HONDURAS ECONOMIC REFORM: CENTRAL BANK REFORMED AND

UNCLAS SECTION 01 OF 04 TEGUCIGALPA 002826

SIPDIS

SENSITIVE

STATE FOR WHA/CEN, WHA/EPSC, AND EB
STATE PASS AID FOR LAC/CAM
STATE PASS USTR
TREASURY FOR DDOUGLASS

E.O. 12958: N/A
TAGS: EFIN ECON PGOV HO IMF
SUBJECT: HONDURAS ECONOMIC REFORM: CENTRAL BANK REFORMED AND
MODERNIZED BY NEW LAW

REF: A) 04 Tegucigalpa 2765

B) 03 Tegucigalpa 2062
C) 04 Tegucigalpa 232


1. (U) SUMMARY: In September 2004, at IMF insistence, the
GOH passed four banking reform laws aimed at strengthening
the nation's financial system. This is the second in a
series of four cables that analyze each of these laws,
assess their impacts on the Honduran financial system, and
outline challenges of implementation or additional needed
reforms that remain. Ref A analyzed the reform of the
deposit insurance agency; this cable focuses on the reform
of the Central Bank.


2. (U) The Central Bank reform law, which took effect on
September 22, 2004, changes the structure of the Central
Bank's Board of Directors, provides greater flexibility in
the areas of exchange rate policy, monetary policy, and
liquidity management, and provides for a stronger
capitalization of the Central Bank from the central
government. In many of these areas, the law creates the
legal opportunity for reforms which the bank plans to
implement only gradually. These changes should strengthen
the financial system by allowing the Central Bank greater
political autonomy and more flexibility in its operations.
However, increased capacity-building and training will be
necessary if the Central Bank is to implement fully all the
changes permitted by the new law. END SUMMARY.

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Background: The Need for Reform
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3. (SBU) As summarized in ref B, a 2003 joint IMF/World Bank
"Financial System Stability Assessment" for Honduras
concluded that the Honduran banking system is "highly
fragile at a systemic level, impairing sustainable economic
growth," and outlined several reforms needed to strengthen
the system. These reforms were then incorporated into the
Letter of Intent signed by the GOH and the IMF in February
2004, which required the passage of four financial sector
reform bills: the Deposit Insurance Law; the Central Bank of
Honduras Law; the Banking Commission Law; and a new
Financial Institutions Law.


4. (SBU) Specific to the Central Bank, the FSAP identified a
number of weaknesses, including both credit and operational
risks in the payments system, tension between monetary
policy and exchange rate policy, and a lack of political
autonomy which could leave the Central Bank Board of
Directors vulnerable to political influences. However, in
response to these weaknesses, the report recommended
incremental improvements to the Central Bank's legal
framework and operations, rather than a major overhaul of
the bank's structure or management.

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Changes Under The New Law
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5. (U) Of the four laws, the Central Bank reform law makes
the least dramatic short-term changes in the operation of
the Honduran financial sector. The law grants no new
responsibilities to the Central Bank, but revises previous
legislation to lift legal restrictions against certain kinds
of Central Bank operations. The Bank must now choose how
and when to take advantage of this new flexibility to
gradually modernize and enhance its services.


6. (U) EconOff met with Vice President of the Central Bank
Analia Napky on November 24 and received a detailed overview
of the ways that the new law will give greater flexibility
to the Bank's operations. Napky highlighted three broad
areas of reform in the new law: changes to the structure of
the Central Bank's Board of Directors; greater flexibility
in the areas of exchange rate policy, monetary policy, and
liquidity management; and a stronger capitalization of the
Central Bank from the central government.

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Make-up of the Board of Directors
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7. (U) Presently, the Central Bank is managed by five
officers: the President, Vice President, and three other
directors. All five are appointed by the President and
serve a four-year term concurrent with the President's term.
This arrangement leads to two potential problems. First,
there is a lack of policy continuity and a loss of
institutional memory as the entire board of directors leaves
office at the same time as the entire GOH financial team
every four years. Second, the Bank's political independence
may be compromised, as the entire board is appointed by a
newly-elected President and thus tends to be directly
associated with that President and his administration.


8. (U) Under the new law, the appointments of the three
lower directors are staggered. The Central Bank President
and Vice President will still be appointed by the newly-
elected President of Honduras and will serve terms
concurrent with his term. However, the other three
directors will serve terms that begin in each of the next
three years. As a result, an incoming President can only
appoint two-fifths of the Central Bank board upon arrival in
office, and will start off working with a Central Bank board
three-fifths of which was appointed by his predecessor.
According to Napky, the biggest gain of this new arrangement
is that most of the Central Bank's Board of Directors will
remain in place across a Presidential transition, enabling
the bank to maintain policy continuity and emphasizing the
Central Bank's political independence.

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Greater Operational Flexibility
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9. (U) The new law grants the Central Bank greater
flexibility in its operations in the areas of exchange rate
policy, monetary policy, and management of the payments
system, by lifting restrictions that existed under previous
legislation. While Napky stressed that the Central Bank
does not plan to adopt reforms in all of these areas at
once, she praised the law for providing the necessary legal
framework for future developments, so that over time the
bank's operations may be modernized.


10. (SBU) The new law gives the Central Bank the flexibility
to change its exchange rate management, though Napky
stressed that in the short term they have no intention of
doing so. Previously, the Central Bank was required by law
to purchase all foreign currency from Honduran banks at the
end of each day, and make it available to banks only through
means of an auction held once and only once per week. The
rate itself is set through means of a managed float, with
the nominal rate devaluing within a band at roughly six
percent per year to keep the trade-weighted real exchange
rate stable. The new law loosens these requirements
somewhat, and hence grants the Central Bank the legal
ability to move to a more flexible exchange rate regime in
the future. Napky said that this legal change was made by
means of a deliberately subtle change in wording, so as not
to generate either worries or expectations that the Central
Bank plans to change its exchange rate policy in the near
future. The change in wording is so subtle, she joked, that
"only a lawyer or a central banker would understand what we
meant." Napky said that significant changes to the current
exchange rate regime might only be made "in 10 or 20 years
time, if the conditions are right."


11. (U) The new law also gives the Central Bank greater
flexibility in the exercise of monetary policy. Currently,
the Central Bank's only tool for conducting open market
transactions is the issuance of Certificates of Monetary
Absorption (known as CAMs in Spanish). However, until the
September reform law, these CAMs were non-negotiable, and
therefore no secondary market for these instruments
currently exists. Also, the CAMs currently exist
exclusively as actual pieces of paper, and cannot be issued
or traded electronically. The new law lifts both of these
restrictions. First, under the new system, while the
auction of these CAMs will remain the Central Bank's main
instrument of monetary policy, the CAMs will become
negotiable. Second, the law will permit
"dematerialization," that is, allowing CAMs to be bought and
sold electronically, apart from the transfer of any physical
document. (Note: The Ministry of Finance is currently
contemplating a similar reform in the area of government
bonds, which are currently also non-negotiable and limited
to their face value. End note.)


12. (U) The law also allows the Central Bank a more active
role in its function as the hub of the payments system. As
with the issuance of CAMs and bonds described above, until
the recent reforms, the payment system still required checks
to be exchanged physically as there was no legal framework
for the recognition of electronic signatures and documents.
The new law removes this restriction, and allows the Central
Bank to grant overnight loans and short-term loans in the
process of managing the payments system. The result should
be an improvement in the efficiency of the payments system,
reducing the time and costs of routine transactions, as well
as an eventual reduction in the risk that a failed large
transaction would trigger a disruption throughout the
system. As a result of the new law, Honduras moves closer
to compliance with the internationally-recognized Committee
on Payment and Settlement Systems (CPSS) Core Principles for
systematically important payment systems.

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Capitalization
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13. (U) Finally, the law establishes a mechanism through
which the government capitalizes the Central Bank for past
operating losses, as explicitly required by the February
Letter of Intent. The law requires the Ministry of Finance
to take on the Central Bank's accumulated losses from the
period 1997 to 2004 - approximately 3.2 billion lempiras
($177 million) at the end of 2003. The exact cost of this
operation must be specified within the first two months of
2005, at which time government bonds will be issued by the
Ministry of Finance and the cost will be incorporated into
the central government accounts.

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The Challenge of Implementation
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14. (U) The Central Bank is currently preparing the
regulations for the new law, in conjunction with the
National Banking and Insurance Commission (CNBS) and with
the assistance of consultants funded by the IDB and the
World Bank. Additional regulations on the management of the
payment system are also being drafted, though Napky said it
has not yet been decided if these changes will be brought
into effect through the regulations of the Central Bank
reform law or whether they will require a new law to be
brought to Congress next year.


15. (U) As for implementation, the Central Bank reform law
imposes no new responsibilities upon the Central Bank.
However, since it does allow the bank to modify its
operations, technical assistance and training will be needed
to enable the bank to take on new activities. Napky also
stressed that as the bank modernizes its activities over
time, there will be a need for new computer hardware and
software, and training to use them, none of which is
currently provided for in the Central Bank's budget. Much
assistance of this sort is already being provided by the
World Bank (as part of its Financial Sector Strengthening
Credit) and the IDB. Napky hopes to raise the possibility
of additional assistance of this type during the upcoming
assessment visit of Treasury Department specialists in
government debt issuance and management, tentatively
scheduled for January 2005.

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Comment: Making Progress in Small Steps
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16. (U) Comment: The Central Bank reform law makes no major
structural or operational changes, and is arguably the least
innovative of the four recent financial sector reform laws.
However, the law does contain several important
modifications to the legal framework governing the Central
Bank, which in turn will allow a series of incremental
improvements in the way the bank conducts its operations.
While Napky was obviously pleased and excited about the
prospects of modernizing the Central Bank's activities, she,
like any good central banker, also places a high premium on
stability and predictability, and is not about to run off
impulsively on a series of rapid and potentially disruptive
changes. End Comment.

Palmer