US embassy cable - 04TEGUCIGALPA2826

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 
------------------------------- 
 
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. 
 
------------------------- 
Changes Under The New Law 
------------------------- 
 
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. 
 
--------------------------------- 
Make-up of the Board of Directors 
--------------------------------- 
 
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 
------------------------------- 
 
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. 
 
-------------- 
Capitalization 
-------------- 
 
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. 
 
------------------------------- 
The Challenge of Implementation 
------------------------------- 
 
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. 
 
-------------------------------------- 
Comment: Making Progress in Small Steps 
-------------------------------------- 
 
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