US embassy cable - 03TEGUCIGALPA2792

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 
------------------ 
 
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 
---------------- 
 
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 
---------- 
 
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 
------- 
 
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