Selected Issues

Abstract

Selected Issues

Structural Policies in Panama: Background and Policy Recommendations1

Over the last 25 years, Panama has had the longest and fastest economic expansions in Latin America growing at an average annual rate of 6 percent. To sustain high growth and avoid falling in the “middle-income trap”, Panama needs to adopt a structural reform agenda to enhance productivity. Continuously improving the business environment, advancing the quality of education, mitigating institutional vulnerabilities and fostering innovation lie at the heart of increasing labor productivity and closing the gap to advanced economies. Over the medium term, upgrading the infrastructure and creating economic conditions that facilitate the transition into technology-intensive, innovative industries with a high growth potential will be necessary to achieve high-income living standards.

A. Drivers of Growth: High Investment, but Slowing Productivity

1. Panama needs to maintain high investment rates and boost productivity growth to sustain high economic growth rates. In the last decade, Panama experienced extraordinarily high investment rates. Mainly driven by large projects such as the Panama Canal expansion and the construction of one of the largest copper mines in the world, the additional capital may not have contributed immediately to additional output, leading to negative TFP growth. The delayed impact on output is likely to add to TFP growth in the next few years while investment rates are expected to normalize to below 40 percent of GDP. With moderate population growth, future growth will increasingly rely on improvements in total factor productivity.2

Figure 1.
Figure 1.

Panama: Growth Accounting

Citation: IMF Staff Country Reports 2020, 125; 10.5089/9781513541679.002.A005

Sources: Penn World Table 9.1 and IMF staff calculations.
Figure 2.
Figure 2.

Panama: Labor Allocation Across Sectors

Citation: IMF Staff Country Reports 2020, 125; 10.5089/9781513541679.002.A005

Sources: INEC and IMF staff calculations.

2. While productivity growth has been exceptionally high in some segments of the economy, relatively unproductive sectors still make up a large share of employment. Labor productivity is especially low in non-tradable sectors, including commerce, hotels and restaurants, education, health, social services, sectors which employ about half of the labor force. Labor productivity growth has been high in construction, electricity, finance and transportation services, suggesting gains from reallocating labor in addition to policies that support productivity growth within sectors.

3. Slow reallocation of labor among sectors and lack of skilled labor is holding back growth. Structural transformation of the economy and enabling labor to move into the high productivity sectors will be key to sustain growth and reduce inequality. Education to prepare the labor force for high skilled jobs, reducing informality and improving labor mobility can help to facilitate reallocation of workers into more productive and growing sectors. While years of schooling are in line with the regional benchmark, enrollment in secondary education and educational quality need to be improved, including higher education. Initiatives to boost teacher training, reduce dropout rates and better align the curriculum with businesses needs are important to develop a skilled work force. At the same time adult education, on-the-job training and offerings of technical careers can help with upgrading the current labor force.

4. Continuing to attract investment, secure large infrastructure projects along the Panama Canal and developing tourism will foster growth in the medium-term. The completion of two large investment projects, the expansion of the Panama Canal and the construction of the large copper mine, has been reflected in lower demand for labor and partly accounts for the downturn in construction observed over the last year. Although there are several other large projects still in progress which can absorb part of this freed up labor, like the 3rd metro line, the 4th bridge over the canal and investment in port infrastructure along the canal, construction is unlikely to return to the levels of growth it saw during the boom.

Figure 3.
Figure 3.

Panama: Competitiveness Indicators Show Some Room for Improvement

Citation: IMF Staff Country Reports 2020, 125; 10.5089/9781513541679.002.A005

Sources: World Economic Forum and IMF staff calculations.Note: Dashed line corresponds to ranking under GCI 4.0 which contains changes in methodology relative to previous versions.

5. Regional disparity in growth is high. Most of the growth has been concentrated in Panama City and Colon, the urban center of Panama. These regions benefit from the proximity to the canal and make up the center of the services-oriented Panamanian economy. However, growth in Colon has slowed with the decline in activity in the Colon Free Zone and will depend on a successful shift in the zone’s business model, for example by converting the zone into a hub for e-commerce. To allow rural areas also to participate in the economic expansion, it is important to connect them better to public services and enhance the infrastructure and business environment for agriculture and tourism – sectors which can grow economic activity outside of the urban centers.

6. Increasing productivity in agriculture could also help to diversify the economy and develop rural areas, decreasing poverty and inequality. Along with non-tradable services, agriculture employs a large share of the population but is relatively inefficient. Instead of subsidies that sustain the status quo, policy should focus on improving efficiency, releasing excess labor for other sectors and achieving higher wages for the remaining agriculture workers. The commercial ties with China open new markets for Panama’s agriculture exports such as the recent first shipment of meat products while fostering upgrades of quality and sanitary standards.

B. Growing Capital with a Favorable Business Environment

7. Panama outperforms the regional peers in different competitiveness indicators, but progress has stagnated recently. Panama’s rank dropped from 55 (out of 135 countries) in 2017 to 66 (out of 141 countries) in 2019 according to the Global Competitiveness Index (GCI) of the World Economic Forum. Moreover, the GCI score is lower than would be predicted by Panama’s level of income. The ranking highlights the stable macroeconomy, business dynamism and health as strong pillars. However, low ratings for institutions, product and labor markets, skills, Information and Communication Technology (ICT) adoption and innovation capability require policy action.

8. While the business environment in the special economic zones (SEZ) is highly competitive, the conditions are less favorable for firms outside these areas. Firms in the free zones (around 3500 firms generating over 30,000 jobs, around 1.7 percent of total employment in 2010)3 benefit from tax incentives and a relatively efficient bureaucracy. For 2010, Hausmann et al. (2016) find wage differences between SEZs and the local labor markets unexplained by worker characteristics which points to firm productivity differences as the main explanation. Outside the SEZ many firms are small, often operate in the informal sector and face a higher administrative burden. For 2010 the Enterprise Survey estimates that around a third of firms have less than 20 employees.4 Enhancing firm productivity for small and medium enterprises will be crucial for future economic growth to ensure that growth is not limited to special zones. Different competitiveness indicators suggest similar priorities which can be a starting point for the policy agenda.

9. Business dynamism and depth of financial system are key to Panama’s competitiveness, despite weak insolvency framework. The GCI places Panama on rank 77 out of 141 in this category. When it comes to the time it takes to open a business, Panama reaches rank 32, and regarding attitudes towards entrepreneurial risk, the cost of starting a business and growth of innovative companies are all better than the median country. The depth of the financial system with good access to venture capital and credit for SMEs places Panama well-above the regional peers. Ranked as the 46th best country in this pillar, the financial system remains a key competitive strength. This competitive advantage can be leveraged further. However, a low insolvency recovery rate and a weak assessment of the insolvency regulatory framework hold Panama back.

Figure 4.
Figure 4.

Panama: Global Competitiveness Index

Citation: IMF Staff Country Reports 2020, 125; 10.5089/9781513541679.002.A005

Sources: World Economic Forum and IMF staff calculations.

Policy Options

  • Reduce red tape, and administrative and compliance cost incurred with formal status of firms.

  • Expand use of one-stop shops for business creation and licenses.

  • Address deficiencies in the insolvency framework, especially the low insolvency recovery rate.

10. The openness of the economy gives Panama a high rating in “Product markets”, especially due to low barriers to trade. Advances in the negotiation of the trade agreement with China, improvements in sanitary standards and the implementation of the WTO trade facilitation agreement should all contribute positively to sustain the competitiveness of product markets. The main obstacle to competition stems from distortive taxes and subsidies (GCI 107th out of 141 countries), the product of various tax exemptions, subsidies and presence of tax evasion (see chapter 1 for more details). Simplifying the tax code, increasing transparency and better enforcement by the tax and customs administration can address these distortions and improve revenue collection at the same time.

11. Traditional competitiveness indicators do not account for the tight restrictions on many occupations. Several occupations in Panama can only by exercised by Panamanian nationals and no work authorization will be granted to foreigners, independent of their qualifications. These occupations range from medicine, dentistry, law and some fields of engineering to journalism, sociology, and accounting. While there exists no quantitative estimate of the effect on competitiveness in Panama, these regulations create incentives for rent-seeking and the varying degree of restrictiveness can create distortions across sectors. While traditional indicators highlight the difficulty in hiring foreign labor, the indicators do not capture the effect of restricted occupations in the market for professional services.

Institutions and Governance

12. The institutional framework needs to be strengthened to avoid the middle-income trap. While GDP growth has moved Panama into a higher income category, the governance framework requires reform to enable sustained growth in the future. The recent UNDP report on Human Development in Panama (2019)5 emphasizes the importance of institutional reform to address low levels of trust in institutions by citizens as well as weaknesses such as the judicial system and corruption identified by international investors. Similarly, Panama ranks 110th in “Institutional checks and balances “of the GCI.

Corruption Perception Index in the Americas 1/

(2018, Low er score=more perceived corruption)

Citation: IMF Staff Country Reports 2020, 125; 10.5089/9781513541679.002.A005

Sources: Transparency International and IMF staff calculations.1/ Includes 90 percent confidence interval for Panama.

13. The public administration needs to build capacity to become more efficient and meet standards appropriate for a high-income economy. The UNDP report urges the authorities to move to a results-based institutional culture where policy actions are motivated by the impact on citizens. It proposes a number of reforms such as limiting the strong association between state operations and the current government in power that leads to high rotation of government officials and a lack of professionalization of the civil service. It highlights that an adequate adaptation and implementation of laws, directives and incentives would be a first step to increase the citizen’s trust in Panama’s institutions.

Policy Options

  • Professionalization of public administration, including a shift towards results-based objectives.

  • Increase transparency and efficiency of public spending, i.e. phase out turnkey project, strengthen accountability of public officials and improve communication (website, data provision to the public, press releases).

14. Deficiencies in the judicial system generate large costs to businesses and undermine the credibility of Panama’s legal framework. Judicial independence is ranked very low (129 out of 141 countries) and is deteriorating. While the last ten years saw some new laws to modernize the judicial system (such as Carrera Judicial Tribunal de Integridad y Transparencia, Código Procesal Penal de Corte Acusatorio), the system is perceived as slow and as lacking accessibility and transparency. Many unaddressed cases, the lack of convictions on corruption and a weak track record on settling disputes (GCI rank 110 out of 141 countries), all demonstrate the need for reform in this area. The new administration started a process for constitutional reform, but there is still no social consensus on some of the content of the reform. Moreover, the avenue for passing the reform is unclear. The reform package was withdrawn from the National Assembly at the end of 2019 and the UNDP will now coordinate the dialogue with civil society to draft the reform. Before the end of this lengthy process, progress should continue with more effective implementation of the already existing institutional framework.

Policy Options

  • Increase the budget of the justice administration (currently 1.3 percent of the general budget, 2 percent – 6 percent is the international recommendation by UNDP) to ensure independence of the judicial system and enable it to implement reforms.

  • Address shortcomings of the judicial system

  • Facilitate access to the many Panamanians that cannot afford the cost of legal assistance.

C. Increasing Human Capital and the Availability of Skilled Labor

15. Inflexible wage setting and strong restrictions on hiring and firing practices stifle competition in the labor market and lead to inefficient allocation. When it comes to the link between pay and productivity and hiring and firing practices, Panama ranks among the lowest 30 countries in the world according to the Global Competitiveness Index. Higher flexibility in the labor market can aid the reallocation of resources to its most productive use. However, emerging vulnerabilities created by a reduction in job security require an adequate social safety net.

16. Shortage of skilled labor are an obstacle to many firms. With the expansion in skill-intensive industries such as logistics and other tradable services, firms in Panama complain about difficulties in finding skilled employees. Deficiencies in the education system as well as restrictions on hiring foreign workers already restrict the expansion of high value-added industries and decisive policy action is needed to prevent a continued drag on productivity and growth in the medium-term.

Policy Options

  • Educational reform needs to be a top priority of the government, tackling the low quality of education (teacher training, curriculum) and the low rates of enrollment in secondary education.

  • Strengthen higher education and research institutes, for example, through better funding and more research positions.

  • As a short-term solution, easing restrictions on foreign workers, especially in sectors with high skilled shortages (maybe also qualified teachers) can alleviate the labor constraints.

D. Boost Productivity with Higher Innovative Capacity

17. Panama’s ability to maintain high growth in the future crucially depends on its innovative capacity. This rests in part on the continued attractiveness to FDI, the expansion into high value-added sectors and a skilled workforce to absorb knowledge spillovers. While the number of trademark applications and survey responses on buyer sophistication show promising levels, Panama lags behind in its quality of research institutions and R&D expenditure. In the past, special economic zones were the main attractor of foreign talent and knowledge-intensive industries. However, spillovers to the local economy appear to be limited, also because of restrictions on the mobility of foreign workers.6 The new administrations’ national strategy to raise investment in science, research and development to 1 percent of GDP by investing US$ 4.3 billion until 2024 is a step in the right direction.

E. Upgrading Infrastructure

While the existing infrastructure is strong compared to regional peers, Panama needs to upgrade it further to reach high income economy living standards and sustain its productive capacity in the medium term.

Water

18. Potable water supply is an ongoing challenge. Panama ranks 90 out of 140 countries on the reliability of water supply in the GCI, with the score declining since the previous review. It performs slightly better in the exposure to unsafe drinking water (66/140, 10.2 percent of the population). Water access is higher in urban areas than in rural areas, but a large share of the population in the underdeveloped indigenous territories does not have access to piped water. However, reliability of service also varies in urban areas. The National Water and Sewer Agency (IDAAN) has not raised tariffs since 1982 (plus collection rates are low), runs a sizeable operational deficit which increased US$ 80.5 million (0.1 percent of GDP) in 2018), forcing it to focus on emergencies and maintenance rather than improving efficiency. Although reform plans by the authorities exist, more coordinated action will be required to improve the water infrastructure.

19. Climate change heightens the need for further investment in water supply and water management systems. Panama is one of the countries with the highest precipitation in the world, but it’s largest commercial asset – the Panama Canal – is also a large user of fresh water along with a growing population. Climate change appears to have increased the volatility of rainfall, posing a challenge to maintain water levels sufficiently high during the dry season, especially during El Niño periods, and avoid flooding in the rain season. Currently, 55 percent of the population receives their water from eight water treatment plants that draw water from the canal’s principal reservoirs: the two lakes Gatun and Alajuela. They store water to guarantee enough supply during dry periods, and release excess water to the sea to prevent flooding during the rainy season. As demonstrated by the cargo limitations imposed by the ACP in 2019 due to low water levels, the current capacity of the lakes is becoming insufficient to smooth out fluctuations in precipitation.

Policy Options

  • Amplify fresh-water reservoirs The ACP is currently evaluating several options to enlarge its water reservoirs, including three options to construct a third water reservoir to fresh water resources at a larger distance from the canal. Other possibilities include desalination of sea water or increasing the capacity of the existing reservoirs. These projects are still in the evaluation phase, but the ACP is well-aware of the future challenges related to water management faced by the canal.

  • Improve efficiency of water system Panama loses an estimated 40 to 48 percent of fresh water in the distribution system due to leakages and lack of investment in water infrastructure. At the same time, fresh water is basically free and there are hardly incentives to avoid waste of fresh water. Reforming the structure of water pricing and investing in water management infrastructure to reduce leakages would save a lot of freshwater reducing the need of investing in larger reservoirs.7

Electricity

20. Panama’s electricity sector can meet the rising demand while continuing to strengthen renewable energy sources. Electricity generation has increased on average 7 percent per year over the last five years. Around 60 percent of electricity is hydroelectric (12.4 percent growth rate), with the rest mostly coming from fuel-oil, non-renewable sources. However, the country has potential to expand solar photovoltaic and wind energy. This puts Panama to a competitive position and in line with reaching its climate goal of obtained 70 percent of the national energy mix from renewables by 2050.8

21. Access to electricity is still unequal. While 91.2 percent of households had access to electricity nation-wide in 2017, this number varies between 98.5 percent in Panama City and only 77.1 percent in the province Darien. In the comarcas Ngäbe Buglé and Guna Yala only 7.5 percent and 3.6 percent respectively received electricity from the distribution companies.9

22. The sector is vulnerable to large fluctuations in precipitation amplified by climate change. Dry seasons and El Niño periods drive up the marginal cost of electricity as hydroelectric power generation plummets and thermoelectric power plants are required to help maintain the system voltage. To mitigate this risk, Panama will need to invest in its energy matrix and improve transmission systems linking power plants with areas of high demand. While there has been constant investment in generation capacity, upgrades of the transmission lines proceed at a slower pace.10

23. Panama uses many different tariffs for electricity and cushions price increases with general subsidies. Overall, electricity prices in Panama are slightly higher than the regional average. Basic consumption of less than 100 kWh is cross subsidized from additional payments of consumption exceeding 500kWh. Pensioners, disabled persons, farmers, political parties also benefit from special tariffs. Moreover, the government prevents price increases by using general subsidies which benefit over 90 percent of consumers, households and businesses alike. The latest surge in electricity subsidies originated in wide-spread protests in 2018 which led the government to back track on an increase in electricity prices. In 2019, the government spent US$ 193 million (0.3 percent of GDP) on electricity subsidies and the policy is expected to continue in 2020. Improving the targeting of subsidy or replacing it by social transfers could help to limit the cost and improve the effectiveness of the policy to tackle inequality.

Policy Options

  • Phase-out general electricity subsidy to avoid large cost incurred by government and improve targeting to help most vulnerable population, for example through social transfers or continuing subsidies only for low-income consumers/ small businesses.

  • Continue with investment in transmission lines (e.g. 4th transmission line).

  • Tackle challenges created by climate change – diversify renewable energy matrix and improve water management.

  • Reduce dependence on generators to mitigate effect of high oil prices and phase out non-renewable energy sources.

Source: Doing Business 2020, World Bank.Cost of getting electricity is defined as cost required to complete procedures to obtain an electricity connection. Price of electricity is defined as price based on monthly bill for commercial warehouse in Doing Business study.

Transportation

24. With several large transportation infrastructure projects in place, Panama is well on track to continue to enhance the competitiveness of its transportation system. The ports and Tocumen airport are among the most competitive in the world, enabling growth in the logistics sector and a major factor in attracting FDI. However, these advances have been concentrated in Panama City and Colon, with the rest of the country still in need of better road access. A particular concern is the “last mile”. While highways are relatively developed, more investment is needed in secondary roads. Investments in the regional transportation network would also support growth in tourism and addresses rural poverty.

Information and Communication Technology

Improved access to internet and the spread of financial technology can improve financial inclusion. Despite the developed financial sector, only 46 % of the population had a bank account in 2017, below the average 55 % in Latin America and the Caribbean. Moreover, only 69.1 % of businesses used a current or savings account, compared to 92.9 % in the region. The most common reasons were insufficient funds to open an account (36 %), too expensive financial services (34 %) and distances to the financial institution (18 %) according the Global Findex 2017.11 Fintech promises to avoid the high cost of infrastructure to reach the rural and indigenous population and to reduce the cost of financial services.

25. Panama should make better use of its proximity to a high-speed international internet connection. Panama is located close to a digital interconnection of submarine cables and thus has access to higher bandwidth than even most OECD countries. This could make it an attractive location for IT companies but will require further investments in a skilled workforce.

F. Concluding Remarks

26. An ambitious structural reform agenda is needed to ensure sustainable, inclusive growth in the future. This paper lays out key areas for policy to prevent Panama from falling into the “middle-income trap”. By continuously improving the business environment, advancing the quality of education, mitigating institutional vulnerabilities and fostering innovation Panama can close the gap to advanced economies. Investment in infrastructure and climate change preparedness can upgrade and sustain living standards in line with a high-income status economy. Together with Panama’s strong foundation as a logistics and transportation hub, creating the right economic conditions can transform Panama into a technology-intensive, innovative economy with sustained growth.

References

  • Due Process of Law Foundation (March 2014), “Ley vs. realidad, Independencia y trasparencia de la justica en Centroamérica y Panamá”, Informe de Panamá. http://www.dplf.org/sites/default/files/panama_v05.pdf

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  • IDB, BIDeconomics Panamá (March 2019), Desafíos para consolidar su desarrollo.

  • Ricardo Hausmann, Luis Espinoza and Miguel Angel Santos (2016), Shifting Gears: A Growth Diagnostic of Panama.

  • Ricardo Hausmann, Miguel Angel Santos, and Juan Obach (2017), Appraising the Economic Potential of Panama: Policy Recommendations for Sustainable and Inclusive Growth, CID Faculty Working paper No. 334.

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  • MEF (2017), Dirección de Análisis Económico y Social, Omar Araúz, Eudemia Pérez, Análisis del Mercado Eléctrico Panameño.

  • MEF (2019), Propuesta para la Estrategia de Inclusión Financiera en Panamá.

  • Larsen, Matthew C. (2019). “Water supply and water quality challenges in Panama.” in Advances in Water Purification Techniques, edited by Ajuha, S., 4146.

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  • OECD Multi-dimensional Review of Panama (March 2019), Volume 3: From Analysis to Action.

  • UNDP, Informe Nacional de Desarrollo Humano Panamá 2019, Renovando las instituciones para el desarrollo humano sostenible.

  • World Economic Forum, Global Competitiveness Index 4.0 2019 edition.

  • World Bank, Doing Business Panama 2019.

1

Prepared by Julia Faltermeier (WHD).

2

See Hadzi-Vaskov (2018). “Is There a Middle-Income Trap? Singular Growth Patterns in Panama”. IMF SIP, Washington D.C.

3

Hausmann, Obach and Santos (2016). “Special Economic Zones in Panama: Technology Spillovers from a Labor Market Perspective.

4

This duality in the Panamanian economy is not always well reflected in the available statistics. While aggregate indicators often include the whole country, doing business surveys are generally restricted to small to medium-size, 100 percent domestic firms, thus excluding many firms located in the free zones, which would improve the indicator if they were included.

7

Larsen (2019) estimates that reducing leakages to under 1 percent would be equivalent to constructing a new reservoir of the size of Alajuela.

8

National Energy Plan 2015–50. In addition to decarbonization of the energy matrix, the strategy also sets out to (i) provide universal access, (ii) reduce and improve efficiency of energy use and (iii) ensure energy security.

9

The comarcas have other sources of energy such as solar panels and kerosene.

10

See the MEF report on the electricity (2017) sector for a detailed analysis.

Panama: Selected Issues
Author: International Monetary Fund. Western Hemisphere Dept.