HONDURAS: IMPORT-LED GROWTH?

C O N F I D E N T I A L SECTION 01 OF 02 TEGUCIGALPA 002373 SIPDIS SIPDIS NOFORN STATE FOR EB/IFD, WHA/EPSC, INR/IAA, AND WHA/CEN TREASURY FOR AFAIBISHENKO COMMERCE FOR MSIEGELMAN STATE PASS AID FOR LAC/CAM E.O. 12958: DECL: 12/27/2016 TAGS: ECON EFIN PGOV SOCI HO SUBJECT: HONDURAS: IMPORT-LED GROWTH? Classified By: Ambassador Charles Ford for reasons 1.4 (b) and (d) ¶1. (C) Summary: The Central Bank of Honduras is predicting economic growth for 2006 of 5.3 to 5.8 percent. Some bankers are now openly talking about a possible resurgence of inflation in 2007, and made their fears plain by under-subscribing a recent GOH bond issuance, complaining that yields of 8.25 percent are too low for the coming economic conditions. The shortest-term local-currency denominated notes are currently trading nearly a full percentage point below the monetary policy reference rate of 6.0 percent, suggesting excess liquidity remains in the system. At the same time, increased GOH spending, remittance growth, and a soft-money policy all push more currency into the economy. So why has inflation remained tame? Possible explanations include imported disinflation, CAFTA effects, and domestic economic growth. Yet some seem to be questioning how long the good times can last. End Summary. ¶2. (SBU) In 2006, remittances have grown to nearly USD 2.4 billion (equivalent to 25 percent of Honduran GDP) and the Central Bank's reference interest rate has dropped by some 522 basis points in less than one year. The combination of increased current spending, increased remittances, and undersupplying government bonds has pushed local currency liquidity into the economy. The Central Bank (BCH) move was deliberate, with the aim of driving down interest rates to spur economic growth. The BCH overshot its mark in September 2006, when the target reference rate of 6.00 percent did not hold up and one-year note yields fell to 5.92 percent. Since that time yields have firmed to 6.73 percent. With no fully developed overnight interbank market, the best benchmark for bank sentiment is the seven day note, currently yielding 5.08 percent, well below the target reference rate and likely indicative of excess local-currency liquidity in the financial system. ¶3. (SBU) Despite questions about whether the financial system still has too much local currency liquidity, the most recent auctions of three year government bonds (at 8.25 percent) and BCH one-year notes (at 6.73 percent) were undersubscribed. (The GOH Treasury placed only 240 million lempiras in bonds of a 600 million lempira offering, and the Central Bank auction reportedly placed only about 25 percent of its offering of 700 million lempiras -- about USD 37 million.) Bankers told EconChief that this reflects the uncomfortably narrow yield spread between Honduran and USD bonds, and a growing belief in the financial sector that 2007 will see a mild resurgence of inflation. Inflation rates have fallen from an average of 8.2 percent in 2004 to 4.4 percent (year-on-year as of November 2006). An estimated 1.8 percentage points of that fall is due to government price controls, notably on fuel, according to Minister of the Presidency Yani Rosenthal. Bankers expect inflation could rise by up to two full percentage points over the coming year. ¶4. (C) Remarks by both consumer advocates and GOH officials point to pricing pressures that include: recent increases in the cost of eggs, sugar corn flour, cement, beef, and pork. However, international prices for sugar and corn have risen substantially in the last year, and the price increases seen in Honduras could be attributable to price adjustments rather than harbingers of burgeoning inflation. With the completion (for good or ill) of the proposed fuel imports bid solicitation, GOH fuel price caps are scheduled to be removed, leading some to question whether this too could provoke further price hikes. (Note: Dramatic price spikes in the short term are unlikely, as current gasoline prices are floating below the GOH-imposed price cap. End Note.) Price increases for electricity (politically painful but nearly unavoidable if failing electricity parastatal ENEE is not to put significant pressure on the GOH budget) could do the same. ¶5. (SBU) Finally, public concern about upward pricing pressures are also expressing themselves in wage pressures, as the annual national debate over the minimum wage kicks off. (Note: Last year's wage hikes were an impressive 9.5 percent on average. That said, the minimum wage has little broad economic impact at the lowest end of the wage scale, where current wages hover around USD 4.00 per day depending on the sector. However, many white collar wages are linked to the minimum wage, so any increase in the minimum leads to a greatly multiplied increase in, for example, teachers' TEGUCIGALP 00002373 002 OF 002 wages. End note.) ¶6. (C) With so much liquidity in the economy, why is inflation not increasing sharply? Price controls on certain goods, notably including both electricity and gasoline, contributed to keeping inflation down. But there are other factors as well. The explanation favored by the GOH is that the GOH strategy is bearing fruit, generating economic growth, which is absorbing the liquidity. For example, construction permit applications have reportedly risen 41 percent, according to GOH officials. According to bankers, however, most of the major projects are shopping malls aimed at feeding a growing appetite for consumption and not investments in industry or other production. This suggests two other tantalizing but untested theories: first, perhaps price reductions due to CAFTA are keeping inflation more in check than would otherwise be the case, as trade barriers come down and prices on consumer goods decline. (According to former Minister of the Presidency Luis Cosenza, it was expected that CAFTA would yield an additional one percent of growth in GDP per year due to lower prices and increased investment.) ¶7. (C) A second possibility is that as a very small market, Honduras might actually be importing disinflation from the U.S. An estimated USD 2.4 billion in remittances will flow directly to consumers this year, and much of it will be spent on imports. Because Honduras is such a small market relative to its largest trading partner (the U.S.),this jump in consumption is likely to have little or no effect on price levels. Thus the textbook logic of more money chasing a fixed quantity of goods yielding inflation is broken, and a surge in inflation is perhaps avoided. Anecdotal evidence of the sprouting up of shopping malls tends to support this idea, as do Central Bank import figures. According to the Central Bank, imports rose dramatically in both 2004 and 2005, up over 30 percent over that period, after excluding fuel imports. Preliminary data suggest that in first quarter 2006 imports rose 17 percent year on year, and imports of consumer goods -- 28 percent of all imports -- rose 27 percent. This has led to a projected trade deficit in goods for Honduras of USD 3.0 billion, overwhelmingly financed by those USD 2.4 billion in remittances and nearly USD 1.0 billion in maquila (textile and apparel) sales. ¶8. (C) Comment: How long can this go on? In one sense, for as long as the remittances continue to flow. But if the growth in economic activity is tied overwhelmingly to consumption, and not sufficiently to increases in the productive base, how will the economy grow and create new jobs? Half of Honduras' population is under the age of 18 -- where will they go to find work? And if remittances from an estimated one million Hondurans already living in the U.S. (many illegally) is the real engine of growth in the Honduran economy, what does that imply for future U.S. border security? Finally, does Honduras and the rest of the Central American region risk contracting Dutch Disease, in which the easy money of (in this case) remittances distorts the economy, saps the will to diversify into domestic production, and perhaps ultimately leads to inflation and economic stagnation? ¶9. (C) Comment continued: Post continues to believe that increased productivity and job creation will be key to a stable and prosperous Honduras. Those improvements will depend on attracting investment, which in turn depends on good policies. For its first year the Zelaya team has done too little to put such policies in place, but has largely gotten away with it thanks to a legacy of solid macro-economic fundamentals and abundant remittance inflows. We will continue to press for such policy reforms, and, in the meantime, monitor inflation with interest. Ford FORD