Honduras - Structural Adjustment Credit Project

Document of The.World Bank FOR OMCIAL USE ONLY Rjit No. P-5453-HO REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED STRUCTURAL ADJUSTMENT CREDIT OF SDR 14.3 MILLION TO THE REPUBLIC OF HONDURAS JANUARY 4, 1991 Tbis docment has a resticted distribution and may be used by reipients only In te peoance of their official duties Its contents may not otherise be dbelosed without World ULak authodiation  CURRNCY EQUIVALENTS (as of January 4, 1991) Currency unit - Lempira (L) US$1.0 . L 5.30 L 1.0 - US$0.19 FISCAL YEAR January 1 to December 31 ABBREVIATIONS BANASUPRO Suplidora Nacional de Productos Basicos (National Supplier of Basic Products) ENEE Empresa Nacional de Energia Electrica (Electric Power Company) PHIS Instituto Hondureno de Inversiones Sociales IDA International Development Association IDB Interamerican Development Bank IHMA Instituto Hondureno de Mercado Agricola (National Agricultural Marketing Institute) IMF International Monetary Fund MOE Ministry of Education MOH Ministry of Health RUTA Regional Unit for Technical Assistance SDR Special Drawing Right UNDP United Nations Development Programme  FOR OMCIAL USE ONLY HONDURAS STRUCTURAL ADJUSTMENT CREDIT Table of Contents Paie No. Credit and Program Sumary PART I : COUNTRY POLICIES AND BANK GROUP'S ASSISTANCE 1 STRATEGY A. Past Policies and Recent Economic Performance I B. Government Economic Reform Program 3 C. Agenda for Future Policy Reform 6 D. Medium-Term Prospects and Financing 8 Requirements E. Bank Group Operations 9 F. Summary Assessment 13 PART II : THE RATIONALE FOR SUPPLEMENTAL FINANCE 14 PART III: THE PROPOSED CREDIT 15 A. Credit Amount and Conditions 15 B. Cofinancing 16 C. Disbursement, Procurement and Auditing 16 D. Risks 17 PART IV : RECONMENDATION 17 * ANNEXES I : Balance of Payments Projections, 1991 D II : Projected Financing Requirements, 1991 III : Economic Indicators: National Accounts, External Trade, Balance of Payments, External Capital and Debt, Public Finance and Credit, Social Indicators IV : Status of Bank Group Operations V : Supplementary Credit Data Sheet VI : Matrix of Actions Map : IBRD 19771 This document has a restricted distribution and may be used by recipients only in the performea.Ice of their official duties. Its contents may not otherwise be disclosed without World Bank authorition.  HONDURAS STRUCTURAL ADJUSTMENT CREDIT CREDIT AND PROGRAM SUMHARY Borrower: Republic of Honduras Amounts SDR 14.3 million (US$20 million equivalent) Termss Standard IDA terms, with a maturity of 35 years Including a grace period of 10 years. Description: The proposed credit would support the Government's structural adjustment program for which a Second Structural Adjustment Loan (SAL II) of US$90 million was approved by the Executive Directors on September 13, 1990. It would supplement the financing provided under the first tranche of SAL II to meet Honduras' additional external financing needs, necessitated by the impact of higher oil prices and lower-than expected banana export earnings for 1990-91. Proiect Benefits: Benefits are identical to those expected under SAL II, i.e. that the adjustment program would be expected to (i) accelerate export growth and increase domestic savings while creating the preconditions for a recovery of economic growth and employment and (ii) strengthen the country's creditworthiness, facilitating its access to external financial flows needed to attain long-term, sustainable growth. Proiect Risks: The main risk centers on the Government's ability to maintain the required political consensus to avoid slippage in the pace of implementation of the reforms. Other major risks which can affect the program are the Government's abiAity to generate the required public savings on account of negative shifts on Honduras' terms of trade and on the country's capacity to obtain sufficient foreign capital during the initial years of the program. Estimated Disbursements: The proceeds of the credit would be available for disbursement in one tranche upon credit effectiveness. Appraisal Reports This is a combined Staff Appraisal and President's Report. Ma Ds IBRD 19771  INTERNATIONAL DEVELOPMENT ASSOCIATION REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED STRUCTURAL ADJUSTMENT CREDIT TO THE REPUBLIC OF HONDURAS 1. I submit the following report and recommendation on a proposed Structural Adjustment Credit in the amount of SDR 14.3 million (US$20 million equivalent) to supplement the first tranche released under the US$90 million Second Structural Adjustment Loan (Report No. P-5355-HO) which was approved by the Executive Directors on September 13, 1990 in support of the Government's economic reform program. This is the first IDA credit to Honduras since 1980, and is being proposed in accordance with the recent decision to declare Honduras eligible for IDA credits (see SECM90-1128, dated August 24, 1990). The present estimate of per capita income for Honduras for 1990 is US$481. The other elements of IDA eligibility as described in the memorandum to the Executive Directors remain unchanged. The credit would be on standard IDA terms, with 35 years maturity including a grace period of 10 years. 2. This credit is being proposed in response to the sharp rise in international oil prices stemming from the Gulf crisis and its impact on Honduras' balance of payments, compounded by major banana export losses as a consequence of a banana workers strike in mid-1990 and recent flood damages. These developments have led to a significant gap in the country's external financing plan for 1991. This credit forms part of a concerted donor effort to assist Honduras in meeting the external funding requirements of its stabilization and adjustment program. PART I - COUNTRY POLICIES AND BANK GROUP'S ASSISTANCE STRATEGY A. Past Policies and Recent Economic Performance 3. Introduction. Honduras is one of the poorest countries in the Western Hemisphere with a population of 5.0 million that is growing at 2.8Z a year. Following a series of currency devaluations this year, Honduras' per capita income is estimated at US$481 in 1990, higher only than that of Bolivia, Haiti and Nicaragua. Extreme poverty affects over 50 percent of the population nationally and nearly 80 percent in rural areas. Infant mortality is over 60 per 1000 live births. Malnutrition is severe, particularly among children, and nearly two thirds of the population lack adequate housing and sanitary facilities. More than 30 percent of the adult population is illiterate. 4. Until recently Honduras' development strategy was inward-looking, based on import substitution behind high protective barriers and extensive government intervention involving credit subsidies, price controls and tax incentives. As a result of this strategy, the manufacturing sector is inefficient, much of agricultural production does not reflect the country's comparative advantage and overall productivity is low.  5. Honduras' most important sector is agriculture, with output dominated by two crops - coffee and bananas - which account for 55 percent of total exports. Honduras' dependence on two major commodities with widely varying prices has been partly responsible for persistent balance of payments difficulties, as booming exports have tended to fuel domestic expenditures, which failed to contract when export prices declined. 6. Honduras, together with other Central American countries, experienced a severe drop in economic activity during the early 1980s. While real GDP growth had averaged 5 percent per annum during the 1960s and 1970s, it averaged only 1.1 percent per annum during the first half of the 1980s, well below annual population growth. Between 1981 and 1988 gross domestic investment as a share of GDP averaged 16Z, compared to 22Z during the 1970s, due primarily to the sharp decline in private investment which fell from an annual average of about 14 percent in the 1970s to less than 8 percent during most of the 1980s. 7. Access to abundant bilateral and multilateral credit allowed the Government to stave off a major balance of payments crisis and to avoid for several years the painful adjustment measures needed to address the economy's structural problems. As a consequence, Honduras external debt grew sharply during the 19809 almost tripling to over US$s.O billion by 1989; a significant factor for this increase was the financing of a large hydroelectric project, El Cajon, in which the Bank participated. Approximately 75 percent of the total external debt is held by official creditors while multilateral debt accounts for 45 percent of the total. In 1987, however, both coffee prices collapsed and the pattern of net positive capital inflows stopped, unmasking the underlying structural distortions constraining economic growth. 8. Recent Economic Developments. A series of ad hoc measures by the Government in 1987 temporarily averted a massive financial disequilibrium. However, the Government's recourse to arrears and the financing of the public sector deficit from domestic sources intensified pressures on the balance of payments and triggered an acceleration of inflation. By 1988 Honduras was in arrears with all of its creditors, inflation was on the rise, and the difference between the official and parallel exchange rates widened to 40 percent. The Government's efforts to undertake a program of economic reform were supported by a Bank Structural Adjustment Loan (Ln. 2990-HO) for US$50 million approved by the Executive Directors in September 1988. The economic reform program was aborted shortly after the release of the first tranche as the Government grew increasingly reluctant to adopt the necessary strong stabilization and adjustment measures. Negotiations with the IMF on a standby were derailed and the economic situation continued to deteriorate with accumulated external debt service arrears reaching over US$450 million by March 1989 and the gap between the official and parallel exchange rates growing to 60?. 9. Honduras' economic performance in 1989 reflected the fundamental structural weaknesses in the economy that made lonig-term growth unsustainable unless a major economic reform program was implemented. Real GDP growth fell from 4.7 percent in 1988 to 2 percent in 1989. Gross domestic investment and national savings declined during the 1980s,  reaching 13 percent and 6.1 percent of GDP, respectively in 1989. At 9.2 percent of GDP, the overall public sector deficit remained high despite sharp declines in public investment, and public sector savings were negative (-2 percent of GDP). The current account deficit of the balance of payments reached 6.7 percent of GDP, and the Government's insistence on maintaining an overvalued exchange rate continued to reduce the competitiveness of Honduras' exports. Net external financing, including grants, was not sufficient to cover the fiscal deficit and the Government resorted to domestic financing in an amount equivalent to 5.1 percent of GDP. The rate of domestic inflation as measured by the WPI increased to about 20 percent in 1989 (4.8 percent in 1988), and Honduras' arrears on its external debt reached US$630 million. By the end of 1989, Honduras had entered into stagflation, while the black market exchange rate reached over L4/US$l, i.e. more than double the L2/US$1 official rate. HONDURAS: Basic Economic Indicators Growth Rates (Z per annum) 1973-80 1980-88 1988 1989 Gross Domestic Product 5.3 2.3 4.7 2.1 Total Consumption 6.1 2.5 6.0 0.6 Gross Domestic Investment 9.3 -3.8 -4.9 0.9 Exports 3.6 1.4 3.6 4.6 Imports 7.3 -1.3 1.5 0.5 Inflation (CPI period averages) 9.9 5.7 4.5 9.8 Population 3.5 3.5 3.1 2.8 B. Government Economic Reform Program 10. The Callejas Government, which assumed office in late January 1990, has set out to redefine the role of the state through a radical but long overdue economic reform and restructuring program. The essential aim is to reduce the complex regulatory framework and costly subsidies which pervade the economy, and to encourage private sector investments through reform of the trade regime, public sector management reforms, changes in pricing and credit policies, financial sector reforms, and establishment of a long-term macroeconomic framework free of distortions. 11. On March 2, 1990, in e sharp break with past economic policies, the Government embarked on a bold program of economic reforms for which it sought the support of the Bank, IMP and Interamerican Development Bank (IDB). The major policy changes included: (i) a trade reform, reducing the range of the tariff structure from 90-1 percent to 20-5 percent by 1992 and eliminating most exemptions and surcharges; (ii) adoption ofl a flexible exchange rate management policy with an initial adjustment of the exchange rate to L4/US$l (with the exception of debt equity conversions which remained at the official L2/US$l rate); (iii) a fiscal revenue package, which by introducing changes in the rates of sales and other taxes, eliminating exemptions in the trade regime and imposing temporary taxes on  - 4- exports, was expected to increase Central Government revenues from 16 percent of GDP in 1989 to 21 percent of GDP in 1990; and (iv) a Government budget for 1990 which limits current expenditures to about 21 percent of GDP, turning around the consolidated public sector savings to about 0.5 percent of GDP (-2 percent in 1989). Despite the effect of the devaluation on public sector debt service (an increase of about 2 percent of GDP), the overall public sector deficit was targeted to be reduced to 6.9 percent of GDP, permitting its financing with only small recourse to domestic credit (0.5 percent of GDP). 12. In order to cushion the social effects of its adjustment program, the Government has created the Honduran Social Investment Fund (PHIS) to operate flexibly and efficiently. The FHIS combines an emergency employment strategy with the objective of poverty alleviation through the financing of social infrastructure such as rehabilitation of health posts, schools, water and sewerage systems, emergency employment programs, targeted projects in health, nutrition, and education, and a limited number of productive projects. The Government is also developing a program, with the support of the Bank and in the context of SAL II, to address the longer-term issues of education and health services. 13. Under the umbrella of the Bank-chaired Consultative Group for Honduras, a bridge financing package was arranged with the support of the U.S., Japan, Venezuela and Mexico, and in late June/early July 1990 Honduras cleared all outstanding arrears with its multilateral creditors. On July 3. 1990, the Executive Directors approved the release of the second tranche of SAL I. A standby arrangement was approved by the IMF's Board on July 27, 1990. In support of the Government's stabilization and adjustment efforts, a Second Structural Adjustment Loan (Ln. 3257-HO) for US$90 million was approved by the Bank on September 13, 1990. A detailed description of the Government's adjustment program and SAL II tranche conditionality is contained in the SAL II President's Report. The policy matrix is attached as Annex V to this report. Honduras reached agre*ment with its bilateral creditors at a September 14, 1990 meeting of the Paris Club, receiving the most favorable terms recently adopted by the Club for highly-indebted, lower-middle income countries. 14. Macroeconomic Stabilization. The Government's request for a standby arrangement for SDR 30.5 million was approved by the IMP's Executive Board on July 27, 1990. The first disbursement of SDR 16.95 million was made on August 3, 1990. The IMP completed its first review on December 19, 1990. The second disbursement of SDR 4.3 million was made on December 26, 1990. Although the standby performance criteria for end- September were met for cumulative central government expenditures, the contracting of public sector debt, and increases in short-term credits, the Government was unable to meet the criteria for net international reserves, net domestic assets of the Central Bank, external arrears and net domestic financing of the public sector. The Government requested a waiver for the nonobservence of the performance criteria for end-September and a modification of some of the performance cUiterta for end-December. In light of the authorities implementation of corrective measures to bring the program back on track, the IMF approved the waiver and other modifications requested. The next review is scheduled for January 1991.  15. Adiustment Performance. Implementation progress to date under the adjustment program has been good. Following further discussions and agreement between the Government and the IMF on corrective stabilization measures in late October and early November 1990, the first tranche of US$45 million of SAL II was released on November 15, 1990. The trade reform is proceeding as announced by the Government. In addition, the temporary tax on non-traditional exports was phased out in October in advance of the Decermber 31, 1990 target date under SAL II. In the fiscal area, the Government has continued to adhere to the agreed targets despite * the adverse effects of the oil shock, banana strike and recent flood damages. Although the expected increase in tax revenues did not materialize because of tax administration deficiencies, the targeted reduction in the fiscal deficit was achieved because of a higher-than- planned reduction in current expenditures (excluding interest payments). To strengthen the finances of public enterprises, major price hikes for public utilities (water, telephones and electricity) were approved by the Congress in September 1990. Fuel prices were increased significantly in October 1990, which has resulted in full pass-through of international prices for oil products to domestic consumers, discontinuing the earlier policy of subsidization and its negative fiscal impact. 16. In spite of restrictive fiscal and monetary policies, the initial adjustment of the exchange rate was not sufficient to deter continued speculation against the Lempira and the exchange rate was further adjusted in May 1990 to L4.2/US$l. Public uncertainty regarding the Government's ability to sustain the fiscal reform effort widened the gap between the official and parallel rates to 35Z, prompting the Government to introduce a two-tier exchange rate regime with an official exchange rate of L4.2/US$l and freely floating exchange rate that reached L5.8/US$l by September of 1990. In October, the official exchange rate was adjusted to L5.5/US$l and the previously free segment of the foreign exchange market was eliminated. The exchange rate was further adjusted in late October to L5.4/US$l and again in December to L5.3/US$l. 17. In the financial area, interest rate lending ceilings for trade commerce and consumer loans were eliminated in October 1990. In November, lending interest rates were also fully liberalized for industry and agroindustry, leaving ceilings for only domestic agriculture and low-cost housing (representing about one third of commercial banks' loan portfolio). The remaining ceilings will be adjusted in line with the average effective rate in the free interest rate segment of the market and will be eliminated by the end of the IMF stand-by program (July 1991). A Bank supervision mission to review compliance with SAL TI second tranche conditionality will be visiting Honduras in January/February 1991. The policy matrix attached to this report indicates our current assessment of compliance by condition for the second tranche, with a number of conditions to be reviewed in detail during the mission.  - 6- C. Agenda for Future Policy Reform 18. Key Issues. Honduras' medium-term growth strategy requires measures that will provide a stable economic environment to increase domestic savings, and a. price incentive system which will maximize private sector investment in export-oriented and efficient import-substitution activities. Htaintaining sound monetary, exchange rate and fiscal policies under a stabilization program will be fundamental to the success of adjustment policies required for long-term growth. The major elements of such a program will need to include (i) a continuing reduction of the public sector def:.cit; (ii) a reduction in inflation to international levels; (iii) full liberalization of domestic interest rates; and (iv) a freely floating exchange rate regime to be achieved as part of the IMF standby arrangement by July 1991. The principal areas of the medium-term adjustment policy agenda include (i) further reform of public enterprises; (ii) rationalization of the price incentive framework; (iii) measures to reduce poverty through social sectors reform; and (iv) prudent management of the country's natural resources and environment. 19. Public Enterprise Reform. The public enterprises in Honduras have contributed to the fiscal deficit and external public debt service. The public enterprise sector grew rapidly during the 1960s and 1970s, reflecting the Government's desire to spearhead economic development, create employment and promote the growth of underdeveloped areas. However, the sector has performed erratically, and its contribution to the national economy has not been commensurate with the amount of 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 viability. 20. Reform of the public enterprise system will requires (i) institutional and regulatory changes in the framework governing the functioning of the enterprises and their relationship with the Central Government; (ii) modifications in the price adjustment and collection mechanism; and (iii) strengthening of the internal organization and management of the enterprises themselves. A case of special concern is that of the power company, ENEE (which holds about 252 of Honduras' foreign debt). The financial obligations incurred for the construction of E1 Cajon, together with the additional financial requirements associated with the weakening of the US dollar (69X of ENEE's external debt is denominated in currencies other than the US dollar) have forced the company to incur arrears with most of its lenders. The Energy Sector Adjustment loan will support, inter alia, a financial restructuring of ENEE and the development of a comprehensive energy sector policy and strategy, focusing on the application of tariff and investment principles based on economic and financial criteria.  - 7 - 21. 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 private sector-led growth. Considerable progress has already been made in these areas. Price controls constitute a problem primarily in the agriculture sector. The Government's program calls for a major overhaul of its pre-1990 policies for agriculture. The guarantee price system and quantitative restrictions on basic grains currently administered by IHMA (National Supplier of Basic Products) should be eliminated and in the case of corn replaced by a flexible tariff system. Public sector interference in marketing of other agricultural products should be phased out. To that end, IHMA and BANASUPRO's (National Agricultural Marketing Institute) purchasing and marketing activities are to be increasingly transferred to the private sector, with prices determined competitively. Specific action programs to meet these objectives have been agreed with the Bank under SAL II. 22. Social Sectors. There is still widespread poverty in Honduras, reflected in the low per capita income figure and low health, nutrition and education indicators. Basic infrastructure for health and education are inadequate and social services delivery is inequitable. The primary health care system currently reaches only 60X of its target population. There is a lack of basic equipment and supplies for health posts and an insufficient number of paramedical personnel. In education, there is a shortage of classrooms, textbooks, and teaching materials. This situation has been exacerbated by the austerity measures undertaken as part of the Government's stabilization and adjustment program. The major issues in the social sectors include: (i) inadequate emphasis on primary education, (ii) a focus on curative rather than preventive health care, (iii) inadequate incentives for teachers and health workers resulting in inefficiency in delivery of social services, (iv) excessive centralization of budget, staff and services, (v) insufficient cost recovery, and (vi) lack of institutional capacity of social ministries and line agencies. 23. Recognizing the lack of capacity of the social ministries to address the long-term issues of health and education efficiently and equitably, the Government has requested the Bank's support to improve service delivery of the MOH and MOE. This would imply a broad and far- reaching restructuring of the social sectors. The Bank has been helping the Government analyze the issues and has started discussions on possible strategies for restructuring the sectors. 24. Natural Resource Management and the Environment. Honduras' main environmental problems are deforestation, waste of wood resources and land erosion. Deforestation has proceeded at an alarming rate. Forests accounted for 6.8 million ha. in 1964, but only for 5 million ha. in 1988. Because of promising world market prospects for wood, appropriate management techniques of this forest is of special value for the country's long-term economic prospects. Land 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 were appropriate for annual crops and the  - 8 - difference was suitable for perennial crops, or artificial pasture. However, crops and pastures utilized 2.8 million ha. of which 1.5 million ha. were for crops cultivated in 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 become a major problem by reducing the life of hydroelectric plants. 25. Deforestation and land misuse have been encouraged by economic policy and legislation which does not guarantee private property rights over the forest. The Government's agricultural strategy, supported by the proposed Agricuture Sector Adjustment loan, would address these issues, based on an examination of the legal provisions which have led to the waste of forest resources and the inadequate use of land, and of the regulatory environment and the economic incentives and disincentives for the conservation and exploitation of forest resources. D. Medium Term Prospects and Financing Requirements 26. As the initial impact of the March 1990 measures filtered down, employment and growth deteriorated. Agricultural production is expected to increase only slightly in 1990 because of the losses in banana production. Modest gains in production levels in the manufacturing sector were offset by a slowdown in construction and services. Real GD? is now projected to decline by 3-4 percent in 1990. The rate of inflation has also increased as the CPI rose by an annualized rate of 32 percent in the first eleven months of the year. 27. Despite this short-term deterioration, the stabilization and adjustment measures taken sa far have improved the country's long-term balance of payments and growth prospects. Honduras' rich agricultural resources, tourism and hydrocarbon potential offer the opportunity for diversified growth in many sectors of the economy, with excellent prospects for exports, given its easy access to the U.S. market and its comparative advantage in agricultural production. 28. As indicated pr'viously, the full potential of the Honduran economy has been construined during the 19809 by the deterioration of the terms of trade and by the misallocation of resources cre^-ted by the Government's macroeconomic policies. Although little can be done to avoid the effects of external shocks on the domestic economy, a shift in domestic policies away from protectionism and Government intervention in the economy should encourage the private sector to invest in activities where Honduras holds a strong international comparative advantage. With the appropriate exchange rate policy, trade liberalization should increase the real exchange rate, shifting resources toward the production of exportable goods where Honduras is internationally competitive such as bananas, coffee, shrimp farming, vegetable production, and fruit to be supplied in the Northern winter period such as melon, watermelon, etc. Moreover, efficient import substitution would complement the effects of export expansion by reducing the country's imports of basic grains. Early indications suggest a record harvest for corn, which may even permit corn exports in 1991. Because of the high labor content of all these activities, Honduras' unemployment rate is expected to gradually drop and employment to shift from subsidized jobs (in Government or supported by the Government's protectionist policies), to jobs sustainable over the long term.  - 9 - 29. Flexible management of the exchange rate and the fiscal adjustment measures taken by the Government should result in a real devaluation that restores the puichasing power parity of the early 1970s. Although import volumes are initially squeezed as their domestic currency price rises, Honduras' cost competitiveness is expected to rise strongly as the Government's trade liberalization measures are implemented. Conversion of quantitative restrictions to tariffs will increase public sector revenues. Over the medium-term, however, trade liberalization will reduce the revenue impact of tariffs and will change the pattern of imports. Border pricing will eliminate distortions which adversely affect agricultural sector productivity. Interest rate liberalization and an ending to credit allocation policies will increase private savings and private investment. 30. Bank projections (Annex III) indicate that implementation of the stabilization and adjustment measures would help maintain Honduras' price stability, strengthen long-term growth prospects, and improve the balance of payments situation. Public sector savings should turn around from negative in 1988-89 to around 3.5 percent of GDP in 1995. The overall public sector deficit is projected to fall to 2.8 percent of GDP by 1995, allowing a drop in the net domestic financing to the public sector from 5.1 percent in 1989 to less than 1 percent in 1995. Led by the private sector, total investment is expected to recover, reaching 19 percent of GDP in 1995. 31. Acceleration in the growth of non-traditional exports should result from the liberalization of the trade regime and the flexible management of the exchange rate, which would provide incentives for private sector investment in export-oriented activities. Real exports are expected to grow at about 6.0 percent per annum after 1992, with non-traditional exports increasing at a rate of almost 7.0 percent per annum. The rate of GDP growth is expected to increase slowly, reaching almost 3.5 in 1993, and after initially jumping in response to the exchange rate adjustment of 1990, the current account deficit of the balance of payments is projected to fall to around 4 percent of GDP by 1995. 32. The 1991-95 financing requirements for this scenario are shown in Annex ITT. Although gross funding requirements would remain large (because scheduled amortization is expected to be quite heavy--on the order of US$150 million until 1994, equivalent to 52 of the average 1989-91 GDP), the economy is expected to become less dependent on foreign transfers. All debt indicators would improve. Inflows from grants are projected to drop from US$175 million in 1990 to about US$70 million in 1995. A large portion, however, would remain financed by bilateral sources, indicating the importance of aid coordination efforts in mobilizing resources from bilateral and multilateral sources to ensure the success of the program. E. Bank Group Operations 33. Composition of Lending Operations. Total lending from the World Bank Group as of November 30, 1990 stands at US$785.9 million, consisting of 36 loans for US$700.9 million and 12 credits for US$85 million. The 12  - 10 - credits are fully disbursed; 30 loans are also fully disbursed. The remaining 6 loans have US$81 million undisbursed as of November 30, 1990. Honduras has repaid the Bank Group US$200.8 million and has a total outstanding IBRD debt of US$422.4 and IDA debt of US$77 million. A summary of operations for the last ten years is given in Table 1 below. Table I HONDURAS: Distribution of Lending. FYBl-91 (US$ millions) Sector Amount 2 No. of Prolects Agriculture 70.0 21.2 2 Industry and Finance 65.5 19.9 2 Transport 23.2 7.0 1 Water 19.6 6.0 1 Municipal Development 6.9 2.1 1 Education 4.4 1.3 1 Adjustment Operations 140.0 42.5 2 TOTAL 329.6 100.0 10 34. Past lending initially concentrated on developing basic infrastructure in power and transport where inadequate facilities hampered the country's development. In the last decade, it has diversified to support the expansion of productive capacity in agriculture and industry and meet urgent needs in education, municipal development and water supply. In contrast, the present lending strategy emphasizes medium-term structural adjustment prompted by the major economic distortions which emerged as external aid flows to Honduras diminished. In view of the urgent need to control the current financial crisis, the Bank Group's strategy is also focused on support for the Government's program of macroeconomic adjustment in the short-term (para. 18). 35. Operational Objectives. The main objectives of the Bank's assistance strategy for Honduras over the medium-term are tot (i) promote development of the country's growth and export prospects and strengthen its creditworthiness by supporting the Government's program of structural adjustment through a series of SALs and SECALs; (ii) assist the Government in mobilizing and diversifying sources of the external finance needed for Honduras' public sector investment program especially on concessional terms through coordination of the Consultative Group for Honduras and greater cofinancing of Bank Group operations; (iii) support a limited number of investment projects in priority sectors, especially in programs targeted to alleviate the impact of adjustment on the poorest sectors of the economy; and (iv) resume regular investment financing around the second year of the adjustment program as country creditworthiness is strengthened.  - 11 - 36. Bank support for the macroeconomic adjustment effort has included: the reactivation of SAL I (on July 3, 1990, the Executive Directors approved the release of the second tranche); a second structural adjustment loan for US$90 million, which is being supplemented by this proposed credit; and sector adjustment loans in Energy and Agriculture currently scheduled for Board presentation in CY91. 37. SAL II. Major actions supported by SAL II include: (i) Export and Trade - flexible management of the exchange rate, rationalization of the tariff structure with reduction in the range from 90-1 percent to 20-5 percent by 1992, elimination of all 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 increasing savings from the telephone and water companies, reforms in the tax system and tax administration; (iii) Agriculture Sector - elimination of all guaranteed prices and price controls, with the exception of corn for which a flexible tariff system will replace the price guarantee system; agreement on a program to rationalize the Government purchasing and marketing agencies; and targets for food and employment assistance; and (iv) Financial Sector - implementation of a flexible interest rate policy, administrative unification of all rediscount and credit lines, phasing out subsidized credit, improvement of the portfolio classification system for the commercial banking system as well as agreement on a minimum capital to asset ratio for all banks, and reorganization of the agricultural financial system. 38. Energy Sector. To complement the ongoing efforts under the adjustment program to streamline decentralized enterprises, the Energy SECAL under preparatior. will support improvements in the power company's (ENEE) finances and management and a reduction in its dependence on fiscal resources. It would also support a new energy sector policy and a program for petroleum exploration and supply management. Some initial actions have already been taken, including an electricity tariff increase in September 1990 and debt rescheduling relief obtained through the Paris Club. Other actions to strengthen the financial and operating performance through greater autonomy and less Government interference in ENEE's day to day operations form part of the conditionality being discussed with the Government in the context of the Energy SECAL. 39. A2riculture Sector. Given the dominance of the agriculture sector in output and exports, the Bank has initiated preparation of an Agriculture SECAL which would continue with major reforms initiated under SAL II and would support policy reforms to take advantage of the country's comparative advantage in agriculture and strengthen agriculture growth in both traditional and non-traditional exports. The proposed adjustment loan would address issues related to (i) price and trade policy for agricultural products; (ii) forest sector policies; (iii) land markets and land tenure policies; (iv) research and extension; (v) the rural financial sector; and (vi) institutional reform. The reforms being supported under the loan are intended to achieve a better use of land and forest resources, increase productivity by improving research and extension, including expanding the  - 12 - role of the private sector and making existing institutions more lean and responsive to farmers' needs, particularly small farmers. Project preparation in both the agriculture and poverty alleviation areas has been able to draw on the resources of the Regional Unit for Technical Assistance (RUTA) which is a UNDP/IDB/World Bank supported regional assistance program to the Central American countries. 40. Infrastructure. Our analysis of the infrastructure required for the success of the export-oriented strategy indicated the need for strengthening the role of the country's transport system, as well as for the development of transport policies to make more effective and efficient use of road and port facilities. The Bank is considering an Infrastructure Rehabilitation Project which would serve to address these issues. A sector study is being initiated to identify the principal constraints the sector faces and the areas where Bank support can most effectively be targeted. 41. Poverty Alleviation. The Bank has taken an active role in assisting the Government in its two-pronged approach for addressing poverty through both sustained economic growth and better targeted social programs for the country's neediest groups. A Social Investment Fund project is expected to be presented to the Board in early 1991 to support the FHIS as well as establish a pilot food coupon scheme for mothers and children under 5 years of age, which, if successful, is to be broadened throughout the country. The Bank also recently completed an indepth analysis of issues in the social sectors. This is expected to lay the basis for a second social Sector 'project to improve and enhance the delivery of social services through the strengthening of the Ministries of Health and Education. The December 1990 Consultative Group meeting in Paris focused on obtaining international donor support for these projects and followed on a meeting on poverty issues in Central America attended by government representatives and donors held in Paris in June 1990. 42. Future Lending. Depending on the progress made in implementing the key elements of the program, follow-up operations may be proposed during the five-year programming period, most likely in PY93-FY94, in the areas of agriculture, natural resource management and the social sectors. We also plan to support small, technical-assistance focused projects to help strengthen specific areas of public sector management and to improve access of the poor to basic services, one of the Government's key objectives. 43. Economic and Sector Work. The Bank's economic and sector work (ESW) in Honduras provides the intellectual basis for our policy dialogue and lending activities. Short issues-papers reviewing the overall macroeconomic situation and identifying measures for immediate policy action in specific sectors were prepared and discussed with the new economic team as well as major reports on public sector expenditure and trade liberalization. A report outlining possible actions for restructuring the social sectors was reviewed with the Government and served as one of the background documents for the December 1990 Consultative Group meeting which focused on the Government's poverty alleviation efforts. Reports on fiscal reform, a new export incentive system and the public sector investment program are under preparation. These reports will recommend the detailed actions to satisfy the conditionality for the second tranche release of SAL II.  - 13 - 44. As part of the next phase of ESW, annual reviews of public sector investment will be undertaken, complemented by assistance to be provided to the Government to strengthen its capacity to plan and prepare a multi-year investment program, including the ability to evaluate projects and prioritize investments across sectors. We also plan to complete a general economic review and an indepth study of the financial sector to follow up the reforms begun under SAL II. Our sector work will focus on the preparation of studies in the areas of water supply and sanitation, transport, marketing infrastructure and education which would underpin our sector policy dialogue, assist the Government in consolidating the gains under the adjustment program and providing a foundation for future lending. 45. Relations with the IMF and Aid Coordination. The Bank and IMF have been working in close collaboration in Honduras and, along with the IDB, have assisted the new Government in developing its economic reform program. The Bank will continue to work closely with the IMF in providing policy recommendations to maintain macroeconomic stability and to ensure consistency in policy reforms. Because of Honduras' significant external financing needs, particularly with the clearance of long-standing 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 for Honduras, in conjunction with informal donor meetings organized around specific macroeconomic policy issues, including establishment of public investment priorities and the building of consensus for addressing long-term development issues. Cofinancing of Bank Group adjustment operations is extensive and could amount to more than US$200 million, with the IDB as one of the major sources. The Federal Republic of Germany is cofinancing SAL II and is expected to participate in the Social Investment Fund project. Discussions are underway to determine the interest of the Government of Japan in cofinancing this proposed credit and the Agriculture SECAL. Close collaboration will be maintained with the IDB and other cofinanciers through joint project preparation and supervision. 46. IFC Operations. IFC, beginning in 1984, has made four loan and equity investments in Honduras totalling US$11 million in pulp and paper, leather tanning, textiles and shrimp farming. 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 to use the Caribbean Project Development Facility to develop viable project proposals. F. Summary Assessment 47. Honduras has begun a long overdue process of economic reform. Preliminary results of the program have been encouraging although there is evidence of widespread popular discontent with continued austerity policies. The private sector remains uncomfortable with the shift to greater reliance on market forces in lieu of the more traditional means of  - 14 - seeking relief through direct Government intervention. Consequently, the country's economic and financial situation remains fragile, particularly due to the oil price increases and recent flood damages (para. 51), and could deteriorate rapidly if under political pressure or inadequate levels of external financing, tba Government reverts to the economic polices of the past two decades. ThI- Bank's program of assistance, including this proposed supplemental crcuit to SAL II, plays a key role for supporting the Government's efforts to deepen its structural reforms and obtain the financial support of the international donor community. 48. Our assistance strategy is conditional on the continued willingness and ability of the Government to carry out the adjustment effort; it will require constant close monitoring and regular reviews to adjust the strategy as events develop. Criteria to judge progress would include a supportive macroeconomic framework, particularly management of the exchange rate and public finances; public sector management and public enterprise performance; and progress in social sectors reform. Each sector adjustment loan would be coordinated with, and tied to, the macroeconomic adjustment program as well as to relevant elements of other sector loans, where appropriate. 1I - THE RATIONALE FOR SUPPLEMENTAL FINANCING 49. Both the impact of higher oil prices and banana export losses have adversely affected Honduras' balance of payments in 1990 and 1991. Honduras is totally dependent on imports for all of its petroleum needs, taking advantage of the San Jose Accord for the supply of crude oil and oil products from Mexico and Venezuela. The rapid rise of oil prices, stemming from the Gulf crisis, seriously worsened the country's balance of payments and GDP growth, increasing imports of petroleum products and derivatives from 5.62 of GDP to an estimated 6.8 percent. While prices under the San Jose Accord are set at world market levels, Honduras receives long-term financing from Mexico and Venezuela equivalent to 20 percent of its oil bill for use in the development of energy-related projects. 50. The original estimate for imports of petroleum and derivatives for 1990 was US$138 million. This is compared with oil imports of US$146 million in 1989 and is based on slight estimated declines in price and in consumption. Total oil imports are now estimated at US$167 million for 1990. In addition to the financing scheme mentioned above a recent agreement under the San Jose Accord effective October 1, 1990, extends six months financing for 30Z of the cost of oil shipments when the price per barrel exceeds US$21. Oil imports for 1991 are projected at US$198 million. 51. Both banana production and exports were severely hurt by the banana workers' strike which lasted from June 22 to August 10, 1990. Approximately 2.6 million cases of bananas were destroyed or could not be transported, resulting in export losses of US$18.9 million. Losses of another 5.4 million cases of bananas at a value of US$39 million have been  - 15 - attributed to the strike as a result of neglect and inadequate maintenance of plantings. Recent flooding in the northern coastal areas following heavy rains have caused additional damages dampening any prospects for a quick recovery in production. 52. Taking into account the current account balance impact of both the oil shock and reduced export earnings from bananas (see Annex I), Honduras' external financing requirements for 1991 are estimated at US$628 million, after debt relief provided by the Paris Club rescheduling. Projected disbursements of grants, loans and credits, including SAL II, net direct foreign investment and other sources, will provide about US$554 million (see Annex II). This will leave a net financing gap of about US$74 million to be met through additional financing. 53. In view of the impact of the oil shock on Honduras' balance of payments, combined with banana export losses, the Government's stabilization and adjustment program requires additional external support. Lack of adequate financing will affect the flow of crucial imports, with significant adverse implications for growth in the productive sectors, as well as Government revenues for the budget. Filling this gap is essential to the Government's efforts to keep the adjustment program on track. Support from the World Bank Group and other donors to sustain the program is critical, especially since the Government has taken important actions to respond to these shocks and keep their reform program on course. It is in this context that we are proposing this credit which will act as a catalyst for mobilizing additional resources quickly to meet Honduras' urgent needs for fast-disbursing funds. This amount will cover an important part of the gap for 1991; the rest of the gap will be covered through cofinancing support from the IDB and bilateral donors (see para. 55 below) and the short term financial relief provided by Mexico and Venezuela under the San Jose Accord. Short-term commercial borrowings would meet any remaining gap. PART III - THE PROPOSED CREDIT A. Credit Amount and Conditions 54. The proposed credit would be SDR 14.3 million (US$20 million equivalent) and would be disbursed upon credit effectiveness to supplement the first tranche of SAL II. The credit includes two conditionst Mi) for effectiveness that the macroeconomic policy framework is consistent with the objectives of the Government's adjustment program (this condition is also a requirement for the second and third tranche disbursements of SAL II); and (ii) that the Loan Agreement for SAL II be amended in order to establish as an additional condition for disbursement of the second and third tranches, that domestic prices for oil derivatives are adjusted as necessary in line with changes in world market prices or changes in the exchange rate between the US dollar and the Lempira.  - 16 - B. Cofinancing 55. To meet Honduras' increased need for external financing, the Government has sought additional support from the international donor community. In response, the IDB increased the amount of its cofinancing of the agriculture policy reforms of SAL II from US$50 million to US$60 million. Venezuela, on a bilateral basis has provided US$20 million in assistance. The Federal Republic of Germany has indicated its intention to cofinance SAL II with DM15 million. The Honduran Government is engaged in discussions with the Government of Japan to determine its interest in cofinancing this proposed credit in an amount equivalent to US$20 million. US$5 million in additional balance of payments support to Honduras has already been approved by the Government of Japan. C. Disbursement, Procurement and Auditing 56. The proposed credit would finance the CIF cost of eligible imports by the public and private sectors. Ineligible goods comprise goods financed by other multilateral and bilateral sources, luxury goods and goods intended for military use. Since the proposed credit is a supplement to the first tranche of SAL II, retroactive financing of up to the full credit amount of SDR 14.3 million will be provided for expenditures incurred after September 15, 1990, i.e., four months prior to the expected date of signature of the Development Credit Agreement. 57. Procurement will be carried out in accordance with the Association's Procurement Guidelines. Contracts of the public and private sectors estimated to cost more than US$5 million equivalent will be procured through simplified ICB procedures similar to those provided for under SAL II. However, as the result of the positive findings of a recently completed Country Procurement Assessment, contracts of the private sector, valued at less than US$5 million, while following established procurement practices which are satisfactory to the IDA, would not any longer require quotations from eligible bidders from at least two foreign countries. The SAL II Loan Agreement would be amended accordingly, to become consistent with the SAC. Contracts of the public sector, valued at less than US$5 million, would be procured following Government procurement practices acceptable to the Bank. The Central Bank will be responsible for the collection of relevant documentation and for preparing and submitting withdrawal applications under the loan. Disbursements against contracts valued at less than US$5 million equivalent would be made on the basis of a Statement of Expenditures to be submitted by the Central Bank, with detailed documentation being retained by the Central Bank for review by the Bank as required. For auditing purposes, a separate account would be kept by the Central Bank for all expenditures made under the credit. The account and statements of expenditure would be audited by independent auditors and the audit report would be submitted to the Association no later than four months after the end of the Borrower's fiscal year.  - 17 - D. Risks 58. Implementation of the program has been substantially on track and aonduras' growth prospects are favorable in the medium and long term. Nevertheless, there are a number of risks. First, the economy is still vulnerable to external shocks. Further rises in petroleum prices, increases in the debt-service burden from rising interest rates, devaluation of the US dollar vis-a-vis other major currencies, or drops in the prices of coffee or bananas could render the external accounts very difficult to manage and erase the gains obtained under the program. Second, popular pressure for relief under continued austerity policies may result in policy backsliding by the Government. Third, the level and timeliness of external capital flows may fall short of what is required to maintain financial balance. The first two risks would be addressed through the ongoing policy dialogue between the Bank and the Government and through the careful sequencing of adjustment measures, which are designed to build on and strengthen previous reforms both at the macroeconomic and related sectoral levels. To minimize the third risk, the Bank will continue to seek extensive cofinancing support for Bank Group operations. In this regard the Bank chaired a Consultative Group meeting in Paris on December 5, 1990 to assist the Government in mobilizing additional external financing in support of the adjustment program and for reforms and investment in the social sectors. PART IV - RECOMMENDATION 59. I am satisfied that the proposed credit would comply with the Articles of Agreement of the Association and recommend that the Executive Directors approve the proposed credit. Barber B. Conable President Attachments Washington, D.C. January 4, 1991  18 ANNEX I HONDURAS - BALANCE OF PAYMENTS PROJECTIONS, 1991. (US$ Million) 1991 Resource Balance -15841 Trid. Balance -176.9 Exports of Goods (FOB) 1047.J Imports of Goods (CIF) 1224.2 NFS Balance 2J8. Exports of NFS 170.9 Imports of NFS 147.1 Net Factor Income -209.8 Factor Receipts 16 2 Factor Payments -805.6 (o/w) MLT Interest -197.0 Net Private Current Transfers a0.6 Current Account Balance -411.7 Official