Honduras: Request for a Three-Year Arrangement Under the Poverty Reduction and Growth Facility and Interim Assistance Under the Enhanced Initiative for Heavily Indebted Poor Countries—Staff Report; Staff Statement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Honduras

Honduras’s request for a Three-Year Arrangement Under the Poverty Reduction and Growth Facility and Interim Assistance Under the Enhanced Initiative for Heavily Indebted Poor Countries is discussed. The social consultation has allowed the government to implement a vital reform of public sector wage policy. A reduction in the pressure of the civil service wage bill is the key for restoring the sustainability of the public finances. An ambitious financial sector reform is designed to address bank fragilities; and far-reaching transparency and anti-corruption measures aim to improve governance.

Abstract

Honduras’s request for a Three-Year Arrangement Under the Poverty Reduction and Growth Facility and Interim Assistance Under the Enhanced Initiative for Heavily Indebted Poor Countries is discussed. The social consultation has allowed the government to implement a vital reform of public sector wage policy. A reduction in the pressure of the civil service wage bill is the key for restoring the sustainability of the public finances. An ambitious financial sector reform is designed to address bank fragilities; and far-reaching transparency and anti-corruption measures aim to improve governance.

I. Background

A. Political and Social Environment

1. Honduras faces difficult political and social conditions.

  • Long-standing institutional problems have tended to weaken economic performance. Honduras has been ranked poorly in the areas of rule of law, corruption control, and government effectiveness (Table 1). These deficiencies in governance have deterred private investment and undermined support for reforms. Policy-making is complicated by an unusually long presidential campaign (up to two years, out of a four-year term), intense pressures by labor unions (particularly teachers and health workers), and a congress influenced by interest groups. Social indicators remain among the weakest in Latin America, with an unequal income distribution, two-thirds of the population living in poverty (half in extreme poverty), and a weak social safety net (Table 2). Honduras ranks among the poorest countries in the latest UNDP Human Development Report (115th out of 175 countries in 2002).

  • In recent months, policy-making has been further constrained by social unrest. Social protests intensified in 2003, in a fractured political environment. Protests covered concerns about corruption and selective bailouts, fears of new taxes and salary cuts, and demands for poverty alleviation. The governing coalition, which has a slim majority in congress, votes together only on a case-by-case basis. The government’s scope for action is expected to be further curtailed in 2004 with the start of the campaign cycle for the November 2005 presidential election.

  • To overcome these difficulties, the government has undertaken a broad process of consensus-building to diffuse social tension and rally support for reforms—through a National Dialogue and the preparation of a Fiscal Responsibility Pact, both following on the PRSP participatory process that has continued since 2000. This effort has built broad acceptance for an adjustment program, but also delivered a key message from participants that, for the burden of adjustment to be acceptable, it must be equitably shared across all sectors of society. Thus, the government has begun ambitious governance reforms, including difficult measures to increase judicial independence and reform the electoral process.

Table 1.

Honduras: Comparative Governance Indicators 1/

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Source: Kaufmann, Kraay, Zoido-Lobaton (2002), http://info.worldbank.org/governance/kkz/

Percentile rank with a higher number denoting better governance.

Table 2.

Honduras: Comparative Social Indicators

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Sources: World Bank World Development Indicators 2002; Szekely, Lustig, Cumpa, and Mejia (2000); and UNDP Human Development Report 2001 and 2002.

Not comparable across countries due to methodological issues. For Guatemala, Honduras, and Nicaragua, the information refers to the Poverty Reduction Strategy Paper.

B. Economic Background

2. Honduran development has been impeded not only by weak institutions and the political cycle but also by a concentrated export base and high dependency on foreign aid. As a result, standards of living have remained low, the external debt level is high, and the economy has been vulnerable to external shocks.

3. In 1998–2002, macroeconomic performance was particularly affected by adverse external shocks, and social conditions remained depressed (Table 3). After Hurricane Mitch struck in 1998, larger foreign assistance than could immediately be spent boosted international reserves and led to a sharp real appreciation of the lempira. These factors facilitated a steady reduction in inflation, but at the cost of declining external competitiveness. Also, public savings dropped sharply, mainly on account of government wage increases; financial system fragilities increased; and the external current account deficit remained large. Real GDP per capita declined by an average of ½ percent a year; the poverty reduction strategy stalled; while Paris Club rescheduling and interim HIPC assistance helped to alleviate the debt burden.

Table 3.

Honduras: Selected Economic Indicators

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Sources: Central Bank of Honduras; Ministry of Finance; and Fund staff estimates and projections.

As of end-October for 2003.

Includes external financing gap starting in 2004.

Refers to the following year’s imports of nonmaquila goods and nonfactor services.

Includes medium- and long-term public and publicly guaranteed external debt, after HIPC and beyond HIPC debt relief. HIPC completion point is assumed in March 2005.

Debt service paid.

4. In 2003, despite some improvement in macroeconomic indicators, notably inflation, economic and financial conditions remained difficult.

  • Growth picked up moderately to an estimated 3 percent—still very low in per capita terms—led by construction, tourism, and the reexport industry (maquila).

  • Inflation slowed to 6¾ percent, in line with the crawling peg, and despite higher world oil prices.

  • The external position weakened further. The current account deficit widened to an estimated 5¼ percent of GDP, reflecting higher oil prices and buoyant imports related to investment in the leading sectors. Gross international reserves declined by around 5.2 percent, and now cover about four months of imports.

  • The fiscal position also deteriorated, contributing to pressure on reserves in the absence of any additional access to foreign financing, and causing domestic bank financing to rise sharply, to 2¾ percent of GDP in 2003 from minus 1 percent in 2002.

  • The debt burden remained heavy, with total public debt amounting to 73 percent of GDP at end-2003.

5. The combined public sector deficit widened to 4½ percent of GDP in 2003. Revenue measures adopted in April (Box 1) and steps to contain the upward trend of the wage bill were offset by transfers of more than 1 percent of GDP to write off 50 percent of agricultural loans (the Agricultural Decree), a decline in the operating surplus of the public enterprises due to delays in tariff adjustments, and higher quasi-fiscal losses of the central bank. Hence, public savings continued to decline (Tables 4 and 5). The government also assumed the cost associated with the resolution of a small problem bank. To contain the deficit, it was necessary to delay anti-poverty spending and investment outlays.

Table 4.

Honduras: Operations of the Central Government

(In percent of GDP)

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Sources: Central Bank of Honduras; Ministry of Finance; and Fund staff estimates and projections.

Comprises HIPC interim relief from IBRD/IDA starting in 2000, and the IDB and the Fund starting in 2001.

Assumes savings from a central administration reform equivalent to 0.2 percent of GDP per year in 2005–06. However, these savings could materialize in other current expenditures.

Includes the cost of support plan for agricultural loans (1 percent of GDP in 2003).

On an accrual basis.

Includes the costs of closing and merging financial institutions: Bancorp (1999), Solfisa and Banhcrecer (2001), and Banco Capital (2002), and Banfaa (2003), equivalent to 0.6, 0.2, 0.5, 0.5, and 0.2 percent of GDP, respectively.

From the state telephone company, HONDUTEL.

Assumed to be covered with program loans from the World Bank and the IDB and rescheduling from the Paris Club with comparable treatment from non-Paris Club official bilateral and commercial creditors.

Table 5.

Honduras: Operations of the Combined Public Sector

(In percent of GDP)

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Sources: Ministry of Finance; Central Bank of Honduras; and Fund staff estimates and projections.

Includes contributions to the social security system.

Comprises HIPC interim relief from IBRD/IDA starting in 2000, and the IDB and the Fund starting in 2001.

Assumes savings from a central administration reform equivalent to 0.2 percent of GDP per year in 2005–06. However, these savings could materialize in other current expenditures.

Includes the cost of support plan for agricultural loans (1 percent of GDP in 2003).

On an accrual basis.

Includes the change in deposits of HONDUTEL held abroad.

Assumed to be covered with program loans from the World Bank and the IDB and rescheduling from the Paris Club with comparable treatment from non-Paris Club official bilateral and commercial creditors.

6. Monetary policy accommodated fiscal pressures and private sector demand for credit, leading to a sizable loss of international reserves in 2003. Broad money rose by about 11 percent, in line with nominal 2003 GDP. In addition to the fiscal pressures, the maintenance of low interest rates for the first half of 2003 contributed to a pickup in private sector credit growth (to 13 percent, from 7½ percent in 2002). Net international reserves fell by US$78 million during the year (Tables 6 and 7). To contain the loss, the central bank raised open market interest rates by around 220 basis points in the second half of the year.

Table 6.

Honduras: Monetary Survey 1/

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Sources: Central Bank of Honduras; and Fund staff estimates and projections.

At current exchange rate.

Comprises the central bank, commercial banks, savings and loans, and development banks, including a second-tier bank.

Includes open market paper held by the private sector.

percentage change refers to amount in lempiras.

Table 7.

Honduras: Indicators of External Vulnerability

(In units indicated)

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Sources: Central Bank of Honduras; and Fund staff estimates.

Debt due within a year after exceptional financing.

End-of-period change. As of end-August for 2003.

Held by commercial banks and domestic private investors.

Refers to the interest rate on CBH 90-day certificates.

7. The lempira depreciated by nearly 6¼ percent in real effective terms through November 2003. This reflects mainly the depreciation of the U.S. dollar vis-à-vis the euro and other major currencies, and only very partially offsets the lempira’s 50 percent real appreciation in 1997–2001. The exchange rate is set in daily auctions, within a crawling band of plus/minus 7 percent around the base rate—but the central bank has kept the rate at the most appreciated side of the band, with the aim of stabilizing expectations. Since October 2001, the rate of crawl has been set in line with the expected inflation differential between Honduras and its main trading partners.

8. The financial system remains vulnerable, although banking supervision has improved. Official data put nonperforming loans at 14 percent of total loans in September 2003, with only about one-third covered by provisions; these data may understate the extent of problem loans (Table 8). The banking system fragilities underlie the authorities’ reluctance to use interest rates more actively to defend reserves.1 However, the authorities took steps to improve on-site supervision based on the 2003 FSSA recommendations, and undertook several bank resolutions in 2003. Financial dollarization remained broadly stable at around one-third of deposits; banks’ short-term net foreign assets are equivalent to two-thirds of foreign currency deposits.

Table 8.

Honduras: Structure and Performance of Banking Sector

(In percent unless otherwise indicated)

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Sources: National Commission of Banking and Insurance; and Fund staff estimates.

Includes contingent assets.

As of end-August for 2003.

NPLs exclude restructured loans, mostly to the agricultural sector.

Assets include off-balance sheet items.

9. External sector imbalances remain significant. The external current account deficit widened in 2003, partly reflecting a continued decline in the terms of trade (Table 9). While the high aid flows that followed Hurricane Mitch have declined, they continue to exceed scheduled debt service.

Table 9.

Honduras: Balance of Payments

(In millions of U.S. dollars; unless otherwise indicated)

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Sources: Central Bank of Honduras; and Fund staff estimates and projections.

Includes special imports for private energy projects of US$177 million in 2004 and US$78 million in 2005.

Includes HIPC grants from the World Bank, IDB, and the Fund.

Net of debt relief operation granted by the Central American Bank for Economic Integration (CABEI) in 2000, with purchase of zero-coupon bond recorded in portfolio investment.

Includes debt relief from Paris Club (1999–2002), the Central American Emergency Trust Fund (1999–2000), and HIPC relief from CDC.

To be covered with program loans from the World Bank and the IDB and rescheduling from the Paris Club with comparable treatment from non-Paris Club official bilateral and commercial creditors.

Public sector external debt due within a year after exceptional financing.

Medium- and long-term public and publicly guaranteed external debt, after HIPC and beyond HIPC debt relief. HIPC completion point is assumed in March 2005.