Honduras - Structural Adjustment Loan Project

Document of The World Bank FOR OFFiCIAL USE ONLY Report No. P-4874-HO REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEIELOPFENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED STRUCTURAL ADJUSTMENT LOAN IN AN AMOUNT EQUIVALENT TO US650.0 MILLION TO THE REPUBLIC OF HONDURAS August 25, 1988 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit - Lempira (L) US$1.0 - L2.0 L1.0 = US$0.5 FISCAL YEAR January 1 to Dec-iber 31 ABBREVIATIONS BCH Central Bank of Honduras CACM Central American Comion Market CETRA Certificado Transferible de Opcion a Divisas para Exportacifn (Negotiate Foreign Exchange Certificate) COHDEFOR Honduran Corporation for Forestry Development CONADI National Industrial Development Corporation DERFE External Finance Regulatory Department (BCH) ENEE Empresa Nacional de Energia Electrica (Electric Power Company) FONDEI National Industrial Development Fund  FOR OMCIAL USE ONLY BONDURAS STRUCTURAL ADJUSTHMNT LOAN LOAN AND PROGRAM SUMMARY Borrowers Republic of Honduras Amount: US$50.0 million equivalent Terms: 20 years, including 5 years grace, at the standard variable interest rate. Description: The proposed loan would support the Government's structural adjustment program. The main areas covered by the Government's program include: public sector reform, public investment program, balance of payment management, credit and monetary policies and financial sector reform. Benefits: The adjustment program would support the country's stabilization process while laying the basis for addressing major macroeconomic constraints affecting long- term recovery and growth. In addition, by supporting productive employment it would enhance living conditions of the majority of the population. Risks: The principal risk relates to the Government's ability to achieve the political consensus necessary to carry the adjustment process through the medium term. In the short term, the main risks concern the consolidation of the stabilization process to establish the basis for medium- term adjustment: generation of the needed public savings, achievement of the monetary targets, and mobilization of the needed external resources to maintain capital flows at an adequate level. Estimated Disbursements: The proceeds of the loan would be disbursed in two equal tranches: US$25 million upon loan effectiveness and US$25 million after a satisfactory performance review in January 1989. Appraisal Report: This is a combined staff appraisal and President's Report. This document has a restricted dindbution and may 'B - by cipients only in perfomance of their official duties. Its contents may not otherwist be disacsed whout World Bank authoriation.  REPORT AND RECOMMENDATION OF THE PRESIDENT 0" THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED STRUCTURAL ADJUSTMENT LOAN IN AN AMOUMIT EQUIVALENT TO US$50 MILLION TO THE REPUBLIC OF HONDURAS 1. I submit the following report and recommendation on a proposed Structural Adjustment Loan (SAL) to the Republic of Honduras for the equivalent of US$50.0 million. The proposed loan would have a term of 20 years, including 5 years grace, with interest at the standard variable rate. 2. A Country Economic Memorandum (Report No. 6332-HO) was circulated to the Executive Directors in April 1987. In February 1988, the Government requested the Bank's support to develop a plan to confront both the financial crisis that began to emerge in 1987 and the underlying structural problems constraining growth of the economy. On April 12, 1988, the Executive Directors approved the modification of Loan 2703-HO, in support of the emergency measures taken by the Government of Honduras under what is expected to be a three-year adjustment program supported by the Bank. The measures focused on emergency actions required to maintain the short-term stability of the economy (President's Yemorandum R88-76 to the Executive Directors of March 31, 1988). Disbursement of the quick-disbursing portion of the modified loan occurred on April 19, 1988. Besides providing the basis for the short-term stabilization of the economy, implementation of the emergency actions created the conditions for the medium-term adjustment effort. The Government formally requested a SAL in March 1988. Bank missions visited the country in May and June 1988, to prepare the program. The Government's adjustment program was appraised in August 1988. The conclusions of these missions are reflected in this report. Country data sheets are attached as Annex I. PART I - THE ECONOMY A. Background 3. Honduras is one of the poorest countries in the Western Hemisphere. In the last two decades, it has made slow economic progress, with per capita income reaching only US$760 in 1987 for a population of 4.3 million that is growing at 2.82 a year. Malnutrition is severe (about one third of the population cannot afford a diet satisfying minimum caloric requirements) and infant mortality of about 8Z of live births is very high. About half of the population is without safe water, 252 has no access to health services, and 752 of the households are without access to sanitary waste disposal. Adult illiteracy is 422, and about two thirds of the population is inadequately housed, with an accumulated deficit of about 500,000 units as of end 1986.  - 2 - 4. Agriculture is Honduras' most important sector, employing over half of the labor force, accounting for about one fourth of GDP, and generating two thirds of merchandise exports. Productivity is low, however, and there is considerable scope for increasing output by improving yields. The industrial sector, which is still at an embryonic stage, employs about 182 of the labor force, accounts for about 23t of GDP, and generates about 20X of exports. The service sectors--including public administration--employ about 28S of the labor force and account for about 48? of GDP. 5. During 1965-75, GDP growth averaging 3.8? a year barely exceeded population growth of 2.9? a year, and high dependence on a few export crops hindered the modernization of the economy. In 1975-80, GDP growth accelerated to 7.6? per annum, but the populatica also grew at a faster pace (over 3? a year) as mortality rates declined and high fertility rates persisted. The economic upturn during this period was aided by relatively easy access to external borrowing, which fueled rapid growth in expenditures. The infant manufacturing sector also began to emerge during this period, under high protective barriers. Export performance improved in the latter half of the 1970s, reflecting recovery of banana production after a devastating hurricane in 1974 and expansion of coffee production in response to high international prices. However, imports grew much faster, averaging 9? throughout the decade. As a consequence, balance of payments troubles began %:o emerge by the late 19708. 6. Strong economic performance in the late 1970s was followed by stagnation in t.'e early 1980s. The world recession, deteriorating terms of trade, a drying up of commercial bank lending, and the adverse political climate in Central America all contributed to the slowdown, which had a particularly strong effect on private investment--it fell by 50X as a share of GDP between 1980-83. A surge in public investment, linked mainly to a large hydroelectric project, El Caj6n, cushioned the impact of the drop in private economic activity on the economy as a whole. Nevertheless, the recession, combined with mounting population pressure, led to a 10 drop in per capita output during the period and a doubling of unemployment to over 20? of the libor force. Moreover, economic management deteriorated, as the Government's effort to resume growth through expansionary policies aggravated both fiscal and external imbalances and did not contribute to solve the economy's long-term structural problems. 7. In 1983, the overall deficit of the consolidated public sector reached 12.62 of GDP (compared with 9.1? in 1980), reflecting a sharp deterioration in Central Government savings, which dropped to -3.2S of GDP (compared with 0.5? in 1980). Furthermore, recourse to domestic financing more than doubled over the period to 5.4? in 1982, tapering to 5.6? in 1983. Financial management also weakened, with several public institutions experiencing problems of insolvency and even bankruptcy. 8. In 1984 and 1985, increasing transfers from abroad and continued $igh expenditures for El Caj6n fueled a modest recovery. Banana production also recovered from serious wind damage suffered in 1983, but private investment continued to be depressed. The overall deficit of the public  - 3 - sector dropped from 11.2Z to 6.62 of GDP from 1984 to 1986. According to official estimates, inflation slowed down from a high of 182 in 1980 to an average of 4Z in 1984-86. Wages behaved moderately throughout the 1980-86 period. 9. The external sector remained weak during 1980-86. Export performance reflectedt, on the one hand, slack international demand and production setbacks for some crops and, on the other, a deterioration in export competitiveness. Imports declined in the early 1980s, but later recovered owing to the relaxation of import restrictions and large foreign government grants, which grew from negligible levels in the late 19708 to US$109 million in 1986, or about 3Z of GDP. The current account deficit of the balance of payments after grants declined from 12.5? of GDP in 1980 to 2.8? in 1986; grant receipts accounted for slightly less than half of this improvement. In addition to significant levels of transfers, Honduras received substantial capital inflows in 1980-85, averaging 6.1Z of GDP on a net basis. B. Recent Economic Performance and Prospects 10. During 1987, a series of external shocks unmasked the long-term structural problems affecting the Honduran economy. First, the price of coffee, Honduras' most important export, dropped 412. Second, net voluntary external financing to the public sector--which amounted to $227 million in 1985 and $94 million in 1986--plummeted to -$23 million. The combined drop in foreign inflows cut the supply of foreign currency to the economy by about 7.9? of GDP, precipitating a balance of payments crisis. The Government was able to avert a massive financial disequilibrium in 1987 through a number of unorthodox, ad hoc measures: (a) a large increase in arrears was allowed to accumulate; (b) the spread between the official and free market exchange rates was permitted to expand, encouraging increased underinvoicing of exports; and (c) a strong increase in the money supply was used to finance the public sector deficit. 11. The financial crisis has continued to deepen through 1988; in fact, throughout the year, the country has been unable to fully service its external debt obligations. Moreover, as the excess supply of money issued in 1987 has not yet been totally eliminated, the spread between the official and free market exchange rates widened further, reachin6 50? (L3.OIUS$1.0) in July. Eventually, unless corrective actions are taken, a large nominal devaluation of the Lempira would have to occur. 12. Honduras' medium-term prospects are bleal Although inflation has remained low (2.5? in 1987), if action is not taken soon the monetary expansion of 1987 could translate into a return to the high levels of 1980. The projected level of the current account deficit of the balance of payments is unsustainable in the face of the reduction in voluntary capital inflows, and unless public sector savings are increased and the relation between prices of tradeable and non-tradeable goods is brought in line, a path of stability with growth cannot be expected. Action is therefore needed to improve the management of the balance of payments, public finances, monetary program, and the financial sector, if the country is to avoid a profound stagflation process in the years to come.  - 4 - 13. Recognizing the serious nature of the disequilibria affecting the economy, the Government has defined, in cooperation with the Bank, a three- year adjustment program to address both short-term macroeconomic issues and medium-term strucLural issues. The objectives of the three-year program are to achieve: (a) growth of exports and efficient import substitution through: (i) a more competitive real exchange rate and (ii) trade policy reform aimed at reducing the anti-export bias of the trade regime; (b) increases in public savings to levels consistent with a sound public expenditure program and available external financing; and (c) increases in private savings and greater efficiency of financial intermediation through liberalization of interest rate policies and institutional measures. The proposed loan would support actions to be taken during 1988 and early 1989. It is expected that follow-up operations would support the Government's three-year economic program (paras. 79-83). Rationale for Bank Support 14. Although short-term macroeconomic adjustment would ordinarily be supported by the IMF, the slow progress in the fiscal and exchange rate actions together with the existence of arrears to the IMF impeded an agreement on the use of IMF resources. However, negotiations continued and an IMF mission will visit Honduras in early September 1988. Provided the Government is able to clear its arrears with the IMF, a Stand-By Arrangement is possible for 1989. 15. The leading role adopted by the Bank in the face of the ongoing financial crisis has permitted progress to be made in several important areas. First, it has allowed the Bank to work with the Government on a multi-year adjustment program, in spite of the fact that the current administration's term of office is nearing its final year. The Government has encouraged discussions with opposition leaders and leading presidential candidates, smoothing the way for continuation of the process through the transfer of dower to a new administration ain 1990. Similarly, it permits the Bank to help assure coordination of short- and medium-term adjustment objectives. 16. Second, the adjustment program supported by the Bank has become the focal point for other lenders and donors. The Bank has been able to coordinate closely with other international and bilateral agencies, which will permit a more rational planning of the timing and level of financial flows to Honduras in the next couple of years. In the short term, this coordination will be important in timing the release of balance of payments support, to assure the viability of the external financing plan while avoiding over-financing. In the medium-term, the request of the Government for Bank support in carrying out a review of public expenditures and investment programming, which has arisen from close collaboration in the course of developing the adjustmen' program, will provide the Bank the opportunity to help mobilize the needed external financing for the investment program and to assure the economic viability of the program itself. To this end, the Bank is organizing a consultative group of donors which is expected to hold an initial formal meeting to discuss Honduras' financing needs in October 1988.  - 5 - PART II - THE GOVFRNMENTS ADJUSTMENT PROG&AH 17. The first phase of the three-year program consists of an action plan for 1988 and early 1989 aimed at stabilizing the economy. The action plan provides for carry-over into 1989; a full action plan for 1989 would be defined in early 1989. The main goals of the 1988-89 action plan as agreed with the Bank, are to: (a) increase publtc sector savings to 1.1? of GDP (vs. 0.6X in 1987); (b) reduce the overal... fiscal deficit by 0.7 percentage poir.ts of GDP on a cash basis, compared with 1987 performance; (c) promote external balance and increase transparency in the foreign exch3nge market by permitting a greater proportion of transactions to take place at market-determined rates; (d) sterilize the excess money supply and avoid its inflationary impact; and (e) begin the process of liberalization of interest rate policies by elimination of distortions among rediscounted credit lines. 18. The second phase of the program, which will begin in 1989, will follow up the stabilization measures and deepen the process of structura'l adjustment. The main goals of this phase of the program would be to: (a) increase public sector savings to 2.5? of GDP; (b) reduce the overall fiscal deficit by 1.8 percentage points of GDP on a cash basis, compared with 1988; (cj continue movement of external transactions toward market- determined rates; (d) continue the program of monetary restraint begun in 1988; (e) continue the process of liberalization of interest rate policies; (f) carry out a program of reform for decentralized institutions; (g) carry out an action plan for divestiture of publicly held firms; 'h) design and begin implementation of an action plan to reduce effective protection through tariff reduction and elimination of quantitative restrictions; ii) carry out an action plan to reform the regulations with a view to strengtheax capital requirements for finaucial institutions, ceilings on credit granted to related parties, requirements for publication of information, and definition of the Superintendency of Banks' role and authority to monitor and regulate financial institutions. 19. The third phase of the program, beginning in 1990, sould intensify structural adjustment efforts in the public sector and key sectors. Adjustment programs for the financial and agriculture sectors, to be prepared during 1989, would be carried out. 20. The first phase of the program was initiated with an emergency action plan carried out in February/March 1988 in accordance with conditions established for consideration of the modification of the Third Industrial Credit Project (para. 2). Under this emergency plan, the Government took the following actionst (a) a freeze on all public sector salaries and the number of public sector jobs at the levels established as of February 15, 1988; (b) a freeze ox. all current expenditures for goods and services at their 1987 level; (c) reduction of Central Government transfers to autonomous institutions and proposal to Congress of legislation to reduce city governments' share of port revenues; (d) extension of eligibility to receive CETRA benefits (a mechanism to permit trading of foreign exchange at market prices)(see para. 35 below),  - 6 - from 11 to 28 non-traditional export products; (e' r-u;.. tion of excess liquidity in the system through reestablishment of a 1UO2 reserve requirement on deposits held in commercial banks pending availability of foreign exchange; and (f) elimination of payment in cash by the Central Bank for all converted external debt for which purchase is approved by the Government after February 15, 1988. 21. The above actions achieved important gains toward fiscal and monetary restraint and improving flexibility of the exchange rate regime. More action was needed, however, to achieve the targets for 1988 in public finance, balance of payments, and monetary policy. A complete program of actions for the remainder of 1988 was defined during May/June, with a timetable for implementation through the end of the year. The proposed loan is intended to support this program. The following paragraphs discuss the issues to be addressed under the program, progress achieved to date, and actions planned for future phases of the three-year adjustment program. The policy matrix in Annex IV provides a summary of the issues and actions to be taken under the program in 1988-89 (SAL I). A. Public Sector Finances 22. Public savings (excluding transfers), which were more than 52 of GDP in the late 19709, dropped to less than 12 in 1987 (Table 1). Fixed public investment, which represented close to 102 of GDP in 1978, and 11.6? at the peak of the construction of the El Caj6n dam, accounted for only 52 of GDP in 1987. In contrast, current expenditures grew faster than current revenues from 1980-81. Thus, the recent reductions in the public sector drficit from a peak of over 12Z of GDP in 1983 to slightly more than 62 in 1987, have taken place at the expense of public investment. Table :s HNDURAS - CONSOLDOATID INM-IlNANCZM PUBUC SSCTOR (Percent of Current GDP) 1980 1901 1962 1988 1984 19865 108 1987 Current Revenues 22.9 22.1 22.9 28.4 25.0 20.4 25.6 27.6 (of which Taxes) 14.2 18.1 18.9 12.4 14.2 14.7 18.7 14.4 Current Expenditures 20.1 20.1 21.6 28.2 28.9 25.0 24.5 20.9 Public Sector Saving 2.8 1.9 1.8 0.2 1.7 1.5 1.1 9.0 Capital Expenditures 10.4 6.0 9.5 11.2 11.6 8.0 7.0 6.0 Net Lending / 1.6 1.8 2.6 1.6 1.8 0.4 0.7 1.1 Overall Bleance -9.1 -8.6 -10.8 -12.0 -11.2 -7.5 -0.6 -0.2 External Financing, Net 5.8 6.2 6.8 0.4 8.5 6.8 2.0 1.9 Domeetic Financing, Net 8.2 2.2 5.4 5.0 0.8 6.2 2.0 2.9 Foreign Grants o.9 0.1 0.1 0.6 1.9 1.6 1.7 1.4 / Lees capital revenues. Source: Banco Central de Honduras.  23. Increases in public revenues require improvements in tax collection and reform of the country's tax structure. Although Honduras' tax ratio is high, (close to 182 of GDP if the oil price differential and local taxes are considered) the structure of tax revenues is inadequate and heavily dependent on external trade taxes. Revenues from income, property, and value-added taxes represent only about 37X of total non-export tax revenues; these taxes should account for at least half of non-export tax revenues. 24. Alteration of the tax structure will require improvements in tax administration as well as possible modification of tax rates. The Ministry of Finance estimates that actual tax revenues from income and sales taxes are only 30X of potential revenues. Although the maximum marginal income tax rate is 402, income-tax revenues account for less than 4? of GDP. Despite a value-added tax rate of 5?, revenues from its collection are less than 2? of GDP. An administrative reform to reduce evasion and allow cross reference of information between the sales and income taxes would likely produce strong increases in revenues without resorting to drastic increases in tax rates. 25. The Government has taken initial action in this regard. Tax revenues relative to GDP rose in 1987 following measures to improve il1ection of valued-added, excise and import taxes. Strong increases in ncr.-tax revenues were obtained in 1U7, mainly the result of improvements in oil-related revenues stemming from the differential between domestic and international prices of oil. This differential, which was insignificant before 1985, rose to more than one percent of GDP in 1986 and 1987. Although the drop in international oil prices helped, the increase in public revenues came primarily from improvements in the administration of revenue collection. As a combined consequence of these measures, the tax system hp- become less dependent on export taxes; export tax revenue, which represented close to three percentage points of GDP in the late 1970s, has fallen to about one percentage point since 1983. The Government's program includes measures for further improvement of tax administration and it has begun a study, with assistance from consultants, to identify specific measures needed. Agreement with the Bank on an action plan for improving tax administration during 1989 is a condition for release of the second tranche of the proposed loan (see para. 51, below). 26. Led by higher interest payments, current expenditures have increased faster than GDP since the late 1970s. Current expenditures represented 17X of GDP in the late 1970's and 272 in 1987. The rapid rise in current outlays was mainly the result of a massive rise in the public sector's wage bill (explaining almost half of the increase in the ratio) and the increasing interest payments (explaining 20? of the rise). The large increase in the wage bill is more a consequence of expanding public employment than of higher public wages as the latter deteriorated in real terms during the period, except those of special sectors (teachers and health related personnel). The wage bill alone increased 15? during 1987, reflecting increases in both public employment and wage adjustments benefiting mainly teachers and health sector workers. However, the  - 8 - Government is committed to reducing public expenditures, especially in the current account. It has defined spending cuts for the last half of 1988 equivalent to at least L40 million (about 0.5Z of GDP) and would continue the program of spending restraint through 1989. 27. At a time tihen critical foreign exchange shortages and debilitating debt service obligations exist, the role of the public enterprises in Honduras needs to be carefully examined to obtain greater fiscal discipline and efficiency of resource use. The public enterprise sector grew at an extraordinary rate in the 1960s and 1970s in an attempt to spearhead economic development, create employment, and promote the growth of underdeveloped areas. However, the sector has performed erratically and has not contributed to the national economy proportionately to the resources it has absorbed. Some public enterprises have developed an excessive and unsustainable dependence on public financing. At the same time, a rapid build-up of Government arrears to some public utilities threatens their financial stability. 28. The Government's adjustment program includes actions to address these problems. Under SAL I, provision has been made to assure the consistency of the 1989 budgets of the autonomous public sector institutions with the targets for reduction of the overall non-financial public sector deficit. A public expenditure review to be carried out before the end of 1988 will include a careful examination of the entire public sector investment program, and agreement on the investment program for 1989 is a condition of second tranche release (see para. 51, below). Action plans for improvement of the management and efficiency of each public enterprise will be prepared prior to second tranche release (see para. 52, below). The action plans will provide the basis for a program of public enterprise adjustment to be prepared for Bank financing (see para. 79, below). Finally, a few public enterprises (notably the National Investment Corporation (CONADI) and the National Forestry Development Corporation (COHDEFOR) have assumed ownership of a number of (originally private sector) firms. The Government approved legislation in 1985 to permit resale of these firms to the private sector and is committed to carrying out this process, though progress has been slow. Preparation of action plans with monthly targets for execution of the privatization programs for COHDEFOR and CONADI would be completed prior to release of the second tranche (see para. 52, below). 29. A case of special concern is that of the power company, ENEE. With the commissioning of El Caj6n Hydroelectric Project (partially financed under Loan 1805-HO and Credit 989-HO) in 1985, Honduras entered into a period of excess generation capacity, which is expected to continue at least until 1993. The expected benefits from the construction of El Caj6n have not yet been realized. With low revenues, ENEE's cash flow has been insufficient to meet its financial obligations. In particular, the financial requirements derived from the construction of El Caj6n and from the recent weakening of the US dollar (69? of ENEE's external debt is denominated in currencies other than the US dollar) have forced the company to incur arrears with some of its lenders. (They may reach $100 million by the end of 1988).  - 9 - 30. The Government has requested the Bank's assistance to define a program of reform and financial restructuring for ENEE to restore the enterprise's solvency and eliminate the burden it has imposed on public finances. The program is currently under preparation and is expected to be initiated during 1989. The Bank plans to support implementation of the program through an adjustment operation for ENEE (see para. 79, below). B. Balance of Payments 31. As a result of huge eurrent account deficits incurred, Honduras' external debt increased from $200 million in 1973 (212 of GDP), to $2.4 billion in 1987 (60? of GDP). Service payments in the last few years absorbed more than 902 of national savings, 40? for interest payments alone. Savings must increase to sustain GDP growth. In view of the fact that massive foreign savings are unlikely to materialize, domestic savings will have to rise substantially. Table 2: HWONUA - MIN ALMCE OF PAUENTS CONCEPTS (X GOP) 1970-50 1080 1981 1982 1098 1984 1985 1986 1987 Resource Balance -4.8 -7.8 z3.4 -1.8 -8.? -0.8 -4.6 -1.4 -2.7 Current Acet. 8al. (excl. trans.) -8.8 -18.8 -11.9 -8,8 -8.? -12.8 -10.0 -7.0 .-8.2 Current Account -7.5 -12.5 -10.9 -7.8 -7.8 -9.8 -5.9 -2.0 -4.0 Long-Term Capital e., 9.9 8.4 4.5 4.9 7.7 7.6 2.8 4.9 Short-Term Capital 0.5 0.4 0.5 -1.8 1.4 1.5 -4.0 -0.9 0.0 OveralI SOP 0.4 -2.1 -2.2 -4.8 0.4 0.4 -4.5 0.2 -0.7 Source: Banco Central de Honduras 32. Exports of coffee and bananas represented 50? of the total foreign exchange earnings of the country in the early 1980s, and more than 60S in the last couple of years (Table 3). The concentration of foreign exchange earnings in two products with unstable international prices has generated wide swings in Honduras' export earnings. The country's capacity to diversify and expand its exports is critical to the reduction in the current account deficit of the balance of payments. This capacity has recently been demonstrated by the increase of shrimp, vegetables and cardamon exports reflecting Honduras potential to diversify its export base. This can only be achieved however, by adoptitg a more flexible exchange rate regime and by reducing the anti-export bias of the trade regime.  - 10 - Table 8: HOINURAS - COV'OSMON OF EXPUirs, 1S1WT (VI llI to US Dol lor) 1980 1981 1982 1991 1984 1986 1986 1e87 Total Exports LFOB) 850.8 788.9 676.5 698.1 787.0 789.6 891.8 s62.6 coffee Value 204.1 172.9 158.1 151.2 109.1 186.2 822.1 268.4 As X of Total 24.03 22.11 22.61 21.61 22.9% 28.5X 86.1X 24.21 Bananas Value 228.0 218.8 216.8 208.1 282.2 278.5 256.8 824.8 As X Of Total 28.sx 27.2x 82.8x 29.1X 8.51 84.1x 28.0% 87.6x Total Exports (MNMS) 100.0 91.8 90.8 86.1 89.6 98.1 99.6 94.7 Annual Change 16.6X -8.21 -1.6X -4.6X 4.1% 8.81 7.01 -4.9x Source: Banco Central do Honduras 33. Exchange Rate Manatement. Honduras' official exchange rate has remained unchanged at L2/US$1 since 1920. A flexible exchange rate policy, however, has been implemented since 1985 to partially correct price distortions between tradeable and non-tradeable goods in the economy. .4. Initial steps to adapt the exchange rate system were taken in 1985. The Central Bank authorized specific exporters to sell or use a portion of their foreign exchange proceeds in a quasi-free market arrangement by permitting them to select the purchaser of their foreign exchange. In this way, the actual receipts from sales of foreign exchange exceeded its value at the official rate. 35. In early 1988, increased flexibility in the exchange rate regime was introduced with the creation of tradeable documents (CETRAs) issued by commercial banks to exporters, which enable their holders to buy their face value in foreign exchange at the official rate. Exporters of eligible products (initially specified in a positive list of 11 products) receive a CETRA for the equivalent of a proportion (in;itially 302) of the value of their exports and may then freely sell the document during the first 30 days after its issuance. The CETRA is sold to importers at a premium over its face value, reflecting the free market foreign exchange rate. The document can be traded only once and has to be used within seven months to purchase foreign exchange. The importer who presents CETRAs with his application for his import license has his request approved immediately after verification of the legality of the imports. Because the price of the CETRA is freely determined, the transactions involving CETRAs are equivalent to trading the corresponding foreign exchange in a free market. Therefore, an expansion in the coverage of the CETRA would increase transparency in the foreign exchange market and provide added incentives to export expansion.  - 11 - 36. To accomplish this, the Government has approved under the proposed SAL I extension of CETRA coverage to all products (except bananas and minerals, which are subject to separate regimes permitting exporters to retain some of their earnings in foreign exchange) and an increase in the proportion of export earnings covered by CETRAs (see para. 54, below). These measures provide the added flexibility needed in the system at this stage. 37. Trade Regime. On December 27, 1987, Honduras enac I new tariff legislation adopting the modified Brussels nomenclature and replacing specific duties with ad valorem rates. The new tariff structure and nomenclature are similar to those recently idopted by the Central American Common Market (CACM) countries; while Honduras is not a member of the CACM, it has maintained close ties with it under bilateral agreements. Although the new tariff system, together with the new import valuation and customs laws that accompanied it, represents an improvement over the previous system, the existence of numerous exemptions and import surcharges affect the transparency and dispersion of the trade regime. The Ministry of Finance estimates that of the total value of merchandise imports, close to 50? enter under some form of tariff exemption. By 1985, the basic tariff only accounted for 26.5Z of all import duty revenues collected, with the other 73.5X accruing from tariff surcharges. Correction of the distortions caused by the exemptions and import surcharges is essential. Accordingly, the Government has presented to Congress legislation which would eliminate exemptions and surcharges. Approval of this legislation by Congress is a condition of second tranche release of the proposed SAL (see para. 55, below). 38. Quantitative import restrictions were introduced in mid-1982. All imports required a foreign exchange license, issued by the External Finance Regulatory Department (DERFE) of the Central Bank. Imports were classified into five categories of descending essentiality: (1) essential consumer goods (e.g. foods, medicines); (2) fuels and lubricants; (3) inputs for agriculture and industry; (4) capital goods; and (5) all other goods. If no foreign exchange at the official rate was requested by the importer, the license was issued immediately (para. 35). Otherwise, the importer waited until foreign exchange became available, the waiting period depending on the category in which the goods to be imported were classified. Importers requesting foreign exchange at the official rate were required to deposit an equivalent amount in Lempiras. The size of the deposits made by importers as advance payments for foreign exchange was an index of the availability of foreign exchange at the official rate, and therefore of the importance of import restrictions; such deposits were high in 1984 and 1985, dropped in 1986, but grew again in 1987-88. 39. Under the proposed operation, the Government has agreed to reduce the above classifications to twos those products for which importers are entitled to foreign exchange at the official rate and those excluded from access (see para. 54, below). This change effectively eliminates quantitative restrictions for products in the second category.  - 12 - 40. The Government's medium-term adjustment program includes a full reform of the trade regime. Preparation of the reform measures would begin in 1989. C. Savings and Investment 41. Savings and investment declined substantially since 1978 (Table 4). Public investment fell by about three percentage points of GDP in 1978-87. Discouraged by poor macroeconomic policies, private investment also declined. In a misguided effort to promote investment, the Government resorted to special tax and credit incentives, which have not only failed to reverse the downward trend, but have now further complicated the implementation of sound policies to improve the country's incentive system for export-oriented investments, and have cut public savings further. Credit allocation has become increasingly arbitrary, as similar kinds of loans carry differing interest rates and other charges, depending on the special privileges granted by the financing source. Tabl- 4: INNWtAS - DIESTNT FINMCNSO (As X of GOP) 1978 1980 1982 1983 1984 1986 1986 1987 Or.., Domestic Investment 27.2 24.5 18.5 14.9 19.9 18.1 16.7 15.8 Private (Inc. change In 17.9 16.2 4.8 4.8 6.9 7.8 7.9 8.5 stocks) Public 9.8 9.4 9.2 10.1 12.2 10.8 7.7 6.8 Total Savlngs 27.2 24.5 18.6 14.9 19.0 19.1 15.7 15.8 Foreign Savings 8.2 12.5 7.8 7.8 9.6 5.9 2.8 4.6 Qroes National Savings 19.0 12.1 5.7 7.6 9.8 12.8 12.9 10.7 Private 18.9 9.2 4.8 6.8 5.7 9.2 19.1 8.7 Public 5.1 2.8 1.4 0.8 8.6 8.1 2.6 2.0 42. The low level of savings and investment has been the consequence of: (a) an extraordinary inflow of foreign resources (from both lending and grants), which stimulated expenditures; (b) distortions in the system of incentives, which encouraged investors to seek privileges rather than economically profitable investment opportunities; (c) high levels and wide dispersion in nominal import tariffs, which discouraged exports, the most promising source of growth; (d) inadequate interest rate policies and (a) lack of confidence, stemming from the political conflict in Central America. As the availability of foreign resources drops, the country will need to provide appropriate incentives to increase private savings, in order to maintain a level of investment to assure future economic growth.  - 13 - 43. The proposed SAL will support the Government's program to reduce distortions in the system of investment and savings incentives. Actions to carry out measures under the program has already begun. Legislation eliminating import duty exemptions and surcharges was presented to Congress in June 1988. The process of unification of the Central Bank's rediscount rates for its lines of credit was begun with the increase of the minimum rate to 9? in June 1988 (see para. 57, below). A further increase of the minimum rate to 10? is a condition of second tranche release of the proposed loan (see para. 57, below). Finally, several laws providing tax exemptions and credits have been repealed. D. Monetary Policy 44. During 1987, the money supply rose almost 20? in one year, against an average annual rate of 5? during 1985-1986. This increase was due in part to the need to finance domestically the public sector deficit. Despite the accumulation of arrears to reduce the cash deficit, domestic credit to the public sector increased a full percentage point of GDP in 1987. Second, the conversion of external public debt also added to growth of the money supply in 1987. The Government bought the converted external debt with bonds, which were fully cashed by the Central Bank through monetary expansion. If not corrected, this monetary expansion will result in an acceleration of inflation, leading to a destabilization process of the Honduran economy, which would make the adoption of adjustment measures a more difficult task in the future. A monetary program that limits both sources of money expansion is therefore required. 45. The proposed SAL includes a monetary program (with monthly targets) consistent with the other macroeconomic objectives of the adjustment program (see para. 56, below). Achievement of the targets for September-December 1988 will be a condition for release of the second tranche. E. Financial Sector Issues 46. The allocation of credit is far from satisfactory from an economic point of view. Credit is too dependent on rediscount lines from the Central Bank (funded mainly with foreign resources) often lent at interest rates well below the market. Moreover, the diversity of rediscount rates on different Central Bank lines of credit leads to distortion in market signals. Although the ceiling on interest rates (now at 17Z) is high in real terms, it still introduces serious distortions in the determination of free market interest rates. Moreover, based on special mechanisms and privileges (bonds with a guarantee of redemption, bonds that can be used as reserve requirements, tax-exempt bonds, etc), the public sector squeezes out the private sector, absorbing an increasing share of the available credit. The proposed loan will support the start of a program to eliminate interest rate subsidies (see para. 57, below). 47. Finally, it is important to strengthen monitoring capacity and authority of the Superintendency of Banks to supervise the financial system in order to make it more efficient in mobilizing and channeling private  - 14 - savings. In this connection, and as part of the adjustment program supported by the proposed loan, the Government vill undertake immediately the technical assistance to the Superintendency of Banks financed under Loan 2704-HO. Consultants have been selected and agreement on an action program based on the recommendations of the study is a condition for the release of the second tranche of the proposed loan (see para. 58, below). PART III - THE PROPOSED LOAN A. General 48. The proposed Structural Adjustment Loan would support the Government's 1988-89 program of economic adjustment. The loan was prepared with the Government between May and July 1988. Negotiations took place in Washington, D.C. on August 23, 1988. The Honduran delegation was led by Ms. Marta Julia Cox, representing the Minister of Finance and Public Credit. The components of the SAL program are summarized below; further details are provided in Annexes III and IV. 49. The program backed by the proposed operation is expected to be supported also by international institutions, USAID, and may be supported by cofinancing from other bilaterals. A full financing package for 1988 has been defined. Further debt relief may be required in the form of debt rescheduling by the Paris Club. B. The Adiustment Program 50. The Bank has agreed with the Authorities on the policy elements of the first stage of a three-year adjustment program (a summary is presented in Annex IV in matrix form), consisting of an action plan for 1988-89 aimed at stabilizing the economy. The main goals of the action plan are to: (a) increase public sector savings to 2.52 of GDP in 1989, vs. 0.62 in 1987 (the target for 1988 is 1.1? of GDP); (b) reduce the overall fiscal deficit in 1989 by 2.5 percentage points of GDP on a cash basis, compared with 1987 performance (the target for 1988 is a reduction of 0.7 percentage points of GDP); (c) promote external balance and increase transparency in the foreign exchange market by permitting a greater proportion of transactions to take place at market-determined rates; (d) sterilize the excess money supply and avoid its inflationary impact; and (e) begin the process of liberalization of interest rate policies by elimination of distortions among rediscounted credit lines. Management of the Public Sector 51. As noted in the preceding paragraph, a goal of the SAL program is to reduce the overall public sector deficit by at least 2.5 percentage points of GDP on a cash basis and raise public savings by a corresponding amount in 1988-89. The public investment program will be reviewed in late 1988 to verify that its size and composition are consistent with the adjustment program's goals and constraints. This work will be carried out  - 15 - in the context of a comprehensive review of public expenditure. Agreement on a 1989 public expenditure program will be a condition of the release of the SAL's second tranche. Following submission to the Honduran Congress of a tax bill that should increase revenues by about L20 million, the Government has extended the freeze on new hirings, and instructed the public sector to reduce current expenditures by limiting salary increases and expenses on non-essential expenditures such as travel, acquisition of new equipment, etc. The measures contemplated for 1988189 are expected to increase annual revenues by L125 million and reduce annual current expenditures by L75 million on a sustainable basis. The Government has agreed with these targets. It has presented an action plan for the remainder of 1988 that will: (a) reduce consolidated public sector expenditures by at least L40 million (about 0.5S of GDP); (b) reduce the consolidated public sector deficit by at least L65 million (0.72 of GDP) on a cash basis; (c) reduce Central Government current expenditures, excluding increases in interest payments, to no more than 17.62 of GDP in 1989; and (d) limit investment expenditures in 1988 and 1989 to no more than 5? of GDP. Achievement of these targets, approval by Congress of a budget for 1989 consistent with the goal of reducing the public sector deficit by 1.8 percentage points of GDP with respect to 1987, and agreement with the Bank on an action plan for improvement of tax administration (para. 25) would be conditions for release of the second tranche. 52. The program also aims to strengthen public sector management through laying the basis for structural adjustment of public enterprises and institutions in the medium term. To this end, action plans will be prepared under the proposed SAL that will provide the basis for adjustment programs to be carried out during the next several years. Conditions of second tranche release are preparation of: (a) an action plan with monthly targets for the implementation of the divestiture programs for CONADI and CORDEFOR; (b) an action plan for institutional adjustment and streamlining of major public enterprises; and (c) an action plan for the institutionallfinancial restructuring of ENEE (paras. 29-30). Balance of Payments 53. The three-year adjustment program will be oriented tot (a) reduce the dependence of foreign exchange earnings on exports of coffee and bananas; (b) reduce the current account deficit to levels that can be financed with net voluntary inflows from bilateral and multilateral sources; and (c) increase the transparency of the foreign exchange market. Under SAL I, the Government will adopt a more flexible exchange rate regime and start reducing the anti-export bias of the trade regime. 54. Exchange Rate Management. The objective of the program is to gradually move to a free exchange rate market. On June 30, 1988, the Government announced that all exporters will have access to the CETRA system, but limited the foreign exchange earnings that exporters can change through the CETRA system to 30? and 152 for non-traditional and traditional exports, respectively. Further actions were needed to increase the transparency of the foreign exchange market. During appraisal, the Government agreed to increase the coverage of CETRA benefits to 40? of  - 16 - export earnings for all eligible products except coffee and timber. Exporters of coffee and timber receive CETRAs equal to 1S? of their earnings. Excluded from the CETRA system are exporters of bananas and minerals, which are already covered by special arrangements permitting exporters to retain 50-55Z of their earnings in foreign exchange. Complementing the above measures, the Government has agreed to exclude imports equivalent in value to at least 402 of total imports from access to foreign exchange at the official rate. Verification that these agreements have been implemented will be a condition of second tranche release. Further actions toward the complete liberalization of the foreign exchange market will be pursued through a second SAL operation currently planned for late 1989. 55. Trade Reform. Reductions in the maximum tariff rates to levels comparable to those being considered by Central American countries will be the goal of the three-year adjustment program. The elimination of the present system of import duty exemptions and surcharges will be carried out under SAL I. On June 30, 1988, the Government initiated the process by sending to Congress a package of measures that would eliminate the exemptions and surcharges, thus reducing the average level of effective protection in the trade regime. Congressional approval of the legislation will be a condition of second tranche release. Monetary and Financial Sector Measures 56. The goals of the agreed 1988 monetary program are to reduce the excess supply of money that developed in 1987 and to allow interest rates to reach levels consistent with the credit expansion and fiscal targets. Ceilings have been set for total credit at end-1988 as follows: (a) total domestic credit, L2,292 million; (b) total credit to the public sector, L1,278 million; and (c) total Central Bank credit to the Central Government, L739 million. In addition, net international reserves would increase by US$17 million. Meeting these targets would be condition for release of the second tranche. 57. As the short-term emergency is resolved and long-term investment needs become urgent, larger proportions of GDP will have to be generated as savings to finance such investment. Thus, measures to increase domestic savings and to improve their allocation in the economy will become crucial to the long-term success of the adjustment program. To this end, the Government and Central Bank have agreed to undertake gradual unification of rediscount rates charged to financial intermediaries under its lines of credit. The first step, raising the minimum rediscount rate to 9?, was agreed during appraisal. Raising all rediscount rates to at least 101 would be a condition for release of the second tranche. 58. As a first step toward a long-term solution to these problems, the Government agreed during appraisal to carry out a study under the ongoing Third Industrial Credit Project which would focus on (a) measures to improve banking supervision and control procedures; (b) improve information systems; and (c) needed changes in the Banking Law regarding regulations on  - 17 - capital requirements, ceilings on credit granted to related parties, information that must be published, and strengthening and better defining the role and authority of the Superintendency of Banks and its interaction with the country's financial institutions. Consultants have been selected to carry out the study and agreement on an action plan based on the recommendations of the study would be a condition for second tranche release. Implementation of the action plan would be a condition of a future financial sector adjustment loan (see para. 82, below). C. Imnact of the Adiustment Program and Financial Reauirements 59. The projections presented in Annex I show the magnitude of the adjustment effort required. The main assumptions ares (a) an increasing share of external transactions to the CETRA market gradually occurs during 1988/1989 and the real effective exchange rate increases by more than 20? between 1987 and 1990; (b) imports will be progressively traded in the CETRA market, and tariff rates will be brought down along with the increase in the real exchange rate; (c) foreign transfers decline 10? per year starting in 1989, thus making the country increasingly independent of foreign grants; (d) tax revenuea increase about 0.5Z of GDP in 1989; (e) current expenditures share in GDP declines 2.6 percentage points between 1987 and 4990 as a result of a rationalization of operations in the main public enterprises; (f) the money supply (M1) will be reduced to 12? of GDP in 1989, thus the excess supply that developed in 1987 is eliminated in 1988/89; and (g) domestic interest rates are liberalized allowing an increase in the GDP share of quasi-money savings. 60. After a temporary setback in 1988, GDP growth averages 3.3? per year between 1989 and 1992 (Table 5). The accelerated growth would come from new investments in export-oriented activities, higher investment productivity resulting from related actions contemplated in the program, and the expansion of non-traditional exports. Domestic inflation would remain close to international inflation, and the public sector deficit (including foreign transfers as revenues) would decline on a cash basis from 4.8? of GDP in 1987 to 2? in 1990. The current account deficit (including foreign transfers as revenue) is reduced to 2? of GDP in the outer years of the projection. Table 5: HONDDUAS - RZCNT PEUROWANCE AND GROWN PPISPECTS (? Annual Average Growth Rate) 1980-87 1988 Projected Actual Estimate 1989-93 GDP 1.7 1.5 3.3 Consumption 1.7 -1.2 2.4 Total Investment -3.4 2.2 7.3 Exports (GNFS) 1.4 4.4 5.4 Imports (GNFS) -1.7 -3.9 5.0 ICOR 12.7 9.9 5.0 Marginal Savings Rate 0.28 .54 .31  - 18 - 61. However. gross requirements of foreign funds remain high for 1988. They are estimated at about $500 million (Table 6). USAID ESF funds, and the refinancing of bilateral and commercial arrears should satisfy the bulk of these gross requirements. The World Bank would contribute with $65 million, including the first tranche of this operation. Despite the ambitious program proposed, World Bank net disbursements would become only moderately positive after 1988. Cofinancing from bilateral sources for Bank-assisted projects should provide the res: of the foreign flows required. Table 6: HONDURAS -- PROJECTED FINANCING PLAN, 198P-92 (Ml lion of US$) 1986 1989 19M 1991 1992 Gross Financina Recuirements 1/507 476 446 440 458 A. Grante 161 143 188 129 128 B. Not Direct Investment 87 87 8T 48 49 C. Gross Disbursements 296 298 272 287 291 1. IBR Project Lending 80 9 15 27 8E 2. IBRD Policy Lending 85 7T es se 89 8. Cofinaneing 86 70 e8 se as 4. I 2 44 60 79 69 S. Suppliers 19 12 18 12 12 6. Other Offietel 169 94 64 69 104 D.Other Private and Not Short Trom 9 O 0 0 E. Debt Service Arrears 28 9 O O O I/ Accumulated arrears are assumed to be refinanced In 1989 and are excluded from gross financing requrement. 62. If the actions of the program are carried out in the three year period as assumed, non-traditional exports would increase at a rate faster than traditional ones reducing, albeit slowly, Honduras' dependence on traditional exports from 642 in 1987 to 602 by 1990. The resource balance would be in equilibrium by 1990 and would show surpluses from 1990 onwards. The current account deficit (excluding transfers as revenues) would drop from 8.2? of GDP in 1987 to 42 in the 90s and the country's dependency on foreign transfers would be steadily reduced from 3.6Z of GDP in 1987 to less than 22 in 1993. 63. Domestic resource mobilization also needs to improve. National savings (including foreign transfers) would increase from 10.7Z of GDP in 1987 to 17.1? in 1992 (Table 7). Both public savings and private sector savings would increase. That is the reason why actions to improve incentives for new investmenta and a more efficient and stronger financial sector are an essential fea-ure of the program.  - 19 - Table 7: HONDURAS -- SAVINGS REQUIREMENTS, 198692 (As percent ot GDP) 198? 1988 198 19O 1991 1992 Total Flnancing 15.8 18.0 17.0 18.0 18.0 19., Foreign Savings 4.0 2.5 2.4 2.0 1.9 1.e National Saving.19.7 18.5 14.? 16.9 16.7 17.1 Public 2.1 2.8 8.8 4.6 4.7 4.7 Prlvate 8.7 11.2 10.8 11.5 12.0 12.C 64. iublic finances is another critical element for the success of the program. The public sector deficit (including foreign transfers as revenue) needs to drop on a cash basis from 4.8? of GDP in 1987 to 2.3S in 1989 and afterwards. External financing would provide about half of the financial requirements; the other half would have to come from non- inflationary domestic sources. If these actions materialize, public savings, which were 22 of GDP in 1987, would increase to more than 4? after 1990. D. Loan Amount and Tranchina 65. The proposed loan of US$50 million would meet about 10? of Honduras' annual gross financing capital requirements for 1988-89. It is equivalent to about 5? of merchandise imports during the period. The loan would be disbursed in two equal tranches. The first would be released for disbursement upon loan effectiveness. The second would be made available in early 1989, after compliance with the second tranche conditions. The proposed tranching would allow the Bank to ensure that the entire adjustment program for 1988 is carried out and that the necessary pre- conditions for continuation and extension of the program in 1989 are established. 66. Release of the second tranche (expected to take place early in 1989) would be conditional on satisfactory progress toward setting the basis for an improvement, beyond the program, of the macroeconomic policy framework and a satisfactory plan showing how the estimated foreign exchange requirements during 1989 would be met and on: (a) Achievement of target for reduction of the consolidated public sector deficit by at least L65 million on a cash basis during July-December 1988. (b) Approval by Congress of the 1989 Central Government budget. Approval by Executive Branch of 1989 budget for autonomous institutions. Verification that both budgets together would achieve reduction of consolidated public sector deficit by at least 1.8? of GDP on a cash basis in 1989, compared with 1988 level, and that the Central Government budget would reduce Central Government current expenditures (excluding increase in interest payments) to 17.6? in 1989, compared with 18.3? in 1987.  - 20 - (c) Agreement on a public investment program for 1989 that would limit public investment expenditures to no more than 52 of GDP. (d) Agreement on an administrative reform program to improve tax collections in 1989. (e) Agreement on an action plan with monthly targets for 1989 for esecuting CONADI's program for enterprise divestiture, as defined in Decretos Nos. 161/85 and 197/85. (f) Preparation of a program of reforms for autonomous institutions to be initiated in 1989. Preparation of a plan of action to rationalize expenditures, investment, and management of ENEE and to restructure its financial debt during 1989. (g) Verification that the import list defined for purchase exclusively with foreign exchange procured at free market rate (i.e. to be excluded from access to foreign exchange at the official rate) and the system for control and registration of CETRAs are in effect. (h) Approval by Congress of legislation eliminating tariff exemptions and surcharges. (i) Verification of compliance with monetary targets for December 1988, as follows: (') Total domestic credit, L2,292 million; (2) Total credit to the public sector, L1,278 million; (3) Total Central Bank credit to the Central Government, L739 million. (j) Increase of the rediscount rate on Central Bank lines of credit to 102 on January 1, 1989, except for basic grains. (k) Presentation to Bank of an action plan to be based on the conclusions and recommendations of consultants selected to carry out a study to identify measures for strengthening the Superintendency of Banks. B. Creditworthiness 67. If the proposed adjustment program is implemented, Honduras' long- term creditworthiness would be strengthened. Three major factors contribute to this result. First, Honduras' external debt would remain manageable, growing slowly through 1992, and declining as a proportion of GDP from about 632 in 1987 to about 512 in 1992. Second, a significant  - 21 - fraction of the debt would remain on concessional terms. Third, non- traditional exports would grow at an accelerated rate, leading a stronger growth of exports in general. As a result, all debt indicators would improve. The debt-service would decline from 39Z in 1987 to less than 251 in the same period. IBRD debt-service ratios would increase from 19.4 in 1987 to 21 in 1990 as the result of the Bank's support to the Government's three-year economic program. The ratio of debt to exports would drop from 2.5 in 1987 to 1.9 in 1990. The ratio of interest payments to exports would drop from 17Z to 122. F. Poverty Impact 68. About half of Honduras' population of 4.3 million lives in poverty. About 82? of the rural population and 44? of the urban population earn less than L1500/year (US$750/year). Unemployment levels exacerbate the poverty condition. Though reliable statistics scarce are they indicate that over half of the labor force (over 12 years of age) is unemployed or underemployed. Moreover, the demand for employment will increase as a result of the rapid rate of population growth experienced in the last two decades. It is estiiated that the combined effect of population growth and migration will lead to a doubling of the labor force in urban areas by 1995, and that the rural labor force will increase by 39?. Thus, unless productive jobs are created, unemployment in Honduras will increase, adding large numbers of persons to the population currently living in poverty. 69. The condition of the poor is not alleviated significantly by health and nutrition programs, owing to inadequate access of the poor to such programs. Indeed, most of the beneficiaries of public sector services are civil servants, professionals (teachers, banking personnel), and middle class urban workers, the great majority of them living in Tegucigalpa and San Pedro Sula, Honduras' two largest cities. The total number of beneficiaries receiving nutrition or health services from the public sector in 1987 was about 206,000, compared with about 2.1 million people living in poverty. 70. The challenge, then, lies in defining an economic program which would provide for the creation of productive employment and better delivery of social services to the poor in Honduras. The initial stages of the Government's adjustment program may temporarily deepen poverty in Honduras; expenditures will have to be cut, increasing unemployment in the short term. However, poverty would increase more without the proposed program: under recent policies, an inflation-cum-devaluation cycle would develop that would deepen poverty. The Government's adjustment program will incorporate measures to ameliorate the adverse impact on the poor: cuts to public services directed to the poor would be minimized, and the Bank's review of the 1989 public expenditures program will facilitate minimization of the negative consequences of cuts in expenditures. Under the second phase of the program, which the Bank proposes to support with a second SAL, measures will be defined to better target public social expenditures to the truly needy. Finally, the opening of the economy should help improve productivity and therefore increase real wages and employment.  - 22 - G. Risks 71. The difficult political situation in Honduras highlights the substantial risk associated with the proposed adjustment and lending strategy. The likely initial increase in unemployment could disturb the relatively peaceful equilibrium that Honduras has enjoyed, adding to the Government's own perception of the political risk of adjustment. Further, the Government is nearing its last year in office, and the political campaign to replace this administration has already started, increasing the difficulties of reaching consensus for the adjustment policies--a difficult and time-consuming process. 72. On the positive side, the financial crisis facing the country has become apparent both to political leaders and to the private sector, raising their awareness of the need to undertake the agreed reforms quickly. Their concern has led to increased willingness to accept measures they would otherwise resist, providing the Government (and the Bank) with a window of opportunity to enact the adjustment measures in the next few months. Provided the proposed financial support from external donors materializes according to the proposed schedule, the support of important groups can be consolidated, giving continuation of the adjustment program through 1989 and beyond a good chance of success. Therefore, we believe the risks are manageable. R. Procurement. Disbursement. Administration and Auditing 73. International competitive bidding would be required for all eligible purchases exceeding US$5.0 million. The purchasers' normal procedures would be followed for purchases of lesser value. Private firms would follow normal commercial practice. Public sector imports would be purchased in accordance with standard Government practices, which assure reasonable prices. 74. The loan would finance the CIP cost of eligible imports for which payment is made after loan signing. Retroactive financing will be permitted for up to US$10 million for imports for which payment was made after May 15, 1988, but before loan signing. Public and private sector imports would be eligible, except for military equipment and luxury consumer goods. The Central Bank would be responsible for the coordination and collection of relevant documentation and preparing withdrawal applications under the loan. Applications would be submitted to the Bank using statements of expenditure; the Central Bank would retain all detailed documentation for review by the Bank as required. Collaboration with the IM? 75. Close contact has been maintained between Bank and IMF staff throughout preparation of the program. However, IMF staff have been unable to participate actively in the Bank's policy discussions with the Government regarding the program. The Government has indicated its willingness to clear all arrears with the Fund in the near term and its  - 23 - interest in initiating conversations on a Stand-By Arrangement as soon as payment is completed. Provided arrears can be cleared, the Governnent expects that formal negotiations of a Stand-By Arrangement for 1989 could take place in late 1988. Agreement on such an Arrangement would reinforce the stabilization efforts made during 1988, and help strengthen the foundation for structural adjustment in the medium term. Therefore, the Bank has and will continue to strongly encourage the Government to take the necessary steps toward a successful conclusion of negotiations with the IMF. PART IV - BANK OPERATIONS STRATEGY 76. Since 1955, Honduras has received 33 Bank loans totalling US$543.5 million and 12 IDA credits totalling US$85.0 million, both net of cancellations. Of the Bank Group's total lending to Honduras, 39t has been for the energy sector, 24Z for transportation infrastructure, 172 for agricultural credit and regional development, 152 for industrial credit and tourism, 2Z for education, 32 for water supply and drainage, and 1S for municipal development. Bank Group lending initially concentrated on developing basic infrastructure in transport and power, where inadequate facilities hampered the development of the country. In the last decade, it has diversified to support expansion of productive capacity in agriculture, industry, and tourism, and to address major needs in education and water supply. 77. The Bank's strategy for Honduras emphasizes medium-term structural adjustment. In view of the urgent need to address the macroeconomic issues in order to lay the basis for adjustment in the medium term, however, the Bank's strategy is also focussed on short-term macroeconomic adjustment, an effort which has been fully discussed with the rMF. The reallocation of US$20 million under the Third Industrial Credit Project, approved by the Executive Directors in March 1988, to finance general imports supported the first steps of this short-term adjustment. The proposed structural adjustment loan would support the complete 1988 action plan for adjustment. 78. In 1989, the Government has agreed to continue and to deepen the process of adjustment by following through the macroeconomic adjustment effort begun in 1988 and focussing increasingly on the structural issues thwarting development. Bank support for the Government's effort could continue through a second SAL operation next year. In preparation for this operation, the Bank will be carrying out a complete public sector expenditure review before the end of 1988. The purpose of the review will be to identify areas of potential reduction in current expenditures and to help the Government to rationalize its investment planning process through application of economic criteria for project selection. Such operation would also support the Government's work toward the design of an overall tax reform, advance reforms in other areas, such as the trade regime and financial sector management, and continue institutional improvements in public sector management, particularly in tax administration.  - 24 - 79. To achieve and sustain the increases in public savings necessary for medium-term stability and growth, strong actions are needed in the management of the public enterDrise sector. The Government plans to undertake a major overhaul of the management of the public enterprises, with a view to increase their operational and financial efficiency as well as the discipline governing their financial relationship with the Central Government. The Bank could support this effort through a public enterprise loan, focused on 10-15 of the largest enterprises. The severe adverse impact that the deficits of ENEE, the electric power company, have had on the Central Government's fiscal accounts in recent years warrant special attention to this enterprise. A separgte operation will therefore be proposed to address ENEE's problems. The programs designed as the basis for these loans would be carefully linked with the objectives and constraints imposed by SAL I and II, to assure consistency with the macroeconomic adjustment process. 80. The key factors constraining export growth include the overvalued currency, the generally high level of protection in the trade regime, and the wide dispersion of protection resulting from both the range of nominal tariffs and from the complex structure of exemptions and surcharges in place. The distortions resulting from the last problem will be partially corrected under SAL I, from the elimination of the exemptions and phasing out of surcharges. SAL I will also begin the process of adjustment of exchange rate management, to be followed up in 1989. Once sufficient adjustment in the real exchange rate is achieved, a program of trade liberalization will be important to improve the competitiveness of exports. In preparation for the design of a reform of the trade regime aimed at the reduction of the level and dispersion of effective protection, a study would be carried out in 1989. The Bank could support this process under SAL It and through an export development loan. 81. Key issues to be addressed in the agriculture sector include elimination of restrictions and government intervention in basic grains markets, reduction of public sector participation in production and distribution of improved seeds and rental of agricultural machinery, elimination of public sector participation in export marketing of forest products and establishment of improved mechanisms for efficient management and protection of forest resources, and improvement of credit distribution systems. An agricultural credit loan, scheduled for Board consideration after SAL I, would address the last issue. The others would be addressed under SAL II and would be the focus of an agriculture sector loan planned for Board consideration in FY90. 82. Financial intermediation is a major source of inefficiency in the economy, contributing to low domestic savings; intermediation costs are high, and real interest rates remain highly positive, in spite of excess liquidity in the banking system and relatively low inflation. Both the policy framework for the sector and the mechanisms and capacity for supervision of banks by the Central Bank need to be strengthened. The process has begun, with the help of technical assistance provided under the Third Industrial Credit Project. A financial sector loan could support further actions for the sector.  - 25 - 83. The above strategy is conditional on the continued willingness and ability of the Government to carry out the adjustment effortt it will require constant close monitoring and may require interim adjustments to the strategy as events develop. Proceeding with each successive step would be contingent on satisfactory implementation of agreed actions. The first timetable oi such actions will be incorporated into the SAL agreement. Each sector adjustment loan would be coordinated with and tied to the SAL, as well as to relevant elements of other sector loans, where appropriate. The tranching of disbursements under all adjustment loans would be matched to Government performance in meeting agreed conditions, thus assuring that the risks attached to increases in Bank exposure are managed through improvements in the country's medium-term prospects and creditworthiness. 84. As the process of adjustment advances and creditworthiness is strengthened, the Bank would gradually increase project lending. The sectors and projects to be supported by such lending would be identified in the course of the examination of the public investment program included In the public expenditure review planned for late 1988, to be carried out with the Bank's collaboration (para. 50). Collaboration with Other Agencies 85. Even with the strong Bank support envisaged, the success of Honduras' economic adjustment program still faces clear risks unless strong financial support is obtained from other bilateral and multilateral sources (para. 61). The improvement of Honduras' creditworthiness strongly depends on its access to external financing that would remain largely on concessional terms. Some of the financing would be provided by USAID and the IDB. USAID has approved a US$75 million ESF for 1988-89. IDB has a major investment program which is essential for the satisfaction of the country's infrastructure requirements. Preliminary discussions with officials from other bilateral agencies are scheduled in October 1938, when a Consultative Group meeting hosted by the Bank takes place in Paris. PART V - RECOMMENDATION 86. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank and recommend that the Executive Directors approve it. Barber B. Conable President Attachments Washington, D.C. August 25, 1988  26 - sOAS - UA1OAnL ACCWS AN EX I 1986 Par Ca ito CNP In US6: 740.0 ----A----------------------- ttachment Is Nid-1986 Population (mile.) 4.53 (Pi 1 of 2) Actu l Pr - Projected A. National Accounts ---------------___-----___-----------____-----______--___ --___________ -__ --_-- (As S ot current CDP) 1I7O 17 1980 1961 19S2 1c8a 1964 1985 1986 1907 1968 1989 1990 199 Crose Dosetic Product *.p. 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.. 100.0 Net Indirect Taxes 10.1 9.8 10.6 10.8 10.0 10.2 10.9 12.1 12.4 12.1 12.1 12.1 12.1 12.1 Agriculture 29.7 26.9 24.1 22.7 22.5 Z2.9 21.4 21.0 21.6 21.9 21.9 21.9 21.9 21.9 Industry 1.S 20.2 20.6 19.6 21.3 21.1 21.2 20.1 19.0 16.6 18.6 18.6 16.6 18.6 (of which tianufecturing) 13.0 14.2 13.5 18.1 18.8 1S.8 14.1 13.3 12.7 15.86 -- -- _ Services 41.7 48.1 44.7 46.9 46.2 46.4 46.5 46.6 47.0 59.6 59.8 59.5 s9.s s9.5 Reegurce Balance -6.5 -9.0 -7.2 -6.4 -1.8 -8.7 -t.8 -4.5 -1.4 -2.7 -0.9 -0.5 0.0 0.5 Exports of a8S 29.2 80.7 87.1 81.9 26.7 26.6 26.8 26.0 26.7 24.5 25.5 28.6 27.5 29.0 Imports of G4FS 85.7 89.7 44.8 88.8 26.S 80.8 98.1 SO.5 28.1 27.1 26.4 27.1 27.8 28.5 Total Expenditures 106.8 109.0 107.2 106.4 101.8 103.7 106.8 104.S 101.4 102.7 100.9 100.5 100.0 99.5 Total Coneumption 64.6 10.0 62.7 68.7 66.8 88.8 67.8 S6.4 88.7 07.4 64.9 08.4 81.9 80.8 Privats Consumption 72.6 77.6 69.4 72.0 74.4 '74.8 78.1 71.4 70.6 71.8 59.8 69.0 67.9 65.3 General Government 12.0 12.4 18.8 18.7 18.9 14.5 14.7 15.0 l.1 16.0 1S.1 14.5 14.0 14.0 Cros Dometic Investent 21.9 19.0 24.5 20.7 18.5 14.9 19.0 18.1 1I.7 15.8 16.0 17.0 18.0 19.2 Fixed Investment 19.4 21.2 24.3 16.9 16.8 17.8 19.8 17.6 15.1 14.8 16.0 17.0 18.0 19.2 Chances in Stocks 2.5 -2.2 0.2 1.8 -8.8 -2.9 -0.8 0.8 0.6 1.0 0.0 0.0 0.0 0.0 Cros Domestic Saving 15.4 10.0 17.8 14.8 11.7 11.2 12.2 18.6 14.8 12.6 15.1 16.6 1S.1 19.7 Net Factor Income -3.8 -2.6 -6.0 -5.5 -7.0 -8.0 -S.S -5.6 -5.6 -5.5 -8.0 -4.9 -4.7 -4.1 Net Current Transf.er 0.9 1.6 0.8 1.0 1.0 1.8 2.5 4.2 4.2 8.6 8.4 8.0 2.7 1.9 Gross National Saving 18.0 9.0 1.1 9.8 5.7 T.? 9.2 12.8 12.9 10.7 13.5 14.7 16.0 17.5 Actual Pr.. Projected 8. National Accounts Growth ----------------------__------------_ (Constant Prices) 70-7S 75-80 1980 191 190 192 1964 1965 1966 197 1988 19 1990 -W93 Oroa Domestic Product *.p. 8.7 ?.8 1.8 1.5 -2.0 -0.2 2.8 8.2 2.7 4.2 1.5 1.5 8.0 4.0 Net Indirect Taxes 8.1 9.0 22.7 3.2 -8.7 1.? 9.6 14.1 5.8 2.2 1.5 1.5 3.0 4.0 Agriculture 0.0 6.1 -1.7 8.1 0.8 -0.1 2.0 2.9 1.4 5.6 1.5 1.8 8.0 4.0 Induotr2y 6.4 8.1 -6.1 -8.5 3.9 1.4 8.4 -1.6 0.2 1.7 1.6 1.S 8.0 4.0 (of which Nanufacturing) 6.8 6.2 -2.9 -2.4 -8.6 S.3 8.4 -2.2 2.7 1.5 -- -- -- -- Servies 8.4 7.8 2.7 5.0 -4.8 -1.5 0.4 2.9 8.9 5.0 1.5 1.5 8.0 4.0 Exports of NFS 0.2 6.4 -8.8 2.8 -11.8 9.5 1.6 2.7 4.4 2.8 4.4 8.4 8.9 5.2 Imports of CNFS 1.0 10.0 8.6 -12.2 -27.7 17.9 16.6 0.4 -0.5 1.5 -8.9 5.0 5.1 5.0 total Expenditures 2.8 8.7 4.8 -4.2 -7.6 1.4 ?.9 2.4 1.0 4.0 -0.7 1.4 2.8 8.9 Total Consumption 8.8 7.7 8.3 -0.5 1.0 -1.7 1.5 8.2 8.1 4.9 -1.2 0.1 1.6 8.4 Private Consumption 3.1 7.S 8.8 -28.4 -96.2 15.6 1.5 14.5 8.9 4.0 -0.6 0.7 1.8 8.8 Omneral Oov.rnment 4.5 6.7 11.8 -13.2 6.5 18.8 84.8 -14.1 -19.6 9.0 -4.1 -2.4 0.1 4.1 Gross Dometic Investmet 1.1 12.2 -4.9 -16.2 -40.8 21.3 41.1 -0.7 -7.1 -1.0 2.2 8.3 9.4 6.2 Fixed Investment 5.6 9.7 9.9 -52.7 -17.4 14.6 19.8 -8.2 -9.0 -4.8 9.2 0.8 9.4 6.2 Capceity to Import -0.1 11.7 -4.9 -12.5 -18.8 10.6 5.8 7.8 11.2 -4.5 4.6 6.6 7.1 5.5 Term of Trade Adjustment 17.6 -19.0 -20.5 202.0 15.9 6.7 -10.8 -18.1 -24.2 -7.8 0.2 1.5 1.8 0.8 Crom Domestic Incme 2.6 9.1 2.0 48.8 -.4 -4.9 4.2 4.7 4.6 2.4 1.5 1.8 8.8 4.1 Gros Nationl Income 2.9 0.4 1.8 -4.2 -4.4 0.7 4.0 4.8 4*5 2.8 2.1 1.9 8.5 4.8 arms National Product 4.0 6.6 0.7 2.8 -3.7 1.8 2.5 2.7 2.8 4.7 2.1 1.6 8.2 4.2 Cress Doemetic Saving 7.0 1.9 -26.6 16.5 -26.9 18.4 7.4 0.6 -1.0 0.8 18.6 0.7 10.8 6.5 Net Fater Income -8.5 82.8 18.4 -18.8 87.1 -24.2 6.2 12.7 9.9 -4.9 -9.4 -1.0 -1.5 -0.6 Net Currant Tranfoere - - -- -- - - - - - -16.5 -7.0 -10.4 -4.7 -6.4 Cross National Saving 9.6 -8.8 -85.6 80.5 -42.5 49.4 7.1 -4.0 -5.7 -2.9 28.8 7.7 10.4 6.6  - 27 - *WMA - lai04A lttM~ tcwnSinu.d At I AttachMnt Is (Page 2 of 2) Actual Pro. Projected Croth Rates. S .-. C. Pritc Indices (19800100): 1i0O 1991 1902 19683 194 1908 1906 1907 l96 1909 70-75 7540 04-7 Consumr Price. (IFS 64) 100.0 109.4 119.2 129.1 185.2 189.7 145.6 149.4 161.8 171.4 6.4 9.6 5.6 Implicit 00P DeOtetor 1CO.0 107.5 113.7 119.5 124.4 130.2 187.4 140.2 152.1 161.7 6.8 9.7 4.0 Itplicit Sapendituroe DO lator 100.0 l11.0 121.5 127.8 130.5 184.8 140.4 145.4 188.5 168.0 7.7 8.0 S.S 0. Other Indicators: 70-75 75n60 S0-67 t7-90 90-99 1970 1975 1900 1904 1905 1I06 Groeth Ratea ( p.u.): Share o Labor Population (UFS a) 8.2 8.6 8.8 2.9 2.9 ----- Labor Force 2.8 2.8 8.0 - -- Agr;culturre 68.85 60.01 55.t 83.45 83.41S 68.51 Oro" Not l. Inc.. p.C. 0.5 -4.4 2.8 -0.8 1.8 Induetr 18.4% 14.91 17.01 18.05 18.05 17.95 Privet. Conaumption p.c. 0.1 -8.6 1.9 -1.4 0.4 Service. 28.15 5.25 27.2i 28.65 28.6S 23.65 tIport Eletiaity: TYOt I 1005 10t tOO1 1o00 1005 1001 Zporta (O*FS) / ODP(mp) 0.27 1.87 -o.99 0.76 1.24 marginal Savings Rot": 0t wrt. 04W 0.59 -0.07 0.17 0.78 0.23 0DS art. WY 0.55 0.04 0.28 0.68 0.60 COFR (Ieggd): 7.2 4.0 12.7 10.1 5.6 Actual Pr.. Projected E. National Account -------- -- (1960 ln. LeWira) 1900 1981 1982 1988 1984 1985 1986 1987 1988 1989 19O 1991 1992 199S eroea Doastic Product a.p. 8.088 5.164 5.061 S.051 S. 192 5.868 .S508 5.74 5.820 S 900 6.088 6.298 eS650 6s,44 Net Indirect Taxes 89 586 509 516 86 64 654 698 709 719 741 767 798 834 Agriculture 1,228 1.266 1,272 1.271 1.297 1.884 1.S8 1.429 1.480 1.472 1.516 1,869 1.632 1.705 Induatry 1,047 98 M99 1.009 1.064 1.047 1.049 1,067 1.088 1,09 1.222 1.172 1,218 1.273 (of which anufacturing) 687 671 646 681 788 722 741 782 - -- - - - -- Services 2,274 2.384 2.235 2,234 2.266 2,832 2.418 2,539 2,587 2,616 2,694 2,789 2,900 8.031 PACure Wilac (870) (51) 270 175 (79) (86) 60 7Y 247 237 297 818 844 864 Export. of tNS 1.666 1929 1,702 1,668 1.693 1,944 2,080 2,077 2,169 2.2e6 2,420 2.849 2,684 2,820 Import, of aS 2,26 1,901 1,482 1,688 1,972 1,980 1,970 2.000 1922 2,019 2,128 2,260 2,f40 2,456 Total Ep.Wnditurea 8.458 8.216 4,791 4.876 5,271 5,894 5,448 8.87 5,874 5,640 8,787 8.979 6.206 6,480 Toetl Can.uaption 4,210 4,170 4,167 4,119 4,203 4,888 4.4S 4.681 4.,76 4,60, 4.605 4.720 4,866 8,065 Private Conuwmtion 8,852 8,881 8.529 8.892 8,223 8,492 5,781 83944 8.869 8.870 8,918 4.008 4,122 4.28S General Governant 678 S 889 727 90o 841 676 787 707 90 890 715 744 779 Groe DOmetic nvestmnt 1,240 1,048 624 787 1,069 1,01 986 976 998 1.0180 1,182 1,269 1,840 1.416 Fiexd Inveatmnt 1,235 988 769 904 1,0608 1.048 94 917 1,001 1,084 1,166 1.264 1,845 1,421 Chenna in Stock, is 91 (164) (146) (14) 18 82 s5 (4) (4) (4) (8) (8) (5) Capacity to Import 1,8 6 1,"60 1,86 1,490 1,883 1,698 1,084 1,827 1.918 2,048 2,187 2,810 2,484 2,611 Term of Trade AdJuatment 0 (270) (8) (36) (810) C247) (146) (280) (254) (242) (238) (239) (49) (249) Oroag Domestic Inco. 5,068 4,895 4.798 4.686 4,861 8,112 8,857 8,485 8,6 5,6661 83,82 6,059 6,801 S,95 a National Inca" 4,781 4,6110 4,365 4,411 4.865 4,777 4,969 8,184 8,249 ,8812 8,842 5,7S8 S,997 6.294 Gross National Product 4,781 4,900 4,690 4,776 4,695 8,028 8,U15 5,884 5.506 8,8s9 5,n77 5,994 6,246 6.542 Groin Donmetic Saving O76 75 61 S 67 680 m9 9o0 SO8 9 1,106 1,247 1.889 1,484 1,681 Not Fector Inca.. (S07) (62 (6 (SW (6) O0) (1) (814) (810) (02) (804) 14 turrent Transf.r, -