The Honduran economy has performed well in the past few years in terms of both growth and stability, despite a previous history of low growth and volatility. Growth surpassed 6 percent of GDP on average during the last four years, inflation has been kept in one digit, the fiscal deficit has been manageable, international reserves increased and foreign investment has been dynamic. At the same time, debt relief obtained from the Enhanced HIPC, the MDRI and the IADB have allowed to bring the external debt down from 60 percent of GDP in 2004 to 16 percent in 2007. The combination of growth and reduced indebtedness also freed the Honduran government to devote significant resources to education and poverty reduction. Over 80 percent of debt relief resources were devoted to education and health. Although the absolute level of poverty remains high, overall poverty has been reduced by 6 percent and extreme poverty by 11 percent in the last two years.

The Honduran economy is particularly vulnerable to external shocks, ranging from hurricanes to terms-of-trade fluctuations and heavy reliance on imported oil for power generation. Over the past year, a number of imbalances have started to develop. Inflation increased to near 9 percent last December. As in many other developing countries, inflation was boosted by increases in food and oil prices. Bank credit expanded rapidly and led to imports increases and a weakening of the external current account deficit. Imbalances in the energy sector also contributed to the overall problem.

Our Honduran authorities seek support for a precautionary, 12-month SBA in the amount of 38.85 million SDR (30 percent of the quota) that will help them anchor economic policy ahead of the primary elections later this year, as well as to provide a bridge for a PRGF before the end of 2008. The program seeks to correct the economic imbalances that have developed and it is centered on strengthening macro stability through policies in key areas. On the fiscal front the program is ambitious and it seeks to reduce the overall fiscal deficit from 2 ¼ percent in 2007 to 1 ½ percent in 2008. The program also seeks to maintain inflation in single digits, to reverse the widening account deficit, to bring credit expansion to a sustainable basis and to promote exchange rate flexibility. The program also seeks to restore the financial soundness of the energy sector.

The previous PRGF, approved in 2004, focused on fiscal consolidation and structural reforms to support growth and reduce vulnerabilities in the financial sector, which was considerably strengthened in its legal, prudential and supervisory frameworks. Medium-term reforms were geared at strengthening the central bank and monetary policy operations, the banking commission (CNBS) and the tax administration office (DEI). Debt relief support, mentioned above and amounting to over US$ 3 billion, was also a key element but it raised expectations for higher spending. The program achieved important goals and was partially successful.

The new government took over in early 2006 with a strong commitment to reduce poverty, as well as to maintain social and macroeconomic stability, in spite of record-levels oil prices and rising food prices. Wage pressures and the need to protect the most vulnerable groups contributed to the imbalances that developed, and the government started to take measures to correct them.

On the fiscal front, although the deficit rose, real progress has been made and tax revenues have increased considerably. On the monetary side, expansionary policies and the entry of foreign banks led to competition for market share, and a rise in credit of 30 percent and prudential measures to guarantee sustainable growth have already been taken. The central bank raised policy interest rates to 7.75 percent in February 2008 and increased reserve requirements.

The real exchange rate is near its long-term equilibrium and it has remained stable in the last two years, although the official regime allows the Lempira to fluctuate in a 7 percent band. The exchange rate policy will be managed to maintain external competitiveness. Net international reserves (NIR) fell by $100 million in 2007, although their level is still adequate to cover four months of non-maquila imports. They are expected to recover throughout the program.

The program proposed for 2008 aims at supporting conditions for sustained growth and poverty reduction through policies in three key areas: a tightening of fiscal policy and stabilization of the wage bill, monetary policy geared to containing inflation and recovering NIR, while bringing credit down to sustainable levels. The exchange rate policy will utilize more actively the existing system to support monetary policy.

In the energy sector a key imbalance was caused by losses in ENEE, the national electricity enterprise, which also accumulated arrears to private generators and contractors. It is worth noting that the Honduran government has already reacted and electricity rates were increased by 16 percent in January, and a new tariff structure will come into effect this month with an additional 11 percent increase. The energy sector will be strengthened with support of the World Bank and IADB, and electricity rate increases will cover ENEE operational costs and arrears with private generators.

In contrast to previous years, the 2008 budget is expected to have a higher degree of financing by concessional external lending, allowing for sharply reduced net domestic financing. A new key source of financing is provided by Venezuela through Petrocaribe, which is expected to yield US$ 350 million in 2008-09, with US$ 80 million in 2008 for investment in hydroelectric projects, and to improve electricity transmission and distribution to reduce losses. This is critical to correct the present heavy dependence on fossil fuels for generation in the power sector.

To ensure that the resources provided by Petrocaribe are used in a transparent manner and for infrastructure only, a trust fund has been set up in the central bank, and periodic reports will be presented to a blue ribbon panel with civil society representatives created for this purpose. The government also intends to use the one-time proceeds for the sale of a mobile phone band, equivalent to 0.6 percent of GDP, to finance already budgeted investments in infrastructure projects, mostly roads.

Risks include a less-favorable external environment, primarily related to the downturn of the US economy, as well as expansionary policies ahead of the primary elections later this year. The deceleration in the US economy is expected to lead to a slowdown in the Honduran economy. It is also expected that remittances will also be affected. In addition to these, there is the concern about the level of oil prices, given the electrical sector’s reliance on fossil fuels.

Honduras’ debt outlook is positive and the debt ratios should remain below their indicative thresholds and resilient to shocks over the medium and long term. This is due to the low initial ratios, product of debt relief and the consolidation of macro stability. Public debt should continue on a sustainable path, even under the most extreme test.

The government is fully committed to its growth and poverty reduction agenda and its continuing to update and refine its medium-term policies for poverty alleviation and growth. In coming months, it plans to finalize a program, including and updated PRSP, that could be supported under the Poverty Reduction and Growth Facility.

It is important to note that the 2008 budget was approved by Congress on the terms accorded with the Fund on April 2. Prior actions related to the policy interest rate, NIR and NDA of the Central Bank were also fulfilled at the end of March. The last prior action related to open market operations was fulfilled on April 3. These actions reflect the strong commitment of the government to this program. Our Honduran authorities seek support for this Stand-By Arrangement from the Executive Directors to regain mometum in the structural reform process and to anchor economic policy in this critical year. This SBA would also serve as a bridge to a PRGF that would be presented later this year.