HONDURAS REACHES PRELIMINARY AGREEMENT WITH IMF ON

C O N F I D E N T I A L SECTION 01 OF 03 TEGUCIGALPA 002792

SIPDIS

TREASURY FOR U/S TAYLOR
TREASURY ALSO FOR RAMIN TOLOUI
STATE FOR WHA/CEN, WHA/EPSC, EB/IFD/OMA
STATE PASS AID FOR LAC/CEN

E.O. 12958: DECL: 11/28/2013
TAGS: EFIN ECON PGOV EAID ETRD EINV HO
SUBJECT: HONDURAS REACHES PRELIMINARY AGREEMENT WITH IMF ON
PRGF PROGRAM - BALL IS NOW IN THE COURT OF HONDURAN CONGRESS

REF: A. TEGUCIGALPA 2648


B. TEGUCIGALPA 1581

C. TEGUCIGALPA 2662

Classified By: Ambassador Larry Palmer for reasons 1.5 (b) and (d).


1. (C) Summary. On November 25, the GOH and visiting IMF
mission announced a preliminary agreement on a Letter of
Intent (LOI) for a three-year Poverty Reduction and Growth
Facility Program (PRGF). The central government deficit
targets are 3.5 percent of GDP in 2004, 3.0 percent of GDP in
2005, and 2.5 percent of GDP in 2006. The program contains
four prior actions that must be taken before the program can
go to the IMF Board of Directors for approval. The first
three require adoption of legislation by Congress of a
government salary law, a new fiscal package of revenue and
expenditure measures and a revised 2004 budget. The fourth
prior action is adjustment of Honduras' poverty reduction
strategy. The program includes requirements for adoption of
new financial sector reforms, overall civil service reform, a
new tax code, a prohibition on new agricultural debt
bailouts, and pricing of electricity. The ball is now
squarely in the court of the National Congress to adopt the
necessary legislation in early December. All four of the
prior actions will be politically unpopular and will touch on
the interests of key political constituencies. At this
point, however, it should be clear to the Congress that the
measures are indispensable requirements if an IMF agreement
is to be reached. End Summary.


2. (C) As planned, an IMF mission led by Adrienne Cheasty
arrived during the week of November 10 to work with the GOH
to pound out the long-awaited PRGF program. The negotiations
began to founder during the second week as key legislators,
including the President of Congress, came out publicly
against new tax measures or a cut-back on teacher salary and
benefit hikes, causing the GOH to back away from promises
made in October. Over the November 22-23 weekend, the
mission convinced the GOH that there was no further
flexibility possible, and the hard legislative measures were
absolutely necessary to obtain an IMF agreement. On November
25, the GOH announced that tentative agreement on a letter of
intent was reached, but has not publicized the content. The
program, as described to Emboffs by IMF and GOH officials, is
similar to the proposal outlined in October (see ref A).

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The Fiscal Targets
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3. (C) The central government deficit targets in the draft
LOI are: 3.5 percent of GDP in 2004, 3.0 percent of GDP in
2005, and 2.5 percent of GDP in 2006. The 2003 deficit is
expected to be 5.5 percent of GDP, by IMF calculations (the
GOH uses 4.5 percent, using a different accounting basis).
For the consolidated public sector, the deficit targets in
the draft LOI are: 3.0 percent of GDP in 2004, 2.5 percent of
GDP in 2005, and 1.7 percent of GDP in 2006. Central
government wage bill targets are 10.6 percent of GDP for
2004, 10.4 percent of GDP for 2005 and 10.0 percent for 2006.
The program contains four prior actions that must be taken
before the program can go to the IMF Board of Directors for
approval. The program also includes requirements for
adoption of new financial sector reforms, overall civil
service reform, a new tax code, and a prohibition on new
agricultural debt bailouts.

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Prior Conditions
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4. (C) The first prior condition is adoption by Congress of a
government salary law that establishes executive branch
control of central government wage policy (with raises keyed
to inflation),folds the teachers into the unified civil
service salary policy by June 2005, freezes the collateral
benefits for public sector teachers and freezes salaries for
medical personnel. The text of the law was discussed at
length by IMF staff and the GOH, both in October and
November. The GOH has also mentioned returning to an
alternative model of folding in the teachers: leaving the
collateral benefits untouched, but stretching out the planned
wage increases for 2004-2005 over four years. Although this
would provide similar (perhaps slightly higher) fiscal
relief, it would mean a further two-year delay in
establishing executive branch control over teacher salaries
to June 2007, and the IMF staff have tried to dissuade the
GOH from pursuing it. However, President Maduro's advisors
are continuing negotiations with the teachers unions over the
form of the adjustment of teacher compensation. These
negotiations are expected to continue for about a week.

5. (C) The second prior condition is adoption of a third
fiscal package by Congress that results in at least one
percent of GDP (about USD 60 million) in central government
fiscal savings. The content of this fiscal package will be
closely held for now, and is expected to include a fuel tax
increase (0.5-0.6 percent of GDP) and other tax measures (tax
on tobacco products and legislative action that implements
fully the reduction in sales tax exemptions that were adopted
in April 2003). On the expenditure side, 2004 government
spending will be cut by 600 million lempiras, affecting all
Ministries and government organizations that receive
transfers from the Central Government. The GOH had
originally proposed a much larger fuel tax increase to cover
the fiscal gap for 2004, but the IMF staff had urged
moderation (and compensation with other measures) because of
the probable impact on the poor. Previous promises not to
add more new taxes, by President Maduro and National Congress
President Pepe Lobo, will complicate the passage of this
legislation. However, given the size of the budget deficit,
the lack of non-inflationary financing, and the disappointing
results of the previous two fiscal packages, adoption is
unavoidable for stabilization of GOH finances.


6. (C) The IMF Mission also is requiring a change of the 2004
budget (presented as required by law in September 2003) to
reflect the lower expenditure envelope, before its adoption
in December. The fourth prior action is the adjustment of
the Poverty Reduction Strategy to reflect spending targets.
IMF staff are also requiring publication in the Official
Gazeta of the increase in electricity rates (keeps rates
equal to marginal cost). The National Electricity Commission
has already approved this rate hike, which will take effect
January 1, 2004, but the decree has yet to be published
(presumably due to political pressure). GOH interlocutors
did not mention this issue.

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Other Key Requirements in the PRGF Program
--------------


7. (C) In the negotiations, the GOH committed to enactment of
a Financial Sector reform by June 2004 that will include a
series of vital reforms for this very fragile banking system.
The GOH will implement consolidated supervision of all
financial intermediaries. Banks will be required to increase
capitalization and provisioning for bad debts. There will be
reforms to the Central Bank's role as a lender of last
resort. This ambitious set of reforms is key to financial
sector stability in October 2004, when the 100 percent
government guarantee of bank deposits ends.


8. (C) The LOI includes mention of enactment of overall civil
service reform in 2004. This is a key measure that was also
included in Honduras' last PRGF program, and is a prior
action for World Bank program loans. The IMF staff will be
working closely with the World Bank to ensure the requirement
is handled in a way that doesn't conflict with rules on
cross-conditionality.


9. (C) The program also requires enactment of a new tax code
in 2004 that, among other things, provides harsher sanctions
for tax evasion. The GOH has been working on the text of
this law for some time.


10. (C) The final program requirement mentioned by Embassy
interlocutors is a prohibition on new bailouts for
agricultural loans and a limitation on expenditures to
implement the 2003 Agricultural Credit law (see ref B). The
law authorized expenditures up to two billion lempiras for
agricultural debt forgiveness, but the GOH has committed to
limiting its share of cost to 1.2 billion lempiras and paying
the smaller farmers first. Given the political influence of
many of the larger beneficiaries and the continuous pressure
for other bailouts, post expects implementation of this
program condition will continue to be a struggle for the GOH
over time.

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Next Steps
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11. (C) The GOH told the Fund staff there would be a 3-4 day
delay before announcing the details of the preliminary
agreement with the IMF to the public, to provide more time
for negotiations with unions and with key Congressional
deputies. Although the GOH had previously planned to submit
and obtain passage of needed legislation by November 28
(hence the urgency of the arrival of the IMF mission),
National Congress President Porfirio Lobo has decided to keep
the Congress in session during the first 20 days of December
and consider any legislation related to the IMF program
during that period (traditionally, the special December
session of Congress only considers the budget).


12. (C) If the GOH submits and the Congress adopts the needed
legislation in its entirety, without changes that affect
fiscal targets, the IMF mission will send the LOI directly to
the Board of Directors. The LOI will need to be reopened,
however, if Congress makes substantive changes (the IMF
mission believes its room for flexibility is now exhausted).
If the GOH fails to send the laws to Congress, the efforts to
reach an IMF program would go back to square one.

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Comment
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13. (C) The fiscal targets in the program are substantially
looser than those sought by the IMF staff in previous visits,
reflecting an enhanced understanding of the GOH's political
constraints. All four of the prior actions will be unpopular
politically and will touch negatively on the interests of key
political constituencies. At this point, however, it should
be clear to the Congress that the measures are indispensable
if an IMF agreement is to be reached and macroeconomic
stability is to be reestablished. Much will now depend on
the GOH's and Congress' leadership in taking hard measures
and explaining the need for them to the public. As indicated
in ref C, post believes it likely that the Congress will
approve the legislation and that the government can withstand
any subsequent protests. End Comment.
Palmer