Honduras Asks for Help on Paris Club and HIPC

UNCLAS SECTION 01 OF 09 TEGUCIGALPA 002494

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STATE PLEASE PASS TO USAID, USTR, EXIM, OPIC, USED IDB, USED
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E.O. 12958: N/A
TAGS: EFIN ECON EAID EINV ETRD PGOV SENV HO
SUBJECT: Honduras Asks for Help on Paris Club and HIPC



1. (U) Summary and Action Request. The Honduran government
has requested support of the USG (and other donors) to
extend to June 2003 in its Paris Club debt service deferral
and changes in the methodology used for HIPC and Paris Club
debt relief and funding of the GOH's Poverty Reduction
Strategy. Washington agencies are requested to provide
guidance for a response. End Summary and Action Request.


2. (U) In an August 5 letter signed by the Minister of the
Presidency, the Minister of Finance and the President of the
Central Bank, the Honduran government updated the
international donor community Ambassadors on the actions
taken by the Maduro administration to date to improve
government finances and meet conditionality of its Poverty
Reduction and Growth Facility program with the IMF. In the
letter, the Ministers indicated that after analyzing the
implications of the deterioration in government finances in
2001 and the miscalculations in the Flores government's 2002
budget, the GOH took a number of steps designed to improve
tax collection, reduce public spending and make the
government more efficient. In the letter, the GOH
emphasizes that it will continue to work towards fiscal
responsibility and seeks to negotiate a new three-year
agreement with the IMF in October.


3. (SBU) The letter included an attachment outlining some of
the difficulties the GOH has encountered in meeting the
obligations in its Poverty Reduction Strategy Paper (PRS)
and the HIPC debt relief requirements. The attachment ends
with an appeal to the donor countries to support the GOH's
requests for Paris Club debt service deferral through June
2003, for lowering the amount of debt relief assigned to pay
for poverty reduction projects, and for its efforts to reach
an agreement with the IMF on a new three-year PRGF program
by the end of 2002. An informal translation of the letter
is provided in para 5. An informal translation of the
lengthy attachment on the Poverty Reduction Strategy is
provided in para 5.


4. (U) Begin informal translation of August 5 letter.

Dear Ambassador Almaguer,

The purpose of the following letter is to make you aware of
the actions that the Government of Honduras, under the
Maduro administration, has taken during 2002 to stabilize
Honduras' medium-term macroeconomic outlook in light of
serious public finance problems.

As the IMF confirmed during its visit in May 2002, public
finances significantly deteriorated in 2001 leading to
Honduras' non-fulfillment in December 2001 of the
macroeconomic targets that had been agreed by the IMF and
the previous Honduran government. The central government
deficit was six percent of GDP in 2001, while the
consolidated public sector debt was three percent. These
deviations resulted in an unexpected situation for the new
government, especially since the close relationship between
the IMF and the previous government until the end of 2001
had raised expectations that Honduras' fiscal situation was
within the norms established under the IMF agreement. This
situation severely limited our capacity to act over the last
year.

To complicate matters, the previous government's budget for
2002, which was approved by the National Congress in
December 2001, did not include important spending
obligations and overestimated projected income for 2002 by
about 1.5 percent of GDP. Our belief that there were
miscalculations was confirmed by the marked difference
between actual and projected tax collections.

Conscious that this situation was totally unsustainable and
with the intention of orienting the country towards a medium
and long-term vision of fiscal stability, the Honduran
government implemented and is in the process of implementing
a number of corrective measures, including:

-- Issuing Executive Decree PCM-005-2002 which contains a
series of austerity measures to reduce public spending and
save the government an approximately usd 12.3 million in
spending.

-- Passage in Congress of the Financial Stabilization Law
which expands the tax base, reduces tax exemptions,
contemplates sanctions for tax evasion (including the
temporary closure of business),reduces import taxes to
discourage contraband, harmonizes tariffs with the rest of
the region and simplifies payment procedures for tax payers.
Unfortunately, prolonged development of the law and
discussion in the National Congress caused its
implementation to be delayed until July, thus delaying
improvement in tax receipts before then.

-- After a long and difficult negotiation, the Honduran
government agreed to phase-in increases, over a four-year
period, in public school teacher salaries that were due in

2002. Beginning in 2006, new salary increases will be
granted based on increases in the minimum wage. This
agreement will help reduce steep annual salary increases for
public school teachers and will allow the discussion of
teacher's salaries to be included in the government's
unified salary policy in 2006.

-- In July 2002, Honduran authorities began closing
businesses (note: temporarily) that were not paying sales
tax. This is the first time that businesses have been
closed for sales tax evasion and we hope this measure will
help instill a culture of honoring tax commitments in
Honduras.

-- In the second half of 2002, the Honduran government will
begin implementing new administrative procedures to improve
tax collection. We will also conduct a study to re-engineer
the public sector. The results of the study will allow for
greater efficiency and quality of service in the public
sector and at the same time reduce its size.

-- We will soon submit to the National Congress a modern and
equitable Income Tax Law that will complement the expansion
of the tax base and the administrative simplification
process. We will also review the Tax Code.

-- The Ministry of Finance presented to the National
Congress for consideration a report on budget performance
for 2001 and the first six months of 2002. The revised
budget was also published in the two Honduran daily
newspapers with the highest circulation.

-- A new budget formulation policy was designed for 2003,
consistent with the IMF's budget transparency code, which
will eliminate global expenditures (note: large budget line
items which previously were left to the discretion of the
Honduran president to assign to different ministries).

-- By December 2002, a comprehensive, coherent and
consistent civil service reform law will be submitted to the
National Congress.

To complement the government's fiscal measures, the
government has made progress in other important areas to
create an environment that encourages economic growth,
including:

-- The Honduran government has improved its institutional
framework by proposing to create the Supreme Accounts
Tribunal, instituting a new selection process for Supreme
Court Justices, implementing the new Criminal Procedures
Code, making government procurement more efficient and
transparent, transferring management of government
procurement to organizations like the United Nations
Development Program and the World Food Program, who are
improving prices and reducing the potential for corruption,
and working with the Anti-Corruption Commission.

-- With the help of the World Bank and the IDB, the
government is committed to increasing private sector
participation in public services and infrastructure projects
and has begun the public bid process for a new cellular
system contract, selected port services, national mail
service and electricity distribution.

-- The Poverty Reduction Fund Law was approved and
legislative reforms to strengthen the financial system are
close to being approved in the National Congress.

-- The Central Bank of Honduras has instituted open market
operations to orient the market towards an interest rate
more consistent with the decreasing inflation rates
experienced in recent years and obtain monetary base growth
rate in line with the expectations of GDP growth for 2002.

-- The recently approved Monetary Program for 2002 includes
measures to eliminate during July and September the
obligatory investments in government securities by financial
institutions, equivalent to three percentage points of local
currency obligations, and update the minimum capital
requirements for financial institutions. In conformity with
the Monetary Transparency Code, an external audit of Central
Bank operations was completed for the first time.

-- Reforms to the Insurance Deposit Law have been introduced
to the National Congress and immediate actions were taken to
confront two longstanding bank insolvency problems. Assets
and deposits were also transferred from one problematic bank
to a stable institution. Technical assistance has been
solicited from the World Bank to help the Deposit Insurance
Institution value the two intervened banks and formulate a
strategy for their sale over the next year. In the short-
term, the IMF and the World Bank will assist in an analysis
of the financial system that will serve as the basis for
further consolidation of the financial sector.

-- Implementing regulations for the Securities Market Law
have been issued to improve the functioning of Honduras'
securities markets. Technical assistance has been
contracted with IDB funds to issue implementing regulations
for the Insurance Law. The Private Pension Fund Law will be
discussed soon in the National Congress.

-- A program will begin in September with IDB funds to
improve the technical capacity of bank auditors in the
National Banking and Insurance Commission. Basic and
advanced CAMEL training for Banking Commission officials,
with assistance from the IMF's resident advisor in the
Banking Commission, is also underway.

-- The National Competitiveness Council, under the
leadership of the Vice President, was created to encourage
private investment in sectors that have the greatest
potential to generate economic growth.

-- By the end of 2002, a project will be underway to
restructure the different institutions in the public sector
and reduce duplicative functions by government agencies,
eliminate excess jobs and in general terms improve the
provision of services by the public sector to guarantee
efficiency and efficacy in the assignment of financial
resources, public spending and better service to the public.
Before beginning this project, measures will be taken by the
end of the year to reduce the size of the public sector.

The measures described above clearly demonstrate that the
Honduran government is committed to fulfilling its medium
and long-term macroeconomic goals by maintaining balanced
public finances, creating an environment to achieve high and
sustainable economic growth necessary to reduce poverty,
improving the efficiency and quality of public spending,
widening the coverage and reach of programs to reduce
poverty and social spending, eliminating the domestic
financing needs of the public sector and maintaining a
monetary and exchange rate policy in accord with the
requirements of economic growth and competitiveness for the
productive sectors.

The Honduran government presented to the IMF a proposal to
establish a joint work plan for the rest of 2002:

-- The Honduran government reiterates its commitment to
continue coordinating and working with the IMF in
preparation for negotiations by October 2002 of a new three-
year program beginning in 2003.

-- The Honduran government confirms its decision to define
achievable goals within a reasonable timeframe to reduce the
public wage bill as a percentage of the GDP.

-- The Honduran government is committed to take additional
measures to strengthen tax collection, either through
technical assistance by hiring auditing firms and/or
reducing public spending, to achieve a non-inflationary and
sustainable deficit with foreign resources available at
concessional rates.

We hope that the IMF, international donors and other
multilateral institutions accompany the Honduran government
down this difficult road. We are convinced that maintaining
a balanced budget is fundamental to achieving equitable
economic growth, reducing inflation and generating resources
to combat poverty.

Recognizing that it is important that international
bilateral donors and multilateral institutions are informed
about Honduras' current fiscal situation and the actions the
Honduran government has taken and will take to resolve the
fiscal situation, attached are copies of the reformulated
2002 budget, a document reiterating the Honduran
government's medium-term fiscal goals and a detailed
analysis of the current fiscal situation.

End informal translation of letter.


5. (SBU) Begin Informal Translation of Attachment.

Introduction

A crucially important element for any country is to have a
clear vision of its medium and long term goals, along with a
strategy for the design and implementation of the means and
actions that will allow the country to gradually close the
gap between the current situation and the long-term vision.

In this sense, in 2001, the Government of the Republic of
Honduras developed the Poverty Reduction Strategy (PRS)
which represents in and of itself both a commitment and a
shared effort between the Government and Honduran society.
At the same time, this strategy will serve as a general
framework so that the country promotes investment in
projects that are oriented towards the goal of reducing
poverty.

In this regard, a concern of the current administration is
maintaining a macro-economic environment that promotes a
sustainable economic growth. Macroeconomic stability is one
of the fundamental pillars of the strategy, without it, the
country will not be able to generate the necessary funds to
implement the priority investments defined within the
framework of the PRS.

We should note that the main premises that make up the PRS
are sustained economic growth, with equity, macroeconomic
stability, and sustainable government finances.

Within this conceptual framework, we present the medium and
long-term vision of the non-financial public sector (NFPS),
an analysis of the current situation in order to determine
the existing gap between the two situations, and the fiscal
policy measures that the current Government will implement
to close that gap and provide the optimal fiscal framework
to sustain the PRS.

Medium and long-term vision (plan) for the non-financial
public sector

To achieve the necessary conditions to reduce poverty, the
plan that the non-financial public sector needs to have
centers on four primary aspects:

a) Maintain balanced public finances in order to avoid
inflationary pressures and reduce market distortions, thus
guaranteeing the growth of a more solid private sector.

b) Generate the necessary financial resources to carry out
the programs designed to reduce poverty and social costs, as
delineated within the Poverty Reduction Strategy.

c) Improve the efficiency and quality of public spending,
increasing the extent and reach of the programs designed for
social sectors.

d) Reduce the amount of public financing using domestic
resources as much as possible to guarantee that the private
sector will have funds available to finance its productive
activities and generate economic growth and employment.

This plan is based on the principle that the primary
generator of economic growth should be the private sector
and the role of the public sector should be focused on
social activities with the goal of poverty reduction,
establishing a regulatory framework for the development of
the private sector and maintaining the macro economic
stability of the country.

Nevertheless, we need to keep in mind the fact that the non-
financial public sector is made up of diverse players which
we can group as: central government, social security
institutes, government owned companies and municipalities;
each one of these should define their own objectives so that
they may accomplish the goals set out in the global plan.

Central Government

The objectives of the central government should be:

a. Finance the deficit solely with foreign assistance
available at concessional terms to assure the availability
of domestic resources to meet the needs of the private
sector.

b. Increase savings in the current account to raise the
funds required for the execution of infrastructure and
social benefits programs.

c. Control the growth of salaries in administrative
positions and functions that have no positive impact on the
delivery of services to social sectors. This group has had
the most pressing impact on government spending in recent
years. In this way coverage of services can be amplified
without provoking inequality in public financing.

Social Institutes

The objectives that social institutes should set according
to the established plan are:

a. Continue generating a surplus of 1.5 to 2% of GDP

Public Companies

a. Public companies should generate surpluses of 0.5 to 1%
of GDP

b. Establish competitive tariffs for services to citizens,
using existing tariffs in other countries in the region as
an example.

c. Improve and expand service coverage.

d. Control spending growth, especially related to salaries
and payrolls.

Municipalities

Taking into consideration that the process of
decentralization will put municipalities into a more
preponderant role in the country's destiny. Based on the
experiences of other countries in similar situations,
municipalities should work from a balanced budget in such a
way as the total expenditures are entirely financed by the
municipalities own income plus transfers received from the
central government.

Expected Results

The results expected upon completion of the outlined
objectives:

a. Reach a consolidated net deficit for the non-financial
public sector of 0.0% GDP.

b. The net deficit of the central government should be no
more than 2% of GDP

c. Finance the central government deficit entirely with
available concessional foreign funding

d. The rest of the non-financial public sector should
generate a surplus equal to 2% of GDP.

e. Reach annual inflation levels of 2 to 3%

f. Generate real economic growth no less than 5% per year
g. Maintain stability in the monetary exchange market,
guaranteeing the Lempira maintains its competitiveness.

h. Generate a substantial reduction in extreme poverty,
keeping with the goals and indicators as defined in the
Poverty Reduction Strategy.

Actual Situation and estimates for 2003-2007

In order to determine the need to take measures aimed at
achieving the objectives set out in the plan of the Poverty
Reduction Strategy, an analysis of the current situation is
presented which shows the different parts

Central Government

At the central government level, we have seen a decrease in
income through 2001, falling from 19.4% of GDP in 1999 to
18.2% of GDP in 2001. For this reason, the government
presented to Congress the Financial Stabilization and Social
Protection law. It is hoped these measures will increase
income to the Central Government to 20.2% in 2002. After
2002, income will remain relatively stable with revenues
reaching 20.1% of GDP in 2007.

On the expenditure side, there has been marked growth in the
last few years, reaching 25.6% of GDP in 2001 and an
estimated 27.2% of GDP for 2002.

The main source of spending growth is the public sector wage
bill which has grown consistently in the last four years
reaching 10.5% of GDP in 2002. Due to this fact and since
the projections have been elaborated under the assumption of
salary adjustments based solely on inflation, for 2007 we
won't have reached sustainable salary and payroll levels
related to GDP (less than 9%.)

As a result of these tendencies in income and spending, it
is estimated that the central Government could meet its
objectives congruently with the public sector plan presented
earlier and with the fundamental principles of the Poverty
Reduction Strategy up to 2005, at which time the central
Government would generate a savings in their current account
equal to 1.3% of GDP and a net deficit of 1.6%.

Additionally, it should be taken into consideration that for
the years 2003-2005 the projections indicate that the
central government will have to refinance the deficit by
emitting bonds (though this is not congruent with the
objective of reducing the crowding out of the private sector
and maintaining inflation at low levels) or by requesting
new external loans.

According to these projections, the country will be counting
on money inflows on the order of $230 million yearly, a
figure the World Bank has established as adequate to
maintain a reasonable level of indebtedness for the country.
Therefore, financing this gap by additional external loans
could generate problems in the ability to sustain the
foreign debt.

Remainder of the non-financial public sector

In the rest of the non-financial public sector we see a
definite tendency towards a decline in income, after
reaching 14.5% of GDP in 1999 to an estimated 12.3% of GDP
in 2007. This behavior stems from the continued
deterioration of incomes from the most important public
enterprises without any adjustment to the prices of their
services.

This factor has been partially compensated by a declining
trend in expenditures by public enterprises, principally due
to the lack of investment; but after 2002, expenditures are
expected to increase considerably due to planned investments
in HONDUTEL and SANAA. In spite of being necessary for
modernizing and improving customer service this investment
had been postponed in previous years.

In terms of surplus, we see that the rest of the non-
financial public sector could present a surplus of around 2%
of GDP, established as a goal of the PRS, until 2006. This
surplus has shown a downward trend since 2000. This trend
will continue until 2003, when the trend will reach the
point of inflection and turn towards moderate stability.

Overall, the decreases in revenue by the rest of the NFPS
will not be compensated by the revenues to the Central
Government, resulting in declining revenues for the
consolidated NFPS. Simultaneously, the expenses for the
rest of the NFPS, as for the Central Government, show a
downward trend; but not sufficient to counteract the drop in
revenues. The NFPS is expected to be in deficit for 2001-

2005. By 2005, the NFPS should reach its goal of a balanced
financial account. (Chart shows deficit beginning late
2000, dipping and bottoming out in 2001 to 2003 then
reducing the deficit to zero in 2005 and then a surplus
after that.

Conclusions

From our analysis, it is evident that the measures taken
during the course of the current year are insufficient to
generate the conditions of fiscal sustainability required to
achieve the objectives of the Poverty Reduction Strategy.

Some of the most relevant factors that the Honduran
Government face are the salary pressures generated by the
Medical Statute and Teachers Statute (Congressional statutes
requiring exorbitant salary levels for doctors and
teachers). These factors have contributed significantly to
the constant increase in spending in the last few years. It
is also necessary to strengthen the tributary administration
by reducing fiscal evasion and creating a plan for a
reversal of the downward trend in income for the rest of the
NFPS.

Taking the necessary measures to confront the difficult
fiscal situation that faces the country is an undeniable
fact, especially if we consider the deviation between the
projections presented in this document and the macro-
economic framework of the Poverty Reduction Strategy.


Comparative Table of the Deviations
with respect to the PRS
Deficit of the NFPS as a % of GDP

Year Projections PRS Deviation

1999 0.6 1.5 -0.9
2000 0.1 1 -0.9
2001 (2.6) (0.8) (1.8)
2002 (2.5) (0.6) (1.9)
2003 (2.5) (1.9) (0.6)
2004 (1.7) (0.7) (1.0)
2005 (0.2) (0.3) 0.1

Note: Positive numbers represent a surplus and negative
number represent a deficit.

Complementary measures in the implementation process

In order to correct the deviations and close the existing
gap between the current fiscal situation and the medium-term
plan presented, the current Honduran Government has
identified additional methods for the short term in the
following areas:

Measures for strengthening tax revenue
Reengineering Government Program
Additional revenue enhancement measures

Means of strengthening tax revenue

In this area, the Honduran Government will emphasize the
enlargement of the tax base by exchanging information with
municipalities, large contributors and Ministries and
Decentralized Institutions. Also, the government will
ll
conduct prompt audits to detect businesses that are not
registered (additionally eliminating the penalties for not
registering) and businesses that fail to pay taxes, and to
take steps that will instill a new tax-paying culture in the
country. The recent initiative of closing businesses that
evade paying sales taxes is a clear example of this.
Additionally, we will be receiving technical assistance and
initiating a program of external audits to complement these
measures to combat tax evasion.

As a complement to the actions leading to the expansion of
the contributor base, we will be submitting an equitable and
modern Income Tax Law to the National Congress for approval,
emphasizing tax simplification as well as the transformation
from a Sales Tax to a Value Added Tax effective 2004,
consistent with the best tax practices worldwide.

Additionally, the DEI (note: Honduran tax authority) will be
restructured in order to strengthen the tax administration
and make it more efficient. The DEI will be restructured
according to type of taxpayer, consolidating administrative
functions and clearly defining collection operations for
small businesses. To complement this, new automated systems
for information exchange and the administration of the
taxpayer accounts are being established.

Reengineering Program

The objectives of the government-reengineering program are:

Evaluate the composition of the quality and technical
capacity of government personnel to determine a uniform
evaluation and position classification system with
respective requirements for qualification.

Identify the processes and procedures employed in the
performance of duties and provision of services and
improvements needed to increase quality and efficiency.

Define and implement plans to reduce and rationalize
each agency's funding.

Complete an institutional restructuring that will allow
for a reduction in the number of agencies that comprise up
up
the Public Sector and modernize their functions.

We have elaborated the terms of reference and budget for the
re-engineering project. With the support of the World Bank,
we will solicit an international bid in the near future,
with progress expected by the end of the year. As a
preliminary step, we have identified the necessity to reduce
by 21% (equivalent to 5,000 jobs) the number of governmental
administrative positions.

Additional revenue measures

In addition, the Government will be designing a set of
measures designed to improve tax collection that will be put
into effect in January 2003.

Required support

With everything shown here, it can bee seen that Honduras
has advanced considerably in its objective to achieve fiscal
sustainability and the medium-term plan for the public
sector, through the design and implementation of measures
for improvement of tax collection, modernizing spending and
improving the efficiency and effectiveness of public
spending.

It is worth noting that the current Government is aware of
the need for a civil service framework law, which is why it
maintained a firm position during the negotiations with the
teachers. The government expects similar pressures from
other unionized groups in the Public Sector will arise
(Social Security and HONDUTEL). Facing this, the Honduran
Government considers reducing the expectations the other
labor groups have in regards to salary increases to be a
fundamental step. Similarly, we have initiated the process
of drafting a Civil Service Framework Law, for presentation
to the National Congress. This law will emphasize
compensation systems based on inflation and efficiency.

To reach the medium and long-term plan for public finances
and in order to achieve the objectives established in the
Poverty Reduction Strategy, the Honduran Government requests
the support of its allies and multilateral organizations in
the following ways:


1. Receive an extension on Paris Club debt deferral until
June 2003, at which time we hope to reach the HIPC
completion point.


2. Allow the traditional relief received from the Paris
Club to be used for budgetary relief, as has been done since
1991 when the framework was negotiated in the Paris Club for
the first time, and that the debt relief received under the
HIPC initiative be used to finance projects in the Poverty
Reduction Strategy.


3. Include the costs that the government incurs in
increasing the coverage of services in the areas of health,
education and security as part of the expenses to be
financed with HIPC relief funds for a three-year period,
after which they will become a part of the normal expenses
anticipated by the Government and financed with domestic
funds.


4. Support the efforts of the Honduran Government to
improve its public finances and achieve a three-year
agreement with the International Monetary Fund by the end of
this year.

End informal translation of attachment.

ALMAGUER