IMF PROGRAM APPEARS IN REACH IF/IF GOH ADOPTS

C O N F I D E N T I A L SECTION 01 OF 05 TEGUCIGALPA 001581

SIPDIS

STATE FOR WHA/CEN, WHA/ESPC, DRL/IL, EB/IFD/OMA
STATE PASS AID FOR LAC/CEN
STATE PASS USTR FOR ANDREA GASH DURKIN
TREASURY FOR C. KUSHLIS
DOL FOR ILAB

E.O. 12958: DECL: 07/02/2013
TAGS: EFIN ECON PGOV EAID ETRD ELAB HO EAGER
SUBJECT: IMF PROGRAM APPEARS IN REACH IF/IF GOH ADOPTS
CIVIL SERVICE REFORM; IS USG PUSH POSSIBLE?

REF: A. (A) TEGUZ 865

B. (B) TEGUZ 1141

C. (C) TEGUZ 494

D. (D) TEGUZ 10

Classified By: AMBASSADOR L. PALMER FOR REASONS 1.5(B) AND (D)

--------------
Summary and Action Request
--------------


1. (C) For its entire year and a half in office, the Maduro
administration has struggled to reach agreement with the
IMF on a Poverty Reduction and Growth Facility (PRGF)
program that will put Honduras back on a growth track and
allow badly-needed permanent debt relief to resume. With
the April adoption of a second tax package that should
increase tax receipts by USD 300 million annually, the GOH
made a major step toward an IMF agreement. World Bank and
IDB approval of projects to strengthen the Honduran banking
system is another important milestone. In the context of
work on the banking sector, the GOH has issued a long
analytical report on the new agricultural credit program
laying out a persuasive case that the law limits and
rationalizes (rather than expands) subsidies provided for
agricultural financing. The most important requirement now
for an IMF program is enactment of a Civil Service
Framework Law that will put a brake on the unsustainable
growth in the central government's wage bill. The IMF

is urging measures that, as part of the creation of a
professional civil service, would fold in the public sector
teachers and medical workers into a single civil service
pay structure. However, President Ricardo Maduro and his
top political advisors fear that change to the special
statutes governing teacher and doctor compensation will
provoke a strong, adverse political reaction; the President
has not yet approved the submission of the bill to Congress
(where it would indeed face a stiff fight). In the
meantime, Honduras' failure to reach an IMF agreement has
ended the technical deferral of Paris Club debt service
payments, once again putting overdue loan payments to the
U.S. into active status. In late June, ExIm Bank took
Honduras off-cover for public sector loans. Lack of
payment on overdue U.S. Department of Defense Loans in mid
July and early September could trigger Brooke Amendment
sanctions. However, the GOH is not at liberty to pay only
one official creditor under Paris Club rules.


2. (C) Action Request: Maduro badly needs reassurance that
(1) the civil service reforms (and the ensuing political
fight) are indispensable, (2) the international community
will support him if he does take this move, and (3) that an
IMF agreement would likely be forthcoming quickly after
passage of the law even if all IMF targets for reduction of
the public sector wage bill are not completely met. Given
the importance of reaching an IMF agreement this summer,
the critical nature of this long-awaited structural reform
and the advances made in other areas, Post recommends a
full court press by the Embassy and Washington agencies to
provide this reassurance and urge that the Civil Service
Framework Law (and the related elimination of the
compensation provisions in the teachers and medical workers
laws) be introduced to Congress immediately. End Summary
and Action Request.

-------------- --------------
Projections Show that Second Tax Bill Will Deliver Promised
Revenue Increases
-------------- --------------


3. (C) As reported in ref A, on April 2, the Honduran
Congress adopted a second fiscal package (the first was
adopted in May 2002) designed to broaden the tax base, help
reduce chronic budget deficits and move the government on
the road to an IMF agreement. Congress modified some
politically difficult provisions in the government-proposal
but increased taxes on tobacco and alcohol in order to
replace the foregone income. The target had been an annual
increase of 3.5 billion lempiras (USD 202 million) - of
which about 2 billion lempiras (USD 116 million) would be
collected in the remaining months of 2003, but at the time
of passage IMF staff were skeptical that these targets
would be met by the revised bill.


4. (C) Current GOH projections show that in fact the second
tax bill should almost exactly meet its targets. Tax
revenue in 2003 is projected to rise from the baseline
level of USD 1.1 billion (16. 0 percent of GDP) to the
current 2003 projection of USD 1.23 billion (17.5 percent
of GDP) and then to USD 1.43 billion in 2004 (18.6 percent
of GDP).


5. (C) Combined with earlier austerity measures taken in
2002 and 2003, the tax reforms should bring the central
government's fiscal deficit down from 5.6 percent in 2002
to an estimated 3.5 percent of GDP in 2003, as predicted.

-------------- --------------
Civil Service Law and Modification of Estatutos Still Key
Sticking Point
-------------- --------------


6. (C) The most problematic issue remains: getting public
sector wages under control. The IMF mission has emphasized
repeatedly the importance of enactment of a new civil
service framework law that will provide the GOH with
control over wage policy for all central government workers
by superseding the salary provisions in the
profession-specific laws (called estatutos) that were
adopted in the mid-1980s. The Fund has also urged the GOH
to reduce the central government wage bill from 10.7
percent to 10.1 percent of GDP in 2003 and reduce the wage
bill of the entire public sector by one percent of GDP
annually in 2004 and 2005.


7. (C) Enactment of civil service reform was a key
(unfulfilled) condition in the previous three-year PRGF
agreement with the IMF, and has taken center stage in the
negotiations that have been going on between the Fund and
the GOH since early 2002. Under the current regime,
doctors and teachers have received high salary increases
each year while non-unionized public sector workers have
seen their salaries frozen. The salary provisions in the
teacher "estatuto" are particularly complex, with the
various provisions on salary and benefits resulting in
compensation increases at rates far above inflation. This
issue took on added saliency in July 2002 when the GOH
reached an agreement with the majority of teachers to
provide a 44 percent salary increase over four years
(2002-2005),without affecting the concomitant increase in
the benefits (called colaterales). Among other aspects
that rankled the IMF staff to no end, this agreement
provided the teachers with two separate wage increases in

2005.


8. (C) As seen in previous Embassy reporting, the Maduro
Administration has been promising to introduce the civil
service bill for many months, but kept breaking that
promise. Behind the scenes, an intense debate was
occurring over the extent to which teacher, doctor and
nurse compensation would be covered by the new civil
service rules. The GOH wanted to include only the basic
salary, while the IMF was adamant that all salary and
benefits provisions in the "estatutos" would need to be
eliminated if the law was to have its intended effect of
reining in the growth of the wage bill. The Fund staff
also pushed for elimination of one of the scheduled teacher
raises in 2005. At the same time, the GOH was negotiating
with the doctors to accept the revised pay structure.
Although doctor and nurse salaries comprise only a small
percentage of the government wage bill, their salary
demands are so obviously out of line with regional norms
that the GOH hoped they could be pressured (or shamed) into
an agreement. This strategy was not successful and the GOH has
suspended negotiations for now.


9. (C) Post understands that the IMF and the Finance
Ministry have now worked out language for the Civil Service
law that would eliminate all salary provisions in the
teacher and medical worker statutes except for the hardship
locality differential (called the zonaje) and the June and
Christmas bonuses. Teachers would be covered by the new
law starting in June 2005 (allowing the government to avoid
that second pay increase for 2005). The law would call for
establishment of civil service grades and pay scales within
six months of enactment of the law. Those government
employees whose current salary exceeds the pay scale of
their new civil service grade would forego future raises
until such time as their salary was no longer above the
cap.


10. (C) This formulation for teacher compensation will be
politically difficult to sell, but at least allows the
government to avoid reducing any teacher salaries below
their current level (almost inconceivable in the Honduran
political climate). The flip side is that maintenance of
current teacher salary levels means that the government
would have no room to provide any increases for other
government workers in 2004. This could mean a third year
of a wage freeze for these other public sector workers, an
unpalatable but probably necessary result of the current
fiscal situation. Low public sector salaries are one
important cause of corruption and incompetence in GOH
agencies.

-------------- --------------
The Financial Sector and the Agricultural Credits Law
-------------- --------------


11. (C) In its Article IV review of Honduras, the IMF Board
noted the importance of addressing the extreme fragility of
the Honduran financial system. In late June 2003, the
World Bank adopted an USD 11 million loan to address the
weaknesses identified in the recently concluded Financial
Sector review (FSAP). Comment: This push to analyze and
address the deep problems in the financial sector is a GOH
initiative (specifically by the current Banking and
Insurance Commission President Ana Cristina de Pereira).
It is a complicated task, and the difficulty of the task
should not be underestimated. But, the Maduro
administration is making a far more serious attempt than
any previous Honduran government. End Comment.


12. (C) The GOH appears to have been sincerely puzzled and
shocked by the controversy generated in the IMF and USG
over the adoption of Decree 68-2003, which consolidated the
agricultural loans, interest rate subsidies, amnesties and
other measures in three previous laws adopted by Congress
during 2000-2002. The government believes that the new law
actually lowers the cost of its assistance to the
agriculture sector substantially and limits its exposure.
As previously promised, the Ministry of Finance and the
Banking and Insurance Commission have developed a 32-page
analysis of the four laws and their implications for
government finances. During the week of June 23, this
analysis was sent to the IMF along with a computer disk
containing the names of all the beneficiaries. A copy of
the paper, written in Spanish, is being faxed to State
(WHA/CEN/Brett Makens) and Treasury; a fuller summary will
be provided septel.


13. (C) The previous three laws, adopted starting in 2000,
were motivated by a wish to help farmers and the banks to
overcome the financial losses suffered during and in the
aftermath of Hurricane Mitch in late 1998 and the ensuing
stagnation in the sector. According to the GOH report,
the measures provided interest rate subsidies for loans
totaling USD 252 million, loan forgiveness of USD 39.6
million, financed by bonds, and commitments to extend these
benefits to an additional USD 83 million worth of loans.
The previous decrees also authorized automatic guarantees
for ag loans (50-70 percent) that represented an additional
contingent obligation for the government, estimated at USD
144.5 million.


14. (C) Decree 68-2003 was developed to consolidate the
committed fiscal resources into one mechanism, in order to
rationalize the credit programs, avoid additional
contingent liabilities, relieve pressure on the banks with
large outstanding agricultural portfolios and encourage the
provision of new loans to the Honduran ag sector.
Delinquency in loan repayment and other high risk factors
have resulted in a rapid contraction of agricultural
lending by the Honduran financial system. The GOH report
notes that new agriculture loans accounted for 8.3 percent
of bank lending in 1999 and only 4.1 percent in 2002.


15. (C) The IMF staff working on the Honduran program
reacted strongly and adversely in April to the news of
Decree 68-2003, terming it a new subsidy program that
benefited large, politically influential landowners that
would have an immediate negative impact on government
finances and the IMF program under negotiation. The GOH
report is an attempt to demonstrate that this program is
not at all new and that the costs are actually lower than
would be the case under the previous system. The
beneficiaries are limited to those individuals who already
were entitled under the previous three decrees. Note: A
modification made by Congress in April to the bill would
have made the benefits available to additional (unlimited)
beneficiaries now and in the future; Econoffs heard in May
from members of the Bankers' Association that this news was
resulting in widespread loan payment delinquency and new
requests for debt forgiveness. The government subsequently
worked with the Congress to correct this issue in the final
version of the law, before it was signed by the President
and published. End Note.


16. (C) The tables below provide the government's estimates
of the costs implicit in the earlier regime and the new
one. The cash cost of the various agricultural credit
programs has been reduced slightly in nominal terms and
significantly in present value terms.

Financial Costs of Previous
Scheme

Nominal Present Value
-------------- --------------
(USD million) (USD million)

Interest Subsidies 86 65
Interest on bonds 21 13
Transfers to BANADESA 33 19
Funding of FONGAC 28 28
Bond issue -- 17
-------------- --------------
168 142

Financial Costs of Current Scheme

Nominal Present Value
-------------- --------------
(USD million) (USD million)

Transfers to trust 98.0 80.0
Interest on bonds 9.6 7.4
Transfers to BANADESA 33.0 19.6
Funding of FONGAC 11.3 --
Subsidies already paid 11.0 --
-------------- --------------
162.9 107.0

Note: The current exchange rate is 17.3 lempiras to the
dollar.


17. (C) Why wasn't there better consultation with the IMF
and USG? The GOH explanation is that they did consult, but
they really didn't see it as a new program with new fiscal
costs. The law was mentioned in passing by the Finance
Minister to IMF Mission chief and IMF permanent rep early
in the year. Banking Commission President Ana Cristina
Pereira indicates she had discussed it with members of the
IMF-World Bank FSAP team, but the resident director of the
World Bank program is not aware of these discussions (the
FSAP included a large number of small teams working on
different aspects of the financial sector). President
Maduro did not raise the issue during his meeting with US
Treasury Secretary Snow, probably for the same reasons. In
response to complaints from Washington about the lack of
consultation, the GOH is now doing its best to put as much
information on the table as possible.

-------------- --------------
The Implications for Debt Deferrals and Forgiveness
-------------- --------------


18. (C) In the meantime, Honduras' failure to reach an IMF
agreement has ended the deferral of Paris Club debt service
payments, once again putting overdue loan payments to the
U.S. into active status. In late June, ExIm Bank took
Honduras off-cover for public sector loans. The Embassy
has informed the GOH that lack of payment on overdue
Department of Defense Loans -- USD 12,187 in mid July 2003
and USD 1,762,150 in early September 2003 -- could trigger
Brooke Amendment sanctions. Embassy also is exploring
whether other overdue loans could trigger 620Q sanctions.
The GOH is not at liberty to pay only one official creditor
under Paris Club rules. According to the GOH's accounts,
outstanding debt service owed to the USG (Department of
Defense, Eximbank and AID) totals USD 17.7 million Of
this amount, 8.1 million is over 6 months overdue and could
trigger Brooke or 620Q sanctions.
--------------
Can the USG Help Push This to A Close?
--------------


19. (C) In candid conversations with the Ambassador and
other USG officials, President Maduro and Minister of the
Presidency Luis Cosenza (and their political advisors) have
repeatedly emphasized (1) how difficult politically it
would be to change the teacher and medical worker statutes
and (2) how unfairly the IMF has treated the Maduro team,
when the very policies that have caused the underlying
fiscal problems were enacted by the two previous
administrations without protest from the IMF at the time.
For the last year and a half, while the macroeconomic team
has conducted the difficult negotiations with the Fund, the
top level of government has flailed around trying to get
high-level donor pressure on the Fund to back down on some
of its conditionality. Many in the donor community
(including members of the EU and international financial
institutions) have expressed sympathy for the position.
But none of these urgent requests for flexibility have
helped soften the IMF position (recently confirmed during

the Article IV consultations). In addition, some have
suggested that it might be best for the GOH to request a
change in the IMF mission staff so that past differences of
opinion do not continue to color future negotiations. The
GOH has asked the Embassy for its recommendations on this
rather sensitive suggestion.


20. (C) Comment: There is a lot of truth to the GOH claims
that the underlying macroeconomic problems (such as the
statutes, the web of special tax exemptions and the ag debt
forgiveness programs, to name three) were inherited from
previous administrations and that the IMF perhaps should
have stood stronger against these policy lapses at the
time. However, the problems are real and, if left
unaddressed, will continue to prevent the achievement of
macroeconomic stability and growth. President Maduro needs
to get control over the public sector wage bill for the
good of the country, as well as for the purposes of an IMF
agreement. Deep down, he knows this. In addition to the
harm caused to efforts to balance the budget and invest in
the country's future, the statutes put the teachers and
doctors in a privileged class of public servants, to the
detriment of other public workers. They must be changed at
some point.


21. (C) And, finally, the GOH has come a long way. Post
believes strongly that now is the time for the USG to give
a little push. Maduro badly needs reassurance from high
level USG officials that (1) the IMF-suggested civil
service reforms (and the ensuing political fight) are
indispensable, (2) the international community will support
him if he does take this move, and (3) that an IMF
agreement would likely be forthcoming quickly after passage
of the law even if all IMF targets for reduction of the
public sector wage bill are not completely met. Post seeks
Washington agencies' input and advice on whether this is
appropriate and how best to achieve it. End Comment.

Palmer