HONDURAS IMF AGREEMENT FULL STEAM AHEAD -- PRIOR

C O N F I D E N T I A L SECTION 01 OF 04 TEGUCIGALPA 000232

SIPDIS

TREASURY FOR U/S TAYLOR
TREASURY ALSO FOR RAMIN TOUOUI
STATE FOR WHA/CEN, WHA/EPSC, EB/IFD/OMA, AND DRL/IL
STATE PASS AID FOR LAC/CEN
DOL FOR ILAB

E.O. 12958: DECL: UPON SIGNATURE OF THE HONDURAN LETTER OF INTENT
OR DECL OF 03 TEGUCIGALPA 2792 (WHICHEVER COMES FIRST)
TAGS: EFIN ECON PGOV EAID ETRD EINV EPET ELAB HO
SUBJECT: HONDURAS IMF AGREEMENT FULL STEAM AHEAD -- PRIOR
CONDITIONS NOW FULFILLED AND BOARD APPROVAL OF PROGRAM
SCHEDULED FOR FEBRUARY 18

REF: A. 03 TEGUCIGALPA 2792


B. 03 TEGUCIGALPA 1581

C. PARIS 674

D. 03 TEGUCIGALPA 2915

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


1. (C) Summary. The Honduran government has fully completed
the prior conditions listed in the preliminary Letter of
Intent (LOI) for a three-year Poverty Reduction and Growth
Facility Program (PRGF) agreed to with the IMF mission on
November 25. In addition, the GOH has put to rest two new
IMF concerns prompted by the flurry of measures taken in the
last days of 2003. On January 20, the Congress modified
significantly a problematic price control law and, also in
mid-January, the government made further changes to the
administration of the new fuels tax to comply with concerns
by the principal oil product importers and distributors.
Based on this progress, the IMF staff has negotiated a few
remaining changes in the program, and the final Letter of
Intent is due to be signed in Tegucigalpa on February 2.
Honduras' PRGF will be considered by the IMF Board on
February 18. Embassy recommends USG support for this
hard-fought and long-awaited program. End Summary.

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Key Elements of the Program
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2. (C) As described in ref A, the central government deficit
targets in the Honduran PRGF program are: 3.5 percent of GDP
in 2004, 3.0 percent of GDP in 2005, and 2.5 percent of GDP
in 2006. For the consolidated public sector, the deficit
targets in the 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 of
GDP for 2006. Public sector wage bill targets are 10.4
percent of GDP in 2004, 10.0 percent of GDP in 2005, and 9.6
percent of GDP in 2006. 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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The GOH's Concerted Efforts to Meet the Prior Conditions
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3. (C) The Letter of Intent listed four prior actions, with
which the Honduran government has now complied: adoption of a
government salary law that reestablishes executive branch
control of central government wage policy; adoption of a
fiscal package of expenditure cuts and revenue measures that
results in fiscal savings of one percent of GDP (about USD 60
million); adoption of a budget for 2004 that is consistent
with expenditure reduction commitments in the program; and
adjustment of the Poverty Reduction Strategy to reflect
spending targets. The IMF also privately insisted upon the
publication of a previously-decided hike in electricity rates.

The Long-Awaited Reining in of Government Wages
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4. (SBU) On December 19, 2003, the Congress adopted Decree
220-2003, the Law on Restructuring of the Compensation System
of the Central Government. It was signed by President Maduro
on December 31, 2003, and published in the official La Gazeta
on January 12, 2004. This law establishes executive branch
control of public sector wage policy, folds the teachers into
the unified civil service salary policy by January 2008,
freezes the collateral benefits for public sector teachers at
December 2003 levels, and freezes salaries for medical
personnel in 2004 (with future increases tied to the rate of
inflation). Planned salary increases for teachers for 2004
and 2005 have been reduced by half and stretched out over a
three-year period (2004-2006). The legislation explicitly
overrides any previous legislation, effectively repealing the
economic clauses in the special professional statutes that
have resulted in the unsustainable growth in the central
government wage bill in recent years. Decree 220-2003
directs the Finance Ministry to decide each year on
government wage increases, based upon the availability of
budget resources, using the projected rate of inflation as a
guideline.


5. (SBU) The Congress changed the final law to put creation
of a unified wage scale for teachers (to include basic salary
plus benefits) in the hands of a special bipartite
government-teacher commission. The IMF has added language
to the program, explicitly requiring that the work of this
commission be carried out in a manner consistent with the IMF
program. The repeal of the economic clauses of the teacher
and doctor statutes represents a major success by the GOH, as
it is a basic structural reform that has been urged by the
IMF and World Bank, and a few Honduran commentators, for
years.

Austerity Measures
--------------


6. (SBU) Also on December 19, the Congress passed the Law of
Rationalization of Public Finances, a new fiscal package of
revenue and expenditure measures. It was signed by President
Maduro on December 31, 2003, and published in the official La
Gazeta on January 12, 2004. It includes steps that will
reduce government spending and ensure better tax policy
implementation. It freezes the number of government
positions, except in health, education and security. It
establishes a monthly salary cap of 60,000 lempiras (USD
3,300) for all public sector employees, including their
collateral benefits. It freezes salaries in 2004 for
employees with monthly salaries over 30,000 lempiras (USD
1,650). It directs government reorganization and cutbacks,
including in the Honduran Foreign Service. Mining royalties
and lottery proceeds will go directly to the government
treasury.


7. (SBU) In early December, the government decided not to
include in this law an increase in the tax on fuels in the
fiscal package, but instead to reimpose a customs duty
(between 10 and 12.5 percent, depending on the product) on
fuel products by executive decree. This decree was put into
place on December 31.


8. (SBU) The revised 2004 budget was adopted by the Congress
on December 30 and published on December 31. It stayed
within the expenditure constraints agreed upon by the IMF
staff and GOH in late November. The fourth prior action, the
revision of the poverty reduction plan and adoption of a
monitoring process, was also completed in December. The IMF
agreed to allow funds spent for salaries of public sector
teachers and doctors to be counted in the tallying of the
Poverty Reduction Strategy Paper (PRSP) spending, which
brings government spending on these essential social services
in alignment with the PRSP targets. The GOH also published,
in December, the electricity commission's increase in
electricity rates (as promised to the IMF).

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The Fuel Tax Controversy
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9. (SBU) The IMF has had strong reservations about the GOH's
decision to raise the fuel tax instead of other broader
revenue measures, primarily because of the impact on Honduran
competitiveness and probable public outcry for this
regressive tax. And, in fact, in an ill-advised attempt to
avoid putting all the pressure on consumers and to avoid
public criticism, close advisors to the President decided at
the last minute to include in the fuel tax executive decree
some unilateral changes to the formula used to determine the
price of a gallon of fuel at the pump. The reference price
used to estimate product cost was summarily changed from the
Caribbean posting to the Gulf posting plus two cents. This
simplistic move had been previously urged in August 2003 by
former Minister of Industry and Trade Juliet Handal.
Chevron-Texaco and Exxon reps told EconOffs that the Gulf
posting price underestimates their costs by six cents, and
thus this change pretty much wiped out the long-standing 4.7
cent per gallon margin that has been used in the formula for
years. The companies were willing to reduce their margin
somewhat, but were not able to accept an imposed arrangement
that implied they would work for close to breakeven.


10. (C) Intense negotiations over the first two weeks of
January resulted in a deal between the GOH and the oil
companies in which a new decree was issued on January 23 that
puts the reference price back to the Caribbean posting for
three months while the GOH and oil companies negotiate a
final settlement. In the meantime, Handal has been attacking
the GOH in the press for leaving the impression in the press
that the change in the pump price formula she had proposed
was the cause of the jump in gas prices (covering up the
import duty). The GOH, after some obfuscation, has now
satisfied the IMF staff that the revenue targets from the oil
tax will meet revenue projections. The oil companies have
purportedly agreed to absorb half of any price increase that
may be required by the new formula during the first month.

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A Problematic Price Control Decree Rolled Back Substantially
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11. (SBU) Another complication developed on December 19, when
the Honduran Congress decided to soften the blow of the
fiscal measures by enacting a price freeze for six months on
about 180 products (mostly foodstuffs). The Congress did not
consult with the responsible Ministry, the Ministry of
Industry and Trade, prior to the enactment of the measure.
The Ministry currently monitors the prices of only 40
products and, with only twelve consumer protection
inspectors, has little capacity to implement a price control
system throughout the country. However, the IMF staff (and
other economists) were concerned about the poor precedent set
by this measure. Newspapers carried daily reports of price
increases in the covered products and government's inability
to curb them, putting the GOH under constant attack. The IMF
immediately responded that a price control program was
contrary to the letter and the spirit of the program, and
insisted upon a rescinding of the law or drastic cutback in
the number of products. Finally, on January 20, the Congress
cut back the number of products covered to about 38, and the
GOH agreed to a provision in the Letter of Intent agreeing to
refrain from any further price controls for the life of the
PRGF program.

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Other Key Elements of the Program
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12. (C) 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. The World Bank
is implementing a financial-strengthening project to achieve
these recommended reforms.


13. (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.


14. (C) The program 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. The GOH is also working with the Supreme
Court to establish two special tax courts by the end of 2004.


15. (C) The IMF has also included a provision requiring the
GOH to add more flexibility to its foreign exchange price
band system, so that it could be used to cushion the economy
from unanticipated shocks in the future if necessary. In
recent years, the Central Bank has consistently bought and
sold foreign exchange at a previously announced crawling peg
rate, instead of letting the rate vary within its band.


16. (C) The final significant program requirement is a
prohibition on new bailouts for agricultural loans and a
limitation on expenditures to implement the 2003 Agricultural
Credit law. The law authorized expenditures of up to two
billion lempiras for agricultural debt forgiveness, but the
GOH has committed to limiting the cost to 1.2 billion
lempiras (USD 66 million) (shared between the GOH and the
banks) and paying the smaller farmers first.
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Comment
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17. (C) Final evaluation of the program will have to await a
review of the actual text of the Letter of Intent. However,
it appears that after two long years, the Government has
finally put together a credible macroeconomic program and the
IMF has provided as much flexibility as is prudent and
responsible. President Maduro, Congress President Pepe Lobo
and the macroeconomic team can be justifiably proud of the
work on reestablishing control over public sector salaries,
increasing government revenues and making progress toward the
goal of having the Honduran government live within its means.
The program will help avoid further ill-advised
Congressional mandates, such as price controls and massive
debt forgiveness for large agricultural interests, that have
plagued government finances up to now. Protests resulting
from congressional passage of these controversial measures
have, to date, been muted (although a sizable demonstration
on these issues is planned for February 5 (septel)). While
not perfect (the heavy reliance on fuel taxes is one
example),this program puts Honduras well on the way toward a
period of stability, growth and investment in poverty
reduction. Embassy recommends USG support at the February 18
board meeting. End Comment.

PALMER