, 2020[16]). The country performs better than other Latin American countries such as Honduras, Guatemala or Ecuador, but its level of economic complexity is still much lower than in more developed countries such as Estonia. El Salvador’s main export goods have rather low levels of economic complexity. Textiles have an average level of economic complexity of -0.93, and agricultural products have an average level of -0.48 (2018)5 (Harvard University Growth Lab, 2020[16]). The export products from El Salvador that have the highest levels of economic complexity are complex measuring instruments, flat-rolled alloy steel and electrical capacitors, and a number of paper and plastic products (OEC, 2020[19]).

Raising the sophistication of El Salvador’s exports could stimulate economic growth. There is a clear and strong positive relationship between income per capita and the level of economic complexity of a country’s exports. Furthermore, countries with a level of economic complexity greater than the one predicted by their level of income tend to experience higher economic growth rates (Hausmann et al., 2011[18]). Using 2017 data, the economic growth rate projected for El Salvador through to 2027 based on its economic complexity score and income per capita would be only 2.07% (without accounting for the COVID-19 pandemic) (Harvard University Growth Lab, 2020[16]). Shifting to the production of more sophisticated goods could improve El Salvador’s economic growth performance (Alvarado and Amaya, 2015[20]).

El Salvador’s exports are concentrated in goods with low technology and skill intensities. Even though El Salvador has diversified its exports over time, low-tech goods that require little human capital still account for a large share of the country’s exports. In 2019, 55.9% of El Salvador’s exports were low-tech manufacturing goods, 23.9% were natural resource manufacturing goods, and only 8.4% and 6% of exports respectively were medium- and high-tech manufacturing goods. El Salvador’s medium-tech exports represented 11% of the country’s export volume prior to the economic and financial crisis of 2008-09, falling to 6.3% of exports in 2011 following the crisis. Even in 2019, medium-tech exports as a share of El Salvador’s total export volume had recovered only partially from this shock (ECLAC, n.d.[21]).

Exports to the Central American region represent an opportunity for El Salvador to decrease the share of low-tech manufacturing goods in its manufacturing exports. While El Salvador’s exports to the United States are dominated by low-tech goods (77.7% of exports to the United States in 2019), only 43.8% of its exports to Central America (Costa Rica, Guatemala, Honduras, Nicaragua and Panama) and the Dominican Republic are low-tech goods, and 32.4% of its exports to Central American countries and the Dominican Republic are natural-resource manufacturing goods. El Salvador’s exports to Central America and the Dominican Republic include more medium-tech goods (12% in 2019) than those to the United States (2.8%) (ECLAC, n.d.[21]). In 2018, El Salvador’s main exports to countries in the Central American region were agricultural goods (32.6% of El Salvador’s exports to Central America and the Dominican Republic), textiles (26.1%), chemicals (22.4%), metals (9.6%), and minerals (5.2%) (Harvard University Growth Lab, 2020[16]). Exports to Central America are also more diversified within categories of technological sophistication than exports to the United States, which points to potential for a greater integration of regional value chains (Vázquez López and Morales López, 2018[22]).

El Salvador’s integration with the rest of the Central American region is deepening. El Salvador is part of the Central American Integration System (the Sistema de la Integración Centroamericana, or SICA). It is also part of CAFTA-DR, a trade agreement between the United States, Central American countries and the Dominican Republic. In 2018, El Salvador also joined a customs union with the so-called Northern Triangle (Triangulo Norte) countries, Honduras and Guatemala, as part of the so-called in-depth integration process (proceso de integración profunda) (Secretaría de Comercio e Inversiones, 2020[23]). The Central American integration process has also opened up other avenues. For example, Central America negotiated a bi-regional Association Agreement with the European Union, with political, co-operation and trade pillars (although only the latter is being implemented, as has been the case since 2013) (Caldentey del Pozo, 2022[24]). El Salvador has a National Committee for Trade Facilitation (Comité Nacional de Facilitación del Comercio), led by the Ministry of the Economy, and has adopted a number of measures for facilitating trade, including measures for greater regional integration with Central America. El Salvador’s exports to the Central American region have increased in recent years, representing 45% of its total exports in 2019 (UN, 2022[17]). Many companies in El Salvador rely on imports and exports passing through neighbouring countries’ ports, most importantly in Guatemala and Honduras.

There is scope to further deepen El Salvador’s regional trade integration with Central and Latin American countries. The adherence of El Salvador to the customs union of Guatemala and Honduras is not yet operational as of mid-2022, but an action plan is in place to implement it by the end of 2022. Insufficient regional integration is a significant obstacle for private investors, in particular those that rely on imported inputs for production in El Salvador. Cross-border planning for infrastructure, the operationalisation of the customs union with Guatemala and Honduras, and the inclusion of more Central American countries in the customs union would all serve to increase the size of the market, whilst at the same time considerably reducing costs and transport delays for investors. A larger market would facilitate the integration of the region’s countries into global value chains (Secretaría de Comercio e Inversiones, 2020[23]).

There are opportunities to increase the volume of trade between El Salvador and Central America. Among the set of products for which El Salvador has a revealed comparative advantage (RCA) greater than one, and for which world imports have experienced positive growth over the past five years (2015 to 2019), El Salvador represents less than 50% of Central American countries' imports in several sectors such as leather, footwear, chemicals, electronics, food, plastics, textiles and others (Figure 3.8, Panel A). In particular, there are opportunities to expand El Salvador's exports of textiles and chemicals to Central American countries. El Salvador has a large number of products with a revealed comparative advantage in both of these sectors (86 and 35 products respectively), but the country currently satisfies only a fraction of Central American countries’ import demand for this set of textile and chemical products (14.7% and 7.6% respectively).

Figure 3.8. There are opportunities in multiple sectors to increase El Salvador’s exports to Central America and the world

There are opportunities to increase El Salvador's exports not only to Central America, but also to the world. The country’s share in world imports of the products for which it has an RCA greater than one, and which have seen international trade increase in 2015-19, is currently less than 1% in all sectors (Figure 3.8, Panel B). In particular, opportunities exist in the chemical sector and in base metals, as El Salvador has a relatively large number of products with a revealed comparative advantage in these sectors, but a small share of the global market (BCR, 2021[25]; UN, 2022[17]).

In order to promote and facilitate international exchanges, and exports in particular, El Salvador has been negotiating a range of trade agreements. A new trade agreement between Korea and several Central American countries, including El Salvador, came into force in January 2020 (MINEC, 2020[26]). Korea is the ninth biggest importer in the world and one of El Salvador’s main Asian trading partners, and the stock of Korean investment in El Salvador is more than USD 40 million (MINEC, 2021[27]; MINEC, 2020[26]). In order to take full advantage of this new trade agreement, El Salvador launched an action plan, which includes the identification of potential export products to Korea, and support for private companies in meeting Korea’s import requirements. A similar action plan to make the most of the trade agreement with the United Kingdom is also in place. El Salvador is implementing similar action plans to support Salvadoran companies in taking advantage of existing trade agreements, including the ones with the EU and the United States. These actions include communication and promotion activities, as well as the implementation of measures linked to the administration of agreements. Furthermore, El Salvador is currently negotiating several new trade agreements. These include an investment protection agreement with Qatar, a limited-scope trade agreement with Bolivia (which was signed in 2018 but whose ratification is still pending), and amendments to improve existing trade agreements (MINEC, 2020[26]).

There is scope for El Salvador to benefit more from existing trade agreements. The average growth rate of El Salvador's exports to the countries with which it has concluded trade agreements has in all cases been positive following their entry into force, except for the trade agreement with the European Union (EU). In the case of the recent trade agreement that El Salvador concluded with Korea, its exports increased significantly. The absolute value of El Salvador's exports to Korea increased fivefold, and the share of exports to Korea in El Salvador's total exports increased six-fold between 2018 and 2020. El Salvador's sugar exports to Korea more than tripled between 2019 and 2020 (increasing from USD 14.7 million in 2019 to USD 48 million in 2020) (UN, 2022[17]). Exports to Panama, Mexico and the Dominican Republic also increased considerably, both in absolute value, and as a percentage of El Salvador's total exports, following the conclusion of trade agreements with these countries (Figure 3.9). However, the share of total exports to other countries with which El Salvador has concluded trade agreements, such as Cuba, Colombia, Chile, and Chinese Taipei, has increased at a more moderate pace, and has even declined in the case of the United States and the EU. El Salvador's exports to the EU fell both in absolute value and as a share of its total exports after the entry into force of its agreement with the bloc in 2013 (BCR, 2021[25]). This has partly been due to a fall in coffee production linked to an outbreak of coffee rust, and the fall in the price of coffee, which is an important export good to EU countries. In addition, and as part of its economic diplomacy efforts, El Salvador started posting economic counsellors to its diplomatic missions in 2022, with 15 of these officials already in place as of 2022. Their mission is to support the promotion of exports, the attraction of investment, and the promotion of tourism.

Figure 3.9. Some trade agreements have boosted exports from El Salvador, but not all have had the desired impact

FDI in El Salvador is directed towards low-skilled activities, and does not flow to the most innovative and technology-intensive sectors

FDI can make significant contributions to raising productivity in El Salvador. Through FDI, foreign technology and cutting-edge technical know-how can be transferred to host economies. Most significantly, this can happen via linkages between foreign firms and local suppliers or partners. Through such linkages, local firms can get access to, and adopt, new technologies, practices and managerial and technical skills, boosting their productivity. Foreign firms’ quality standards and technical requirements can provide further incentives for local suppliers to upgrade their technology. Technology transfers can also happen through imitation. Thus, local firms can imitate foreign firms’ technologies and practices through observation, or by hiring workers who have been trained by foreign firms. In addition to knowledge transfers, FDI can also improve local suppliers’ and partners’ access to international markets, eventually deepening the economy’s integration into international trade. FDI can further contribute to productivity gains by increasing competition in the local market, forcing less productive firms to close down, and resulting in a re-allocation of resources to more productive firms (OECD, 2015[28]; World Bank, 2017[29]).

FDI inflows in El Salvador are moderate. Net inflows of FDI averaged 2.1% of GDP between 2015 and 2019, as compared to 3.7% of GDP in Latin America and the Caribbean on average (World Bank, 2022[1]). Between 2012 and 2017, 51.3% of FDI net inflows in El Salvador were directed to the industrial sector, and 48.3% to the services sector. Net inflows of FDI in services were mainly directed to financial and insurance activities (27.7% of FDI), commerce (12.4%), and information and communication (4.1%) (Sierra, 2019[9]). Between 2014 and 2018, the main countries of origin of FDI inflows in El Salvador were Panama (32.7% of FDI inflows) and the United States (27.8% of FDI inflows) (ECLAC, 2019[30]).

El Salvador performs relatively well in terms of domestic supply-chain linkages between foreign and domestic firms. In El Salvador, foreign manufacturers purchase 37% of their inputs domestically (Figure 3.10, Panel A). El Salvador performs better than other Latin American countries, including Guatemala, Panama and Ecuador, also outperforming developed countries such as Estonia, but it still lags behind Costa Rica (48%) and Morocco (65%). El Salvador ranks 23^rd in terms of foreign manufacturers’ share of domestic purchases amongst the 61 countries for which data are available. However, foreign manufacturers’ average share of inputs purchased domestically remains less than half of that of top-performers such as Colombia (93%) (OECD, 2019[31]).

FDI in El Salvador tends to be labour intensive. Foreign firms in El Salvador perform well in job creation by comparison with international levels. On average, 5.7 new jobs are created in El Salvador per million US dollars of (announced) greenfield FDI (Figure 3.10, Panel B). This is fewer jobs than in Costa Rica (7.4 jobs created), but more than in other Latin American countries, and indeed in a set of comparator countries in Asia, Africa and Europe (OECD, 2019[31]). This is evidence that FDI in El Salvador is directed towards relatively labour-intensive sectors. Indeed, both, the textile and apparel sector, and the food industry – two important sectors in El Salvador’s economy – figure amongst the ten top performing sectors worldwide in terms of job creation per million US dollars of (announced) greenfield FDI (OECD, 2019[31]), because these sectors tend to be very labour intensive.

Figure 3.10. El Salvador performs relatively well in terms of FDI-induced job creation and local linkages

Foreign firms in El Salvador outperform their domestic peers in terms of productivity, wages, and the degree of technological sophistication of the sectors in which they invest. Foreign firms in El Salvador perform better than their domestic peers in terms of productivity, and they pay higher wages on average (Figure 3.11, Panel A). Thus, foreign firms in El Salvador seem to be cost-competitive, and more productive and efficient than their domestic counterparts. Furthermore, FDI in El Salvador is concentrated in sectors that perform better in terms of process and product innovation (Figure 3.11, Panel B).

However, foreign firms in El Salvador perform worse than domestic firms in terms of process innovation and skills intensity (Figure 3.11, Panel A). Furthermore, FDI in El Salvador is not concentrated in sectors that are particularly skills-intensive. What is more, it is concentrated in sectors with low research and development (R&D) intensities (Figure 3.12, Panels A and B). Across OECD countries, FDI is concentrated in sectors with higher labour productivity and higher R&D intensity.

Figure 3.11. Foreign firms in El Salvador are more productive and pay higher wages, but FDI is not directed towards El Salvador’s most productive and R&D-intensive sectors

El Salvador could leverage FDI to make a larger contribution both to improvements in productivity and to moving the country’s businesses up the value chain. In future, attracting more innovation and skills-intensive FDI into the economy’s most productive sectors could help El Salvador to move up the value chain and to increase productivity. Attracting FDI into lower value-added sectors can also contribute to improvements, for example in tradable light manufacturing. An international comparison with other developing economies shows great variation in the degree to which different countries attract FDI to R&D and skills-intensive sectors (Figure 3.12, Panels C and D). To leverage the potentially transformational effect of FDI, it is necessary, therefore, to align investment promotion policies with economic transformation policies.

Figure 3.12. In international comparison, El Salvador performs poorly in terms of FDI’s skills and innovation and R&D intensities

El Salvador’s participation in Global and Regional Value Chains (GVCs) has untapped potential to increase productivity

Emerging analysis suggests that participation in GVCs can bring multiple benefits to countries. In particular, it can bring about increases in productivity, along with higher degrees of diversification and sophistication in production (Cadestin, Gourdon and Kowalski, 2016[32]). Participation in GVCs can take multiple forms, and it is often measured through the use of foreign inputs in production (backward participation), and the supply of intermediate goods to value chains (forward participation). Evidence suggests that participation in GVCs leads to increased productivity through multiple channels: it allows for greater vertical specialisation, generates competition in domestic markets for inputs, allows firms to access technology and knowledge embodied in new varieties of inputs, and is a vehicle for FDI-driven knowledge spill-overs (Criscuolo and Timmis, 2017[33]).

There is scope to increase the Salvadoran firms’ participation in GVCs. The experience of major export sectors in El Salvador that are embedded in GVCs shows that their internationalisation can boost productivity. On the other hand, performance among sectors providing commodities and raw-material-based intermediate goods to regional and global value chains is mixed. There is, therefore, also potential to increase the contribution of internationalisation to productivity by improving firms’ prospects and capacities within GVCs. Finally, regional value chains can potentially sustain productive transformation by generating greater value added in the region (as in the case of textiles), and by generating productive capacity in products that may not yet be competitive globally.

El Salvador’s participation in GVCs is in line with that of its regional peers, but lower than comparator countries that play a larger role in their regional production networks (Figure 3.13). The expansion of GVCs slowed down significantly following the global financial crisis (WTO, 2019[34]). While complex GVCs have subsequently grown faster than less complex ones, this has resulted in a reduction in measured participation in GVCs in El Salvador, and indeed across most countries in the comparison group.

Figure 3.13. The participation of El Salvador in Global Value Chains is in line with regional peers, but has fallen marginally in the past decade

The participation of El Salvador in Global Value Chains takes place largely through backward channels in key export sectors. The largest export sector, textiles and apparel, used just under 25% of imported inputs in its export production, according to data from the UNCTAD-Eora Global Value Chain Database (UNCTAD/Eora, 2020[35]). The same pattern is found in other important export sectors, both in manufacturing (petroleum, chemicals and non-metallic mineral products, electrical and machinery), and in certain services such as transport (Figure 3.14). Certain primary-sector exports are more integrated into GVCs, especially fishing and mining, but they represent a much smaller fraction of exports. They are also placed very much upstream in their respective value chains, while most manufacturing sectors are placed downstream in their respective value chains. In other words, sectors with high forward participation in El Salvador use relatively few imported inputs to produce exported intermediate goods, in large part because the products that they export do not require complex transformation. In contrast, sectors like textiles and apparel export final goods, and are therefore at the end of the production value chain.

Figure 3.14. El Salvador participates in GVCs largely through backward channels in key export sectors

Regional value chains play a major role in the insertion of El Salvador into GVCs. As much as 8% of value added embedded in Salvadoran exports is generated elsewhere in Central America (including the Dominican Republic), while 6% is generated in the United States. Conversely, of the 4.7% of Salvadoran exports that is embedded in third-country exports, 1.5% is exported to the Central American region. The nature of regional and global value chains sometimes differs. For example, although there is a regional value chain in the production of textiles and apparel, it is largely directed at exports to the United States of America, which imports 71% of El Salvador’s textile and apparel exports, mostly in finished goods. The importance of regional value chains reflects the growing importance of regional trade for El Salvador. Trade with Central America grew from 28% to 55% of the country’s exports between 2000 and 2018 (BCIE, 2020[36]).

Sectors with backward linkages have grown in size and productivity in the past few years. Figure 3.15 shows growth in value added by aggregate sector linked to each sector’s backward and forward GVC linkages, while Figure 3.16 shows the relationship between GVC linkages and growth in value added per worker. Sector selection was determined by matching supply-use tables and the UNCTAD-Eora Global Value Chain Database, and excluding professional and business services, which are classified differently in the two databases. Forward linkages can sustain demand through derived demand for global export products. However, the sectors with the largest forward participation in GVCs did not perform particularly well during the period. While mining and quarrying saw significant growth in value added, it was with very modest productivity growth. On the other hand, most sectors with significant backward linkages not only saw growth in value added, but this growth was driven – at least in part – by growing labour productivity.

Despite the good performance of manufacturing sectors with deeper GVC links, GVC integration still has untapped potential in El Salvador. Indeed, overall GVC participation remains relatively low in the country. In addition, the sub-region as a whole, plus certain sectors with GVC integration, have not seen increased productivity. Making the most of GVC integration begins with trade policy, as multiple border crossings lead to a compound application of tariffs on final products. Moreover, evidence suggests that, in the framework of GVCs, small improvements in trade facilitation can significantly increase the potential trade in value added. Analysis of the key determinants of GVC participation by the OECD finds that trade facilitation and customs performance, the quality of infrastructure and institutions, the protection of intellectual property, and the quality of electricity supply, are particularly important (Kowalski et al., 2015[37]).

Figure 3.15. Backward GVC linkages have sustained growth in a range of sectors

Figure 3.16. Sectors with deeper backward GVC linkages saw higher productivity growth

Only a small fraction of Salvadoran firms are globally competitive, and there are wide differences within sectors

Total factor productivity is a key measure of performance at the level of individual firms. It captures the efficiency with which factors of production are used. At the aggregate level, it captures not only the technology of production, but also institutional factors, which can play a major role in the efficiency of production, both in terms of the organisation of production (such as managerial practices), and in terms of the profitability of an enterprise (through the quality of factors of production, which is usually not well measured, and through the appropriability of returns or other costs of doing business that limit value added at the firm level). This section uses TFP estimates calculated on the basis of the World Bank’s Enterprise Surveys to show the distribution of productivity of Salvadoran firms compared to the global distribution of productivity in the same sector (Francis et al., 2020[38]).6

The total factor productivity (TFP) performance of firms in El Salvador’s main manufacturing industries remains poor by comparison to international levels. Figure 3.17 shows the distribution of firms’ TFP relative to global distribution within the same sector. If a given sector in El Salvador had the same distribution of productivity as world distribution, then it would have 33% of firms in each of the global quantiles. In El Salvador’s main manufacturing industries – textiles and apparel, and food manufacturing – the large majority of firms (73.7% and 84% respectively) are in the world’s bottom third of companies in terms of TFP performance. Almost all companies (98.1%) in furniture manufacturing – another important manufacturing industry in El Salvador – are in the world’s 33% least productive firms. Both in textiles and apparel, and in furniture manufacturing, El Salvador has no firms that are in the world’s top third of most productive companies. In food manufacturing, meanwhile, the share of Salvadoran companies that are in the world’s top third of companies in terms of TFP performance is small (4.7%). If all manufacturing firms are assigned to their group in the global distribution of productivity, only 17% of Salvadoran firms appear in the top third (Figure 3.18). This is largely due to the country’s small share of globally competitive firms in key manufacturing sectors (such as textiles and apparel, and agri-food). On the other hand, when all firms are compared to the global distribution of TFP, 31% of Salvadoran firms are in the top third. This is explained by the presence of highly productive firms in other sectors (such as publishing).7

Figure 3.17. Differences in TFP exist not only between manufacturing sub-sectors, but also within sub-sectors

Figure 3.18. A relatively small share of Salvadoran manufacturing firms are globally competitive in terms of TFP

Highly productive firms in El Salvador are the ones that innovate. The distribution of productivity is skewed to the left for almost all sectors: in most sectors, there are few firms that are highly productive, and many that have low productivity. It is, therefore, particularly important to determine their characteristics. Innovation stands out among the predictors of high productivity. Indeed, 29% of firms that introduced a new product, service, or process in the past three years enjoy levels of productivity that are in the upper third, compared to just 3% of those that did not. The result is similar whether innovation is measured by the introduction of new products, services or processes. However, when comparing internationally, only 42% of Salvadoran firms are in this group. This is similar to some sub-regional peers like Dominican Republic (42%), but significantly behind others like Costa Rica (68%). Export orientation also helps to identify more productive firms, although to a lesser degree. In this vein, 22% of exporters are highly productive, compared to 17% of non-exporters. Other factors do not seem to play a major role. Foreign-owned firms are less likely to be highly productive, even though they perform better on average. Firms with international certifications are also less likely to be highly productive, which indicates that certification serves to capitalise on existing advantages (including cost advantages), rather than necessarily to generate new ones.

The size of the informal sector is a drag on productivity and job quality in El Salvador

The informal sector in El Salvador is sizeable. According to a micro and small enterprise survey carried out in 2017 by El Salvador’s National Commission for Micro and Small Businesses, the Comisión Nacional de la Micro y Pequeña Empresa (CONAMYPE), 75% of micro and small enterprises in El Salvador are informal (i.e. they are not registered for value added tax [VAT]) (CONAMYPE, 2018[40]). In addition, 69.1% of employment was informal in 2019, a rate that has not changed significantly in the past decade (ILO, 2022[2]).

Informal firms generate lower value added and pay lower wages to their employees. Among micro and small enterprises in El Salvador, labour productivity is strongly associated with average wages, both among informal firms, and among those that are registered. Formal small and medium-sized enterprises (SMEs) in the most productive quintile pay wages that are eight times higher than those of the least productive firms (Banegas and Winkler, 2020[41]). In turn, informal workers receive hourly wages that are 5.8 times lower than those of formal workers. This is one of the highest ratios among the 40 countries that are covered by the OECD database of Key Indicators of Informality based on Individuals and their Households (KIIbIH) (OECD, 2021[42]). According to El Salvador's 2019 Multi-purpose Household Survey, the average wage of formal workers was USD 492.64 per month, while the average wage of informal workers was only USD 208.10 per month (DIGESTYC/MINEC, 2020[3]).

Informal jobs are of a lower quality than formal-sector jobs in other dimensions too. In emerging countries, informal workers do not only earn less, but they are also more likely to work very long hours than formal workers (OECD, 2016[43]). In El Salvador, a higher proportion of informal workers work more than 49 hours per week (29%, compared to 27% among formal employees). Furthermore, a higher proportion of informal workers work fewer than 20 hours per week (14%, compared to 5% of formal workers). This reflects the difficulty of generating gainful employment, even in the formal sector. Informality is also strongly associated with vulnerability and lower wages in El Salvador. In 2014, 71.4% of the poor were employed in the informal sector 8, and 56.3% of the vulnerable, compared to 36.1% of the middle class (OECD et al., 2019[44]).

The informal sector is also less productive than the formal sector in El Salvador. Informal firms are, on average, smaller and less productive than formal firms in developing countries. In El Salvador, there is a clear and strong negative relationship between the level of informality of an economic sector, and the average value added per worker by sector (Figure 3.19). All sectors with high levels of informality exhibit low labour productivity, while highly productive sectors have relatively low informality (this notwithstanding, the meat processing sector, for example, has high value added per worker despite having over 40% informal employment). Indeed, formality is not a sufficient condition to ensure high productivity. Sectors in El Salvador with a relatively low degree of informality (less than 35% informal employment) are sub-divided into sectors with low value added per worker, and sectors with high value added per worker. In the services sector, the sectors with both a relatively low share of informal employment and a relatively low level of value added per worker are public administration, as well as sectors with a high degree of public-sector participation (education and health). In manufacturing, the distribution of sectors with low informality in terms of their value added per worker reflects the two-speed nature of the Salvadoran economy. Some manufacturing industries with modest productivity levels, mainly light manufacturing, including apparel, coexist with highly productive manufacturing and especially service sectors.

Low levels of education among informal entrepreneurs, as well as low levels of innovation in informal enterprises, contribute to low levels of productivity in the informal sector in El Salvador. Among managers of informal enterprises in El Salvador, 14% have no formal education, and 46.4% have completed primary education only. Only 8.3% of informal enterprise managers have a university education. The innovation levels and growth prospects of informal enterprises in El Salvador are quite limited. Only 1% of informal enterprises have links with universities on innovation and development issues, and only 3% have links with the government when it comes to innovation issues (ILO, 2019[45]).

Figure 3.19. High informality is associated with low productivity in El Salvador

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Notes

← 1. Costa Rica, Dominican Republic, Guatemala, Honduras, Nicaragua and Panama.

← 2. El Salvador does not publish official data on underemployment in rural areas. For this analysis, the official method used for urban areas was replicated and applied to the employed population over 15.

← 3. Light manufacturing produces consumer goods for final consumers and, in some cases, intermediate products, generally from partially processed materials. It requires less capital and technology than heavy industry. It includes sectors such as textiles and shoes, food and drink products, pharmaceutical products, electronic products, cosmetics, books, magazines and newspapers.

← 4. The main reasons for the decline of the coffee sector were the civil war and government control of coffee sales and exports in the 1980s, land reforms in the 1980s and early 1990s, reforms liberalising El Salvador’s economy at the end of the civil war in the 1990s, and increased competition from other countries in the 1990s and early 2000s.

← 5. On a scale of 2.56 (for the product with the highest level of economic complexity in 2018) to -3.33 (for the product with the lowest level of economic complexity in 2018) (Harvard University Growth Lab, 2020[16]).

← 6. This data also has a number of limitations. Importantly for El Salvador, it does not include services sectors, which were partly surveyed, but which do not reply to questions on capital inputs. Additionally, the sample is built to ensure the representativeness of a small number of manufacturing sectors, but it cannot be construed as representative of all sub-sectors (given the relatively small size of the sample).

← 7. However, the Enterprise Survey for El Salvador is not built to be representative at the level of individual manufacturing sub-sectors, which prevents sector-by-sector comparisons.

← 8. Informality is measured by workers without pension rights, health insurance, social protection, employment contracts, and other rights and benefits of formal employment.

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