Honduras - Energy Sector Adjustment Program Project

Dmecut of The World Bank FOR OMCLAL USE ONLY Repot No. P-5592-HO REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION ON A PROPOSED CREDIT OF SDR 37.95 MILLION (US$50.6 MILL-ION EQUIVALENT) TO THE REPUBLIC OF HONDURAS FOR AN ENERGY SECTOR ADJUSTMENT PROGRAM SEPTEMBER 19, 1991 This document has a restricted distribution and may be used by recipients only in the performance of thedr oMfcial ties. Its contents may not othenvise be disclosed witbout World Bank authorization.  CURRENCY EQUIVALNITS (as of September 13, 1991) Currency Unit Lempira US$1.0 a L 5.30 L 1.0 = US50.19 FISCAL YEAR January 1 to December 31 WEIGHTS AND MEASURES Electricity kVA - Kilovolt ampere kW - Kilowatt kWh = Kilowatt hour GWb (Gigawatt hour) - 1,000,000 kWh kV (kilovolt) = 1,000 Volts MW (Megawatt) - 1,000 kW GLOSSARY OF ACRONYMS CAP Petroleum Administrative Comiission (Comisi6n Administrativa de Pdtroleo) CG Consultative Group COBDEFOR Forestry Development Corporation (Corporaci6n Hondureina de Desarollo Forestal) CONAMA National Commission of the Environment and Development (Comisi6n Nacional del Medio Ambiente y Desarrollo) CP Contract Plan CSIR Country Strategy and Implementation Review DGMH General Directorate of Mines and Hydrocarbons (Direccidn General de Minas e Hidrocarburos) KNEE National Power Company (Empresa Nacional de Energfa Eldctrica) ENP National Port Company (Empresa Nacional Portuaria) ESAP Energy Sector Adjustment Program ESMAP Energy Sector Management Assistance Program FIAS Foreign Investment Advisory Service FHIS Honduran Social Investment Fund FRP Financial Rehabilitation Program GOH Government of Honduras GTE Technical Energy Group (Crupo Tdcnico de Energfa) HONDUTEL National Telecommunications Company (Empresa Hondurenia de Telecomunicaciones) IDA International Development Association IDB Inter-American Development Bank IFAD International Fund for Agricultural Development KfW Kreditanstalt Fur Wiederaufbau MIS Management Information System MNR Ministry of Nattonal Resource s (Secretaria de Recursos Naturales) MOE Ministry of Education MOH Ministry of Health MORP Management and Operational Restructuring Program NEC National Energy Commission (Comisi6n Nacional de Energia) OAS Organization of American States PLP Petroleum Liberalization Plan PPAR Project Performance Audit Report PURC Public Utilities Regulatory Commission (Comisi6n Nacional Supervisora de Servicios PLblicos) SAL Structural Adjustment Loan SANAA National Water Company (Servicio Aut6nomo Nacional de Acueductos y Alcantarillados) SECAC Sector Adjustment Credit SECPLAN Ministry of Planning (Secretaria de Planificaci6n) STENEE Worker's Union of ENEE (Sindicato de Trabajadores de ENEE) UNDP United Nations Development Programme  FOR OFFICAL USE ONLY ENERGY SECTOR ADJUSTMENT PROGRAM Table of Contents Paae No. CREDIT AND PROGRAM SUMMARY ...................................... i-ii PART I - COUNTRY POLICIES AND BANK GROUP ASSISTANCE STRATEGY .... 1 A. Legacy of the Past ...................................... 1 B. Government's Adjustment Program ........... ................. 2 C. Agenda for Reform ......................, 3 D. Macroeconomic Stabilization and Adjustment Performance ...... 5 E. Recent Economic Developments ............................... 7 F. Medium Term Projections and Financing Requirements ... ...... 8 G. Country Assistance Strategy ................................ 10 H. Relations with the IMF ..................................... 15 I. Summary Assessment ......................................... 15 PART 1I - THE SECTOR ADJUSTMENT PROGRAM ......................... 16 A. Sector Background ........ .................................. 16 S. Government Program ....... .................................. 17 Energy Sector ............................................ 17 Policy and Strategy .................................... 17 Institutional Framework ...... .......................... 17 Interfuel Substitution ............................... . 18 Electric Power Subsector ................................. 18 Corporate Autonomy ............................8......... I Management and Operational Performance ............. .... 20 Investment ............................................. 22 Sector Finances ........................................ 23 Electricity Pricing ...... .............................. 25 Petroleum Subsector ....... ............................... 27 Exploration ............................................ 27 Supply Management ....... ............................... 27 Private Sector Participation ..... ........................ 28 Environment .............................................. 29 PART III - THE PROPOSED OPERATION ..... .......................... 30 A. Background ............... . . 0..... 30 Bank Group Involvement in the Energy Sector ........... ... 30 Rationale for the Proposed Operation . . ........ ... 31 B. Project Cost and Financing ... ........................... 32 Adjustment Component ..... ... ................ 32 Technical Assistance ... ................ . ................ . 32 This document has a restricted distribution and may be used by recipients only ir tt. 3 performance of their official duties. Its contents may not otherwise be disclosed without World Dlla-.k authorization.  - is - C. Credit Conditions .......................................... 33 Actions Taken Prior to Board Presentation . . 33 Effectiveness and Tranche Release Conditions ........... .. 34 (i) Conditions for Release of the Second Tranche ... 34 (ii) Conditions for Release of the Third Tranche ...... 34 (iii) Events of Default ............. .. ................. 35 D. Procurement, Disbursement and Audit Reporting .......... .... 35 Procurement ..................................................... 35 Disbursements ................. I ......................... 36 Audit Reporting . * .................................. 36 E. Benefits, Risks and Environmental Impact ........ ........... 36 Benefits ................................................. 36 Risks ... ................................................. 37 Environmental Impact . ........ . .................... 38 PART IV - RECOMMENDATION ........................................ 38 ANNEXES I Country Economic Data . . . 39 II Statement of Bank Loans and IDA Credits and IFC Investments ...46 III Letter of Sector Development Policy ...48 IV Policy Matrix ...56 V Electric Power Subsector - Evolution, Situation and Prospects .61 VI Contract-Plan: General Outline .. ...70 VII ENEE's Financial Rehabilitation Plan .... ............ 76 VIII Petroleum Liberalization Program ... 81 IX Supplementary Credit Data Sheet .84 Map IBRD 22912 - Honduras Electric System  HONDURAS ENERGY SECTOR ADJUSTMENJT PROGRAM JESAP Credit and Program Summary ftEr,owerz Republic of Honduras IWEMSENnting A=cenav Governmenrt of Honduras (GOH) Amount: SDR 37.95 million (US$50.6 million equivalent). Termss 40 years, including 10 years of grace, with a charge of 0.75% p. . Descrigtion: The proposed operation would support the GOH's comprehensive program of reforms in the energy sector, within the framework of its ongoing structural adjustment program. It would be cofinanced by the Inter-American Development Bank (IDB) through a US$105 million hybrid loan (US$55 million adjustment, US$50 million investment). The main objectives of the reform program are to: (1) establish a comprehensive energy policy and strategy and a sound regulatory framework; (2) strengthen the efficiency, planning and financial soundness of the national power company (ENEE); (3) improve electricity pricing and resource allocation in the sector; (4) promote petroleum exploration and production; (5) liberalize petroleum product trade; and (6) encourage greater private sector participation in the development of the energy sector. To achieve these objectives, the program includes the following main elements: (1) sector institutional reform and strengthening; (2) electricity pricing to be based on sound economic criteria and financial improvement targets; (3) clearer policy-making and supervisory responsibilities on the part of the GOH and performance accountability on the part of ENEE through a contract-plan; (4) a Management and Operational Restructuring Program (MORP) to improve ENEE's performance and a Financial Rehabilitation Plan (FRP) to restore ENEE's financial soundness; (5) detailed Dlans of action, which include; Lfo Power, targets calling for significant improvements in ENEE's operations, such as progressive reduction of electricity losses and of accounts receivable, and steps to set rates at levels consistent with long-run marginal costs; and tor ,etroleum, liberalization of imports in a first phase followed by a second phase for liberalizing retail sales; and (6) technical assistance for (i) petroleum exploration promotion and related environmental protection regulations, (ii) deregulating the petroleum industry, and (iii) carrving out an interfuel substitution study to address inter alia concerns about deforestation through excessive use of fuelwood.  ii jd 4lLkJs. The Energy Sector Adjustment Program (ESAP) would alleviate the heavy financial burden of the electric power subsector on the Government budget by making ENEE a financially viable entity capable of servicing its large debt. It would also address the constraints posed by the country's sizeable oil import bill (about US$143 million or 13% of total export earnings for 1990) by promoting the development of Honduras' oil and gas potential by the private sector. A sound pricing policy for both electricity and petroleum products would be central to the reform program, and would promote energy conservation, and reduce investments required in the future. Environmental concerns would be addressed through the enforcement of strict rules for both investment and operations and by providing technical assistance for the preparation of environmantal protection regulations with respect to petroleum exploration. The main risks facing the ESAP are the possible lack of political support to continue with institutional changes and pricing actions, in the face of labor union opposition, public discontent with continued austerity policies and the upcoming election cycle. Other risks are linked to the success of the economic adjustment/stabilization program of which the proposed operation is an important part. These risks are tempered by the Government's commitment to the energy and macroeconomic adjustment programs, as evidenced by the significant reforms already introduced. Estimated Digbursements: The proceeds of the proposed operation would be disbursed in three tranches; the first tranche of SDR 15 million (US$20.0 million equivalent) at effectiveness (estimated for December 1991); the second tranche of SDR 11.25 (US$15.0 million equivalent), when the intermediate steps of the program have been satisfactorily implemented (estimated for August 1992); and the third tranche of SDR 11.25 (US$15.0 million equivalent), when all the reforms under the program have been completed (estimated for March 1993). US$0.6 million equivalent would be disbursed for consultant services engaged for technical assistance, during a 24 month period. Retroactive financing for up to 20% of the credit amount (US$10 million equivalent) is be_.ng proposed for eligible expenditures incurred after May 15, 1991.  INTERNATIONAL DEVELOPMENT A8SOCIATION REPORT AND RECOMMENDATION OF THE PRESXDENT TO THE EXECUTIVE DIRECTORS ON A pQP-OED ENERRY SECTOR ADJUSTMENT PROGRAM CREDIT TO THE REPUB : OF HONDURAS 1. I submit the following report and recommendation on a nroposed credit in the amount of SDR 37.95 mil4ion (US$50.6 million equivalent) to the Republic of Honduras in support of the implementation of an Energy Sector Adjustment Program (ESAP). This program is described in a Letter of Energy Sector Development Policy received from the Government (Annex III). The credit would be on s%andard IDA terms, with an amortization period of 40 years, including a grace period of 10 years. The Interamerican Development Bank (IDB) is cofinancing the program through a US$105 million sector adjustment and investment hybrid operation (US$55 million adjustment, US$50 million investment), of which US$46 million would be on concessional terms and would be allocated to the adjustment component of the operation. PART I - CONY POLICIES AND BAN ROUP ASSISTA-NC 8. .S M'K A. LEGACY OF THE PAST 2. Honduras ranks among the least developed countries in the Western Hemisphere. Although some economic progress has been made over the last two decades, per capita GNP in 1990 remains low at an estimated US$538. Furthermore, 40 percent of the population over 10 years of age is illiterate, 72 percent of children under 5 years suffer from malnutrition, the infant mortality rate is nearly 79 per 1,000 live births, and 60 percent of the population is inadequately housed. About 75 percent of the population lives in poverty conditions. 3. Until recently, Honduras' development strategy was based on import-substitution, industrialization behind high protective barriers, and extensive government intervention involving credit subsidies, price controls and tax incentives. This created strong price distortions and kept productivity low. In the 1970s, GDP growth averaged an annual rate of 4.5 percent, bolstered by high expenditures (both public and private) financed by the country's increasing access to external resources. Exports, which in a small economy like Honduras should be a driving force for growth, grew at an average annual rate of only 3.7%. Foreign exchange earnings were based (and continue to be) primarily on coffee and bananas. Despite a strongly protective trade regime, imports grew rapidly throughout the 1970s, reaching more than 40% of GDP by the early 1980s. The combination of strong domestic demand and sluggish exports resulted in the emergence of balance of payments problems by the early 1980s. 4. Access to abundant bilateral and multilateral credit allowed the Government to stave off a major balance of payments crisis in the early 1980e and to avoid for several years the painful adjustment needed to address the economy's structural problems. In 1987, however, both coffee prices and positive net capital inflows collapsed, unmasking the structural distortions constraining Honduras' growth. Partly as a result of its fears that hard  economic policy decisions might destabilize the domestic social and political situa:ion, the Government did not address the abrupt drop in foreign exchange inflows in 1987 through a comprehensive program of economic reforms, but carried out instead a series of ad hoc measurea which averted only temporarily a massive financial disequilibrium. The Government's recourse to the accumulation of arrears and financing of the public sector deficit from domestic sources intensified pressures on the balance of payments and sowed the seeds of an accelerated inflationary process. By February 1988, Honduras was in arrears with all of its creditors, inflation was beginning to accelerate, and the difference between the official and the parallel market exchange rates had widened to 40 percent. 5. Honduras' economic performance in 1988 and 1989 reflected the fundamental structural weaknesses of the economy that made long-term growth unsustainable unless a major economic reform program was implemented. Real GDP growth fell from 4.7 percent in 1988, to 2.3 percent in 1989. Gross domestic investment declined to less than 13 percent of GDP, and national savings dropped to 3.9 percent of GDP. In 1989, the overall public sector deficit remained high at 9.2 percent of GDP despite a sharp decline in public investment, and public sector savings were negative (-1.9 percent of GDP). The current account deficit of the balance of payments reached 7.0 percent of GDP, and an overvalued exchange rate continued to undermine the competitive- ness of Honduras' exports. Net external financing, including grants, was not sufficient to cover the fiscal deficit, and the Government resorted to domes- tic bank financing (equivalent to 4.3 percent of GDP) and to an accumulation of external arrears (amounting to 3.7 percent of GDP) to finance the gap. The rate of domestic inflation, as measured by the Wholesale Price Index, reached about 20 percent in 1989. 6. As alluded to above, reliance on external financing was an important element -f macroeconomic management during the 1980.. In fact, Honduras' total external debt more than doubled between 1980 and 1989, from US$1.5 billion to about US$3.2 billion. The rate of accumulation of debt far exceeded the growth rates of domestic output and exports during this period, with the result that the debt burden increased sharply. The ratio of total external debt to GDP increased from 58 percent in 1980 to about 65 percent in 1989 (at the official exchange rate); if the average parallel market rate were used, the external debt to GDP ratio exceeded 100 percent. With debt service to exports increasing from 21 percent in 1980 to 30 percent in 1988 and rising, the Government began to accumul&te arrears on its external debt. After an extended period of non-payment, Honduras' Bank portfolio was declared in non-accrual status on April 1, 1989; the IMF declared the country ineligi- ble on November 30, 1989; and the IDB placed the country in non-accrual status in December 1989. By the end of 1989, Honduras had accumulated arrears of about US$744 million on its external debt, and the parallel market exchange rate reached above L4/US$l (compared to the official rate of L2/US$1). B. GOVERNMENT'S ADJUSTMENT PROGRAM 7. In January 1990, a new administration headed by President Callejas took office, and embarked on a bold program of economic reform, based on a fundamental redefinition of the role of the state. The essential aim of the  adjustment program was to reduce tte complex regulatory framework and costly subsidies which pervaded the economy, and to encourage private sector investments through reform of the trade regime, public sector management reforms, pricing and marketing deregulation, financial sector reforms, and establishment of a long-term macroeconomic framework free of distortions. Reducing the size of the public enterprise sector through privatization and/or leasing arrangements, increasing the efficiency of strategic enterprises which remain publicly-owned, and limiting the fiscal burden of these companies on the Central Government budget, were also key elements of the Government's reform program. 8. The major policy changes introduced in March 1990 included: (i) trade reform, reducing the maximum import tariff rate from 90 percent to 40 percent and eliminating most exemptions and eurcharges; (ii) an adjustment of the exchange rate that brought the official rate to L4/US$l (with the exception of debt/equity convere .ons which remained at the previous official L2/US$l rate); (iii) a revenue package, which by introducing changes in the rates of the sales and other taxes, eliminating exemptions in the trade regime, and imposing temporary ta:zes on exports, aimed to increase Central Government revenue from 16 percent of GDP in 1989 to 21 percent of GDP in 1990; and (iv) " Government budget for 1990 which was to limit current expenditures to about 21 percent of GDP, increasing consolidated public sector savings to about 0.5 percent of GDP from a deficit of 2 percent in 1989. Despite the effect of the devaluation on public debt service (an increase of about 2 percent of GDP), the overall 1990 public sector deficit was budgeted to be reduced to 6.9 percent of GDP, permitting its financing with only slight recourse to domestic credit (0.5 percent of GDP). 9. In order to cushion the social effects of the adjustment program, the Government created the Honduran Social Investment Fund (FHIS), structured to operate flexibly and efficiently. The FHIS combines an emergency employment strategy with the objective of poverty alleviaticn through the financing of social infrastr:'cture, such as rehabilitation of health posts, schools, water and sewerage systems, targeted projects in health, nutrition, and education, and a limited number of productive projects. An IDA Credit of SDR 14.3 million was approved in February 1991 to support these social safety net activities. The Government is also developing a program, with the support of the Bank Group and the IDB, to address the longer-term issues of increasing the efficiency and equity of education and health services, which may lead to possible social sector lending operations (para. 13). C. AGENDA FOR REFORM 10. Achievement of sustainable growth requires a stable economic environment that will increase private sector confidence, promote domestic savings, and encourage investment in export-oriented and efficient import- substitution activities. Consolidation of stabilization, through continued sound monetary, exchange rate and fiscal policies will be fundamental. The policy agenda for subsequent phases of the economic restructuring program will need to include: (i) further reform of public enterprises; (ii) rationalization of the incentive framework; (iii) measures to reduce poverty through social sector reform; and (iv) sustainable management of the country's  natural resources and environment. The proposed Energy Sector Adjustment Program (ESAP) is designed to support some of these policy actions under this subsequent phase of economic reform. 11. public Enterorise Reform. Public enterprises have contributed significantly to Honduras' fiscal deficit and 'ieavy external debt burden. The public enterprise sector grew rapidly during the 19609 and l9?0s, reflecting the Government's desire to spearhead economic development, create employment and promote the growth of underdeveloped areas. However, the performance of these enterprises has generally been poor, and their contribution to the national economy has not been commensurate with the amount of resources channelled to them. 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 viability. Reform of the public enterprise system will require: (i) institutional and regulatory changes in the framework governing the functioning of the enterprises and their relationship with the Central Government and Congress; (ii) modifications in price adjustment and collection mechanisms; and (iii) strengthening of the internal organization and management of the enterprises themselves. The proposed credit will support, iterala, a financial restructuring of the National Power Company, ENEE, and the implementation of a comprehensive energy sector policy and strategy that will require the application of tariff and investment principles based on economic and financial criteria. 12. Incentive Framework. Continued financial sector and fiscal reform, further price and trade liberalization, and a reduction in Government regulation of economic activities are essential for fostering irivate sector- led growth. Considerable progress has already been made on financial, fiscal, and agricultural trade/pricing issues. The remaining frontier where substantial efforts are still required is in the area of deregulation and reform of the investment code, particularly as it applies to foreign investors. A recent analysis of the legal framework and investment climate by the Foreign Investment Advisory Service (FIAS) identified the following as critical impediments to foreign investment in Honduras: (i) the unstable nature of the legal framework and excessive number of regulations; (ii) regulations limiting reliable access to foreign exchanget (iii) a complex tax regime, often resulting in high taxation rates; (iv) lack of security of land titles and prohibitions against land rentall and (v) the absence of medium and long term finance for capital investments. Improving the inves--tent environment will require actions to revise the legal framework, introduce policy reforms, reduce government intervention, and develop the financial markets. Some of the tax issues and constraints related to land ownership are being addressed in the context of SAL II and may be subject of a possible Agriculture Sector Adjustment operation (para. 38). 13. Povgrty. Poverty is widespread in Honduras, and is reflected in low per capita income and in low health, nutrition and education standards. Poverty among households headed by women is a particular problem. Basic infrastructure for health and education is inadequate and social services delivery is inequitable. The primary health care system currently reaches only 60% of its targeted population. Health posts lack basic equipment and supplies, and suffer from an insufficient number of paramedical personnel. In the education sector, there is a shortage of classrooms, textbooks, and  teaching materials devoted to primary education, and teacher/student ratios are disturbingly low In rural areas. The major issues requiring attention in the social sectors includet (i) inadequate emphasis on primary education; (iit a focus on curative rather than preventive health care} (iii) inadequate incentives for teachers and health workers, resulting in low quality delivery of social services; (iv) excessive centralization of budget, staff and services; (v) insufficient cost recovery; and (vi) weak inatitutional capacity of social mtenistries and line agencies. Recognizing the need to address the long-term issues of health and education efficiently and equitably, the Government has requested the Bank Group's support to improve service delivery of the Ministries of Health (MOH) and Education (MOE), and other social service agencies, as a complement to the IDA Credit alrealy approved for the FHIS. The Bank Group prepared a Social Sector Review in FY91 which analyzed the issues involved in a restructuring program for the social sectors, and has started discussing with Government officialo possible strategies for improving sector performance. 14. Natural-Resource Manaaemeat.and the 3nXironM2nt. Honduras' main environmental problems are deforestation, waste of wood resources and land erosion. Deforestation has proceeded at an alarming rate. Forests covered 6.8 million ha. in 1964, but the area declined to 5 million ha. in 1988. Because of good world market prospects for wood, slist%inable management of this forest land is of special value for the country'oj long-term economic prospects. Lai.d misuse is also a costly problem. According to 1986 data, the area suited for cropping was about 1.9 million ha., of which 1 million ha. were appropriate for annual crops and .9 million ha. were suitable for perennial crops or artificial pasture. However, in practice, crops and pastures occupied 2.8 million ha., of which 1.5 million ha. were for crops cultivated on lands suitable only for forest. Soil erosion is increasing. if present trends continue, land erosion may affect food supplies, increase the possibility of flooding and reduce the electricity generation potential of hydroelectric plants (para. 58). Deforestation and land misuse have been encouraged by economic policy and legislation which do not guarantee private property rights over the country's timber and land resources. The Government's agricultural strategy, supported by a possible Agriculture Sector Adjustment operation (para. 38), would address these i'9ues, including necessary legal revisions to the regulatory and policy framework. D. HACROECONOMIC STABILIZATION AND ADJUSTMENT PRFORMANCE 15. In support of the new administration's economic reform program (including the social safety net), the Bank-chaired Consultative Group for Honduras arranged a bridge financing package with the support of the U.S., Japan, Venezuela and Mexico, and by mid-1990 Honduras cleared all outstanding arrears with its multilateral creditors. This paved the way for an IMP stand- by arrangement approved in late July 1990 (para. 46) and for Bank Group and IDB financial support of the Government's adjustment program. Subsequently, Ronduras reached agreement with its bilateral creditors at a September 14, 1990 meeting of the Paris Club, receiving the most favorable terms adopted by the Club for highly-indebted, lower-middle income countries.  16. Working closely with the IMF and the IDS, the Bank Group is supporting the Government's program with a Second Structural Adiustment Loan (SAL II) of US$90 million and IDA with a Structural Adiustment Credit (SAC) of 8DR 14.3 million, which were approved by the Board of Directors on September 13, 1990 and January 29, 1991, respectively. SAL II became effective in November 1990, and the first tranche of US$45.0 million was disbursed immediately. The SAC became effective in April 1991; its single tranche was disbursed immediately upon effectiveness. Major actions supported by the SAL 1I and SAC include: (i) Vxnort and Trade - flexible management of the exchange rate; rationalization of tariff structure with reduction in the range of tariffs from 90-1 to 20-5 percent by 1992; elimination of all tariff exemptions and surcharges; elimination of all import licenses; and introduction of a new export incentive system; (ii) Public Sector Manaaement - limits on public sector investment; targets for public sector savings, including specific targets for increasing savings from the publicly-owned telephone and water companies; automatic adjustment of petroleum prices; reforms in tax administration; and a tax reform; (iii) Aoriculture Sector - elimination of all guaranteed prices and price contrc!.a (with the exception of corn, for which a flexible tariff system will replace the price guarantee system); rationalization program for the Government purchauing and marketing agencies; and targets for food and employment assistance; and (iv) rinancial Sector - flexible interest rate policy; administrative unification of all rediscount and credit lines; limits on subsidized credit; improvement of the portfolio classification system for the commercial banking system, as well as a minimum capital to assets ratio for all banks; and reorganization of the agricultural financial system. 17. As of September 1991, substantial progress has been achieved in implementing the SAL II program. With respect to trade, import tariffs have been reduced from a range of 0-90% before SAL II effectiveness to 4-35% in January, 1991; import licenses have been replaced by an automatic statistical registration procedure; and temporary export taxes have been eliminated for non-traditional exports and are being phased out for traditional exports. Regarding gublic sector manacement, tariffs of the major public sector enterprises have been incredred and the savings target for the phone and water companies (0.3% of GDP) has been significantly exceeded (1.4% of GDP); and an automatic adjustment mechanism for domestic petroleum prices has been adopted to respond to changes in the exchange rate and/or international oil prices. A program to strengthen the Ministry of Finance's capacity to collect domestic taxes is also being successfully implemented. In the aariculture sector, substantial decontrol of agricultural prices has taken place, and many restrictions to agricultural imports have been eliminated. Initial steps to remove the public sector monopoly over grain imports have been taken, with further actions in process. Financial sector reforms have inciuded abolishing ceilings on lending rates for most lending operations (with the exception of loans for basic grains and low-income housing). The Honduran authorities are  - 7 - in the process of completing remaining actions for second tranche release under SAL II, and disbursement is expected to take place in late 1991. E. RECENT ECONOMIC DEVELOPMENTS 18. Real GDP declined by about 1% in 1990, partly as a result of stabilization measures and partly due to exogenous factors: a banana workers' strike, flooding in agricultural production areas, and the increase in oil prices arising from the Gulf crisis. There are, however, indications that the economy has begun to recover during the first semester of 1991 from last year's recession. The Central Bank estimates that during January-July 1991, the monthly index of economic activity increased by 2.8% over the same period one year earlier. During January-July 1990, that index had declined by about 2% compared to January-July 1989 levels reflecting the initial impact of the stabilizatio: policies. 19. Tax revenues did not increase substantially during 1990, as a result of delays in implementing needed tax administration reforms and a reduction in imports in the last quarter of 1990 (the latter was partly the consequence of restrictive foreign exchange allocation policies adopted in September 1990). In addition, delays in adjustments of domestic prices of oil products resulted in a decline in oil tax revenues from about 1.2% of GDP in 1989 to about .4% of GDP in 1990. As a result, the fiscal deficit reached 9.1% of GDP in 1990, well above the projected 6.9% of GDP. Public savings, on the other hand, stayed at the same level as in 1989 (about -1.7% of GDP) compared to a target of .5% of GDP. The external debt rose marginally to US$3.4 billion in 1990, but external outflows increased substantially (in excess of US$400 million) as Honduras cleared its arrears with the multilateral financial institutions and resumed servicing of its external debt. 20. Inflation, as measured by the Consumer Price Index, increased from about 10% in 1989 to about 23% in 1990 as a result of a 20% increase in money supply narrowly defined (M1) that took place at the end of 1989, and of increases in international oil prices in the second half of 1990. The increase in money supply was, in turn, the result of the increase in credit to the public sector to finance the fiscal deficit. 21. Basic economic indicators for 1990, with comparisons to earlier years, are summarized in Table 1 below. More detailed country economic data and projections are presented in Annex I.  - a - Table I ONDURPAS: Basic Economic Indicatorg Growth Rates (% per annum) Projections 1980-89 1990 1991-95 Grose Domestic Product 2.2 -1.0 3.3 Total Consumption 3.1 -2.6 1.8 Gross Domestic Investment -1.7 5.6 2.8 Exports 1.2 -1.1 7.4 Imports .2 -3.1 2.8 Inflation (CPI period average) 7.4 23.0 13.6 Population 3.0 2.8 2.8 22. Despite developments in 1990, prospects for program performance in 1991 are encouraging. The fiscal deficit is projected to decline to 4.9% of GDP as a result of the full impact of the March 1990 tax reform on revenues, new tax measures (increases in oil tax revenue, linkage of the banana tax to the exchanga rate and a new coffee tax), and increases in electricity tariffs that have been taking place since June 1991 (para. 86). The projected fiscal deficit would be consistent with a reduction in public sector indebtedness with the Central Bank if the projected external financing materializes in a timely manner. In the financial sector, lending interest rates have been largely liberalized, except for low-cost housing and basic grain productiont controls of lending rates on the latter are to be phased out by the end of 1991. These actions should allow the Government to adhere to the goals and targets of the stabilization and adjustment program by encouraging savings in domestic currency and by eliminating Central Bank financing of the fiscal deficit. With respect to the trade regime, foreign exchange restrictions introduced in September 1990 limited the impact of trade liberalization on the economy. In May 1991, the Government Introduced greater flexibility Into the system by removing restrictions on the use of the parallel markst for financing import transactions. As a result of the measures outlined above, we anticipate that the recession should bottom out within the next few months and medium-term prospects for sustainable growth should improve. F. MEDIUM TERM PROJECTIONS AND FINANCING REQUIREMENTS 23. Honduras' macroeconomic prospects will depend on the Government's ability to address the various issues discussed earlier, which stand in the way of increased private sector confidence. The economic projections are based on the assumptions that the Government, will (i) continue its fiscal and monetary policies to stabilize the economy; (ii) pursue a flexible exchange rate policy to avoid any real exchange rate appreciation that could threaten the effects of the trade reform on export growth; and (iii) make periodic adjustments in public utility tariffs to avoid their erosion by inflation. It  - 9 - is also assumed that significant amounts of assistance will continue to be provided on concessional terms. 24. Under that scenario, Honduras' growth prospects improve with still low GDP growth (1.5%) in 1991 gradually increasing to about 5% by the end of the decade. Continued implementation of the stabilization and adjustment measures would preserve price stability, strengthen Honduras' long-term growth prospects, and improve its balance of payments. Interest rate liberalization and the ending of credit allocation policies are expected to increase private savings and private investment efficiency. Growth would be sustained through increases in production of exportables and efficiency gains in investment resulting from the structural adjustment measures. National savings are projected to increase from 2.9 percent of GDP in 1989 to about 9.2 percent of GDP by 1995, after falling to -2.1 percent of GDP in 1990 as a result of the deterioration in the terms of trade. 25. Tax revenues are projected to increase from 13.2% of GDP in 1989 to about 15.7% of GDP in 1991, when the full impact of the Government's austerity measures will be felt. The measures to reduce public consumption would yield additional savings of about 1.2 percentage points of GDP over 1989 levels in 1991. Despite a projected increase in interest payments by about 3.0 percentage points of GDP in 1991 (as compared to 1989 levels), public sector savings, which were negative during 1988-90, are projected to improve and reach about 3.0% of GDP. Tax revenues will decline as a percentage of GDP during 1992-95 as the rate of growth of private consumption (one of the determinants of sale and import taxes) falls below that of real GDP, to about 14.3% of GDP by 1995 and would remain at that level thereafter. Modest rates of growth in public consumption would allow the public sector to attain savings equivalent to 3.8% of GDP by 1995. The overall public sector deficit would decline to 3.2% of GDP by 1995. 26. The trade reform implemented as part of the structural adjustment measures is leading to a more open economy, which will require shifting resources toward the production of exportable goods such as bananas, coffee, shrimp, vegetables and out-of-season fruits, for which Honduras has an international competitive advantage. A condition to enable this to take place is that investors are confident about the Government's commitment to these policies. Pursuing a flexible exchange rate management will be particularly important in this regard. Moreover, efficient import substitution would complement the effects of export expansion by reducing the country's imports of basic grains. Total exports are projected to grow at about 7.3 percent per annum in real terms during 1992-95, while non-traditional exports would increase at a rate of 8.6 percent per annum. 27. An adequate level of imports will be needed to sustain the projected level of GDP growth. It is expected that the trade reform will encourage an increase in imports to match the projected higher levels of exports. Import volume is projected to grow at an annual average rate of 3.4 percent during 1992-95, a rate that is below the projected export growth rate. As a result, the resource balance surplus at constant prices would increase from 3.0 percent of GDP in 1992 to about 5.7 percent of GDP by 1995. At current prices, the resource balance surplus would increase from .2 percent of GDP in 1992 to 3.4 percent of GDP by 1995. The projected improvement in the resource balance should help to bring down the current account deficit of the  - 10 - balance of payments from 9.5 percent of GDP in 1992 to 3.3 percent of GDP by 1995. 28. The 1991-95 financing requirements and likely sources of funds, are shown in Annex I. Gross funding requirements will remain large because of scheduled amortization payments amounting to an average US$223.2 million per year. Inflows from grants are projected to drop from the exceptionally high figure for 1990 of US$208.0 million (which includes undisbursed grants from the previous year amounting to US$70 million) to US$70 million by 1995. Based on the pipeline of existing and proposed projects, gross disbursements from multilateral institutions are projected to increase from US$36.3 million in 1989 to an average US$181.8 million per annum during 1991-95. This amount of multilateral financing includes estimated Fifth Dimension supplemental credits at the FY92 Board-approved level of 90% of IBRD interest due. Should Fifth Dimension and donor flows be less than estimated, financing gaps could emerge. 29. The growth scenario described above is very sensitive to departures from the adjustment program, in particular, to any deviations from the trade reform program. The rate of economic growth projected under the structural adjustment scenario would not be sustainable if import substitution policies replace the trade reform program. Were this to occur, the two major sources of economic growth, namely, export growth and efficiency gains in investment productivity would not materialize, and real GDP growth would fall below population growth. 30. The growth scenario described above is also sensitive to any failure to implement the fiscal adjustment program. If the projected reductions in the public sector deficit do not materialize, the Central Bank would have to finance the higher fiscal imbalances with monetary creation. As a result, inflationary pressures would increase, and the exchange rate would become unsustainable as the monetary imbalances filtered out through balance of payments deficits. Systemic deficits in the balance of payments would totally exhaust Central Bank (net) international reserves and a balance of payments crisis similar to the one that occurred in 1989 would develop. Thus, full service of the external debt would become untenable and Honduras' access to external funding would be severely hampered as the IFI's would reduce their lending to a minimum core program. 31. In our view, neither of these pessimistic scenarios is highly probable. We consider that the medium term projections under the structural adjustment scenario are realistic in view of the measures that the Government is taking. G. COUNTRY ASSISTANCE STRATEGY 32. Past Operations. Since 1955, Honduras has received 36 Bank loans totalling US$ 696.5 million and 14 IDA credits totalling USS 125.0 million equivalent, both net of cancellations. Thirty-one loans and thirteen IDA credits are fully disbursed. The undisbursed balance of the loans and credits under active implementation totalled about US$ 89.5 million equivalent, as of June 30, 1991. Honduras has repaid the Bank Group US$ 226.9 million  - 11 - equivalent, and has a total outstanding IBRD obligation of USS 493.9 million and an outstanding IDA obligation of US$ 95.2 million equivalent. 33. Bank group lending initially concentrated on developing basic infrastructure in transport and power, where inadequate facilities hampered the country's development. In the last decade, the Bank diversified its lending to support the expansion of productive capacity in agriculture, industry and tourism and to address major needs in education, municipal development and water supply. As the economic situation deteriorated in the late 1980s and early 90s, financial support for implementation of economic adjustment programs has been emphasized. A statement of Bank loans and IDA credits is presented in Annex II. The distribution of Bank Group lending during the past ten years is shown in Table 2 below. Table 2 HONDURAS: Distribution of Lending FYS1-91 (US$ millions) Sector Amount I Proiects Agriculture 70.0 19 2 Industry/Finance 65.5 18 2 Social/Poverty 24.4 7 2 Transport 23.2 6 1 Water Supply 19.6 5 1 Municipal Devt. 6.9 2 1 Adjustment 160.0 43 3 TOTAL 369.6 100.0 12 34. Country Assistance Strate-v. In view of the country's urgent need to manage its short term external financing difficulties and to promote medium term structural change, the country assistance strategy for Honduras emphasizes IDA support for the Government's macroeconomic and sectoral adjustment efforts through fast-disbursing policy based lending, complemented by selected investment projects, particularly those targeted to poverty alleviation and to improving infrastructure public and institutions so as to remove bottlenecks to economic growth. The main objectives of IDA's medium term assistance are to help: (i) consolidate and deepen the structural adjustment measures taken to date and support the economic reform process, thereby promoting the country's growth and development; (ii) alleviate poverty and the impact of adjustment on the poorest sectors of the economy; (iii) increase public sector efficiency; (iv) protect the environment and improve management of natural resources; and (v) mobilize and diverrify the Government's concessional sources of external finance for the public sector investment program. To ensure effective coordination of IDA assistance with other donor programs, regular meetings of the Consultative Group for Honduras will be held, and co-financing will be actively sought for all operations. 35. In view of the country's low per capita income and marginal creditworthiness, Honduras was declared IDA eligible in August 1990. In August 1991, after a review of Honduras' economic situation and per capita income level and in light of the severe development constraints imposed by the country's substantial external debt, Bank/IDA management decided to discontinue Bank lending and initiate an IDA-only assistance strategy  - 12 - beginning in FY92. Because of Honduras' heavy debt service obligations, its creditworthiness indicators are expected to improve only towards the end of the decade. Also, per capita GDP is only expected to increase slowly in real terms from its present level of US$538 per capita. Consequently, continued high levels of concessional assistance from the IDA as well as mobilizing maximum co-financing on highly concessional terms will be critical elements in carrying out our financial assistance strategy. The shift to an IDA-only strategy should prove beneficial in this respect as it would permit other donors to consider providing their development assistance and/or debt relief on the most generous terms available to lower middle income countries. 36. Bank Groun Lending Program. Implementation of the strategy outlined above began in July 1990, following clearance of Honduras' arrears to the Bank Group. Since then, the Bank Group lending program has included: (i) reactivation of the second tranche of SAL I in July 1990; (ii) approval of SAL II in September 1990 (US$ 90 million); (iii) approval of a Structural Adjustment Credit (SAC) in January 1991 to assist the Government with the short-term impact of higher oil prices (SDR 14.3 million); and (iv) approval of an IDA credit in February 1991 to support the operation of the Honduran Social Investment Fund (FHIS) and other targeted poverty alleviation initiatives (SDR 14.3 million). 37. During FY92, the lending program would give priority to supporting the Government's sectoral adjustment programs in the energy and agriculture sectors. Thereafter, the lending program will place greater emphasis on investment projects, addressing issues of poverty alleviation, social sector restructuring, and infrastructure rehabilitation. Based on the experience with the on-going and proposed adjustment operations, by FY94 we will consider whether follow up adjustment operations would be appropriate to consolidate the benefits of the first phase of economic reform and adjustment lending. Implementation of the proposed lending strategy will be dependent on continued availability of sufficient IDA resources for Honduras and on the country's adjustment program "staying on track." Should significant policy slippages occur, a reassessment of IDA's assistance role in Honduras would be made and a much reduced level of core credit operations focussing mainly on the social sectors would need to be considered. Summary information on proposed operations in the early years of the pipeline is presented in the paragraphs below; the proposed Energy Sector Adjustment Credit is discussed in detail in Part III. 38. Given the dominance of the agriculture sector in output, exports, and employment, the Bank and the IDB are working closely with the Honduran authorities on the preparation of an Agricultural Sector Adjustment operation that would consolidate the agricultural sector reforms initiated under SAL II and support additional policy reforms designed to allow taking advantage of the country's comparative advantage in agriculture and to strengthen agricultural growth in both traditional and non-traditional exports. The possib.e adjustment operation would address issues related to: (i) price and trade policy for agricultural commodities; (ii) forest sector policies and sustainable management of timber resources; (iii) land markets and land tenure policies; (iv) the rural financial sector; and (v) public sector management in the agricultural sector (expenditure programming and budgeting, institutional reform, etc.). This sector adjustment operation, tentatively scheduled for  - 13 - late thi fiscal year, would be co-financed with the IDS, and other external financial support is also being sought. 39. The Bank Group has actively assisted the Government in defining and implementing a two-pronged strategy for addressing Honduras' Rovgrty. The first element of the strategy has consisted of the rapid establishment of emergency programs, such as the FHIS and targeted food coupon programs, to deploy a safety net to protect the country's neediest groups over the short term. The second component of the strategy is medium term in nature, and consists of the identification of a broad range of policy reforms, whose introduction would result in improved resource allocation among social programs, greater operational efficiency, and better targeting of services to the needier groups of the population. Discussions are currently on-going with the Honduran authorities regarding the appropriate focus and design of one or two follow-up social sector operations, for possible presentation to the Board in FY93, concentrating on social sector restructuring and nutrition/health interventions. 40. An analysis of transport infrastructure recuirements for the success of Honduras' export-oriented strategy indicates the need for reducing transport costs to improve the competitiveness of Honduran goods, as well as for the development of policies to strengthen transport sector management and encourage the participation of the private sector in the provision of transport services. The Government has expressed its interest in an IDA- financed Transport Sector Rehabilitation Project to address these issues, and a possible operation is scheduled for FY94. A sector study is being completed which identifies the principal constraints in the sector as well as the areas where IDA assistance could be most effective; discussions with Government will take place in the coming months. Following consultation with the Government on the study's findings, we expect to share the report with all interested donors for aid coordination purposes. 41. Economic and Sector Work (ESW. As mentioned earlier, during the past fiscal year a major review of social sector programs was completed, and a review of transport sector issues was initiated and substantially completed. in addition, informal studies on fiscal reform, export incentives, and the public sector investment program were prepared during SAL II supervision. These studies have been an important element in the development of action plans by the Honduran authorities to enable them to meet the conditions f second tranche release (para.17). In the medium term we plan to analyze constraints to private sector development, conduct an in-depth study of the financial sector (to follow up the reforms begun under SAL II), and complete a Country Economic Memorandum for Honduras. Sector work will focus on public sector management, national environmental priorities, constraints to women's labor market participation, and water supply and sanitation issues. We expect these studies to lay a sound analytical framework for our future policy dialogue and possible lending activities. 42. Ccuntgy Stratezv and IMplementation Review (CSIR1. The Bank Group and the Honduran authorities have agreed to hold a CSIR meeting in late September 1991, to review implementation issues of the country assistance strategy to date and to exchange views on the appropriate size, composition and focus of the medium term assistance program for the FY93-95 period. The overall assistance objectives, lending strategy, and E8W tasks outlined above,  - 14 - would provide the framework for CSIR discussions, and the outcome of these consultations would be reflected in possible adjustments to the lending pipeline and planned ESW tasks. 43. Aid Coordination. Because of Honduras' significant external financing needs, particularly with the clearance of multilateral arrears, aid coordination has played a crucial role in the success of the program to date. Aid coordination efforts will remain a high priority given the country's large external resource requirements and the many interested donors supporting the reform program. The principal mechanism will be the Consultative Group (CG) for Honduras, in conjunction with informal donor meetings organized around specific themes, including establishment of investment priorities and building consensus for addressing long-term development issues. During the past fiscal year, a CG meeting was held in Paris in December 1990 which focussed on the Government's poverty alleviation efforts. The next CG meeting for Honduras is scheduled for March 1992, and we would expect to convene the Group periodically thereafter at roughly 18 month intervals. 44. Co-financing. Co-financing, particularly on concessional terms, is now a central feature of the InA program with Honduras. In the area of oovertv alleviation, IDA has worked closely with other donors in developing the financing plan for the FHIS, in particular with the Kreditanstalt fur Wiederaufbau (KfW) of Germany, and it is also collaborating with the Government of Japan and UNDP in developing a second social sector operation. IDA will be working with the International Fund for Agricultural Development (IFAD) during FY92 on a rural poverty study, to analyze constraints and identify operational responses which could be supported by the IDA and IFAD. Regarding co-financing for adiustment lendina, IDB has actively participated in preparation and supervision of the SAL II; KfW has participated in a supervision mission and is in the process of reviewing compliance with conditions of approving its co-financing of SAL II second and third tranches. The proposed Energy and possible Agriculture Sector Adjustment Credits have been jointly prepared by IDA/IDS teams; co-financing possibilities with the ID8 are also being explored for the social sector operation under discussion with the Honduran authorities. Discussions are underway to determine the interest of the Government of Japan in co-financing the possible Agriculture Sector Adjustment Credit. As has been the practice, close collaboration will be maintained with cofinanciers through joint project preparation and supervision. 45. IFC Onerations. Beginning in 1984, IFC has made four loan and equity investments in pulp and paper, leather tanning, textiles, and shrimp farming totalling US$11 million. IFC is working to develop additional investment projects in priority sectors with an export orientation and strong sponsors. Projects in agriculture and export processing zones are under discussion. IFC could also render assistance in privatization transactions. IFC will continue frequent promotion missions and will use the Caribbean Project Development Facility to develop viable project proposals, where necessary. At the request of the Government, FIAS reviewed the Honduran legal and regulatory framework for private investment and made recommendations to the authorities for improving the country's investment code (para. 12). This effort was partly financed by USAID.  - 15 - H. RELATIONS WITH THE IMF 46. The Bank and the IMF have been working in close collaboration in Honduras and the programs of the two institutions are mutually consistent and reinforcing. In July 1990, the IMF's Executive Board approved Honduras' request for a standby arrangement of SDR 30.5 million, with an initial purchase of SDR 16.5 million upon Board approval. The first review was completed in December 1990, with purchase of SDR 4.3 million immediately thereafter. A letter of intent was signed in May 1991, defining the economic program and targets for the remainder of 1991. The second review was completed in early June 1991, paving the way for a purchase of SDR 2.3 million. The program period has been extended through February 1992, with remaining purchases tied to end-of-quarter performance criteria through the end of calendar 1991 and to a third review to be completed by October 1991. I. SUMMARY ASSESSMENT 47. Honduras has begun a long overdue process of economic reform. Preliminary results of the program are encouraging, and medium-term prospects for sustainable growth are improving. Nevertheless, the country's economic and financial situation remains fragile, as the economy is still highly vulnerable to external shocks. Increases in the debt-service burden resulting from rising international interest rates, devaluation of the U.S. dollar vis- a-vie other major currencies, or drops in the prices of coffee or bananas could render the external accounts very difficult to manage. The authorities are also likely to face popular resistance to continued austerity measures, as well as a lack of support from parts of the private sector, uncomfortable with the shift to greater reliance on market forces, in lieu of the more traditional means of direct Government intervention. IDA's proposed program of assistance, including the proposed Energy Sector Adjustment operation, plays a key role in supporting the Government's efforts to deepen its structural reforms and ensuring that inadequate or untimely levels of external finance are not a cause of policy backsliding. 48. Implementation of the IDA assistance strategy is conditional on the continued willingness and ability of the Government to carry out the adjustment effort; it will require close monitoring and may require interim management reviews of necessary adjustments to the strategy as events develop. Criteria to judge progress would include a supportive macro-economic framework, particularly management of the exchange rate and public finances; public sector management and public enterprise performance; and progress in poverty alleviation and social sector reform. Each sector adjustment credit would be coordinated with, and tied to, the macroeconomic adjustment program, as well as to relevant elements of other sector credits, where appropriate. Before effectiveness and the release of each tranche of the proposed Enercv Sector Adjustment Credit. the soundness and consistency of the medium-term economic framework would be reviewed to ensure that the Rroaram remains on track (oaras. 108. 108 ti) a. and 103 (ii) a).  - 16 - PART Ex - MHE SCORN= UTMN R0R~ A. SECTO BACbQKGRUND 49. The energy sector has played, and will continue to play, an important role in the economlc development of Honduras. The sector relies mostly on two major indigenous energy resources: fuelwood and hydropower. At present the country does not produce any petroleum, and is totally dependent on imports to meet its needs. oil consumption is about 16,000 bbl/d and has been growing at an average of 7.2% per year during the laet four years. The impact on the balance of payments is significant as the oil import bill in 1990 amounted to US$143 million, representing about 13% of export earnings. 50. Fuelwood and biomass meet around 67% of the total final energy demand; petroleum, 29%; and electricity, 4%. Households account for 60% of total energy use, followed by transportation and agriculture (26%) and by industry (14%). The low level of industrial usage reflects the country's modest degree of industrialization. Food processors are the main industrial users (50%), followed by the petroleum refinery and chemical companies (13%). Sl. The degree of electrification in Honduras is low compared with other Latin American countries. only about 36% of Honduras' inhabitants have access to electricity. While 80-90% of the urban population receive electricity, only about 19% of rural inhabitants are connected. These figures compare with shares among the total population of 42% urban and 58% rural, and reflect the low level of electrification in rural areas. By the end of 1990 the total number of connected consumers was 325,500, of which 294,300 were residential. Electricity consumption per capita was about 323 kWh in 1990 (this figure may be compared, for example, with 192 Kwh for Guatemala, 438 kWh for the Dominican Republic, and 1,000 kWh for Brazil). A description of the evolution, situation and prospects of the electric power subsector is given in Annex V. 52. In the late 1970s, influenced by concerns about rising oil prices and prospects for potential electricity exports for the region, and in the expectation of easy access to the world's financial markets, Honduras initiated construction of a large hydropower project, El Cat6n, with Bank and IDA assistance. Though El Caj6n served to reduce oil imports, exports of surplus electricity to neighboring countries were less than expected because of the social and political turmoil in the region, and the debt service burden related to the project became increasingly onerous due to the devaluation of the dollar vAJ Ljvil the various currencies in which the debt is denominated. In 1990, the external debt of the national power company, Empresa Nacional de Energia Bl6ctrica (ENEE), stood at US$721 million, which represents about 22% of Honduras total foreign debt. As a result, ENES's debt service, amounting to about US$90 million in 1991, will bear heavily on Honduras foreign exchange needs.  - 17 - B. GOVERNMENT PROGRAM 53. The Government with the assistance of IDA and the IDB has prepared the ESAP to address the main energy sector issues as discussed below. The USAP would involve institutlonal reforms and specific policy measures to be implemented under detailed plans of action for each area of the energy sector. The Government's Letter of Energy Sector Development Policy and the Policy Matrix summarizing the objectives and the key actions to be taken for each area under the ESAP are provided in Annex III and IV, respectively. These efforts would complement reforms initiated under SAL II for public enterprises, thus deepening the ongoLng adjustment effort. 54. The main obiegtives of the prooram are to help (i) establish a comprehensive energy policy and strategy and a sound regulatory framework for the sector; (ii) restore ENEE's financial soundness and operational efficiency and thereby contribute significantly to the achievement of the Government's structural adjustment program; (iii) improve electricity pricing and resource allocation in the sectorl (iv) promote petroleum exploration and produ:tion; (v) liberalize petroleum product trade; and (vi) encourage greatur private sector participation in the sector. RAerY setor 55. Policy and Strateay. Historically, Honduras has not had a comprehensive energy policy or strategy for developing the sector. This is largely a result of inadequate planning and poor coordination among institutions involved in the sector -- many of which with ill-defined or overlapping functions -- along with politicized decision-making. In view of the important role of the sector in the economy, the Callejas AdministratLon has developed a formal energy policv and strategy. This strategy will serve to consolidate the gains achieved under the macroeconomic adjustment program and will ensure the contribution of the sector to the country's development in the medium and long-term. The main objectives of the Government'e energy sector pollzy are to provide a reliable energy supply at least-cost, and to reduce the negative impact of the sector on fiscal resources and on the country's balance of payments. To implement this policy, the principal elements of the Government's sector itrateay involve setting electrleity prices based on economic principles (i.e. long-run marginal costs) and financial considerations, and allowing market forces to play effectively their resource allocation role for oil products through competition and promotion of private investment in oil and gas exploration. Thi Government's sector policies are presented in its letter of sector development policy (Annex III). S6. Institutional Framework. There are several agencies responsible for energy activities, whose efforts are poorly coordinated. These agencies and their respective responsibilities ares the Ministry of Planning (SECPLAN), for approving sector plans; ENEE for electricity supply; the Ministry of Natural Resources, for petroleum exploration; the Ministry of Economy, for petroleum distribution, pricing, and reiinery supervision; the Ministry of Public Works, for transport; and the Forestry Development Corporation (COHDEFOR), for wood/charcoal production.  - 18 - 57. To address the lack of coordination among sector entities, the Government has formed the National Energy Commission (NEC) composed of the Economic Cabinet and the Minister of Public Works (who is the President of ENEE), which will be responsible for establishing sector policy. The NEC is in charge of implementing policy refornis and is being supported by a Technical Energy Group (GTE) which will act as the NEC's technical support body, comprising officials from the different ministries and entities involved in sector activities. Satisfactorv performance of the NEC. defined as executino its responsibilities as provided for undgr its establishing decree. woula be a condition for release of the second and third tranches (Rara. 108 Aii c and fii) c). 58. Interfuel Substitution. Fuelwood is the main source of energy in Honduras. While the country is not experiencing overall fuelwood shortages nor is there any prospect of natural shortages for the foreseeable future, Honduras' energy strategy should focus on optimizing the contribution of forest resources to the economy. The expansion of the agricultural frontier and excessive fuelwood demand in some regions has brought about cases of localized deforestation. Such deforestation has already affected several watersheds and, in the case of the El Caj6n reservoir, may reduce its electricity generation potential. ENEE has initiated sound basin management programs to address this issue (para. 98). Until recently, the Government's energy policy has not adequately taken into account the optimization of use of forestry resources for the economy. The limited access of the rural poor to alternative sources of energy implies that they are likely to continue to rely significantly on fuelwood as long as it is relatively abundant and is the lowest cost alternative. 59. To assist the Government in its efforts to investigate the potential for energy savings and interfuel substitution where local fuelwood shortages do exist, the proposed operation includes under the technical assistance component of the ESAP, a comprehensive study on interfuel substitution. The study would be carried out by qualified consultants under terms of reference acceptable to IDA to analyze the effects of the measures included in the ESAP regarding prices of energy products, and to ensure that the usage of fuelwood remains sustainable, within a suitable policy and institutional framework to improve the management of forestry resources. Completion and submission of the study to IDA would be a condition of release of the second tranche Joara. 108 (i) b). Presentation to IDA of a setisfact2ry final version of the interfuel substitution study.includino a satisfactory action plan would be a condition of release of the third tranche lara.- 108 (ii) bl. Electric Power Subsector 60. Corporate Autonomv. ENEE, which is responsible for the public supply of electricity within the country -- except for a few small isolated systems -- does not operate within an institutional framework which provides for adequate autonomy. Legal changes in the late 1980s have gradually curtailed its operating independence, contributing to inefficiency and poor financial performance. The most important changes have been modifications to the Public Administration Law of 1986, under which any electricity tariff changes and ENEE's annual work program and budget have to be approved by Congress. A separate Government decision to provide electricity without any  - 19 - charge to public sector institutions has also negatively affected ENEE's finances and has promoted waste of energy. 61. In addition to the above changes, Government interference in ENEE's day-to-day operations has increased sharply, involving political appointments to top management positions, hiring excessive personnel, implementing uneconomical rural electrification programs, and interfering in ENEE's commercial (billing and collection) practices, resulting in a large accumulation of accounts receivable. More recently (May 1991), the Government was forced to intervene to settle a strike by ENEE's labor union (STENEE), which is the country's strongest union. The terms of the settlement, which gave the union a say on policy decisions regarding tariffs, efficiency improvements, staffing levels and privatization, have permitted the Government to move forward with its energy sector adjustment program in spite of the union's continued uneasiness, particularly towards privatization and staff reduction initiatives. 62. The Government's program addresses in a two-step approach ENEE's need for autonomy to allow it to sperate on a commercial basis, free from day- to-day Government interference. As a first step, the Government has established a Public Utilities Regulatory Commission (PURC) which will have the authority to set tariffs for the four largest public enterprises (ENEE, HONDUTEL, SANAA and ENP). The law which created the PURC is in the process of being amended to ensure the creation of a sufficiently qualified and representative technical body. The anproval of satisfactory amendments to the PURC law and the issuance of satisfactory reaulations for the functionina of the PURC would-be a condition of credit effectiveness fgara. 108). The issuance and imolementation of specific cuidelines for tariff settina for the electricity sub2sector. consistent with the agreed electricity orgicina volicy would be a condition of release of the second tranche (para. 108 {i) c). Satisfactory i_erformance by the PURC. which would imply execution of its resoonsibilities as iprovided for under the law which established it and the relevant reaulations and guidelines, would be a condition of release of the second and third tranches (para. 108 (i) c and (iii c). As a second step, the Government will carry out a two-phase institutional reform study -- to be financed from an IDB Project Preparation Facility -- on possible changes to the legal status of ENEE which could ensure full autonomy, including the possibility of full commercialization of the company. Presentation to the Bank of a satisfactory action Plan to implement the reforms recommended by the study. including the hirina of consultants for the second phase of the study would be a condition of release of the second tranche (oara. 108 (i} di. Satisfactory implementation of the olan would be a condition of release of the third tranche Joara. 108 fi) d\. 63. In order to avoid political interference in ENEE's day-to-day operations, the Government and ENEE have signed a contract-plan (CP) which clearly establishes mutual responsibilities and a system of control through performance targets appropriate for a revenue earning entity. A summary of the CP is presented in Annex VI. ENEE's management is already using the CP to prepare a detailed business plan under which to operate and has instructed its organizational units to draw up individual operational plans. Implementation of the CP and achievement of sDecified targets would be monitored in addition to the other actions described below in oaras. 71-72. 77. 83 to iudae cmliance with the action plan to imorove ENEE's operational and financial  - 20 - performance for release of the second and third tranches (para. 108 Uil e and (fl) e}. 64. Management and operational Performance. Due in part to the intensive institutional development efforts of the Bank/IDA starting in 1959 (para. 101), by the mid seventies ENEE was a well run power utility and its efficiency indicators were in line with, or better than most utilities in countries in a similar stage of development. However, since the mid 1980s, ENEE's management was weakened as appointments were frequently made on the basie of political criteria rather than technical and management skills and Government interference in ENEE'e operations increased. 65.