HONDURAS: IMF MISSION ASSESSES GOH RESPONSE TO

C O N F I D E N T I A L TEGUCIGALPA 000518


SIPDIS

STATE FOR WHA/CEN, WHA/EPSC, EEB/OMA
TREASURY FOR ANNA JEWEL, SARA GRAY, AND WILLIAM FOSTER
STATE PASS TO USAID/LAC

E.O. 12958: DECL: 05/29/2018
TAGS: EFIN EAID ENRG EPET PGOV PREL IMF HO
SUBJECT: HONDURAS: IMF MISSION ASSESSES GOH RESPONSE TO
EXTERNAL PRICE SHOCKS

REF: TEGUCIGALPA 242

Classified By: Ambassador Charles A. Ford, reasons 1.4 (b) and (d)


1. 1. (C) Summary: An IMF team that visited Honduras May
13-21 left
satisfied with GOH efforts on the fiscal side to accommodate
food and fuel price shocks. Meetings with the Central Bank
on monetary policy were very tense, but the Central Bank
followed IMF advice by raising its base interest rate by 25
basis points May 28 and permitting another micro-devaluation
and may take further measures to prevent reserve losses and
reduce inflationary
pressures. Following the visit, the IMF resrep is cautiously
optimistic that Honduras will meet the revised targets under
its Precautionary Standby Agreement at the first quarterly
review, which should take place in late
July or early August. The IMF believes strict adherence to
these measures could still result in economic growth of 3-4
percent this year. But
the team left feeling that too much pressure from the IMF
could be counterproductive and requested USG assistance in
encouraging the GOH to implement sound economic policies.
End Summary.

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IMF Team Studies Impact of Price Shocks
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2. (C) An IMF team visited Honduras May 13-21 to examine the
effect of skyrocketing global food and fuel prices on the the
Honduran economy and specifically on whether Honduras can
meet the targets in the Precautionary Standby Agreement the
IMF Board apaproved for Honduras in April. The trip was
necessary, in part, because assumptions in the agreement,
such as USD 85
per barrel oil, had proved to be too optimistic. IMF resrep
Mario Garza told Econoff that authorities in the Finance
Ministry and the national
electric company, ENEE, were very open to IMF recommendations
and appeared willing to continue to reduce unsustainable fuel
and electricity subsidies. On the monetary side, Garza said
discussions with Central Bank (BCH) President Edwin Araque
were tense, even rising to the level of name-calling on one
occasion. In the final meeting, however, Araque agreed to
raise interest rates May 28 and work with the IMF on a plan
to allow more exhange rate flexibility while avoiding
excessive volatility and inflation.

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Fiscal Policy Responding to Shocks
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3. (C) Finance Minister Rebeca Santos and ENEE Director Rixi
Moncada were very amenable to IMF suggestions on fiscal
policy, recognizing that maintaining the current deficit
level and making room for emergency spending would depend on
limiting the cost of fuel and electricity subsidies. Fuel
subsidies alone cost the GOH 1.4 billion lempiras (USD 74
million) through April, compared with 1 billion lempiras (USD
53 million) for all of 2007. Santos agreed to continue to
allow pump prices to rise -- they have already increased
around 17 percent in nominal terms over the last two months
for diesel fuel and premium gasoline. She even agreed
tentatively to raise the price of kerosene, used for cooking
and lanterns by poor and isolated rural households. Garza
said the price of regular gasoline, still frozen at 64
lempiras (USD 3.37) a gallon, would also go up soon.


4. (C) ENEE Director Moncada told IMF advisors she plans an
electricity rate hike of 15 percent in June, a surprising
announcement given it came before IMF
recommendations were offered. Electricity rates have already
been going up in stages since last December, for a cumulative
increase of more than 40 percent for some customers, and the
impact on household electric bills has become a major public
discussion topic lately. The current price is consistent
with a fuel oil (bunker) price of USD 82 per barrel, but the
world price is currently hovering around USD 97. Fuel oil is
used to produce about 70 percent of Honduras's electricity.
Garza said that even after the 15 percent rate increase, ENEE
would still be losing money on a cashflow basis, although he
was not sure by how much. Thus, even as ENEE is paying down
its old arrears to private power producers, it continues to
accumulate new debt.


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Market for GOH Debt
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5. (C) Working closely with post's resident Treasury/OTA
technical
advisor, Santos has been very active in raising money through
bond auctions to pay off old debt, almost all of which is
from ENEE arrears. The GOH is
currently on track to place bonds for 3.75 billion out of a
needed 4 billion lempiras (USD 212 million) before the end of
June. About 2.8 billion lempiras have already been placed,
mostly to banks that already have ENEE debt in their
porfolios and to pension funds. Due to unconventional
reserve requirement policies set by the BCH, banks that focus
on consumer credit have not participated. Demand for the
bonds is dwindling and the May 27 auction for
lempira-denominated bonds raised a paltry 200 million out of
a hoped-for 1 billion lempiras. New bonds were offered for
two, three, four, or five years (previously only three and
five year bonds had been offered),but the bond rate has not
been adjusted for inflation and the GOH has not been flexible
about the yields needed to attract more banks to place bonds.
The BCH also attempted this week to sell short term notes and
managed to sell only 80 million out of a hoped for 1 billion
lempiras. Banks did purchase more than 600 million lempiras
worth of seven-day notes, indicating a preference to stay
liquid. Subsequent bond auctions between now and June will
be important measures of investor expectations about
inflation.

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Public Investment Faltering
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6. (C) Due to overruns on fuel subsidies, only about
one-third of the envisaged
investment took place in the first quarter. Public
investment thus not only fell short of the target in the IMF
Agreement, it was significantly lower than the first quarter
of 2007. The IMF team agreed that in order to strengthen the
safety net, the GOH could reduce investment from 6.5 percent
to 5.3 percent of GDP. Half of this cut will be dedicated to
programs to respond to rising food prices while the remainder
will go to maintain fuel subsidies. While the IMF was
discussing how to ensure spending is targeted and efficient,
the GOH has already asked the World Bank for an emergency
loan to address this issue. The discussion with the World
Bank is centered on whether to use the loan on the demand
side (to subsidize consumers) or the supply side (to increase
food production). The Bank's preference is conditional cash
transfers to the poorest and most affected parts of the
population, while the GOH prefers
to stimulate food production.

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Central Bank Resists Austerity Measures
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7. (C) BCH President Edwin Araque resisted IMF
recommendations on the monetary front, often suggesting tepid
substitute measures that Garza compared to closing the window
against a tsunami. Araque complained that he would never
succeed in selling tougher policies to President Zelaya.
When Araque
balked at raising the BCH benchmark rate (TPM),the team
leader explained that consumer price inflation, including
food, fuel and electricity rates,
would inevitably exceed 12 percent within two months without
tighter monetary policy. The IMF team recognized that
increasing interest rates during a supply shock can create
wage pressure that could push inflation to a higher,
permanent plateau. But there is evidence that supply is
starting to react slowly to rising commodity prices, which
should help to moderate prices.


8. (C) Garza said that in the final meeting before the team
departed May 21, Araque agreed to raise the monetary policy
rate by 25 basis points on May 28. Garza worried that the
lack of a press release might indicate Araque
would go back on his word, but the rate increase was quietly
implemented as scheduled.


9. (C) On the exchange rate, Araque attempted to impose a new

operational rule within the BCH, in which the exchange rate
could not move by more than 0.005 U.S. cents (0.11 lempira
cents) per day. The IMF team told Araque this went against
the spirit of flexibility within the exchange rate band,
which is plus or minus 7 percent, and could create a black
market or force a large interest rate increase. The team
suggested that a reasonable rise in interest rates could help
meet targets, and has designed a program of flexibility
without huge day-to-day devaluations, which it shared with
Araque, but Garza declined to describe the specifics until
Araque agrees.


10. (C) Econoff inquired about the May 3 devaluation, which
was implemented and retracted in the same day. Garza said
Araque had implemented the devaluation by cutting dollar
availability in auctions to 20 percent of usual levels
starting April 27 for three days in a last ditch effort to
meet the target for reserves at the end of April under the
Standby Agreement. But he created a panic by calling bankers
on the May 1 holiday and trying to convince them to buy more
notes. Garza chalked it up to poor exchange rate management.
Additional small devaluations have taken place in the last
few days.


11. (C) Interim figures suggest the BCH is USD 70 million
short of its June
30 reserve target. Garza said this is not a huge amount.


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Cautious About Pushing Too Hard
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12. (C) The IMF team left Honduras feeling the IMF cannot
push too hard, because it could result in policy reversals in
several key areas. However, the team also recognized that
the external food and fuel price shock is probably permanent,
so it will need to help Honduras figure out how to pass price
increases on to households while mitigating the impact on the
poor. This will be especially important among urban
populations, which benefit most from electricity and fuel
subsidies and more likely to take to the streets to protest.
Therefore, the IMF plans to help the GOH design a revised
strategy that maintains the current deficit target (1.5
percent of GDP),while making room for emergency spending.
Garza is pleased with the level of public outreach GOH has
done to explain the electricity rate increases, and plans to
talk to private sector and civil society groups to get
political buy-in for some difficult but necessary decisions
in the short term.


13. (C) The two sides signed an Aide Memoire at the
conclusion of the mission with revised targets for the
Standby Agreement, subject to approval by the IMF Board at
the upcoming quarterly review. The GDP growth projection for
2008 has been reduced to 3.5-4.0 percent. The zero limit on
non-concessional borrowing would be raised to accommodate
borrowing for needed port improvements at Puerto Cortes. The
GOH is seeking USD 160 million for this project; which is
twice what the World Bank's IFC thinks it should
realistically cost.

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Comment
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14. (C) The IMF team appears to have succeeded in convincing
GOH technocrats, even the BCH president, of what needs to be
done to maintain macroeconomic stability in Honduras.
Obtaining approval from President Zelaya will be the biggest
challenge. Garza requested that the USG praise Finance
Minister Santos for her public outreach on fiscal policy,
emphasizing to GOH officials, including Zelaya and Central
Bank head Araque, that more tough decisions are to come and
that we recognize the need to consider the effect on the
poor. Post agrees that GOH backsliding on fiscal and
monetary policy is a real possibility. At this time, the
revised targets in the Aide Memoire may represent the best
hope for keeping the GOH on a sustainable financial path.
However, in reviewing the Aide Memoire, we recommend the USED
raise questions about the cost estimates for upgrading Puerto
Cortes and the refusal of the National Port Enterprise,
headed by Zelaya ally Roberto Babun, to allow private
investment in the port.

FORD
FORD