Report No. 28222-HO Honduras Development Policy Review Accelerating Broad-Based Growth November 8, 2004 Central America Department Latin America and the Caribbean Region Document of the World Bank LLECE LatinAmerican Laboratory for the Assessment o f Educational Quality MDG Millennium Development Goal NAFTA NorthAmerican Free Trade Agreement NGO Non-governmentalOrganization PA0 Annual Operating Plans PRGF Poverty Reduction and Growth Facility PRSC Poverty Reduction Support Credit PRSP Poverty Reduction Strategy Paper ROAA ReturnonAverage Assets ROAE Return on Average Equity SANAA Public water and sanitation utility company SAT Scholastic Assessment Test SEFIN Secretaria de Finanzas (Finance ministry) SERNA Secretaria Recursos Naturales y Ambiente (Environment ministry) SIAFI Integrated financial management system SIARH Public sector human resource database SIDNSAREC Swedish InternationalDevelopment Agency SIERP Integrated Poverty ReductionTracking System SIGADE Integrated Debt Management System SINACOIN Integrated system for recording foreign assistance inflows SISPU IntegratedSystem for Public Investment S M L Securities Market Law SSP Secretaria de Salud (Health Secretariat) SOPTRAVI Secretaria de Obras Publicas y Transporte (Transport ministry) SWAPS Sector wide approaches TFPG Total Factor Productivity Growth TGR Treasury TSC Tribunal Superior de Cuentas (Supreme Audit Court) UIF Unidad de Informaci6n Financiera UMCE External Educational Quality Assessment Unit UNDP UnitedNations Development Programme UPEG Sector Planning and Evaluation Groups WE31 World Bank Institute Vice-president David D e Ferranti Country Director Jane Armitage PREMDirector Emesto M a y HONDURAS DEVELOPMENT POLICY REVIEW Accelerating Broad-BasedGrowth November 8. 2004 Table of Contents EXECUTIVE SUMMARY AND RECOMMENDATIONS ........................................................... i RESUMENEJECUTIVO Y RECOMENDACIONES .................................................... xxiv Chapter I:RECENT ECONOMIC DEVELOPMENTS AND GROWTH PERFORMANCE ..... 1 A. Country Context ....................................................................................... 1 B. RecentEconomic Developments ................................................................... 5 10 D. MainConclusions .................................................................................... C. The Main Determinantsof Economic Growth inHonduras .................................... 15 Chapter 11: EDUCATION AND GROWTH ............................................................. 18 A. Status andEvolutionof EducationinHonduras ................................................ 20 B. Education SpendinginHonduras .................................................................. 23 27 D. Summary andRecommendations.................................................................. C. The Fiscal Challenge of Expanding Primary and SecondaryEducation ..................... 32 Chapter 111: PUBLIC INFRASTRUCTUREAND GROWTH ........................................ 35 A. Coverage. Quality andEfficiency of Infrastructure Services inHonduras .................. 35 B. Patternof Public Expenditures on Infrastructure ................................................ 44 C. Expanding the Role of Private Participation ...................................................... 45 D. Strengtheningthe Policymaking andRegulatory Framework ................................. 49 E. Refocusing Infrastructure Pricing and Subsidy Policies ....................................... 51 F. Summary andRecommendations.................................................................. 53 Chapter IV: FINANCIAL SECTOR DEVELOPMENT AND ECONOMIC GROWTH .......... 56 A. Brief Overview of RecentFinancial Sector Developments .................................... 56 B. Tackling the AgriculturalCredit Problem ....................................................... 60 63 D. SummaryandRecommendations .................................................................. C. Strengtheningthe Financial System ............................................................... 67 Chapter V: IMPROVING GOVERNANCE INHONDURAS ....................................... 70 A. Review of Governance Indicators ................................................................ 70 B. Public ExpenditureManagementReform ....................................................... 72 C. Civil Service Reform ................................................................................ 78 D. Judicial Reform ...................................................................................... 81 E. Concluding Remarks andRecommendations.................................................... 84 ANNEXES: A: The Key Determinants of Growth inHonduras B: The Evolution of the Central Government Wage BillinHonduras C: The Main Providers of Secondary Education Services in Honduras D: The EstimatedCost of RaisingPrimary and Secondary Education Outcomes E: A Preliminary Assessment of the HonduranNational InnovationSystem . F: CAFTA and its Implicationsfor Honduras Text Tables Table 1.1. Honduras . Sector Shares of GDP ........................................................... 3 Table 1.2. Honduras . 4 Table 1.3. Honduras . Macroeconomic Framework.................................................... Gross Domestic Expenditure and Product .................................... 9 Table 1.4. Honduras . Contributions to Output Growth............................................... 12 Table 1.5. Honduras . Alternative Long Term Growth Scenarios.................................... 13 Table 1.6. Honduras . Project Evolution of Poverty Headcount Indicators under Alternative Growth Assumptions ............................ 14 Table 1.7. Honduras. The Key Determinants of Growth in Honduras.............................. 15 Table 2.1. Honduras. Key Education Indicators by Level, 2001...................................... 20 Table 2.2. The Income Distribution of Primary Completion Rates................................... 23 Table 2.3. Honduras: Evolution of Public Spending on Education: 1997.2002 ..................... 24 Table 2.4. Honduras: Total Education Spending per Student by Level ............................. 24 Table 2.5. Honduras: Expenditures by the Education Ministry........................................ 25 Table 2.6. Honduras: Estimated Public Subsidy by Educational Level, 2002 .................... 27 Table 2.7. Alternative Fiscal Scenarios for Expanding Secondary Education ...................... 30 Table 3.1. Key Infrastructure Indicators in 2000....................................................... 37 Table 3.2. RoadTransport Indicators in Central America............................................. 37 Table 3.3. Electricity Service Coverage in Honduras, 1989.2002 .................................... 40 Table 3.4. Cost of Calls to USA, 2003..................................................................... 41 Table 3.5. Access to Water and Sanitation Services in Honduras..................................... 42 Table 3.6. The Distribution of Access to Infrastructure Services, 2003............................. 43 Table 3.7. Honduras: Public and Private Investment (inmillion US$).............................. 44 Table 3.8. Principal Entities Involved inInfrastructure Services, 2003............................. 47 Table 4.1. The Banking Systems in Central America, 2001.......................................... 57 Table 4.2. Selected Banking Sector Indicators in Central America, 2002........................... 59 Table 4.3. Honduras: Balance Sheet of the Consolidated Banking System ......................... 60 Table 4.4. Financial Sector InstitutionsinHonduras, 2003........................................... 69 Table 5.1. Selected Indicators of Judicial System Performance....................................... 81 Boxes Box 2.1 The Rate of Return to Education inHonduras............................................... 22 Box 4.1 The'Structure of Honduras's Financial System.............................................. 57 Box 5.1 Systematic Recommendations of the CFAA Action Plan for Honduras ................ 77 Box 5.2 Land Insecurity inHonduras ................................................................. 84 Box 5.3 Key Short-Term Actions Proposed by the National Anti-Corruption Council for Combating Corruption inHonduras ........................... 85 Figures Figure 1.1. Central America: Real Effective Exchange Rates.. ....................................... 6 Figure 1.2. Central America's Growth Performance; 1960 - 2000.................................. 11 Figure 1.3. Perceptions of Corruption inLatin America & Caribbean, 1999-2000.. ............. 16 Figure 2.1. Primary Education Spending and Outcomes inHonduras .............................. 26 Figure 3.1. Access to Infrastructure Services in Central America.. .................................. 36 Figure 3.2. The Relationship between InfrastructureDevelopment and per Capita GDP inLatin America.. .................................................... 38 Figure 4.1. Honduras: Indicators of Financial Development.. ........................................ 58 Figure5.1. Governance inHonduras versus LatinAmerica and the Caribbean: 2002.. ............ 71 Figure 5.2. Governance inHonduras versus Lower Middle Income Countries: 2002.. ............ 72 TECHNICAL ANNEX TABLES Table 1. Gross Domestic Expenditure and Product (shares o f GDP, current prices) Table 1A. Gross Domestic Expenditure and Product (current prices) Table 2. Annual growth rates of National Income and Product (constant prices) Table 2A. Gross Domestic Product by Expenditure, National Income and Savings (constant Ls.) Table 3. Prices Table 4. ConsolidatedPublic Sector Finances (percent of GDP) Table 4A. ConsolidatedPublic Sector Finances (Ls. Millions) Table 4B Augmented Public Sector Balance Table 5. Banking Survey and Interest Rates (Ls. Millions) Table 6. Balance o f Payments (US$ millions) Table 7. Trade (US$ millions) Table 8. External Debt and Debt Service Table 9. Financial Sector Indicators Table 10. Investment Climate Table 11. Vulnerability Indicators Table 12. Millenium Development Goals and Indicators - Acknowledgments This report was prepared by a core team led by Ulrich Lachler (Lead Economist, LCSPE) and comprising Emanuela Di Gropello (LCSHS), Aquiles Almansi (LCSFF), Paulo Correa (LCSFR), Dante Mossi (LCSHN) and Ema Budinich (Consultant). The main DPR mission visited Honduras in June 2003. Emanuela Di Gropello prepared the background paper on education for Chapter 11,Ema Budinich and Dante Mossi prepared background papers on the infrastructure sectors for Chapter 111, Aquiles Almansi prepared a background paper on the financial sector for Chapter IV, and Paulo Correa (with inputs from Lorenzo Constantino (ECSPF) and Patrick Kann (LCSFR)) prepared a report on the Honduran National Innovation System, reproduced in Annex E. Annex F on the Implications of CAFTA is based on a Consultant Report prepared by Martha Delgado, and inputs provided by Carlos Felipe Jaramillo (LCC2C). Dante Mossi prepared the Technical Annex Tables. Chapter V benefited from inputs received from Albert0 Leyton (LCSPS), Rajeev Swami (LCOAA), and Linn Hammergren (LCSPS). Peer Reviewers of this report are Pablo Fajnzylber (DECRG), Luis Guasch (LCSFP) and Carolina Sanchez-Paramo (LCSPP). HONDURAS DEVELOPMENT POLICY REVIEW Accelerating Broad-BasedGrowth Executive Summary and Recommendations i. ThisDevelopmentPolicyReview(DPR)discussesHonduras's development agenda with a special focus on accelerating economic growth. This focus emerges from the Honduras Poverty Reduction Strategy Paper (PRSP), which identified growth as the main determinant of the evolution of poverty, and guides the review of policy developments in various economic, social and infrastructure sectors. The DPR seeks to provide an analytical basis for developing the growth strategy outlined in the PRSP and, in doing so, hopes to provide some analytical underpinnings for the program supported by a Poverty Reduction Support Credit, which was approved by IDA'SBoard of Directors inJune 2004. A. COUNTRY CONTEXT, MACROECONOMIC DEVELOPMENTSECONOMIC AND GROWTH *. 11. Honduras i s a lower middle income country, with a per capita income of US$920 in 2002 (Atlas methodology). It has a population of around 7 million inhabitants (in 2004), growing at an annual rate of 2.4 percent and of which about 42 percent are under 15 years of age. An estimated 64 percent of the population currently lives below the poverty line, while 45 percent lives in extreme poverty. Roughly one-half of the population resides inrural areas, where the incidence of poverty i s almost 75 percent, versus 57 percent in urban areas. Honduras' social indicators are among the worst in the Latin America and Caribbean region, but comparable to the indicators observed on average among the other lower middle income countries. In October 1998, Honduras bore the brunt of hurricane Mitch, which caused major human and physical damage, and temporarily interrupted the progressive decline of poverty observed since 1990. iii. Hondurashasahistoricalrecordofpooreconomicgrowth,butrelativelyhighincome stability, compared to other Latin American countries. It grew at an average annual rate of 0.8 percent in per capita terms over the period 1960-2000, which is less than half the Latin American average of 1.7 percent and lower than the 1.2 percent averaged by all developing countries worldwide. On the positive side, Honduras has exhibited very little output volatility and has historically had low inflation rates compared to other countries in the region. iv. Honduras i s the most open economy in Central America and ranks among the most open in the world. It has a trade ratio averaging around 90 percent, with exports accounting for 40 percent of GDP and imports for a little over 50 percent. Economies that are this open normally are very vulnerable to external shocks and Honduras i s no exception. Its economy i s periodically affected by major terms of trade fluctuations, natural disasters and developments inits major trading partners. .. 11 v. Honduras has been able to reduce its vulnerability to terms of trade shocks over the last decade through a greater diversification of exports. The country's three main export commodities (coffee, bananas, and shrimps) used to account for over 40 percent of total exports of goods and services inthe early 1990s, but now represent less than 20 percent. (Part of their declining share i s explained by the fall in international commodity prices since 1999, especially for coffee and shrimps.) These traditional exports have been superseded by nontraditional exports and, especially, maquila exports (mainly textiles), whose value-added alone grew from 9 percent of total exports of goods and services in 1995 to 22 percent in 2002. While reducing the vulnerability to terms of trade fluctuations, the growth of the maquila sector has increased Honduras's vulnerability to trade shocks through greater competition from low-cost Asian producers in apparel and textiles once the WTO agreement on quotas ends, as currently scheduled, in January 2005, and possibly to trade disputes associated with the exemptions granted to export processing. vi. Honduras's overall economic production pattern mirrors the evolving composition of exports. Most visible i s the declining importance of agriculture, whose share of current GDP declined from 19 percent in the mid-1990s to less than 12 percent in 2002, while the share of services increased from 42 to 49 percent of GDP. Sector output shares have remained more stable in real terms, however, with the share of agriculture only declining from 25 percent of GDP (in constant prices) to 23 percent over that same period. Similarly, the share of the Honduran work force employed in agriculture also has remained largely unchanged at around 39 percent. This suggests that opportunities to shift labor and capital outside the agriculture sector in response to declining sector prices have been limited so far. Improving access to education and financial market deepening - to issues that are emphasized in this report - will be essential for increasingfactor mobility. vii. Another important structural change that took place over the last decade i s the growth of foreign remittances, which have reached an estimated US$SOO million in 2003, or about 12 percent of GDP. Even though foreign aid transfers have been declining again, after a temporary surge in the wake of hurricane Mitch, net current transfers from abroad have continued to increase from an estimated 7 percent of GDP in the mid-1990s to currently 15 percent of GDP. This increase in current transfers has permitted domestic absorption to increase since the mid-1990s without adding to the country's high debt burden, while helping to sustain the real exchange rate in the face of external shocks that weakened export performance. viii. With an external public debt-to-GDP ratio of around 66 percent, Honduras is a highly indebted country. It was declared eligible to participate in the Heavily Indebted Poor Countries (HIPC) initiative in 1999 (under the fiscal window), and reached the HIPC Decision point in July 2000. At that time, Honduras was expected to reach the HIPC Completion point at the end of 2002, but difficulties in implementing a stable macroeconomic program have set back the implementation of the PRSP and delayed the Completion point until possibly 2005. Honduras completed a full PRSP in July 2001 and its first PRSP Progress Report in December 2003. The Honduran authorities are hoping to reach the HIPC Completion point by early 2005. ... 111 Recent Economic Developments ix. In the early 1990s, Honduras reconsidered its inward-looking policies and began a process of reform that included the reduction of trade barriers, more flexible exchange rate arrangements, financial market liberalization, adjustments of public utility tariffs, and the development o f a legal framework to strengthen property rights. This reform process was not sustained, however, as the quality of economic management varied greatly over the political cycle. Accordingly, fiscal discipline was relaxed in the run up to the November 1993 elections, and many of the trade liberalizing reforms taken in the early 1990s were reversed in order to prevent a collapse of reserves. A similar pattern occurred also in the run-up to the 1997 and 2001 elections. In both cases, PRGF-supported programs that had been arduously negotiated with the IMF in the first half of the electoral period subsequently went off-track due to deviations from the fiscal targets and an inability to implement programmed structural reform measures as the elections came nearer. x. As the new authorities assumed office in January 2002, Honduras once again was in the midst of an economic slowdown and deteriorating public finances. Economic growth increased modestly to 3 percent in 2003 (or barely 0.4 percent inper capita terms), driven by a mild recovery in construction, tourism and maquila activity, while inflation declined to 7.2 percent, in line with the exchange rate crawl. Unfortunately, the fiscal and external deficits also increased, limiting the prospects for a more robust economic take-off. The external current account deficit increased from 3.1 percent of GDP in 2002 to 5.2 percent in 2003, reflecting a continuing deterioration of the terms of trade, weak export growth (except for the maquila services sector), and a significant jump in imports that i s largely attributable to higher oil prices. Depressed global economic conditions are partly responsible for the lackluster export performance. Another contributing factor appears to have been the real exchange rate, which exhibited a 35 percent appreciation between 1997 and 2001, reflecting post-hurricane Mitch aid inflows, the rapid growth of foreign remittances and a sluggish exchange rate setting mechanism. Since then, the real exchange rate has depreciated by a cumulative 8 percent, partly compensating for the previous appreciation. xi. Looking toward the future, Honduras's external sector i s about to receive a major jolt with the entry into force of the U.S. - Central America Free Trade Agreement (CAFTA). Negotiations on the CAFTA between the Central American countries and the United States were successfully concluded in December 2003. Once the agreement i s ratified by the respective legislatures, Honduras and its Central American neighbors will be faced with major opportunities as well as challenges. The free trade agreement promises significant opportunities for export-led growth and employment creation, but it i s also likely to require internal adjustments in response to increased external competition and declines in tariff revenues. The preliminary findings from recent studies indicate that CAFTA i s expected to have a positive impact on trade and investment in the Central American countries, including Honduras, and thus ultimately on growth and poverty alleviation. One important reason for this positive impact is increased market access: CAFTA has consolidated and expanded the generous access that Central American producers currently enjoy in the U.S. market, while extending broadly reciprocal access to U.S. goods. Caribbean Basin Initiative benefits were consolidated for the Central American countries, and further duty free access to markets of iv goods that had been previously exempted from those preferences were obtained. Another significant result has been the moderate flexibilization of rules o f origin for textiles and apparel, as well as the relaxation of some non-tariff barriers for non-traditional agricultural exports. The other key benefit i s associated with the strengthening o f domestic reforms: CAFTA commitments lock in a number of recent reforms that opened competition in previously protected sectors (e.g., telecoms, financial services, energy) and the modernization of key norms and regulations (government procurement, intellectual property rights, treatment of foreign investors) by locking in the level of access currently enjoyed b y U.S.- based investors and bidders. (The main implications of CAFTA for Honduras are discussed in Annex F.) xii. The public sector deficit also has been exhibiting a progressive deterioration, reaching 4.6 percent in 2003. This deterioration i s mainly attributable to declines in the operating surpluses of the public enterprises and the erosion of tax revenues. The decline in operating surpluses i s largely associated with rising oil prices and sluggish tariff adjustments by the public enterprises, while the erosion of tax revenues i s due to the proliferation of tax exemptions, weakening tax administration and declining import duties. Administrative measures taken by the government have halted the deterioration in the operating surpluses of the public enterprises in 2003, but not reversed it. The government also implemented a three- stage tax reform (in October 2002, May 2003 and December 2003), which succeeded in reversing the earlier tax revenue decline. xiii. Total public expenditures have exhibited a little more stability in recent years. The composition of public expenditures has changed considerably, however, and in a direction that contributes to a stagnation of economic production. In particular, current expenditures and central bank losses have both increased, while capital expenditures declined. The main factor driving the rise in current expenditures has been the public sector wage bill, which increased from 9 percent GDP in 1997 to 13.6 percent in 2003. xiv. The increases in the public sector wage bill are mainly linked to the special wage regimes that emerged for various public sector employee groups (described in Annex B). These regimes cover more than 80 percent of the total central government labor force, most significantly teachers and health workers. A consequence of these regimes i s that public sector wages have become the product of political negotiations in Congress and are set in a manner that i s not linked to performance or budget considerations. Moreover, as real wages have risen over time, labor productivity and worker morale in the public sector have declined, reflecting even deeper problems with the civil service system. The authorities took an important first step to reverse this process with the approval in December 2003 of a public wage framework law, which was designed to restore central government control over the public wage setting process, and i s expected to halt the upward creep in the wage bill as a percent of GDP. xv. The deteriorated fiscal and external deficits have led to negative primary (non-interest) balances that are clearly not sustainable. This has put pressure on international reserves and has led to an increase in arrears on the repayment of Honduras's substantial foreign debt. Seeing that this situation i s untenable, the authorities have been negotiating with the IMF V since early 2003 on a macroeconomic program to be supported through a new PRGF arrangement. Agreement on a new program was reached at the end of 2003, and was approved by the IMFBoard inFebruary 2004. The Medium Term Macroeconomic Framework xvi. The economic program negotiated with the IMF and presented in the first PRSP Progress Report seeks to reverse Honduras's fiscal deterioration in order to create the basis for faster growth and reduced poverty in line with PRSP and MDG targets. It aims to raise growth to 4.5 percent per annum by 2006 and to reduce inflation gradually to the rates prevailing among the country's main trading partners in 2008. Also, the authorities are seeking to implement all the reforms needed to reach the HIPC completion point by early 2005. xvii. The program contemplates a progressive decline in the overall fiscal deficit to 3.0 percent of GDP in 2004, 2.5 percent in 2005 and 1.7 percent in 2006. This fiscal adjustment will reduce the amount of crowding-out in the domestic financial market and, thereby, permit an expansion of credit to the private sector. The deficit reduction i s to be brought about through measures on the revenue and expenditure sides. Adjustments in public tariffs, especially in the energy and telecommunications sectors, are contemplated in the program to improve the operating surpluses of the public enterprises, while greater discipline in setting public sector wages will help bring down current expenditures. Additional reforms in the area of human resources are contemplated to reduce labor costs further and increase labor productivity in the public sector. The resulting increase in public savings will permit the expansion inpublic investment within an overall deficit reduction context. xviii. The strategy for accelerating growth rests on five elements: (i) an increase in public investment to meet key infrastructure needs, especially in roads, telecommunications and low income housing, (ii)increases in private investment in electricity generation, telecommunications, tourism, maquila and agriculture, attracted b y CAFTA and an easing o f credit conditions, (iii)reforms in governance and transparency designed to improve the overall investment climate, (iv) structural reforms to improve the efficiency of the public sector and restore a sound financial sector, and (v) entry into force of the CAFTA, which i s expected to open up further access to foreign markets and promote a more competitive environment for domestic producers. Key Determinants of Growth in Honduras xix. The restoration of greater fiscal discipline and external balance constitutes an important step toward improving the prospects of achieving growth and poverty reduction. As Honduras's historic record shows, however, maintaining a stable macroeconomic framework i s not enough to achieve a significant acceleration of growth. The absence o f growth i s not a recent phenomenon in Honduras. It has been lagging behind its Central American neighbors since at least the early 1960s. It began the 1960s as the poorest country in the region, and lackluster growth during the subsequent forty years meant that its income level continued to diverge even further from that of its neighbors, except Nicaragua. vi xx. Honduras shares the general pattern of growth common to most other countries in Latin America and the Caribbean (LAC) during the last four decades: it grew steadily during the 1960s and 1970s, and experienced a major slump during the so-called "lost decade" of the 1980s. Growth recovered during the 1990s, but at significantly lower rates than those achieved in the 1960s and 1970s; also reflecting the general pattern inLAC. Where Honduras stands out in this per capita growth comparison i s not interms of pattern, but interms of level, which generally remained below the L A C average in each of the last four decades. Even during the 1960s and 1970s, when Latin America exhibited the greatest growth dynamism, Honduras only managed to grow by 1.8 percent per annum in per capita terms. A growth accounting framework (discussed in Chapter I) reveals that the difference in growth i s almost entirely due to Honduras's low factor productivity growth. xxi. To analyze the main determinants of growth in Honduras, this report applies the empirical findings of a cross-country study by Loayza, Fajnzylber and Calder6n (2002), which relates growth to twelve key explanatory variables, that have repeatedly emerged from the growth literature as the most significant and robust influences on economic growth. The regression results presented in this study also are used to predict the future level of growth in individual countries on the basis of forecasts of the future values of the explanatory variables. Inmakingthese forecasts, three scenarios have been considered: the first one assumes that the explanatory variables continue to evolve over the next decade according to past historical trends. The second scenario assumes the implementation of policy reforms that raise all the explanatory variables to the top 25thpercentile of their distribution in Latin America and the Caribbean. The third scenario assumes the implementation of even more aggressive reforms, whereby the explanatory variables are adjusted to the top 25th percentile of their worldwide distribution. xxii. The simulations indicate that Honduras cannot expect to accelerate its per capita growth significantly by allowing its growth-determining variables to evolve along their historical trends. This would only boost annual growth from the average of 0.1 percent achieved inthe 1990s to 0.5 percent during 2001-10. B y introducing reforms that would raise the values of the explanatory variables to the top 25thpercentile of the LAC distribution, Honduras could hope to achieve a significant improvement in growth in the coming decade; to an average of 2.8 percent per annum. To achieve the country's Millenium Development Goal of reducing extreme poverty in half by 2015, however, it would have to grow even faster. This target could be attained in principle under the third simulation scenario, where the explanatory variables are raised in reference to a global standard, which yields an average growth rate of 4.4 percent. xxiii. Among all the variables that contribute to the increase in growth under the different reform scenarios, there are four that stand out in this analysis as particularly important for Honduras. These variables pertain to levels of human capital, public infrastructure, financial market development and governance. Honduras appears to be lagging significantly behind in its development vis-&vis other Latin American countries and the rest of the world, so policy advances in these areas would have the largest payoff in terms o f raising growth. This does not mean that the other growth determinants can be ignored or neglected. Even though vii adjusting these other outcome variables in line with L A C or global `best practice' would only be expected to generate a modest improvement in growth in Honduras, allowing those policies to slip could have disastrous consequences in terms of yielding a growth decline. Rather, it means that Honduras has been managing these other policy areas reasonably well by world and regional standards, and would do well simply by maintaining their historic trend. However, staying on its historic trend in all policy areas would leave Honduras on an unacceptably slow growth path, so additional efforts need to be exerted in at least some areas to bring about significantly faster growth. The preceding discussion suggests that this additional effort would have its greatest impact on growth if invested in human capital development, infrastructure development, financial market development and improved governance. The key issues and obstacles to development ineach of these areas are addressed inthe rest of this report. B. EDUCATION GROWTH AND xxiv. The growth simulations summarized in paragraph xxiii (and presented in Chapter I and Annex A) identify education attainment as the single most important growth determinant for Honduras. Closing the gap vis-&vis other countries in education will also require parallel efforts to close the gap in technology to avoid bottlenecks that would eventually paralyze growth. For countries that, like Honduras, lie very far from the technology frontier, the most important technology policy i s arguably their basic education policy, coupled with an open trade policy. Accordingly, the primary focus of attention in this report will be on Honduras's basic education system, while other areas of technology policy are reported on a case by case basis. (A discussion on measures to begin closing the technology gap i s provided inAnnex E, inthe context of a preliminary assessmentof Honduras's national innovation system.) xxv. Honduras has exhibited a steady improvement in its educational indicators over the last four decades, although at a slower pace than in the rest o f Latin America. The mean years of schooling o f its adult population increased from 1.69 in 1960 to 4.08 in 2000; a gain o f 2.38 years, compared to an average gain of 2.80 years achieved b y the other Latin America countries. A notable achievement i s the very high gross and net enrollment rates attained in primary education, with over 90 percent of children in the range of 7-12 years attending school. xxvi. Honduras also exhibits important shortcomings relating to education coverage and efficiency, however. These are (i) a very low coverage of pre-primary education, (ii) low internal efficiency at the primary level, which translates into low completion rates, (iii) low coverage of secondary education, at both the lower and upper levels, and (iv) substantial inequities across the urbadrural divide at the secondary level. The education system i s characterized by very high drop-out rates, with the result that only 1student out of 2 makes it to grade six, 1 student out o f 5 reaches grade nine, and less than one student out o f 10 reaches grade 12. Furthermore, only 1 student out of 3 makes it to grade six in six years and less than 1out of 10makes it to grade nineinnine years. xxvii. In sum, even though gross enrollment rates at the primary level in Honduras are quite high, and comparable to those in other countries of Latin America, highdesertion rates at the ... V l l l primary level and low coverage at the secondary level have largely nullified this benefit, with the consequence that its net enrollment and completion rates at the secondary levels are among the worst in Latin America. In 2000, only 17.1 percent of the adult population had at least some secondary or tertiary education, which i s less than half the amount exhibited on average by the rest of Latin America (35.4 percent). Only Guatemala and Haiti exhibit a lower share of post-primary education attainment. xxviii. Improving the completion rate in primary education and expanding coverage in secondary education must be given high priority in Honduras in order to raise the education attainment level of its workforce, which exerts an important influence on the country's economic growth and distribution of skills. Accelerating economic growth and reducing the current inequality in the distribution of skills (and in the associated income opportunities) would make a major contribution toward helping the country meet its poverty reduction goals. To achieve these sector objectives, Honduras needs to tackle several key problems at the sector and sub-sector levels: xxix. At the overall sector level, Honduras stands out by spending an extremely high share of its GDP on education. However, its education outcome indicators are not commensurate with such high sector spending levels, indicating serious problems of efficiency in the sector. Inadequate control over teacher remuneration and performance i s a major problem. While teachers' wages have spiraled up inrecent years, contributing to overall fiscal indiscipline and crowding out other sector expenditures needed for a good quality education, teacher absenteeism remains rampant and student test scores are declining. The issue of teacher management needs to be addressedurgently, giving attention to the following measures: e Implementing the recently approved wage policy framework law to contain the growth in teacher wages and free up resources for education quality-enhancing expenditure items. e Completing a `teacher post review' in all departments, and reconcile the payroll figures with the findings of the review. e Revisingthe Teacher Statutes, possibly in conjunction with more comprehensive civil service reform legislation, so that any allowances paid are attached to positions, rather than to individuals. e Establishing an effective supervisory system to permit a more rational and equitable teacher allocation across geographic areas. e Developing and maintaining a comprehensive human resource data base for the education sector (SIARDH). e Establishing an effective monitoring system to improve teacher attendance rates. e Expanding further the number and role of Local Education Development Associations (ADELs)inassisting teachers and monitoring teacher performance. xxx. With respect to the allocation of public expenditures on education, there are efficiency concerns arising from the rapidly increasing share of sector expenditures devoted to headquarters administration functions, as well as equity concerns about the very regressive distributional pattern of sector expenditures, especially at the secondary and tertiary levels. ix To address these concerns, the report recommends that education sector expenditures be reallocated as follows: 0 Reducing the share of total sector spending devoted to headquarters administration and reassigning those savings to secondary education, especially inrural areas. 0 Reducing the share of total sector spending devoted to the tertiary level and reassigningthose savings to secondary education, especially inrural areas. xxxi. Honduras has made substantial progress in raising enrollment rates and eliminating urbadrural disparities in the provision of primary education, while the share of public spending devoted to this level conforms to international norms. However, primary completion rates are very low and not improving, while repetition and drop-out rates are very high, largely canceling out the gains achieved by raising the enrollment rates. Also, primary education outcome indicators are very unequally distributed across income groups, thus contributing to the persistence of social inequalities. To address these shortcomings, the authorities are advised to aim for achieving universal completion, without sacrificing quality, by implementing a comprehensive reform package, such as the one promoted under the Education for All - Fast Track Initiative (EFA-FTI). This reform package should involve the following key elements: 0 Improving internal efficiency through the development of academic standards, efficient student promotion practices and special programs for over-age children. 0 Improving teacher performance and teacher quality by strengthening in-service training, evaluation & supervision mechanisms, and through performance incentives. 0 .Promoting network mechanisms in rural areas to create economies of scale in delivering services to dispersed rural settlements. 0 Preparing a diagnostic study on completion rates in urban areas (which have shown a declining tendency in recent years), and designing a plan for raising them. 0 Using the fiscal savings generated by the efficiency gains made at the primary level to expand the provision of services at the secondary level. xxxii. Even though investments in education appear to yield the highest rate o f return at the upper secondary level in Honduras, gross and net enrollment levels in secondary education are extremely low, while repetition and drop-out rates are very high. Also, the distribution of secondary education i s very unequal, both across urbadrural lines and across income lines. Most secondary education i s currently being provided by private schools, while the education ministry devotes a very low share of its budget to this level. To correct these shortcomings, the authorities are advised to prioritize the expansion of secondary education as follows: 0 Implementing reforms to improve internal efficiency by reducing repetition rates. 0 Increasingthe share of the education sector budget devoted to the secondary level. 0 Promoting different public schooling options (Le., CEBs, EducatodosBAT, TelebBsica) to address the special needs of different groups. Preparing a study that analyzes the scope for introducing demand-side subsidies to help poor households overcome the economic disincentives to secondary school attendance. X xxxiii. Although Chapter I1mainly focuses on primary and secondary education, an important finding with respect to tertiary education is its highly inequitable nature. Policymakers are advised to review the distribution of education spending in this light, and to consider a more pro-poor allocation of resources in the sector. Studies elsewhere have indicated that the proportion of private to public goods tends to be higher in tertiary education than in primary and secondary education. On efficiency grounds, therefore, the beneficiaries of tertiary education should contribute more to the financing of tertiary education. This calls for greater cost-recovery in the universities. xxxiv. Annex E of this report also draws attention to the importance o f vocational training in the national innovation system. As indicated in a recent FIAS report and the 2004 Investment Climate Assessment (ICA), the main institution responsible for vocational training, INFOP, has low capacity, high administrative costs, and a reputation of being an inefficient service provider. Key policy recommendations emerging from the FIAS report and I C A (2004) are to 0 Eliminate INFOP'S monopoly as a publicly-funded provider of vocational training services. 0 Separate the functions of providing training services from the functions of setting training policy. 0 Attract greater private sector involvement in directing vocational training policy, in order to achieve a better balance between serving the needs of the productive sector and achieving the national priorities set by the government. 0 Review the role of the public and private sectors in the sector, with the public sector being responsible for establishing accreditation, standards and curriculum, and certification systems, and with private institutions becoming mainly responsible for providing training services. c. PUBLICINFRASTRUCTUREAND GROWTH xxxv. The empirical findings discussed earlier identify public infrastructure as the second most important determinant of growth in Honduras. Honduras's infrastructure endowment historically has been very poor. A Public Expenditure Review for Honduras prepared jointly by the World Bank and Inter-American Development Bank in 1995 had recommended reforms in several areas to support the development of modern, efficient and well functioning infrastructure services. These included decreasing the over-extended role o f the state in many infrastructure sectors and stimulating greater competition in the provision of infrastructure services, reforming a rigid and obsolete structure of regulation combined with the application of clear, de-politicized policies for settingtariffs, eliminating excessive micro-management by government of public enterprises, and increasing attention to maintenance requirements in many sectors. xxxvi. A subsequent Public Expenditure Review completed in 2001 concluded that in spite of some advances inthese areas, Honduras has yet to overcome the fundamental institutional and policy weaknesses identified in the 1995 Review. Although public expenditures in the infrastructure sectors appear adequate, virtually all indicators of access, efficiency and service quality continue to be low in absolute numbers and in comparison with other countries in the xi region. The main reasons identified for this sub-par performance are that sector structures and the related regulatory environment are not grounded in clear objectives of improving operational efficiency and the quality of services to consumers, and that public spending has been channeled predominantly to maintain affordability of services to existing users, rather than to expanding access to new users, especially poor ones. That report concluded with four sets of recommendations that focus on (i) attracting more private participation into the infrastructure sectors under arrangements that give primary attention to improving access, quality and efficiency, rather than maximizing the fiscal revenues of privatization, (ii) strengthening the regulatory and policy environment, (iii) restructuring infrastructure pricing and subsidies, and (iv) ensuring adequateinfrastructure maintenance. xxxvii. This DPR concludes that Honduras has continued to advance since 2001, but still exhibits many shortcomings in access, quality and efficiency of infrastructure services. In transport, the overall provision of services i s comparable to or better than in the other countries in the region with similar per capita income levels. Key issues in the sector are the low quality of urban bus transportation, the distorted structure of price controls and subsidies, the inefficient management of Puerto Cortis and the congested state of the Tegucigalpa airport. The following key recommendations are made for this sector: To strengthen the regulatory and policy framework, (i) create a regulatory entity for the sector, comprising surface transport, civil aviation and ports, (ii)set up a proper system to monitor weight and size of circulating vehicles, (iii) eliminate the subsidy on urban transport in Tegucigalpa, or replace it with a more efficient mechanism, (iv) eliminate price controls on freight transport, (v) review the legal framework for charging tolls, (vi) review SOPTRAVI's system of issuing licenses, (vii) restructure the mechanisms for regulating public passenger transport, with greater involvement by consumers and possibly transferring this function to the municipalities, and (viii) rationalize frontier and customs procedures to eliminate waiting times. With regard to ports and airports, (i)approve the proposed ports framework law, (ii) create the new ports authority and provide adequate resources for its operation, and (iii) follow up on the contractual obligations under the airports concession in regard to investments agreed for improving passenger service in Tegucigalpa and freight services in San Pedro Sula. To improve the sector's fiscal sustainability, (i) ensure that the road fund i s given the full amount of resources earmarked for this purpose and, if necessary, supplement with general budget resources to provide adequate resources for maintenance of the primary roads, (ii)strengthen the road fund's institutional capacity to supervise and monitor the quality of maintenance activities, (iii) analyze the feasibility of concessioning to the private sector certain segments of the road network, (iv) prepare an institutional and financial analysis for improving the condition of urban road networks, including mechanisms to transfer funds to the municipalities for this purpose. To improve competitiveness, (i) give Puerto CortCs inconcession to a private operator, (ii) analyze the feasibility o f including the other main ports (San Lorenzo and Castilla) in the concession scheme, and (iii) divest the provision of ports services to private operators, including piloting, towing and stevedoring services. xii To improve sector planning, develop a transport master plan, with an inter-modal vision and comprehensive road investment plan, to guide the allocation of resources inthe sector. xxxviii.In the electricity sector, Honduras has exhibited a rapid increase in coverage of electricity service during the 1990s, but the distribution of access i s very unequal across income groups and the quality of service i s low. The public utility, ENEE, i s extremely inefficient and its operations are characterized by large distribution losses and inadequate regulation. Key recommendation in this sector are: Separate the accounts of ENEE into its generation, transmission and distribution functions, in order to improve management information; better accounting and in general a more efficient and transparent operation. Evaluate strategic options for the most appropriate organization o f the different activities of ENEE, especially in distribution, by assessingthe optimal structure of the market. Validatemeview the Government Strategy for the Electricity Sector and update the legal framework to support the reform program of the Government in accordance with this Sector Strengthen the sector policy making capacities and institutions by creating a permanent institutional arrangement for the Energy Cabinet, capable of following up on any policy decisions that have been reached. Strengthen and provide greater autonomy to the regulatory agency, CNE. Eliminate the cross-subsidy (from non-residential to residential users) in electricity tariffs and adjust electricity tariffs to cover costs. Develop a rural electrification fund, with adequate financing provisions, that i s designed to expand access to electricity services inrural areas in an efficient manner. xxxix. The telecommunications sector in Honduras i s characterized by low access indicators, low quality of service and a very distorted tariff structure. Key recommendations in this sector are: Allow HONDUTEL's monopoly to expire at the end of 2005 and open up the sector to competition. Rebalance telephone tariffs (raising local rates and reducing international rates) in a way that achieves a gradual transition to an open market environment by the end of 2005. Grant greater autonomy to the sector regulatory agency, CONATEL, and strengthen its institutional capacity, possibly by incorporating it into a multi-sectoral utility regulatory agency (that would have to be created). Create a planning and policymaking entity, independent of CONATEL, incorporating a permanent institutional arrangement capable of following up on decisions reached in the sector. Develop a rural telecommunications fund, with adequate financing provisions, that i s designed to expand access to telecommunications services inrural areas. Carry out the investments necessary to relieve immediate bottlenecks in the fixed-line telephony sector, but hold off on other investments until the sector i s opened up to free competition. ... X l l l xl. Honduras has made remarkable progress in expanding access to water and sanitation services during the 1990s, but the quality of service and efficiency of public service providers i s poor. The key recommendations made for this sector are given below: To improve operating efficiency, (i) an analysis of the operations and commercial prepare viability o f each of the systems currently being operated by SANAA, and discuss their optimal organizational structure, (ii)prepare an inventory of assets owned by each water and sanitation system, and (iii) prepare 3-year rolling operating plans, coupled with a management contract, for each service-providing system with clear targets for improving operational efficiency. To attract private management expertise into the sector, (i) define a plan for transferring the water and sanitation systems to the municipalities, as contemplated in the recently passed sector framework law, spelling out the collaborative arrangements with the private sector to be considered, (ii) develop a set of alternatives and models to incorporate the private sector in the operation of these systems in the municipalities, and (iii) prepare a plan to give the Tegucigalpa system in concession, or other form of participation, to the private sector, buildingon the lessons learned from the experience in San Pedro Sula. To reduce fiscal burdens, (i)develop guidelines for setting utility tariffs that cover operating costs as well as the capital costs needed to reach given expansion targets, and that are based on publicly verifiable indicators to trigger tariff adjustments, (ii) develop a subsidization scheme to encourage the expansion of water and sanitation services to marginal urban and rural areas, and (iii) develop a fund to finance start-up operations o f the rural administration committees in charge of managing the water and sanitation systems being transferred from SANAA. To strengthen institutional capacity, (i) provide adequate funding for the newly created regulatory agency and for the policy and planning entity, CONASA, and (ii) prepare and implement a plan to build capacity in the municipalities to manage their water and sanitation in a financially sustainable manner, and define the mechanisms for providing technical assistance to the municipalities willing to reform the current service provision model. D. FINANCIAL SECTOR DEVELOPMENT GROWTH AND xli. The empirical analysis described in Chapter Iidentifies financial market development as the third most important determinant of growth in Honduras. The degree of financial deepening in Honduras i s comparable to that exhibited by other countries in the region. With total assets of US$3.3 billion, the commercial banking system i s small in absolute terms, but represents a larger share of GDP than the banking systems in most other Central American countries, as well as in Latin American on average. However, Honduras's financial system, (and Latin America's in general) i s significantly underdeveloped b y world standards, so that there remains considerable room for improvement in this sector, with a view toward raising economic growth. xlii. In recent years, Honduras's banking system, which i s the mainstay of its financial system, has runinto serious problems that have paralyzed new lending in the country's largest productive sector, agriculture, and impose a major impediment to the resumption of growth. xiv These problems were triggered by several external shocks (most importantly hurricane Mitch and falling commodity prices) and propagated by various institutional weaknesses in the financial system, resulting in an overhang of bad debts in bank loan portfolios. Compared to neighboring countries, Honduras's banking system currently stands out as having the highest share of non-performing loans and least amount of provisioning. Also, the system's administrative costs are among the highest in the region, while its profitability i s among the lowest. The most relevant institutional weaknesses that contributed to this problem are a general disregard of systemic risk factors in the management of financial transactions and the open-ended deposit guarantee offered by the government. These have fostered a'moral hazard environment that has progressively paralyzed the process of financial intermediation in Honduras. xliii. To address the immediate causes of the credit crunch in agriculture and permit the resumption of credit growth, two issues mustbe tackled simultaneously: 0 The Government needs to define and enforce a final (Le., politically and financially enforceable) distribution of the losses accumulated since 1998, taking into account the existing fiscal constraints and the incentive structures facing banks and borrowers. 0 The Government needs to introduce institutional changes to make sure that insurance and price hedging instruments are put in place and financial contracts are no longer written as if systemic risks did not exist. In parallel, CNBS will have to develop the specific regulatory framework and supervisory skills required to guide and monitor these activities. xliv. Honduras's financial system also exhibits a number of other institutional weaknesses that stand in the way of healthy development in financial intermediary services and that were recently addressed by a joint World Bank-IMF Financial Sector Assessment Program review. These weaknesses are most pronounced in the areas of bank supervision and regulation, creditor rights and insolvency systems, and payments and securities settlement. The main recommendations offered to correct these weaknesses are presented below. xlv. To improve bank supervision and regulation: 0 Prudential regulations need to be enhanced in the areas of (i) consolidated supervision, (ii) capital adequacy, (iii) classification and provisioning, and (iv) corporate governance loan and risk management. 0 A resolution framework needs to be developed for taking prompt corrective actions when banks encounter problems. 0 CNBS needs to expand its range of instruments, including Action Plans and Memoranda of Understanding, to enforce preventive and corrective actions, and banking legislation needs to be revised to clearly state the objective criteria for triggering the use of these instruments. xlvi. To strengthen property rights and streamline insolvency proceedings: 0 New legislation i s required to introduce a modem and safe registration system of property rights and securities, both for immovable and movable assets. xv 0 New bankruptcy legislation, which contemplates the possibility of reorganization and out- of-court agreements, i s required to render insolvency procedures more efficient and less time consuming. 0 Appropriate institutional capacity needs to be developed in the Judicial system to deal with the new legislation on property rights and insolvency procedures. xlvii. To strengthen the payments and securities settlement functions, 0 The Government should establish a depository function for securities settlement. 0 The Central Bank should define a payments system policy, stating clearly its objectives (such as achieving finality for certain classes of payments) and the instruments (gross and net settlement systems for different types of payments, their respective operational rules, etc.) to reach them. xlviii. There i s a potential danger that efforts to tighten prudential norms and to enforce them better may slow down the expansion of credit, at least temporarily, which could have an adverse impact on growth. This i s a modest danger in the case of Honduras, since the banks already have paralyzed much of their lending activity. Furthermore, it i s important to keep in mind the earlier finding of this report that the evolution of economic growth in Honduras is mainly explained by changes in productivity growth, and not by changes in factor quantities. Applied to the context of the banking sector, this suggests that primary attention should focus on the quality of lending, rather than on quantity. In other words, to the extent that there i s a tradeoff between faster credit growth and better application of prudential norms, Honduras would be advised to move more inthe direction toward improved prudential norms. xlix. Taking a longer-term perspective, the report also recommends that the authorities review the governance framework for pension funds, with the aim of reducing political risk and promoting greater asset diversification. The capacity to supervise insurance companies and other non-bank financial institutions also needs to be strengthened. Although these are still relatively small in size, many of these (notably cooperatives) are growing rapidly and, thus, could eventually constitute a threat to financial stability. Finally, even though an effective legal framework to combat money laundering and the financing of terrorism i s in place, the institutions involved in these areas need to be strengthened. E. GOVERNANCE GROWTH AND 1. Governance i s an important determinant o f economic development. This raises concerns about Honduras's future growth prospects, given that it ranks well below the averages in Latin America and the Caribbean in most governance indicators. This finding of relative deficiency should not come as a very great surprise, however, given that governance indicators are positively correlated with per-capita income levels and considering that Honduras i s one of the poorest countries in the Latin American region. More revealing results emerge by comparing Honduras with other lower middle income countries around the world, which shows that Honduras does not fare equally badly in all dimensions of governance tracked by the World Bank Institute. It achieves a similar or higher score than the comparator group in three dimensions of governance, which refer to Voice & Accountability, Political xvi Stability and Regulatory Quality. However, Honduras scores significantly below the comparator group in the remaining dimensions, namely Government Effectiveness, Rule of Law and Control of Corruption. This result suggests that governance problems in Honduras are not primarily related to a faulty political system or to inadequate laws and regulations, but more to faulty public sector management and an incompetent civil service, which i s incapable of enforcing those laws appropriately, and to a weak judiciary. These latter areas, public sector financial management reform, civil service reform andjudiciary reform, also happen to be the ones where the Honduran authorities have focused most of their recent efforts to improve governance. Public Sector Financial Management Reform li. TheHonduranauthoritieshavemadesignificantprogressindevelopingthebudgetas an expenditure management tool over the last year, but many systemic deficiencies still remain: A significant amount of donor grant and in-kind assistance i s omitted from the budget, which makes it difficult to gauge the full extent of public efforts in certain areas and coordinate public activities. The same i s true of revenues raised b y many ministries through the sale of services. Final budget allocations are based on incremental allocations, often made with little or no input from ministries, and the final allocations are not reconciled with annual operating plans. This has weakened the usefulness of sector operating plans and has resulted in low budget credibility. A significant number of budget amendments are passed throughout the year that reflect Congress's discretionary powers to reallocate financial resources for political purposes, rather than strategic priorities. Although Congress has a constitutional role to oversee public sector management, it lacks the capacity to fulfill this role. A weak planning capacity at the sector level adds to the overall weakness in budget preparation and contributes to the need for repeated budget amendments. The budget i s presented on the basis of expenditure objects, rather than a programmatic classification, which hampers its use for monitoring and evaluating public efforts in relation to agreed priorities inpromoting economic growth and reducing poverty. lii. The implementation of an integrated financial management system (SIAFI) has improved the Government's ability to control and manage expenditures. SIAFI's usefulness has been limited, however, by rigidities in its format, a lack o f comprehensive access to the system b y all sectors that results in delays in recording transactions, and a failure to integrate SIAFI with various other government information systems. This has led to a proliferation o f information systems in other agencies, without a common platform of operating and technical standards, resulting in a duplication of databases and effort, and an overall incompatibility of the flow of information within the government. liii. Internalcontrolsarewidelydispersedanduncoordinated. Furthermore, theOfficeof the Budget (DGP) exerts a centralized ex-ante control that does not allow for efficient budget execution. At the same time, internal audit functions are not well defined and continue to be controlled by the supreme audit institution ("Tribunal Superior de Cuentus", TSC), blurring the lines between internal and external audits. xvii liv. Fiscal management responsibilities are dispersed among several public entities, rather than being concentrated in the Treasury (TGR), which exhibits significant institutional weaknesses. The dispersion of fiscal responsibilities has resulted in functional voids that directly affect the security and control of management of public funds. Adding to this void i s the TGR's practice of issuing negotiable checks, which prevents the verification of the final recipient of government payments. lv. Procedures governing tax collections are deficient and unclear. There i s no proper reconciliation between the funds paid by the taxpayers with the funds declared by the banks as collected; and there i s no reconciliation between the funds received by the banks and the funds transferred to the treasury accounts. There i s little security with respect to the funds collected by the banks, whose solvency i s not previously certified. lvi. The Government has invested in building its debt management capacity, which represents one of the stronger areas in the public financial management system. Debt management can be improved further, however, with the inclusion of contingent liabilities. These are currently not reported in the Government's financial statements and, thus, not included indebt analyses. lvii. The external audit functions are still evolving in the wake of the constitutional reforms in2002 that led to the creation of the TSC. The effectiveness of the TSC is currently limited by a lack of qualified personnel, insufficient financial resources to fully discharge its responsibilities and a lack of operational guidelines and regulations. lviii. Honduras does not have an adequate system for government procurement. The new legal framework for public procurement enacted in June 2001 represents an important improvement over the previous framework in that it (i) covers all government agencies under one set of guiding principles with respect to economy, transparency and efficiency, (ii) provides for the creation of a Procurement Regulatory Office to give a common and consistent approach to standard bidding documents, criteria and practices, (iii) provides for the use of open competitive procedures that include public bid opening and non- discriminatory participation of suppliers under a wide range of procurement methods, and (iv) requires public notification of procurement opportunities. However, the system remains ineffective because o f 0 Weak implementationo f the procurement rules and procedures, 0 Lack of dissemination of the new system in the public and private sectors 0 Non-establishment of the Procurement Regulatory Office, 0 Lack of capacity among working level staff and members of the tender committees and approving authorities, and 0 Absence of project managers and procurement practitioners, and of a career stream in project and procurement management. lvix. These deficiencies have seriously undermined trust in local procurement legislation and systems, with the result that the Government has appointed UNDP as its primary procurement agent to handle aid resources. Originally contemplated as a temporary measure, xviii the use of foreign systems and procurement agents has gradually become a permanent practice in Honduras. Unless these shortcomings are tackled in a decisive manner and coordinated with the donor community, it will remain a serious constraint for the effective implementation of government plans. lx. The quality of governance in the public sector, and the accountability of senior public officials that goes with it, need to be upgraded. Efforts in this direction need to focus on strengthening the legal and accountability framework for public financial management, improving transparency and oversight mechanisms of public financial management systems, streamlining processes and procedures, and rationalizing and strengthening the institutions responsible for ensuring accountability. In response to these needs, the Government of Honduras has embarked on an ambitious program to reform public financial management with the assistance of the World Bank, IDB and other donors. Important advances to date include (i) the drafting of a Financial Management Law, Public Ethics Code, and Law on Public Access to Information, (ii) improved budget formats and internal controls to facilitate a sector-wide approach in Education, (iii) expansion of SIAFI to increase its programmatic the functionality, (iv) the production o f the first government financial statement preparedby the Accountant General's Office and a preliminary inventory of all government assets, and (v) the promulgation of new regulations for external audits by the TSC. A recent IMF-World Bank joint assessment of Honduras's poverty reduction tracking mechanism also has noted significant improvements Honduras's public financial management due to reforms in critical areas. A detailed list of recommendations to guide further efforts in this area are presented in the CFAA Action Plan. Civil Service Reform lxi. Although the existing civil service legislation in Honduras appears to cover all matters related to public personnel management, i t has hardly been binding during the last two decades. Instead, by the mid 1990s, many separate employment regimes have been created which provide extraordinary benefits to particular sectors of the public labor force, such as teachers and health workers. These special regimes have led to an uncontrolled increase in the public wage bill, imposing an unsustainable fiscal burden on society, and they have created enormous disparities across public servant, both in terms of benefits and administrative procedures. At the same time, human resource administration in the central government and in the rest of the public sector has evolved in ways that are not conducive to an effective and transparent administration of public personnel. The hiring process, performance evaluation and dismissal procedures have become very politicized, reducing the capacity of public institutions to attract qualified personnel and to deliver public services efficiently. Thus, the institutional capacity of the whole public administration has been weakened. lxii. The overall size of public sector employment in Honduras i s not excessive in comparison to other Central American and HIPC countries, but there are serious staff imbalances across sectors. This i s due to years of weak personnel management policies and a lack of clarity on the role and purpose of different public sector entities. The consequence has xix been that many entities are clearly overstaffed in certain unneeded functions, and understaffed inother areas, which limit their capacity to deliver adequate services. lxiii. The most important issues to be addressed in connection to the administration of public employment refer to: 0 The need to restore control over salary and wage policies, in order to restore a sustainable fiscal situation and a more equitable distribution of benefits. 0 The need to review the macro-structure of the public sector, clarifying the roles, functions and service delivery responsibilities of different public entities, and to re-dimension these entities (including their employment composition) in accordance with these functions and responsibilities. 0 The need to establish a new normative and institutional framework to govern public employment, which limits political influence over the civil service, and 0 The need to follow through with the implementation of the new civil service framework once it has been approved. lxiv. To address these issues, the authorities have been working on a two-fold strategy that addresses both short-term and medium-term objectives. A public salary law passed in December 2003 restores government control over the wage bill and wage administration. It eliminates the special wage regimes, folds various wage bonuses ("colaterales") into the base salary, broadens the scope of wage policy to cover all government employees and allows reserves for the government (as opposed to Congress) the role of formulating wage policy in line with anticipated inflation. It also encompasses other features to reestablish more equity inthe wage structure. lxv. The other part of this reform strategy i s designed to address several structural issues over a medium-term horizon. These measures are to be carried out in parallel and involve the following: 0 preparation of a comprehensive reengineering study of the whole public administration, which identifies the functions that will remain in the centralized public sector (as well as those to be divested to the private sector, NGOs or municipalities) and then determines the appropriate size and composition of public entities in accordance with these functions, 0 submission to Congress of a new law to reform public administration, which includes provisions to establish transparent procedures for hiring, evaluation and dismissal of public servants, to limit the number of political appointees in the civil service, and to create an independent oversight institution for the civil service, and 0 completion of reengineering studies and gap analysis in certain entities, and implementation of the new civil service regime in those entities. Judicial Reform lxvi. The judiciary's statistical base on caseloads and on what judges do with it i s very bad. All the evidence available at this time, however, indicates that the Honduran system as a whole i s expensive and that the monies are not used efficiently, that the justices of the peace xx (which constitute the majority of the judges) are very underutilized, and that while urban trial courts may be handling larger caseloads, they have great delays in coming to judgment, relatively few judgments and problems with the enforcement ofjudgments. lxvii. Honduras has been pursuingreforms to modernize the judiciary since at least the early 1990s,but progress has been limited. With the reforms in 2002, however, the members of the Court have been given more independence through a longer tenure, which provides a more promising environment for implementing reforms. The newly appointed Supreme Court, supported by a reformist national administration, offers a unique opportunity that calls for redoubling efforts to reform the justice system. lxviii. There i s a need to modernize the judiciary, including fighting corruption, promoting greater judicial independence, and improving the overall efficiency and efficacy of the judicial system. Access to justice needs to be improved, giving special attention to less expensive and expedient conflict resolution procedures and other services targeted at disadvantaged population groups (particularly women, indigenous populations and the poor). Youth violence and crimehecurity problems also need to be addressed through coordinated social solutions and justice sector measures. Another important issue that needs to be addressed, especially with a view toward promoting growth, i s the strengthening of land security. In view o f these many demands for reform and institutional challenges, proper sequencing and prioritization of reforms are needed to avoid institutional, financial, or political capacity overload. It may be advisable, therefore, to begin with three intermediate development objectives that deserve special attention: (i) buildingJudicial Branch governance capacity. The mandate of the current Supreme Court runs through 2009 so the opportunity exists to strengthen its management capacity, including the establishment of planning and administrative structures, promotion of inter-institutional coordination with other justice sector institutions and civil society, setting judicial career norms, and promoting professional development of judges and staff; (ii)building confidence and trust among citizens by implementing basic first-stage anti-corruption, transparency and accountability initiatives with stakeholder input; and (iii) improving access to justice for high priority target populations by designing, piloting, and extending selected access tojustice measures. Where populations are very dispersed, the authorities may consider introducing circuit judges (who move between several locations) in order to increase access in an efficient manner. lxvix. More broadly, judicial leadership also needs better information on present demand for judicial services, the nature and causes o f delays, inconclusiveness of cases, and low enforcement, as well as on potential demand (who i s not using the courts and why). This would allow attacking the problems of inefficiency at a higher level by ensuring that the courts focus on the most important cases in terms of poverty reduction, economic growth and conflict mitigation, rather than just helping the courts process better the cases that they already are getting. There appear to have been problems with on the demand side in terms of abusive use of the courts to delay contract enforcement or to delay politically sensitive administrative decisions on the part of the government. Some of these problems can be addressed through better management in the judiciary, but others will require legal changes (e.g., simplification of procedures to reduce the opportunity for dilatory practices), coordination with other sector entities (e.g., the Public Ministry and its prosecutors), and xxi higher level political decisions as to what the judiciary should be reviewing. As some of these decisions may involve facilitating access to potential claimants who are currently not using the courts, an understanding of their needs and the alternatives for addressing them is also essential. lxx. The main recommendations for improving governance in Honduras that emerge from these findings call for: e Implementing the Country Financial Accountability Assessment (CFAA) Action Plan to improve public sector financial management. e Completing the Country Procurement Assessment Review (CPAR), and implementing a CPAR Action Plan to improve public procurement processes. e Completing a comprehensive reengineering study of the public sector, to determine the appropriate functions and skill requirements of different public sector entities, and begin the reorganization of certain public entities in accordance with the new civil service regime. e Preparing, submitting to Congress, and passing a new law to reform public administration, which establishes transparent procedures for hiring, evaluating and dismissing public servants, limits the number of political appointees in the civil service, and creates an independent oversight institution for the civil service. e Developing an accurate and comprehensive statistical database on the judiciary and developing its management capacity (which will require proper management information systems). e Preparing an in-depth diagnostic study of (i)demand for judiciary services in Honduras, (ii) main obstacles to accessing the judiciary system, and (ii) low the the productivity of the judiciary, and prepare a plan of actions for removing those obstacles and increasing the efficiency of thejudicial system in Honduras. F. CONCLUDING REMARKS lxxi. To the extent that the measures and reforms recommended in this report are able to generate a more attractive investment climate in Honduras, they will clearly serve to promote a faster accumulation of physical capital, which i s one component of economic growth. The main thrust of most of these reforms, however, i s to improve the quality o f factor services and the efficiency of factor allocation, which, in a growth accounting framework, are reflected in faster productivity growth. This is important for Honduras, whose comparatively slow growth in recent decades has been traced mainly to weak productivity growth. The measures to expand the coverage and quality o f education will have a direct impact on labor quality and the accumulation o f productive skills. Similarly, the measures recommended to promote financial market development mainly serve to improve the quality o f financial intermediation, rather than to stimulate the volume of total savings and investment. In the area of public infrastructure, the measures to remove price distortions, attract greater private investment and improve the regulatory framework may result in more infrastructure investment through the private sector. But the main impact i s likely to accrue through more efficient delivery and better quality of infrastructure services. This i s also true of the measures contemplated on the governance front, especially in the area of improving public sector financial management and xxii the civil service, which mainly improve the quality and composition of public services, considering that their quantity will be limited for some time by the country's tight fiscal constraints. lxxii. As indicated earlier (para. xi), Honduras will soon be facing a rapidly changing external environment once the CAFTA agreements are ratified. The policy and institutional reforms recommended in this report are necessary to allow Honduras to seize the opportunities o f faster growth and development offered by CAFTA. That is, CAFTA i s a complement, rather than a substitute for the productivity-enhancing policy and institutional reforms proposed in this report. The beneficial impact of CAFTA on economic growth i s expected to emerge from three sources - trade expansion, greater private investment and technology transfers - which are linkedto the reforms recommended in this report: As noted in Annex F, empirical studies point toward a close relationship between greater export and output growth, and reduced transport costs. The efficiency of ports appears to be particularly important intrade facilitation. Accordingly, the measures recommended in Chapter I11to improve access to and the quality o f transport infrastructure will permit Honduras to take better advantage of the trade opportunities offered b y CAFTA. Investor surveys indicate that foreign direct investment i s especially sensitive to the governance environment and availability o f infrastructure services, especially inthe power and telecommunications sector. While CAFTA will make Honduras more attractive to foreign investors, significant improvements in infrastructure and the governance environment will be required to trigger a major investor response. This i s especially the case in rural areas, whose lack of infrastructure represents a major inhibiting factor for private investment. Improvements in secondary enrollment and the education attainment of the population are crucial for permitting Honduras to move beyond low-skill, labor-intensive assembly operations. This i s important, both in terms of attracting technologically more sophisticated foreign direct investment, as well as for preparing the country to adapt new technologies. The trade agreements reached in the CAFTA negotiations offers new opportunities to expand Honduras's exports of agricultural products. A significant response in agricultural exports i s not likely to be forthcoming, however, until the current problems in the area of agricultural credit have been addressed. Moreover, the capacity to expand commerce and production, in general, will depend on a strong financial sector, which requires the financial strengthening measures recommended in Chapter IV. In addition to opportunities, CAFTA also presents some risks and challenges. The most pressing challenge i s posed by the decline in tariff revenues following the elimination of intra-regional tariffs. As indicated in Chapter I, Honduras needs to make a serious effort to restore a sustainable macroeconomic framework, even without the prospect of CAFTA. With CAFTA, this task becomes even harder, but the potential rewards interms of growth and development also become correspondingly greater. xxiii 0 Another less pressing, but equally important challenge arising from CAFTA i s the potential impact on the livelihoods of significant segments of the rural population of the elimination of tariffs (after a 10-year grace period) of several sensitive crops. Assistance programs specially targeted to the poor to help them adjust to these changes may be needed. HONDURAS INFORME SOBRELA POL~TICA DEDESARROLLO Acelerando el Crecimiento de Base Amplia ResumenEjecutivoy Recomendaciones 1. Este Informe sobre la Politica de Desarrollo (DPR, por sus siglas en ingle's)representa una discusidn de la agenda de desarrollo de Honduras con un enfoque especial en la aceleraci6n del crecimiento econ6mico. Este enfoque surge del Documento de Estrategia de Reduccidn de Pobreza en Honduras (PRSP, por sus siglas en ingle's), el cual identific6 a1 crecimiento como el determinante principal en la evoluci6n de la pobreza, que encabeza el informe sobre la politica de desarrollo en varios sectores economicos, sociales y de infraestructura. L a DPR intenta proveer una base analitica para el desarrollo de la estrategia de crecimiento que aparece en el PRSP y, como resultado, espera proporcionar algdn tipo de soporte analitico para el programa apoyado por el Cre'dito de Soporte para Reducci6n de la Pobreza, que fue aprobado por la Junta Directiva de la AIF en Junio de 2004. A. CONTEXT0DEL PA&, DESARROLLO MACROECONdMICO Y CRECIMIENTO ECONdMICO .. 11. Honduras es un pais de ingresos medios-bajos, con un ingreso per capita de U S $920 en 2002 (metodologia Atlas). Cuenta con una poblaci6n de alrededor de 7 millones de habitantes (2004), que est8 creciendo a una tasa anual del 2.4 por ciento, y de la cual aproximadamente un 42 por ciento es menor de 15 aiios de edad. Se estima que un 64 por ciento de la poblaci6n vive actualmente bajo la linea de pobreza, mientras que el 45 por ciento vive en pobreza extrema. Alrededor de la mitad de la poblaci6n reside en zonas rurales, donde la incidencia de pobreza es de casi un 75 por ciento, versus 57 por ciento en las fireas urbanas. Los indicadores sociales de Honduras se encuentran entre 10s peores de la regi6n de Ame'rica Latina y el Caribe, per0 son comparables a 10s indicadores que se observan en general en 10s demAs paises de ingresos medios-bajos. En octubre de 1998, Honduras sufri6 el impact0 del HuracBn Mitch, que cam6 grandes daiios humanos y fisicos, e interrumpi6 temporalmente el declive progresivo de pobreza que se habia observado desde 1990. ... 111. Honduras tiene un re'cord hist6rico de crecimiento econ6mico deficiente, per0 una estabilidad relativamente alta de 10s ingresos altos, en comparaci6n con otros paises de Ame'rica Latina. Honduras creci6 a una tasa promedio anual de 0.8 por ciento en te'rminos per capita durante el period0 de 1960 a1 2000, l o que representa menos de la mitad del promedio latinoamericano de 1.7 por ciento y es menor a1 1.2 por ciento promedio de todos 10s paises en vias de desarrollo en el mundo. En el aspect0 positivo, Honduras ha presentado muy poca volatilidad del crecimiento y ha gozado de un historial de tasas de inflaci6n bajas, en comparaci6n con otros paises en la regi6n. iv. Honduras es la economia m8s abierta de Ame'rica Central y est8 clasificada entre las m8s abiertas en el mundo. Este pais cuenta con una tasa de comercio exterior promedio de alrededor de 90 por ciento, con exportaciones equivalentes a 40 por ciento de su PIB e Honduras -DPR ACELERANDOEL CRECIMIENTO BASEAMPLU xxv Rrsumen Elecutivo DE importaciones de m6s de un 50 por ciento. Las economias con este nivel de apertura generalmente son muy vulnerables a impactos externos, y Honduras no es ninguna excepci6n. Su economia se ve afectada peri6dicamente por fluctuaciones grandes en las condiciones de comercio exterior, 10s desastres naturales y 10s sucesos de sus principales socios comerciales. v. Honduras ha logrado reducir su vulnerabilidad en cuanto a impactos comerciales durante la liltima de'cada, a trave's de una mayor diversificacibn de sus exportaciones. Los tres articulos de mayor exportaci6n del pais (cafC, bananas y camarones) solian representar m6s de un 40 por ciento de las exportaciones totales de bienes y servicios a principios de 10s aiios 1990s, per0 ahora representan menos de un 20 por ciento. (Parte del declive de su participaci6n se explica con la caida de 10s precios de productos b6sicos desde 1999, especialmente del cafC y 10s camarones.) Estas exportaciones tradicionales han sido reemplazadas por exportaciones no-tradicionales y, especialmente, exportaciones de maquilas (principalmente textiles), cuyo valor agregado por s i solo aument6 de 9 por ciento de exportaciones totales de bienes y servicios en 1995, a 22 por ciento en el 2002. A pesar de que reduce la vulnerabilidad a las fluctuaciones de 10s tirminos de intercambio, el crecimiento del sector maquilador ha incrementado la vulnerabilidad de Honduras a 10s choques comerciales, dada la mayor competencia que presentarhn 10s productores AsiBticos de ropa y textiles de bajo costo, una vez que termine el acuerdo de cuotas de la OMC actualmente programado para enero del 2005, y posiblemente por disputas comerciales asociadas con las excepciones arancelarias que se le conceden a 10s procesos de exportaci6n. vi. El patr6n de producci6n econ6mica general de Honduras es un reflejo de la composici6n evolutiva de sus exportaciones. L o m6s evidente es el declive de la importancia de la agricultura, cuya participaci6n en el PIB baj6 de 19 por ciento a mediados de 10s 1990s, a menos de un 12 por ciento en el 2002, mientras que la participaci6n de servicios aument6 de 42 a 49 por ciento del PIB. L a participaci6n porcentual del sector ha permanecido m6s estable en tkrminos reales, con un declive en la participacibn agricola de tan s610 25 por ciento del PIB (en precios constantes) a 23 por ciento durante ese mismo periodo. Similarmente, la participacibn de la fuerza laboral hondureiia empleada en agricultura tambiCn ha permanecido sin muchos cambios, en aproximadamente un 39 por ciento. Est0 sugiere que las oportunidades de trasladar mano de obra y capital fuera del sector agricola, en respuesta a1 declive de precios del sector, han sido limitadas hasta ahora. Las mejoras en el acceso a la educaci6n y la profundizaci6n de 10s mercados financieros-dos temas que se enfatizan en este reporte-serBn esenciales para aumentar la movilidad de 10s factores. vii. Otro cambio estructural importante que tom6 lugar durante la de'cada anterior es el crecimiento de remesas provenientes del extranjero, que alcanzaron un estimado de U S $800 millones en el 2003, o alrededor del 12 por ciento del PIB. Aunque las transferencias de ayuda extranjera se han visto reducidas una vez mBs, despuis de un incremento temporal a raiz del HuracBn Mitch, las transferencias corrientes netas del extranjero han continuado incrementando de un estimado 7 por ciento del PIB a mediados de 10s 1990s, a un 15 por ciento del PIB actualmente. Este incremento en transferencias corrientes ha permitido el aumento de la gasto interno bruto desde mediados de 10s 1990s, sin aumentar la ya alta deuda del pais, mientras ayuda a equilibrar el tip0 de cambio real frente a impactos externos que debilitaron el desempeiio de las exportaciones. Honduras -DPR Resumen Ejecutivo ACELERANOO EL CRECMIENTO DEBASE AMPLIA xxvi viii. Con una proporci6n de deuda externa p6blica de alrededor del 66 por ciento del PIB, Honduras es un pais altamente endeudado. Se declar6 su elegibilidad para participar en la iniciativa de Paises Pobres Muy Endeudados (PPME) en 1999 (dentro del mandato fiscal), y alcanz6 el punto de Decisi6n como PPME en julio del 2000. En esa fecha, se esperaba que Honduras alcanzara el Punto de Culminaci6n como PPME para fines del aiio 2002, per0 las dificultades en la implementacibn de un programa macroecondmico estable han retrasado la finalizaci6n del PRSP y retardado el Punto de Culminaci6n hasta posiblemente el 2005. Honduras finaliz6 un PRSP completo en julio del 2001 y su primer Informe de Progreso del PRSP en diciembre del 2003. Las autoridades hondureiias esperan alcanzar el Punto de Culminaci6n como PPMEpara principios del 2005. Desarrollos econo'micosrecientes ix. A principios de 10s 1990s, Honduras reconsider6 sus politicas proteccionistas y empez6 un proceso de reforma que incorporaba la reducci6n de las barreras comerciales, mayor flexibilidad del tipo de cambio, liberaci6n del mercado financiero, ajustes a las tarifas de servicios p6blicos y el desarrollo de un marco legal para fortalecer 10s derechos de propiedad. Sin embargo, el proceso de reforma no se sostuvo, ya que la calidad de la gesti6n econdmica sufri6 enormes variaciones durante el ciclo politico. Asimismo, la disciplina fiscal se suaviz6 en el periodo precedente a las elecciones de noviembre de 1993, y muchas de las reformas de liberaci6n de comercio exterior que se adoptaron a principios de 10s 1990s se revirtieron para prevenir un colapso de las reservas. Un patrdn similar ocurri6 tambiCn en 10s periodos antes de las elecciones de 1997 y el aiio 2001. En ambos casos, 10s programas con el apoyo de PRGF, que habian sido negociados arduamente con el FMIdurante la primera mitad del periodo electoral, se descarrilaron debido a desviaciones de 10s objetivos fiscales y la incapacidad de implementar las medidas de reforma estructural programadas a medida que se acercaban las elecciones. x. Cuando el nuevo gobierno tom6 posesi6n en enero del 2002, Honduras se encontraba una vez m8s en medio de una ralentizaci6n econ6mica y el deterioro de sus finanzas p6blicas. Elcrecimiento econ6mico aument6 modestamente a un 3 por ciento en el 2003 (0 a penas 0.4 por ciento en tirminos per capita), impulsado por una leve recuperaci6n en construccibn, turismo y maquilas, mientras que la inflaci6n baj6 a 7.2 por ciento, en proporcidn con el declive del tip0 de cambio. Lamentablemente, 10s deficits fiscal y externo tambiCn aumentaron, limitando 10s prospectos de un despliegue econ6mico miis robusto. El ddficit externo en cuenta corriente aument6 de 3.1 por ciento del PIB en el 2002, a 5.2 por ciento en el 2003, reflejando un deterioro continuo de 10s tdrminos de intercambio, uncrecimiento debil en las exportaciones (except0 en el sector de servicios de maquila), y un alza considerable en importaciones que se debe en gran parte a la subida de precios del petr6leo. L a depresidn en las condiciones econ6micas globales es parcialmente responsable por el sombrio desempeiio de las exportaciones. Otro factor que aparenta haber contribuido es el tipo de cambio real, que present6 una apreciaci6n del 35 por ciento entre 1997 y el 2001, reflejando el flujo de ayuda que lleg6 a1 pais debido a1 huraciin Mitch, el riipido crecimiento de las remesas provenientes del extranjero y un mecanismo lento para el establecimiento del tip0 de cambio. Honduras -DPR ACELERANDOEL CRECIMIENTO BASEAMPLIA xxvii Resumen Ejecurivo DE Desde entonces, el tipo de cambio real se ha depreciado en un 8 por ciento acumulado, compensando parcialmente a la apreciaci6n anterior. xi. Viendo hacia el futuro, el sector extern0 de Honduras est6 a punto de recibir gran empuje con la entrada en vigencia del Tratado de Libre Comercio entre 10s Estados Unidos y CentroamCrica (CAFTA). Las negociaciones del CAFTA entre 10s paises centroamericanos y 10s Estados Unidos concluyeron exitosamente en diciembre del 2003. Una vez que el acuerdo quede ratificado por las legislaturas correspondientes, Honduras y sus vecinos centroamericanos se ver6n frente a enormes oportunidades y enormes retos. El tratado de libre comercio promete oportunidades significativas para un crecimiento impulsado por exportaciones y la creaci6n de empleos, per0 tambiCn es posible que se requieran ciertos ajustes internos en respuesta a la mayor competencia externa y la baja en ingresos por la desaparici6n de tarifas. Los descubrimientos preliminares de estudios recientes indican que se espera que el CAFTA tenga un impacto positivo en el comercio exterior y las inversiones de 10s paises centroamericanos, incluyendo a Honduras, y en dltima instancia en su crecimiento y la atenuaci6n de su pobreza. Una de las razones importantes para este impacto positivo es un aumento en el acceso a mercados: El CAFTA ha consolidado y expandido el generoso acceso que 10s productores centroamericanos disfrutan actualmente en el mercado estadounidense, mientras otorgan acceso reciproco a 10s bienes de este pais. Los beneficios de la Iniciativa de la Cuenca del Caribe fueron consolidados para 10s paises centroamericanos, y se obtuvo tambiCn mayor acceso libre de aranceles a 10s mercados de bienes que anteriormente habian estado exentos de dichas preferencias. Otro resultado importante ha sido la flexibilizaci6n moderada de las normas de origen para ropa y textiles, asi como la suavizaci6n de algunas barreras no-arancelarias contra las exportaciones agricolas no-tradicionales. El otro beneficio clave est6 asociado con el fortalecimiento de las reformas nacionales: Los compromisos del CAFTA solidificaron una serie de reformas recientes que abrieron a la competencia en sectores previamente protegidos (por ejemplo: telecomunicaciones, servicios financieros, energia) y la modernizaci6n de normas y regulaciones clave (adquisiciones gubernamentales, derechos de propiedad intelectual, trato de inversionistas extranjeros) a1 asegurar el nivel de acceso del que disfrutan actualmente 10s inversionistas y licitadores basados en 10s Estados Unidos. (Las implicaciones m6s importantes del CAFTA para Honduras se exponen en el ApCndice F.) xii. El dCficit del sector pdblico tambiCn ha estado exhibiendo un deterioro progresivo, llegando a 4.6 por ciento en el 2003. Este deterioro se atribuye principalmente a 10s declives de excedentes operativos de las empresas pdblicas y la erosi6n de 10s ingresos fiscales. El declive en excedentes operativos se debe en gran parte a las alzas de precio del petr6leo y la lentitud de 10s ajustes tarifarios de las empresas pdblicas; mientras que la erosi6n de 10s ingresos fiscales se debe a la proliferaci6n de exenciones de impuestos, a la debilitaci6n de la administraci6n fiscal y a1 declive de 10s impuestos en importaciones. Algunas medidas administrativas que ha tomado el gobierno detuvieron el deterioro de 10s excedentes operativos de las empresas pdblicas en el 2003, per0 no lograron empujarlo en la otra direcci6n. El gobierno tambien implement6 una reforma fiscal en tres etapas (octubre del 2002, mayo del 2003 y diciembre del 2003), la cual logr6 encauzar el declive anteriormente mencionado de 10s ingresos fiscales en direcci6n positiva. Honduras -DPR Resumen Ejecurivo ACELEMNDO EL CRECIMIENTOBASE DE AMPLIA xxviii xiii. Los gastos pdblicos totales han presentado un poco m8s de estabilidad durante 10s aiios recientes. Sin embargo, la composicion de 10s gastos pdblicos ha cambiado considerablemente y en una direccidn que contribuye a1 estancamiento de la producci6n econ6mica. En particular, tanto 10s gastos corrientes como las pe'rdidas del Banco Central han aumentado, mientras 10s gastos de capital han declinado. El factor principal en el incremento de 10s gastos corrientes ha sido la masa salarial del sector pbblico, que aument6 de 9 por ciento del PIB en 1997 a 13.6 por ciento en el 2003. xiv. Los aumentos de la masa salarial se asocian principalmente con 10s regimenes de sueldos especiales que surgieron para varios grupos de empleados del sector pbblico (descritos en el ApCndice B). Estos regimenes cubren a m8s del 80 por ciento de la fuerza laboral total del gobierno central, especialmente a maestros y empleados de salud. Una de las consecuencias de estos regimenes es que 10s sueldos del sector pbblico se han convertido en el product0 de las negociaciones politicas en el Congreso y est8n establecidos de manera que no dependen del desempeiio de 10s empleados o de consideraciones presupuestarias. Asimismo, a medida que 10s sueldos reales han aumentado con el tiempo, la productividad de la mano de obra y la moral de 10s trabajadores en el sector pdblico han declinado, reflejando problemas abn m8s profundos en el sistema de servicio civil. Las autoridades tomaron el primer paso importante para revertir este proceso con la aprobacibn, en diciembre del 2003, de un marco legal para salarios pbblicos, que fue diseiiado para restaurar el control del gobierno central del proceso de fijacion de 10s salarios, y se espera que est0 detenga el asenso de la masa salarial como porcentaje del PIB. xv. El deterioro de 10s dificits fiscal y extern0 ha resultado en balances primarios (sin incluir intereses) negativos que, claramente, no son sostenibles. Est0 aplica presi6n en las reservas internacionales y ha resultado en un incremento de 10s pagos morosos de la considerable deuda externa de Honduras. A1 determinar que esta situaci6n es insostenible, las autoridades han estado negociando con el FMI desde principios del 2003 un programa macroecon6mico con el soporte de un nuevo arreglo de PRGF. Se lleg6 a un acuerdo para un nuevo programa a fines del 2003, y fue aprobado por la Directiva del FMI en febrero del 2004. El marco macroecondmicoa medianoplazo xvi. El programa econ6mico negociado con el FMI, presentado durante el primer Reporte de Progreso del PRSP, intenta revertir el deterioro fiscal de Honduras para poder crear m8s r8pidamente una base de crecimiento y reducci6n de pobreza alineados con 10s objetivos del PRSPy 10s Objetivos de Desarrollo del Milenio (ODM). Su meta es acelerar el crecimiento a 4.5 por ciento per annum para el 2006, y reducir gradualmente la inflaci6n a las tasas que mantengan 10s principales socios comerciales del pais para el 2008. Asimismo, las autoridades est8n buscando la manera de implementar todas las reformas necesarias para llegar a1Punto de Culminacidn PPME para principios del 2005. xvii. Elprograma contempla undeclive progresivo del dCficit fiscal general a 3.0 por ciento del PIB para el 2004, 2.5 por ciento para el 2005 y 1.7 por ciento para el 2006. Este ajuste fiscal reducir8 el desplazamiento (crowding out) en el mercado financier0 nacional y, por l o Honduras -DPR ACELERANDOEL CRECIMIENTO BASEAMPLIA DE xxix Resiimrn Ejecutivo tanto, permitirfi una expansi6n de crCdito a1 sector privado. L a reducci6n del dCficit se deberi lograr a travCs de medidas por el lado de 10s ingresos y 10s gastos. Los ajustes en tarifas pdblicas, especialmente en 10s sectores de energia y telecomunicaciones, estin contemplados en el programa para mejorar 10s excedentes operativos de las empresas pdblicas, mientras que una mayor disciplina en el establecimiento de sueldos en el sector pdblico ayudari a reducir 10s gastos corrientes. Se contemplan tambiCn reformas adicionales en el &rea de recursos humanos para reducir adn mis 10s costos de mano de obra e incrementar su productividad en el sector pdblico. El incremento resultante en ahorros p6blicos permitirii la expansi6n de inversiones pdblicas dentro de uncontext0 de reducci6n general del dkficit. xviii. L a estrategia de aceleraci6n de crecimiento yace sobre cinco elementos: (i) un aumento en inversiones pdblicas para satisfacer las necesidades clave de infraestructura, especialmente en carreteras, telecomunicaciones y viviendas de escasos recursos, (ii) aumentos en inversiones privadas para la generaci6n de electricidad, telecomunicaciones, turismo, maquila y agricultura, atraidas por el CAFTA y mayor facilidad de condiciones de crCdito, (iii) reformas de gobernabilidad y transparencia, disefiadas para mejorar el clima general de inversibn, (iv) reformas estructurales para mejorar la eficiencia del sector pdblico y restaurar un sector financier0 sblido, y (v) entrada en vigencia del CAFTA, el cual se espera brindari un mayor acceso a 10s mercados externos y fomentari un ambiente mis competitivo para 10s productores nacionales. Determinantes clave del crecimiento en Honduras xix. L a restauraci6n de mayor disciplina fiscal y equilibrio extern0 constituyen un paso importante hacia la mejora de prospectos para lograr crecimiento y reducci6n de la pobreza. Sin embargo, como lo demuestra el rCcord hist6rico de Honduras, mantener un marco macroeconomico estable no es suficiente para lograr una aceleraci6n significativa en el crecimiento. L a ausencia de crecimiento no es un fen6meno reciente en Honduras; se ha encontrado entre 10s paises centroamericanos desde, a1 menos, principios de 10s 1960s. Honduras comenz6 10s aiios 1960 siendo el pais miis pobre en la regibn, y su crecimiento sombrio durante 10s cuarenta afios subsecuentes result6 en un nivel de ingresos cada vez m8s lejano a1de sus vecinos, con la excepci6n de Nicaragua. xx. Honduras comparte el patr6n general de crecimiento comdn de la mayoria de 10s demis paises en AmCrica Latina y el Caribe (LAC) de las filtimas cuatro dkcadas: creci6 constantemente durante 10s 1960s y 1970s, y experiment6 un desplome considerable durante la llamada "dCcada perdida" de 10s 1980s. El crecimiento se recuper6 en 10s 1990s, per0 a un paso considerablemente m8s lento que el de las dCcadas de 10s 1960s y 1970s; reflejando el patr6n general en LAC. Honduras sobresale a1 comparar su crecimiento per capita, no en cuanto a su patrbn, sino en cuanto a su nivel, el cual permaneci6 en general por debajo del promedio de L A C en cada una de las cuatro dicadas anteriores. Aun en 10s 1960s y 1970s, cuando AmCrica Latina exhibia el dinamismo m8s alto de crecimiento, Honduras tan s610 l o g 6 crecer un 1.8 por ciento per annum en tkrminos per capita. Utilizando un marco de contabilidad de crecimiento (que se discute en el Capitulo I) se descubre que la diferencia en crecimiento se debe casi en su totalidad a1bajo crecimiento de la productividad de 10s factores del pais. Honduras -DPR Resiimen Ejecirtivo ACELERANDO CRECIMIENTODE BASEAMPLIA xxx EL xxi. Para analizar 10s principales determinantes de crecimiento en Honduras, este reporte utiliza 10s descubrimientos empiricos de un estudio regional realizador por Loayza, Fajnzylber y Calder6n (2002), que relaciona el crecimiento con doce variables explicativas clave, que aparecen repetidamente en la literatura sobre crecimiento como las influencias mas significativas y robustas del crecimiento econ6mico. Los resultados de las regresiones que aparecen en este estudio se utilizan para predecir el nivel futuro del crecimiento en paises individuales, en base a predicciones de 10s valores futuros de las variables explicativas. A1 hacer estas predicciones, se han considerado tres panoramas: el primer0 asume que las variables explicativas continuarh evolucionando durante la pr6xima dCcada, de acuerdo a las tendencias historicas. El segundo panorama asume la implementaci6n de reformas de politica que elevan a todas las variables explicativas a1 25" percentil superior de su distribuci6n en AmQica Latina y el Caribe. El tercer panorama asume la implementacidn de reformas atin mis agresivas, donde las variables explicativas se elevan a1 25" percentil superior de su distribuci6n mundial. xxii. Los simulacros indican que Honduras no puede esperar acelerar su crecimiento per capita significativamente si las variables que lo determinan contintian evolucionando en base a sus tendencias hist6ricas. Esto s610 aumentaria el crecimiento anual promedio, de 0.1 por ciento que se logr6 en 10s 1990s, a 0.5 por ciento durante 10s afios 2001 a12010. A1 introducir reformas que aumentarian 10s valores de las variables explicativas a1 25" percentil superior de la distribuci6n de LAC, Honduras podria aspirar a lograr una mejora significativa en crecimiento para la dkcada pr6xima; a un promedio de 2.8 por ciento per annum. Sin embargo, para lograr el Objetivo de Desarrollo del Milenio del pais de reducir la pobreza extrema a la mitad para el 2015, el crecimiento tendria que ser atin mis ripido. Este objetivo podria lograrse, en principio, con el tercer panorama simulado, bajo el cual las variables explicativas se elevan en referencia a un estindar global, que resulta en una tasa promedio de crecimiento del 4.4 por ciento. xxiii. Entre todas las variables que contribuyen a1 aumento en crecimiento bajo 10s diferentes panoramas de reforma, hay cuatro que sobresalen en este anilisis como especialmente importantes para Honduras. Estas variables se refieren a 10s niveles de capital humano, infraestructura ptiblica, desarrollo del mercado financier0 y la gobernabilidad. Honduras aparenta estar considerablemente atrasada en su desarrollo vis-&vis otros paises latinoamericanos y del resto del mundo; por l o tanto, 10s avances de politicas en estas Areas tendrian 10s mejores resultados en elevar el crecimiento. Esto no significa que 10s d e m h determinantes del crecimiento se puedan ignorar o relegar. Aunque a1 ajustar estas otras variables en linea con las "mejores pricticas" en L A C o en el mundo s610 generaria una mejora modesta en el crecimiento de Honduras, permitir que estas politicas se deterioren podria traer consigo consecuencias desastrosas en cuanto a la posibilidad de un declive en crecimiento. En su lugar, esto significa que Honduras ha estado administrando estas otras Areas de politicas razonablemente bien en comparacidn a estindares mundiales y regionales, y le iria bien con simplemente mantener su tendencia hist6rica. Sin embargo, permanecer en su tendencia hist6rica en todas las Areas de su politica seria dejar a Honduras en un trayecto de crecimiento inaceptablemente lento, asi es que se necesitan esfuerzos adicionales en a1menos algunas de las ireas para poder impulsar un crecimiento significativamente mis ripido. L a Honduras -DPR ACELERANDOEL CRECIMIENTO BASEAMPLIA xxxi Resumen Ejecutivo DE discusi6n anterior sugiere que este esfuerzo adicional tendria su mayor impacto en crecimiento si se invierte en el desarrollo del capital humano, el desarrollo de infraestructura, el desarrollo del mercado financier0 y una mejor gobernabilidad. Los temas y obsticulos clave en cada una de estas keas se detallan en el resto de este reporte. B. LAEDUCACIONY ELCRECIMIENTO xxiv. Los simulacros de crecimiento que se resumen en el pirrafo xxiii (y presentados en el Capitulo Iy el Ape'ndice A) identifican 10s logros educativos como el determinante individual mis importante para el crecimiento de Honduras. Para reducir la diferencia vis-&vis otros paises en educacidn tambih se requeririn esfuerzos paralelos para disminuir la brecha en tecnologia, para evitar asi embotellamientos que puedan eventualmente paralizar el crecimiento. Para 10s paises que, como Honduras, se encuentran muy por debajo de la frontera tecnolbgica, la politica tecnol6gica mis importante es argumentablemente su politica de educaci6n bgsica, aunada a una politica abierta de comercio. Asi, el enfoque primordial de atenci6n de este reporte sera el sistema de educaci6n bisica de Honduras, mientras que las demis keas de politica tecnol6gica se reportan cas0 por caso. (Una discusi6n de las medidas para empezar a reducir la brecha en tecnologia aparecen en el Apindice E, en el context0 de una evaluaci6n preliminar del sistema de innovaci6n nacional de Honduras). xxv. Honduras ha exhibido una mejoria constante en 10s indicadores de educaci6n en las tiltimas cuatro dicadas, aunque a un ritmo mas lento que el resto de Ame'rica Latina. L a media de aiios de preparaci6n escolar de su poblacidn adulta aument6 de 1.69 en 1960 a 4.08 en el 2000; un aumento de 2.38 aiios, en comparaci6n con el aumento promedio de 2.80 aiios de otros paises latinoamericanos. Un l o g o notable son 10s altos indices brutos y netos de matriculas que se lograron para la educacidn primaria, con una asistencia de mis del 90 por ciento de 10s niiios en edades de 7 a 12 aiios a la escuela. xxvi. Sin embargo, Honduras todavia exhibe desperfectos importantes en cuanto a su cobertura y eficiencia educativas. Estas son: (i) cobertura muy baja de educaci6n pre- una primaria, (ii) eficiencia interna baja a nivel primaria, que se traduce en indices de finalizaci6n bajos, (iii) cobertura de educaci6n secundaria, tanto a1nivel inferior como superior, e (iv) baja desigualdades substanciales entre 10s grupos urbanos y rurales a1nivel secundario. El sistema educativo est5 caracterizado por indices muy altos de abandono de estudios, resultando en que s610 uno de cada dos estudiantes llega a 6" grado, un estudiante de cinco llega a 9" grado, y menos de un estudiante de cada 10 llega a 12" grado. Ademis, s610 un estudiante de cada tres llega a 6" grado en seis aiios y menos de uno de diez llega a 9" grado en nueve aiios. xxvii. En resumen, aunque 10s indices brutos de matriculas a nivel primaria en Honduras Sean muy altos, y comparables a 10s de otros paises en America Latina, 10s altos indices de abandono de estudios a nivel primario y la baja cobertura del nivel secundario han nulificado en gran parte este beneficio, y, como consecuencia, sus matriculas netas y sus indices de finalizaci6n a niveles de educaci6n secundaria se encuentran entre 10s peores en Ame'rica Latina. En el 2000, s610 17.1 por ciento de la poblaci6n adulta tenia a1 menos algo de educaci6n secundaria o terciaria, lo cual es menos de la mitad de la cantidad que exhibe en Honduru! -DPR ACELERAVDO EL CREClMlENTO DEBASE AMPLIA xxxii Resumm Ejecutivo promedio el resto de Amdrica Latina (35.4 por ciento). S610 Guatemala y Haiti exhiben un porcentaje m i s bajo en logros educativos a nivel post-primaria. xxviii. El mejoramiento del indice de finalizacibn de estudios primarios y la expansi6n de la cobertura de l a educaci6n secundaria deben recibir alta prioridad en Honduras para poder elevar el nivel educativo de su fuerza laboral, la cual ejerce una importante influencia en el crecimiento econ6mico y la distribuci6n de las habilidades en el pais. L a aceleraci6n del crecimiento econ6mico y la reducci6n de las actuales desigualdades en la distribuci6n de habilidades (y en las oportunidades de ingresos asociadas) seria una contribuci6n importante para ayudar a1 pais a cumplir con sus objetivos de reducci6n de pobreza. Para lograr 10s objetivos de este sector, Honduras necesita resolver varios problemas clave a niveles del sector y sub-sectores: xxix. A1 nivel general del sector, Honduras sobresale por gastar un porcentaje extremadamente alto de su PIB en educaci6n. Sin embargo, sus indicadores de resultados de educaci6n no son equivalentes a 10s niveles de gastos tan altos del sector, indicando serios problemas de eficiencia en dste. El control inadecuado en la remuneraci6n y el desempeiio de 10s maestros es un problema grande. Mientras 10s sueldos de 10s maestros han subido en 10s aiios mis recientes, contribuyendo a la indisciplina fiscal en general y desplazando 10s gastos en otros sectores necesarios para una educaci6n de buena calidad, el ausentismo de 10s maestros continda fuera de control y las calificaciones de 10s estudiantes siguen bajando. El tema de gesti6n del profesorado necesita una intervenci6n urgente, poniendo especial atenci6n a las siguientes medidas: Implementacion del marco legal recidn aprobado en las politicas de sueldos, para contener el crecimiento de 10s sueldos de maestros y liberar recursos para ser gastados en temas que mejoren la calidad de la educaci6n. Completar la revisi6n de puestos docentes en todos 10s departamentos, y reconciliar las cifras de las n6minas con 10s resultados de dicha revisibn. Revisar 10s Estatutos de Maestros, posiblemente en conjunto con una legislaci6n m i s completa de servicio civil, para que todo pago est6 asignado a 10s puestos, en vez de a 10s individuos. Establecer un sistema eficaz de supervisidn para permitir una distribuci6n mis racional y equitativa de maestros en todas las Areas geogrificas. Desarrollar y mantener una base de datos completa de recursos humanos para el sector educativo (SIARDH). Establecer un sistema de monitoreo eficaz para mejorar 10s indices de asistencia de 10s maestros. Expandir mis el ndmero y el rol que juegan las Asociaciones de Desarrollo Educativo Local (ADELs)en asistir a 10s maestros y monitorear su desempeiio. xxx. Con respecto a la distribuci6n de gastos p6blicos en educacibn, existen ciertas preocupaciones sobre su eficacia, que surgen a raiz del ripido incremento de 10s gastos del sector destinados a las funciones de las oficinas administrativas centrales, a1 igual que otras preocupaciones sobre la equidad del muy regresivo p a t h distributivo de 10s gastos del sector, especialmente en 10s niveles secundario y terciario. Para responder a estas HonduraA -DPR xxxiii Rrsumen Ejeciifivo ACELEKAkDO EL CRECIMIENTODEBASE AMPLIA preocupaciones, el reporte recomienda que 10s gastos del sector educativo se redistribuyan de la siguiente forma: Reducir el porcentaje de gastos totales del sector destinados a la administraci6n de las oficinas centrales y reasignar esos ahorros a la educaci6n secundaria, especialmente en Areas rurales. Reducir el porcentaje de gastos totales del sector destinados a1 nivel terciario y reasignar esos ahorros a la educaci6n secundaria, especialmente en Areas rurales. xxxi. Honduras ha progresado considerablemente en aumentar las tasas de matriculaci6n y en eliminar las diferencias urbano-rurales en la provisi6n de educaci6n primaria, a1 mismo tiempo que el porcentaje de gasto p6blico destinado a este nivel se conforma con las normas internacionales. Sin embargo, 10s indices de finalizacidn de primaria son muy bajos y no estAn mejorando, a la vez que la repetici6n de aiios escolares y el abandono de las clases son muy altos, lo cual cancela 10s avances que se logran por el aumento en 10s ndmeros de matriculas. AdemAs, 10s indicadores de resultados de la educaci6n primaria estAn distribuidos de forma muy desigual entre 10s diferentes grupos de ingresos, contribuyendo as! a la persistencia de desigualdad social. Para responder a estas fallas, se le ha aconsejado a las autoridades apuntar hacia una finalizacibn universal, sin sacrificar la calidad, implementando unpaquete de reforma completo, tal como el que se promueve bajo lainiciativa Educationfor All - Fast Track Initiative (EFA-FTI: Educaci6n para todos - Iniciativa por via rApida). Este paquete de reforma deberia abarcar 10s siguientes elementos clave: Mejorar la eficiencia intema a travks del desarrollo de estandares acadkmicos, prkticas eficaces para la promoci6n de estudiantes y programas especiales para niiios en sobre-edad. Mejorar el desempeiio y la calidad de 10s maestros, fortaleciendo 10s mecanismos de entrenamiento, evaluaci6n y supervisi6n durante el servicio, y a traves de incentivos por buen desempeiio. Promover mecanismos de red en keas rurales para crear econom'as de escala a1 ofrecer servicios en asentamientos rurales dispersos. Preparar un estudio de diagn6stico sobre 10s indices de finalizacih en las keas urbanas (que han demostrado una tendencia de declive en aiios recientes), y diseiiar un plan para hacerlos aumentar. Usar 10s ahorros fiscales generados por las mejoras de eficiencia en el nivel primario para expandir la provisi6n de servicios a1nivel secundario. xxxii. A pesar de que las inversiones en educaci6n aparentan proporcionar un rendimiento mAs alto a1nivel secundario superior en Honduras, 10s niveles de matriculaci6n brutos y netos en la educaci6n secundaria son extremadamente bajos, mientras que 10s indices de repetici6n de aiio y abandono de clases son muy altos. AdemAs, la distribuci6n de la educaci6n secundaria es bastante desigual, tanto entre a niveles urbano-rural como entre grupos de ingresos. L a mayor parte de la educaci6n secundaria se imparte actualmente en escuelas privadas, a la vez que el ministerio de educaci6n asigna un porcentaje muy bajo de su presupuesto a este nivel. Para corregir estas fallas, se le aconseja a las autoridades otorgarle prioridad a la expansi6n de la educaci6n secundaria de la siguiente manera: HonduraA DPR - ACELEFUNIjO EL CREClMlENTO DE BASEAMPLIA xxxiv Resumen Ejecutivo 0 Implementar reformas para mejorar la eficiencia interna, reduciendo 10s indices de repeticidn de aiio. 0 Incrementar el porcentaje del presupuesto del sector educativo asignado a1 nivel secundario. 0 Fomentar diferentes opciones de escuelas p6blicas (por ejemplo: CEBs, Educatodos/SAT, Telebasica) para responder a las necesidades especiales de 10s diferentes grupos. 0 Preparar un estudio que analice el alcance de introducir de subsidios por el lado de la demanda, para ayudarle a 10s hogares pobres a superar la falta de incentivos econ6micos para asistir a secundaria. xxxiii. Aunque el Capitulo I1se enfoca principalmente en la educaci6n primaria y secundaria, uno de 10s descubrimientos miis importantes es la naturaleza desigual de la educaci6n terciaria. Se les aconseja a 10s encargados de la creaci6n de politicas revisar la distribuci6n de 10s gastos en educaci6n con esto en mente, y considerar una distribuci6n mas favorable de 10s recursos del sector para 10s individuos miis pobres. Los estudios en varios lugares han indicado que la proporcih entre beneficios privados y pdblicos tiende a ser mas alta en la educaci6n terciaria que en la educaci6n primaria y secundaria. Por lo tanto, en tdrminos de eficiencia, 10s beneficiarios de la educaci6n terciaria deberan contribuir mas a1financiamiento de Csta. Esto implica mayor recuperacih de costos en las universidades. xxxiv. El ApCndice E de este reporte tambiCn recalca la importancia del entrenamiento vocacional en el sistema de innovaci6n nacional. Como lo indica un reporte reciente del Servicio de Asesoria sobre Inversi6n Extranjera (FIAS) y la Evaluaci6n del Clima de Inversiones (ICA, por sus siglas en inglCs) del 2004, la instituci6n principal responsable por el entrenamiento vocacional, INFOP, tiene poca capacidad, altos costos administrativos y una reputaci6n de ser un proveedor ineficaz de servicios. Las recomendaciones clave en politicas que surgen del reporte FIAS y la I C A (2004) son las siguientes: 0 Eliminar el monopolio de INFOP como proveedor p6blico de servicios de entrenamiento vocacional. 0 Separar las funciones de proveer servicios de entrenamiento de aquCllas que establecen las politicas de entrenamiento. 0 Atraer mayor participaci6n del sector privado en la direcci6n de la politica de entrenamiento vocacional, para lograr un mejor equilibrio entre servir las necesidades del sector productivo y lograr las prioridades nacionales que establece el gobierno. 0 Revisar el rol de 10s sectores p6blico y privado en el sector, siendo el sector pdblico el responsable por establecer la acreditacibn, estandares, planes de estudio y 10s sistemas de certificacibn; y las instituciones privadas principalmente responsables por impartir 10s servicios de entrenamiento. c. LAINFRAESTRUCTURAPUBLICAY EL CRECIMIENTO xxxv. Los descubrimientos empiricos que se discuten a1 principio identifican a la infraestructura piiblica como el segundo determinante mas importante de crecimiento en Honduras -DPR Resumen Ejecutivo ACELERANDDEL CRECIMIENTOBASEAMPLIA xxxv DE Honduras. L a infraestructura de Honduras ha sido histdricamente muy pobre. Una Revisi6n de Gastos Pdblicos de Honduras preparada en conjunto por el Banco Mundial y el Banco Interamericano de Desarrollo en 1995 habia recomendado reformas en varias keas para apoyar el desarrollo de servicios de infraestructura modernos, eficientes y de buen funcionamiento. Estas incluian una reducci6n del sobre-extenso papel que juega el estado en muchos sectores de infraestructura, estimular mayor competencia en la provisi6n de servicios de infraestructura, reformar una estructura rigida y obsoleta de regulaciones combinindola con la aplicacidn de politicas claras y exentas de politizaci6n para establecer tarifas, eliminar excesos de micro-administracibn de las empresas pdblicas de parte del gobierno, y poner mis atenci6n en 10s requerimientos de mantenimiento de varios sectores. xxxvi. Posteriormente, otra Revisi6n de Gastos Pdblicos finalizada en el 2001, concluy6 que a pesar de algunos avances en estas keas, Honduras todavia tenia que superar debilidades institucionales y politicas, identificadas como fundamentales en la Revisi6n de 1995. Aunque 10s gastos pljblicos en 10s sectores de infraestructura parezcan adecuados, pricticamente todos 10s indicadores de acceso, eficiencia y calidad de servicio contindan siendo bajos en nljmeros absolutos y en comparacidn con otros paises de la regi6n. Las principales razones identificadas para este desempeiio inferior a la norma son estructuras sectoriales y un ambiente regulador que no estin enfocados en mejorar la eficiencia operativa y la calidad de 10s servicios a 10s consumidores, y que 10s gastos p6blicos se han canalizado principalmente para mantener el acceso a 10s servicios para 10s usuarios existentes, en vez de expandir el acceso a nuevos usuarios, especialmente a 10s mis pobres. Ese reporte concluye con cuatro conjuntos de recomendaciones que se enfocan en (i) mayor participaci6n privada en 10s atraer sectores de infraestructura bajo acuerdos que le brindan atenci6n primordial a las mejoras de acceso, calidad y eficiencia, en vez de maximizar las ganancias fiscales de la privatizacih, (ii)fortalecer el ambiente regulador y de politicas, (iii)reestructurar 10s precios y subsidios de la infraestructura, y (iv) asegurar unmantenimiento adecuado de dicha infraestructura. xxxvii. Este DPR concluye diciendo que Honduras ha avanzando desde el 2001, per0 que todavia exhibe muchas fallas en acceso, calidad y eficiencia de servicios de infraestructura. Entransporte, la provisi6n general de servicios es comparable o mejor a la de otros paises en la regi6n con niveles de ingresos per capita similares. Los principales temas en el sector son: la baja calidad que existe en el transporte urbano de autobuses, la distorsionada estructura de controles de precio y subsidios, la ineficiente administracih de Puerto CortCs y el estado de congestionamiento del aeropuerto de Tegucigalpa. Las siguientes recomendaciones clave se ofrecen para este sector: 0 Para fortalecer el marco regulador y de politicas: (i) un organism0 regulador para el crear sector, compuesto por transporte terrestre, aviaci6n civil y puertos, (ii) establecer un sistema adecuado para monitorear el peso y el tamaiio de 10s vehiculos en circulacibn, (iii) eliminar el subsidio del transporte urbano en Tegucigalpa o reemplazarlo con un mecanismo m8s eficiente, (iv) eliminar 10s controles de precio en el transporte de carga, (v) revisar el marco legal para 10s cobros de peaje, (vi) revisar el sistema de SOPTRAVI's para la emisi6n de licencias, (vii) reestructurar 10s mecanismos para la regulaci6n del transporte p6blico de pasajeros, con mayor participaci6n de 10s consumidores y posiblemente transferirle esta funci6n a las municipalidades, y (viii) racionalizar 10s procedimientos de fronteras y aduanas para eliminar retrasos. Honduras -DPR Rerumen Ejecurivo ACELERANDOEL CREClMlENTO DE BASEA,WPLlA xxxvi En cuanto a 10s puertos y aeropuertos: (i) aprobar el marco legal propuesto para 10s puertos, (ii) crear una nueva autoridad de puertos y proporcionar recursos adecuados para su operacibn, y (iii) seguimiento a las obligaciones contractuales bajo la concesi6n de dar aeropuertos con respecto a las inversiones acordadas para mejorar el servicio a pasajeros en Tegucigalpa y 10s servicios de carga en San Pedro Sula. Para mejorar la sostenibilidad fiscal del sector: (i) asegurar que el fondo de carreteras reciba la cantidad total destinada a este fin y, si fuera necesario, suplementarlo con recursos del presupuesto general para proveer recursos adecuados para el mantenimiento de las carreteras principales, (ii)fortalecer la capacidad institucional del fondo de carreteras para supervisar y monitorear la calidad de las actividades de mantenimiento, (iii) analizar la posibilidad de consecionarle a1 sector privado ciertos segmentos de la red de carreteras, (iv) preparar una andisis institucional y financier0 para mejorar la condici6n de la red de caminos urbanos, incluyendo mecanismos de transferencias de fondos a las municipalidades, para este fin. Para mejorar la competitividad: (i) Puerto CortCs en concesi6n a algdn operador otorgar privado, (ii) analizar la posibilidad de incluir 10s otros puertos principales (San Lorenzo y Castilla) en el esquema de concesiones, y (iii) traspasar 10s servicios de aprovisionamiento de puertos a operadores privados, incluyendo 10s servicios de pilotaje, remolque y otras operaciones de embarque y desembarque. Mejorar la planificaci6n del sector, desarrollar un plan maestro de transporte, con una visidn inter-modal y unplan completo de inversi6n de carreteras, que sirva de guia para la distribucidn de 10s recursos en el sector. xxxviii. En el sector de electricidad, Honduras exhibi6 un aumento rapid0 en la cobertura de servicio elictrico durante 10s 1990s, per0 la distribuci6n del acceso es muy desigual entre 10s diferentes grupos econ6micos y la calidad del servicio es baja. La compafiia de servicios pdblicos, la ENEE, es extremadamente ineficiente y sus operaciones se caracterizan por pirdidas grandes de distribucidn y regulaciones inadecuadas. Las recomendaciones clave para este sector son: Separar las cuentas de la ENEE por sus funciones de generacidn, transmisi6n y distribucidn, para poder mejorar la administracidn de informacibn; fomentar una mejor rendici6n de cuentas y, en general, una operaci6n mhs eficiente y transparente Evaluar las opciones estratigicas para la organizacibn mis adecuada de las diferentes actividades de la ENEE, especialmente en distribucih, a travCs de la evaluacidn de la estructura dptima del mercado. Validar o revisar la Estrategia Gubernamental para el Sector ElCctrico y actualizar el marco legal para apoyar a1programa de reforma del Gobierno en este sector. Fortalecer las capacidades de formulaci6n de politicas y las instituciones del sector creando un arreglo institucional permanente para el Gabinete de Electricidad, capaz de dar seguimientos en cualquier decisi6n de politica que se haya logrado. Fortalecer y proporcionar mayor autonomia a la agencia reguladora, CNE. Eliminar 10s subsidios cruzados (de usuarios no-residenciales a residenciales) en tarifas elictricas y ajustar dichas tarifas para cubrir 10s costos. Honduras -DPR xxxvii Reumen Ejrcurivo "4CELERlrVDO EL CREClMlENTO DE BASEAMPLIA Desarrollar un fondo de electrificacih rural, con provisiones de financiamiento adecuado, que est6 diseiiado para extender el acceso a 10s servicios de electricidad en Areas rurales, de manera eficiente. xxxix. El sector de telecomunicaciones en Honduras est6 caracterizado por indicadores de bajo acceso, baja calidad de servicio y una estructura de tarifas muy distorsionada. Las recomendaciones clave en este sector son: Permitir que la exclusividad de HONDUTEL expire a finales del 2005 y el sector se abra a la competencia. Rebalancear tarifas telefbnicas (subiendo las tarifas locales y reduciendo las internacionales) de tal forma que se logre una transicih gradual hacia un ambiente de mercado abierto para finales del 2005. Otorgar mayor autonomia a la agencia reguladora del sector, CONATEL, y fortalecer sus capacidades institucionales, posiblemente incorporAndola a una agencia reguladora de servicios p6blicos multi-sectoriales (que tendria que ser creada). Crear un organism0 de planificacibn y formulacih de politicas, independiente de CONATEL, incorporando un arreglo institucional permanente capaz de hacer seguimientos de las decisiones que se toman en el sector. Desarrollar un fondo de telecomunicaciones rurales, con provisiones adecuadas de financiamiento, que est6 disefiado para extender el acceso a 10s servicios de telecomunicaciones en Areas rurales. Efectuar las inversiones necesarias para aliviar 10s embotellamientos inmediatos en el sector de telefonia de lineas fijas, per0 posponer otras inversiones hasta que el sector est6 abierto a la competencia libre. Honduras logr6 un progreso sobresaliente en expandir el acceso a 10s servicios de aaua Y saneamiento durante 10s 1990s, per0 la calidad h e 10s servicios y la eficiencia de 10s proveedores de servicios p6blicos es deficiente. Las recomendaciones clave para este sector aparecen a continuacih: Mejorar la eficiencia operativa: (i) preparar un analisis de las operaciones y la viabilidad comercial de cada uno de 10s sistemas que actualmente opera la SANAA, y discutir su estructura organizacional bptima, (ii) preparar un inventario de 10s activos que poseen tanto el sistema de agua como el de saneamiento, y (iii) preparar planes operativos renovables de 3 aiios, junto con un contrato de administracih para cada sistema- proveedor de servicios, con objetivos claros para mejorar la eficiencia operativa. Para atraer a expertos en administracih del sector privado a este sector: (i) definir unplan para transferir 10s sistemas de agua y saneamiento a las municipalidades, como lo contempla el nuevo marco legal del sector, definiendo 10s arreglos a ser considerados en colaboraci6n con el sector privado, (ii) desarrollar un conjunto de alternativas y modelos para incorporar a1 sector privado en la operaci6n de estos sistemas en las municipalidades, y (iii) preparar un plan para otorgar el sistema de Tegucigalpa en concesih, u otra forma de participacih, a1 sector privado, tomando en cuenta las lecciones aprendidas de la experiencia en San Pedro Sula. Honduras -DPR Resumrn Ejecutivo ACELERA~VDO CKECIMIENTO EASEAMPLIA EL xxxviii DE 0 Para reducir la carga fiscal: (i)desarrollar lineamientos para establecer tarifas de servicios pdblicos que cubran 10s costos de operaci6n, asi como 10s costos de capital necesarios para cumplir con 10s objetivos de expansi6n establecidos, basados en indicadores que se puedan verificar pdblicamentepara iniciar ajustes tarifarios, (ii) desarrollar un esquema de subsidio para promover la expansibn de servicios de agua y saneamiento en ireas urbanas y rurales marginadas, y (iii) desarrollar un fondo para financiar el lanzamiento de las operaciones de 10s comites de administracibn rural a cargo de la gesti6n de 10s sistemas de agua y saneamiento transferidos de SANAA. 0 Para fortalecer la capacidad institucional: (i) proveer el financiamiento adecuado para la agencia reguladora reciCn creada y para el organism0 de politicas y planificacibn, CONASA, y (ii) preparar e implementar unplan para capacitar a las municipalidades en la administracidn de su agua y saneamiento de forma econdmicamente sostenible, y definir 10s mecanismos para proveer asistencia tdcnica a las municipalidades enfocadas en reformar el modelo actual de provisibn de servicio. D. ELDESARROLLODELSECTORFINANCIER0Y ELCRECIMIENTO xli. El analisis empirico descrito en el Capitulo Iidentifica el desarrollo del mercado financiero como el tercer determinante m6s importante de crecimiento en Honduras. El grado de profundidad financiera en Honduras es comparable a1 que exhiben otros paises en la regibn. Con un total de activos de U S $3,300 millones, el sistema de banca comercial es pequefio en terminos absolutos, per0 representa una porci6n m6s grande del PIE3 que 10s sistemas de banca en la mayoria de 10s dem6s paises centroamericanos, o de la regibn de America Latina en general. Sinembargo, el sistema financiero de Honduras (y el de America Latina en general) se encuentra considerablemente subdesarrollado en comparaci6n a 10s estindares mundiales, por lo que hay suficiente terreno para mejoras en este sector, apuntando a1aumento del crecimiento econ6mico. xlii. En afios recientes, el sistema bancario de Honduras, que es el eje de su sistema financiero, se ha enfrentado con serios problemas que han paralizado 10s nuevos pristamos en el sector de produccibn m6s grande del pais-la agricultura-y que presentan un impediment0 de gran envergadura para continuar el crecimiento. Estos problemas empezaron a raiz de varios impactos externos (principalmente el Hurach Mitch y la caida de 10s precios de 10s articulos b6sicos) y se propagaron debido a diferentes debilidades institucionales en el sistema financiero, resultando en deudas mal administradas en las carteras de prCstamo de 10s bancos. Comparado a 10s paises vecinos, el sistema bancario de Honduras actualmente sobresale como el que tiene el ndmero m6s alto de prCstamos no-redituables y la menor cantidad de reservas. Asimismo, 10s costos administrativos del sistema se encuentran entre 10s m6s altos de la regibn, mientras que su rentabilidad es de las m6s bajas. L a debilidad institucional m6s relevante que contribuye a este problema es la desatencibn general hacia 10s factores de riesgo sistem6ticos en la administracidn de transacciones financieras y la garantia abierta de dep6sitos que ofrece el gobierno. Est0 ha fomentado un entorno de moral hazard que ha paralizado progresivamente el proceso de intermediacibnfinanciera en Honduras. Honduras -DPR Resumen Ejecutivo ACELERANOO EL CRECl,UlENTO DE BASEAMPLU xxxix xliii. Para responder a las causas inmediatas de la pronunciada restriccih de cridito en la agricultura y permitir el crecimiento del cridito, se deberan resolver dos temas simultiineamente: 0 El gobierno necesita definir e imponer una distribucih final (Le., con posibilidad de cumplirse politica y financieramente) de las pirdidas acumuladas desde 1998, tomando en cuenta las restricciones fiscales existentes y las estructuras de incentivos que enfrentan 10s bancos y 10s prestatarios. 0 El gobierno necesita introducir cambios institucionales para asegurar que 10s instrumentos de seguro y proteccih de prkstamos est& colocados, y que 10s contratos financieros no se definan como si no existieran riesgos sistemiiticos. A1 mismo tiempo, CNBS tendrii que desarrollar un marco regulador especifico y las habilidades de supervisih necesarias para guiar y monitorear estas actividades. xliv. El sistema financier0 de Honduras tambiin exhibe varios otros tipos de debilidades institucionales que erigen barreras hacia un desarrollo saludable de sus servicios de intermediacih financiera y a 10s que se refiri6 recientemente el Programa de Evaluacih del Sector Financier0 realizado en conjunto entre el Banco Mundial y el FMI. Estas debilidades son miis pronunciadas en las heas de supervisi6n y regulacih bancaria, 10s derechos de 10s acreedores y 10s sistemas de insolvencia, y la liquidaci6n de pagos y garantias. Las principales recomendaciones que se ofrecen para corregir estas debilidades se presentan a continuacih: xlv. Mejorar la supervisih y regulaci6nbancaria: 0 Es necesario hacer mejoras en las normas de disciplina y control en las heas de: (i) supervisidn consolidada, (ii)capital adecuado, (iii)clasificacion y asignaci6n de pristamos, y (iv) gobernabilidad corporativa y administracibn de riesgos. 0 Es necesario desarrollar un marco de resoluciones para tomar medidas correctivas inmediatas cuando 10s bancos encuentren problemas. 0 CNBS necesita expandir su gama de instrumentos, incluyendo Planes de Acci6n y Memorandos de Acuerdos, para imponer el cumplimiento de acciones preventivas y correctivas; y la legislaci6n bancaria necesita ser revisada para establecer claramente 10s objetivos y criterios para el us0 de dichos instrumentos. xlvi. Fortalecer 10s derechos de propiedad y simplificar 10s procedimientos de insolvencia: 0 Es necesario introducir una legislacih nueva para introducir un sistema de registro modern0 y seguro de derechos de propiedad y garantias, tanto para activos inmuebles como para activos mobiliarios. 0 Una nueva legislacih de bancarrotas, que contemple la posibilidad de reorganizacibn y acuerdos fuera de las cortes, es necesaria para proporcionar procedimientos de insolvencia mas eficientes y con menos retrasos. 0 Se necesita desarrollar una capacidad institucional adecuada en el sistema juridic0 para lidiar con la nueva legislacih de derechos de propiedad y procedimientosde insolvencia. xlvii. Fortalecer las funciones de liquidaci6n de pagos y garantias: Honduras -DPR Resumen Ejecurivo ACELEUNO0 EL CREClMlENTO DE BASEAMPLIA x l 0 Elgobierno deberii establecer unafunci6n depositaria para laliquidaci6n de garantias. 0 El Banco Central deberi definir una politica de sistema de pagos, definiendo claramente sus objetivos (tales como la firrneza de liquidaci6n de ciertas clases de pagos) y 10s instrumentos (sistema de liquidaci6n bruta y neta para diferentes tipos de pagos, sus reglas operativas respectivas, etc.) para cumplirlos. xlviii. Existe un peligro potencial de que 10s esfuerzos para endurecer y hacer cumplir las normas de disciplina y control, puedan decelerar la expansi6n de crCdito, a1 menos temporalmente, lo que podria tener un impacto adverso en el crecimiento. Est0 representa un peligro modesto en el cas0 de Honduras, ya que 10s bancos ya han paralizado mucha de su actividad de prdstamos. Ademis, es importante tener presentes 10s descubrimientos iniciales de este reporte que indican que la evolucidn del crecimiento econ6mico en Honduras se explica principalmente por 10s cambios en el crecimiento de productividad y no por cambios en las cantidades de factores. Aplicado a1 context0 del sector bancario, est0 sugiere que la atenci6n se debe enfocar principalmente en la calidad de 10s prdstamos, en vez de su cantidad. Es decir, siempre que exista una disyuntiva entre el crecimiento mis acelerado del crkdito y una mejor aplicaci6n de las normas de disciplina y control, es miis recomendable para Honduras continuar avanzando en la direcci6n de mejorar dichas normas de disciplina y control. xlix. Adoptando una perspectiva a largo plazo, el reporte tambidn recomienda que las autoridades revisen el marco regulatorio de 10s fondos de pensibn, con el objetivo de reducir 10s riesgos politicos y fomentar una diversificaci6n mayor de activos. L a capacidad de supervisar a las compafiias de seguro y a otras instituciones financieras no bancarias tambiin necesita fortalecerse. Aunque &as todavia Sean relativamente pequefias, muchas de ellas (principalmente las cooperativas) estin creciendo ripidamente y, por tanto, podrian eventualmente constituir una amenaza a la estabilidad financiera. Finalmente, aunque exista unmarco legal efectivo para combatir el lavado de dinero y el financiamiento del terrorismo, las instituciones involucradas en estas keas necesitan ser fortalecidas. E. LAGOBERNABILIDADY ELCRECIMIENTO 1. La gobernabilidad es un determinante importante del desarrollo econ6mico. Esto presenta polimicas sobre 10s prospectos de crecimiento futuro de Honduras, puesto que Cste pais ocupa un lugar muy por debajo del promedio de Amdrica Latina y el Caribe en la mayoria de 10s indicadores de gobernabilidad. Sin embargo, este descubrimiento de deficiencia relativa no es ninguna sorpresa, dado a que 10s indicadores de gobemabilidad presentan una correlaci6n positiva con 10s niveles de ingreso per-capita, hay que considerar que Honduras es uno de 10s paises mis pobres de la regi6n latinoamericana. Se presentan resultados atin mis relevantes a1 comparar a Honduras con otros paises de ingresos medios- bajos en el resto del mundo, que muestran que Honduras no se compara tan negativamente en todas las dimensiones de gobernabilidad que estudia el Instituto del Banco Mundial. Honduras obtiene un puntaje similar o mis alto a1 del grupo de comparacion en tres dimensiones de gobierno, que se refieren a Voz y Rendici6n de Cuentas, Estabilidad Politica y Calidad Reguladora. Sin embargo, Honduras est6 clasificado considerablemente por debajo Honduras -DPR ACELERANDOEL CRECIMIENTO BASEAMPLIA xli Resumen Ejecurivo DE del grupo de comparacih en las demis dimensiones: Efectividad de Gobierno, Principios de Derecho y Control de Corrupcih. Estos resultados sugieren que 10s problemas de gobernabilidad en Honduras no estin primordialmente relacionados a un sistema politico defectuoso o a leyes y regulaciones inadecuadas, sino mis bien a una administracih defectuosa del sector pdblico y a un servicio civil incompetente, que es incapaz de imponer el cumplimiento adecuado de sus leyes, ademis de un sistema judicial dCbil. Estas dltimas Areas-la reforma de la administracibn financiera del sector pdblico, reforma del servicio civil y reforma judicial-tambiCn representan aquCllas en las que las autoridades hondureiias han enfocado sus esfuerzos mis recientes para mejorar la gobernabilidad. Reforma de Administracio'nFinanciera del sector priblico li. Lasautoridades hondurefiashanprogresadoconsiderablemente duranteeltranscurso del aiio pasado en el desarrollo del presupuesto como herramienta de administracibn de gastos, per0 todavia existen varias deficiencias sistemiticas en el sistema: Una cantidad considerable de donaciones y asistencia por servicios se omite en el presupuesto, lo que dificulta calcular la extensidn total de 10s esfuerzos pdblicos en ciertas Areas y coordinar actividades pdblicas. L o mismo sucede con 10s ingresos de varios ministerios por la venta de servicios. 0 Las distribuciones finales del presupuesto estin basadas en distribuciones incrementales, muchas veces realizadas con poca o ninguna participacih de 10s ministerios, y las distribuciones finales no se reconcilian con 10s planes operativos anuales. Esto ha debilitado la utilidad de 10s planes operativos del sector y ha resultado en una baja credibilidad del presupuesto. Hay un ndmero considerable de enmiendas a1 presupuesto se realizan durante el aiio, reflejando 10s poderes discrecionales del Congreso para redistribuir 10s recursos financieros para fines politicos, en vez de darles prioridad estratkgica. Aunque el Congreso tiene la responsabilidad constitucional de supervisar la administracibn del sector pdblico, Cste carece de la capacidad de cumplir con esta funcih. 0 L a dCbil capacidad de planificacih a nivel sectorial se afiade a la debilidad general de preparacih de presupuesto y contribuye a la necesidad de repetidas enmiendas en el presupuesto. El presupuesto se presenta en base a 10s objetos de gastos, en vez de una clasificacih programitica, lo cual impide su us0 para la supervisih y evaluacih de 10s esfuerzos pdblicos para la promoci6n del crecimiento econdmico y la reducci6n de la pobreza. lii. LaimplementacidndeunSistemaIntegraldeAdministracihFinanciera(SIAFI) ha mejorado la capacidad del gobierno de controlar y administracih gastos. L a utilidad del SIAFIse ha visto limitada por la rigidez de su formato, la falta de acceso completo a1sistema de todos 10s sectores, lo cual resulta en retrasos en el registro de las transacciones, y la falta de integracih del SIAFI con varios otros sistemas de informitica gubernamentales. Esto ha resultado en una proliferacibn de sistemas de informBtica en otras agencias, sin una plataforma comdn de estindares operacionales y tCcnicos, produciendo una duplicacih de bases de datos y esfuerzos, y una incompatibilidad general en el flujo de informaci6n dentro del gobierno. Honduras -DPR Resirmen Ejecutivo ACELERANDOEL CRECIMIENTO DE BASEAMPLlA xlii liii. Loscontrolesinternosseencuentranbastantedispersosysincoordination. AdemAs, el Departamento General del Presupuesto (DGP) ejerce uncontrol centralizado ex-ante que no permite una ejecucih eficiente del presupuesto. A1 mismo tiempo, las funciones de auditoria interna no estAn bien definidas y contindan siendo controladas por la instituci6n de auditoria suprema, el Tribunal Superior de Cuentas (TSC), desvaneciindose las lineas entre las auditorias internas y las externas. liv. Las responsabilidades de administracidn fiscal estAn dispersas entre varios organismos pdblicos, en vez de estar concentradas en la Tesoreria (TGR), que exhibe debilidades institucionales considerables. L a dispersi6n de las responsabilidades fiscales ha resultado en funciones que quedan no asignadas y que afectan directamente la seguridad y el control de la administracion de 10s fondos pdblicos. Aunada a estas funciones no asignadas se encuentra la prActica de la TGR de emitir cheques negociables, lo cual previene la verificacih del destinatario final de 10s pagos del gobierno. lv. Los procedimientos que regulan la recoleccih de impuestos son deficientes y poco claros. No existe una reconciliacih adecuada entre 10s fondos pagados por 10s causantes de impuestos y 10s fondos declarados por 10s bancos cuando 10s recaudan; y no hay reconciliacih entre 10s fondos que reciben 10s bancos y 10s fondos que se transfieren a las cuentas de la tesoreria. Existe poca seguridad en cuanto a 10s fondos que recaudan 10s bancos, cuya solvencia no se certifica previamente. lvi. El gobierno ha invertido en mejorar su capacidad de administracih de deuda, lo cual representa una de las Areas mAs fuertes en el sistema pdblico de administracidn financiera. Sin embargo, la administracih de deuda se podria mejorar, con la inclusion de 10s pasivos contingentes. Estos no se reportan actualmente en 10s estados financieros del gobierno y, por tanto, no estan incluidos en 10s analisis de deuda. lvii. Las funciones de auditoria externa contindan evolucionando a raiz de las reformas constitucionales del 2002 que resultaron en la creacidn del TSC. L a eficacia del TSC se encuentra limitada en el presente dada la falta de personal de calificado, recursos financieros insuficientes para cumplir por completo sus responsabilidades y la falta de lineamientos y regulaciones operativas. lviii. Honduras no tiene un sistema adecuado de adquisiciones para el gobierno. El nuevo marco legal de adquisiciones pdblicas, que entr6 en vigencia enjunio del 2001, representa una mejora importante del marco de trabajo anterior debido a que: (i) cubre a todas las agencias gubernamentales bajo un conjunto de principios-guia en cuanto a economia, transparencia y eficiencia, (ii)estipula la creacih de una Oficina Reguladora de Adquisiciones para establecer un mitodo comdn y consistente de documentos, criterios y prActicas estiindares para licitaciones, (iii)estipula el us0 de procedimientos de competitividad abierta que incluyen la apertura de licitaciones pdblicas y la participacih no-discriminatoria de proveedores bajo una amplia gama de me'todos de adquisiciones, y (iv) requiere una notificaci6n pdblica de las oportunidades de adquisiciones. Sin embargo, el sistema permanece siendo ineficaz debido a l o siguiente: 0 De'bilImplementacih de las reglas y 10s procedimientos de adquisicih, Hondurus -DPR Resumrn Ejecutivo ACELERANDO EL CRECIMIENTO DE BASEA.MPLIA xliii 0 Falta de diseminaci6n del nuevo sistema en 10s sectores pdblico y privado, 0 L a no existencia de la Oficina Reguladora de Adquisiciones, 0 Falta de capacidad del personal a nivel de trabajadores, y 10s miembros de 10s comitks de oferta y las autoridades aprobatorias, y 0 Ausencia de gerentes de proyecto y personal de adquisicih, y de carreras en administracih de proyectos y adquisiciones. lvix. Estas deficiencias han menoscabado seriamente la confianza en la legislaci6n y 10s sistemas locales de adquisicibn, lo cual ha resultado en que el gobierno haya nombrado a1 Programa de las Naciones Unidas para el Desarrollo (PNUD) como su agente principal de adquisiciones y encargado de la administracibn de 10s recursos provenientes de donaciones. Originalmente contemplados como medidas temporales, el us0 de sistemas y agentes de adquisicih extranjeros se ha convertido gradualmente en una practica permanente en Honduras. A menos que estas fallas se reparen de forma decisiva y se coordinen con la comunidad de donantes, permaneceran siendo una restriccih grave en la implementacibn efectiva de 10s planes del gobierno. lx. L a calidad de la gobernabilidad del sector pdblico, y la rendici6n de cuentas de 10s funcionarios pdblicos de mayor rango que est0 implica, necesita de mejoras. Los esfuerzos en esta direcci6n necesitan enfocarse en fortalecer el marco legal y la rendicibn de cuentas de la administracibn financiera pdblica, mejorar la transparencia y la supervisi6n de 10s mecanismos de 10s sistemas pdblicos de administracibn financiera, agilizar 10s procesos y 10s procedimientos, y sistematizar y fortalecer a las instituciones responsables de asegurar la rendicibn de cuentas. En respuesta a estas necesidades, el Gobierno de Honduras ha iniciado un ambicioso programa para reformar la administracibn financiera pdblica con la ayuda del Banco Mundial, el BID y otros donantes. Algunos adelantos importantes hasta la fecha incluyen: (i) la definicih de una Ley de Administracibn Financiera, un Cbdigo de Eticas Pdblicas y una Ley de Acceso Pdblico a la Informacih, (ii)mejoras en 10s formatos presupuestarios y controles internos para facilitar un enfoque sectorial en Educacih, (iii) la expansi6n de SIAFI para aumentar su funcionalidad programiitica, (iv) la produccidn del primer estado financier0 del gobierno, preparado por la Oficina del Contralor General y un inventario preliminar de todos 10s activos del gobierno, y (v) la promulgacih de nuevas regulaciones para auditorias externas realizadas por el TSC. Una evaluaci6n reciente del mecanismo de seguimiento de la reduccibn de pobreza de Honduras, efectuada por el FMIy el Banco Mundial, tambie'n ha notado mejoras significativas en la administracih financiera pdblica de Honduras gracias a las reformas en Areas criticas. Una lista detallada de recomendaciones para canalizar mayores esfuerzos en esta Area aparece en el Plan de Acci6n de la ERCP. Reforma del Sewicio Civil lxi. Aunque la legislacibn existente de servicio civil en Honduras aparenta cubrir todos 10s asuntos relacionados con la administracibn del personal p6blico, ha sido muy poco cohesiva en las dltimas dos de'cadas. En su lugar, para mediados de 10s 1990s, muchos regimenes de empleo se habian creado, proveyendo beneficios extraordinarios para ciertos sectores de la fuerza laboral pdblica, tales como maestros y trabajadores de salud. Estos regimenes Honduras -DPR Re.rumen Ejecutivo ACELERANDO CRECIMIENTODEBASEAMPLIA EL xliv especiales han resultado en un aumento descontrolado de la masa salarial pdblica, imponiendo una carga fiscal insostenible, y han creado diferencias enormes entre 10s empleados pdblicos, tanto en ttrminos de beneficios como en procedimientos administrativos. A1 mismo tiempo, la administraci6n de recursos humanos en el gobierno central y en el resto del sector p6blico ha evolucionado en formas que no son propicias para la gesti6n efectiva y transparente del personal p6blico. El proceso de contratacibn, evaluaci6n de desempefio y 10s procedimientos de despido se han vuelto temas muy politizados, reduciendo la capacidad de las instituciones pdblicas de atraer personal calificado y de ofrecer servicios pdblicos eficientes. Por lo tanto, la capacidad institucional de toda la administraci6n p6blica se ha debilitado. lxii. El ndmero general de empleos del sector p6blico de Honduras no es excesivo en comparaci6n con otros paises de AmCrica Central o de 10s PPME, per0 existen desequilibrios serios en todos 10s sectores. Esto se debe a 10s afios de politicas dCbiles de administracih del personal y la falta de claridad en el papel y la finalidad de 10s diferentes organismos del sector p6blico. L a consecuencia ha sido que varios organismos claramente cuentan con mas personal del necesario en ciertas funciones innecesarias y, por otro lado, carecen de personal necesario en otras keas, lo cual limita su capacidad de proveer servicios adecuados. lxiii. Los temas mas importantes en cuanto a la administraci6n del empleo pdblico se refieren a: L a necesidad de restaurar control en las politicas de salarios y sueldos, para poder restablecer una situacih fiscal sostenible y una distribuci6n mas ecuanime de 10s beneficios. L a necesidad de revisar la macro-estructura del sector ptiblico, clarificar 10s roles, funciones y responsabilidades en la oferta de servicios de diferentes organismos ptiblicos, y re-dimensionar a estos organismos (incluyendo su composici6n de empleo) de acuerdo a estas funciones y responsabilidades. L a necesidad de establecer una nueva normatividad y un marco institucional para el empleo pbblico, que limite la influencia politica del servicio civil, y L a necesidad de adherirse a la implementaci6n de un nuevo marco de servicio civil, una vez que haya sido aprobado. lxiv. Para responder a estos temas, las autoridades han estado trabajando en una estrategia bipolar, con objetivos a corto y a largo plazo. Una ley de salarios pdblicos que entr6 en vigencia en diciembre del 2003 restablece el control del gobierno de la masa salarial y la administracidn de 10s sueldos, elimina 10s regimenes de sueldos especiales, incluye varios tipos de bonos "colaterales" en 10s salarios base, ensancha el alcance de la politica de sueldos para abarcar a todos 10s empleados del gobierno, y le otorga a1 gobierno (en vez del Congreso) la capacidad de formular una politica de sueldos alineada a la inflaci6n anticipada. TambiCn incluye otras funciones para restablecer mayor equidad en la estructura de sueldos. lxv. L a otra parte de esta estrategia de reforma esta disefiada para responder a varios temas estructurales en un horizonte a mediano plazo. Estas medidas se efectuaran paralelamente e incluirhn lo siguiente: Honduras -DPR Resumen Ejecurivo ACELERANIIOEL CREClMlENTO DEBASEAMPLIA xlv 0 Preparar un estudio completo de reingenieria de toda la administracibn pdblica, que identifique las funciones que permaneceriin en el sector pdblico centralizado (a1 igual que aqudllas que se le comisionen a1sector privado, ONGs o las municipalidades) para entonces determinar el tamaiio y la composici6n adecuadas de 10s organismos pdblicos de acuerdo a estas funciones, 0 Presentar a1 Congreso una nueva ley para reformar la administracion pdblica, que incluya el restablecimiento de procedimientos transparentes de contratacih, evaluacih y despido de empleados pdblicos, para limitar el ndmero de puestos otorgados por politica en el servicio civil, y para crear una institucih de supervision independiente para el servicio civil, y 0 Completar estudios de reingenieria y analisis de diferencias en ciertos organismos, y la implementacibnde unnuevo rdgimen de servicio civil en dichos organismos. Reforma Judicial lxvi. L a base estadistica del poder judicial, sobre el ndmero de casos y las acciones de 10s jueces, es bastante mala. Sin embargo, toda la evidencia disponible en este momento indica que el sistema hondureiio en general es costoso y que el dinero no se usa eficientemente, que 10s jueces de paz (el grupo que constituye la mayoria de 10s jueces) no se utilizan a su potencial, y que aunque las cortes urbanas podrian estar manejando un n6mero miis alto de casos, se retrasan enormemente en dictaminar sentencia, hay relativamente pocas sentencias y existen problemas con el cumplimiento de &as. lxvii. Honduras ha estado considerando reformas para la modernizacih del poder judicial por lo menos desde principios de 10s 1990s, per0 el progreso ha sido limitado. Con las reformas del 2002, sin embargo, 10s miembros de la Corte han recibido mayor independencia a travCs de periodos m8s largos de permanencia en sus cargos, que proveen un ambiente miis prometedor para la implementacih de reformas. L a nueva Corte Suprema, apoyada por una administracih nacional reformista, ofrece una oportunidad dnica que exhorta a1 redoblamiento de esfuerzos para reformar el sistemajudicial. lxviii. Existe la necesidad de modernizar el sistema judicial, incluyendo la lucha contra la corrupci6n, la promocih de mayor independencia judicial y mejoras en la eficiencia y eficacia general del sistema judiciario. El acceso a la justicia necesita mejorar, brindhdole especial atenci6n a 10s procedimientos de resolucidn de conflictos menos caros y miis eficaces, y otros servicios enfocados en 10s grupos miis desamparados de la sociedad (especialmente mujeres, poblaciones indigenas y 10s pobres). Los problemas de violencia juvenil, crimen y seguridad tambih necesitan respuesta por medio de soluciones sociales coordinadas y medidas del sector de justicia. Otro tema importante que necesita de atencih, especialmente dentro del marco de fomentar el crecimiento, es el fortalecimiento de la seguridad de la tierra. En base a todas estas demandas de reforma y desafios institucionales, se necesita ordenar por orden de importancia las reformas para evitar una sobrecarga en la capacidad institucional, financiera y politica. TambiCn es recomendable, por consiguiente, comenzar con tres objetivos de desarrollo intermedio que merecen atenci6n especial: (i) desarrollar la capacidad de gobernabilidad del Poder Judicial. El mandato de la Corte Suprema actual estarii en vigencia hasta el 2009, por lo tanto hay una oportunidad para Honduras -DPR Resumen Ejecurivo ACELERANDOEL CREClMlENTO DE BASEAMPLIA xlvi fortalecer sus estructuras administrativas, fomentar la coordinacih inter-institucional con otros organismos del sector de justicia y la sociedad civil, establecer normas para la carrera judicial y promover el desarrollo profesional de 10s jueces y su personal; (ii) desarrollar la confianza de 10s ciudadanos a travis de la implementacibn de iniciativas bisicas de anticorrupci6n, transparencia y rendicidn de cuentas, junto con la retroalimentacih de partes interesadas; y (iii) mejorar el acceso a lajusticia de las poblaciones de alta prioridad, a travis del diseiio, pilotaje y extensi6n de acceso select0 a las medidas de justicia. En sitios donde la poblaci6n sea muy dispersa, las autoridades podrian considerar la introduccih de jueces de circuit0 (que se desplazarian entre varias localidades) para poder aumentar el acceso de forma eficiente. lxvix. En un sentido mis amplio, el liderazgo judicial tambiin necesita mejor informacih sobre la demanda actual de servicios judiciales, la naturaleza y las causas de 10s retrasos, 10s casos inconclusos y la falta de imposici6n de cumplimiento, asi como en la demanda potencial (quiin no est6 usando las cortCs y por qui). Est0 permitiria atacar 10s problemas de ineficiencia a un nivel mis alto, asegurando que las cortes se enfoquen en 10s casos que tenga un mayor impact0 en la reducci6n de pobreza, el crecimiento econ6mico y mitigaci6n de conflictos, en vez de solamente ayudarles a procesar mejor 10s casos que ya tienen pendientes. Aparentemente hub0 problemas por el lado de la demanda, en tirminos de abusos en el us0 de las cortes para retrasar el cumplimiento de contratos o para retardar decisiones administrativas con sensibilidad politica de parte del gobierno. Algunos de estos problemas se pueden resolver a travis de una mejor administracih del poder judicial, per0 otros de ellos necesitarin cambios legales (Le., simplificacih de procedimientos para reducir las oportunidades de us0 de pricticas dilatorias), coordinacih con otros organismos del sector (i.e., el Ministerio Pdblico y sus fiscales), y decisiones politicas de alto nivel sobre lo que el poder judicial deberia estar examinando. Como algunas de estas decisiones podrian facilitarle acceso a demandantes potenciales que no est& usando las cortes en determinados momentos, tambiin es esencial comprender sus necesidades y las alternativas pertinentes para satisfacerlas. lxx. L a principales recomendaciones que surgen a raiz de estos resultados para mejorar la gobernabilidad en Honduras incluyen l o siguiente: Implementar del Plan de Acci6n de la Evaluacidn de la Rendicidn de Cuentas del Area Financiera del Pais (ERCP) para mejorar la administraci6n financiera del sector pdblico. Completar el Reporte de Evaluaci6n de Adquisiciones del Pais (REAP), e implementar un Plan de Acci6n REAP para mejorar 10s procesos de adquisiciones pdblicas. Completar un estudio completo de reingenieria del sector ptiblico, para determinar las funciones adecuadas y las habilidades que se requieren de 10s diferentes organismos del sector pdblico, y empezar la reorganizacibnde ciertos drganos pdblicos de acuerdo a1nuevo rigimen de servicio civil. Preparar, presentar a1Congreso y ejecutar una nueva ley de reforma de administracih pdblica, que establezca procedimientos transparentes para la contratacih, evaluaci6n Honduras -DPR Resumen Ejecutivo ACELERANDO CRECIMIENTODE BASEAMPLIA xlvii EL y despido de empleados pdblicos, que limite el ndmero de puestos politicos en el servicio civil y que Cree una institucih de supervisi6n independiente para &e. 0 Desarrollar una base de datos estadistica veraz y completa del poder judicial y desarrollar sus capacidades de administracih (lo cual requeriri de sistemas adecuados de administracih informitica). 0 Preparar un estudio diagn6stico a fondo de (i) la demanda de 10s servicios judiciales en Honduras, (ii) 10s obsticulos principales de acceso en el sistema judicial, y (ii) la baja productividad del poder judicial, y preparar un plan de acciones para remover 10s obsticulos y aumentar la eficiencia del sistema judicial en Honduras. F. CONCLUSION lxxi. Enla forma que las medidas y reformas recomendadas en este reporte puedangenerar un clima de inversiones mis atractivo en Honduras, claramente servirin tambie'n para fomentar una acumulacih mis ripida de capital fisico, lo cual representa uno de 10s componentes del crecimiento econ6mico. Sin embargo, el mayor impulso de la mayoria de estas reformas, es mejorar la calidad de 10s servicios de factores y la eficiencia de la distribuci6n de factores, 10s cuales, dentro de un marco de contabilidad de crecimiento, estin reflejados en el crecimiento mis ripido de la productividad. Est0 es importante para Honduras, cuyo crecimiento comparablemente bajo de las dCcadas recientes se puede adjudicar a1crecimiento de'bilde su productividad. Las medidas para expandir la cobertura y la calidad de la educaci6n tendrin un impacto direct0 en la calidad de la mano de obra y la acumulacih de habilidades productivas. Similarmente, las medidas que se recomiendan para fomentar el desarrollo del mercado financiero, sirven principalmente para mejorar la calidad de la intermediacih financiera, en vez de estimular el volumen total de ahorros e inversiones. En el Area de infraestructura pdblica, las medidas para remover las distorsiones de precios, atraer mayores niveles de inversiones privadas y mejorar el marco regulador, podrian resultar en mis inversiones de infraestructura del sector privado. Per0 es posible que el impacto mis grande se acumule a traves de una oferta mis eficiente y mejor calidad de servicios de infraestructura. Esto es tambiCn cierto para las medidas que se contemplan en el &-ea de gobernabilidad, especialmente en el irea de mejoras a la administracih financiera del sector p6blico y el servicio civil, la cual principalmente mejora la calidad y la composicih de 10s servicios pdblicos, considerando que su cantidad estari limitada por algdn tiempo por la estrangulacih de las restricciones fiscales del pais. lxxii. Como se indica anteriormente (Piin-. xi), Honduras pronto se estari enfrentando a un ambiente extern0 de cambios vertiginosos una vez que se ratifiquen 10s acuerdos del CAFTA. Las reformas politicas e institucionales que se recomiendan en este reporte son necesarias para permitir que Honduras aproveche las oportunidades de crecimiento y desarrollo mis acelerados, que ofrece el CAFTA. Es decir, el CAFTA es un complemento, en vez de un sustituto de las reformas politicas e institucionales en pro de la productividad que se proponen en este reporte. Se espera que el impacto de beneficios del CAFTA en crecimiento econ6mico surja de tres fuentes-expansih comercial, mayores inversiones privadas y transferencias tecnolbgicas-las cuales estin enlazadas a las reformas recomendadas en este reporte: Honduras -DPR Resumen Ejecutivo ACELERANDO CREClMlENTO DE BASEA.WPLIA xlviii EL Como se indica en el ApCndice F, 10s estudios empiricos apuntan hacia una estrecha relaci6n entre un mayor crecimiento de las exportaciones y la producci6n, y una reduccidn en 10s costos de transporte. L a eficiencia de 10s puertos aparenta ser particularmente importante para la facilitacidn del comercio exterior. Igualmente, las medidas recomendadas en el Capitulo I11para mejorar el acceso y la calidad de la infraestructura de transporte permitiran que Honduras se aproveche mejor de las oportunidades de comercio que ofrece el CAFTA. Las encuestas de inversionistas indican que las inversiones extranjeras directas son especialmente sensibles a1 ambiente de gobernabilidad y a la disponibilidad de servicios de infraestructura, especialmente en el sector de energia y las telecomunicaciones. Aunque el CAFTA hara que Honduras sea mas atractivo para 10s inversionistas extranjeros, se requeriran tambiCn mejoras significativas en infraestructura y en el entorno de gobernabilidad para activar una respuesta dinamica de dichos inversionistas. Esto es especialmente cierto en las Areas rurales, cuya falta de infraestructura representa un factor inhibidor importante para las inversiones privadas. Las mejoras en el n6mero de matriculas en secundaria y 10s logros educativos de la poblaci6n son cruciales para que 10s hondureiios puedan progresar miis all6 de las operaciones de ensamblaje que requieren pocos conocimientos y una mano de obra intensiva. Est0 es importante, tanto en tCrminos de atraer inversiones extranjeras directas con mayor sofisticaci6n tecnolbgica, como en la preparaci6n del pais para adaptarse a la aparici6n de nuevas tecnologias. Los acuerdos comerciales alcanzados en las negociaciones del CAFTA ofrecen nuevas oportunidades para expandir las exportaciones de 10s productos agricolas de Honduras. Sin embargo, no es factible que haya una respuesta significativa de las exportaciones agricolas en un futuro prbximo, hasta que 10s problemas actuales en el &ea de crCdito agricola se hayan resuelto. Asimismo, la capacidad de expandir el comercio y la producci6n en general, dependera de un sector financiero fuerte, lo que requiere de las medidas de fortalecimiento financiero recomendadas en el Capitulo IV. Ademis de oportunidades, el CAFTA tambiCn presenta algunos riesgos y desafios. El desafio mAs urgente es el declive que habra en ingresos tarifarios despuks de la eliminaci6n de las tarifas intra-regionales. Como se indica en el Capitulo I,Honduras necesita hacer un esfuerzo serio para restablecer un marco macroecon6mico sostenible, aun si no existiera el prospecto del CAFTA. Con el CAFTA, esta tarea se vuelve todavia mas dificil, per0 las recompensas potenciales de crecimiento y desarrollo tambiCn se han vuelto proporcionalmente m6s altas. Otro desafio, menos urgente per0 de igual importancia, que surge a raiz del CAFTA, es el impact0 potencial en el sustento de ciertos segmentos significativos de la poblaci6n rural, por la eliminaci6n de tarifas (despuCs de un period0 de gracia de 10 aiios) en varios tipos de cultivos. Es posible que haya necesidad de implementar programas de asistencia dirigidos especialmente a 10s pobres, para ayudarles a ajustarse a estos cambios. Chapter I. RECENT ECONOMIC DEVELOPMENTS AND GROWTH PERFORMANCE Introduction 1.1 This Development Policy Review (DPR) discusses Honduras's development agenda with a special focus on accelerating economic growth. This focus emerges from the Honduras Poverty Reduction Strategy Paper (PRSP), which identified growth as the main determinant of the evolution of poverty, and guides the review of policy developments in various economic, social and infrastructure sectors. The DPR seeks to provide an analytical basis for developing the growth strategy outlined in the PRSP and, in doing so, hopes to provide some analytical underpinnings for the program supported by a Poverty Reduction Support Credit, which i s scheduled for approval by the International Development Association (IDA) in mid- 2004. 1.2 The next sections of this chapter present the country context and discuss recent economic developments. This is followed by a review of Honduras' growth performance since 1960 and an analysis of the main determinants of growth. That section concludes by identifying the main areas where further reforms or policy interventions promise to yield the greatest growth impact. These areas comprise education, infrastructure, finance and governance. The main issues associated with each of these areas and their link to growth are addressedinthe subsequent chapters. A. Country Context 1.3 Honduras i s a lower middle income country, with a per capita income of US$920 in 2002 (Atlas methodology). It has a population of around 7 million inhabitants (in 2004), growing at an annual rate of 2.4 percent and of which about 42 percent are under 15 years o f age. An estimated 64 percent of the population currently lives below the poverty line, while 45 percent lives inextreme poverty. Roughly one-half of the population resides inrural areas, where the incidence o f poverty i s almost 75 percent, versus 57 percent in urban areas. Honduras' social indicators are among the worst in the Latin America and Caribbean region, but comparable to the indicators observed on average among the other lower middle income countries. InOctober 1998, Honduras bore the brunt of hurricane Mitch, which caused major human and physical damage, and temporarily interrupted the progressive decline of poverty observed since 1990. 1.4 Honduras has a historical record of poor economic growth, but relatively high income stability, compared to other Latin American countries. Honduras grew at an average annual rate of 0.8 percent in per capita terms over the period 1960-2000, which i s less than half the Latin American average of 1.7 percent and lower than the 1.2 percent averaged by all developing countries worldwide. On the positive side, Honduras has exhibited very little 2 output and consumption volatility.' Similarly, the Honduran economy has historically had low inflation rates compared to other countries in the region. This reflects a traditional adherence to conservative monetary policies and a preference for fixed exchange rates. 1.5 Honduras i s the most open economy in Central America and ranks among the most open in the world.2 It has a trade ratio averaging around 90 percent, with exports accounting for 40 percent of GDP and imports for a little over 50 percent. Economies that are this open normally are very vulnerable to external shocks and Honduras i s no exception. Its economy i s periodically affected by major terms of trade fluctuations, natural disasters and developments in its major trading partners3 The 2 percent contraction of GDP in 1999, for example, is entirely attributable to the devastation caused by hurricane Mitch. This renders it all the more surprisingthat Honduras's income levels should rank among the least volatile in the region. 1.6 Honduras has been able to reduce its vulnerability to terms of trade shocks over the last decade through a greater diversification of exports. The country's three main export commodities (coffee, bananas, and shrimps) used to account for over 40 percent of total exports of goods and services inthe early 1990s, but now represent less than 20 percent. (Part of their declining share i s explained by the fall in international commodity prices since 1999, especially for coffee and shrimps.) These traditional exports have been superseded b y nontraditional exports and, especially, maquila exports (mainly textiles), whose value-added alone grew from 9 percent of total exports of goods and services in 1995 to 22 percent in 2002. While reducing the vulnerability to terms of trade fluctuations, the growth of the maquila sector has increased Honduras's vulnerability to trade shocks through greater competition from low-cost Asian producers in apparel and textiles once the WTO agreement on quotas (the old Multi-Fiber Agreement) ends, as currently scheduled, in January 2005, and possibly to trade disputes associated with the exemptions granted to export processing zones.4 ' See,e.g., David De Ferranti, G.E. Perry, IS. Gill and L. ServBn, Securing Our Future in a Global Economy (World Bank, June 2000) which indicates (in Table 2.1) that Honduras ranks 3`d and 5" out of 21 countries in the LatinAmerican and Caribbean region interms of least volatile output and consumption during the last 40 years. The standard deviation of growth rates in Honduras over 1961-1999 is 3.0 percent for GDP and 3.8 percent for total consumption, compared to the L A C median of 5.2 and 5.5 percent. Honduras also * Based exhibits relatively low volatility in most sub-periods, including the 1990s; Table 2.2 in D e Ferranti et al.. on the structure-adjusted measures of trade openness used in Loayza, Fajnzylber and Calder6n (2002). The figures on the degree of openness, as well as all other figures expressed as ratios of GDP, may be biased on account of a possible sub-valuation of Honduras's GDP. A study financed by IDB is currently underway to review the national accounts. The Financial Sector Assessment Program document (April 2003) reports some statistical estimation results that illustrate Honduras's high degree o f vulnerability to external shocks. One finding i s that a 1 percent increase in the terms of trade is correlated with a 0.05 percent increase of GDP growth. The terms of trade index for Honduras exhibited annual fluctuations within a range of -20 and 40 percent of the mean during the period, 1975-2001, which translates under this statistical relationship into GDP variations of -1 percent and + 2 percent. Another finding i s that a one percent increase in the GDP of the USA (Honduras's main trading partner) is associated with a 0.75 percent increase in Honduras's GDP. Recent rulings by the World Trade Organizations prohibit the operation of export-processing or free-trade zones, except for countries with a annual per-capita incomes below US$l,OOO. Honduras's per capita income level is approaching this threshold, which could lead to retaliatory actions from trading partners that inhibit the continuation of maquila operations. 3 1.7 Honduras's overall economic production pattern mirrors the evolving composition of exports. Most visible i s the declining importance of agriculture, whose share of current GDP declined from 19 percent in the mid-1990s to less than 12 percent in 2002, while the share of services increased from 42 to 49 percent of GDP; Table 1.1. Sector output shares have remainedmore stable inreal terms, however, with the share of agriculture only declining from 25 percent of GDP (in constant prices) to 23 percent over that same period. Similarly, the share of the Honduran work force employed in agriculture also has remained largely unchanged at around 39 percent. This suggests that the opportunities to shift labor and capital outside the agriculture sector in response to declining sector prices have been limited so far. Improving access to education and financial market deepening - two issues that are emphasized inthis report - will be essential for increasing factor mobility. Table 1.1. Honduras: Sector Shares of GDP 1995 1996 1997 1998 1999 2000 2001 2002 2003 Prelim. Prelim. Prelim. GDP at current mkt. prices (Ls. mill.) 37507 47763 61321 70438 77096 89401 99032 108123 120322 Sector shares of currentGDP Agriculture 18.7 19.2 19.9 16.3 13.6 14.0 12.2 11.9 11.3 Industry 26.7 26.5 25.9 26.2 27.6 27.4 27.4 27.3 28.2 Services 41.6 40.4 40.8 42.8 44.2 45.3 47.8 49.2 48.9 Taxes less subsidies on prod. 13.0 13.8 13.4 14.7 14.5 13.3 12.6 11.4 11.6 GDP at market prices 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Sectorshares of Constant(1978)GDP Agriculture 25.0 24.8 24.6 23.5 21.9 23.1 22.4 22.9 22.7 Industry 22.0 21.8 21.8 22.0 23.3 23.2 23.1 22.6 23.3 Services 43.8 43.7 43.9 44.6 45.7 45.5 46.8 47.6 47.3 I Taxes lesssubsidieson prod. 9.2 9.7 9.7 10.0 9.1 8.2 7.7 6.9 6.7 GDP at market prices 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Source: Statistical Annex Tables 1and 2A. 1.8 Another important structural change that took place over the last decade i s the growth of foreign remittances, which have reached an estimated US$SOO million in 2003, or about 12 percent of GDP.' Even though foreign aid transfers have been declining again, after a temporary surge in the wake of hurricane Mitch, net current transfers from abroad have continued to increase from an estimated 7 percent of GDP in the mid-1990s to currently 15 percent of GDP. This increase in current transfers has permitted domestic absorption to increase since the mid-1990s without adding to the country's high debt burden, while helping to sustain the real exchange rate in the face of external shocks that weakened export performance. 1.9 With an external public debt-to-GDP ratio of around 66 percent, Honduras i s a highly indebted country.6 It was declared eligible to participate in the Heavily Indebted Poor Countries (HIPC) initiative in 1999 (under the fiscal window), and reached the HIPC Honduras's domestic savings rates traditionally have exceeded its national savings rates by a wide margin, mainly reflecting the negative net factor inflows on account of Honduras's large external debt; Table 1.2. While the external debt burden has been declining, the growth of remittances has reversed the relative size of domestic and national savings, representing a swing of about 12 percent of GDP between 1995 and 2002. In net present value terms, the external public debt represents about 45 percent of GDP. Honduras's domestic public debt is significantly smaller, accounting for less than 10 percent of GDP. 4 Decision point in July 2000. At that time, Honduras was expected to reach the HIPC Completion point at the end of 2002, but difficulties in implementing a stable macroeconomic program have set back the implementation of the PRSP and delayed the Completion point until possibly 2005. Honduras completed a full PRSP in July 2001 and its first PRSP Progress Report in December 2003. The Honduran authorities are hoping to reach the HIPC Completion point by early 2005. Table 1.2. Honduras:GrossDomesticExpenditureandProduct 1995 1996 1997 1998 1999 2000 2001 2002 2003 Prelim. Prelim. Prelim. Sharesof gross domesticexpenditureat currentprices 1.Finalconsumption 72.8 74.0 73.5 76.7 80.3 83.3 86.8 89.5 89.2 2. Gross capitalformation 31.6 31.1 32.2 30.9 34.7 30.6 29.6 25.6 27.4 3.TotalAbsorption (1+2) 104.4 105.1 105.6 107.7 115.0 113.9 116.4 115.1 116.7 4. Resource balance -4.4 -5.1 -5.6 -7.7 -15.0 -13.9 -16.4 -15.1 -16.7 a) Exportsof goods & services 43.7 46.9 46.2 46.4 41.0 41.3 37.8 38.0 38.3 b) Importsof goods & services 48.1 52.0 51.8 54.1 56.0 55.2 54.2 53.1 54.9 5. Gross domesticproduct (W) 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 6. Net incomefrom abroad -6.8 -6.4 -4.6 -4.0 -3.0 -2.6 -2.8 -2.9 -2.8 7. Grossnational income(5+6) 93.2 93.6 95.4 96.0 97.0 97.4 97.2 97.1 97.2 8. Netcurrenttransfersfrom abroad 6.7 6.8 6.6 9.3 13.6 12.4 14.5 14.5 na 9. Gross nationaldisposable income (7+8) 93.9 94.4 96.3 99.4 104.5 103.9 105.7 105.6 na ~10.Nationalsavings (41) 21.1 20.4 22.8 22.7 24.2 20.6 18.9 16.1 na 111. Domesticsavings (5-1) 27.2 26.0 26.5 23.3 19.7 16.7 13.2 10.5 10.8 Source: StatisticalAnnex Table 1.1 Earlier Economic and Political Developments 1.10 Honduras' economy slumped in the early 1980s, in tandem with the other Central American economies. Adverse terms of trade shocks, tighter global credit conditions associated with the international debt crisis and raging civil wars in neighboring countries all contributed to this slump. These shocks also brought about the collapse of the Central American Common Market (CACM),7 of which Honduras was a member. Furthermore, the import substitution policies that were in place at that time had rendered the economy especially vulnerable to such shocks. The Honduran authorities reacted to the ensuing deceleration of growth by tightening currency and trade controls even further, and by increasing public investment financed with external borrowing. This led to rapid, unsustainable increases in the fiscal deficit and the country's external debt, which eventually resulted in debt service arrears that caused Honduras to fall temporarily into suspension with the World Bank and other multilateral institutions. 1.11 In the early 1990s, Honduras reconsidered its inward-looking policies and began a process of reform that included the reduction o f trade barriers, more flexible exchange rate arrangements, financial market liberalization, liberalization of agricultural trade, adjustments of public utility tariffs, and the development of a legal framework to strengthen property Intra-CACM exports as a share of total exports by the countries in the region declined from 25.4% in 1980 to 10.4% in 1986, at which time the regional currency clearing house (Camara de Compensacih Centroamericana) collapsed. Since then, the intra-CACM trade ratio has recovered to 27% in 2003, as the CACM has undergone a gradual resuscitation, but without the protectionist framework that had characterized it in the 1960sand 70s. 5 rights. This reform process was not sustained, however, as the quality of economic management varied greatly over the political cycle. Accordingly, fiscal discipline began to be relaxed in the run up to the November 1993 elections, and many of the trade liberalizing reforms taken in the early 1990s were reversed in order to prevent a collapse of reserves. A similar pattern occurred also in the run-up to the 1997 and 2001 elections. In both cases, PRGF-supportedprograms that had been arduously negotiated with the IMFinthe first half of the electoral period subsequently went off-track due to deviations from the fiscal targets and an inability to implement programmed structural reform measures as the elections came nearer. B. Recent Economic Developments 1.12 The Honduran economy has been stagnant since 2001. Economic growth increased modestly to 3 percent in 2003 (or barely 0.4 percent in per capita terms), driven by a mild recovery in construction, tourism and maquila activity, while inflation declined to 7.2 percent, in line with the exchange rate crawl. Unfortunately, the fiscal and external deficits also increased, limiting the prospects for a more robust economic take-off. The external sector 1.13 The external current account deficit increased to 5.2 percent of GDP in 2003 (from 3.1 percent in 2002), reflecting a continuing deterioration of the terms o f trade, weak export growth (except for the maquila services sector), and a significant jump in imports (9 percent) that i s largely attributable to higher oil prices. Depressed global economic conditions, particularly in the United States, are partly responsible for the lackluster export performance. Another contributing factor i s likely to be the appreciated real exchange rate. The real effective exchange rate depreciated b y a cumulative 8 percent in 2002 and 2003, but this has only partly compensated for the 35 percent appreciation that occurred between 1997 and 2001. As shown in Figure 1.1, Honduras exhibits the greatest real exchange rate appreciation since 1997 in Central America. 1.14 The real appreciation of the Lempira has been driven by three forces, the first o f which was the significant inflow of foreign aid in the aftermath of hurricane Mitch. These aid inflows have abated as post-hurricane reconstruction activities came to an end, but were replaced b y the rapid growth of foreign remittances; see para. 1.8. A third influence has been the exchange rate setting mechanism. The exchange rate i s determined in daily auctions, within a crawling band of plus/minus 7 percent. However, even though the exchange rate band allows significant flexibility, the market exchange rate has remained at the most appreciated side of the band since 1998.* 1.15 Looking toward the future, Honduras's external sector i s about to receive a major jolt with the creation of the U.S. - Central America Free Trade Area (CAFTA). Negotiations on the CAFTA between the Central American countries and the United States were successfully concluded in December 2003.9 Once the agreement has been ratified by the respective This did not change after October 2001, when the rate of crawl was targeted to the expected differential in the rateof inflation expectedin Hondurasand among its main trading partners. Costa Ricajoined the CAFTA agreement in January 2004. 6 legislatures, Honduras and its Central American neighbors will be faced with major opportunities as well as challenges. The free trade area promises significant opportunities for export led growth and employment creation, but it i s also likely to require internal adjustments in response to increased external competition and declines intariff revenues. The preliminary findings from several recent studies" indicate that CAFTA i s expected to have a positive impact on trade and investment in the Central American countries, including Honduras, and thus ultimately on growth and poverty alleviation. One important reason for this positive impact is increased market access: CAFTA seems to have consolidated and expanded the current generous access that Central American producers enjoy into the U.S. market, while extending broadly reciprocal access to U.S. goods. Caribbean Basin Initiative benefits were consolidated for the Central American countries, and further duty free access to markets of goods that had been previously exempted from those preferences were obtained (i.e., tuna, shoes, and leather goods). Another significant result was the moderate flexibilization of rules of origin for textiles and apparel as well as the relaxation of some non tariffbarriers for non traditional agricultural exports. The other key benefit is associated with the strengthening of domestic reforms: CAFTA commitments lock in a number of recent reforms that opened competition in previously protected sectors (e.g., telecoms, financial services, energy) and the modernization of key norms and procedures (government procurement, intellectual property rights, treatment of foreign investors) by locking in the level of access of currently enjoyed by U.S.- based investors and bidders. (Key measures needed to maximize the potential benefits offered by CAFTA are discussed inAnnex F.) Figure 1.1. Central America: RealEffective Exchange Rates 150.0 I 140.0 130.0 120.0 110.0 100.0 90.0 80.0 70.0 60.0 ++I 50.0 1 I I 1 I I I I Source: IMF. Note: increases inthe REER denote an appreciation. lo These studies include a Bank report on the experiences with free trade areas in other countries ("Lessons from NAETA") and a Bank report on strategies to address the challenges of free trade with a dominant trading partner ("CAFTA Challenges for Central America"). 7 Thefiscal situation 1.16 The public sector deficit (after grants) has been exhibiting a progressive deterioration, from 0.2 percent of GDP in 1999 to 4.6 percent in 2003. This deterioration is mainly attributable to declines in the operating surpluses of the public enterprises and the erosion of tax revenues. The decline in operating surpluses i s largely associated with rising oil prices and sluggish tariff adjustments by the public enterprises, while the erosion of tax revenues i s due to the proliferation of tax exemptions, weakening tax administration and declining import duties. Administrative measures taken by the government have halted the deterioration in the operating surpluses of the public enterprises in 2003, but not reversed it. The government also implemented a three-stage tax reform in October 2002, May 2003 and December 2003, which succeeded inpartially reversingthe earlier tax revenue decline.' 1.17 Total public expenditures have exhibited a little more stability in recent years. The composition o f public expenditures has changed considerably, however, and in a direction that contributes to a stagnation of economic production. In particular, current expenditures and central bank losses have both increased, while capital expenditures declined. The main factor driving the rise in current expenditures has been the public sector wage bill, which increased from 9 percent GDP in 1997 to 13.6 percent in 2003. 1.18 The increases in the public sector wage bill are mainly linked to the special wage regimes that emerged for various public sector employee group. These regimes were created by Congress in 1997, and initially responded to a continuing erosion of real wages during the first half of the 1990s; see Annex B. These regimes cover more than 80 percent of the total central government labor force. The two largest regimes pertain to the teachers and health workers, which together account for three-fourths of the total central government wage bill. A consequence of these regimes is that public sector wages have become the product of political negotiations in Congress and are set in a manner that i s not linked to performance or budget considerations. Moreover, as real wages have risen over time, labor productivity and worker morale in the public sector have declined, reflecting even deeper problems with the civil service system. The authorities took an important first step to reverse this process with the approval of a public wage framework law in December 2003. This law was designed to "The first tax reform included measuresto broadenthe salestax base, unify certain corporate tax rates, raise fees on permits and licenses, and grant a partial tax amnesty. This reform also was accompanied by revenue-reducing measures that included the phase out of selective consumption taxes and reduction of import duties on vehicles, apparel and other goods to 15 percent. The net yield of these measures was estimated at 0.5 percent of GDP on an annual basis. The second tax reform ("Ley de Equidad Tributaria") included measures to close tax loopholes for corporations, broaden the sales tax further, reduce fiscal evasion and improve tax administration. The net yield of this reform was estimated to be around 2.5 percent of GDP on an annual basis. The third set of tax measures ("Ley de Racionalizaci6n de las Finanzas Publicas") included the application of the income tax to public enterprises, increasing the sales tax base and production tax rate on cigarette products, and modifying the taxes on petroleum and relatedproducts. At the same time, an existing 2.5 percent tax retention scheme was abolished. [The net yield of these last measures i s estimated to be less than 0.5 percent of GDP.] 8 restore central government control over the public wage setting process,12 and i s expected to halt the upward creep inthe wage bill as a percent of GDP. 1.19 The deteriorated fiscal and external deficits have led to negative primary(non-interest) balances that are clearly not sustainable. This has put pressure on international reserves, which exhibited a decline of US$lOO million in 2003 (or 7 percent of total gross reserves), and has led to an increase in arrears on the repayment of Honduras's substantial foreign debt. The authorities have been reluctant to allow the monetary base to decline (and interest rates to rise) in response, fearing that this could exacerbate weaknesses in the very fragile financial system.13 In the absence of adjustment, however, further reserve losses are bound to ensue. Seeing that this situation i s untenable, the authorities have been negotiating with the IMF since early 2003 on a macroeconomic program to be supported through a new PRGF arrangement. Agreement on a new program was reached at the end of 2003, and was approved b y the IMF Board inFebruary 2004. The Medium Term Macroeconomic Framework 1.20 The economic program negotiated with the IMF and presented in the first PRSP Progress Report seeks to reverse Honduras's fiscal deterioration, and create the basis for faster growth and reduced poverty in line with PRSP and MDG targets. It aims to raise annual growth to 4.5 percent by 2006 and to reduce inflation gradually to the rates prevailing among the country's main trading partners in 2008. Also, the authorities are seeking to implement all the reforms needed to reach the HIPC completion point by early 2005. 1.21 The program contemplates a progressive decline in the overall fiscal deficit to 3.0 percent of GDP in 2004, 2.5 percent in 2005 and 1.7 percent in 2006; Table 1.3. This fiscal adjustment will reduce the amount of crowding-out in the domestic financial market and, thereby, permit an expansion of credit to the private sector. The deficit reduction i s to be brought about through measures on the revenue and expenditure side. Revenues are scheduled to increase with the implementation of the 2003 tax reform over a full year. Further measures include the strengthening of customs administration and a Tax Code reform designed to improve tax collection and enforcement. Adjustments in public tariffs, especially in the energy and telecommunications sectors, are contemplated in the program to improve the operating surpluses of the public enterprises, while greater discipline in setting public sector wages will help bring down current expenditures. Additional reforms in the area of human resources are contemplated to reduce labor costs further and increase labor 12The law eliminates the special wage regimes, broadens the scope of wage policy to cover all government employees, and places caps on government salaries. A temporary exemption was made for teachers, who will be fully incorporated into the new wage framework by the end of 2006. Untilthat time, the base pay of teachers will increase by slightly less than the inflation target rate, while non-base wage payments (e.g., seniority, education attainment) are capped at end-2003 levels. l3The financial system was especially hurt by hurricane Mitch, since it left many of the system's borrowers, especially in rural sectors, unable to repay their loans. According to official data, non-performing loans currently account for around 14 percent of the banks' total portfolio, with only one-third covered by provisions. The official data may be understating the share of non-performing loans, however, so that the actual state of the financial system is likely to be worse than is indicated here. 9 productivity in the public sector. The resulting increase in public savings will permit the expansion inpublic investment within an overall deficit reduction context. 1.22 The strategy for accelerating growth rests on five elements: (i) increase in public an investment to meet key infrastructure needs, especially in roads, telecommunications and low income housing, (ii)increases in private investment in electricity generation, telecommunications, tourism, maquila and agriculture, attracted by CAFTA and an easing of credit conditions, (iii)reforms in governance and transparency designed to improve the overall investment climate, (iv) structural reforms to improve the efficiency of the public sector and restore a sound financial sector, and (v) a successful conclusion of the CAFTA negotiations, which i s expected to open up further access to foreign markets and promote a .. more competitive environment for domestic producer~.'~ Table 1.3. Honduras: Macroeconomic Framework 1999 2000 2001 2002 2003 2004 2005 2006 actual prelim. program Annual GDP growth rate -1.9 5.7 2.6 2.7 3.0 3.5 4.0 4.5 Inflation rate (CPI, end of period) 10.9 10.1 8.8 8.1 6.8 6.7 6.0 5.0 ConsolidatedPublic Sector percent of GDP Total Revenues 29.7 27.8 27.1 25.8 26.7 27.7 28.1 28.2 olw Tax revenues 18.2 17.3 17.0 16.8 17.5 18.4 18.3 18.3 Operating surplus of PES 5.3 4.6 3.8 2.5 2.4 2.5 2.7 2.7 Total Expenditures 30.6 29.5 32.0 30.6 32.2 31.8 32.0 31.3 Current non-interest 16.7 17.2 20.5 20.8 21.8 20.6 20.0 19.9 olw wages and salaries 10.2 11.4 12.8 13.5 13.6 13.1 12.7 12.3 Interest payments (NFPS) 3.8 3.0 2.2 2.0 2.0 1.9 1.8 1.6 Central Bank losses 0.2 0.0 0.4 0.9 1.1 1.1 1.1 1.1 Capital (incl. net lending) 9.9 9.3 8.9 6.9 7.3 8.2 9.1 8.7 Public Savings 8.9 7.1 3.7 2.0 1.5 3.9 5.0 5.4 Grants 0.7 1.0 1.8 1.1 0.9 1.0 1.4 1.4 Overall Balance (after grants) -0.2 -0.8 -3.2 -3.6 -4.6 -3.0 -2.5 -1.7 Overall Primary Balance (after grants) 2.0 0.5 -2.7 -3.2 -4.1 -2.5 -2.3 -1.8 Investment-Savings Balance Fixed Capital Formation 29.9 26.1 23.6 22.1 23.5 26.0 25.0 25.4 Private Sector 16.8 18.0 19.8 18.5 19.4 Public Sector 5.3 5.5 6.2 6.5 6.0 Gross National Savings 25.4 22.2 18.9 19.0 18.4 18.9 20.5 21.6 Private Sector 17.0 17.0 14.9 15.6 15.7 Public Sector 2.0 1.4 4.0 4.9 5.9 External Savings (including grants) 4.5 3.9 4.7 3.1 5.1 7.1 4.5 3.8 Public Debt Public Sector Debt 81.8 75.8 74.1 72.9 72.1 66.7 51.5 50.7 Public Sector External Debt 77.8 71.5 69.6 68.1 66.4 61.1 46.5 46.2 Source: IMFStaff Report, February 2004 l4The emphasis on productive infrastructure, financial sector strengthening and governance is consistent with our findings in the next section, which identify these three variables, plus education attainment, as the four most important determinants of growth in Honduras. 10 1.23 The government has expressed a commitment to maintaining competitiveness in the more open environment fostered by CAFTA, through an appropriate exchange rate policy and concerted measures to increase domestic productivity. This will require a strengthening of monetary management, in addition to the fiscal adjustments described earlier. To this end, the authorities will capitalize the central bank to compensate for past operating losses, and implement measures, with technical assistance from the IMF, to improve the central bank's ability to conduct open market operations, strengthen the signaling effects of interest rates and strengthen the central bank's lender of last resort functions. In parallel, the government has embarked on a comprehensive reform program to improve the soundness of the financial system. That program builds on the findings of a Financial Sector Assessment Paper prepared jointly by IDA and IMF staff in 2003, and includes actions to (i) improve the prudential regulatory framework and supervision, (ii) enhance the efficiency and effectiveness of the financial safety net,l5and (iii) strengthen mechanisms to prevent money laundering. Also, the government is fully aware of the financial and governance implications of previous bail-outs, while recognizing that the support of depositors in failed banks pre-empts the use of scarce public resources for poverty reducing purposes. Accordingly, the authorities will try to avoid conducting such bail-outs in the future, and inco orate the financial costs of any bail-outs that are deemed unavoidable fully into the budget. Irg C. The MainDeterminants of Economic Growth inHonduras 1.24 The absence of growth emerges as a key issue in the preceding overview. It has been acutely felt during the last five years, as the country recovered from the devastation wrought by hurricane Mitch in October 1998. This poor growth performance i s not a recent phenomenon, however. Honduras has been lagging behind its Central American neighbors since at least the early 1960s; Figure 1.2. It began the 1960s as the poorest country in the region, and lackluster growth during the subsequent forty years meant that its income level continued to diverge even further from that of its neighbors, except Nicaragua, whose economy collapsed during the 1980s on account of civil war. 1.25 Honduras shares the general pattern o f growth common to most other countries in Latin America and the Caribbean (LAC) during the last four decades: it grew steadily during the 1960s and 1970s, and experienced a major slump duringthe so-called "lost decade" of the 1980s. Growth recovered during the 1990s, but at significantly lower rates than those achieved in the 1960sand 1970s; also reflecting the general pattern inLAC. Where Honduras stands out inthis per capita growth comparison i s not interms of pattern, but interms of level, which generally remained below the L A C average in each of the last four decades. Even during the 1960s and 1970s, when Latin America exhibited the greatest growth dynamism, Honduras only managed to grow by 1.8 percent per annum inper capita terms. l5 These measures are especially important, given that the current universal deposit guarantee system i s scheduled to expire in October 2004. Support of the government's financial sector reform program is being supported by an IDA technical assistance credit and by the IMFthrough the PRGF arrangement. Further IDA assistance is contemplated in the Country Assistance Strategy through a separate Financial Sector Adjustment Credit, but not through the PRSC. 11 A growth accountingframework 1.26 To analyze the sources of Honduras's low growth, it i s useful to decompose GDP growth into the growth of factor input quantities and the growth of total factor productivity (TFPG). TFPG is a residual that captures changes in the "quality" of factors used and in the efficiency of factor allocation. The results of this decomposition are summarized in Table 1.4. While the growth of labor and capital inputs account for most of the growth of output, the changes in output growth over different decades are mostly due to changes inTFPG. That is, the contribution of factor productivity growth exhibits greater absolute variability from one decade to the next than the contribution of capital and labor inputs, even after controlling for capital utilization rates. Figure 1.2. CentralAmerica's GrowthPerformance;1960-2000 I I 6000.0 0 #4000.0 `E. `P3000.0 s s S G;,2000.0 ~8L 1000.0 Honduras NI 0 0 I o m 8 & 8 8 oCuD l o a o 1 Source: Own calculations with data from Loayza, Fajnzylber & Calder6n (2002) 1.27 The growth of human and physical capital inputs are related to a country's investment decisions. Looking at the last row o f calculations in Table 1.4, it does not appear that Honduras i s handicapped by unusually low investment levels compared to other Latin American countries. Physical capital growth contributed an average o f 1.76% per annum to growth in Honduras during the four decades between 1960 and 2000, compared to an average of 1.65% for L A C as a whole. This suggests that Honduras' relatively slower growth i s not due mainly to insufficient investment, but to a relatively low growth of total factor productivity. (TFPG averaged close to zero in Honduras over the last four decades, compared to 0.47 percent for L A C as a whole.) O f even greater concern in this regard i s the evolution of total factor productivity. Unlike in other L A C countries, TFPG does not appear to have recovered in Honduras after its decline in the 1980s. (The average annual TFPG i s 0.70% for L A C as a whole during the 1990s, compared to an average of -0.89% for Honduras.) 1.28 The prominent role played by TFPG in the evolution of overall growth suggests that the explanations for Honduras's poor growth performance are more closely related to inadequate factor allocation, than to factor accumulation. This means, in turn, that the 12 economic policy framework, which provides the incentive system that influences decisions on resource allocation, deserves special attention when seeking to identify actions that could help boost growth in a sustained manner. Table 1.4: Honduras Contributionsto Outmt Growth I - output I Componentsof Growth growth 11 I Labor Capital I I TFPG Period SimpleSolow ResidualMethod 1961-70 4.76% I I 1.83% I 1.95% I 0.97% 1971-80 5.39% 2.20% 2.16% 1.03% 1981-90 2.43% 2.30% 1.10% -0.97% 1991-00 3.21% 2.27% 1.83% -0.89% Solow Residual after Accounting for Human Capital 1961-70 4.76% 2.29% 1.95% 0.51% 1971-80 5.39% 2.93% 2.16% 0.30% 1981-90 2.43% 3.91% 1.10% -2.58% 1991-00 ' 3.21% 2.86% 1.83% -1.48% Solow Residual after Controlling for Capital Utilization 1961-70 4.76% -- _- _ _ 1971-80 5.39% 2.05% 2.12% 1.22% 1981-90 2.43% 2.98% 1.14% -1.68% , 1991-00 3.21% 5.30% 1.87% -3.95% Source: Loayza, Fajnzylber& Calderh (2002) The Key Determinants of Growth 1.29 Annex A analyses the main determinants of growth in Honduras, based on the findings of a cross-country study by Loayza, Fajnzylber and Calderh (2002), which relates economic growth to twelve key explanatory variables. These variables include five indicators related to structural policies and institutional development (comprising education attainment levels, financial depth, trade openness, government consumption and public infrastructure), four indicators related to macroeconomic policy outcomes (comprising measures of price stability, output volatility, real exchange rate over-valuation and the prevalence of systemic banking crises), and three exogenous variables (including the terms of trade). These regression results can be used, among other, to predict the future level of growth in individual countries on the basis of forecasts of the future values of the explanatory variables. Inmakingthese forecasts, three scenarios have been considered: the first one assumes that the explanatory variables continue to evolve over the next decade according to past historical trends. The second scenario assumes the implementation of policy reforms that raise all the explanatory variables to the top 25thpercentile of their distribution in Latin America and the Caribbean. The third scenario assumes the implementation of even more aggressive reforms, whereby the explanatory variables are adjusted to the top 25'h percentile o f their worldwide distribution. 1.30 One important finding from the analysis reported in Table 1.5 and Annex A i s that Honduras cannot hope to achieve a significant improvement in its growth performance if its policies simply continue to follow their historical trend. Under that scenario, Honduras's per 13 capita economic growth would barely rise from the 0.12 percent per annum average observed inthe 1990s to 0.51 percent on average over the next decadeunder this scenario. With such a slow growth rate, Honduras would missits PRSP targets for reducing the incidence of poverty b y wide margins; see Table 1.6. Also, this projected increase in growth for Honduras (0.39 percent) compares unfavorably with the other Central American countries, whose average growth rate under a historical trend scenario would increase b y almost one percentage point. This comparison suggests that the progress on reforms historically has been slower in Honduras than inthe other countries inthe region. Per capita growth rates Sources of Differences in Growth 2001-10 1990s Difference External Structural Macroecon. projected actual Factors Variables Variables Historical Trend Scenario HONDURAS 0.51 0.12 0.39 -0.29 0.65 0.04 Average CA 2.83 1.88 0.95 -0.61 1.08 0.49 Average LAC 2.56 1.44 1.12 -0.48 1.08 0.50 Reform Scenario I (75thpercentile of LAC distribution) HONDURAS 2.84 0.12 2.72 -0.29 2.72 0.29 Average CA 4.12 1.88 2.24 -0.61 2.09 0.78 Average LAC 3.64 1.44 2.2 -0.48 1.78 0.90 Reform Scenario II (75th,percentileof global distribution) HONDURAS 4.44 0.12 4.32 -0.29 4.12 0.49 Average CA 5.66 1.88 3.78 -0.61 3.44 0.96 Average L A C 5.22 1.44 3.78 -0.48 3.17 1.09 1.31 Honduras would be able to boost its growth rate significantly by implementing reforms that raise its values of the explanatory variables that determine growth. Under the first reform scenario, which advances the explanatory variables to the top 25th percentile of the LAC distribution, Honduras's average annual per capita GDP growth would increase from a projected 0.5 percent under the historic trend scenario to 2.8 percent. This represents a significant advance for Honduras, but would still fall short in terms of allowing the country to cut the incidence of extreme poverty rate in half by 2015. To achieve this poverty reduction target, Honduras would have to raise the sights on its reform efforts even higher. This would be the case under the second reform scenario, which places Honduras at the top 25% percentile of the worldwide distribution. This scenario would boost Honduras's average growth rate to 4.4 percent. At that rate, it would be feasible for Honduras to meet its poverty reduction target by 2015. 1.32 Table 1.5 also reveals that most of the gain in growth under the two reform scenarios i s due to improvements in the structural variables, rather than improvements in macroeconomic management. This applies on average to Central America and Latin America, but i s particularly pronounced for Honduras. This outcome indicates that, on balance, Honduras's macroeconomic management has been fairly stable compared to that in 14 most other countries in the region, while its structural policies have been relatively less effective. In all cases, external factors are projected to exert a negative influence on growth duringthis decade. Table 1.6: Honduras -- Projected Evolution of Poverty Headcount Indicators 5% annual growth pc 41% 23% Source: Calculations based on a gross elasticity of poverty reduction to growth of 0.63 for total poverty and 0.99 for extreme poverty. These elasticity estimates are from World Bank, Honduras Poverty Diagnostic 2000, June 29,2001. 1.33 Table 1.7 focuses on the impact from each of individual determinants of growth that are included among the structural and macroeconomic variables. It shows that most of the growth increase in Honduras under the two reform scenarios emerges from the simulated expansions of education and public infrastructure. In third place, i s the simulated impact of an expanded financial system. Lmprovements in these three areas explain 95 percent of the increase in growth under the first reform scenario and 92 percent of the increase under the second reform scenario. By way of comparison, the simulated improvements in stabilization polices jointly account for only about 11 percent of the total simulated growth increase in Honduras. The last set of rows in Table 1.7 measures the additional impact of implementing measures to bring about Reform Scenario I1 versus continuing along the historical trend scenario. The results for Honduras once more confirm that the strongest gains in growth would be due to improvements in education, public infrastructure and financial development, in that order. In other words, if Honduras could at least focus on improving these three growth determinants, it could significantly boost growth. 1.34 The simulated expansion in these three growth determinants explains a much smaller proportion of the total projected growth increase in the other countries in the region; about 73 percent for Central America and 61 percent for all of Latin America. The relatively higher impact on growth exhibited by these three variables in Honduras indicates that Honduras lags significantly behind its Central and Latin American neighbors in terms of education attainment, public infrastructure and financial development. Therefore, of the nine policy related determinants of growth considered in this analysis, catching up in these three areas would yield the greatest growth payoff in the future and, thus, merit priority attention. 15 Table 1.7. The Key Determinants of Growth in Honduras Structural Policies Stabilization Policies Education Financial Trade Gov't. Public Sum: Inflation Cyclic. RER Bank Sum: Depth Open. Cons. Infrastr. Volatility Overval. Crises HONDURAS 0.12 0.08 0.05 -0.33 0.73 0.65 0.03 0.03 -0.02 0.00 0.04 Average CA 0.29 0.13 0.23 -0.04 0.48 1.08 0.10 -0.02 0.04 0.36 0.49 Average LAC 0.39 0.14 0.25 -0.12 0.42 1.08 0.09 -0.05 0.04 0.42 0.50 Reform Scenario I (75n' percentile of LAC distribution) HONDURAS 1.37 0.14 0.00 0.14 1.07 2.72 0.04 0.25 0.00 0.00 0.29' AverageCA 0.82 0.13 0.06 0.48 0.60 2.09 0.10 0.13 0.19 0.36 0.78 Reform Scenario I1(75"' percentile of Global distribution) HONDURAS I 1.72 1 0.60 1 0.16 10.00 1 1.64 14.12 1 1 0.07 1 0.42 I 0.00 I 0.00 10.49 Source: Annex A. Notes: the figures for Central America exclude Guatemala and include Panama. 1.35 Finally, there i s a case to be made for also considering governance among the areas where additional efforts may yield a very high growth impact. Measures of governance were not included among the nine policy related growth determinants because they turned out to be statistically insignificant when included among the other variables. However, the governance indexes exhibited among the highest positive bivariate correlations with per capita GDP growth of all the explanatory variables used in the regression analyses. Loayza et a1 (2002) interpret this finding to mean that the effect of governance on economic growth works through the actual economic policies that governments implement. Furthermore, Honduras consistently ranks among the worst performers in international governance comparisons. For example, Transparency International's Corruption Perceptions Index ranks Honduras well below the regional and global averages; Figure 1.3. In other words, Honduras also lags far behind in this area, so that the adjustment of governance indicators toward regional or global standards could have a potentially large pay-off interms of growth. D. MainConclusions 1.36 Honduras has a record of poor economic growth over the last four decades, even though its macroeconomic environment during that period featured a high degree of income stability and low inflation compared to most other countries in the region. Following the advent of hurricane Mitch in late 1998, Honduras exhibited a progressive deterioration in its fiscal accounts, which threatened to destabilize the economy and, thus, raise additional hurdles to growth. Aware of this danger, the Honduran authorities have begun to implement corrective measures in 2003 to reverse this deteriorating trend, under a program that has earned the IMF's support through a new PRGF arrangement that was approved in February 2004. The restoration of greater fiscal discipline constitutes an important step toward improving the prospects of achieving growth and poverty reduction. As Honduras's historic 16 record has shown, however, maintaining a stable macroeconomic framework i s not enough to achieve a significant acceleration of growth. Rather, the authorities also will need to address deficiencies in other areas that have been shown to be related to economic growth. Unfortunately, most developing countries - and Honduras i s no exception - generally exhibit important deficiencies in very many areas. Attempts to address all of these deficiencies simultaneously, on the other hand, are bound to fail on account of limited resource and managerial capacities. The challenge facing the authorities, therefore, is being able to focus their limitedresources on the most relevant growth determining factors. Figure 1.3: Perceptionsof CorruptioninLatinAmerica & Caribbean, 1999-2000 CPI 2000-2002 LAC Countries Source: Transparency International. Note: the CPI index is an inverse measure of corruption perception: ranging from a value of 0 (most corrupt) to 10 ("corruption free"). 1.37 The preceding analysis has sought to identify the growth determining factors that appear most relevant for Honduras. First, it established that Honduras's poor growth i s not due mainly to insufficient investment, but to low total factor productivity growth. This finding draws attention to the quality of factor inputs and their efficient deployment (which are closely related to the country's policy framework and incentive structures), rather than to the quantity of factor inputs. Secondly, the analysis identified four broad areas (human capital, public infrastructure, financial market development and governance) where Honduras appears to be lagging significantly behind in its development vis-&-vis other Latin American countries and the rest of the world, and where policy advances could have a potentially large payoff in terms of raising growth. This does not mean that the other growth determinants can be ignored or neglected. For example, even though setting the outcome variables (Le, inflation, cyclical volatility, etc.) associated with stabilization policies to the 75thpercentile of their world distribution would only be expected to generate a modest improvement in growth in Honduras, allowing those policies to slip could have disastrous consequences in terms yielding a growth decline. Rather, it means that Honduras has been managing these other policy areas reasonably well by world and regional standards, and would do well simply by maintaining their historic trend. However, staying on its historic trend in all policy areas would leave Honduras on an unacceptably slow growth path, so additional efforts need to be 17 exerted in at least some areas to bring about significantly faster growth. The preceding discussion suggests that this additional effort would have its greatest impact on growth if invested in human capital development, public infrastructure development, financial market development and improved governance. The key issues and obstacles to development in each of these areas are the subject of the remaining chapters of this DPR. 18 19 Chapter 11. EDUCATIONAND GROWTH Introduction 2.1 Chapter Ihas drawn attention to the importance of education, or human capital in general, as a determinant of growth. In particular, the growth regressions reported in Annex A identify the expansion of education levels as the single most important growth determinant for Honduras, followed by the expansion of public infrastructure and financial sector deepening. 2.2 These findings go hand in hand with those of the World Bank's 2002 L A C Flagship Report,' whose central premise i s that skills and technology interact in important ways that are fundamental for explaining the large observed differences in productivity and incomes across countries. According to that report, the main challenge for restoring growth in Latin America i s the need to close the gap in skills and technology that separate the slower growing Latin American and Caribbean (LAC) economies from the faster growing economies in the rest of the world. This challenge has largely superseded the earlier challenge of needing to close the external and fiscal financing gaps, which have afflicted the L A C economies in earlier decades. Moreover, just as the external and fiscal financing deficits had to be closed in tandem, the gaps in skills and technology must also be closed simultaneously in a quick, sequential and coordinated manner. The report finds that leapfrogging over different stages of development i s seldom successful and often results ininefficient and unequal development. 2.3 With respect to technology, it is useful to consider three broadphases of development: Countries at the `adoption' stage are characterized by poorly developed and incipient innovation-related institutions, low levels of skilled labor and generally low levels of market competition. Firms at this stage often adopt technologies that are well below the frontier and innovations are generally imported. Technological advance i s external for these economies and the key to improving productivity i s the adoption of those advances into domestic enterprises. At the "adaptation" stage that follows next, firms begin to adapt existing technologies and bring about process or product innovations, taking advantage of local resources and adjusting to local conditions. Skill needs become more specialized at this stage, as does the policy environment. Finally, there i s the "creation" stage that applies to firms that have been present in global markets - adapting existing technologies and selling their products at lower cost than their competitors. As these firms are faced with increasing competition from other low cost producers, they are forced to defend their market positions by creating new products and processes, which require increasing amounts of research and development activity and a highly skilled labor force. IDe Ferranti, G. Perry, IGill, J.L. Guasch and N. Schady, "Closing the Gap in Education and Technology", World Bank LatinAmerican and CaribbeanStudies(Washington, D.C.: World Bank, 2002). 20 2.4 Turning to labor skills, we can think of a natural progression in the education profile of the population, which begins with a gradually narrowing education `pyramid', with a wide base consisting of workers with at most a primary education, a middle layer of workers with some secondary education and a small top layer of workers that have completed the secondary level and may have some university training. As education coverage at the primary level becomes universal and increasing numbers of students enter secondary school, the education profile evolves into a `diamond' shape characterized by a wide middle section. As education attainment levels increase further and attendance at the secondary level becomes universal, the education profile turns into an `inverted pyramid' where most workers have complete the secondary level and may have some university training. 2.5 The Flagship report finds that for sustained development and rapid growth, the transition across the different technological stages i s best accompanied b y a parallel transition in the country's education profile. I do not occur inparallel, there is a high likelihood they that the shortcomings on one side will constitute bottlenecks for the other. That is, a lack of sufficiently trained workers will inhibit the adaptation or creation of new technologies, and conversely, the failure to adopt or adapt more sophisticated technologies keeps down the demand for high-skilled labor, depressing their wages and reducing the incentives of workers to acquire more education.2 2.6 Honduras i s in the first (adoption) stage of technology development and in the pyramidal stage of the educational progression. Accordingly, this chapter will mainly focus on the primary and secondary levels of education, which are the most relevant for countries at this stage. Its purpose is to identify the main bottlenecks to the improvement of education indicators in Honduras and to discuss measures for overcoming these bottlenecks as part of a broader strategy to boost growth. Section A, which follows next, describes where Honduras stands in terms of educational outcomes, highlighting the main challenges ahead in the education sector. Section B reviews the patterns of education spending in Honduras, including its efficiency and distribution. Section C discusses the fiscal challenge of expanding primary and secondary education coverage levels to achieve the target increases contemplated in Honduras's Poverty Reduction Strategy Paper (PRSP). The concluding section presents the main policy recommendations. 2.7 As pointed out earlier, closing the gap in education will also require parallel efforts to close the gap in technology to avoid bottlenecks that would eventually paralyze growth. A discussion on measures to begin closing the technology gap i s provided in Annex E, in the context of a preliminary assessment of Honduras's national innovation system. For countries that, like Honduras, lie very far from the technology frontier, the most important technology policy i s arguably their basic education policy, coupled with an open trade policy. Accordingly, the primary focus of attention in this report i s Honduras's basic education system, while other areas of technology policy are reported on a case b y case basis. *Similarly, attempts to leapfrog across the different stages are likely to fail. Some countries exhibit `anvils' in their education profile, where the base and top layers of the education distribution are wider than the middle, which consists of individuals with some secondary education. Such a pattern has many drawbacks: it means that university students are drawn from small pools of applicants that may not include the most gifted in society, it perpetuates income inequalities, and leads to large-scale skill mismatches during the adaptation stage of technological development, which depends heavily on workers with secondary education. 21 A. Status and Evolutionof Education inHonduras 2.8 Honduras has exhibited a steady improvement in its educational indicators over the last four decades, although at a slower pace than in the rest of Latin America. The mean years of schooling o f its adult population increased from 1.69 in 1960 to 4.08 in 2000; a gain of 2.38 years, compared to an average gain of 2.80 years achieved by the other Latin America countries. A notable achievement i s the very high gross and net enrollment rates attained in primary education, with over 90 percent of children in the range of 7-12 years attending school; Table 2.1 Table 2.1. Honduras: Key Education Indicators by Level, 2001 Source: Based on figures from the Ministry of Education, adjusted for the 2001 Population census and 2002 Household Survey; 2002 School Mappingand SIDNSAREC 2001. Notes: (A) The secondary enrollment rates refer to the year 2002, while tertiary enrollment rates refer to 2000. (B) The Coverage rate refers to the proportion of the relevant school age population that i s in school: 5-6 years for pre-primary, 7-12 years for primary, 13-15 years for lower secondary and 16-18 for upper secondary. (C) the Gross Completion Rate i s calculated as the ratio of students enrolled in the last grade minus repeaters and drop-outs (whatever their age) and the relevant school age population. (D) The Expected Completion Rate i s defined as the Gross Intake Rate multipliedby the Survival Rate. 2.9 Table 2.1 also shows important shortcomings relating to education coverage and efficiency. These are (i) a very low coverage of pre-primary education, (ii) internal low efficiency at the primary level, which translates into low completion rates, (iii) low coverage of secondary education, at both the lower and upper levels, and (iv) substantial inequities across the urbadrural divide at the secondary level. The education system i s characterized by very high drop-out rates, with the result that only 1 student out of 2 makes it to grade six, 1 student out of 5 reaches grade nine, and less than one student out of 10 reaches grade 12. Furthermore, only 1 student out of 3 makes it to grade six in six years and less than 1out of 10 makes it to grade nine in nine years. 2.10 Insum, even though gross enrollment rates at the primary level inHonduras are quite high, and comparable to those in other countries of Latin America, highdesertion rates at the primary level and low coverage at the secondary level have largely nullified this benefit, with the consequence that its net enrollment and completion rates at the secondary levels are among the worst in Latin America. In 2000, only 17.1 percent of the adult population had at least some secondary or tertiary education, which i s less than half the amount exhibited on average by the rest of Latin America (35.4 percent). Only Guatemala and Haiti exhibit lower 22 share of post-primary education attainment. The low coverage at the secondary education level i s especially worrisome from a growth standpoint in view of the high rate of return earned on investments inthis level of education; Box 2.1. Education Quality 2.11 There i s compelling evidence, based on international and national standardized tests, suggesting that the educational quality of the primary cycle in Honduras i s very low. This may explain the country's high repetition and drop-out rates. In 1998, Honduras participated inan international study that assesses language and math skills inthe third and fourth grade of ed~cation.~Out of the 12 Latin American countries participating in that study, Honduras ranked last for language and next-to-last for math. Also, Honduras has been applying annual standardized tests since 1997 to a sample of schools through the External Educational Quality Assessment Unit (UMCE), to measure language and math skills in grades 3 and 6. These annual tests consistently yield results that average out to a rating of "very low". Furthermore, there does not appear to be a perceptible improvement in the ratings over time. This may be reflecting in part the high levels of teacher absenteeism and little spending on materials & supplies that characterize Honduras's public education system. Analyses of the determinants o f educational quality carried out with the 2002 UMCE database indicate that, in addition to the standard socio-economic factors, test scores are also significantly correlated with effective hours of schooling, the availability of teaching materials and teacher experience. Explaining School Desertion 2.12 According to recent survey results: the main reason why children drop out of school in Honduras has to do with performance and adaptation problems (which accounts for 37.5 percent of all survey responses), followed by economic reasons (32.1 percent) and accessibility problems (12.2 percent). When separated b y age groups, performance and adaptation problems (52.7 percent) were the dominant reason for desertion in the first two grades, while economic reasons (49.3 percent) dominated from grade six onwards. That is, children over 12 years of age mainly drop out for economic reasons, which have to do with the opportunity cost of labor or the direct costs of attending school. 2.13 The preceding survey results indicate that the most important barriers to the expansion o f secondary education may lie on the demand side in Honduras. Offhand it i s not clear, however, whether the dominant obstacle i s the opportunity cost of lost labor income or direct costs associated with school fees. Secondary school fees are likely to be significant in Honduras, given that over 50 percent o f total secondary schooling in Honduras takes place through private schools. Estimates of the rate of return to education in Honduras indicate that the yield to completing secondary education i s especially high compared to the returns to The First International Study on Math and Language and Associated Factors in LatinAmerica, coordinated by the Latin American Laboratory for the Assessment of Educational Quality (LLECE). 4The 2001 National Family Health and Epidemiological Survey collected data on reasons for leaving school for children aged 7 to 14 years, as reported by their mothers. These survey responses can be classified into three groups: economic reasons (which include an inability to pay schooling fees and the opportunity cost of lost labor income), poor class performance or a dislike of school (both of which are highly correlated) and access problems (which include the absence o f school facilities within reasonable distance). 23 primary and tertiary education. This last finding argues against the notion that students drop out before completing secondary education because additional investments in this level of education are not adequately rewarded. Box 2.1: The Rateof Returnto EducationinHonduras Education i s still a very scarce asset in Honduras. As argued in the human capital literature (e.g., Psacharopoulos,1994), education obeys the same pattern of declining marginal returns as any other capital asset. This is corroborated by cross-country empirical evidence, which indicates that the rates of return to education across countries are negatively correlated with the amount of education attainment (or mean years of schooling) observed inthose countries. Therefore, given the low levels of education attainment observed in Honduras, we should expect to find the rate of return to education to be very high. The rate of return to education at different levels in Honduras was estimated, using 1998 data, by regressing the natural log of labor earnings against age and a series of dummy variables that refer to the completion of different schooling cycles, as well as other explanatory dummy variables denoting, gender, territory and location. This estimation procedure corresponds to the "extended" earnings function method, where the coefficients obtained on the education dummies are interpreted as the private rate of return to an additional year of education at that level. The regression yields the following coefficients (all of them significant at the 1 percent level): Education Dummy Var. Coefficient Other Explanatory Variables Coefficient Primary 0.080 Age 0.680 Lower Secondary 0.083 Age Squared -0.001 Upper Secondary 0.141 Female -0.230 Tertiary 0.132 Rural -0.294 Post-Graduate 0.050 The rate of return to primary education and lower secondary education i s 8 percent, while the highest rate of return i s exhibited by the upper secondary level (14.1 percent), followed by the return at the tertiary level (13.2 percent). The high return to upper secondary education diverges from the pattern seen in other Latin American countries, where the tertiary level generally yields a significantly higher rate of return than the secondary level. Regression results for Colombia and Chile, for example, yield rates of return between 5 and 8 percent for secondary education and between 18 and 22 percent for tertiary education. The high rate of return for upper secondary education may be reflecting Honduras's low enrollment rates at that level, which translates into a scarcity of skills. It i s also signaling that there i s demand for those skills, which i s not being met. Finally, the regression results also point to significant wage disparities along gender and ruralhrban lines. 2.14 To the extent that the direct cost of secondary education i s an important obstacle to education, the authorities may consider measures to reduce these direct costs, either through the subsidization o f school fees (e.g., through scholarship programs) or the provision of public secondary schools in remote areas. To the extent that the opportunity cost of lost labor income i s relevant, the government could consider corrective measures through compensatory transfers or the promotion of more flexible, alternative delivery mechanisms that permit schooling while holding down a job (such as the `Educatodos' or SAT programs discussed below). Demand side responses also could include advertising campaigns to influence perceptions about what constitutes an appropriate level of education. As people begin to 24 perceive that a completed secondary education i s becoming the norm for most children, they are likely to demand more education for their own children to avoid the risk of their falling behindinsocio-economic status. Distribution of Education Outcomes 2.15 Honduras i s in the first (adoption) stage of technology development and in the pyramidal stage of the educational progression. Accordingly, this chapter will mainly focus Enrollment and completion rates at the primary level are fairly equally distributed across urban and rural areas, pointing to the success of previous efforts to raise primary enrollment in rural areas.5 Unfortunately, these gains do not extend to the secondary level, which continues to exhibit extremely highdisparities in enrollment rates at both the lower and upper levels; Table 2.1. This finding suggests that access to secondary schooling remains a significant problem inrural areas. 2.16 Primary completion rates also are very unequal across income quintiles in Honduras. The proportion of children that complete the primary cycle increases systematically with the level of income, and i s almost twice as high for children in the richest quintile as those in the poorest quintile; Table 2.2. It is also notable that completion rates do not seem to have improved over the last decade and, in some cases has even deteriorated. Source: Household Survey, various years. B. EducationSpendinginHonduras 2.17 Public education expenditures6 remained fairly steady during most of the 1990s and then increased rapidly after 1998, both as a share of GDP and of total public expenditures; Table 2.3. This rising trend after 1998 was triggered by increased foreign assistance in the wake of hurricane Mitch, much of which was directed to the social sectors. As a consequence, Honduras currently devotes over 7 percent of GDP on public education, which ranks among the highest education spending ratios inCentral and Latin Americae7 These efforts were supported, among other, by the World Bank through the PROHECO model. As calculated here, total public education spending includes all public funds, from domestic and external sources, directed to the educational system through public institutions. Private spending on public education i s estimated to be an additional 30 percent of this total, while private spending on education channeled through private institutions represents another 32 percent of total public education spending. During 1995-97, public education expenditures averaged 3.4 percent of GDP in Central America and 4.1 percent in Latin America and the Caribbean; UNDP Human Development Report, 2002. The latter figure is comparable to Honduras's pre-1998 education spending. 25 Table 2.3 Honduras: Evolutionof PublicSpendingon Education; 1997-2002 I 1997 I 1998 I 1999 I 2000 I2001 I 2002 I (In constant 2002 USDollars) GDP per capita 969 965 916 956 954 957 ~ GDP (millions) 5,794 5,964 5,852 6,138 6,298 6,469 Total Central Govt. Expenditures(millions) 1,167 1,210 1,441 1,635 1,687 1,694 Central Govt. Spendingon Education(mill.) 245 237 316 374 451 465 I I (Dercentapes1 I Educationspending/ Total Govt. Exp. " I 21.0 19.6 22.0 22.9 26.7 27.4 Educationspending/GDP 4.2 4.0 5.4 6.1 7.2 7.2 Total Govt. Exp./GDP 20.1 20.3 24.6 26.6 26.8 26.2 2.18 The recent trend in education expenditures also translates into significant increases in per student spending at all levels; Table 2.4. Even though Honduras was able to almost double public spending in education, however, it continues to rank near the bottom of the Latin American region interms of the absolute amount spent per student. This finding simply reflects Honduras's income level, which i s extremely low by Latin American standards. Table 2.4 Honduras: Total EducationSpendingper Student by Level Secondary 197.7 306.4 372.6 433.0 439.0 Tertiary 811.3 828.0 906.9 933.0 na TOTAL 126.5 155.3 189.3 217.3 na As % of per-capitaGDP 13% 17% 20% 23% na 2.19 The primary education level absorbs about 40 percent of the total education budget in Honduras. This i s broadly in line with the share devoted to primary education in other Latin American countries.8 The share devoted to the pre-primary level i s 5 percent of the total, while secondary education absorbs 18 percent. Both of these shares are significantly below the average in Latin America. (The average share in L A C for secondary education i s around 30 percent.) The share of the education budget spent on higher education in Honduras (through transfers to the two autonomous public universities) i s also 18 percent (Le., as much as on secondary education). This last share i s comparable to the shares spent on this level by the richer, southern cone countries of Latin America. One worrisome feature in Table 2.5, i s the rapidly increasing share of spending on headquarters administration, which currently absorbs almost one-fifth of the education ministry's total budget. * Honduras'seducation cycle consists of five levels: (i)non-compulsory pre-primary cycle of 2 to 3 years, (ii)a a primary cycle of 6 years, (ii)a lower secondary cycle ("ciclo comu'n") of 3 years, (iv) a higher secondary cycle of between 2 to 4 years, depending on whether it culminates in a baccalaureate or in technicalhocational training, and (v) a tertiary cycle lasting from 2 to 8 years. 26 2.20 An important organizational aspect of the Honduran education sector i s the degree of private sector participation, which varies greatly across levels. Private schools only account for an estimated 5 to 10percent of the total enrollment at the pre-primary and primary levels, and almost 20 percent of total enrollment at the tertiary level. Incontrast, they are responsible for slightly over half of the total enrollment at the secondary level. The private secondary schools are virtually all located in cities, so that the availability of secondary schooling in rural areas depends entirely on public provision. Whereas the Honduran government made a concerted effort in the 1990s to expand the coverage of primary education in rural areas, no similar effort has been made at the secondary level. Source: SEFIN (SIAFI). Figures for 2002 refer to the budget. 2.21 Given Honduras's low education achievement indicators, the rising trend in education spending i s very welcome. However, there are serious concerns about the effectiveness of these expenditures. Most of the increase in per student spending has been driven by increases in the education sector wage bill, without proportional improvements in education outcome indicators. For example, even though per student spending on primary education increased from US$ 89 in 1998 to US$151 in 2002, two key education achievement indicators - the sixth grade completion rate and test scores - have been stagnant or decreasing over the same period; Figure 2.1. This finding suggests that the increase in spending was accompanied by significant losses in sector efficiency. 2.22 The main factor responsible for driving up the education sector wage bill has been the rising trend in teachers' wages, which is largely associated with the approval of the Teacher Statutes in 1997. This Statute boosted teachers' wages through three channels: (i) the indexation of teachers' base salaries to the minimum wage, beginning in 1998, (ii)the introduction of new salary allowances9 in 1998 and 2000, and (iii) increases in the base salaries negotiated in excess of the inflation rate during 1998-2002. This combination of factors raisedteachers' gross wage by about 40 percent inreal terms over 1998-2002. The "Estatuto del Docente" establishes seven types of allowance associated with (i) (ii)years of teaching title, experience (seniority), (iii)academic achievement (academic title), (iv) professional achievement and merits, (v) geographic location ("zonaje"), (vi) managerial rank or position, and (vii) school category. The allowance for "title" i s particularly generous, amounting to 69 percent of the base salary. I t is given to all teachers that have a tertiary degree or that are licensed to teach as secondary level professor, independent of whether they are teaching at the primary, secondary or tertiary level. Teachers that have started, but not yet completed, their tertiary degree are given half the title allowance. Once an allowance has been granted - be it for title, management rank or geographic location - it i s rarely revoked, even when the teacher is subsequently reassigned to a different position or location that would not merit the allowance. 27 Figure 2.1. PrimaryEducationSpendingandOutcomesinHonduras 160 i T 140 UnitCosts Rimry (US$/student) u) 120 2 ;100 I E 80 - Primary completion rate I v) B I -m .- 60 L Spanish test scores 40 - L - 1 20 0 I , , Source: UMCE (2000, 2001), Schiefelbein (2001) 2.23 Real teachers' wages had been declining prior to 1998, which helped to raise political pressures in favor of the Teachers' Statute. The adjustment that took place since then has fully compensated for the earlier real wage erosion. Household survey data show that the yearly net income received by public primary and secondary teachers in 2002 (US$3,550 and US$5,000) i s in line with the salaries receivedby other public servants with similar levels of education. When these salaries are evaluated in relation to the hours effectively worked, however, teachers receive a substantially higher wage rate than their peers elsewhere in the public sector. They also receive a proportionately higher wage inrelation to the country's per capita GDP than their colleagues in other countries inthe region. 2.24 According to the education ministry's payroll figures, another factor contributing to the rising wage bill, albeit to a lesser degree, has been the increase in the number of teachers employed (especially at the primary level) and an increase in class hours being taught at the secondary level. These payroll figures, however, are not supported by other education ministry statistics, which show that student-teacher ratios have been constant or increasing during 1998-2001. This suggests the presence of "ghost" teachers on the payroll and an over- estimation of class hours. Teacher absenteeism i s particularly high in Honduras. According to some estimates, only 110days are effectively worked in some years, out of the 200 days in the official school calendar. 2.25 The Honduran government took a major step forward to contain the growth of teachers' wages, and the public sector wage bill in general, with the approval of the wage policy framework law in December 2003. This law places the ministry o f finance in control of the wage bargaining process and phases out most of the provisions of the special wage regime for teachers b y 2006. While this measure will help reduce the cost of public education, further measures are needed to improve the quality of spending and labor productivity in the sector. This includes additional civil service reforms to provide better performance incentives, and well as sector-specific measures to eliminate "ghost" workers 28 from the payroll and reduce teacher absenteeism. Steps to decentralize the education sector, by transferring more resources and management responsibilities to local communities, could significantly improve the monitoring of teacher performance. TheDistributional Equity of Education Spending 2.26 A personal benefit incidence analysis prepared on the basis of the 2002 September Household Survey indicates that education spendingi s distributed in a pro-poor manner at the lower levels o f education, but becomes increasingly unequal at the higher levels, Table 2.6. Public spending at the pre-primary and primary levels yields the highest benefit for people in the lowest social-economic quintiles, which have the highest proportion o f children enrolled at those education levels. This situation i s reversed in the case of secondary education, where the richest quintile receives twice the benefit of the poorest quintile. Public spending on tertiary education exhibits the greatest inequities, with the richest quintiles receiving as much as seventy times more than the poorest quintile. This result follows directly from two factors: public spending per student i s highest at the tertiary level, but almost no members from the lower quintiles attend the universities. If the average subsidy provided to tertiary students were cut by 75 percent, equating it to the average subsidy provided per student in the education system overall, it would yield an estimated fiscal saving of almost US$ 50 million, or about 0.8 percent of GDP. Quintiles: I I1 I11 lv V Average (poorest) (richest) Per capitasubsidy: Pre-primary level 1.57 1.54 1.29 1.24 1.09 1.39 Primary level 35.48 I 33 Secondary level 8.89 I 16.35 I 12.55 I Source: INE, Householdsurvey, September 2002, Table 3. (Note: weighted data) C. The Fiscal Challenge of Expanding Primary and SecondaryEducation 2.27 Honduras needs to expand its primary and secondary education attainment levels by a significant amount if it hopes to close the education gap vis-&vis its Latin American peers and catch up interms of growth performance. The country already devotes an extremely high share of its GDP to education, however, and a further expansion, especially through fiscal means, would jeopardize macroeconomic stability. It will, therefore, have to rely primarily on efficiency reforms to achieve the desired education expansion. 2.28 In 2002, Honduras was among the first countries to apply to the Education For All - Fast Track Initiative (EFA-FTI) and in doing so committed itself to raise the completion rate in the primary cycle from 69 percent in 2001 to 100 percent in 2015. Honduras also established several targets for secondary education in its 2001 Poverty Reduction Strategy Paper, which include raising the net coverage rate at the lower secondary level to 70 percent by 2015, and to 50 percent at the upper secondary level. If these targets are met, Honduras's 29 gross secondary enrollment rate would approximately double over the course of the next decade, raising i t to the 75thpercentile of the Latin America distribution. Other things equal, such an increase could boost growth by as much as 1.4 percent per annum, according to the calculations in Annex A. Raising the Primary CompletionRate 2.29 To achieve the target o f universal completion in the primary cycle, the EFA-FTI initiative contemplates an ambitious reform program that focuses on four areas: (i) improving the efficiency o f primary education cohort flows, (ii) improving the coverage and quality of pre-school education to prepare and retain students who will enter primary education, (iii) improving teacher quality and efficiency, and (iv) improving the demand for education and participation in disadvantaged communities. Other important elements to improve cost- efficiency at the primary level include slowing down the growth of teacher wages and raising the pupil-teacher ratio. The successful implementation of these reforms i s essential for achieving the universal completion target without adding to the country's already high fiscal burden. 2.30 The simulations described in Annex D show that under reasonable assumptions about the gains in internal efficiency," it i s possible to reach the universal completion target, while reducing the recurrent costs associated with primary education from the current level of 2.6 percent of GDP to 2.0 percent of GDP in 2015 . (These simulations would yield even greater cost savings by cleaning up the payroll figures to reduce the number of ghost teachers.) This i s an encouraging result, given that the country also faces the challenge of expanding secondary education, which i s likely to require a reallocation of public resources toward this currently under-funded sector. Expanding Secondary Enrollment Rates 2.31 This section presents service expansion projections and fiscal cost estimates for achieving the secondary net coverage targets given inthe PRSP. The gross enrollment needed in each year to reach these targets is estimated from the growth projections of the total population and of the relevant sub-groups associated with each school cycle, taking into account repetition rates. The total projected enrollment i s then distributedbetween the public and private providers of secondary schooling by assuming that private schooling grows at its historic rate of 3.6 percent per annum, while the public schools absorb the remaining increases in enrollment. Since total enrollment has to grow faster than 3.6 percent per year to reach the 2015 targets, this assumption implies that the public provision of secondary schooling would have to grow faster than the private provision." lo These assumptions involve (i)gradual increase in the average pupil-teacher ratio from 35 in 2001 to 37.5 in a 2015, (ii)reductions in repetition rates over that same period, from 19 to 4 percent in grade 1, from 11to 3 percent in grade 2, from 8 to 2 percent in grade 3, from 5 to 2 percent in grade 4 and from 4 to 1percent in grade 5, and (iii)a reduction in the target drop-out rate from 3.4 percent in 2001 to 0 in 2015. l1 result As a of that assumption, the share of secondary schooling provided by the private sector would decline from 52% in 2001 to 37% in 2015. 30 2.32 Two scenarios are assumed for each of the two secondary cycles: the first scenario assumes that there are no changes in efficiency levels, while the second scenario allows for increases in efficiency, simulated by gradual reductions in repetition rates.l2 In addition, two sub-scenarios are considered for the lower (common) secondary cycle: the first one retains the current structure of service provision, with the traditional secondary institutes predominating over alternative programs (CEBs, Educatodos, SAT, Telebhsica), while the second one places increasing weight on the alternative programs, which generally involve lower costs. These alternative programs only apply to the lower secondary cycle and are described inAnnex C. 2.33 In the presence of efficiency gains, the number of places needed to reach the net coverage targets at the lower and upper secondary levels by 2015 i s clearly lower than in the absence of efficiency gains. The simulation results summarized in Table 2.7 indicate that 67,300 fewer places would be needed in 2015 to reach the secondary net coverage targets in the PRSP, if measures are taken to reduce repetition rates by the indicated amounts. This difference also translates into proportional savings in the number of teachers that need to be hired and in the amount of new school infrastructure needed to harbor the additional students. The adoption o f alternative secondary programs in place of the traditional public institutes would permit additional savings through increases in pupil-teacher ratios and reduced infrastructurerequirements. l3 2.34 The fiscal scenarios in Table 2.7 indicate that in the absence o f any reforms to improve efficiency levels or to change the structure of service delivery in secondary education, public sector spending would have to increase from a current level of 1.05 percent of GDP to 2.35 percent by 2015 to meet the PRSP targets for expanding secondary education. With the implementation of efficiency generating reforms that reduce repetition rates, the fiscal cost of reaching these targets only rises to 2.17 percent of GDP in 2015, while the simultaneous adoption of alternative delivery structures for secondary education services yield additional fiscal savings that would keep the total fiscal cost under 2 percent of GDP. This last scenario involves an increase inthe total fiscal cost by 0.87 percent of GDP, which i s slightly more than the fiscal savings of 0.6 percent of GDP simulated earlier with the implementation of reforms to improve efficiency at the primary level. The remaining difference could be made up by reducing the highly inequitable subsidy that i s currently provided for tertiary students. In other words, the simultaneous implementation of reforms at the primary and secondary levels would allow Honduras to achieve its education targets in a fiscally neutral manner.14 With efficiency gains, the repetition rate in grades 7 through 9 i s assumed to decline from 16 percent to 8 percent in 2015, and the repetition rate in grades 10 through 12 i s assumed to decline from 18 percent to 9 percent. l3The average student-teacher ratio is 25 in traditional secondary institutes and 33 in Basic Education Centers (CEBs). Non-traditional programs (e.g., SATs, Educatodos) rely on private voluntary agencies, so that their expansion would not require the State to hire additional teachers. Instead, there would be other costs borne by the State through financial transfers to communities and NGOs that operate these programs. Similarly, it i s calculated that the infrastructure costs associated with a given number of places at the secondary level would decline by about 40 percent with a greater participation of alternative, non-traditional programs. l4This is not to suggest that the savings from reforms in primary and tertiary education should necessarily be earmarked for spending at other education levels. Rather, the efficiency generating reforms at the primary level and equity raising reforms at the tertiary level are desirable in their own right. Source, ESA Consultores, "Secondary Education Coverage Increase: Cost Analysis and Projection" (July 2003), background paper prepared for the World Bank. Notes: These simulations are calibrated to-yield a net coverage rate of 70 percent for the lower secondary cycle, and of 50 percent for the upper secondary cycle by 2015. The school-age population is assumed to grow annually by 2.64 percent, and real GDP growth by 4 percent. The adoption of an alternative service delivery structure i s simulated by assuming that the shares of total secondary services delivered through the traditional public institutes (plan bisico) declines from 56% to 26% in 2015, while the shares of all other providers increases as follows: CEM from 32% to 39%, Educatodos/SAT from 10% to 30%, and TelebBsica from 1% to 5%. Discussion 2.35 The preceding simulations for expanding secondary education indicate a shift in the balance of public and private funding toward greater public sector funding, either through direct provision in traditional secondary schools and CEBs, through fiscal transfers to programs, such as Educatodos and SAT, and possibly through voucher programs and subsidies to private schools (which have not been analyzed so far). Although the private sector has been the main provider of secondary education services until now, it i s not likely to maintain its dominant position if the system i s to expand coverage in rural areas and among the poorer strata of society. This shift should not be regarded as a negative development, but as an inevitable corollary of tackling the equity gaps in secondary education. 2.36 Increasing the use of relatively low-cost options given by the CEB model or the Educatodos and SAT models constitutes an important element of the secondary expansion strategy. Apart from cost considerations, there are other reasons for wishing to expand these non-traditional service delivery mechanisms: they can better address the needs of isolated and low-income communities, and are compatible with maintaining a job while studying. This helps to address possible demand-side constraints that may exist among poor families with highinternaldiscount rates. The scope for expansion of these alternativeprograms should not be over-estimated, however, as most urban families will continue to prefer the traditional option of a formal school and full range of services. Also, it i s important to ensure that the same rigorous quality requirements are applied throughout the' system, including the alternative delivery models, to avoid the risk o f developing a two-tier education system. The evidence available so far on the quality of outcomes obtained with the Educatodos and SAT programs i s heartening. The challenge i s to ensure that these outcomes are maintained as alternative programs are expanded on a massive scale. 2.37 The expansion of secondary net coverage rates envisioned in the PRSP requires a sufficient flow o f primary school graduates that continue into the secondary level. Ensuring that flow should be relatively easy to achieve, given that (i) enrollment ratios at the gross primary level already are very high (111percent), (ii) the increase inprimary graduation rates 32 required to supply enough primary graduates for reaching the secondary net coverage rate is very modest, and (iii)the margins for efficiency improvements to increase primary completion rates are also extremely high. As indicated earlier, the problems of coverage at the primary level are mainly attributable to substantial inefficiencies at that level, and not to resource constraints. While it will be necessary to increase the staffing of many single- teacher schools, much can be achieved by a rational redistribution of the existing teaching force from over-staffed schools in urban areas and through the creation of rural teaching network^.'^ This implies that it i s not very meaningful to speak of a trade-off between achieving primary and secondary education targets. Moreover, these findings indicate that public efforts to expand second education should not be postponed untilthe universal primary graduation goal i s achieved, but rather that both goals can and should be pursued simultaneously. 2.38 A potentially more important trade-off involves the choice between assigning more resources to promote the expansion of pre-schooling versus expanding secondary education. Existing studies provide little guidance on which investment yields the higher social return. Most countries, however, have chosen to expand their provision of primary and secondary education on a free, or heavily subsidized, basis before moving on to provide free pre-school education. Also, Honduras has been experimenting with alternative programs, managed b y NGOs, that could be considered low-cost alternatives to traditional mechanism for providing pre-school services. These alternative programs should be taken into account when analyzing this trade-off, which requires further study. 2.39 The expansion of secondary education i s likely to confront important demand-side constraints. In addition to the survey findings described earlier (para. 2.1l), the well-known tendency in Honduras for children to leave primary school when they reach the age of 13, whether or not they have completed sixth grade, i s further evidence of a demand-side problem. This problem affects the poor much more than the non-poor, and could largely be addressed through a mix of different education delivery mechanisms, giving priority to mechanisms that are accessible to poor families whose young adults need to work. It may eventually make sense to consider other stimuli, such as cash incentives to remain in school, but only after low cost secondary schooling is widely available and demand-side problems demonstrably persist. D. SummaryandRecommendations 2.40 Improving the completion rate in primary education and expanding coverage in secondary education must be given high priority in Honduras in order to raise the education attainment level of its workforce, which exerts an important influence on the country's economic growth and distribution of skills. Accelerating economic growth and reducing the current inequality in the distribution o f skills (and in the associated income opportunities) l5Honduras is currently piloting the use of rural teaching networks to overcome the problems of education quality facing dispersed rural communities. These communities are generally served by single-teacher schools, which inevitably results in a dilution of the substance to be taught at each class level. The network principle contemplates the transformation of neighboring, multi-class schools into single-class schools, so that children in the network area are assigned to a school according to their class level, rather than according to the immediate vicinity o f their home. 33 would make a major contribution toward helping the country meet its poverty reduction goals. To achieve these sector objectives, Honduras needs to tackle several key problems at the sector and sub-sector level: 2.41 At the overall sector level, Honduras stands out by spending an extremely high share of its GDP on education. However, its education outcome indicators are not commensurate with such high sector spending levels, indicating serious problems of efficiency in the sector. Inadequate control over teacher remuneration and performance i s a major problem. While teachers' wages have spiraled up in recent years, contributing to overall fiscal indiscipline and crowding out other sector expenditures needed for a good quality education, teacher absenteeism remains rampant and student test scores are declining. The issue of teacher management needs to be addressedurgently, giving attention to the following measures: Implement the recently approved wage policy framework law to contain the growth in teacher wages and free up resources for education quality-enhancing expenditure items. Complete a `teacher post review' in all departments, and reconcile the payroll figures with the findings of the review. Revise the Teacher Statutes, possibly in conjunction with more comprehensive civil service reform legislation, so that any allowances paid are attached to positions, rather than to individuals. Establish an effective supervisory system to permit a more rational and equitable teacher allocation across geographic areas. Develop and maintain a comprehensive human resource data base for the education sector (SIARDH). Establish an effective monitoring system to improve teacher attendance rates. Continue expanding the number and role o f Local Education Development Associations (ADELs) in assisting teachers and monitoring teacher performance. With respect to the allocation of public expenditures on education, there are efficiency concerns arising from the rapidly increasing share of sector expenditures devoted to headquarters administration functions, as well as equity concerns about the very regressive distributional pattern of sector expenditures, especially at the secondary and tertiary levels. To address these concerns, we recommend that education sector expenditures be reallocated to, Reduce the share of total sector spending devoted to headquarters administration and reassign those savings to secondary education, especially inrural areas. Reduce the share of total sector spending devoted to the tertiary level and reassign those savings to secondary education, especially inrural areas. 2.43 Honduras has made substantial progress in raising enrollment rates and eliminating urbadrural disparities in the provision of primary education, while the share of public spending devoted to this level conforms to international norms. However, primary completion rates are very low and not improving, while repetition and drop-out rates are very high, largely canceling out the gains achieved by raising the enrollment rates. Also, primary 34 education outcome indicators are very unequally distributed across income groups, thus contributing to the persistence of social inequalities. To address these shortcomings, the authorities are advised to aim for achieving universal completion, without sacrificing quality, by implementing a comprehensive reform package, such as the one promoted under the EFA- FTIinitiative. This reform package should involve the following key elements: Improve internal efficiency through the development of academic standards, efficient student promotion practices and special programs for over-age children. 0 Improve teacher performance and teacher quality by strengthening in-service training, evaluation & supervision mechanisms, and through performance incentives. Promote network mechanisms in rural areas to create economies of scale in delivering services to dispersed rural settlements. Prepare a diagnostic study on completion rates in urban areas (which have shown a declining tendency inrecent years), and design a plan for raising them. Use the fiscal savings generated by the efficiency gains made at the primary level to expand the provision of services at the secondary level. 2.44 Even though investments in education appear to yield the highest rate of return at the upper secondary level in Honduras, gross and net enrollment levels in secondary education are extremely low, while repetition and drop-out rates are very high. Also, the distribution of secondary education i s very unequal, both across urbadrural lines and across income lines. Most secondary education i s currently being provided by private schools, while the education ministry devotes a very low share of its budget to this level. To correct these shortcomings, the authorities are advised to prioritize the expansion of secondary education as follows: 0 Implement reforms to improve internal efficiency by reducing repetition rates. Increase the share of the education sector budget devoted to the secondary level. Promote different public schooling options (Le., CEBs, EducatododSAT, Telebisica) to address the special needs of different groups. 0 Prepare a study that analyzes the scope for introducing demand-side subsidies to help poor households overcome the economic disincentives to secondary school attendance. 2.45 Although this chapter has mainly focused on primary and secondary education, one important finding that emerged with respect to tertiary education refers to its highly inequitable nature. Policymakers are advised to review the distribution of education spending in this light, and to consider a more pro-poor allocation of resources in the sector. Most studies elsewhere have shown that the ratio of private to public goods tends to be much higher in tertiary education than in primary and secondary education. On efficiency grounds, therefore, the beneficiaries of to tertiary education should contribute more to the financing of tertiary education. This calls for greater cost-recovery in the universities. 2.46 Annex E also has drawn attention to the importance of vocational training in the national innovation system. The main institution responsible for this sector inHonduras i s the public training institute, INFOP, which i s responsible both for managing the funds earmarked for vocational training from the payroll tax and for directly providing the vocational training 35 services. As indicated in a recent FIAS report16and the 2004 Investment Climate Assessment (ICA), INFOP has low capacity in terms of numbers of workers that can pass through the system, highadministrative costs, and a bad reputation as an inefficient service provider in the Honduran business community. There also exists a private, non-profit organization that provides vocational training, CADERH. Though more efficient that INFOP, its coverage of training services i s limited and not coordinated with other service providers. Key policy recommendations emerging from the FIAS report and ICA (2004) are to 0 Eliminate INFOP's monopoly as a publicly-funded provider of vocational training services. 0 Separate the functions of providing training services from the functions of setting training policy. 0 Attract greater private sector involvement in directing vocational training policy, in order to achieve a better balance between serving the needs of the productive sector and achieving the national priorities set by the government. 0 Review the role of the public and private sectors in the sector, with the public sector being responsible for establishing accreditation, standards and curriculum, and certification systems, while private institutions are mainly responsible for providing training services. l6ForeignInvestment Advisory Services (FIAS), "Honduras: Reform of Labor Skills Training to Strengthen the Competitivenessof the HonduranPrivateSector-InternalDraft", (IFC and World Bank, 2004) 36 37 Chapter 111. PUBLICINFRASTRUCTURE AND GROWTH 3.1 The empirical findings discussed in Chapter Iidentified public infrastructure as the second most important determinant of growth in Honduras. As described in the 2001 IDB report on "The Business of Growth", there i s a pronounced, multi-directional relationship across countries between income levels and quality of infrastructure. B y helping to reduce transportation costs, expand the scope of the market and facilitate the transmission o f information and knowledge, infrastructure provides the efficiency platform for achieving higher economic productivity and growth. At the same time, higher income levels feed back into larger demands for energy, transportation and communication, strengthening the link between economic development and infrastructure. 3.2 Honduras's infrastructure endowment historically has been very poor. A Public Expenditure Review for Honduras prepared jointly by the World Bank and Inter-American Development Bank in 1995 had recommended reforms in several areas to support the development of modern, efficient and well functioning infrastructure services. These included decreasing the over-extended role of the state in many infrastructure sectors and stimulating greater competition in the provision o f infrastructure services, reforming a rigid and obsolete structure of regulation combined with the application of clear, de-politicized policies for setting tariffs, eliminating excessive micro-management by government of public enterprises, and increasing attention to maintenance requirements inmany sectors. 3.3 A subsequent Public Expenditure Review completed in 2001 concluded that in spite of some advances in these areas, Honduras has yet to overcome the fundamental institutional and policy weaknesses identified in the 1995 Review. Although public expenditures in the infrastructure sectors appear adequate, virtually all indicators of access, efficiency and service quality continue to be low in absolute numbers and in comparison with other countries in the region. The main reasons identified for this sub-parperformance are that sector structures and the related regulatory environment are not grounded in clear objectives of improving operational efficiency and the quality of services to consumers, and that public spending has been channeled predominantly to maintain affordability of services to existing users, rather than to expanding access to new users, especially poor ones. That report concluded with four sets of recommendations that focus on (i) attracting more private participation into the infrastructure sectors under arrangements that give primary attention to improving access, quality and efficiency, rather than maximizing the fiscal revenues of privatization, (ii) strengthening the regulatory and policy environment, (iii) restructuring infrastructure pricing and subsidies, and (iv) ensuring adequate infrastructure maintenance. These four areas also serve as the organizing framework for this chapter, which begins with a review of the access, quality and efficiency of infrastructure service provision in Honduras. A. COVERAGE, QUALITY AND EFFICIENCY INFRASTRUCTURE OF SERVICES INHONDURAS 3.4 Honduras's infrastructure coverage indicators have broadly improved over the last four decades, but at an uneven pace; Figure 3.1. For example, the paved road network 38 expanded rapidly in the 1960s and 1970s, but stagnated in the 1980s, and then declined inthe late 1990s, as attention focused on road rehabilitation, rather than network expansion, in the wake o f damages caused by hurricane Mitch. The growth of electricity generation capacity exhibited a similar pattern of early growth and subsequent stagnation, but was followed with a major growth spurt in the late 1990s, reflecting increased private sector participation. The telecommunications sector, in contrast, has been growing steadily since the early 1970s, but starting from a very low base. The most significant progress appears in the access to water and sanitation services during the late 1980s and early 1990s, where Honduras was able to increase coverage b y an estimated 15 and 25 percentage points. However, this sector also suffered setbacks from hurricane Mitch in 1998, from which it has not yet recovered. Figure 3.1. Access to Infrastructure Services in Central America t0 2.00 0.50 Qd 2 1.80 0.45 1.60 c 0.40 0 1.40 0.35 c 1.20 p 6&0.30 1.00 $ 0.25 p2 0.80 0.20 0.60 0.15 0.40 g 0.10 P 5 0.05 u) 0.20 0.00 0.00 1965 1970 1975 1980 1985 1990 1995 2000 2 250 160.00 & 140.00 0 200 A 0 CR 120.00 3 z g 100.00 -.-.: 150 E 80.00 100 60.00 3 r 40.00 0 50 =Q 20.00 c 0.00 e2 Q 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 Source: Own calculationsusingdata from Fay, Marianneand Tito Yepes, "Investing in Infrastructure" (2003). 3.5 The evolution of infrastructure development in Honduras generally follows the same pattern observed in other Central American countries, notably El Salvador and Guatemala. As i s also the case with these two countries, Honduras ranks well below the mean and median in Latin America and the Caribbean inmost infrastructure indicators, except the provision of safe water; Table 3.1. This i s not surprising, however, given that these countries also have among the lowest incomes per capita in the region. As shown in the cross-country 39 comparisons in Figure 3.2, Honduras's infrastructure indicators are generally in line with those observed inother countries with similar per-capita incomes.' I Electricity 1Paved RoadsI 2000 Telephone Lines I Safe I Sanitation I ~~ Generation Fixed Mobile Water KW/capita Mtdcapita Linedcapita % household access Latin America & Carib. 0.45 1.44 135 102 86 80 Central America & Pan. 0.25 0.84 104 81 88 87 HONDURAS 0.13 0.43 48 24 88 75 Rank in L A C (of 23) I 2Oth 16Ih 2Oth I 22"d 1 1lth 17'h TransportServices 3.6 Honduras's official road network consists of 13,600 kilometers. In addition, there i s an unofficial network estimated to be between 7,000 to 12,000 Krns in length that i s not registered with the transport ministry. About 24 percent of the official road network consists of primary roads, of which 76 percent i s paved. Secondary roads represent 19 percent o f the total and are mostly made of gravel. The paved road network appears to be in good condition, and although most roads are unpaved, a significant port i s classified in fair to good condition. Measured inrelation to population, Honduras's official road network and stock of vehicles lie within the range exhibited by the other Central American countries; Table 3.2. This i s a respectable ranking given that Honduras i s the second poorest country in the region. Moreover, when the unofficial road network i s also factored in, Honduras's road coverage indicators are even better. One aspect that stands out with regard to the stock of vehicles in Honduras i s that the overwhelming majority consists of passenger cars. As discussed below, this reflects the low quality of public transportation services, most of which are supplied through light passenger vehicles. Table 3.2. RoadTransport IndicatorsinCentralAmerica I I I I I I I I I I I I I I I HONDURAS Nicaragua Guatemala ElSalvador Panami CostaRica Source: World Bank Indicators. ' Honduras's coverage indicators for roads, telephone mainlines, safe water access and sanitation access are slightly above the L A C regression trendline in Figure 3.2, while the indicators for electricity generation and mobile telephones are slightly below. In all cases, however, Honduras remains reasonably close to the trendline and does not constitute an outlier. ._._I". E 0 z 0 0 0 7 r 4 0 0 0 0 03 0 m 0 0 0 0 0 0 (D 0 (0 0 0 a a d d a 0 0 a 0 N 0 N 0 0 0 0 a 0 0 0 m 0 a 0 0 0 0 - 0 0 0 0 I_ 0 r 7 m 5 t 0 0 8 II CQ N 111 w 0 a * C 8 c - P -b'P 0 c PI 0 d 0 m a P 0 N 0 41 3.7 Freight transport prices are highinHonduras compared to other developing countries.2 Contributing to the high cost are long delays in ports and airports, drawn out customs procedures, high vehicle maintenance costs, highway robberies and accidents, inappropriate pricing by the government and a lack of competition in the sector. Price controls are particularly damaging for passenger transport, where SOPTRAVI has been fixing passenger fares at between one-fourth and one-half of the appropriate, cost-covering price. This has had the consequence of discouraging bus transport, whose share in total public transport vehicles declined from 80 percent to 65 percent from 1990 to 1997. The resulting substitution of light vehicles for buses has aggravated urban traffic congestion. User surveys indicate that public transport quality i s deficient and the poor have limited access. In Tegucigalpa, bus owners receive a subsidy for each passenger trip, costing the government US$ 8 million per year. Due to the poor quality of services offered, however, passengershave been abandoning public buses in spite o f the heavily subsidized fare, in favor of other transport modalities that often cost significantly more. Another major issue in road transport i s the weak traffic management and regulation, which contributes to the highlevels of traffic congestion inthe cities. 3.8 The quality of ports services is very poor and their productivity is low by international standard^.^ InPuerto CortCs, for example, container ships lie idle 22 percent of the time spent in port, compared to an international standard of 5 percent. Freight management is equally inefficient: general cargo i s moved at the rate of 24-55 tons per hour, versus an the international standard of 90 tons per hour, while dry cargo in bags moves at 89 tons per hour versus the international standards of 1,000 tons per hour. One factor contributing to the low productivity rates i s an excess of personnel. Although the national ports enterprise has reduced the amount of personnel in recent years, it still has five times more staff than needed to operate efficiently (200 persons versus the current level of 1,200 employees). In spite of the low productivity rates, the ports fees charged are in line with international levels, assuring the ports enterprise monopoly a comfortable profit margin(26.6 percent of total sales in 1999 versus the international standard of around 8 percent). As noted in the Investment Climate Assessment (ICA 2004), the loss of competitiveness associated with the low quality of ports services i s substantial. 3.9 The operational efficiency o f the international airports appears to be relatively good.4 They exhibit a labor productivity of 4,134 passengers per employee, which i s considered acceptable b y international standards (which range from 2000 to 5000). Although the charges per passengers are on the high side (US$5 to US$25 to exit), aircraft charges are near the international averages (e.g., US$660 per Airbus 310). The main problems identified inthe air travel sector are the poor quality service at Tegucigalpa due to the lack of electronic aids, extremely short landing strip and overcrowded passenger terminal, high ticket prices due to 2The Honduras PER (2001) reports that the cost of sending containers between Tegucigalpa and Puerto Cortes is US$1.16 per TEUkm, which i s almost twice the international standard of US$0.65 per TEUkm. Puerto CortCs on the Atlantic coast is the largest port in Honduras, and the second largest in Central America. It manages about 90 percent of Honduras's total maritime traffic, while most of the remaining 10 percent is channeled through San Lorenzo, on the Pacific coast. The largest airport i s San Pedro Sula, which transports more than half o f all international passengers in Honduras and 90 percent of air freight, most of which is associated with the maquila industry. It has been growing rapidly in recent years, while the second largest airport, Tegucigalpa, has been experiencing modest passengergrowth and declining freight traffic. 42 low traffic volumes, lack of competition in the airlines sector, lack of effective consumer protection mechanisms, inadequate handling capacity in San Pedro Sula and weak air traffic control of lower airspace. ELECTRICITY SERVICES 3.10 Access to electricity services increased rapidly over the last decade, from 33% in 1989 to 62% in 2003,5 which approaches the coverage indicators achieved in Guatemala and El Salvador (70 percent).6 The distribution of access to electricity across income groups i s very uneven, however. While 93 percent of households in the richest quintile are connected to the electricity network, only 25 percent of households in the lowest quintile are hooked up; Table 3.6. These figures may understate the true access to electricity services, however, given the highlevel of illegal connections. Although the price of electricity inHonduras is close to that charged in other Central American countries, the quality of service i s less satisfactory, as firms often experience longandcostly power outages (ICA 2004). 3.11 Distribution losses are estimated to be 20 percent, which i s not as high as the losses reported in Nicaragua, but significantly higher than the 12-13 percent reported in the other Central American countries. These distribution losses are mainly explained by illegal connections in poor neighborhoods in the urban periphery and the underestimation of bills to commercial clients. On the cost side, the public electricity distribution utility, ENEE, has an extremely bloated labor force, employing 476 employees for every 100,000 customers. B y way of contrast, the ratio among private power distribution utilities inLatin America normally ranges between 3 to 12employees per 100,000 customers. I Table 3.3: Electricity Service Coverage inHonduras, 1989-2002 Year 1 PoPulation I PopulationGrowth I Homes IResidential customers1 Coverage I ~~ Millions % Millions Millions % 1989 4.60 3.3 0.85 0.28 0.33 1990 4.76 3.3 0.88 0.31 0.35 1991 4.92 3.3 0.91 0.33 0.36 1992 5.08 3.3 0.94 0.35 0.38 1993 5.25 3.3 0.97 0.39 0.40 1994 5.42 3.3 1.oo 0.43 0.43 1995 5.46 3.2 1.01 0.46 0.45 1996 5.61 2.7 1.04 0.49 0.47 1997 5.75 2.6 1.06 0.53 0.50 1998 5.90 2.6 1.17 0.59 0.50 1999 6.05 2.5 1.20 0.62 0.52 2000 6.20 2.4 1.21 0.66 0.55 2001 6.35 2.4 1.24 0.71 0.57 2002 6.69 2.4 1.26 0.76 0.60 2003 6.86 2.5 1.30 0.8 1 0.62 2004 7.03 2.4 1.33 0.88 0.66 INE, National HouseholdSurvey, May 2003, www.ine-hn.org. CEPALECLA, "Istmo Centroamericano:La Regulacidn de la Distribucidn de Energia ElBctrica en 10s Paises con empresasprivadas", LC/MEX/L/536, 3l/Julio/2002. 43 Telecommunications Services 3.12 Honduras has made modest progress in increasing telecommunications coverage since the mid-1990s. The number of fixed lines per 1000 inhabitants increased from 27 in 1995 to 48 in 2000, but has not been able to expand much since then.' In spite of these advances, the access to fixed telephone services remains extremely difficult, even in urban areas, and it worsens dramatically in rural areas8 The waiting time for a phone line i s about eight years, reflecting the high inefficiency of the operation of the state owned monopoly, HONDUTEL. Service quality i s poor, as the standard quality indicators (e.g., number failures reported each year, the speed of repairs and call completion rates) compare unfavorably to international benchmark levels. International phone calls are among the most expensive in the region (Table 3.4), while local calls are among the most inexpensive, which has contributed to HONDUTEL's lack of enthusiasm in expanding domestic coverage. HONDUTEL has reduced its workforce significantly since 1998, from about 4,444 to 2,500 employees, raising its labor productivity levels from 44 lines per employee to 120 lines per employee. Although a significant improvement, labor productivity levels are still below those in Costa Rica (179) and Guatemala (147). Table 3.4. Cost of Callsto USA, 2003 US$/Min. Costa Rica 0.60 ElSalvador 0.25 I Guatemala I 0.28 I Nicaragua 0.90 Panama 0.72 3.13 HONDUTEL'S poor performance contrasts starkly with that of the deregulated telecommunication industries - such as broadcast radio and television, data transmission, internet services - which offer a greater variety o f services at better prices, ample coverage, and better quality.' It also contrasts with the mobile phone market, whose growth has been more dynamic. The number of mobile phones per 1000 inhabitants doubled between 2000 and 2002, and now exceeds the coverage indicators exhibited by fixed line telephony. The situation with respect to quality of service, waiting times and call completion rates i s somewhat better in the mobile phone than fixed line market. However, the price of mobile services has been very high. This i s bound to change now with the entry of a second, private operator who initiated services inDecember 2003. 'Animportant reason for the recent stagnation of fixed line coverage indicators has been the freeze on new investment in HONDUTEL, pending its privatization. An attempt to privatize HONDUTEL failed in 2000 and has not been re-launched. Instead, the authorities are considering opening up the telecoms market to * full competition at the end of 2005, similarto the strategy adopted inEl Salvador. In 1998, the density of telephone lines in the capital city was 2.4 times greater than the national average in Honduras. This i s worse than in Nicaragua (2.2), but not as disparate as in the other Central American countries, whose difference in densities differed by an average factor of 3.3. Comisi6n Nacional de Telecomunicaciones, CONATEL, www.conatel.hn 44 Water and Sanitation Services 3.14 Honduras has been experiencing one the most rapid urbanization trends in Central America. The share of the population living in urban areas increased from a mere 27 percent in 1970 to 41 percent in 1990 and almost 50 percent today. This has created an enormous pressure on urban services (including water & sanitation) in the most important urban centers. The rapid rate of urbanization has led to the expansion of settlements into ecologically vulnerable marginal areas with scarce urban infrastructure services and generally not apt for human habitation. Even so, Honduras succeeded in increasing the national coverage of water from 73 percent of all households in 1990 to 92 percent in 1997, and sanitation coverage from 66 percent to 83 percent. These indicators are similar to those reported in the other Central American countries, but higher than the averages re forted in the rest of Latin America and the Caribbean and low income countries worldwide.I The steady improvement in water and sanitation indicators suffered an important reversal with hurricane Mitch, especially in rural areas. ITable 3.5. Access to Water and Sanitation Services inHonduras I 1990 I 1993 I 1997 I 1999 I2002 1 2003 Source: INE, Encuesta National de Hogares de Prop6sitos Mtiltiples, various years. Note: The Honduras PRSP defines access to water services as having access to potable water inside the home (for urban areas) or access to pipedwater or wells (inrural areas). Access to sanitation services i s defined as having access to a toilet in urban areas and at least to a latrine inrural areas. 3.15 The distribution of access to water and sanitation services varies somewhat across urban and rural areas, but most significantly across income levels. As shown in Table 3.5, earlier rural-urban differences had been substantially eliminated by the mid-1990s in the case of water coverage, and significantly reduced in the case of sanitation coverage. These differences became more accentuated again in the wake of hurricane Mitch, which appears to have caused a significant deterioration in the access in rural areas, but not in urban areas. This is an indication of the much greater vulnerability of rural areas to ecological shocks. loUsing a different database, the World Bank's World Development Indicators, 2003, reports water coverage indicators of 88% for Honduras for the year 2000, compared to 86.5% for all o f Latin America & the Caribbean and 59.1% for the Heavily Indebted Poor Countries (HIPCs). Urban sanitation coverage i s reported as 93% for Honduras, compared to 86% for L A C and 79.1% for the HIPCs. I t bears mentioning that the figures on coverage of water and sanitation services in Honduras vary greatly across different data sources. The bi-annual Household Survey (INE), the Housing and Population Census (INE), the World Bank's World Development Indicators , the Honduras PRSP, and the Grupo Colaborativo de Agua y Saneamiento, all report seemingly independent figures on water and sanitation coverage, which casts some doubts on their accuracy. 45 3.16 Differences in access to water services are significant across income levels, but not as pronounced as differences in access to sanitation services. In water coverage, 94 percent of households in the richest quintiles has access to water services, compared to 63 percent in the poorest quintile. In sanitation coverage, households in the richest quintile are more than 10 times as likely to have access to sanitation services than households in the poorest quintile. Another revealing feature in Table 3.6 i s that the richer households are much more likely to have access to public providers of water and sanitation services, while the poorer households have to rely more on private service provision. This has the consequence that poorer households tend to pay much more for these services." Table 3.6 The Distribution of Access to Infrastructure Services, 2003 (percentages) Source: INE, Household Survey, May 2003. 3.17 Even though Honduras's water coverage indicators are very high, the quality o f service i s extremely low. More than 90 percent o f the water provided appears intermittently, averaging 6 hours of service per day. Only 44 percent of the water provided i s chlorinated, and the absence of quality control has resulted in a high incidence of water-related diseases that affect infant mortality and morbidity. Less than half of the urban population i s connected to a sewerage system and only a very low fraction of waste water receives any kind o f treatment. The rapid increase in sanitation coverage was mainly achieved through the widespread installation o f latrines in rural and peri-urban areas, while the urban infrastructure i s largely obsolete and in need of rehabilitation. The problem with urban systems i s especially acute in Tegucigalpa, which also i s lacking adequate fresh water sources. 3.18 The level of efficiency in providing water and sanitation services is generally low, especially among the non-metropolitan systems. The public water utility, SANAA, i s not subject to market discipline, and its tariffs are fixed on the basis of political criteria at financially unsustainable levels. The Tegucigalpa water system has too many employees, which account for almost half of the total operating costs. Fifty percent of the water channeled through the system i s not billed due to water losses or illegal connections; compared to a technically acceptable benchmark o f 15 percent. Only two out of every 3 consumers has a water meter, and many of those are in disrepair due to inadequate 11 According to the findings of a survey conducted in the marginal areas of Tegucigalpa (ESA Consultores, 2001, pg. 83), householdsthat were not connectedto the public water mains paid an average of US$2.90 per cubic meter of water and consumedonly 3.7 cubic meters per month, while households that were connected to the water main paid only US%O.lO per cubic meter and consumed an average of 10 cubic meters per month. 46 maintenance and replacement. The other urban water systems managed by SANAA exhibit even worse efficiency indicators, comparing unfavorably with the municipally operated system in Puerto CortCs, where service i s provided on a continuous basis with no significant interruptionsp; 97 percent of customers are metered and water losses only amount to 30 percent. Also, its operating costs are 15 percent lower than in Tegucigalpa, even though its per-capita water through-put i s 40 percent higher. Another relevant example i s San Pedro Sula, where the private concessionaire, contracted in 2000, has invested more than US$15 million, improving the access, quality and efficiency of the services in spite of significant political pressures. B. PATTERN OF PUBLIC EXPENDITURESINFRASTRUCTURE ON 3.19 During the 1990s, annual spending by the major public sector entities in the infrastructure sectors averaged 14 percent of GDP, of which 8.3 percent consisted of capital expenditures. The main spenders have been ENEE (41 percent of the total), HONDUTEL (29) and SOPTRAVI (20 percent), while the remaining 10percent of the infrastructurebudget i s divided evenly between ENP and SANAA. 3.20 The two main issues in infrastructure finance are cost recovery and the financing of capital programs. With respect to cost recovery, the public entities in charge of electricity, telephone and ports services (ENEE, HONDUTEL and ENP) depend on user charges to cover most (>70%) of their expenditure requirements. On the other hand, the public works ministry (SOPTRAVI), does not generate any operating income, while the water utility (SANAA) only funds a small portion (28 percent) of its total expenditures from tariff income. Both rely mainly on transfers from the central government. o/w Private 14.0% 15.2% 18.9% 22.8% 23.6% 20.3% 16.9% 17.4% Public 10.0% 8.8% 6.8% 5.4% 6.3% 5.9% 6.8% 4.8% o/w Infrastructure 3.2% 2.2% 2.7% 3.1% 2.9% 2.7% 2.3% 2.3% Source: www.bch.hn 3.21 With respect to capital program financing, total public investment spending has remained fairly constant in absolute US Dollar terms over the last eight years, which translates into a significant decline over time as a share of GDP. This pattern reflects a tightening of fiscal policy to maintain macroeconomic stability, which will continue under the new PRGFarrangement approved in February 2004. The level of public investment spending devoted to infrastructure sectors in 2001 and 2002 (2.3 percent of GDP), appears to be enough 47 to maintain the current coverage levels of infrastructure services in the context of a growing population. It will not permit, however, a significant expansion in access to infrastructure services. Instead, the bulk of the funds for expanding the infrastructure network under this macroeconomic framework will have to come from the private sector. 3.22 As in most developing countries, infrastructure maintenance often gets overlooked in Honduras and has often not been integrated adequately into the fiscal budgetary planning process. In the roads sector, however, important progress has been made with the privatization of maintenance from force account to contracted maintenance inthe early 1990s, followed in 2000 b y the establishment of a Road Maintenance Fund that i s funded in part by tax income generated by a fuel surcharge. (Following this reform, SOPTRAVI's Road Maintenance Department was initially pared down from 5,500 public employees to 700, and then replaced by the Road Maintenance Fund, which employs 40 staff.) The Road Maintenance Fund marks a potentially significant improvement in financing road maintenance by providing a predictable source of revenues for maintenance activities. Since it started operating in 2000, however, the road fund has not been given the full amount of the resources to which it i s entitled.12 Ensuring that these earmarked funds are transferred and used effectively, therefore, will require more attention to institutional and accountability mechanisms. c. EXPANDING ROLEOFPRIVATE THE PARTICIPATION 3.23 As in most other developing countries, the public sector traditionally has played the dominant role in the infrastructure sectors in Honduras. This i s changing slowly, as private participation in these sectors has been gradually increasing over the last decade; Table 3.7. Inenergy, the sector was opened up to private participants inthe generation segment, but not in transmission or distribution. Currently, private thermal providers account for 42 percent of the total generation, but distribution i s still completely in the hands of ENEE. Two large, privately-financed generation plants are currently being constructed on the Atlantic and Pacific side of Honduras. Once they come on line, these plants will raise the private share o f the generation market to over 50 percent. Inwater and sanitation, most utilities are runby SANAA or the municipalities. SANAA operates the water and sewerage systems o f Tegucigalpa and of several secondary cities, while private participation has been limitedto partnershipswith communities for rural and marginal urban water supply systems and one formal private sector provider. In 2000, the second largest city, San Pedro Sula awarded a 25-year concession to an Italian private operator to run its water and sewerage system. In Puerto Cortks, the water and sanitation l2 A law establishes a fixed charge of US$ 0.05 (equivalent) per gallon of gasoline to be used for the conservation of the road network and attention to social programs and tourism; Decreto 131-98, Arts. 40 & 41. According to this decree, the Road Fund was to receive 35 percent of the total resources raised by this fuel tax during its first year of operation, 38 percent during the second year and 40 percent from the third year onward. During its first two years of operation, however, the road fund has only received less than 75 percent of these amounts. Ninety percent of the Road Fundresources are to be used for maintenance and the remaining 10 percent can be used for highway rehabilitation. 48 system has been corporatized through the formation of a municipally owned company. In August 2003, the Honduran Congress passed a water framework law ("Ley Marco del Sector Agua Potable y Saneamiento") that contemplates the decentralized provision of water and sanitation services by transferring permanent (and non-transferable) ownership o f all water and sanitation systems currently operated by SANAA to the municipalities over a 5-year period. The law also establishes a sector policy and planning agency (CONASA) and a sector regulatory agency. 0 In transport, most domestic passenger and freight services are privately run. The four major airports in the country were awarded in a 20-year concession to a US-based private consortium (Inter-Airports) in 2000. Although Honduran ports still remain in public hands, the authorities submitted to Congress a ports framework law ("Ley General de Puertos") in 2003 that enables private sector participation in the management o f ports, defines institutional responsibilities for policy and regulatory functions, and establishes parameters and regulations to manage ports in line with international security standards. Although road construction continues to be managed b y the public sector, maintenance activities are being contracted out to private firms since the early 1990s. This process has been reinforced b y the Road Maintenance Fund("Fond0 Vial"), which began to operate in 2000 and works through maintenance contracts with private enterprises. 0 In telecommunications, the fixed-line market continues to be dominated by the state monopoly, HONDUTEL, whose privatization attempt in 2000 failed. The market for mobile telephones was opened in 1996 with the award of a 10-year concession to CELTEL and has rapidly become the largest network. In 2003, a second, 25-year concession to operate a mobile telephony system was awarded to a Swedish-Honduran consortium (MEGATEL-EMCE). Data, internet, broadcast and other value-added services have been opened up for competition and exhibit very competitive prices. To increase the coverage of telephony services, especially in rural areas, the government launched a new program ("Telefonia para Todos") in September 2003. This program envisages an expansion of the fixed line network, with HONDUTEL investing in primary "backbone" equipment, while the private sector completes the last segment in connecting customers and resells HONDUTEL's services. 3.24 There i s by now broad acceptance among most Hondurans that some form of private participation i s necessary for closing existing performance and financing gaps in the infrastructure sectors. While significant advances already have been made, there i s further scope for deepening private sector participation in several areas. The energy sector i s expected to require the greatest amount of new investment, especially in the generation segment, which the authorities expect to be satisfied entirely through the private sector.13 There i s clearly also room for attracting private participation on the distribution side, however. Together with transmission, the distribution segment i s facing a wide variety o f technical and financial problems that call for a restructuring of ENEE. In particular, it i s important to separate ENEE's generation, transmission and distribution activities in order to l3The 2001 PER estimates the energy sector's total investment requirement to average US$170 million per year over five years, with 70% dedicated to expanding generation and 20 percent to expansion of the transmission grid. 49 obtain greater clarity on where the main bottlenecks and problems lie.I4 To address these problems and raise sector efficiency, the authorities are contemplating the divestiture of ENEE's distribution system, which may require amending the sector's legal framework. Private Agencies Public Sector Agencies Planning and policy ComisihNacional de Agua y Saneamiento (CONASA, created in 2003) Electricity Production Private generators (42%), Roath ENEE,Puerto LempiraMunicipality and Utila Islands have private concessionaries Transmission ENEE Distribution ENEE Regulation Comisih Nacional de Energia Policy Energy Cabinet Telecommunication Operation CELTEL, MEGATEL-EMCE HONDUTEL(fixed-line services) (mobile services) Reeulation CONATEL 3.25 The country's seaports, especially Puerto CortCs, urgently need an infusion of capital and management expertise to expand capacity, improve efficiency and reduce costs to end- users in order to improve competitiveness. Although the growing demand for ports services l4This would help identify, for example, which activities are mainly responsible for ENEE's very bloated labor force, and which activities are financing it. 50 can be managed for a while through improved ports management, serious bottlenecks will soon develop in the absence of investments to expand capacity. Total investment requirements in the ports sector are estimated to be a multiple of ENP's current investment budget.15 The public sector does not have the fiscal headroom to increase its investments in ports by the required difference, so that the private sector will have to fill in the gap. In airports, the main bottleneck appears to be in Tegucigalpa. The San Pedro Sula airport has the capacity to serve the projected demand in the foreseeable future, but the Tegucigalpa airport already exhibits high levels of congestion and requires investment in the passenger terminal. Those investments should be included and followed-up on in the Investment Plan stipulated inthe concession contract with the private operator. 3.26 Inroad transport, the public sector will need to maintain its dominant role in the years ahead. The road sector will continue to place heavy demands on fiscal resources,16 especially the public investment budget, and so it i s essential to ensure that these are spent efficiently through proper bidding procedures and outsourcing arrangements with the private sector. Attracting private investment through concession arrangements i s currently not considered viable because of insufficient traffic volumes. This option may become viable in the longer term for certain stretches of the main north-south highway and a second by-pass highway around San Pedro Sula, once their projected daily traffic volume exceeds 10,000 vehicles. There i s not enough information available to discuss the investment needs in urban roads. Since municipalities are strapped for resources, however, the problems of urban congestion are bound to become increasingly more critical. This i s an area that requires greater analysis and attention. 3.27 Intelecommunications, the lack of investment inHONDUTEL's fixed-line network in the last few years threatened to hold back the expansion of the entire telephony system. Under the 1995 telecommunications framework law, HONDUTEL' s monopoly position i s scheduled to end in December 2005. It is important that the demise of this monopoly position not be postponed, since it i s expected to draw in significant new private investment - independent of whether the privatization of HONDUTEL i s re-launched or not - in a more competitive market environment. Meanwhile urgent investments were made in 2003 and have been committed for 2004 to prevent immediatebottlenecks inthe fixed-line network and permit the implementation of the government's program to expand telephony access inremote areas with private sector parti~ipation.'~I t i s not advisable to permit HONDUTELto invest beyond that, however, since investment decisions carried out in a monopoly context, could pre-commit the sector to certain technologies that may end up being sub-optimal in the context of a more competitive environment. l5The Honduras PER (2001) estimates that the ports will require an investment of at least US$80 million, spread out over five years, whereas ENP's annual investment budget has only been averaging US$10 million per year. 16TheHonduras PER (2001) estimates that the roads sector will require an annual investment budget of US$l85 million, of which US$57 million i s for maintenance, and the remainder for road rehabilitation and network expansion. l7I t had beenestimated that US$55 million is needed to make up for the lack of investment since the mid-1990s and provide enough new equipment in HONDUTEL to implement the `Telefonia para Todos' program, but HONDUTEL ended up committing US$160 million by also including strategic projects, such as a fiber optic backbone and microwave links. These additional projects are not in line with the liberalization strategy and would have been better made by the private sector. 51 3.28 The necessary sector legislation i s inplace to enable greater private participation in the water and sanitation sector.'* The initial experience with private concessionaries in San Pedro Sula appears to have been very successful and can serve as example for attracting private management and investment capital in the other municipalities, which are now facing greater responsibility for managing their systems. The need to inject new investment and management expertise i s greatest inTegucigalpa's system. 3.29 In seeking to attract greater private participation in the energy, telecommunications and the water and sanitation sectors, it i s important to keep in mind the large gaps in access and operational efficiency that are motivating this process. Accordingly, the private participation arrangements should be designed to improve access and operational performance, rather seeking to maximize fiscal revenue. D. STRENGTHENINGTHE POLICYMAKINGANDREGULATORY FRAMEWORK 3.30 An expanded role for the private sector in the provision of public infrastructure services needs to be accompanied by a strengthened public sector role in the areas of policymaking and regulation, especially in the context of natural monopoly markets. This i s needed to protect consumers and reduce the degree of uncertainty facing private operators, which affects their financing costs. By the mid-l990s, the Honduran authorities had recognized the need to separate operating, regulatory and policymaking functions in the infrastructure sectors. However, the regulatory and policymaking arrangements that were put inplace have been inadequate, as (i) regulatory agencies lack clear mandates inthe areas the of universal access, operational efficiency and consumer protection, (ii) do not count on the necessary autonomy and institutional capacity to carry out their functions effectively, and (iii) often confuse regulatory and policymaking roles. 3.3 1 Important progress in strengthening the regulatory and policymaking framework was made inthe water and sanitation sector with the passage of the framework law in 2003. Prior to this law, responsibility for regulating water quality rested with the Health Secretariat (SSP), the Natural Resource and Environment Secretariat (SERNA) was responsible for regulating the disposal of waste water and sewerage, and the National Supervisory Commission for Public Services (CNSSP) was responsible for approving tariff rates. Tariff setting remained primarily a political exercise with limitedreference to cost recovery. Similarly, inthe area of sector policy and planning, formal responsibility rested with SSP, but inpractice, it was done by the individual project implementing agencies under an informal sector coordination mechanism that included the SSP, other public agencies, donor agencies and NGOs. With the new framework law, all the regulatory responsibilities have been unified under a single Regulatory Agency ("Ente Regulador"). To ensure its functional autonomy, the Agency's operating costs are to be financed by a 1.5 percent tax on water and sanitation services. Inthe same manner, all the planning and policymaking functions are now clearly assigned to a Both SANAA and the municipalities are authorized to transfer the management , but not ownership, of their water and sanitation systems to private operators by the Law of Concessions (passed in 1999) and the Law of Municipalities (passed in 1990 and amended in 1991). Even though this legislation does not permit the divestiture of existing assets to private parties, it does permit the creation of new privately-owned infrastructure. 52 single commission, CONASA, with SANAA acting as its permanent Secretary. With this reform of the legal framework, the main challenge in this sector will be to strengthen the capacity of CONASA and the Regulatory Agency so that they can function effectively. One concern i s that no funds have been reserved in the 2004 budget to finance CONASA and the regulatory agency, which threatens to delay the start of their operations and leave a regulatory vacuum inthe short run. 3.32 Similar reforms still remain to be taken in the other sectors. In energy, the National Energy Commission (CNE) was created in 1994 to regulate the sector, but its autonomy was severely curtailed through a legal amendment in 1997 that made CNE functionally dependent on SERNA. Policy and planning functions in the energy sector are the responsibility of an Energy Cabinet consisting of the Secretaries o f the Presidency, Industry and Commerce, and Natural Resources and Environment, as well as ENEE and CNE. However, the Energy Cabinet i s headed by the President of the Republic and does not count on a permanent secretary to follow up systematically on any decisions reached by the Cabinet. A similar situation prevails in the telecommunications sector, whose regulatory agency, CONATEL, i s functionally dependent on the Presidency and, thus, also limited in its autonomy. Given the absence of a clear sector policymaking entity, it i s often involved in the formulation of sector policy, which confuses its role in the sector. In addition to defining the policymaking responsibilities within this sector, it i s also necessary to appoint a permanent secretary that can give continuity and follow up on the decisions reached inthe sector. 3.33 To address the problems of limited regulatory capacity and autonomy, the authorities should re-consider setting up a multi-sectoral utility regulation structure, that unifies individual regulatory agency under one institutional roof. Such a structure would permit the pooling of scarce technical and professional resources and allow the capture of economies of scope, as many of the activities in consumer protection, conflict resolution and economic analysis are similar across the infrastructure sub-sectors. It may also create the necessary institutional mass, in terms of resources and technical credibility, to better withstand political pressures in making regulatory decisions. Experiences with multi-sectoral regulatory agencies can be found in the Latin American region in Costa Rica, Bolivia and the provinces of Argentina, among others. 3.34 In transport, the need to strengthen regulatory functions is most acute in the seaports and airports sub-sectors, where private participation i s advancing rapidly. The ports framework law that has been submitted to Congress contemplates the creation of a multi- modal regulatory entity for the transport sector (involving civil aviation, ports and surface transport) and the creation of a Ports A~thority.'~It i s important that these entities start to operate as soon as possible inanticipation o f greater private participation in ports. In airports, a strong regulator i s needed to follow up on the contractual arrangements agreed to under the concession agreement to improve the operation of airports. 3.35 An important deficit in the transport sector is the lack of a strategic vision, giving attention to inter-modal considerations that would allow optimizing the use of resources in the l9Currently, regulatory and policymaking functions in the ports sector are combined under CNSSP, which regulates, sets ports charges and oversees the operations of the ENP. 53 sector and to orient future investments in a way that would raise Honduras's competitiveness. A transport master plan with such a vision would identify the combination of investments needed in all the transport sub-sectors to maximize their joint social return. Even with the emergence o f more opportunities for private participation, the public sector will continue to have an active role in maintaining and investing in the road sector. As the main entity responsible for transport policy, SOPTRAVI's capacity to provide strategic vision needs to be strengthened, along with its management capacities in the planning, programming and budgeting areas. Institutional capacity also needs to be strengthened in the areas of (i) monitoring the size and weight of vehicles that circulate on the public road network and (ii) the issuance of taxi and bus licenses.20 At the local level, there i s a need to strengthen municipalities in fulfilling their responsibilities in maintaining the urban road network and in setting traffic rules and norms. Finally, prior to considering a possible private sector involvement in road development, the authorities will need to review and clarify the legal framework authorizing the charging of highway tolls. E. REFOCUSINGINFRASTRUCTUREPRICINGAND SUBSIDYPOLICIES 3.36 Tariff rates in most infrastructure sectors are being set in a way that limits cost recovery, distorts sector development and results inpoorly targeted, regressive subsidization: Inwater and sanitation, the prices charged by SANAA are highly subsidized, given that it only funds 28 percent of its total expenditures from user charges. Most of its capital spending is financed through central government transfers, which implies a significant subsidy from general tax revenues to households connected to piped water, which generally tend to be the better-off households; see para. 3.20. The average price charged for domestic electricity consumption in 2002 was L.1.09Kwh (US$0.073). This i s lower than the average residential rate of private utilities charged in El Salvador and Guatemala (about US$O.lO K w h ) and near the low end of prices charged by the private utilities in Argentina, Bolivia, Chile, Peru and Colombia, whose residential rates (before taxes) range from US$0.07 to US$0.14 per Kwh. Inaddition to low tariffs, Honduras had one of the most convoluted pricing systems for residential electricity service in the world, involving a complex schedule o f rates with multiple blocks and an electricity subsidy for users with consumption o f up to 300 Kwh per month. It i s estimated that under that scheme, 82 percent of the subsidy went to the non-poor.21 The structure of electricity subsidies was finally revised in 2003 and made substantially more transparent and less distorting. Under the current system the total amount budgeted for electricity subsidies per year i s fixed in nominal Lempira terms (at L.275 million), and this is distributed in lump sum fashion across all customers that use less than 300 Kwwmonth. The main problem that remains i s that the basic price o f electricity for residential users still i s held below cost, and cross-subsidized with higher prices charged to non-residential customers. 2o These capacity strengtheningneeds are currently beinganalyzedin two studiesfinancedby the WorldBank. 21 HondurasPoverty Diagnostic 2000, World Bank, 2000 and Estache, FosterandWodon, Infrastructure Reform andthe Poor, WorldBank, 2001. 54 Charges for local telephone calls are among the lowest in'the continent and far less than the economic cost of the service.22 Local calls are cross-subsidized by international long distance calls, which are very expensive by regional standards (Table 3.4) and puts domestic firms engaged in foreign trade at a clear competitive disadvantage. This distorted tariff structure also lies at the root of HONDUTEL's low domestic market penetration, because it enables the company to make comfortable revenues from a small proportion of high-usage customers. This tariff structure is not sustainable beyond December 2005, when the telephony market scheduled to be opened up to full competition, since private providers will undercut HONDUTEL's international prices and the government will not have the fiscal resources to continue paying the huge subsidies required to keep the current low prices on domestic calls. Instead of waiting until the full liberalization takes place, however, it i s important to begin a gradual process of rebalancing tariffs now in order avoid a political backlash later that could hinder the reform process. 0 Bus fares are currently set at about half the prices charged inother parts of Latin America. As argued earlier (para. 3.7), the current structure of subsidies in urban public transport contributed significantly to the decline in the quality of urban transport in Honduras's largest cities. B y channeling the subsidy directly through the bus operators, it inhibits competition on the routes used by these operators and does not give operators any incentives to improve service. Also, these subsidies do not reach the neediest segments in the population, since bus services hardly reach the poorest neighborhoods. Even so, there i s a certain amount of self-targeting taking place under this subsidization scheme - as only the poorer members of society are generally willing to put up with the dirt and congestion associated with urban bus travel. The elimination of bus subsidies, therefore, has to be considered carefully from a poverty reduction perspective and possibly replaced with alternative, more efficient schemes. (The elimination o f such bus subsidies in San Pedro Sula in 1999 did not result in major public outcries, which argues against the need for such subsidies and bodes well for repealing them.) 3.37 A common theme runningacross the existing subsidy schemes discussed above is that they all focus on seeking to maintain affordability of public infrastructure services. However, the end result i s that the lion's share of the subsidy ends up in the hands of those that can best afford to pay higher prices for these services. In many cases, the poor are paying higher prices for alternative service providers because they do not have access to the public providers. It i s therefore recommended that Honduras refocus its subsidy programs to enhance access, rather than seeking to maintain affordability for existing users. This means dismantling the existing subsidy schemes and re-balancing tariffs to reflect production costs, while channeling the resulting budgetary savings to activities that are expressly designed to expand service coverage.23 Honduras already has experienced significant success with the 22Clients receive 200 free minutes in return for a monthly fee of US$2.05, and the marginalrate thereafter i s US$0.021 per minute. 23In the event that some consumption subsidies cannot be entirely discontinued, it is important that the government improve its analytical base for targeting subsidies to develop more efficient targeting mechanisms. The preparation of Poverty and Social Impact Analyses, which already are being undertaken in several areas, couldprove usefulfor this purpose. 55 implementation of access-oriented policies in the water and sanitation sector. A similar effort also needs to be made in the areas of rural electrification and rural telephony, where access indicators were found to be weak and very unevenly distributed. The creation of rural electrification and rural telephony funds, financed with taxes that do not unduly distort demand, have proven to be useful instruments for this purpose in other countries. F. SUMMARY AND RECOMMENDATIONS 3.38 In spite of the advances made during the 1990s, Honduras still exhibits many shortcomings in access, quality and efficiency of infrastructure services, which represents an important constraint on economic growth. In transport, the overall provision of services i s comparable to or better than in the other countries in the region with similar per capita income levels. Key issues in the sector are the low quality of urban bus transportation, the distorted structure of price controls and subsidies, the inefficient management of Puerto Cortds and the congested state of the Tegucigalpa airport. The following key recommendations are made for this sector: To strengthen the regulatory and policy framework, (i) create a regulatory entity for the sector, comprising surface transport, civil aviation and ports, (ii) set up a proper system to monitor weight and size of circulating vehicles, (iii)eliminate the subsidy on urban transport in Tegucigalpa, or replace it with a more efficient mechanism, (iv) eliminate price controls on freight transport, (v) review the legal framework for charging tolls, (vi) review SOPTRAVI's system of issuing licenses, (vii) restructure the mechanisms for regulating public passenger transport, with greater involvement by consumers and possibly transferring this function to the municipalities, and (viii) rationalize frontier and customs procedures to eliminate waiting times. With regard to ports and airports, (i) approve the proposed ports framework law, (ii) create the new ports authority and provide adequate resources for its operation, and (iii) follow up on the contractual obligations under the airports concession in regard to investments agreed for improving passenger service inTegucigalpa and freight services in San Pedro Sula. To improve the sector's fiscal sustainability, (i) that the road fund i s given the full ensure amount of resources earmarked for this purpose and, if necessary, supplement with general budget resources to provide adequate resources for maintenance of the primary roads, (ii) strengthen the road fund's institutional capacity to supervise and monitor the quality of maintenance activities, (iii)analyze the feasibility o f concessioning to the private sector certain segments o f the road network, (iv) prepare an institutional and financial analysis for improving the condition of urban road networks, including mechanisms to transfer funds to the municipalities for this purpose. To improve competitiveness, (i) give Puerto CortCs in concession to a private operator, (ii) analyze the feasibility o f including the other main ports (San Lorenzo and Castilla) inthe concession scheme, and (iii) the provision of ports services to private operators, divest including piloting, towing and stevedoring services. 56 To improve sector planning, develop a transport master plan, with an inter-modal vision and comprehensive road investment plan, to guide the allocation of resources inthe sector. 3.39 In the electricity sector, Honduras has exhibited a rapid increase in coverage of electricity service during the 1990s, but the distribution of access i s very unequal across income groups and the quality of service i s low. The public utility, ENEE, i s extremely inefficient and its operations are characterized by large distribution losses and inadequate regulation. Key recommendation inthis sector are: Separate the accounts of ENEE into its generation, transmission and distribution functions, in order to improve management information; better accounting and in general a more efficient and transparent operation. Evaluate strategic options for the most appropriate organization of the different activities of ENEE, especially in distribution, by assessing the optimal structure of the market. Validatemeview the Government Strategy for the Electricity Sector and update the legal framework to support the reform program of the Government in accordance with this Sector Strengthen the sector policy making capacities and institutions by creating a permanent institutional arrangement for the Energy Cabinet, capable o f following up on any policy decisions that have been reached. Strengthen and provide greater autonomy to the regulatory agency, CNE. Eliminate the cross-subsidy (from non-residential to residential users) in electricity tariffs and adjust electricity tariffs to cover costs. Develop a rural electrification fund, with adequate financing provisions, that i s designed to expand access to electricity services inrural areas in an efficient manner. 3.40 The telecommunications sector in Honduras i s characterized by low access indicators, low quality of service and a very distorted tariff structure. Key recommendations in this sector are: Allow HONDUTEL's monopoly to expire at the end o f 2005 and open up the sector to competition. Rebalance telephone tariffs (raising local rates and reducing international rates) in a way that achieves a gradual transition to an open market environment by the end of 2005. Grant greater autonomy to the sector regulatory agency, CONATEL, and strengthen its institutional capacity, possibly by incorporating it into a multi-sectoral utility regulatory agency (that would have to be created). 57 Create a planning and policymaking entity, independent of CONATEL, incorporating a permanent institutional arrangement capable of following up on decisions reached in the sector. Develop a rural telecommunications fund, with adequate financing provisions, that i s designed to expand access to telecommunications services inrural areas. Carry out the investments necessary to relieve immediate bottlenecks in the fixed-line telephony sector, but hold off on other investments until the sector i s opened up to free competition. 3.41 Honduras has made remarkable progress in expanding access to water and sanitation services during the 1990s,but the quality of service and efficiency of public service providers i s poor. The key recommendations made for this sector are given below: 0 To improve operating efficiency, (i) an analysis of the operations and commercial prepare viability o f each of the systems currently being operated by SANAA, and discuss their optimal organizational structure, (ii)prepare an inventory of assets owned by each water and sanitation system, and (iii) prepare 3-year rolling operating plans, coupled with a management contract, for each service-providing system with clear targets for improving operational efficiency. 0 To attract private management expertise into the sector, (i) a plan for transferring define the water and sanitation systems to the municipalities, as contemplated in the recently passed sector framework law, spelling out the collaborative arrangements with the private sector to be considered, (ii) develop a set of alternatives and models to incorporate the private sector in the operation of these systems in the municipalities, and (iii) prepare a plan to give the Tegucigalpa system in concession, or other form of participation, to the private sector, building on the lessons learned from the experience in San Pedro Sula. 0 To reduce fiscal burdens, (i) develop guidelines for setting utility tariffs that cover operating costs as well as the capital costs needed to reach given expansion targets, and that are based on publicly verifiable indicators to trigger tariff adjustments, (ii) develop a subsidization scheme to encourage the expansion of water and sanitation services to marginal urban and rural areas, and (iii) develop a fund to finance start-up operations of the rural administration committees in charge of managing the water and sanitation systems beingtransferred from SANAA. To strengthen institutional capacity, (i) provide adequate funding for the newly created regulatory agency and for the policy and planning entity, CONASA, and (ii) prepare and implement a plan to build capacity in the municipalities to manage their water and sanitation in a financially sustainable manner, and define the mechanisms for providing technical assistance to the municipalities willing to reform the current service provision model. 58 59 Chapter IV. FINANCIALSECTOR DEVELOPMENTAND ECONOMIC GROWTH 4.1 Perceptions about the role and importance of banks vary greatly, ranging from their portrayal by Alexander Hamilton as the "happiest engines (of growth) ever invented" to that by John Adams, who saw them as threats to "morality, tranquility and even wealth".' Moreover, standard financial theory does not offer much help in measuring the importance of bank credit as a determinant of growth since, according to the Modigliani-Miller theorem, the particular capital structure (mix of debt and equity instruments) chosen to finance economic activity in principle i s irrelevant. Where most observers agree, however, i s on the importance of having some financial intermediation mechanism in place that can efficiently allocate capital among competing alternative uses. There are good conceptual reasons, supported by a substantial body of empirical evidence, for believing that the financial system exerts a strong influence on the rate of economic growth and, in particular, on the rate of productivity growth.2 In Honduras, as in many other developing countries, the financial system i s defined almost entirely by its banking system. It does not have an active securities market nor other type o f organized and transparent capital allocation mechanism, so that the performance of its banking system i s crucial in determining the quality of financial intermediation services and, by extension, the country's ability to sustain economic growth. 4.2 This chapter reviews the state of financial intermediation in Honduras and seeks to identify the main obstacles that are currently inhibitingits performance. It begins with a brief overview of recent financial sector developments in Section A, leading up to the current paralysis in agriculture sector lending, which i s threatening to destabilize the rest of the financial system. Section B discusses the institutional roots of this credit paralysis, together with an assessment of what it would take to tackle this problem and restore agriculture lending on a sustainable basis. The state of the financial system also reflects a number of institutional weaknesses that were recently addressed by a joint World Bank-IMF Financial Sector Assessment Program (FSAP) review, and whose main findings are summarized in section C of this chapter. A concluding section summarizes the main recommendations. A. BRIEF OVERVIEWOFRECENT FINANCIALSECTORDEVELOPMENTS 4.3 Box 4.1 describes the structure of Honduras's financial system, which i s dominated by the commercial banks. With total assets of US$3.3 billion, the commercial banking system is small in absolute terms, but represents a larger share o f GDP than the banking systems in most other Central American countries; Table 4.1. B y this last measure, Honduras's banking system i s also a little larger than the Latin American average, but below the world average. This last finding reflects the fact that financial systems in Latin America generally tend to be underdeveloped incomparison to other regions. Quoted in Levine, Ross, Norman Loayza and Thorsten Beck (2000), "Financial Intermediation and Growth: Causality and Causes", Journal of Monetary Economics, August, v. 46, nl: pp. 31-77. Extensive documentation on the conceptual reasons and empirical evidence linking financial development and economic growth i s given in Levine, Ross (1997), "Financial Development and Economic Growth: Views and Agenda," Journal of Economic Literature, June, 35 (2), pp. 688-726. 60 Box 4.1. The Structure of Honduras's FinancialSystem The Honduran financial system is dominated by commercial banks, which currently account for nearly 70 percent of total assets. Other financial intermediaries are the savings and loans institutions (6 percent), cooperatives (3 percent), insurance companies (4 percent) and the increasingly important public sector pension funds (17 percent); see Table 4.4 The banking system is moderately concentrated, with the six largest commercial banks (out of a total of 19 banks) accounting for 71 percent of total assets and 76 percent of total deposits. After a dynamic increase in the number of banks over most of the 1990s,the system has become more concentrated again since 1999, due to bank exits and some mergers and acquisitions. This process of concentration i s expected to continue over some time because a number of institutions are very weak and expectedto exit the market in the coming years. Honduras's banking sector i s mostly private, with state-owned institutions representing only 1 percent of total assets and deposits. Foreign participation is less than in the rest of the region, as banks with foreign majority (> 50%) equity participation only represent4 percent of total banking sector assets. (If minority shares are also considered, foreign holdings amount to 13 percent of total assets.) There appear to be no legal barriers to entry, so the modest amount of foreign participation is most likely due to the small size of Honduras's financial market, its high economic vulnerability, and the weak legal and institutionalframework of its financial system. 4.4 Honduras exhibited progressive financial deepening between 1960 and 1990, as measured by the steady growth in total assets of the financial system as a share of GDP; Figure 4.1. The evolution of total credit to the private sector followed a similar trajectory at the beginning of this period, but decelerated in the 1980s, inline with the overall stagnation of economic activity observed during that decade. The financial system experienced a significant adjustment in the first half of the 1990s, when the government introduced a first round of comprehensive reforms and gave up its long-time adherence to a fixed exchange rate policy. The resulting devaluation of the currency led to a major realignment of relative prices reflected in the protracted decline in the GDP-share of total financial assets and credit to the private sector. Table 4.1. The BankingSystemsinCentralAmerica,2001 (Inpercent, unless otherwise indicated) Assets Assets Credit to private Deposits Real Interest ($, bln) relative to sector relative to relative to lending rate GDP GDP GDP rate spreads El Salvador 9.0 65.4 40.4 44.1 5.6 4.6 Costa Rica 6.8 43.3 27.7 33.6 11.3 12.1 Guatemala 5.6 27.2 18.3 20.2 10.5 10.2 Honduras 3.3 53.0 35.9 39.3 12.9 9.3 Nicaragua 11 2.0 58.3 30.9 34.9 8.7 13.8 Average (exc. Honduras). 5.8 48.6 29.3 33.2 9.1 10.2 Source: IMF,Intemational Financial Statistics (IFS). 1/ Data for Nicaraguarelativeto GDP are for 2000 and usethe new 1994-baseGDP figures, while the GDP deflator was used to determine the real lendingrate. 61 4.5 The macroeconomic situation stabilized by the mid-l990s, setting the stage for a resumption of financial sector deepening. The reduction in fiscal deficits, which previously had absorbed a large share of total credit and crowded out private borrowers, contributed significantly to the rapid increase in growth of credit to the private sector during 1994-98. B y the end of the 1990s, however, the indicators of financial sector deepening have stopped growing, as the banking system came under significant stress on account of several external and internal developments. Figure 4.1. Honduras: Indicatorsof FinancialDepth 0.60 0.50 % 0.40 8 c 0.30 .c 0.20 s u) 0.10 0.00 I , , I, 1 , , , , , I , , , ,I , , I , , , , , , , , I I ___ Source: Beck, T., A. Demirguc-Kunt, and R. Levine, "A New Database on Financial Development and Structure", World Bank, June 1999,and IMF, IFS. Note: Financial Assets refer to the sum of assets of the commercial banks, other financial institutions and the Central Bank. 4.6 The poor health of the Honduran banking system i s reflected in Table 4.2. Compared to neighboring countries, Honduras's banking system stands out as having the highest share of non-performing loans and least amount of provisioning. Also, the system's administrative costs are among the highest in the region, while its profitability i s among the lowest. 4.7 The current state o f the financial system reflects the impact of a sequence of adverse external shocks that have hit Honduras in the last five years, as well as a number of institutional weaknesses that render it vulnerable to such external shocks. The most important shock occurred with hurricane Mitch in October 1998. It caused damages that were estimated at US$5 billion (valued at replacement cost)3, and largely wiped out agricultural production in 1998. Almost two-thirds of the total damages occurred in the agriculture, livestock and fisheries sector. Since then, the agriculture sector also has been adversely affected by a sharp decline of coffee prices and o f other commodity prices. This sequence of adverse shocks led to a generalized underperformance of agricultural loan portfolios that undermined the profitability and, ultimately, the solvency of the banking system. UNDPECLA, "A Preliminary Assessment of Damages Caused by Hurricane Mitch, December 10, 1998. Table 4.2. SelectedBankingSector IndicatorsinCentralAmerica, 2002 I/ (inpercent unless otherwise indicated) Net Worth NPLs/ Provisions/ Admin.costs ROAE ROAA /Assets All Loans NPLs 2/ /Ave. Assets (pre-tax) (pre-tax) 2/ Costa Rica 9.5 2.8 107.7 5.9 21.7 2.0 El Salvador 8.9 3.1 122.2 3.0 13.2 1.2 Guatemala 4.9 10.9 81.4 5.0 12.2 0.6 Honduras 8.1 15.7 32.6 5.8 11.1 0.9 Nicaragua 7.1 3.5 161.5 4.3 27.7 1.8 Average (w/o Honduras) 7.6 5.1 118.2 4.6 18.7 1.4 Source: Banco Central de Nicaragua. 1/ Data i s as of September for Costa Rica, as of November for ElSalvador, as of April for Guatemala, as of November for Honduras, and as of December for Nicaragua. 2/ Non-Performing Loans in Costa Rica, El Salvador, Honduras and Nicaragua are definedas credits with payments past-due over 90 days and in Guatemala as credits in default at maturity. 4.8 Beginning in 2000, the Government responded to the plight of the agricultural sector by issuingseveral decrees4to restructure the sector's debt with the local banking system, and provide credit insurance and interest rate subsidies on the restructured loans. The actual and contingent fiscal liabilities created by these decrees, together with the full deposit guarantee introduced in 1999,5 implied that the State was willing to absorb a significant share o f the losses accumulated until then by the agricultural producers and their creditors. However, these measures have not been able to restore an environment conducive to a prompt resumption of bank lending to the agricultural sector. Instead, new loans to the agricultural sector have been falling, by 5.9 percent in 1999, 15.8 percent in 2000, 22.1 percent in 2001 and 51.4 percent in 2002. That is, new agricultural lending has virtually disappeared. Without alternative sources of capital, the agriculture sector has been locked in a contractionary trend, while its share of GDP has gradually declined in real terms, from 25 percent in 1997 to 23 percent in 2002.6 4.9 The financial system has been negatively affected, both directly and indirectly, by the poor performance of the agricultural portfolio. In addition to the restructured loans, amounting to nearly L 3,000 million (US$175 million) in unpaid principal and interests, the system also has accumulated a significant portfolio (US$lOO million) of foreclosed assets ("activos eventuales") that generates little or no revenue and that cannot be liquidated without incurring substantial losses; Table 4.3. Bank profitability has thus declined due to, both, the burden of unproductive assets (underperforming loans and foreclosed assets) and the shrinkingpool of creditworthy potentialborrowers. These are Decrees 28-2000, 32-2001, 128-2001,81-2002, and 11-2002-E. The Deposit Insurance Fund (FOSEDE) insures deposits up to the US$lO,OOO per depositor, but in 1999, the government established a blanket guarantee on the remaining deposit amounts, to avert contagion from a bank that was closed at the time. The 100 percent guarantee for deposit amounts in excess of US$lO,OOO was to be in place for only three years, then reduced to a 50 percent guarantee in September 2003 and eliminated entirely in September 2004. The initial reduction in guaranteed amount has been postponed, however, and a revised timetable has not been issued yet. The decline innominal terms has beenmuch more dramatic, from 20 percent of GDP in 1997 to 11.9 percent in 2002, reflecting the additional influence of relative price declines. 63 4.10 Another factor that has exerted a restraininginfluence on banking sector growth i s the increasing dollarization of bank deposits over the last de~ade.~Given the existing, prudential restrictions on Dollar-denominated lending to non-Dollar generating activities, the increasing dollarization of deposits has led to declining domestic financial intermediation and, consequently, a shrinking role for the banking system in the capital allocation process. Lending to Dollar-generating activities in the Honduran agricultural sector has not been successful and so i s also quickly decreasing. Table 4.3. Honduras: Balance Sheet of the ConsolidatedBanking System (as of De, mber 2002) Assets L. Mln. % of bal. Liabilities L. Mln. % of bal. Cash 10,356 13.8 Deposits 46315 61.9 ofw Reserves 5,726 7.6 o/w in FC 15,615 20.8 o/w in FC at CBH 1,905 2.5 Demand 11,184 14.9 o/w inFC abroad 1,973 2.6 Savings 20,926 27.9 Investments 13,487 18.0 Time 14,405 19.2 o/w in CBH securities 3,183 4.2 Other Liabilities 1,540 2.0 o/w inFC 8,295 11.0 Interbank and other bank oblig. 6,932 9.2 Loans 35,305 47.0 o/w on-lendings 3,715 4.9 o/w in FC 9,277 12.4 olw owed to foreign banks 1,828 2.4 o/w NPL 4,257 5.7 Technical Reserves 101 0.1 o/w restructured 2,836 3.8 Deferred Liabilities 626 0.8 Interest due 1,411 1.9 Valuation Reserves 2,842 3.8 Foreclosed Assets 1,692 2.3 otw for doubtful credit and int. 1,649 2.2 Fixed Assets 2,859 3.8 o/w amort. of foreclosed assets 197 0.3 Deferred Assets 537 0.7 Reserves for eventualities 200 0.3 Other Assets 1,024 1.4 Total Liabilities 60,601 80.7 Total Assets 66,671 88.8 Capital and Reserves 6,069 8.1 ContingentAssets 8,448 11.2 ContingentLiabilities 8,448 11.2 ofw Unused Credit lines 4,001 5.3 o/w Guarantees 4,264 5.7 Balance 75,118 100.0 Balance 75,118 100.0 Source: CNBS 3. TACKLING THE AGRICULTURALCREDIT PROBLEM 4.11 Given the international availability o f catastrophe insurance, as well as of active markets for derivatives on coffee and other traditional export-commodities, one may wonder how it i s possible for Honduras's financial system to be buffeted repeatedly by perfectly foreseeable and at least partially insurable adverse scenarios. The mystery disappears, however, when one observes that Honduran banks generally lend to the agricultural sector on contractual terms that do not take into consideration the existing underlying exposure to systemic risk factors, such as commodity prices and natural disasters. Furthermore, the state- owned wholesale bank, FONAPROVI, also ignores systemic risk factors when rediscounting the portfolios of agricultural loans originated by the commercial banks. This institutional set- up may work smoothly in a world where individual credit risks are uncorrelated among each 'Though still moderate in comparison to other countries in Latin America and the Caribbean, dollarization increased rapidly from 2 percent of total bank deposits in 1990to around 35 percent in 2002. 64 other, but falls apart as soon as a substantial component of each individual credit risk can be traced to systemic risk factors. 4.12 The overwhelming prevalence of systemic risk factors in the agricultural sector of Honduras (as nearly everywhere else) implies that this particular institutional or contractual set-up embodies generalized moral hazard or "lack of market discipline". That is, it engenders moral hazard in the behavior of the farmer that borrows expecting to be bailed out when hit by generalized adversity, of the banker that lends expecting to be bailed out, and of the depositors themselves, who expect the deposit guarantee system to bear any losses. Once substantial losses have accumulated, as has been the case in Honduras since 1998, incentive problems are compounded as all economic agents end up waiting for the Government to execute the expected bailout. The credit market becomes increasingly paralyzed by the overhang of bad debts, and so does economic activity in general, given the lack of alternative sources of capital. On the demand side of credit, any servicing of debts originated in past losses i s equivalent to a tax on the expected return of new investment projects. This reduces the incentive to invest. On the supply side, the higher i s the accumulated debt of potential borrowers (which keeps growing without limit in a context of generalized underperformance), the lower i s their perceived creditworthiness and, hence, access to credit. 4.13 To solve the current paralysis of agricultural credit and avoid its destabilizing consequences on the financial system overall, two entirely separate issues must be tackled simultaneously: first, the Government must define and enforce a final (Le., politically enforceable) distribution of the accumulated losses. Secondly, the practice of preparing financial contracts as if systemic risks did not exist must cease. 4.14 A viable arrangement for distributing the losses must take into account the following constraints: Agricultural producers will simply not work just to pay back their old debts in full and they will need clear incentives to pay back whatever i s not bailed out. This means, in effect, that the implicit insurance contract that was in effect when the bad loans were negotiated, will have to kick in and compensate them, once more, for a part of the losses suffered on account of the uninsured natural catastrophes and commodity price declines that took place. The incentives to pay back the remaining part must involve both carrots (their rehabilitation as borrowers) and sticks (a credible threat to execute collateral). As for the commercial banks, their owners cannot be expected to assume a loss larger than their committed capital. Provided they are offered the alternative o f honorably exiting the market, they can be expected to comply with international minimumcapital requirements, but only after their balance sheets have been appropriately cleaned (i.e., somebody else has assumed any losses in excess of their capital) and the conditions for a viable financial intermediation business have been properly reestablished. Finally, regarding the State, its commitment to assume a share o f the accumulated losses will be credible only to the extent that the committed amount does not violate fiscal constraints. 65 4.15 To insure that appropriate insurance and price hedging instruments are put in place, and financial contracts are no longer written as if systemic risks did not exist, institutional changes are needed. One possibility i s to give FONAPROVI the authority to engage in price- hedging and crop-insurance contracts with international counterparts, provided that it develops the managerial skills to handle them. Alternatively, it could be made mandatory for commercial banks to engage directly in this type of hedging transactions when lending to the agricultural sector, as well as to other sectors exposed to systemic risk factors.' Under any conceivable institutional set up, CNBS will have to develop the specific regulatory framework and supervisory skills required to guide and monitor these activities. Also, following the recommendations of the FSAP review, i t i s necessary to introduce various complementary institutional changes that are detailed inthe next section. 4.16 The Government has started to work on both dimensions of this problem. With respect to the distribution of losses accumulated by the producers and creditors o f the agricultural sector, as well as the prevention of its future recurrence, it enacted Decree 68/2003 (discussed below). With respect to introducing the complementary institutional changes recommended by the FSAP, it i s implementing an ambitious technical assistance program supported b y the World Bank, the IMF and the IDB. Separately, the government also introduced an innovative mechanism designed to restore access to credit by small-scale farmers through the state-owned rural development bank, BANADESA.9 4.17 Decree 68/2003 writes off 50 percent of the restructureddebt of the agricultural sector with the banking system and replaces the interest rate subsidies provided by previous decrees with a debt write-off equivalent to the present value of such subsidies (discounted with the same interest rate to be accrued by the remaining 50 percent that agricultural debtors are still expected to pay back). According to government officials, this decree does not represent an increase of fiscal commitments beyond the amounts already committed to by the previous decrees, either in the form of credit guarantees on the restructured loans or as interest rate subsidies on other loans. Under this scheme, the commercial banks are expected to absorb 100 percent of any future underperformance of the remaining 50 percent of the agricultural sector debt. Good examples o f such risk intermediation activities are provided by Fanny Mae and Freddie Mac in the USA, who are the second-tier lenders of the US mortgage market. They absorb a huge part o f the maturity-gap risk of the commercial banks and other mortgage originators, and then reinsure themselves by transferring that (clearly systemic) risk to third parties through interest-rate derivatives. In Honduras, BANADESA already has initiated such activities by packaging both crop and price insurance in the loans granted to small-scale farmers, where the crop risk i s assumed by the bank's insurance company (and reinsured with a German insuranceheinsurance giant), while the price risk is absorbed by the grain merchants (e.g., Cargill, Dreyfus, etc). Another example is Fedecredito (a federation o f credit unions) in El Salvador: they insure their small borrowers (typically municipal-market saleswomen) against catastrophic losses and reinsure themselves with insurance companies. An interesting example of an alternative, incentive-compatible contractual framework, is that offered by the "Monedero BANADESA"; a product recently introduced by the state-owned rural development bank. Targeted to very small-scale farmers without access to other sources of capital, it involves financing, insurance and minimum assured prices for carefully selected crops. This mechanism, however, cannot be easily expanded to cover the entire financial system and its major agricultural debtors. To ensure that the larger borrowers also are also insured, a different strategy may be required. This may include making insurance compulsory (for borrowers and/or bankers) or creating strong incentives for the bankers to buy insurance by, say, imposing differential capital requirements. 66 4.18 Decree 68/2003 has met with criticism from some who feel that bailing out agricultural producers and their creditors once more would irreversibly deteriorate the "credit culture" in Honduras. Given the systemic nature of the problem under discussion, however, the practical implications of not following through with the bail out of producers and creditors would involve the eventual nationalization of banks and/or of significant extensions of agricultural land. A "moral hazard" problem in this context i s not equivalent to a moral problem (requiring interventions based on ethics principles), but rather a problem of distorted incentives that can only be resolved by removing the distortions. In the case of Honduras, that distortion arises from the undistributed status of the systemic losses accumulated over the last six years. This i s the overhang of bad debts that debtors will not repay (either because they cannot do it, or because there i s no incentive for them to do it), and that both the banks and the Bank Supervisor do not fully recognize as "bad"(because it would require a re- capitalization that the banks cannot afford, or do not have enough incentive to meet, and because it would result in payment obligations, triggered by the open-ended deposit guarantee, that exceed the states fiscal capacity). 4.19 Certain aspects of the solution offered through Decree 68/2003 still raise concerns, and need to be addressed and clarified by the Government. These concerns relate to (i) the fiscal viability of the share to be paid by the State in the final distribution of agricultural losses, particularly in view of the ongoing unlimited guarantee of deposits, and (ii) the structure of incentives needed to induce agricultural debtors to pay back the remaining 50 percent of their debts, instead of waiting for further write-offs. (iii) Another concern i s that the balances of the financial institutions, after 50 percent of the restructured debts are written off, may not improve sufficiently to induce bank owners to recapitalize their banks or engage in an orderly exit from the market, instead of holding bank and risking a disorderly liquidation. The first concern leads to the inevitable recognition that the state's capacity to provide deposit insurance i s limited. The second concern draws attention to the need to develop the instruments to force repayment of the portion of agricultural debts that are not bailed out under the Decree (e.g., execution of guarantees, renewed access to credit, etc.). Finally, the third concern is triggered by the low profitability of banks in Honduras, which discourages investments in the business of financial intermediation. Without some form of subsidy, such as a long-term subordinated loan from an ad-hoc fiduciary fund, the hoped-for bank recapitalizationi s unlikely to take place. c. STRENGTHENINGTHE FINANCIAL SYSTEM 4.20 The joint WB-IMF FSAP review identified a number of institutional weaknesses and prepared recommendations that the Honduran Government i s already beginning to implement, with technical assistance from the WB, the IDB and the IMF. This section summarizes the various institutional aspects addressed by the FSAP. Bank Supervisory and Regulatory Framework 4.21 Primary supervisory responsibility rests with the National Banking Commission (CNBS), which i s the only agency empowered to carry out on-site inspections for banking and securities, insurance, and non-bank financial institutions in Honduras. The Central Bank 67 (CBH) regulates foreign exchange operations, minimum paid-in capital of financial institutions, connected lending, and reserve requirements. 4.22 While financial system regulation and supervision have improved over the last few years, some areas remain weak and require urgent correction." The most salient areas where prudential regulations need enhancement refer to (i) consolidated supervision, (ii)capital adequacy, (iii) classification and provisioning, and (iv) corporate governance and risk loan management. There i s also an urgent need to develop a smooth framework for taking prompt corrective actions when banks encounter problems. In addition, the supervisory focus of the CNBS needs to move from formal compliance with laws and regulations to a more risk- oriented, forward-looking, approach. CNBS still lacks the authority to implement consolidated supervision in a meaningful way. The increasing regionalization of banking in Central America, however, demands both a clear authorization to carry out consolidated supervision and a higher degree of coordination among regional bank supervisors. CNBS also needs to expand its range of instruments, including Action Plans and Memoranda of Understanding, to enforce preventive and corrective actions, and banking law should clearly state the criteria and objective facts that trigger the use o f those instruments. CNBS does not yet regulate and supervise cooperatives, which represent a rising share o f total assets of the financial system. Creditor Rights and Insolvency Systems 4.23 The registration system for property rights and securities i s incomplete, outdated, ineffective, and unsafe. Banks are reluctant to provide mortgage-backed credit in areas where property rights are uncertain. Movable assets are not easily taken as securities due to the absence of a Registry for Movables or a Pledges Registry. Deeds filed for registrationtake an average of two to four months to be recorded in the Property Registry, due mainly to the heavy workload and the inefficient system of excessively discretionary registrar review. 4.24 Bankruptcy legislation i s rarely used due to adverse legislative, institutional and cultural factors. Troubled corporations frequently just close down without honoring their debts. Some creditors may anticipate it and demand payment in court by seeking an immediate preventive attachment of assets. This situation could be adversely affecting the conduct of financial institutions in many ways. Inparticular, credit is almost always secured, there i s an excessive reliance on the early use of judicial enforcement mechanisms (a factor that could explain the significant amount of foreclosed assets -"actives eventuuZes"- currently heldby the banks), and the reorganization of distressed businesses often is not considered as a sound alternative (resulting in unnecessary asset-value andjob destruction). The enforcement lo Currently, Honduras complies with only one Base Core Principle - relating to the legal protection of supervisors. It is partially compliant with four core principles that relate to permissible activities, information sharing with foreign supervisors, and country risk. I t is partially non-compliant with 23 core principles related to prudential regulations, the supervisory treatment of risks and the supervision process, and it is non-compliant with two core principles associated with regulatory development and supervisory enforcement. To reach the HIPC completion point, Honduras must comply with various conditions, one o f which calls for the substantive application of the Basel Core Principles to the banking sector. Significant efforts to improve compliance with the Basel Core Principles are still needed before this HIPC condition is satisfied. 68 proceedings for individual claims are lengthy, mainly because numerous defenses and appeals are allowed. Although the "jjuicio ejecutivo" works fairly well in standard cases, its rulings can be appealed and are subject to constitutional challenges through "amparos". 4.25 New legislation i s required for a modern and safe registration system of property rights and securities, both for immovable and movable assets, as well as for insolvency proceedings. While the implementation of effective registries i s a key component of the modernization of property rights and securities, a new law for insolvency proceedings should include the possibility of reorganization and out-of-court agreements. In addition, it is necessary to revise the legislation on securities over movable and intangible assets, as well as the procedural legislation for individual executions, to make more efficient enforcement procedures available to unsecured and secured creditors. It i s necessary also to underpin this legal reform by developing the institutional capacity o f the Judiciary. Payments and Securities Settlement 4.26 There are two systemically important payments systems in Honduras: the electronic checks clearing house (CEPROBAN) owned by the commercial banks and the funds transfer system associated to the accounts of financial institutions and the government at the central bank. The yearly value settled in the checks clearinghouse represents approximately 215 percent of GDP. The yearly value settled in the funds transfer system represents approximately 125 percent of GDP. Both systems process large value transactions, so any of them could potentially trigger or transmit systemic disruptions. 4.27 The securities settlement infrastructure is very weak and undermines financial sector development in Honduras, especially in the capital markets and the interbank money market. Currently, the secondary market i s almost inexistent. The bulk of the market consists of the primary auction of public securities. Establishing a depository function for securities settlement should be considered in order to mitigate risks and allow for a collateralised interbank money market. 4.28 The legal basis of the payment system i s incomplete and lacks the elements required for a modern operation. There i s no legal framework for electronic documents and signatures. Checks still need to be exchanged physically. There i s legal uncertainty about the settlement finality. There i s no legal recognition of netting arrangements and no clear legal basis for ownership transfer of dematerialized securities. Although the Securities Market Law (SML) includes a section about a CSD and legal support for a book-entry system for transfer o f securities ownership, no depository currently exists. Certificates of custody do not have an adequate legal basis for protecting the ownership of the securities. There i s no adequate legal basis for enforcing security interests attached as collateral and of rep0 contracts, especially in cases of insolvency. 4.29 Payments system oversight functions have not been defined and are not being implemented by the Central Bank, and no formal cooperation arrangements exist among different financial authorities and private sector entities. The Central Bank should define a payments system policy, stating clearly its objectives (such as achieving finality for certain classes of payments) and the instruments (gross and net settlement systems for different types 69 of payments, their respective operational rules, etc.) to reach them. In particular, it is important to define clearly who i s in charge of the oversight function, and which are the enforcement instruments. Pension Funds 4.30 Five public-employee pension schemes are in operation in Honduras with total reserves amounting to 16 percent of 2001 GDP. They have large reserves and good dependency ratios which, in principle, makes them solvent. Private sector salaried and non- salaried workers are not covered by any scheme, however. A handful of voluntary schemes are also in operation, with negligible reserves. The governance framework of all funds i s extremely weak and all funds are exposed to a high political risk. The investment portfolios o f all funds are skewed towards member loans, mostly housing loans at a subsidized rate. Current regulation allows funds to bear excessive risk and does not promote diversification. Their investments in short-term bank deposits may be a source of instability for some financial institutions. Insurance companies 4.31 The insurance market in Honduras i s very small in absolute terms, but i s more developed than in other countries with similar levels of per capita GDP. Companies display high reinsurance ratios, which exposes them to a high credit risk if reinsurance activities are not closely supervised, as currently seems to be the case. They have a significant commercial lending activity for which they have no comparative advantage, generating a concentration of risk in specific financial groups. Supervisory capacity in insurance is in the process of being developed. A new law was adopted in 2001, but its effectiveness depends on the implementing regulation, part o f which has been recently drafted and i s under discussion with market players. CNBS i s aware of the need for training supervisors and it i s planning actuarial training as well as technical assistance on inspection and surveillance. Anti-Money Laundering (AML)/Combating the Financing of Terrorism (CFT) 4.32 The new AML Law 45-2002 significantly enhances the legal framework and the available investigative and prosecutorial tools in the fight against money laundering, but gaps remain in monitoring and analysis of suspicious activities, including the fact that financing terrorism (FT) i s not criminalized as a separate offense yet. Limited resources, skills and experience affect all relevant institutions in this area. The UIF has an adequate legal framework; is operational and i s a significant improvement in the detection, reporting, and collection of suspicious transaction information and financial intelligence from the financial sectors. The UIF needs, however, pre-investigative analysis capabilities, resources and additional training. 70 D. SummaryandRecommendations 4.33 The empirical analysis described in Annex A identifies financial market development as the third most important determinant of growth in Honduras. Although the degree of financial deepening in Honduras i s comparable to that exhibited by other countries in the region, it i s significantly underdeveloped by world standards and, thus, offers considerable room for improvement and for raising economic growth. Moreover, Honduras's banking system, which i s the mainstay o f its financial system, has run into serious problems in recent years that have paralyzed new lending in the country's largest productive sector, agriculture, and impose a major impediment to the resumption of growth. These problems were triggered by two external shocks (hurricane Mitch, falling commodity prices) and propagated by various institutional weaknesses in the financial system, resulting in an overhang of bad debts in bank loan portfolios. The most relevant institutional weaknesses that contributed to this problem are a general disregard of systemic risk factors in the management of financial transactions and the open-ended deposit guarantee offered by the government. These have fostered a moral hazard environment that has progressively paralyzed the process of financial intermediation in Honduras. 4.34 To address the immediate causes of the credit crunch in agriculture and permit the resumption o f credit growth, two issues mustbe tackled simultaneously: 0 The Government needs to define and enforce a final (Le., politically and financially enforceable) distribution of the losses accumulated since 1998, taking into account the existing fiscal constraints and the incentive structures facing banks and borrowers. The Government needs to introduce institutional changes to make sure that insurance and price hedging instruments are put in place and financial contracts are no longer written as if systemic risks did not exist. In parallel, CNBS will have to develop the specific regulatory framework and supervisory skills required to guide and monitor these activities. 4.35 Honduras's financial system also exhibits a number of other institutional weaknesses that stand in the way of healthy development in financial intermediary services and that were recently addressed by ajoint World Bank-IMF Financial Sector Assessment Program review. These weaknesses are most pronounced in the areas of bank supervision and regulation, creditor rights and insolvency systems, and payments and securities settlement. The main recommendations offered to correct these weaknesses are presented below. To improve bank supervision and regulation: 0 Prudential regulations need to be enhanced inthe areas of (i) consolidated supervision, (ii) capital adequacy, (iii) classification and provisioning, and (iv) corporate governance loan and risk management. 0 A resolution framework needs to be developed for taking prompt corrective actions when banks encounter problems. CNBS needs to expand its range of instruments, including Action Plans and Memoranda of Understanding, to enforce preventive and corrective actions, and banking legislation 71 needs to be revised to clearly state the objective criteria for triggering the use of these instruments. To strengthen property rights and streamline insolvency proceedings: New legislation i s requiredto introduce a modern and safe registration systemof property rights and securities, both for immovable and movable assets. New bankruptcy legislation, which contemplates the possibility of reorganization and out- of-court agreements, i s required to render insolvency procedures more efficient and less time consuming. Appropriate institutional capacity needs to be developed in the Judicial system to deal with the new legislation on property rights and insolvency procedures. To strengthen the payments and securities settlement functions, The Government should establish a depository function for securities settlement. The Central Bank should define a payments system policy, stating clearly its objectives (such as achieving finality for certain classes of payments) and the instruments (gross and net settlement systems for different types of payments, their respective operational rules, etc.) to reach them. 4.36 There i s a potential danger that efforts to tighten prudential norms and to enforce them better may slow down the expansion of credit, at least temporarily, which could have an adverse impact on growth. This i s a modest danger in the case of Honduras, since the banks already have paralyzed much of their lending activity. Furthermore, it i s important to keep in mind the earlier finding of this report that the evolution of economic growth in Honduras is mainly explained by changes in productivity growth, and not by changes in factor quantities. Applied to the context of the banking sector, this suggests that primary attention should focus on the quality of lending, rather than on quantity. In other words, to the extent that there i s a tradeoff between faster credit growth and better application of prudential norms, Honduras would be advised to move toward a point that involves improved prudential norms. 4.37 Taking a longer-term perspective, it is also recommended that the authorities review the governance framework governing pension funds, with the aim of reducing political risk and promoting greater asset diversification. The capacity to supervise insurance companies and other non-bank financial institutions also needs to be strengthened. Although these are still relatively small in size, many of these (notably cooperatives) are growing rapidly and, thus, could eventually constitute a threat to financial stability. Finally, even though an effective legal framework to combat money laundering and the financing of terrorism i s in place, the institutions involved inthese areas need to be strengthened. - 72 Table 4.4. Financial Sector Institutions inHonduras, 2003 REFERENCE SINCE OFFICES MPLOYEES INSTITUTION NAME Bancode Honduras,S.A. Honduras 2-oct-1889 Tegucigalpa 2 56 BancoAtlintida. S.A. Bancatlin 17-Dec-14 Tegucigalpa 172 1,398 Bancode Occidente, S.A. Bancocci I-Sep-51 Sta. Rosade C. 147 2,531 Lloyds Bank PLC Lloyds 13-Oct-59 Tegucigalpa 9 107 Banco de Los Trabajadores Bancotrab 1-May-67 Tegucigalpa 30 460 BancoSogerin, S.A. 21 -- Sogerin 16-Nov-69 San PedroSula 17 165 Banco Continental,S.A. Bancon 20-May-74 San PedroSula 40 484 Banco FinancieraCentroamericana,S.A. Ficensa 23-Aug-76 Tegucigalpa 25 295 Bancode Las FuerzasArmadas, S.A. 3/ Banffaa 8-Aug-79 Tegucigalpa 36 268 BancoMercantil, S.A. Bamer 14-Feb-80 Tegucigalpa 56 964 Banco Hondureiio del Cafe, S.A. Banhcafe 4-May-81 Tegucigalpa 40 614 Bancodel Pais, S.A. Banpais 9-Jul-92 San Pedro Sula 56 534 BancoUno, S.A. Banco Uno 17-Jul-93 Tegucigalpa 20 125 Banco de la Produccidn, S.A. Banpro 23-May-94 Tegucigalpa 5 99 BancoFinancieraComercial Hondureiia,S.A. Ficohsa 18-Jul-94 Tegucigalpa 48 958 Banco Futuro, S.A. Futuro 1-Jul-97 Tegucigalpa 16 269 Banco de America Central Honduras, S.A. 4/ -- Bac Honduras 18-Mar-98 Tegucigalpa 33 214 BancoGmpo el Ahorro Hondureiio, S.A. BGA 1-Jul-00 Tegucigalpa 69 1,229 Banco Promerica, S.A. Promerica IO-Jan-01 San Pedro Sula 13 268 T 833 11,098 I I Banco Central de Honduras B.C.H. 1-Jul-50 Tegucigalpa 4 na BancoNacional de Desarrollo Agrfcola 5/ Banadesa I-Apr-80 Tegucigalpa I 504 I I 35 I I LaConstancia,S.A. Constancia 19-Nov-77 San Pedro Sula 17 396 Metropolitana, S.A. Metropolitana 20-Nov-78 San Pedro Sula 2 20 Regimende Aportaciones Privadas R.A.P. 1-Mar-93 Tegucigalpa 2 99 FondoNacional para la Producci6ny la Vivienda Fonaprovi 14-Oct-97 Tegucigalpa 1 101 FinancieraCodimersa, S.A. Codimersa 11-Sep-97 Sta. Rosade C. 2 11 Arrendamientosy CreditosAtlintida, SA. Acresa 19-Feb-98 Tegucigalpa 2 39 FinancieraCredi Q,S.A. 7/ Credi Q 13-May-99 Tegucigalpa 3 51 FinancieraSolidaria, S.A. Finsol 1-Jun-99 San PedroSula 13 168 Financieradel Caribe, S.A. Ficasa 5-Aug-99 LaCeiba 1 13 CorporacidnFinanciera Intemacional,S.A. Cofinter 12-Aug-99 Tegucigalpa 1 16 FinancieraPopular Ceibeiia, S.A. FPC 26-Aug-99 LaCeiba 30 Comp&ia Financiera, S.A. Cofisa 16-Sep-99 San Pedro Sula 42 42 FinancieraInsular,S.A. Finisa 1-Sep-03 Islas de la Bahia 1 6 To 29 376 73 CHAPTERV. IMPROVINGGOVERNANCEINHONDURAS 5.1 Governance i s an important determinant of economic development. This finding emerges, among other, from a recent cross-country empirical study by Kaufman and Kraay (2003)', who report a high correlation between different measures of governance and that causality runs from governance to per-capita income levels, but not vice-versa.2 This finding raises questions about Honduras's future growth prospects, given that it ranks well below the averages in Latin America and the Caribbean in most governance indicators; e.g., see Figure 1.3. This Chapter briefly reviews Honduras's governance rankings, identifying the areas where its indicators lag most significantly behind other countries. I t also discusses ongoing initiatives to improve governance and concludes with some recommendations. A. REVIEWOFGOVERNANCE INDICATORS 5.2 To better understand the sources of Honduras's weak performance in governance, it is useful to look at the six dimensions of governance described by Kaufman, Kraay & Mastruzzi (2003).3 Composite indicators based on measures of perceptions were constructed to estimate performance inthese six dimensions, as follows: Two composite indicators refer to the process by which those in authority are replaced and selected. `Voice and accountability' includes a number of indicators measuring aspects of the political process, civil liberties, political rights, and independence of the media, while `political stabilitv' uses sub-indicators that attempt to measure the likelihood that governments in power will be destabilized or overthrown by unconstitutional means. The next two sets of indicators attempt to summarize the government's ability to formulate and implement sound policies. `Government effectiveness' combines perceptions of the quality of public service provision, the quality of bureaucracy, competence of civil servants, independence of the civil service from political pressure and the credibility of the government's commitment to certain policies, while `regulatory qualitv' focuses on the policies themselves and includes measures of the incidence of market un-friendly policies, such as price controls, inadequate bank supervision, andthe burden of excessive regulation. ' Kaufman, Daniel and Aart Kraay, "Growth without Governance", World Bank Working Paper, 2003. As indicated in Chapter I(paragraph 1.35), governance indicators were not included in the regression analyses reported in Annex A because of an apparent statistical multi-collinearity with the other explanatory variables. That is, these governance indicators exhibited extremely an high bivariate correlation with economic growth, but became insignificant when included in a regression with some of the other explanatory variables. Kaufman, Daniel, Aart Kraay & Massimo Mastruzzi, "Governance Matters 111: Governance Indicators for 1996-2002", World Bank Policy Research Paper No. 3106, June 30, 2003. The governance indicators presented here reflect the statistical compilation of responses on the quality of governance given by a large number of enterprise, citizen and expert survey respondents in industrial and developing countries, as reported by a number of survey institutes, think tanks, non-governmental organizations, and international organizations. 74 0 The last two sets of indicators seek to summarize the respect of citizens and the state for the governing institutions. `Rule of law' measures the extent to which agents have confidence and abide by the rules, including perceptions on the incidence o f violent crime, the effectiveness and predictability of the judiciary and the enforceability of contracts, while `control of corruption' measures perceptions of corruption, defined as the exercise of public power for private gain. 5.3 Figures 5.1 shows how Honduras scored on each of these composite indicators in 2002, compared to the averages for Latin America and the Caribbean. In each case, Honduras ranks below the L A C average and, in all but one (Political Stability), the difference between Honduras's score and the regional average exceeds the statistical marginof error.4 FIGURE5.1. GOVERNANCEHONDURAS LATINAMERICA & THE CARIBBEAN; 2002 IN VERSUS HONDURAS (2002) r I I Voice and Rccountability P o l i t i c a l stability Government Effectiveness Regulatory Quality I ` Rule o f Lau Control of Corruption 0 25 58 75 Comparison u i t h regional average [Latin America 8r Caribbean) Ilouer Country's Percentile Rank 8-188) Source: Q . Kaufmnnr A. Kraay and H.Haitruzzir 2003: Governance Hatters 111: Governance Indicators for 1996-2002 (http://wrw.rrsrldbank.orq~ijgourmance/pub+~g~vrmtters3.html~ 5.4 The preceding result should not come as a very great surprise, given that Governance indicators are positively correlated with per-capita income levels and considering that Honduras i s one of the poorest countries in the Latin American region. More revealing results emerge by comparing Honduras with other lower middle income countries around the world. This comparison, shown in Figures 5.2, indicates that Honduras does not fare equally badly in all dimensions of governance. It achieves a similar or higher score than the comparator group in three dimensions of governance, which are Voice & Accountability, Political Stability and Regulatory Quality. However, Honduras scores significantly below the comparator group in the remaining dimensions, namely Government Effectiveness, Rule o f Law and Control of Corruption. This result 4The marginsof error are indicatedby the thin horizontallinesthat intersectthe upper bars inFigures5.1 and5.2. 75 suggests that governance problems in Honduras are not primarily related to a faulty political system or to inadequate laws and regulations, but more to faulty public sector management and an incompetent civil service, which i s incapable o f enforcing those laws appropriately, and to a weak judiciary. These latter areas, public sector financial management reform, civil service reform and judiciary reform, also happen to be the ones where the Honduran authorities have focused most of their recent efforts to improve governance. Key issues and developments in each of these areas are discussed next. FIGURE5.2. GOVERNANCE INHONDURASVERSUSLOWER MIDDLE INCOME COUNTRIES; 2002 HONDURM (2002) Voice and ftccountability Political Stability Governnent Effectiveness Regulatory Quality Rule o f Lau Control of Corruption 0 25 50 75 le0 Conparison uith incone category average ILouer Hiddle Incone) Ilouer bar) Country's Percentile Rank (0-188) Source: 0. Kaufrmnnr A. Kraay and H. Hastruzzir 2003: Governance Hatters 111: Gorernance Indicators for 1996-2002 ~ h t t p : / ~ . ~ r l d b a n k . o r s ~ i / g o r e r n a n c e / p u b s / q o r r m t t e r ~ 3 . h t m l l B. PUBLICSECTOR FINANCIALMANAGEMENT REFORM 5.5 The World Bank, in coordination with the Inter-American Development Bank, completed a Country Financial Accountability Assessment (CFAA) for Honduras in June 2003, and are in the process of preparing a Country Procurement Assessment Review (CPAR). These reviews point to a series of important weaknesses that undermine public sector management in Honduras in the areas of (i) budget preparation, planning and format, (ii) ) management information systems, (iii) internal controls, (iv) expenditure management, (v) tax administration, (vi) external audit, and (vii) procurement policies. The principal findings ineach of these areas are described next. 5.6 The Honduran authorities have made significant progress in developing the budget as an expenditure management tool over the last year. In particular, the 2004 Budget was delivered to Congress on time (by September 15) and in a multi-annual format, which represents a significant improvement over past practice. The comprehensiveness o f the budget also improved considerably with the parallel 76 submission o f the budgets for the decentralized public agencies. There still remain many systemic deficiencies, however. 0 A significant amount of donor grant and in-kind assistance i s omitted from the budget, which makes i t difficult to gauge the full extent of public efforts in certain areas and coordinate public activities. The same i s true of revenues raised by many ministries through the sale of services. Final budget allocations are based on incremental allocations, often made with little or no input from ministries, and the final allocations are not reconciled with annual operating plans. This has weakened the usefulness of sector operating plans and has resulted in low budget credibility. A significant number of budget amendments are passed throughout the year that reflect Congress's discretionary powers to reallocate financial resources for political purposes, rather than strategic priorities. Although Congress has a constitutional role to oversee public sector management, it lacks the capacity to fulfill this role. 0 A weak planning capacity at the sector level adds to the overall weakness in budget preparation and contributes to the need for repeated budget amendments. 0 The budget i s presented on the basis of expenditure objects, rather than a programmatic classification, which hampers its use for monitoring and evaluating public efforts in relation to agreed priorities in promoting economic growth and reducing poverty. 5.7 The implementation of an integrated financial management system (SIAFI) has improved the Government's ability to control and manage expenditures. SIAFI's usefulness has been limited, however, by rigidities in its format, a lack of comprehensive access to the system by all sectors that results in delays in recording transaction^,^ and a failure to integrate SUFI with various other government information systems. This has led to a proliferation o f information systems in other agencies: without a common platform o f operating and technical standards, resulting in a duplication of databases and effort, and an overall incompatibility of the flow of information within the government. 5.8 Internal controls are widely dispersed and uncoordinated. Furthermore, the Office of the Budget (DGP) exerts a centralized ex-ante control that does not allow for efficient budget execution. At the same time, internal audit functions are not well defined and continue to be controlled by the supreme audit institution ("Tribunal Superior de Cuentas", TSC), blurringthe lines between internal and external audits. 5.9 Fiscal management responsibilities are dispersed among several public entities, rather than being concentrated in the Treasury (TGR), which exhibits significant ~~ ~ The HonduranSocial InvestmentFund(FHIS), for example,still operates outsidethe SIAFI system. These information systems include the Integrated Debt Management System (SIGADE), Integrated System for Public Investment (SISPU), Integrated Poverty Reduction Tracking System (SIERP), an integratedsystem for recordingforeign assistance inflows(SINACOIN), and the public sector's human resourcedatabase (SIARH). The governmentplans to have linked SIAFI and SISPUby April 2004, andSIAFIand SIGADEby July 2004. 77 institutional weaknesses. The dispersion of fiscal responsibilities has resulted in functional voids that directly affect the security and control of management of public funds. Adding to this void is the TGR's practice of issuing negotiable checks, which prevents the verification of the final recipient of government payments. 5.10 Procedures governing tax collections are deficient and unclear. There i s no proper reconciliation between the funds paid by the taxpayers with the funds declared by the banks as collected; and there i s no reconciliation between the funds received by the banks and the funds transferred to the treasury accounts. There i s little security with respect to the funds collected by the banks, whose solvency i s not previously certified. 5.11 The Government has invested in building its debt management capacity, which represents one of the stronger areas in the public financial management system. Debt management can be improved further, however, with the inclusion of contingent liabilities. These are currently not reported in the Government's financial statements and, thus, not included in debt analyses. Also, debt servicing provisions are not included in the final budget estimates. 5.12 The external audit functions are still evolving in the wake of reforms that led to the creation of the TSC. The effectiveness of the TSC is currently limitedby a lack of qualified personnel, insufficient financial resources to fully discharge its responsibilities and a lack of operational guidelines and regulations. One reflection of these deficiencies i s that the annual reports for fiscal years 2001 and 2002 have not yet been finalized. 5.13 Honduras does not have an adequate system for government procurement. The legal framework for public procurement is given by law No. 74-2001 ("Ley de Contrataciones del Estado") enacted in June 2001, and by its regulations, enacted inMay 2002. This framework i s an important improvement over the previous procurement framework in that it (i)covers all government agencies under one set of guiding principles with respect to economy, transparency and efficiency, (ii) provides for the creation of a Procurement Regulatory Office to give a common and consistent approach to standard bidding documents, criteria and practices, (iii) provides for the use of open competitive procedures that include public bid opening and non-discriminatory participation of suppliers under a wide range of procurement methods, and (iv) requires public notification of procurement opportunities. In spite of these improvements, however, the system remains ineffective because o f 0 Weak implementation of the procurement rules and procedures, 0 Lack of dissemination of the new system inthe public and private sectors 0 Non-establishment o f the Procurement Regulatory Office, Lack of capacity among working level staff and members of the tender committees and approving authorities, and 0 Absence of project managers and procurement practitioners, and of a career stream inproject and procurement management. 'The constitutional reforms of 2002 transformed the previous Comptroller General's office, headed by one Auditor General, into the Supreme Audit Court (TSC), which i s headedby a board of auditors. 78 5.14 These deficiencies have seriously undermined trust in local procurement legislation and systems, with the result that the Government has appointed UNDP as its primary procurement agent to handle aid resources. Originally contemplated as a temporary measure, the use of foreign systems and procurement agents has gradually become a permanent practice in Honduras. Unless these shortcomings are tackled in a decisive manner and coordinated with the donor community, it will remain a serious constraint for the effective implementation of government plans. Main Areas in Need of Reform 5.15 The quality of governance in the public sector, and the accountability of senior public officials that goes with it, need to be upgraded. Efforts in this direction need to focus on strengthening the legal and accountability framework for public financial management, improving transparency and oversight mechanisms of public financial management systems, streamlining processes and procedures, and rationalizing and strengthening the institutions responsible for ensuring accountability. In response to these needs, the Government of Honduras has embarked on an ambitious program to reform public financial management with the assistance of the World Bank, IDB and other donors. Important advances to date include (i)the drafting of a Financial Management Law, Public Ethics Code, and Law on Public Access to Information, (ii) improved budget formats and internal controls to facilitate a sector-wide approach in Education, (iii) expansion of SIAFI to increase its programmatic functionality, (iv) the the production of the first government financial statement prepared by the Accountant General's Office and a preliminary inventory of all government assets, and (v) the promulgation of new regulations for external audits by the TSC. A detailed list of recommendations to guide further efforts in this area are presented in the CFAA Action Plan, whose key points are described below. 5.16 Budgeting. In order to improve donor coordination and program execution, the Government i s currently engaged in efforts to shift donor assistance toward a programmatic basis. In light of those efforts, it i s necessary to change the budget format to one based on programmatic classifications, and to make it more comprehensive by including all external assistance. This transformation i s already taking place for some sectors; e.g., the Ministry of Education. These changes entail a modernization of the Chart of Accounts in SIAFI, as well as a need for training and capacity building among the sector planning and evaluation groups (UPEGs)throughout the Government. The new programmatic budget should be based on Government spending priorities as articulated in the PRSPERP, and the annual operating plans (POAs) should follow clearly established guidelines for programmatic budgeting. Also, the Government's ability to accelerate budget reform will enable it to implement a medium-term expenditure framework and facilitate the management of sector wide approaches (SWAps). The Education, Health and Agriculture sectors currently provide the best opportunities for piloting SWAps, which hold the promise of generating significant improvements in sector coordination and policy effectiveness. SWAP strategies are also being developed in the areas of water and sanitation, infrastructure, the productive sectors and domestic security. 79 5.17 Budget Execution and Reporting. The quality of budget reporting can be improved through the production of interim reports, and through the inclusion of information about executed budget in state-owned enterprises and decentralized agencies. Quarterly budget reports should be produced and published, along programmatic lines, once the shift in budget classification i s completed. These reports will enable a much broader participation in budget monitoring and evaluation, and will also enable more effective tracking of poverty reduction efforts. The medium-term plan for capacity building and institutional strengthening should include significant actions to strengthen the monitoring and evaluation capacity within the ministerial units. 5.18 Accounting and Financial Reporting. In parallel to the expansion of SIAFI, the Central Government accounting function should gradually move from merely recording transactions toward including analyses that add meaning to Government financial statements, in a manner consistent with international practice. In the meantime, three actions are needed: (i) ensure that all global allocations/transfers to decentralized entities are properly recorded in reports on the use of funds, (ii) reconcile budget execution and cash flow statements, and properly identify any inconsistencies or leakages, and (iii) complement these statements with historical information to evaluate trends, and meaningful notes to enable interpretation and analysis. 5.19 Treasury. The responsibility for revenue and cash management should be vested in TGR. This requires a plan for the gradual shift of responsibilities from DGCP and BCH to TGR. Any reform to redistribute responsibilities must first address the lack of capacity, knowledge and experience in the TGR, which will require technical assistance to develop the rules, regulations and procedures to govern its fiscal operations. An efficient and effective management of the TGR also will depend on a timely transfer of funds and related information from the spending agencies. It is necessary, therefore, to coordinate the capacity building efforts in TGR with parallel efforts to strengthen the spending agencies and to upgrade SIAFI. 5.20 Revenues. The tax collection system needs to be upgraded, and must be subject to a strong and effective regulatory system. This upgrading should include measures to improve the timeliness of revenue reporting, as well as procedures to ensure that revenue projections and collections are includedinperiodic budget reports. 5.21 External Audit. TSC urgently needs a set of regulations to govern its operations. Even though its mandate has been broadened, TSC's first priority should be to continue the ongoing, donor-supported efforts to build the technical capacity o f its staff. TSC does not need more staff. However, it requires qualified staff, fully capable of carrying out the financial audit of the public accounts o f the Government, with sufficient knowledge o f internationally accepted standards and audit methodologies. TSC has plans to review and approve the eligibility of private auditing firms hired by public sector entities and to monitor the work of those firms. This i s a satisfactory approach for the medium term, after it has built up the capacity of its own staff. TSC's long-term sustainability depends on the quality of its human resources and a capacity-building program that focuses on upgrading skills i s by far its highest priority. 80 5.22 Systemic Recommendations. There are also a number of systemic activities that the Government needs to undertake to establish a modern and efficient public financial management system, and which are enumerated in Box 5.1. Box 5.1: Systemic Recommendationsof the CFAA Action Plan for Honduras Budgeting Strengthen programming and evaluation capacity (UPEGs) inboth SEFINand sectors; Develop evaluation methodologies for investment projects or programs in specific sectors; Ensure that approved budget allocations are reconciled with POAs and PRSPERP; Include all resources financing public expenditures (including grants and in-kindassistance); Include revenue projections, and revenue generated from agencies (e.g., Health, Education); Develop performance indicators and the capacity to collect information on performance; Provide wider discretion for spending, based on performance indicators and performance budgeting. Pilot initiatives on performance budget contracts and decentralized budgeting Accounting and Financial Reporting Carry out an integral review of the Government accounting function; On the basisof the review, develop a plan to move from accounts that are merely a record of transactions to ones that provide an analytical capability. Extend the coverage of SIAFI and the proposed single treasury account system to all entities receiving budgetary allocations; Produce cash-basedGovernment financial statements consistent with international practice, while increasing capacity to manage accrual accounting; Update the register and reconciliations of Government assets Treasury - TGR Review TGR's capacity, functions, responsibilities vis-&-vis DGCP and BCH; BuildTGR's capacity to managecash inthe long term, and develop transitional arrangements where the responsibilities and functions move gradually from DGCPBCH to TGR; Create a class of non-negotiable checks that TGR can issue to Government suppliers; Create a Registry of Suppliers; Revenue and ExpenditureReporting Certify the solvency of banks acting as tax collection agents, and provide a plan for the periodic re-certification of those banks; Establishcollection accounts of the TGR for tax collections; Reconcile funds collected and funds transferred; Strengthen the institution engaged in the tax and customs functions (DEI); External Auditing - TSC Enact TSC Regulations; Draft procedures and an operating manual with guidelines; Certify private sector firms to audit public sector agencies; Develop of training plan for capacity development; Oversight of Public Financial Management Strengthen the Congressional committee for budget monitoring and evaluation by providing a technically qualified secretariat. Disclose publicly all Congressional budget proceedings. Ensurethe participation of civil society through creation of social audit mechanisms. I 81 5.23 Procurement. The Government has been addressing the problems inprocurement, but progress has been slow and inconsistent, resultingina significant disconnect between the existing regulatory framework and its enforcement by individual Government agencies. To address this disconnect, a proper reform strategy i s needed to accelerate the pace of reforms and develop crosscutting linkages among relevant actors. The State Modernization Committee (CCME), for example, needs to follow more closely the action plan developed within the donor-supported Program of Efficiency and Transparency in Government Procurement. At the same time, the Government needs to link its procurement reform strategy with relevant public sector and governance initiatives in other arenas, including civil service, decentralization, public investment and finance, anticorruption, competition policy, and civil society. To do so, it needs to involve new stakeholders, including politicians and civil society leaders, in the support and oversight of reforms. A set of specific recommendations in this area are being developed in the context of a CPAR Action Plan, which i s scheduled to be completed by end-2004. 5.24 A successful procurement reform requires qualified human resources, the lack of which constitutes a major obstacle in Honduras. It will be hard, if not impossible, to attract qualified procurement specialists under the current public salary scale and career incentives. To overcome this obstacle, the Government could explore the option of working within a structure where procurement specialists are developed outside the civil service framework and allowed to compete freely with civil servants in the delivery of procurement services. Government efforts could then focus on regulating and enforcing harmonized standards, while the procurement specialists retained b y donor-financed projects become providers of procurement services under a transparent and competitive selection process. Competition among these specialists would improve the quality of public procurement services and save financial resources. At the same time, it provides an incentive to consolidate the fiduciary arrangements of different programs. Pilot exercises such as the Education-For-All SWAPcould pave the road for this approach to closing the gap inprocurement expertise. c. CIVIL SERVICE REFORM 5.25 Honduras's civil service and human resource administration i s currently governed by the Civil Service Law (Decree No 126) of 1968. Although it appears to constitute comprehensive legislation on all matters related to public personnel management, this law has hardly been binding during the last two decades. Instead, b y the mid 1990s, many separate employment regimes have been created which provide extraordinary benefits to particular sectors of the public labor force, such as teachers and health workers. These special regimes have led to an uncontrolled increase in the public wage bill, imposing an unsustainable fiscal burden on society, and they have created enormous disparities across public servant, both interms of benefits and administrative procedures. 5.26 At the same time, human resource administration inthe central government and in the rest of the public sector has evolved in ways that completely undermine the existing civil service law and that i s not conducive to an effective and transparent administration of public personnel. The hiringprocess, performance evaluation and dismissal procedures have become very politicized, reducing the capacity of public institutions to attract 82 qualified personnel and to deliver public services efficiently. Thus, the institutional capacity of the whole public administration has been weakened. Personnel turnover has been increasing over the last decade, mostly affecting high and low level positions of the civil service. Mid-level positions have been less affected by turnover, but the absence o f transparent rules for personnel management have undermined the morale of civil servants, and promoted inefficiency and corruption. 5.27 As discussed in the 2001 Public Expenditure Review, the overall size of the Honduran public sector i s not excessive in comparison to other Central American and HIPC countries. Moreover, as shown inAnnex B, the number of public sector employees has been growing very gradually, so that the proportion of civil servants to the population i s currently the same as in the mid-1990s. [Wage costs, on the other hand, increased by 50 percent as a proportion of GDP over this period, seriously weakening the country's fiscal position.] Even though the overall level of public employment i s not inappropriate, there are serious staff imbalances across sectors. This i s due to years o f weak personnel management policies and a lack o f clarity on the role and purpose of different public sector entities. The consequence has been that many entities are clearly overstaffed in certain unneeded functions, and understaffed in other areas, which limit their capacity to deliver adequate services. 5.28 The most important issues to be addressed in connection to the administration of public employment refer to: 0 The need to restore control over salary and wage policies, in order to restore a sustainable fiscal situation and a more equitable distribution of benefits. 0 The need to review the macro-structure of the public sector, clarifying the roles, functions and service delivery responsibilities o f different public entities, and to re- dimension these entities (including their employment composition) in accordance with these functions and responsibilities. 0 The need to establish a new normative and institutional framework to govern public employment, which limits political influence over the civil service, and 0 The need to follow through with the implementation o f the new civil service framework once it has been approved. Key Reform Actions 5.29 To address these issues, the authorities have been working on a two-fold strategy that addresses both short-term and medium-term objectives. To begin, the government submitted to Congress a Public Salary Law ("Ley de Equidad SaZariaZ"),which was approved in December 2003. This law restores government control over the wage bill and wage administration. It eliminates the special wage regimes, folds various wage bonuses ("colaterales") into the base salary, broadens the scope o f wage policy to cover all government employees and allows reserves for the government (as opposed to Congress) the role o f formulating wage policy in line with anticipated inflation. To reestablish more equity in the wage structure, government salaries have been capped, and certain salaries (e.g., doctors) have been temporarily frozen, while others are permitted to 83 adjust in line with projected inflation.* The law was prepared in consultation with all the affected sectors, and presented in the context of a fiscal responsibility agreement between the government and civil society. 5.30 Another set of measures i s designed to address several structural issues over a medium-term horizon. These measures are to be carried out in parallel and involve the following: 0 preparation of a comprehensive reengineering study of the whole public administration, which identifies the functions that will remain in the centralized public sector (as well as those to be divested to the private sector, NGOs or municipalities) and then determines the appropriate size and composition of public entities in accordance with these functions, 0 submission to Congress of a new law to reform public administration, which includes provisions to establish transparent procedures for hiring, evaluation and dismissal of public servants, to limit the number of political appointees inthe civil service, and to create an independent oversight institution for the civil service, and 0 completion of reengineering studies and gap analysis in certain entities, and implementation of the new civil service regime in those entities. 5.31 If properly followed through, these policy actions will permit the government to (i)restore control over wage administration and thereby eliminate one of the most important threats to fiscal sustainability, (ii) establish a new normative and.institutional framework to implement a comprehensive civil service reform, introducing a result- oriented incentive environment for public servants, and (iii) initiate the implementation of the civil service law in a number of restructured entities and quickly incorporate a critical mass of public servants into the new regime, which will serve to underwrite its credibility. D. JUDICIAL REFORM 5.32 The 2002 Transparency International Corruption Perceptions Index gave Honduras a score of 2.7 on a scale of 1to 10 (with 1signifying the most corrupt and least transparent environment), which placed i t 71St out of the 102 countries surveyed. Similarly, a survey carried out by the World Bank Institute in 2001 among civil society, private entrepreneurs and public officials, found that crime and corruption are perceived to be among the top three most serious problems affecting Honduras, together with the highcost of livingg The highranking given to crime and corruption is symptomatic of a lack of respect for the rule of law. Teachers (which account for 60 percent of total public employment) are subject to a transitional arrangement, whereby they will become fully incorporated into the new wage policy framework by the end of 2006. Meanwhile, their base salaries are targeted to increase by slightly less than expected inflation during 2004-06, and their special wage payments related to seniority and education attainment have been capped. Consejo Nacional Anti-Corrupcibn, Encuesta Nacional Anti-Corrupcibn, Enero 2002. Tegucigalpa, Honduras. 84 5.33 Honduras's system of justice historically has suffered from weak institutional capacity, a limited focus on the needs of the poor, and accusations o f inefficiency and corruption. According to Table 5.1, it appears to be one of the least efficient judiciaries in Latin America. Average annual filings perjudge are less than 150, which is very low by Latin American standards. The larger South American countries normally average between 700 and 1000filings perjudge. Even with this very low caseload, it appears that judges are not deciding most cases in Honduras, and when they do it is with extreme delays. Table 5.1. Selected Indicators of Judicial System Performance Source: LinnHammergren(WorldBank, 2004), basedon data from 2000-02. 5.34 Honduras's judiciary also stands out in Table 5.1 by exhibiting a very low demand for judicial services and a poor judicial response. Litigation rates, defined as cases per 100,000 population, are among the lowest in the region. It i s not clear what produces such low litigation rates, and whether litigation rates are significantly different in rural and urban areas. This may be reflecting significant obstacles to accessjudicial services, be it because individuals cannot go to court without hiring a lawyer or because poor performance on the part of the judiciary produces a lack of interest in litigation - thus perpetuating a vicious cycle. These questions need to be explored more thoroughly inorder to design appropriate reform measuresinthis area. 5.35 The judiciary's statistical base on caseloads and on what judges do with it i s very bad, and consequently the figures pertaining to Honduras in Table 5.1 need to be treated with some caution. All the evidence available at this time, however, indicates that the Honduran system as a whole i s expensive and that the monies are not used efficiently, that the justices of the peace (which constitute the majority of the judges) are very underutilized, and that while urban trial courts may be handling larger caseloads, they have great delays in coming to judgment, relatively few judgments and problems with the enforcement of judgments. 85 5.36 Honduras has been pursuingjudicial reform since at least the early 1990s,largely promoted and funded by external donors and carried out by different justice sector institutions including the Public Prosecutor's Office (or Public Ministry), Judicial Branch, and Human Rights Ombudsman. Aiming to promote human rights and strengthen democratic institutions, the focus has been on legal reforms regarding the structure and content of criminal procedure and the institutions responsible for the enforcement of laws under a revised criminal procedures code. Other areas (civil, commercial, family, labor matters - which represent about half of the caseload and resources used) have received little or no attention. The reform process has been influenced by a multitude of donors, often providing mixed signals and technical advice. Strong on studies, the process has been incomplete in implementation and deficient in providing an integral, medium-term vision.lo 5.37 Not surprisingly, the organizational capacity of the Judicial Branch at all levels and in all functions remains weak, many lack access to justice (especially women and disadvantaged groups, who rarely even seek legal redress from the courts), and corruption i s perceived to be widespread in the lower courts." A general lack of transparency and effectiveness i s hurtinginvestor and business confidence (which i s particularly important at a time when free trade agreements are being negotiated in the region) and preventing the Judicial Branch from deterring family violence and youth crime. Meanwhile debate continues on how to balance the long-term capacity building needs of the judiciary (usually a prerequisite for good service provision) with the need to quickly increase citizen access to the judiciary. 5.38 An important factor contributing to the limited progress made in modernizing the judiciary has been the frequent replacement of judges. Supreme Court judges and most o f the lower leveljudges were customarily changed with every new administration. With the reforms in 2002, the members of the Court have been given more independence through a longer tenure, which provides a more promising environment for implementing reforms. The newly appointed Supreme Court, supported b y a reformist national administration, offers a unique opportunity that calls for redoubling efforts to reform the justice system. lo About US$40-60 million in grants and loans has been supplied by donors to improve the justice sector as a whole over the past decade. There have been investments in infrastructure (about 80 courthouses were built in rural areas for justice of the peace courts, two buildings in San Pedro Sula and Tegucigalpa), however most lack the technologies and tools to support judges and other judicial staff. There has been investment in computers and training to support criminal procedural reform, yet implementation has occurred only in a small number of courts. Incomplete initiatives also include advocacy funding to NGOs and other groups that did not result in adequateresponse and will to reform by thejudiciary, as user confidence has remained low due to corruption and the lack of professionalism within the judiciary. Early efforts pushed with little or no local participation by stakeholders caused additional resistance to change by judges and a loss of confidence in donor assistance by civil society groups. This was at the time when political will for reform was neither high nor deeply enough ''According embedded in the institutions to be reformed. to a WBI survey, 63 percent of users have serious doubts about the impartiality and credibility of thejudges. 86 5.39 The preceding discussion emphasized the need to modernize the judiciary, including fighting corruption, promoting greater judicial independence, and improving the overall efficiency and efficacy of the judicial system. Access to justice also needs to be improved, giving special attention to less expensive and expedient conflict resolution procedures and other services targeted at disadvantaged population groups (particularly women, indigenous populations and the poor). Youth violence and crimehecurity problems also need to be addressed through coordinated social solutions and justice sector measures. Another important issue that needs to be addressed, especially with a view to promoting growth, i s the strengthening of land security; Box 5.2. In view of these many demands for reform and institutional challenges, proper sequencing and prioritization of reforms are needed to avoid institutional, financial, or political capacity overload. It may be advisable, therefore, to begin with three intermediate development objectives that deserve special attention: (i)building Judicial Branch governance capacity. The mandate of the current Supreme Court runs through 2009 so the opportunity exists to strengthen its management capacity, including the establishment of planning and administrative structures, promotion of inter-institutional coordination with other justice sector institutions and civil society, setting judicial career norms, and promoting professional development of judges and staff; (ii) building confidence and trust among citizens by implementing basic first-stage anti-corruption, transparency and accountability initiatives with stakeholder input; and (iii)improving access to justice for high priority target populations by designing, piloting, and extending selected access to justice measures. Where populations are very dispersed, the authorities may consider introducing circuit judges (who move between several locations) in order to increase access in an efficient manner. 5.40 More broadly, judicial leadership also needs better information on present demand (who uses the courts and for what), the nature and causes of delays, inconclusiveness (no judgments), and low enforcement, as well as on potential demand (who i s not using the courts and why). This would allow attacking the problems of inefficiency at a higher level by ensuring that the courts focus on the most important cases in terms of poverty reduction, economic growth and conflict mitigation, rather than just helpingthe courts process better the cases that they already are getting. There appear to have been problems with on the demand side in terms of abusive use of the courts to delay contract enforcement or to delay politically sensitive administrative decisions on the part of the government. Some of these problems can be addressed through better management in the judiciary, but others will require legal changes (e.g., simplification of procedures to reduce the opportunity for dilatory practices), coordination with other sector entities (e.g., the Public Ministry and its prosecutors), and higher level political decisions as to what the judiciary should be reviewing. As some o f these decisions may involve facilitating access to potential claimants who are currently not using the courts, an understanding of their needs and the alternatives for addressing them i s also essential. 87 BOX 5.2 LAND INSECURITY INHONDURAS Land tenure insecurity is one of the most critical deterrents of investment in Honduras, especially in rural areas where 75% of rural households are below the poverty line and of which 80% are classified as living in extreme poverty. (Countrywide, 59% of poor households and 65% of the extreme poor are rural.) It is also a source of social instability, and disincentive to sustainable landuse, contributes to deforestation, and enables corruption in land transactions. Only about 30 percent of the estimated 2.6 million land parcels in Honduras are registered in the property registry. A recent study estimated the total value of these extra-legal assets amounts at about US$12 billion. Failure to use even a fraction of these assets to mobilize credit is an important source of stagnation and inequality. The historical land claims of indigenous and Afro- Honduran communities further complicate the land rights issue and still remain to be adequately addressed. While many land-related policies and laws have been issued already, these are highly fragmented, at times contradictory and, consequently, exacerbatethe problemof land insecurity. In recent years, the Government has taken important steps to address the issue of land insecurity. The Maduro Administration, in particular, has made serious efforts to modernize the land administration system (both legal and physical land records), target the land titling programto the large number of settlers in frontier areas, and title indigenous communities while recognizing ancestral domains. The PSRC is supporting the Government's on-going reforms and actions to enhance land security and access, which aim to address key structural causes of rural and urban poverty. Inparticular, it is supporting the Government's efforts in the areas of (i) land titling and registration to improve land security and the functioning of land markets; (ii) piloting a market- assistedland access program (PACTA) to help address policy constraints and work out modalities for reducing the structural skewedness of land distribution; and (iii) increasing access to rural finance. E. CONCLUDINGREMARKS RECOMMENDATIONS AND 5.41 An important step in combating corruption was taken with the creation of the National Anti-Corruption Council (CNA) in February 2001 (through Executive Decree 015-2001). The Council consists of 24 highly respected members of Honduran society - divided evenly between government officials and non-government representatives - and i s presidedby Cardinal Oscar AndrCs Rodriguez. The main mandate of the CNA was to design and formulate a National Anti-Corruption Strategy, while overseeing the implementation of an associated Anti-Corruption Action Plan. In October 2001, the CNA presented a set of reform proposalsthat focused on (i) reforming the country's legal framework, (ii) reforming the supreme audit institutions, and (iii) ensuring public access to information and civil society participation in combating corruption and the formation of values. The mainactions proposedineach area are listedinBox 5.3. 88 BOX 5.3. :KEY SHORT-TERMACTIONS PROPOSEDBY THENATIONAL ANTI-CORRUPTION COUNCIL FOR COMBATING CORRUPTIONINHONDURAS Reforming the Legal Framework 0 Approval of a NominatingCommitteeLaw for electingSupreme Courtjudges 0 Implementation of the new PenalProceduresCode. 0 Approval andExecutionof the Judicial CareerLaw 0 Approval of a new Immunity Law. 0 Reforming the Law governingthe elections process andpolitical parties. Reforming the Supreme Audit Institution 0 Approval of the FrameworkLaw for State Auditing Institutions 0 Redesignof the institutional framework for public auditors and appraisers Citizens Access and Participation 0 Implementation of social audits 0 Establishing aculture of accountability 0 Providing access to information 0 Providing access to the public management and information systems 0 Preparestudy on the historical evolution of corruption inHonduras Source: CNA, "Resumen Ejecutivo, Encuesta Nacional Anti-Corrupcibn", Enero 2002. 5.42 Honduras has made significant progress in many of these areas since the CNA proposal was presented. With respect to the legal framework, the Nominating Committee Law was passed in 2002 and the current members of the Supreme Court were elected under its provisions. The new Penal Procedures Code i s in the process of implementation. A law that limitsthe immunity granted to legislators and other public officials was passed inJuly 2004, and draft laws to create ajudicial career pathhave been prepared. The two actions contemplated for reforming the supreme audit institution began to be implemented in 2002 with the creation o f the TSC. Finally, citizens' access and participation are being promoted in various ways: the PRSP process has been broadly participative (most recently in connection with the preparation of the first PRSP Progress Report, which was presented to the Boards of the IDA and IMF in December 2003). Social audits are being prepared on a pilot basis to evaluate the provision of social services, with support from several donors and a possible PRSC, and the government i s currently reviewing a draft law on Public Access to Information for eventual submission to Congress. 5.43 The government also has been working on simplifying administrative procedures and improving public security. As noted in the 2004 Investment Climate Assessment, registering a firm in Honduras i s an extremely cumbersome and lengthy process that hampers business development and lends itself to corruption. The passage o f an Administrative Simplification Law in June 2002 marks an important advance in this area, and its implementation should yield significant reductions in the time and cost of doing business inHonduras. High crime rates and inadequate public security also are problems that reduce the attractiveness of Honduras to investors. The deteriorating trend in Honduras's crime indicators over the last decade has been a cause of concern, prompting action by the authorities to sanction youth gangs ("maras"), strengthen the police force and introduce crime prevention plans. 89 5.44 As indicated in earlier sections of this chapter, however, much still remains to be done for improving governance. The main recommendations that emerge from this discussion are to: Implement the CFAA Action Plan to improve public sector financial management. 0 Complete the CPAR and implement a CPAR Action Plan to improve public procurement processes. 0 Complete a comprehensive reengineering study of the public sector, to determine the appropriate functions and skill requirements of different public sector entities, and begin the reorganization of certain public entities in accordance with the new civil service regime. Submit to Congress a new law to reform public administration, which establishes transparent procedures for hiring, evaluating and dismissing public servants, limits the number of political appointees in the civil service, and creates an independent oversight institution for the civil service. Develop a accurate and comprehensive statistical database on the judiciary and develop its management capacity (which will require proper management information systems). Prepare an in-depth diagnostic study of (i) demand for judiciary services in Honduras, (ii) main obstacles to accessing the judiciary system, and (ii) the the low productivity of the judiciary, and prepare a plan of actions for removing those obstacles and increasingthe efficiency of the judicial system inHonduras. Annex A Page 1of 9 ANNEX A The Key Determinantsof GrowthinHonduras 1. This annex estimates the influence of economic policy outcomes on growth based on the results of a comprehensive cross-country study carried out by Loayza, Fajnzylber and Calder6n (2002). That study regressed the economic growth performance of individual countries against a variety of economic, political and social variables. Broadly speaking, such a regression relationship can be expressed as: where variable, Yit denotes the rate of per-capita GDP growth in country iduring period t, and Xit denotes to the vector of explanatory variables, et i s a vector of random errors, and a and P are the equation parameters to be estimated. Assuming that there exists a stable relation between the explanatory variables and per capita GDP growth, it i s then possible to trace Honduras's relatively poor performance in Y to shortcomings in X or to country specific shocks. 2. The study b y Loayza, Fajnzylber and Calderh (2002) carries out this regression analysis using panel data from 78 countries for the period from 1960 to 1999.' The twelve explanatory variables were chosen on the basis of attention received in the academic literature and policy circles, as well as the robustness exhibited in previous empirical studies when tested in combination with other variables. These explanatory variables fall into five categories: a transitional convergence factor (represented b y the initial level of GDP per capita), which captures the notion that richer countries grow faster than poor countries, other things equal, because of decreasing returns to scale inproduction functions; a cyclical reversion term (given as the gap between actual and potential output), which captures the tendency, typical of business cycles, for growth to revert to a trend level after periods of above or below-trend growth; structural policies and institutions (comprising indexes that measure educational attainment levels, financial depth, trade openness, government consumption, and public infrastructurel2; stabilization policies (comprising indexes to measure lack of price stability, output volatility, real exchange rate overvaluation and the prevalence of systemic banking crises); and external conditions (captured by the growth in the terms of trade and period-specific shifts that proxy for general world growth). Different panel data sets are used in the regressions, depending on whether the data i s averaged over the entire sample, over 5-year or 10-year intervals. The regression results are presented in Table 11.3 of Loayza et a1 (2002). Loayza et a1 (2002) initially had also included a measure of governance among the explanatory variables, but this was subsequently dropped because none of the different governance indexes used turned out to have a statistically significant impact on growth when included together with the other explanatory variables (and sometimes exhibited the wrong sign). Annex A Page 2 of 9 3. It is important to note that the structural and stabilization policy variables used in the regressions described above refer to policy outcomes or results, rather than to policy settings or reforms. For instance, the trade openness variable i s the volume of trade (exports + imports) over GDP, rather than some index of tariff rates or quantitative restrictions. Similarly, the index used to measure the coverage of public infrastructure i s the number of fixed telephone lines per capita, rather than some index of success in privatization or strengthened regulatory capacity. In general, one expects GDP growth to be more closely related to policy outcomes than to policy settings or reform^.^ On the other hand, the use of policy outcomes in the analysis requires that we establish a link between specific policy measures or instruments and particular policy outcomes, before these analytic results can be translated into concrete policy advice. Explaining past changes in growth 4. Changes in per capita growth over different periods can now be explained with the estimated parameters of regression Equation (A.1). This i s done by differencing Equation (A.1) as A.2) and inserting the actual values of the differenced explanatory variables. Annex Table A1 summarizes the results presented in Loayza, Fajnzylber and Calder6n (2002) for the Central American countries for the 1980s and 1990s. The first set of results in Annex Table A1 looks at the change in average per capita GDP growth observed in the 1990s vis-&vis the 1980s. Honduras averaged 0.12 percent annual per capita growth in the 1990s, compared to an average annual decline of 0.73 percent in the 1980s. The actual difference between both rates, 0.85 percent per annum, i s very close to the change predicted b y the regression equation, which i s 0.82 percent. This predicted change in per capita growth i s obtained by adding up the effects of changes in the transitional convergence factor (0.04%), the cyclical recovery factor (0.25%), structural and institutional policy settings (0.7 1%), stabilization policy settings (0.16%), and external conditions (-0.35%). This empirical outcome indicates that improvements in structural and institutional outcomes, though modest, have been the main factors contributing to the increase in Honduras's growth rate in the 1990s, vis-&vis the 1980s, while external conditions have experienced a deterioration that conspired against any improvements in growth. 5. It is comforting to observe in Annex Table A1 that the predicted changes in growth rates for the 1980s and 1990s have the same sign as the changes in actual rates, which indicates that the changes in growth rates over time are not exclusively attributable to random shocks. Looking back at the general growth decline experienced during the 1980s, Annex Table A1 (2nd panel) reveals that the main factors contributing to this decline in Honduras were negative external shocks (terms of trade and country specific shocks) and a cyclical adjustment from the relatively high growth rates experienced in the 1970s. In Nicaragua and Panama, the decline of Eduardo Lora, "Structural Reforms in Latin America under Scrutiny" (Inter-American Development Bank, March 2002) reports the results from a similar set of regressions that use policy settings and reform indexes as the explanatory variables. As expected, the regressions in Loayza et a1 (2002) exhibit a better fit than those in Lora (2002). 4Guatemala i s excluded from these tables for lack o f data. Annex A Page 3 of 9 growth in the 1980s reflected a deterioration in structural outcomes and, particularly, those associated with stabilization policies. Honduras, on the other hand, achieved some important gains on the structural front during the 1980s' as did also, to a lesser extent, Costa Rica and El Salvador. This positive outcome counteracted the impact of other negative shocks on the Honduran economy, with the effect that its economic contraction inthe 1980swas not as deep as in the other countries. The structural and institutional policy improvements achieved by Honduras during the 1980s occurred primarily in the areas of expanded schooling and public infrastructure (as proxies by secondary enrollment rates and number of telephone lines). Although some deterioration occurred in containing public expenditures and in maintaining an open trade regime, these had a relatively minor impact on growth. 6. The overall pace of structural and institutional improvement exhibited by Honduras during the 1980s was not sustained in the 1990s, which saw a general improvement in the external environment. Although its structural and stabilization outcomes did not exhibit any major deterioration (and improved in some instances), the overall progress made on both fronts was less aggressive than that shown by the other Central American countries, with the result that Honduras had a milder recovery in the 1990s than the others. (Whereas El Salvador and Nicaragua were able to boost their average per capita growth rates b y more than 2 percentage points through improved structural and institutional outcomes, Honduras only was able to boost its annual growth by 0.7 percentage points on this account.) This growth pattern can already be seen during the first half of the 1990s, before hurricane Mitch exerted its negative influence on Honduras's growth; last panel in Annex Table Al. While the Central American countries as a whole were able to raise their predicted annual growth rate by an average o f 2 percent during the first half of the 1990s,Honduras only achieved an increase of 0.46 percent. 7. To summarize, Honduras's growth was held back during the 1980s by a generally unfavorable external environment, in spite of perceptible advances in growth-enhancing structural developments. Conversely, in the 1990s, Honduras was unable to take advantage of a much improved external environment by failing to sustain the pace of structural and institutional development observed inthe previous decade. Simulatingfuture changes in growth 8. Looking now toward the future, we can enlist the estimated Equation (A.2) to forecast future growth rates on the basis of forecasted values of the explanatory variables. This i s done in Annex Table A 2 under three different scenarios concerning the evolution of the explanatory variables. The first scenario broadly assumes that the explanatory variables evolve according to their historical trend^.^ The second scenario i s more optimistic in assuming the implementation The historic trends are calculated by Loayza, Fajnzylber and Calder6n (2002) with the use of univariate ARMA regression models (in linear, logarithmic or quadratic specifications). This i s used for all variables except for (i) the transitional convergence term, where data for 2000 is used for the initial GDP per capita level, (ii)the prevalence of banking crises, for which a multivariate probit model i s used to estimate the probability of such crises on the basis of other forecasted variables, (iii) the change in inflation rates, output gaps and output variability, which are based on projections from the Latin American Consensus Forecasts and World Economic Outlook, and (iv) the period shift, for which it is simply assumed external conditions (other than the terms of trade) will remain the same in the 2000-10as in the 1990s. Annex A Page 4 of 9 of policy reforms, such that the policy determinants of growth in each country move to the top 25th percentile o f their distribution in Latin America and the Caribbean. The third scenario assumes an even more aggressive reform program, whereby the policy determinants of growth move to the top 25'h percentile of the corresponding world distribution. Annex Table A3, which follows directly from Annex Table A2, shows the marginal gains in projected growth from embarking on different reform scenarios instead of maintaining the historic policy trend. 9. The first panel of Annex Table A 2 shows that Central America on average would be projected to grow almost one percentage point faster per year if the historic policy trend i s maintained. (This growth increase is determined by policy outcome improvements, which contribute 1.57 percent per year, together with adverse external and cyclical factors, which subtract 0.61 percent per year.) Honduras, however, would only be projected to growth faster by 0.39 percent per annum if policies were to follow historic trends. This outcome reflects Honduras's uneven progress on the structural front in past years. In any case, under this scenario, Honduras's per capita income would only be growing by half a percentage point per year during the next decade. With such a low growth rate, Honduras would miss its PRSP target for reducing the incidence of poverty by wide margins; Table 6 inthe main text. 10. Consider now the more optimistic policy reform scenario in the 2ndpanel of Annex Table A2. For the average country in Central America, advancing its structural and stabilization outcomes to the top 25 percent of the L A C region would represent a growth gain of 2.24 percent per annum, which i s close to the average gain for all L A C countries (2.20 percent). For Honduras, the gain would be slightly higher (2.72 percent), which reflects the fact that its level of structural development on average i s slightly below the average Central and Latin American level. This scenario represents a significant advance for Honduras, raising its annual per capita growth rate from a projected 0.5 percent under the historic trend scenario to 2.84 percent. 11. To achieve the adjustments assumed under this scenario, Honduras would have to devote most of its reform effort to the expansion of education and of public infrastructure. Improvements in these two areas account for the lion's share of the total projected increased in growth, equivalent to 2.44 percentage points. This i s much higher than the average impact projectedfor these two policy sectors in Central America (1.42 percentage points) or LAC (0.99 percentage points). Since the impact on growth from each determinant simultaneously reflects the size of the coefficient in the growth equation and the simulated change in the explanatory variable, a relatively highgrowth impact from improvements in a given policy area compared to the average regional impact is indicative of how far a country lags behindits neighbors in these policy areas. The preceding results, therefore, suggest that Honduras i s furthest behind its neighbors in terms of education attainment levels and public infrastructure, and that catching up inthese two areas would yield the greatest growth payoff. B y way of comparison, the simulated improvement in stabilization policies would only generate a relatively modest growth improvement of 0.29 percent per annum, which reflects the fact that Honduras's policy settings in this area already are fairly close to the 75thpercentile of the distribution in LAC. The same applies to the simulated improvements in the other structural policy determinants (Le., financial Annex A Page 5 of 9 depth, trade openness and government consumption), in which Honduras does not appear to lag significantly behind by L A C standards.6 12. It remains an open question whether the simulated structural and institutional improvements, especially for the education and public infrastructure sectors, are feasible. In this regard, it i s useful to notice that the simulated increase in education attainment levels leading to a 1.37 percent annual growth increase over 2001-10 is just a modest amount greater than the 1.13 percent increase achieved by Honduras during the decade of the 1980s (shown in Annex Table Al). The simulated improvement inpublic infrastructure to boost growth by 1.07percent, on the other hand, i s significantly higher than the historic increases achieved in Honduras during the 1980s or 1990s, and does not seem to have had recent precedents in other Latin American countries. (The best LAC performers in the public infrastructure area, Chile and Jamaica, achieved improvements with a growth impact of 0.79 percent and 0.86 percent during the 1990s.) 13. If Honduras could sustain the predicted per capita growth of 2.84 percent attainable through this reform effort, it would achieve significant inroads in poverty reduction. Even so, however, the country would have difficulties meeting its PRSP poverty reduction target set for 2015. As indicated in text Table 6, the poverty decline under this scenario would only extend half-way to the PRSP target. To achieve that target, therefore, Honduras would have to raise the sights on its reform efforts even higher. 14. The third panel inAnnex Table A2 shows the simulated outcome from moving the policy determinants of growth to the top 25 percent of the worldwide sample distribution. This would boost the projected annual growth rate in Honduras to 4.44 percent, which could allow it to attain its PRSP target of reducing poverty by 24 percentage points by 2015. As before, most of the growth impact would be generated b y improvements in structural and institutional policies, especially in the education and public infrastructure areas. In addition, however, the financial sector now also emerges as a third policy area with a potentially significant impact on growth (0.60%). The emerging significance of this factor reflects the fact that financial sector development in the L A C countries as a group appears to be lagging behind in global comparisons. 15. Although the simulated policy changes would generate a level of growth that would permit the country to reach its PRSP target, questions remain about the feasibility of achieving those policy settings during the next decade. The contemplated increase in education to boost growth 1.60 percent would clearly require a greater effort than that mustered in the 1980s, while the increases in public infrastructure needed to boost growth b y 1.64 percent would represent an These observations are broadly consistent with the policy-focused findings of Eduardo Lora, "Las Reformas Estructurales en America Latina: Que se ha reformado y como medirlo", Inter-American Development Bank, Working Paper No. 462, December 2001. Lora's paper constructs five indexes o f structural reform, (trade policies, financial policies, fiscal policies, labor policies and privatization), the first three of which bear a rough correspondence to the outcome-based variables used in the regressions performed by Loayza et a1 (2002); Le., trade openness, government consumption, and financial development. I t also presents an overall index consisting of a weighted average of these separate indexes. Honduras ranks slightly below the L A C regional average in terms of the overall index, is near or above the average in terms o f trade policy and fiscal policy settings, and below the L A C average in the quality of financial policies and labor policies. Annex A Page 6 of 9 extraordinary effort, even by world standards. The simulated increase in private sector credit (as an indicator for financial development) to achieve a growth impact o f 0.60% does have a precedent in Bolivia, which raised growth b y 0.80% through this channel in the 1990s, and Uruguay, which raised growth by 0.66% in the 1980s (though this latter expansion was partly reversed inthe 1990s). Main Conclusions 16. The preceding analysis identified three broad areas (human capital, public infrastructure and financial market development) where Honduras appears to be lagging significantly behind in its development vis-&vis other Latin American countries and the rest o f the world, and where policy advances could have potentially great payoff in terms of raising growth. Of course, this does not mean that the other growth determinants can be ignored or neglected. For example, even though setting the outcome variables (Le, inflation, cyclical volatility, etc.) associated with stabilization policies to the 75`h percentile of their world distribution would only be expected to generate a modest improvement in growth in Honduras, allowing those policies to slip could have disastrous consequences in terms yielding a growth d e ~ l i n e .Rather, what it means i s that ~ Honduras has been managing these other policy areas reasonably well by world and regional standards, and would do well simply b y maintaining the historic trend. However, staying on its historic trend in all policy areas would leave Honduras on an unacceptably slow growth path, so additional efforts need to be exerted in some areas to bring about faster growth. The preceding discussion suggests that this additional effort would have its greatest impact on growth if invested in human capital development, public infrastructure development and financial market development. 17. Finally, as argued in the main text, there i s a case to be made for also considering governance among the areas where additional efforts may yield a very high growth impact. As indicated in the Annex footnote 2, measures of governance were dropped from the discussion because of their statistical insignificance. However, it turns out that the governance index exhibited among the highest positive bivariate correlations with per capita GDP growth of all the other explanatory variables used in the regression analyses. This correlation becomes insignificant in a multivariate context, when the other structural and institutional variables are included. Loayza et a1 (2002) interpret this finding to mean that the effect o f governance on economic growth works through the actual economic policies that governments implement. Furthermore, Honduras consistently ranks among the worst performers in international governance comparisons. For example, as Figures 3 in the main text shows, Transparency International's Corruption Perceptions Index ranks Honduras well below the regional and global averages. In other words, Honduras also lags far behind in this area, so that the adjustment of governance indicators toward regional or global standards could have a potentially large pay-off interms of growth. 'In fact, Honduras experienced a significant fiscal deterioration in recent years, as the overall fiscal balance moved from a surplus of 1.8 percent of GDP in 1998 to a deficit of 4 . 6 percent in 2003. In the absence of corrective measures, this would have destabilizing consequences that reduce investor confidence and slow down growth further. g o E r - E T S TwTmSwL n ..m - - , 0 0 0 0 - 0 v) J; , c I I i I I i! ! I I I c J t I d I o o o m o o ) ~ O * O r o O r o o o m o z $ O d O l n O 0 0 0 0 0 0 0 0 0 0 0 0 0 0 m o v ) o o c ~ m O N O O q m ~ ~ ?N."! z m m d 0 0 0 0 0 0 0 r0 o 0 0 0 0 0 0 ~ o d m o g m O O O d O 0 w m k0 mom^r 0 0 d O ~ 0 0 0 0 0 0 0 0 0 0 0 0 0 0 h L r o o e o r m d L n 9 r ? c q Y : r ! 0 0 0 0 0 0 0 W N d N O m Z d O r O O r 0 0 0 0 0 0 0 I U ..- Annex B Page 1 of4 ANNEX B The Evolutionof the CentralGovernmentWage BillinHonduras 1. The central government wage bill, which accounts for almost 80 percent o f the total Honduran public sector wage bill, has grown rapidly inrecent years. It rose from 6 percent o f GDP in 1997 to an estimated 10.8 percent in2003, which represents one of the highest ratios inLatinAmerica. This trendhasraised significant concerns about the government's ability to maintain fiscal discipline and prevent a crowding-out o f non-salary public expenditures. Withinthe central government, the wage bill increase has beendriven mainlyby the increased remuneration o f education and health sector personnel, raising concerns about the capture o f these sectors by strongly organizedunions. Table B.1. Growthof CentralGovernmentEmployment 1990-94 1994-96 1996-2000 2000-2002 average annual percentage change Teachers 4.0% 7.7% 4.4% 8.4% Health Sector 4.5% 4.5% 2.2% 2.0% Other Civil Servants -1.3% -7.4% -1.5% -0.8% 1 Total 1.9% 2.0% 2.1% 4.6% Population 3.0% 2.9% 2.8% 2.7% Source: WorldBank, Public ExpenditureReview,2001; and UPEGISEFIN. 2. The growth o f public employment only had a modest impact on the evolution o f the government wage bill. Except for 2000-02, total central government employment has been growing at a lower rate than population growth; Table B.l. Only the growth in teacher employment has been consistently exceeding the rate o f population growth over the last decade, reflecting the young age profile o f the country (more than half o f the population i s under 15 years old) and the strong efforts made over the last decade to expand the coverage of primaryeducation. Table B.2. Compositionof CentralGovernmentEmploymentinHonduras 1997 1998 1999 2000 2001 2002 Education 46,607 49,323 50,719 52,663 56,273 61,831 Health sector 14,861 14,833 15,594 15,627 16,146 16,243 Police and Military 24,490 24,488 24,485 24,682 24,081 24,677 Other 7,227 6,701 5,672 5,247 5,160 4,779 Total Central Gov. 93,185 95,345 96,470 98,219 101,660 107,530 Total Population ('000) 5,697 5,851 6,010 6,173 6,340 6,507 % CG employ. 1.64% 1.63% 1.61% 1.59% 1.60% 1.65% Source: UPEGISEFIN, based on data fromthe DGP. Note: These figures only refer to employees that are directly employed by the central government. 3. Total central government employment reached 107,530 direct employees in 2002, o f which more than half consists o f teachers. Police and military personnel (representing 23 percent o f the total) and health sector personnel (15 percent) are the next largest groups. Annex B Page2 of 4 While the social sector personnel has been growing since 1997, other civil servants (not relatedto security) have beendeclining innumbers. 4. Total central government employment represents 1.68 percent o f the Honduran population, which i s somewhat below the Latin American Average (2.3 percent) and significantly below the middle income country average (4.3 percent). The number o f teachers as a share o f Honduras's population i s almost 1 percent, which lies between the average share in Latin America (0.6 percent) and in middle income countries (1.2 percent). The population share of health workers (0.25 percent) i s below the middle income country average (0.7 percent). FigureB.l. Honduras:Evolutionof RealPublicWage Indexes 250 200 0 150 II 0 g 100 r 50 Source: World Bank,PublicExpenditureReview, 2001; and UPEGBEFIN. 5. The main factor pushing up the wage bill since 1997 has been the growth o f public sector wage rates. As shown inFigure B.1, however, the growth inreal wages since 1997 was preceded by a period o f real wage decline in the first half o f the 1990s. The one group that has benefited most from increasing wages has been the health sector personnel, whose real wages have more than doubled since 1995. Teachers' real wages received a strongboost after 1998, but they had also suffered the greatest wage erosion during the earlier part o f the decade. As a result, their real wages in 2002 were only about 15 percent above the 1990 level, while the overall average real wage for the central government i s about 35 percent higher. Inall cases, however, public sector wages have risen relative to the real level o f gross national income per capita. 6. An important force driving the increase in real wages were the special employment regimes ("Estatutos") legislated by Congress. These regimes mandated certain wage adjustments for particular groups of public employees andplaced restrictions on the Annex B Page 3 of 4 government's personnel management for those groups.' The first Estatutos were legislated for workers in the health sector, followed by the teachers, both o f which are represented by powerhl and well organized unions. One indication o f the unions' market power i s provided by the differential inwages receivedby teachers inpublic andprivate schools. During2001- 02, the wage rate o f primary school teachers in private schools averaged 86 percent o f the wage rate received by their public counterparts. Similarly, among secondary teachers, the private wage averaged 81percent of the public wage.2 Table B3. Honduras. Compositionof the CentralGovernmentWage Bill 1997 1998 1999 2000 2001 2002 p millions of 1997Lempiras Base Salary 2780 2847 3088 3475 3900 4857 Estatutos 135 342 415 599 712 265 CoIateraVBonificacion 411 434 602 763 930 979 Other 127 324 353 344 386 361 Total 3454 3946 4458 5181 5928 6462 Social Security Cont. 286 322 387 454 521 528 annual growth rates Base Salary 2.4% 8.5% 12.5% 12.2% 24.5% Estatutos 153.6% 21.4% 44.4% 18.8% -62.8% Colateral/Bonificacion 5.5% 38.6% 26.8% 22.0% 5.2% Other 155.0% 8.9% -2.5% 12.2% -6.4% Total 14.3% 13.0% 16.2% 14.4% 9.0% Social Security Cont. 12.8% 20.1% 17.3% 14.8% 1.3% shares of Total Base Salary 80.5% 72.1% 69.3% 67.1% 65.8% 75.2% Estatutos 3.9% 8.7% 9.3% 11.6% 12.0% 4.1yo ColateraVBonificacion 11.9% 11.0% 13.5% 14.7% 15.7% 15.2% Other 3.7% 8.2% 7.9% 6.6% 6.5% 5.6% Total 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% Social Security Cont. 8.3% 8.2% 8.7% 8.8% 8.8% 8.2% ;ource: UPEGISEFIN. Note: The figures for the `Estatutos' refer to annual increases legislated under the special employment regimes; "ColateraH3onificaciones" comprises the paid vacation time, Christmas bonus and a 14" month payment; the category o f Other" includes a variety o f " irregular payments denoted "Aumento Salarial", "Reestructuracion Salarial y Prestaciones", and "creacion de plazas". 7. The authorities recognized the fiscal unsustainability of the Estatuto-driven trend in public wages and prepared legislation to restore central government control over public wage policy. InDecember 2003, the Honduran Congress passed the public wage policy framework law ("Ley de Reordenamiento del Sistema Retributivo del Gobierno Central", Decreto No. 220-2003), which establishes limits on the growth o f the central government wage bill and supersedes the Estatutos in all matters pertaining to wages and salaries. (On a transitory ' The most important Estatutos (together with their date o f legislation) are the Estatuto del Medico Empleado (1985), Estatuto del Cirujano Dentista (1993), Estatuto del Quimico FarmacCutico (1994), Estatuto del Docente (1997), Estatuto del Microbidogo y Quimico Clinic0 (1997)' Estatuto de 10s Trabajadores Sociales (1997), Estatuto del Personal Profesional de Enfermeria (1999), y Arancel de Honorarios para 10s Profesionales en Ciencias Agricolas (2001). These figures were calculated by IanWalker, based o n INEbi-annual household survey data. Annex B Page4 of 4 basis, teachers will continue to receive separate treatment in their remuneration until 2006, after which they are also subject to the same general wage policy applied to the rest o f the civil service.) 8. An expliiit objective o f the wage policy framework law is to reduce the central government wage bill gradually as a share o f GDP, from an estimated 10.8 percent in2003 to 9.6 percent in 2006. This confronts the authorities with a major challenge in having to reconcile the target o f a declining wage bill with targets established in the PRSP that call for an ambitious expansion o f education coverage at the primary and secondary levels, as well as improvements in the coverage o f health services. The health and education sectors are notably labor intensive, so that increases in the provision o f social services are likely to require increases in teachers and health sector personnel. This i s bound to raise labor costs, given that the government's flexibility in lowering real wage rates i s very limitedS3Under these circumstances, the implementation o f efficiency-generating reforms in these sectors i s crucial. Such reforms (some o f which are described in Chapter 11) provide the only hope for achieving the envisaged increases in social service provision without requiring a massive increase inpublic employment that would boost the public wage bill. The wage policy framework law does not contemplate cuts inexisting wage rates, but it allows the government discretion in setting the rate of growth o f public wages. In this context, the speed at which the real wage rate can be reduced i s determined by the rate of growth o f real GDP and inflation. Annex C Page 1 o f 3 ANNEX C The Main Providers of Secondary Education Services in Honduras 1. This Annex reviews the supply o f secondary education 'services by type of provider, describing the relative importance o f each provider and the type o f service that each one offers. Traditional Programs and Providers 2. Traditionally both cycles o f secondary education have been offered at secondary education institutes, under public as well as private administration. Formal education in secondary education in the third cycle i s delivered through the curriculum o f the Ciclo Comun de Cultura General (Common Cycle o f General Culture, known also as Plan Basico). This is analogous to the American middle school level. A derivative of this is the Basic Technical Cycle, which adds some vocational elements o f skill acquisition, but i s not very important in terms of volume. The fourth cycle, known as the Ciclo DiversiJcado, i s analogous to the American high school level. At this level the academic programs have a duration o f two or three years (two years for the Bachiller en Ciencias y Letras, which i s the traditional precursor to university entrance, and three years for other programs, such as teacher training, secretarial college, commerce and accounting). There are also technical careers available at this level, usually on a three-year program. Inrecent years, various new academic and technical course options have been developed, so that there are now 56 different permutations for formal secondary education in the 10 to 12 grade range. According to the Ministry of Education, in 2001, 55% of traditional secondary schools were private and 51% of students in traditional secondary institutes were attending private institutions, located mainly in the urban areas. Basic Education Centers 3. Public places for secondary education are provided both through traditional institutes that cover 7 to 12 grades and by the recently developed Basic Education Centers (CEB), which are primary schools that have been extended to cover through ninthgrade, buildingon a pilot program that started in 1996. By 2001 there were 409 CEBs established with 31,500 students enrolled in the third cycle (about 15% of the total studyingat this level). To date there are some 500 CEBs established; the lDB is supportingthis strategy through its Honduras education program. The average costs associated with the CEB scheme are estimated to be about two thirds of the cost o f a traditional scheme, due mainly to savings on buildingsand a higher pupil-teacher ratio. 4. The SEP is developing a modular educational plan for CEBs, where further cost savings are achieved by hiring teachers based on the amount o f class-hours effectively involved ineachmodule. A plani s also being developed to provide Ciclo Comun inthe CEBs using only three teachers, compared with 11 separate specialists used in the traditional system'. Another advantage of the CEB model is that it provides a direct incentive to continuing in their studies for the students already enrolled in the first two cycles of the schools that are extendedinto CEBs. ' There is no comparative cost study involving these different CEB modalities, vis-a-vis the traditional basic plan. The Ministry of Education does not have a definition yet with regard to the coverage goal for each o f these BEC modalities for 7' to 9" grades. Annex C Page 2 o f 3 Non-Traditional (Alternative) Providers 5. Several programs provide secondary education options in Honduras through non-traditional pedagogical approaches, mainly aimed at improving coverage inremote and low income communities. Among the non-traditional programs recognized by the SEP are Educatodos, Telebasica, and SAT. 6. The Educatodos program started in 1995 withthe support o fUSAID, as an alternative scheme for supplying basic education to young people and adults outside the traditional study system. By 2000, Educatodos had 88,000 students enrolled, mainly in the first six grades o f primary education. However, recently, Educatodos has been expanding into the secondary range. In 2001 it had 7,510 participants from 7 to 8 grades, and was in the process o f establishing new groups for 7 to 9. Educatodos graduates fkom the third cycle receive the SEP certificate for the Ciclo Comun. The Educatodos scheme i s delivered by trained facilitators (some paid, some volunteers) who work with study groups outside normal work hours, using approved texts and taped programs. The program has developed an integrated curriculum for 7 to 9 grades which conforms to the SEP guidelines and has been officially approved. English as a Second Language i s also taught. The cost per student o f this scheme i s estimated by USAID at US$68 a year, plus the capital and operating expenses o f a motorcycle for the promoter. The scheme i s relatively cheap because it does not hire professional teachers, and many o f the facilitators are not paid. However, many would argue that this reduced assignment o f teacher inputs i s likely to impact negatively on the quality o f the educational outcomes. 7. The Telebasica scheme - also supported by USAID functions in 37 basic education -' centers in Honduras. It uses videos and supporting texts to enhance curricular content and educational outcomes in those centers for 7 to 9 grade, using trained teachers to manage the program. Telebasica helps improve student retention by making school more interesting and relevant. As was seen in section 11.2, a significant proportion o f dropouts after grade 6 are attributed by their mothers to the students not liking school. 8. USAID reports that student retention i s 78.3% in CEBs with Telebasica; compared to 67.5% inCEBswithout Telebasica and 56% intraditional secondary institutes. Telebasica therefore improves the flow rate2, improving both efficiency and quality performance3of the educational system. A recent evaluation o f Telebasica reported that the scheme i s successful and argued that it would be easy to rep~icate.~ 9. InMexico andBolivia, this sort ofscheme has beenusedto expandthe coverage o f secondary education. Although the cost per student for schools with Telebasica i s 17.5% higher than schools without Telebasicas the cost per graduate will likely not be greater, because o f the higher retention shown by the program. The Telebhsica methodology also allows a teacher support three grades in all Ned Van Steenwyk, et al. "TELEBASICA. Los Primeros Graduados del Noveno Grado. Secretaria de Educaci6n- USAID". March 2002. The performance evaluation o f students in 9th grade in2001 was done based on the standardized test in math and Spanish, developed by the Quality Education Evaluation General Office o f the Ministry o f Education in 2000. Patricia Barriga, Gloria Gamero y Seth Spaulding: "Estudio Evaluativo de la Viabilidad Institucional de Telebasica". Tegucigalpa, Secretaria de Educacibn, IEQII y USAID, February 2001. (Taken from Ned van Snteenwyk, et. al. "Telebasica, Los Primeros Graduados del Noveno Grado". (OP. Cit. Pg. 3). Estimates prepared by Ned Van Steenwyk, comparing estimated costs per students inthe Ten Year Plan o f the SE, updated due to teacher salary increases. TELEBASICA (the first graduates from 9' grade) March 2002. Annex C Page 3 of 3 their subjects, as presently being implemented in Mexico, which may lead to greater savings and may help make it feasible to establish CEBs incommunities which are too small to justify hiringthree new teachers. 10. The Tutorial Learning System - TLS (Sistema de Aprendizaje Tutorial - SAT) i s an alternative model for high school education, oriented toward the rural sector. It was founded in Colombia in the 1970s, where it has 50,000 graduates and 30,000 active students. It has been implemented in communities in the Honduran Mosquitia region by the Bayan - Indigenous Socio- Economic Development Association (Asociaci6n de Desarrollo Socio Econ6mico Indigena - Bayan) since 1996. The SAT system i s based on the participative presence methodology, a comprehensive curriculum and content geared toward developingabilities and competencies relevant to students' lives (influenced by the philosophy o f Freire). Once again, the SEP recognizes the degrees granted to the graduates o f these programs a valid high-school qualification. TLS i s still a small scale operation. In 2003, it i s operating in indigenous communities in the Atlantic Coast departments o f Atlantida, Gracias a Dios and C o h , with 70 student groups with an average of 22 students per group: just over 1500 in total. However, during 2004 - 2006 the TLS program plans to expand in other depressed indigenous regions such as the Lenca area (Lempira, Sta. Barbara and Copan) reaching a student population o f 5,000 in220 groups. The Cost of Alternative Service ProvisionModalities 11. The current cost in the traditional public sector is estimated at US$420 student. It is estimated that the third cycle costs of the CEBs represents 70% o f the incurred cost in the traditional method, due, largely, to a higher pupil teacher ratio (33 versus 25). Capital costs for both deliver systems are represented by the classrooms or m2o f construction needed to attend the incremental student population each year. 12. Cost data for the Educatodos and Telebasica programs were provided by USAID- Tegucigalpa. The model estimates the cost o f an Educatodos / SAT hybrid student at $150 a year - this i s close to the real costs o f SAT, but well over double the reported cost o f the Educatodos program, reflecting the authors' concern that the accounted cost may not fully reflect all elements, and that to provide a sufficient quality o f outcome on a sustainable basis the tuition component might need to be increased. The Telebasica places are the most costly of all, since they include the basic cost of a standard secondary school place plus a margino f 17% for equipment costs and materials of this program, giving a total o f $491 per student- year. UnitCosts Provider: (2002 US$) PlanBasico 420 CEB 294 Educatodosl SAT 150 Telebasica 491 Source: ESA consultores (2003) Annex D Page 1 of 3 ANNEX D The EstimatedCost of RaisingPrimaryand SecondaryEducationOutcomes 1. This Annex summarizes the results o f simulations to estimate the fiscal costs o f raising the primary completion rates to 100percent by 2015, and o f raising the secondary net coverage rate to 70 percent inthe lower cycle and 50 percent inthe upper cycle, also by 2015. 2. Table D1presents the estimated cost o f achieving full completion under the Education for All - Fast Track Initiative (EFA-FTI) scenario by 2015 (which, as shown inthe table, aims at obtaining a substantial decrease in the repetition and drop-out rates). Beyond estimations o f the future average wage billper sub-period, the table also reports the sub-period average cost o f the EFA-FTIwhich, summingup all years, would reach a total amount o fUS$368 millions by 2015. The overall recurrent cost associated with this education reform strategy averages US$ 390 millions per year over 2003-15. 3. Assuming substantial real growth rates, timely gains in intemal efficiency, a conservative teacher policy (including salaries adjusting below the pace o f inflation up to 2005 and then at the pace of inflation) and an education budget which keeps up with GDP, we note that the country could achieve full completion by 2015 without having to increase the share o f the primary level in the recurrent budget o f the SE, which already is very high. Instead, the target completion rate could be achieved while decreasing the recurrent budget. (After an initial increase in 2003-2005, the recurrent budget o f SE declines to 35 percent in 2015, while the ratio ofprimary recurrent costs to GDP decreases to 2 percent. This i s an encouraging result inview o f the challenges faced inthe secondary sector, which may requirethe re-allocation o f funds across education levels inthe mediudlong-run. 4. Table D2 summarizes the cost projections o f raising secondary net coverage rates under three scenarios: Scenario 1-No EfJiciency gains and unchanged structure ofprovision Inthis first scenario, the current cost for attention at the lower secondarylevel goes from 0.64 percent of GDP in 2002 to 1.27 percent in 2015, while the one for upper secondary goes from 0.40 percent of GDP in 2002 to 1.08 percent in 2015. Overall, this brings us from an initial share of 1.05 percent of GDP in 2002 to a share of 2.35 percent in 2015. This i s a substantial increase, which implies doubling the share of secondary education in the total SE budget to 38.5 percent. Scenario 2 -EfJiciency gains and unchanged structure ofprovision The results indicate that, with a decreasing repetition rate in both cycles, the total fiscal cost, including infrastructure, for lower secondary would go from 0.64 percent o f GDP in 2002 to 1.18 percent in2015, while for upper secondary, it would go from 0.40 percent of GDP in2002 to 0.98 percent in 2015. Overall, this still entails a significant increase in the total budget for secondaryeducationto 2.16 percentof GDP in2015. Scenario 3 - Efficiency gains and more use of alternativeproviders This is the least costly option. As a result of the increase in alternative programsparticipation, the total cost for attention at the lower secondary level only reaches 1.92 percent of GDP by 2015, or 31.5 percentofthe total SEbudget. Annex D Page 2 of 3 Combining both simulation results, we find that the savings obtained through efficiency- generating reforms at the primary level could finance more than two-thirds o f the increased cost needed to achieve the PRSPtargets insecondary education. Table D1:EFA Simulationsto Achieve UniversalPrimaryCompletionRates(US$ mill.) 2002 Average Average Average Average 2015 2003-2005 2006-2008 2009-2011 2012-2015 Budget Enrollment 1123994 1168723 1307271 1502365 1695897 1768993 Teachers 32205 35502 38987 42443 45886 47186 Total salary recurrent costs 173 190 253 349 495 568 (c> EFA Fast Track 0 28 29 35 21 21 (sum (sum (sum (sum (sum 2003-2005: 2006-2008: 2009-2011: 2010- 2003-2015: 86) 88) 106) 2015: 86) 368) Totalrecurrent costs 173 234 305 418 567 647 Primaryrecurrent costs/SE 45% 47% 41% 38% 35% 35% education recurrent budget Primary recurrent II2.6% I 2.8% I 2.5% I 2.4% I2.1% I 2.0% Budget Primaryrecurrent costs/SE I 45% 150% 149% I 53% I55% 156% education recurrent budget 1Primary recurrent II2.6% I 2.7% I 2.3% I 2.2% 12.0% I2.0% costs/GDP Notes: (a) During the year drop-out; (b) estimates; (c) Include pensions; Source: EFA-FTI (2002) and author's further elaborations usingthe "ITHINK' simulation model. Annex D Page 3 of 3 Table D2: Simulations to Achieve PRS Targets for Secondary Education (US$ mill.) Total Costs 68 89 134 202 333 403 Secondary CostdEducation 17.2% 18.3% 21.1% 24.5% 29.5% 31.5% Budget Costs/GDP 1.05% 1.12% 1.29% 1.49% 1.81% 1.92% Annex E Page 1of 9 ANNEX E A Preliminary Assessment of the HonduranNational Innovation System 1. The discussion in Chapter IIpointed to the close interaction between skills and technology in generating productivity growth, focusing on policies to close the gaps in education that currently exist in Honduras. This Annex focuses on measures to begin closing the technology gap. A country's capacity to absorb and adapt internationally available technologies - and thereby close its technology gaps - depends crucially on its national innovation system (NIS). This refers to the way that public institutions (including universities and research centers) and private firms react to economic incentives and interact among themselves to combine available inputsin an increasingly more efficient and productive ways. 2. Honduras ranks among the countries that lie very far from the technology frontier.' For such countries, the best technology policy may simply be their education policy - pushing them over the threshold of universal primary education attainment - coupled with an open trade policy that enforces market discipline and discourages rent-seeking behavior. Even in these countries, however, the quality of the NIS makes a difference. It determines how well a country absorbs and adapts internationally available technologies, and thus moves on to the next stage o f technological development. This Annex provides a preliminary evaluation of the Honduran NIS, with the objective of drawing attention to its strengths, as well as to shortcomings whose correction could help improve NIS performance, and thereby accelerate the country's technological development. The performance of Honduras's NIS 3. Table C1 presents a summary of key indicators of technology performance in Honduras. Honduras performs relatively well in terms of technology absorption when compared to other countries in Latin America: imports of capital goods are relatively high (double the Latin American average), foreign direct investment (FDI)i s among the highest in the region and royalty payments (an indicator of technology licensing) are second only to Panama. Honduras's imports of capital goods, however, are much lower than those of the East Asian "tigers", which may be pointing to an unexploited opportunity for acquiring embodied technology. Also, FDI impacts in terms o f technology transfer are likely to be limited by the fact that most of the FDIi s directed towards the Muquilu industry, which has few backward or forward linkages with local firms. Honduras also performs relatively poorly in terms of quality and patent applications; two direct indicators of technological progress. While Honduras i s not expected to make a major contribution to knowledge creation, the small amount of firms with I S 0 certification i s more worrisome. For developing countries, I S 0 standards are an important source of technological know-how for economic development ' De Ferranti et al, (2002), "Closing the Gap in Education and Technology", discuss two indicators to assess and classify a country's technological capabilities, or distance from the technological frontier. Based on those indicators, all the Central American countries, except for Costa Rica, lie among the third of countries that are furthest from the technology frontier. Annex E Page 2 of 9 and for improving their capability to export and compete in global markets. It seems, therefore, that Honduras's weakness in terms of its technological performance i s related more to technology diffusion rather than to technology absorption. In the following sections we explore the possible causes for this circumstance. Table C1: Importof CapitalGoods,FDIandRoyaltyPayments,I S 0 Certificationsand CapitalGoods Net FDI Royalty I S 0 9000 Patent Imports Payments Certifications Applications filed (per (% of GDP) (% of GDP) (% of GDP) 100,000 people) Dec. 95 Dee. 00 in the US (1999) Latin America 7.69 3.33 0.15 878 12,648 0.069 Bolivia 9.88 10.81 0.06 0 20 0.025 Chile 7.45 2.46 0.07 21 235 0.203 CostaRica 11.74 3.56 2 79 0.275 El Salvador 6.9 3.75 0.19 1 19 0.000 Guatemala 8.74 1.84 0 8 0.026 Honduras 15.35 3.44 0.22 0 4 0.001 MCxico 14.75 2.52 0.16 145 1,843 0.096 Nicaragua 18.79 7.53 n.a 0 3 0.020 Panama 13.14 7.43 0.33 0 19 0.028 East Asian "tigers" 29.51 2.95* 0.47 5,979 81,919 N/A Sources: De Ferranti et a1 (2002), ibid. "The I S 0 Survey of I S 0 9000 and I S 0 14000 Certificates", (http://www.iso.ch/iso/en/iso9OOO-l4OOO/pdf/surveylOthcycle.pd~;World Bank, 2002, "World Development Indicators", andUSPTOwebsite (http://www.uspto.pov). The inputs:R&D,Skills,ICT, Quality Services andFinance 4. The Honduran government allocates 6 percent of its annual budget to its national university, Universidad Nacional Autdnoma de Honduras (UNAH)2. The Direccidn de Znvestigacidn Cientllficaestimates that less than 3 percent of that amount i s normally allocated to R&D, and in 2000, that figure decreased to roughly 1.8 percent of UNAH's budget in 2000 (Figure Cl).3 Of this total allocated to R&D (roughly equal to US$ 1.7 million4), more than 85 percent i s used to cover administrative expenses, such as payroll of administrative and research staffs. 2The leading public university in Honduras, Universidad Nacional Autdnoma de Honduras accounts for more than 65 percent of the enrollments, and 52% of the national expenditures on tertiary education. In 2001, UNAH's budgetrepresented roughly US$ 1,000 per-student. Direccidn de Investigacidn CientljLica is the UNAH's Research and Development Department. According to this entity, UNAHshouldinvest 6% of its budget inR&D. This estimate i s based on the government's total budget for 2000 (L22,574,798,718) and an average exchange rate of L14.74 per US$dollar during that year. Annex E Page 3 of 9 5. R&D composition. Preliminary evidence indicates that most R&D resources are dedicated to non-applied business re~earch.~There were roughly 243 R&D projects within public and private universities, and governmental as well as non-governmental organizations in Honduras in 2000. These projects emphasized social science studies, economics and environment, which together accounted for 62 percent of the total number of projects. Topics in science & technology accounted for 9 percent of all the projects. Only 5 percent of the projects were funded by the private sector. Figure C1: UNAH's allocation of budget to R&D 1995 1996 1997 1998 1999 2000 Source: UNAH, 2000. "Direccih de Investigaci6n Cientifica". 6. R&D in the private sector. The leading entities in R&D in the private sector are Fundacidn Hondureiia de Investigacidn Agricola (FHIA) and Escuela Agricola Panamericana (Zamorano). FHIA, a private non-profit research center, has an annual budget of almost US$ 4.0 million6, however only 10% of this amount is originated by services' to the private sector. Zamorano i s a non-profit private university with roughly an annual income of US$20 million of which a floating value that ranges 2.5% to 5.0% i s invested in agricultural applied research. 7. Public research centers. The Government owns at least three research centers that provide basic technological services to the business sector: Direccidn de Ciencia y Tecnologia Agropecuaria (DICTA), Instituto HondureAo de Investigaciones Mkdico Veterinarias, and Instituto HondureAo del Cafk (IHCAFE). DICTA'S main purpose i s the transference of agricultural knowledge* to the private sector. COHCIT staff estimate that the total public budget allocated to R&D in research centers doesn't exceed US$ 2.0 million. In addition to them, ESNACIFOR (Escuela Nacional de Ciencias Forestales), a public university with a budget of US$ 3 million, has been doing some research on forestry, and giving consultancy services on agribusiness for SMEs through its staff and students. The allocation of R&D among basic, applied research and experimental development also affects the efficacy of R&D and thereby its impact on growth. COHCIT data does not distinguish between basic and experimental R&D. FHIA was created in 1992with a USAid endowment fund. The institution may use at most 75% of the interest 'Themain generated from this fund annually. services include research for productivity increase of agricultural products such as bananas, plantains, fruits and vegetables. Especially coffee, banana, shrimp, lobster, melon, wood, sugar and tobacco. Annex E Page4 of 9 8. Skills. The average years of schooling of the population aged 25 or older in Honduras i s 4.1, slightly higher than El Salvador and Guatemala but among the lowest in Latin America. Enrollment in primary i s higher than this region's average, but enrollment at secondary and tertiary levels are almost half the regional average. In Honduras, 24% of tertiary students are scientist and engineers, compared to 42 percent in Chile. Roughly 25 percent of the population i s illiterate. Labor training i s mainly provided by the Znstituto Nacional de Fomzacio'n Profesional (INFOP)~. INFOP funds, generated by a 1-percentage payroll tax on companies employing more than five workers (plus 0.5% of government payroll), amounted US$ 22.5 million in 20Olt0. Different from similar institutions around the world that contracts out this service, INFOP not only manages the funds but also directly provides training services. INFOP has the reputation among businessmen of being a highly unproductive service provider. 9. Information and communication technologies (ICT). Table C2 indicates that Honduras i s among the lowest ICT performers in LAC. Data indicate that the current teledensity ratio for fixed line telephony i s particularly low (less than 5 lines per 100people). The very low level of PC penetration among households and businesses also slows Internet adoption: a mere 1.19 PCs per 100 inhabitants cannot sustain growth of the Internet use. Privatization and gradual liberalization of the telecommunication market have sustained the improvement of quality and a decrease in cost of service inthe recent past. Table C2: MainICT Indicators Main Main lines Cellular Total Cellular Number of Estimat. Number of telephone per 100 subscribers telephone mobile internet Internet personal lines in inhabitants per 100 subscribers telephone hosts users per computers operation inhabitants subscribers 100 per 100 inhabitants inhabitants Argentina 8,107,982 22.38 19.26 15,082,921 6,974,939 465,359 11.32 8.28 Brazil 38,810,000 22.32 20.06 73,691,000 34,881,000 1,644,575 8.22 7.48 Chile 3,581,165 23.25 42.83 9,912,900 6,445,698 122,727 20.61 11.93 CostaRica 1,037,986 25.05 12.75 1,566,033 528,047 8,551 9.27 16.90 El Salvador 667,699 10.34 13.76 1,556,517 888,818 975 4.65 2.17 Guatemala 755,956 6.47 9.70 1,889,963 1,134,007 6,630 1.71 1.28 Honduras 322,497 4.80 4.86 649,005 326,508 408 2.98 1.19 Nicaragua 170,163 3.20 4.47 411,560 239,930 2,194 1.69 2.82 Panama 376,500 12.99 16.4 851,850 475,350 7,825 4.14 3.80 Source: ITUStatistics 2002 10. Standards and Testing. The quality system in Honduras i s characterized by the lack of a clear framework for standards and of a suitable apparatus of testing laboratories." There are only 25 mandatory and 4 voluntary technical standards and quality requirements, mainly for Created by decree in 1972, INFOP is an autonomous institution with legal status and own patrimony. lo Dataprovided by Secretaria de Finanzas de Honduras (www.sefin.gob.hn). l1 A crucial component of a NIS is an efficient and viable Metrology, Standards, Testing, and Quality (MSTQ) system in support of the public and private sectors. A reliable MSTQ i s necessary to ensure constant adoption of quality standards across the public and private sectors as well as to sustain the implementation of international standards from local firms, hence facilitating their integration in international markets. Annex E Page 5 of 9 water, food, and sanitation, health and drugs, norms that have been introduced between 1999 and 2000 following international standards. The national quality system hinges on the requirements defined by the Consumers' Protection Law of 1989.'* Few testing laboratories within the public sector meet the immediate needs of testing quality of basic services, such as water and food safety and health services within the Ministry o f Agriculture and Health respectively. Yet, the laboratories within the public sector suffer from inefficiencies due to low quality levels, weak capacity, and obsolete machinery. In general, Honduran firms are reported to be considerably less concerned with performance, labeling and customer safety than those of Latin America region.I3 11. Financing. Innovation i s fundamentally a long-term and risky undertaking, particularly for start-ups, and hence venture capital funds are needed to complement other elements of the NIS.I4 However, equity financing i s very limited in Honduras, where venture capital investments are still in their infancy. Major limitations to venture capitalism are the lack of appropriate financial legislation (i.e. convertible loans, loans with options, restrictive minority shareholders' rights) and inadequate guarantees of exit rights. Yet, even in the presence of adequate regulations, investment opportunities for venture capitalists would remain very limitedgiven the relatively low level of corporate development. Incentives and Coherence: IntellectualProperty Rights, Market Discipline and Tax Breaks 12. Intellectual Property Rights (IPR) regime. Honduras has been gradually aligning its legal framework for the protection of IPRs to international standards, both by ratifying most of the international agreements and treaties related to IPRs, and by amending domestic legislation accordingly.18 The legal basis for IPRs protection in the country i s the Ley de Propiedad Industrial, Decreto No. 12-99-Eof 2000. The Law on Industrial Property covers patents, trademarks and industrial designs, while copyrights and related rights are covered by the Ley del Derecho de Autor y de 10s Derechos Conexos, Decreto No. 4-99-E. (Law on The Law establishes the legal basis necessary to achieve and maintain an adequate protection of Honduran consumers, in order to guarantee them by setting a minimum standard for the acquisition and use of goods and services. l3Wilson, John S. and Otsuki ,Tsunehiro. 2003. Untitled. Internal World Bank document prepared for the Honduras Competitiveness Project. l4 DeFerranti, D. et al, 2002. ibid. l5A crucial component of a NIS is an efficient and viable Metrology, Standards, Testing, and Quality (MSTQ) system in support of the public and private sectors. A reliable MSTQ i s necessary to ensure constant adoption of quality standards across the public and private sectors as well as to sustain the implementation of international standards from local firms, hence facilitating their integration in international markets. l6The Law establishes the legal basis necessary to achieve and maintain an adequate protection of Honduran consumers, in order to guarantee them by setting a minimum standard for the acquisition and use of goods and services. l7 Wilson, John S. and Otsuki ,Tsunehiro. Internal World Bank Document. l8Honduras has ratified the following international treaties and conventions: WIPO Copyright Treaty and the WIPO Performances and Phonograms Treaty in May 2002; the Paris Convention on Industrial Property in 1994; the Berne Convention on Literary and Artistic Works and the Rome Convention on Performers, Producers of Phonograms and Broadcasting Organizations 1990; the Geneva Convention on Unauthorized Duplication of Phonograms in 1990; and the WIPO Convention in 1983. In addition, Honduras has been a WTO member and signatory to TRIPS Agreement since January 1995. Annex E Page 6 of 9 Copyright and Related Rights, Decree No. 4-99-E, January 2000). The alignment of the regulatory framework i s not completed yet, with few areas that need further fine-tuning. For example, the Honduran Congress would still have to adopt reforms related to integrated circuit designs and plant variety protection to be in full compliance with TRPS.l9 Despite the alignment to international standards of national legislation, protection of intellectual property rights is undermined by low enforcement capacity of both the Directorate and the judiciary. Institutionally, the Ministry of Industry and Trade manages IPR protection. In 1994, the Ministry established the Directorate General of Intellectual Property to handle registration of patents, trademarks and copyrights, as well as any complaints regarding their infringement. Although the Directorate seems to be understaffed, it manages to carry out vital functions of registration and control over intangible property rights. Yet, the lack of appropriate resources -bothfinancial andhuman-preventstheDirectoratefromfully implementingitsmissionof enforcing IPRs2'. Complaints concerning IPRs relate mainly to the slow process for registering intellectual properties, an issue often mentioned by foreign investors. Recently, the Directorate has been engaging in international cooperation with the WIPO to strengthen the institutional capacity of the unit and undertake awareness campaigns on intellectual properties. 13. Market Discipline. In the 1990's, Honduras implemented trade reforms that eliminated most administrative non-tariff barriers, and reduced the average import tariff in 2000 to 7.9 percent and the weighted average to 8.3 percent.21 Even so, this remains higher than the weighted average tariff rates observed elsewhere in the region: 3.7 percent in Costa Rica, 6.5 percent in El Salvador, 5.9 percent in Guatemala and 2.9 percent in Nicaragua. At the sector level, Honduras also exhibits a comparatively higher degrees of nominal trade protection. In agriculture, the weighted mean tariff for primary products was twice as high as in Costa Rica and roughly 50 percent higher than in Chile.** Import tariff for certain capital goods also appear to be relatively higher than in neighboring countries.23Establishing a new business in Honduras can take between 3 and 5 months because of the many institutions involved in the registration process, including the Supreme Court and the Mercantile Registry. *'USTRinstance, 19 Country Profile, 2002. For according to an assessment done by Industry Canada, 73 percent of Honduran demand for computer software (estimated at US$4,0000,000 in 1998) is met through software piracy. This was a lower level than in Chile (9 percent in 2000), comparable to Guatemala (7.2 per cent) and El ''See Salvador (7.4 per cent), but higher than in Costa Rica (5.4 percent) and Nicaragua (3.2 percent). Correa, P.: Honduras Competitiveness Proiect. Background Paper for the Honduras Competitiveness Project. October, 2002. World Bank, Mimeo. 23In transport equipment sector, for example, simple mean import tariff in Honduras was 7.8 (10 percent if weighed), which compares to 4.5 percent in Costa Rica. In electrical equipment, import tariffs in Honduras average 4.6, against 2.6 and 3.2 percent in Costa Rica and El Salvador respectively. In2000, one quarter of all tariff lines presented international peaks in Honduras, whereas in El Salvador less than 10percent of tariff lines presented such peaks (and almost zero Costa Rica). Among these product lines with international peak tariffs are certain types of vehicles used by tourism industry (SITC -8403 with 35 percent); construction material (SITC- 6802, 6901 and 7013 with 18 percent) and steel manufactures (SITC-7203 with 15 percent). Source: www.sice.oas.org/datae.asp. Annex E Page 7 of 9 This compares to registration periods of a few weeks in other Central American Countries.24 Private anticompetitive practices, such as collusion and abuse of dominance, may also reduce the degree of rivalry and obstruct entry.25 This regional comparison suggests that there still remain considerable opportunities for improving market openness and competitive discipline in Honduras. considerably less concerned with performance, labeling and customer safety than those o f Latin America region.26 14. Coherence. The Consejo Hondureno de Ciencia y Technologia (COHCIT), established in 1993, i s the main public institution in charge of designing the national innovation policy as well as the definition of programs dedicated to its implementati~n.~~ COHCIT i s also responsible for developing the national standards, setting the framework for the implementation of the quality system and control its development. Yet, the lack of capacity prevents COHCIT from fully performing its functions. COHCIT has 25 staff members and a yearly budget of US$ 0.4 million, mainly allocated to cover administrative costs. Inrecent years, the Council has mostly been functioning as an implementing agency for selected projects of the Honduran government, and has been neglecting its statutory role. The Honduran government currently i s developing efforts to advance an innovation policy agenda for the country.28 15. Linkages. There i s a mismatch between the supply and demand of innovation-related services between universities and firms. The private sector generally perceives the local universities to be of low quality and that there i s no effective way of measuring the quality o f their output to ensure accountability. Most academic courses lean toward the liberal arts, rather than technical and sciences curricula.29The creation of linkages i s hindered by the lack of clear rules for appropriating the results o f public-financed R&LD.~'Bureaucratic 24 I t i s hoped that the recently enacted Ley de SimpliJicacion Administrativa will improve this situation. Tax identification number and municipal permit are also required and other licenses or registrations (such as environmental) may also be necessary. 25 The high costs of transport service in Honduras (it i s reported that the price of transporting a container from Tegucigalpa to Puerto Cortes i s twice the international levels) are attributed at least in part to the existence of collusive practices. Honduras does not have a competition law that provides legal guarantees against such practices even though its constitution guarantees the principle of freedom of trade within the country and prohibits the existence of monopolies. (Other pieces of legislation, however, seem to contradict this principle, such as article 424 of the Codigo de Comercio, which validates agreements between competitors that regulate quantity, quality and the characteristics of goods.) 26 Wilson, John S. and Otsuki ,Tsunehiro. 2003. Untitled. Internal World Bank document prepared for the Honduras Competitiveness Project. 27 At executive level, COHCIT works through the Designated Presidential Office and Ministry of Science and Technology. 28 In late 2002, for instance, the Organization of American States (OAS) has committed to support the Government of Honduras with a project to strengthen the capacity of the COHCIT in designing a national policy for innovation. The World Bank i s also preparing a Trade Facilitation and Productivity Loan with a strong component on quality enhancing and technology absorption. 29InHonduras, 24% of tertiary studentsare studying to become a scientist or engineer, compared to 41% in Chile and 49% in Israel. 30 For instance, at the end of 1997, a group of UNAH's professors created Fundatec, a non-profit private organization aiming R&D and development of linkages with the private sector, but due to issues regarding intellectual property rights, its activities were halted in 2001. Because researches cannot appropriate the benefits of innovation, they have little incentive to undertake innovation and link to the private sector. Annex E Page 8 of 9 requirements also render difficult the interaction between private firms and universities. Finally, there are no clear incentives for private institutes to invest in R&D or make linkages with the private sector.31 Main ConclusionsandRecommendations 16. The low innovative performance in Honduras i s consistent with the country's overall level of economic development. Infact, countries with higher per capita income in the region (e.g., El Salvador) often exhibit a worse performance in this regard. As in most Latin American Countries, the amount of inputs is insufficient to sustain a better performance, economic incentives are relatively weak and linkages between the existing research centers (either government or the university) and the private sector are almost non-existent. It seems, however, that Honduras can do better interms of quality performance. Better information and governance structures could also help to improve the countries performance given the stock of inputs. 17. Main Recommendations. Before considering a comprehensive national policy on innovation suitable for Honduran needs and possibilities, preliminary efforts should be devoted to: 0 Improving the quality of information on R&D activities, including data on the nature of research (basic vs. applied and experimental) and which sector undertakes it (business sector, universities, NGOs and research institutes). At present, data on R&D activities presents some inconsistencies that makes it difficult international comparisons and less fruitful further analysis on possible strategies. A first step i s the development of an `Innovation Budget' within the ordinary national budget that consolidates all public expenditures on innovation. 0 Introducing a mechanism of monitoring and evaluating the federally funded research programs (mainly in public research centers) in order to access the cost effectiveness of public-funds under supervision and coordination of COHCIT. 0 Institutional strengthening o f COHCIT, focusing its work on the coordination and implementation of the national innovation policy (rather than functioning as an implementing agency for selected projects) and providing with the appropriate staffing. 18. A more comprehensive national innovation policy in Honduras requires developing a strategy for improving technology diffusion. Such a strategy should include the following: 0 Defining and implementing a national program for strengthening the National System of Quality, including: (a) establishing the appropriate institution (possibly an autonomous body, such as a National Quality Council) to set national goals and priorities; (b) upgrade laboratories up to international standards, specially those who 31For instance, in August 2000, the Government of Taiwan donated a full laboratory of metrology to Universidad Tecnol6gica Centroamericana (Unitec), a private university, however for lack of incentives this laboratory was never used. Annex E Page 9 of 9 serve the export and (c) provide the appropriate financing for accreditation by private sector. 0 Inorder to improve absorption of internationally available knowledge, consider further measures to facilitate the imports of capital goods and the licensing of foreign technology. 0 Inorder to gain cost-effectiveness, consider the possibility of transforming INFOPinto a contracting agency rather than service-delivery agency. Reforms should take into account the incentive structure for providing training services, to ensure that these match the skills demanded by the private sector, including training in quality management for specific sectors. 0 Defining and implementing a national innovation policy focused on: (a) improving the productivity of public research centers (possibly re-aligning the economic incentives faced by these institutions); (b) increasing linkages between public research institutes and the private sector; (c) creating a legal and economic environment conducive to productivity increase in the public universities' research departments, as well as to the licensing of technology to the private sector, and (d) establishing public funding mechanisms (possibly matching grants) for private R&D. Annex F Page 1of 14 ANNEX F CAFTA and itsImplicationsfor Honduras 1. The U S and the five members of the Central American Common Market have recently finished negotiations for a Free Trade Agreement (FTA) in December of 2003. The Central American Free Trade Agreement (CAFTA), will be the third agreement of this type between the U.S. and Latin American countries, following those signed with Mexico (1994) and Chile (2003). Implementation of the agreement depends on congressional ratification, which is expected for 2005. While Honduras i s already a very open economy, CAFTA offers new opportunities as well as challenges that could have a profound impact on its development prospects. 2. Although Central American countries already enjoy preferential access to the US market through the Caribbean Basin Initiative (CBI), CAFTA will widen the opportunities to boost exports, investment, growth and employment by granting an expanded and more stable access to the largest market economy in the world. CAFTA will provide a broad framework for trade and investment relations between the US and the CA countries that will be substantially more comprehensive and far reaching than the current unilateral preferences under the CBI. First, CAFTA will be a reciprocal trade agreement, granting broader rights and obligations in terms of market access and dispute resolution to both sides. Secondly, it will provide a permanent framework for trade and investment relations, as opposed to CBI preferences which require periodic renewal by the U S congress to sustain the regime in time. Third, in addition to trade in goods, CAFTA will include regulations for trade in services and rules, disciplines for investment relations between member countries and commitments in new areas such as intellectual property rights, government procurement, and labor and environmental standards. 3. The more comprehensive nature of CAFTA i s expected to `lock in' trade liberalization and other structural reforms undertaken in Honduras during the last decade, providing a credibility effect that that will enhance investment and growth prospects in Honduras. However, as the experience of Mexico shows, CAFTA alone i s not enough to generate a large investment and growth response. Honduras needs to advance in key policy and investment areas in order to ensure that CAFTA's potential for economic and social development can materialize. 4. In what follows, the major elements of the agreement for Honduras are presented, together with a review of main changes in norms and regulations required to enforce its regulations. Then a preliminary analysis of the potential impact that CAFTA could exert on the Honduran economy is included. At the end, recommendations of how to ensure that Honduras obtains the most benefits out of CAFTA are presented. The content of CAFTA 5. This section presents a preliminary overview of the main aspects of the FTA recently subscribed by Honduras and the US, with attention to the implications in terms of increased Annex F Page 2 of 14 market access for Honduran roducts, as well as some of the key legal and institutional implications of the agreement. P Marketaccess andrules of origin 6. Agriculture: CAFTA commitments in agriculture include a total elimination of tariffs for most agricultural goods with the only exception of sugar for the United States and white maize for Honduras. This implies a modest expansion of the current market access granted under the CBI, as new duty free access was obtained on a handful of new products which had been excluded from these preferences (e.g., melon and cucumbers). Most significantly, the agreement includes the relaxation of tariffs and some non tariff barriers in selected agricultural products of interest to Honduran and US producers such as yellow corn, rice, meat and dairy products. Tariffs on most of these products will be phased out within 15- 20 years, with grace periods of up to 10 years. In the case of sugar, Honduran duty free access quota to the US market was increased in 70% from its current level of 10 thousand MT. As a result, Honduran authorities estimate an immediate expansion of agricultural exports by $264 million, while imports from the US are expected to increase by $ 169 million.2 7. For agro-industry, the agreement includes more flexible rules of origin for some products by allowing the use of regional or third country inputs without affecting their duty free status. Such i s the case of shrimp larvae and some fruit concentrates not produced regionally which can be imported from third countries. For dairy products and soluble coffee, rules of origin require the use of milk and coffee produced in the region thus contributing to the development of regional productive clusters. 8. In addition, CAFTA includes specific technical cooperation aimed at helping Central American producers to meet standards required to enter the U S market. In the case of Honduras, a schedule was granted for the resolution of sanitary issues that affect exports of poultry, dairy products, tomatoes and peppers, as well as technical assistance to strengthen overall sanitary and phytosanitary standards. 9. Manufacturing: CAFTA will grant duty free access to the U S market to 99.9 percent of industrial exports from Honduras, excluding textile and apparel. Among the products which will immediately benefit from the entry into force o f the agreement are: plywood, wood furniture, plastic and paper products and some iron and steel products (pipes, wire). Honduras, on the other hand, will grant duty free access to nearly 80 percent of U S industrial exports. Tariffs for the remaining 20 percent will be phased out within 5-10 years, giving time to those sectors to prepare for competition and to the government to compensate for the potential lost of fiscal revenue. Flexible rules of origin were agreed for inputs like steel, which could be imported from third countries, with the final product maintaining its preferential access to the US market. 1 CAFTA negotiations ended in December, 17,2003 for El Salvador, Honduras, Guatemala and Nicaragua. For * Rep6blica Costa Rica, negotiations ended in January 2004. de Honduras (2004), Honduras: Tratado de Libre Comercio con Estados Unidos. Informe Final de Negociacidn Annex F Page 3 of 14 10. For textile and apparel exports, the agreement consolidates the benefits granted under the C B I renewal of 2000 (known as CBTPA) and includes important additional provisions which will contribute to the expansion of exports and value added in Honduras. CAFTA conditions grant duty free treatment to apparel made from regional (knit or woven) fabric usingregional yarn. Under the CBTPA, only some goods usingregional fabrics and yarns had duty free access but subject to quantitative restrictions. In addition, the treaty gives duty free benefits (subject to quantitative limits) to apparel made in Central America, using fabrics from NAFTA partners Mexico and Canada. Also, the treaty allows for an expanded use of third country inputs without losing the duty free status. This applies to certain fabrics and materials that are in "short supply" in member countries (based on a list developed in consultation with industry in US and CA), and to some products that undergo a substantial transformation in the region (bras, sleepwear and textile luggage). Furthermore, the share of third-country content to go into apparel was increased from 7% (under CBI) to 10% in CAFTA (`de minimis' provision). All these measures, which are retroactive to'January 1, 2004, offer new opportunities for Honduras to consolidate its apparel industry and to prepare it for the increasingly competitive global market that will arise once the quotas that still regulate world trade are eliminated at the end of 2004, as per WTO agreements. 11. Despite initial fears, CAFTA did not include provisions to change current export promotion regimes, in particular, export processing zones. Yet, the treaty ratifies compliance with W T O obligations, which requires countries to dismantle fiscal subsidies implicit in those schemes by 2010. Honduras, however, as one of the poorest countries in the region with a GDPper capita below $1,000, is exempted from this commitment. Government procurement 12. CAFTA provisions on this front includes commitments similar to those of NAFTA, with minimum thresholds to trigger competitive bidding and other procurement procedures aimed at ensuring transparency and non discrimination among member countries. The agreement requires fair and transparent procurement procedures, such as advance notice of purchases and timely and effective bid review procedures. In addition, strict guidelines are spelled out for when governments can resort to procurement methods other than bidding. CAFTA commits signing parties to make bribery in government contracting a criminal offence. 13. CAFTA gives access to Honduran firms to bids on contracts for purchases by U S federal and state governments, while U.S. firms gain access to bids on contracts from Honduran government ministries, agencies and departments. Low value contracts are e~cluded.~ In addition to locking-in recent reforms, the agreement will require legal and administrative changes in order to strengthen transparency and efficiency in procurement For the US.the minimumthreshold for goods and services i s $56,000 at federal level and $ 180,000 at state level, while for public works the threshold i s $6.8 million. For Honduras the minimumthresholds are $ 58,550 and $ 8.0 millions for goods and public works, respectively. The U.S grants access to Honduran firms to bids on federal contracts in 37 of the 50 states of the Union, as well as inPuerto Rico. Annex F Page 4 of 14 procedures. Particular emphasis should be given to measures aimed at tackling the sources of corruption, which i s a continued charge inpublic procurement outcomes inHond~ras.~ Property rights 14. CAFTA commitments in this area broadly lock in recent reforms implemented by Honduras intended to improving IPR protection and granting firms from member countries no discriminatory treatment. There are, however, some specific changes to current norms that need to be undertaken, as well as the signing o f additional international agreements in order to fully comply with the terms of the treaty. Some of the key commitments include: - In relation to patents, it provides for automatic extension for patents in case of delays in processing of patenting submissions. The agreement requires the protection of confidential information used for patent purposes. It defines the concept o f new product and does not recognize patents for second uses o f a previously patented product (for pharmaceuticals). In addition, it requires a system to prevent the marketing of pharmaceuticalproducts that infringe patents. - Preserves the right to use compulsory licenses for pharmaceuticals to address - public health crisis such as HIV AIDS, Requires transparent procedures for the registration of trademarks, including geographical indications. Includes new figures in trademark protections such as sound trademarks (marcas sonoras) certification trademarks and smell trademarks ( marcas olfativas). - Expands author's rightsfrom 50 to 70 years, - Provides protection for new plant varieties, including obligations to ratify the UPOV treaty of 1991. - Commits C A countries to make best efforts to ratify a number of international agreements dealing with trademarks, patents, internet, satellite TV and other IPR issues. 15. More importantly, CAFTA requires a stricter enforcement of IPR norms, an area in which Honduras has displayed significant failures in the past. The agreement criminalizes end-user piracy and requires the adoption o f more efficient legal and administrative procedures to combat and sanction the infringement of IPR. Among other provisions, it requires all parties to authorize the seizure and destruction of counterfeit and pirate goods and the equipment used to produce them. It also provides for enforcement against goods-in-transit to deter violators from using ports or free trade zones to traffic in pirated products. Under CAFTA, non compliance with IPR provisions will be subject to dispute settlement mechanisms which could eventually lead to the imposition of monetary fines. By strengthening the rule of law and overall investment climate, better enforcement of IPR is likely to have a positive impact on investment, especially in sectors such as information technology, pharmaceuticals and agrochemicals. World Bank Institute, (2002), Governance and Anti-corruption in Honduras: An Input for Action Planning. Annex F Page 5 of 14 Labor and environmental standards 16. CAFTA includes chapters on labor and environmental standards, as mandated by the authorization given by the US. congress to the executive branch. The inclusion of such provisions have generated heated public debate about whether they should be included in FTAs and whether they can effectively contribute to improve standards in developing co~ntries.~ 17. While Honduras has adequate domestic legislation and subscribes to the relevant international treaties in these matters, the problems are in their enforcement. For instance, Honduras has been questioned by the L O and within the C B I review mechanism about potential violations on unionization rights, the lack of enforcement of labor regulations in FTZs, and minimumwage regulations and the failure to enforce international commitments to eliminate child labor. As a result, in 2000 the U. S. extended C B I preferences to Honduras subject to a monitoring of its labor situation. 18. CAFTA commits all signatory countries to enforcing current domestic labor and environmental laws and regulations and bans the relaxation of these regulations to encourage trade and investment. Non compliance i s subject to the dispute settlement provisions of the agreement and could eventually lead to monetary penalties, which could be used b y the offending partyto strengthen its enforcement capacity. 19. The labor chapter contains a three-part strategy to improve working conditions in C A that consists of the following measures: Ensuring effective enforcement of existing domestic labor laws through commitments of signatory parties, Establishing a cooperative program to improve legislation and enforcement with the support of the InternationalLabor Organization, Building capacity of CA nations to monitor and enforce labor rights through specialized consultations and targeted training programs inthe areas of child labor, public awareness of workers rights and labor inspection systems. It includes an annex on labor cooperation which defines priorities and financing. For the fist year, the US committed $6.7 million to educated Central Americans on core labor standards and to improve administrative capacity in labor matters 20. The environmental chapter goes beyond provisions included in the recent U. S. FTAs with Chile and Singapore. CAFTA commits parties to effectively enforce their own domestic environmental laws, making them enforceable through the agreement's dispute settlement procedures. It forbids the weakening of environmental laws to attract trade and investment and enhances the support o f multilateral environmental agreements and organizations. CAFTA includes an environmental cooperation agreement with the following priorities (USTR,2003): Recent studies suggest that their inclusionis unnecessarysince firms engagedin trade are those which better comply with labor and environmentalregulations (Stern, 2003). Annex F Page 6 of 14 - Strengthening the capacity to develop, implement and enforce environmental laws; - Promoting incentive to encourage environmental protection; - Promotion of clean production technologies; - Building capacity to promote public participation in the environmental decision making process. 21. CAFTA commitments are unlikely to require significant changes in current labor and environmental laws and regulations in Honduras, but will contribute to enhance enforcement which has long been considered the key weakness. This positive development may contribute to improve the investment climate for exporting activities, particularly the maquila sector, by defusing ongoing criticism on workers' rights violations and remove the potential for demand side boycotts. Other provisions 22. Customs and trade capacity building: Customs have been a significant bottleneck to trade expansion in Honduras, due to lengthy procedures, multiple inefficiencies and opportunities for fraud and corruption. CAFTA includes commitments to improve and modernize custom procedures, facilitate trade among parties, and reduce room for discretion. Honduras, together with other CAFTA signatories committed to a list of actions within three years to accomplish goals such as the publication of all norms and regulations on the internet, the electronic presentation of certificates of origin, and the automation of most port operations (automatizacih del despacho de bienes). All parties also agreed to share information to combat the illegal trans-shipment of goods. In addition, the agreement includes for the fist time a Committee on Trade Capacity Building to coordinate and provide assistance to promote economic growth, poverty reduction and adjustment to liberalized trade. 23. Despite these actions, Honduras needs to push ahead with its own agenda for reform in this area in order to maximize the potential impact of trade on development. International comparisons suggest that trade facilitation investments and reforms in Honduras should be focused on improving the customs environment and port efficiency. Customs regulations should be streamlined and made more transparent. Ports require improved regulation, enhancement of competition inport services and modern management practices. 24. Dispute settlement: CAFTA provides for all core obligations to be subject to a bilateral dispute settlement panel with high standards for openness and transparency. This represents a considerable gain with respect to CBI regulations, which does not allow recourse to unilateral actions by the U.S. The inclusion of monetary penalties to enforce commercial, labor and environmental obligations provide incentives to comply with provisions and strengthening domestic norms and institutions. However, their actual use i s unlikely due to long consultation periods and tough test for non compliance. PotentialImpact of CAFTA for Honduras 25. CAFTA is likely to have a positive impact on the economy of Honduras by promoting trade, FDI, technology transfer and, ultimately, growth and poverty reduction. Trade flows Annex F Page 7 of 14 should increase by virtue of lower trade barriers and improved customs procedures. FDI should grow in response to greater private sector confidence and a better legal and economic environment. Technological transfer and increased productivity should be the result of new FDIflows, imports and greater overallcompetition. 26. The experience of NAFTA with the Mexican economy i s illustrative for Honduras. As a recent World Bank study on the subject demonstrates: the substantial reduction in tariffs on both sides brought about by NAFTA led to a sharp expansion in trade flows with the U.S., reflected in an increase in the trade openness index from 33.3 percent of GDP in 1994, to 53.1 percent 1995 and 63 percent in 2002. While the same magnitude of trade gains i s unlikely for Honduras, there i s considerable scope for trade creation under CAFTA, directly through enhanced access to the U S market beyond C B I terms, and indirectly through the impact of greater investment on trade flows. In a dynamic context, the later could contribute to transform Honduras's export structure as NAFTA did with Mexico. Before NAFTA, Mexican exports to the U.S. were concentrated in primary products, including oil. After NAFTA, FDI flows broadened greatly Mexico's export base, with manufactures largely surpassing traditional primaryproducts. 27. While trade diversion can be a significant distortion introduced b y some FTAs, this i s unlikely to be significant with CAFTA. The U.S. i s already the largest trading partner for Honduras and the fact that trade flows with the U.S. have grown over the past decade along with those to other natural trading partners (eg., other members of the CACM) suggest that there i s little scope for trade diversion under CAFTA.' 28. Preliminary evidence from recent Bank work suggests that FTAs are associated, on average, with transitory improvements in economic growth. Gould (2004) finds that controlling for other factors, the signing of an FTA yields an average boost in annual growth rates of 0.4 to 0.8 percentage points for the first five years. Available empirical evidence also suggests that FTAs North-South (i..e., between developed and developing countries) have a greater impact interms of export and GDP growth for developing countries, than South-South agreements (Berthelon, 2002, Monteagudo and Watanuki, 2001). This result i s explained by the greater potential for trade creation offered by developed countries due to their higher income and level of competitiveness. Furthermore, the lock-in effect of these FTAs i s likely to be stronger, contributing to the credibility o f trade reforms, which are crucial to promote investment and growth. 29. One way to examine the method to quantify potential effects of CAFTA i s to assume that it will lead to higher trade flows (as a share of GDP) following the Mexican experience. Usingthe growth model of Loayza et a1(2002), it is first assumed that Honduras would reach by 2010 the magnitude of trade openness (corrected for non-policy factors such as area, population and per capita GDP) that Mexico reached in the 1996-1999 period. In this Lederman, D.,W. Maloney and L.Serven, (2003), Lessons from NAFTA for Latin America and the Caribbean. 'This World Bank. has been confirmed by recent estimates of trade creation and diversion by the IMF (Alvin Hilaire and Yongzheng Yang, "The United States and the New Regionalism", IMFWorking Paper WP031206) as well as from the partialequilibrium analysis presentedin this paper. Annex F Page 8 of 14 scenario, Honduras' growth rate would be forecasted to grow at an additional 0.75% per year throughout the decade. If only half of this value were obtained then the per capita growth boost of greater trade flows would be reduced to 0.37% annually. Impact on Agriculture 30. As beneficiary of the CBI since 1983, the majority of agricultural and agro processed products from Honduras enjoy duty-free access to the U.S. market. These benefits were extended through the Trade and Development Act of 2000 (CBTPA) which grants similar benefits to those granted to Mexico by NAFTA.8 In spite of these preferences, U.S. agricultural imports from Honduras have been relatively stagnant since the early 1990s, suggesting that the country has failed to take advantage of these preferences to promote agricultural exports, as Costa Rica and Guatemala have done.' 31. Inaddition, an important number of `sensitive' agricultural products face trade barriers to access the U.S. market. The CBI establishes quotas to products such as meat, dairy products, sugar, peanuts, tobacco and cotton and imports above the volume assigned are obligated to pay MFN tariffs. Other barriers include seasonal tariffs, increased tariffs, automatic licensing procedures and anti-dumping measures which have affected US imports of chocolate, meat products and fruits and vegetables, among others. 32. A recent study sponsored by the World Bank found that Honduras could significantly increase its agricultural exports to the U.S., provided a comprehensive elimination of these barriers takes place under CAFTA. Using the methodology of comparative revealed advantage, the study found that Honduras exhibits comparative advantage in 132 8-digit tariff headings of agricultural and agroindustrial goods (see Table Fl). This amounts to total annual exports of $494 million during the period 1998-2000, or 57 percent of the total value of agricultural and agroindustrial exports. O f these headings, 75 (57%) display comparative advantages in world markets but not in the U.S., and 46 o f them were identified to face some kind of trade barrier in the U.S. The products affected by these barriers include meat, fish (trout) and crustaceans, milk and milk products (powdered milk and cheese); beans; vegetable extracts, animal and vegetable fats, sugar, cocoa, cereal preparations and fruit preparations. 33. On the import front, tariffs for all agricultural products are scheduled to be phased out under CAFTA with the exception of maize due to its sensitive nature in Central American economies. However, for sensitive crops Honduran negotiators obtained grace periods of 10 years in which tariffs will remain at current levels, giving authorities time to aid farmers in increasing their productivity, substitute crops or diversify into non-agricultural activities. Recent studies by the Bank on this issue for other Central American countries reveal that the changes should generate welfare gains to urban consumers as well as to the majority of the rural population (who i s a net consumer of these items). Nevertheless, programs to facilitate * The CBI initially excluded canned tuna which had a tariff of 35%. NAFTA parity reduced it to 18% and to 0% from 2008 onwards. (Monge et a1(2003). Among the CACM members, Costa Rica, Guatemala and Nicaragua substantially increased their agricultural exports to the US, while in El Salvador and Honduras agricultural exports stagnated. (Monge et al., 2003). Annex F Page9 of 14 the transition for those segments of the rural population that will face onerous adjustment costs will be warranted. Table F1 Honduras: Comparativeadvantage and barriers to trade inthe US for Agricultural and agro-industrialproducts I(1) total tariff headings exported to the world with I revealed comparative advantage (RCA) 132 (2) total tariff headings with RCA in the world but not inthe US. 75 % o f tariff headings without RCA inthe US (2)/( 1) 57% (3) Total tariff headings with barriers to trade in the U S 46 % of tariff headings with barriers to trade in the U S (3)/(2) 61% Type o f Barrier: Headings excluded from the C B I 20 Headinns with domestic subsidies inthe U S 2 Headings with ad valorem tariffs inthe U S 3 Headings with specific tariffs inthe US 3 Headings with non tariff barriers inthe US 6 Headings with export subsidies inthe U S 25 Impact on Manufactures 34. To quantify the potential effect of the elimination of U.S tariffs on Honduran exports, Table F2 displays results from partial equilibrium simulations based on market-specific elasticities." The simulations suggest that trade gains from CAFTA would amount to a short- term increase in exports o f 25 percent, ($559 m) compared with their current level. As expected, most of the estimated gains would be concentrated in the apparel sector grouped under the headings 61 and 62 (99% of total gains), assuming no significant capacity constrains. 35. The above results need to be interpretedwith caution. While the use of utilization rates of trade preferences i s an improvement over traditional analysis o f potential apparel gains, simulations cannot easily deal with the complicated structure of export restrictions associated with rules or origin requirements that are likely to be in place in CAFTA for this industry. As for other countries in the region, the greatest potential for expanded Honduran apparel exports resides in a loosening up of current rules of origin. For instance, the current quota for knit apparel made from regional inputs could be expanded to include all types o f apparel and other textile-using products, and the rule of origin associated with this quota could be less restrictive, by establishing that products qualify for tariff free status if component fabrics originate in the CAFTA region. Reforms along these lines could attract investment into yard loResults calculated with SMART software. Annex F Page 10of 14 spinning, fabric making and other related processes for fabrics and apparel into Honduras that could greatly increase local value added in this sector. Similarly, Honduras may also benefit from a flexible "short supply" provision that allows for duty-free exports with inputs from thirdcountries, as included inCAFTA. Table F2.Honduras:Estimatedeffects of US tariff elimination Total Actual CAFTA* Trade Exports Potential Trade Trade After 2001 Gain Diversion Creation CAFTA* Change Product HS Code and Description ($000) ($000) ($ 000) ($000) ($000) ("h) Total 2,235,949 559,178 136,913 422,266 2,795,128 25.01 HS.61 Art of apparel &clothing access, knitted or croc 1,757,745 431,312 100,434 330,878 2,189,057 24.54 HS.62 Art of apparel & clothingaccess, not knitted/cro 459,781 121,411 31,649 89,762 581,192 26.41 HS.24 Tobacco and manufacturedtobacco substitutes 11,163 5,699 4,444 1,255 16,862 51.05 HS.63 Other made up textile articles; sets; worn clothi 1,755 369 199 170 2,124 21.oo HS.02 Meat and edible meat offal 1,285 120 67 53 1,405 9.32 HS.17 Sugars and sugar confectionery. 3,012 108 57 51 3,119 3.57 HS.65 Headgearand partsthereof. 563 66 19 48 629 11.78 HS.56 Wadding, felt & nonwoven; yarns; twine, cordage, 297 30 15 15 327 9.93 HS.54 Man-madefilaments. 84 23 11 11 107 26.79 HS.55 Man-madestaple fibres. 58 18 9 9 76 31.60 HS.64 Footwear, gaiters and the like; parts of such art 8 8 2 6 17 95.71 HS.42 Articles of leather;saddlery/harness; travel goods 18 6 2 4 24 34.75 HS.58 Special woven fab; tuftedtex fab; lace; tapestri 38 3 2 1 41 7.95 HS.52 Cotton. 7 2 1 1 9 29.22 HS.46 Manufacturesof straw, esparto/other plaiting mat 35 2 1 1 37 4.87 HS.21 Miscellaneousedible preparations. 44 2 1 1 45 3.54 HS.19 Prep.of cereal, flour, starchlmilk; pastrycooks' 56 _ _ 1 1 0 57 -. 1.63 Source:Estimations using SMART, exports from UNCOMTRADE, tariffs from TRAINS, adjustedby utilization rates of CBI's preferentialtariffs. * CAFTA estimatedas an unilateraltariff elimination by the US to Central American countries 36. Hopes for expanded apparel exports from the region, however, face significant uncertainties derived from the end of the MFA in January 2005, when all textile quotas among WTO members are to be eliminated. At that point, it i s expected that countries with strong absolute comparative advantage like China may sharply increase their exports to the U.S. market, to the detriment of higher cost participants. But even under a complete Annex F Page 11of 14 elimination of quantitative restrictions on apparel trade, Honduras and other CA countries are likely to continue to enjoy a significant tariff advantage (Le., zero tariff vs. 10-30% MFN tariffs in apparel categories) over Asian competitors. In addition, C A countries benefit from a distance advantage which provides them with a competitive edge in markets where fashion trends change rapidly and just-in-time deliveries and rapid supply response are important. These factors together with the `know how' capabilities developed by Honduran apparel exporting firms should create significant opportunities for development of local linkages for this cluster, beyond the pure assembly model associated with maquila. 37. With respect to non apparel manufactures, partial equilibrium simulations do not reveal significant gains aside from maquila products. However, these simulations traditionally underestimate supply response to FTAs because they cannot anticipate new exports aside from those for which positive exports exist. Simulations made for Mexico before NAFTA also underestimated the expansion of new export categories for the same reason. Before NAFTA, Mexican exports to the U.S. were concentrated in primary products, including oil. After NAFTA, Mexico's export base broadened substantially, with manufactures largely surpassing traditional primary products. ImpactonInvestment 38. CAFTA i s also expected to encourage investment, including FDIflows to Honduras, although the magnitude of such flows i s difficult to anticipate. Investors are likely to be attracted by the new profit opportunities brought about by CAFTA and, more significantly, by the credibility effect (or reduced risk) that CAFTA is likely to introduce. This credibility effect has been found to be a critical factor in Mexico, where the lock-in of trade policies and broader reforms (ranging from regulation and competition policies, to property rights, contract enforcement, and macro stability) and the guarantee of access to partners' markets have contributed to the rapid growth in foreign and domestic investment. Furthermore, empirical analysis have confirmer that FDI flows react positively to FTAs, particularly in the initial stages as was the case o f NAFTA for Mexico. In the case o f CA, however, this effect i s not expected to be as significant in the short run, since most countries in the region have unilaterally liberalized their FDIregimes and have already subscribed investment protection treaties with the US. Impactonpublicfinances 39. In recent years the fiscal situation of Honduras has weakened considerably. The overall public sector position shifted from a surplus of 1.8 percent of GDP in 1998 to a deficit of 4.2 percent in 2002, owing to unsustainable increases in expenditure (mostly public wages) and falling tax revenue (DPR Chapter I). Despite overall tariff reduction, in 2002, import duties accounted for nearly 11 percent of total central government revenue (WTO, 2003). Assuming an extreme scenario where all tariffs on imports from the US are eliminated and volumes remained constant, fiscal losses for Honduras (tariffs +VAT) have been estimated to be inthe range of 5 to 8 percent o f current revenues. However, given the gradual phase out of some the tariffs and the potential for greater imports volumes and overall growth, the net effect in the first years o f CAFTA implementation i s likely to be lower. Compensatory fiscal Annex F Page 12 of 14 measures are likely to be needed to compensate for direct tariff-revenue losses, since gains from collection o f other taxes from greater imports and overall economic growth are unlikely to compensate direct losses." Further fiscal efforts will be required if Honduras wants to make significant progress in complementary areas that will maximize the impact of CAFTA (i.e., education and infrastructure). Recommendations: How to Maximize Benefitsfrom CAFTA 40. CAFTA i s a promising initiative for Honduras to expand trade levels, boost investment and growth and make progress in reducing poverty. CAFTA i s likely to enhance market access to some Honduran products, while making permanent the unilateral preferences offered in the past through C B I legislation. Additionally, the more comprehensive nature of CAFTA i s expected to `lock in' broad reforms and send a strong signal to investors. However, CAFTA alone i s not enough to generate a large investment and growth response, as argued in the recent Bank study "Lessons from NAFTA" (Lederman et. al., 2003), which identifies a number of critical gaps that have limited some o f Mexico's gains (see Box Fl). Lessons from the Mexican experience and others indicate that Honduras needs to advance in key policy and investment areas in order to ensure that CAFTA's potential for economic and social development can materialize. 41. Inorder to identify the most important areas for policy changes, it is helpful to review the key factors that facilitate the attainment of the static and dynamic gains from trade reforms and FTAs. On the static front, gains depend on the ability of the economy to successfully adjust to changes in relative prices. This entails the restructuring of the economy, including the movement of labor to those sectors where labor productivity is higher. On this front, institutions and regulations that facilitate resource mobility and firm entry and exit are critical, as well as infrastructure and other trade facilitation areas. 42. On the dynamic front, the international evidence suggests trade policy changes or FTAs can have a significant impact on aggregate investment and technological progress. In this front, the key determinant is the economy's ability to take advantage of foreign technologies, which involves boosting the education and skills level of the labor force and setting up institutions and regulations that facilitate the importation of new technologies and their adaptation to the Honduran context. 43. For Honduras, actions needed to maximize the static and dynamic gains from CAFTA coincide broadly with the agenda spelled out in this DPR to enhance growth. To optimize the trade and growth gains, key policy and investment areas required to enhance CAFTA's opportunities should include: A. Education and knowledge absorption and generation: CAFTA is likely to bolster FDI and imports with the capacity to improve technology and productivity. However, to ''Inthe absence of compensatory fiscal measures, CAFTA i s expected to have a negative net impact on fiscal revenues over the next five years, estimated to lie between 0.72 and 0.97 percent of GDP per year; see Perry, Guillermo, "Como aprovechar bien CAFTA: Agenda Complementario o Primaria", Presentation made in San Salvador, El Salvador (February 2004), processed. Annex F Page 13 of 14 materialize the potential and enhance technological spillovers will require sufficient levels of human capital and an adequate knowledge and innovation system. In education, this means that Honduras needs to close its `gap in skills', expanding coverage and quality of its primary and secondary schooling system (as explained in Chapter 11of the DPR). On the innovation front, it will need to boost the quality of its institutions of research, increase expenditures on R&D and develop links between public researchers and private sector users (see Annex E). There are important synergies to be exploited between a functioning innovation system and critical higher education initiatives. B. Trade facilitation and infrastructure: While Honduras has made strides inmodernizing its infrastructure in recent years, there are deficiencies that need to be addressed, particularly in road networks and ports (see chapter I11 of this DPR). The latter have suffered from operational and administrative inefficiencies that need to be addressed. International comparisons suggest that trade facilitation reforms in Honduras should also be focused on improving customs environment, where regulations need streamlining and more transparency. C. Institutionaldevelopment and governance: While Honduras has achieved considerable progress in the institutional and governance front over the past decade, serious deficiencies still exist, particularly in the rule of law and personal security front, as evidenced b y corruption, violence and crime indicators. Weaknesses inrule of law are part of the reason for the low growth yield of reforms throughout Latin America in recent years.I2 To reap the rewards of CAFTA, continued improvement in institutions i s required, especially those aimed to improve the rule o f law and fight corruption. This will require substantial local efforts, as such improvements have not been automatic byproducts of North-Southfree trade agreements. D. Facilitating the transition: Attention is also required to ensure that the transition to the new relative prices i s not accompanied b y large increases in temporary unemployment. Poor households that depend on sensitive agricultural commodities, may require technical assistance programs to facilitate technological upgrading, crop substitution or moving out of agriculture, complemented by actions to spur the development of deeper financial markets. This process should be facilitated by grace periods of up to 10 years before tariffs begin to drop for sensitive crops that were accorded in CAFTA. In addition, authorities have time to begin are spread across all levels of Salvadoran society. In addition, to ensure that benefits spread beyond large companies, actions to support MSMEswill berequired, particularly inexpandingtheir accessto finance. E. Macro-fiscal management: Strengthening of macroeconomic policies and debt sustainability i s an important component of the strategy to improve the investment climate in Honduras. This requires addressing the macroeconomic disequilibria that emerged in recent years and achieving HIPC debt reduction, and compensating for potential fiscal '*Recentempirical studies confirm the importanceof institutionsand governance in economic development. (D. Kaufman, A. Kraay, 2002, Governance Matters; Growth Without Governance, World Bank; Easterly and Levine,2002,) These studies have also found that improvements in governance do not occur automatically but require substantialreformefforts. (D. Kaufman, Kraay, 2002). Annex F Page 14of 14 losses associated with CAFTA. CAFTA challenges are likely to require further fiscal efforts to compensate for direct fiscal losses associated with tariff reduction and to finance investments neededto ensure that trade gains materialize. F. Trade policy: In addition to strengthening institutions needed to meet CAFTA commitments in the trade administration sphere, Honduras i s likely to benefit from continuing to pursue its agenda of unilateral, bilateral and multilateral actions to expand trade and broaden integration opportunities. Deepeningtrade and other links with regional neighbors through the CACM will improve allocation of resources in the region and provide economies o f scale needed to launch new viable export ventures. Further progress in reaching FTAs with Canada, the European Union and with other Latin American countries through FTAA will further broaden economic integration and minimize possible trade diversion effects from existing FTAs.A related issue i s the continuing international pressure for the removal of tax incentives in free trade zones. Inthe mediumand long run, Honduras will need to replace these incentives by an improved investment climate that can compensate for lost advantages to established firms, as well to attract new investors. Box F1: The Lessonsfrom NAFTA A recent study "Lessons from NAFTA for Latin America and the Caribbean" by Daniel Lederman, William Maloney, and Luis ServCn (World Bank, 2003) highlights the following lessons: - NAFTA can be credited for boosting Mexico's growth in the post 1994period. B y inducing a reciprocal reduction in trade barriers and locking-in the reforms of recent years, it has yielded a positive impact on trade flows, foreign direct investments, and growth of industrial productivity. It i s also responsible for the creation of many new jobs and some reduction in poverty rates of recent years in Mexico. - Despite the positive growth effect, NAFTA has not sufficed to guarantee income convergence among North American countries. This reflects mainly pending items in Mexico's policy agenda including institutional gaps (Le., corruption and rule of law), deficiencies in education (both coverage and quality), a passive innovation policy, the lack of critical infrastructure (especially in lagging regions) and some weaknesses in macroeconomic policy. The experience has demonstrated that while positive, an FTA with a developed partner is not sufficient to increase growth on a sustainable basis unless an agendaof complementary reforms i s pursued. - NAFTA benefits have been concentrated in states in the North and Center of Mexico. Southern states have not seen much of an impact, due to key deficiencies in institutions, education and infrastructure. -Contrary to some predictions, NAFTA has not had a devastating effect on Mexico's agriculture. In fact, both domestic production and agricultural trade rose during the NAFTA years. The negative effects did not materialize because aggregate demand expanded rapidly in both Mexico and the U.S. in the latter half of the 1990s, some segments of Mexican agriculture recorded substantial increases in productivity (esp. irrigated lands), and outdated subsidies were transformed into targeted efficient programs (e.g., Procampo) which delinked transfers to farmers from current and future production levels. - Mexico's experience also shows that there are some key remaining barriers to trade that have limited the growth potential of certain sectors. In particular, restrictive rules of origin affecting clothing exports to the US. market seem to have limited the ability of Mexican exporters to take full advantage of NAFTA preferences. This issue i s likely to be a key topic for El Salvador and other Central American countries. REFERENCES Barriga, Patricia, Gloria Gamero and Seth Spaulding (2001): "Estudio Evaluativo de la Viabilidad Institucional de TelebBsica". February. Tegucigalpa, Secretaria de Educacidn, IEQII and USAID. Beck, T., A. Demirguc-Kunt, and R. Levine, (1999), "A New Database on Financial Development and Structure", World Bank, June. CEPALECLA (2002), "Istmo Centroamericano: La Regulacidn de la Distribucidn de Energia ElCctrica en 10s Paises con empresas privadas", July. CEPALECLA (1998), "A Preliminary Assessment of Damages Caused by Hurricane Mitch", December 10. Correa, Paul0 (2002). "Honduras Competitiveness Project. Background paper. October. World Bank. De Ferranti, David, et a1 (2002), "The I S 0 Survey of I S 0 9000 and I S 0 14000 Certificates". World Bank. De Ferranti, G. Perry, I. Gill and L. ServCn (2000), Securing Our Future in a Global Economy, World Bank Latin American and Caribbean Studies (Washington, D.C.: World Bank). ESA Consultores, "Secondary Education Coverage Increase: Cost Analysis and Projection: (2003), July. Estache, Foster and Wodon, Q. (2001) "Infrastructure Reform and the Poor", World Bank. Fay, Marianne and Tito Yepes (2003), "Investing in Infrastructure". World Bank working paper.. Hilaire ,Alvin and Yongzheng Yang (2003), "The United States and the New Regionalism", IMF Working PaperWPO3l206. IFC and World Bank (2004). Foreign Investment Advisory Services (FIAS), "Honduras: Reform of Labor Skills Training to Strengthen the Competitiveness of the Honduran Private Sector - Internal Draft". INE,Householdsurvey, various years InternationalMonetary Fund, InternationalFinancial Statistics, various years. Kaufman, Daniel and Aart Krfiay (2002), "Governance Matters; Growth Without Governance", World Bank Working Paper. Kaufman, Daniel and Aart Krfiay (2003), "Growth without Governance", World Bank Working Paper. Kaufman, Daniel, Aart Krfiay and Massimo Mastruzzi (2003), "Governance Matters 111: Governance Indicators for 1996-2002", World Bank Policy Research Paper No. 3106, June 23. References Page 2 of 2 Lederman, D.,W. Maloney and L.ServCn, (2003), Lessonsfrom NAFTAfor Latin America and the Caribbean. World Bank. Levine, Ross, Norman Loayza and Thorsten Beck (2000), "Financial Intermediation and Growth: Causality and Causes:, Journal of Monetary Economics, August, pp. 31-777. Levine, Ross (1997), "Financial Development and Economic Growth: Views and Agenda," Journal of Economic Literature, June, 35 (2), pp. 688-726. Loayza, Norman; Pablo Fajnzylberand Ricardo Calderbn (2002), "Economic Growth in Latin America and the Caribbean." World Bank Report. Lora, Eduardo (2002), "Structural Reforms in Latin America under Scrutiny" (Inter-American Development Bank, March). Lora, Eduardo (2001), "Las Reformas Estructurales en America Latina: Que se ha reformado y como medirlo", Inter-American Development Bank, Working Paper No. 462, December. Perry, Guillermo (2004), "Como aprovechar bien CAFTA: Agenda Complementaria o Primaria", presentation made in San Salvador, El Salvador (February), processed. Republica de Honduras (2004), "Honduras: Tratado de Libre Comercio con Estados Unidos. Informe Final de Negociacibn." UnitedNations Development Programme (2002), Human Development Report, New York, N.Y. Van Steenwyk, Ned (2002), "TELEBASICA. Los Primeros Graduados del Noveno Grado. Secretaria de Educacibn-USAID". March. Wilson, John S. and Otsuki, Tsunehiro (2003), "Honduras Competitiveness Project". World Bank, processed. World Bank Institute (2002), "Governance and Anti-corruption in Honduras: An Inputfor Action Planning", processed. World Bank (2003), "Financial Sector Assessment Program", April, processed. World Bank (2001), Honduras -Poverty Diagnostic 2000, Report No. 20531, June 29. World Bank (2001), Honduras -Poverty Expenditure Review, Report No. 22070, June 28. TECHNICAL ANNEXES HONDURASTable 1. Gross DomesticExpenditure and Product (SharesofGDPbased on currentprice data) EARS 1995 1996 1997 1998 1999 2000 2001 2002 2003 Prelim. Prelim. Prelim. market prices 72.8 74.0 73.5 76.7 80.3 83.3 86.8 89.5 89.2 a) General government 9.3 9.5 8.8 10.1 11.3 12.5 13.9 13.8 13.5 b) Private 63.5 64.4 64.6 66.6 69.0 70.7 72.9 75.7 75.7 . Gross capital formation 31.6 31.1 32.2 30.9 34.7 30.6 29.6 25.6 27.4 a) Gross fLxed capital formation 24.0 24.0 25.7 28.2 29.9 26.1 23.8 22.2 23.4 i)Publicsector 10.0 8.8 6.8 5.4 6.3 5.9 6.8 4.8 5.4 ii)Privatesector 14.0 15.2 18.9 22.8 23.6 20.3 17.0 17.4 17.9 b) Change ininventories 7.6 7.1 6.5 2.7 4.8 4.5 5.8 3.4 4.1 .Total Absorption (1+2) 104.4 105.1 105.6 107.7 115.0 113.9 116.4 115.1 116.7 . Resource balance -4.4 -5.1 -5.6 -7.7 -15.0 -13.9 -16.4 -15.1 -16.7 a) Esports of goods & services 43.7 46.9 46.2 46.4 41.O 41.3 37.8 38.0 38.3 b) Imports of goods & services 48.1 52.0 51.8 54.1 56.0 55.2 54.2 53.1 54.9 .Gross domestic product (3+4) 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 .Net income from abroad -6.8 -6.4 -4.6 -4.0 -3.0 -2.6 -2.8 -2.9 -2.8 . Gross national income (5+6) 93.2 93.6 95.4 96.0 97.0 97.4 97.2 97.1 97.2 , N e t current transfers f r o m abroad 6.7 6.8 6.6 9.3 13.6 12.4 14.5 14.5 0.0 , Gross national disposable income (7+8) 93.9 94.4 96.3 99.4 104.5 103.9 105.7 105.6 91.2 0. Nationalsavings (9-1) 21.1 20.4 22.8 22.7 24.2 20.6 18.9 16.1 2.0 a) Public Sector 8.6 8.8 6.6 3.1 1.4 0.0 18.4 17.7 15.3 16.4 17.3 0.0 HONDURASTable lA. Gross Domestic Expenditure and Product (current prices) (millions oflempiras) E A R S .. GDP by Expenditure , Final consumption a) General government b) Private . Gross capital formation a) Gross f x e d capital formation i)Publicsector ii)Privatesector b) Change ininventories . Total Absorption (lf2) . Resource balance a) Exports of goods & services b) Imports of goods & services . Gross domestic product (3+4) . N e t income from abroad . Gross nationalproduct (5+6) . Fixed capital allowances , N e t Domestic product (?+8) 0. N e t current transfers from abroad 1. Gross nationaldisposable income (?+8) 2. National savings (9-1) 3. External Savings 4. Total Savings* a) Public Sector b) Private Sector I. GDP by Industry of Origin .Agriculture . Industry Construction Gas, electricity, water Miningand quarrying Manufacturing .Services Transportation Trade Dwellings Banking Public administration Other .Total value added at basic prices .Taxes less subsidies on products . Statisticaldiscrepancy . GDP at market prices ource: wwu-.bch. hn Source: IMF Stadstical -Annex S51/03/144. Y E A R S 1996 1997 1998 1999 2000 2001 2002 2003 Prelim. Estimate Estimate IA. GDP by ExDenditure and Income 11.Finalconsumption 5.2 2.7 5.7 0.4 8.0 5.4 2.2 5.2 a) General government 5.3 -1.0 15.4 9.8 15.7 12.1 0.5 0.8 b) Private 5.2 3.1 4.5 -0.9 6.8 4.4 2.5 5.9 2. Gross capital formation -5.7 7.9 1.9 8.1 -3.0 -5.7 3.3 2.6 a) Gross fixed capital formation 6.3 15.8 10.3 6.5 -7.6 -8.1 -5.7 8.8 i)Publicsector 15.4 33.0 20.1 3.1 -10.1 -16.4 3.8 6.2 ii) Private sector -7.1 -15.6 -17.8 21.0 1.2 18.1 -27.0 17.1 b) Change ininventories -32.9 -20.5 -41.7 23.5 36.2 8.3 47.2 -16.7 3. Total -\bsorption 2.0 4.1 4.6 2.5 4.8 2.4 2.5 4.6 4. Exports of goods & services 8.1 1.3 1.6 -11.2 7.3 3.2 4.9 5.2 5. Imports of goods & services 2.4 -1.4 7.5 4.3 3.8 4.0 2.5 9.0 6. Capacity to Import a) 1.6 -2.5 3.5 -11.0 6.1 -3.8 6.0 6.1 7. Real GDI at market prices * -1.4 6.0 2.0 3.0 3.3 8. Real gross nationalincome * -0.4 7.1 2.5 3.9 3.2 9. Real gross national disposable income* -0.5 7.5 2.6 4.1 3.2 1.,ipculture 2.5 4.3 -1.9 -8.5 11.7 -0.5 2. Industry 2.9 4.7 3.9 4.0 5.2 2.1 Construction -11.4 -3.0 5.3 10.5 1.5 -5.2 -14.6 Gas, electricity, water 15.4 7.6 4.9 2.1 10.6 -1.8 A h g and quarrymg 7.3 4.9 3.7 5.4 1.7 -0.8 2.4 Manufacturing 4.6 6.1 3.4 2.6 5.5 5.2 3. Services 3.4 5.5 4.5 0.5 5.3 5.5 4.1 2.5 4. Total value added at basic prices 3.0 5.0 2.6 -1.0 6.8 3.i 3.4 5. GDP at constant prices 3.6 5.0 2.9 -1.9 5.7 2.6 2.5 3.1 H O N D U R A S Table 2A. Gross Domestic Product by Expenditure, National Income and Savings (mdlions ofI978lempiras) a) Gross fixed capital formatton I) Public sector 11) Pnvate sector b) Change mmventones 3. Totalhbsorpnon (1+2) 4 Resource balance a) Exports o f goods & servlces b) Imports of goods & services 5 Gross domesac product (3+4) 6. Factor Payments 7. Realgross domesac product (5+6) 8. Indxect taxes "us subsides 9. Real gross naaond product at factor costs (7+8) 11.Realgross naaonaldsposable income (9+10) 13 Terms of Trade Effect Constructton Gas, electnclty, water Mmmgand quarry" ? 3 H O N D U R A S Table 4. CONSOLIDATEDPUBLIC S E C T O R FINANCES (inpercent ofGDP) - 1995 1996 - 1997 2003 Estimate herall balance includ. grants 0 00 0 O( 0 01 -4.07 -3.86 oral Revenues, incl. current Grants 0 00 0 O( 0 01 26.84 34.19 xpenditures and N e t Lending 0 00 O.O( 0 01 30.92 38.06 herall balance excl. current Grants 0 00 0 O( 0 01 -5.19 -4.99 urrent Revenue/Expenditure urrent Budget Balance, incl. current G r a n 0 00 0 O( 0 01 2.52 4.33 otal Current Revenues, incl. current G r a n 0 00 0 O( 0 01 26.70 34.08 urrent revenue, excluding grants 0 00 0 O( 0 01 25.58 32.95 Direct Taxes 0 00 0 O( 0.01 16.81 18.47 Indirect Taxes 0 00 O.O( 0 01 4.75 12.31 Nontax Receipts 0 00 0 O( 0 01 4.03 2.18 Grants, current 0 00 0 O( 0.01 1.12 1.13 oral Current Expenditures 0 00 0 O( 0 01 24.18 29.75 Interest on External Debt 0 00 0 O( 0 01 1.88 1.51 Interest on Domestic Debt 0 00 0 O( 0 0 0.30 0.37 Other Current Transfers 0.00 O.O( 0 0 5.19 4.67 Subsidies 0 00 0 O( 0 0 0.00 0.00 Consumption 0 00 0 O( 0 0 3.29 8.36 Wages and Salaries 0 00 0 O( 0 0 13.51 14.84 :spitalReceipts/Payments 'otalCapital Revenues 0 00 0 O( 0 0 0.14 0.11 rivatization Proceeds 0 00 0 O( 0 0 0.oc 0.00 'otalCapital Expenditures and N e t Lendin 0 00 O.O( 0.0 6.73 7.39 Capital Transfers and N e t Lending 0 00 O.O( 0 0 1.55 1.42 Budgetary Investment 0.00 0 O( 0 0 5.1E 5.97 'otalDeficit Financing 0.00 0 O( 0 0 4.07 3.86 External Capital Grants 0 00 0 O( 0 0 3.8( 1.90 External Borrowing (net) 0 00 0 O( 0.0 -2.35 0.00 Monetary System Credit (net) 0 00 0 O( 0 0 -0.2c 0.00 Other Domestic Borrowing(net) 0 00 O.O( 0 0 2.8( 3.20 Discrepancy** 0 00 0 O( 0 0 -O.O( -1.24 )ebt (at end year) 'otal Government Debt 0 00 0 O( 88 1 70.42 68.2( 0.00 External Debt 0 00 O.O( 81 1 65.85 64.01 0.00 Domestic Debt 0 00 0 O( 7 0 4.57 4.15 0.00 2,201I M e r Series rimary balance, excluding interest 0 00 0 O( 0.0 -1.15 -1.85 -1.98 lemo Item: 5.811 3,561 ;DP at market prices (mdlions of lempiras 37,507 0 47,763 0 61,321 ( 70,438.0I.77,096.0I189,401.0 99,032.0 I i I II108,123.0 120,322.0 HONDURASTable 4A. CONSOLIDATED PUBLIC SECTOR FINANCES - (mil ms oflei iras) YEARS 1995 -1996 1991 1998 1999 2000 2001 2002 2003 Prelim. Estimate Estimate Overallbalance includ. grants 1,252.0 (200.0) (678.0: Total Revenues, lncl. current Grants 20,415.0 23,632.0 26,106.0 Expenditures and N e t Lending 19,163.0 23,832.0 26,784.0 Overall bdance escl. current Grants 883.0 (569.0) (1,616.0: CurrentRevenue/Expenditure Current Budget Balance, incl. current Grants 8,374.0 7,278.0 6,864.0 Total Current Rerrnues, incl. current Grants 20.270.0I23.536.0 I 25.765.0 Current revenue, escluding grmts Direct Tases Indirect Tases Nontas Receipts Grants, current Total Current Espenditures Interest on Domestic Debt Interest on Esternal Debt Other Current Transfers Subsidies Consumption Wages and Salaries Capital Receipts/Payments Total Capltal Revenues Privatization Proceeds l'otal Capital Espenditures and N e t Lending Capital Transfers and N c t Lending Budgetaq Investment Total Deficit Financing Esternal Capital Grants External Borrowing (net) h l o n e t q System Credit (net) Other Domestic Borrowing (net) Discrepancy** Debt (at end year) Total Government Debt Esternd Debt Domestic Debt Other Series Primary balance, escluding interest as a ' 0 o i G D P Memo Item: GDP at market prices (millions oE lempiras) 37,507 C 47,763 ( 61,321 ( HONDURAS Table 4B. AUGMENTED PUBLIC SECTOR BALANCE* (inpercent ofGDP) v) 2 Y a, Y v) 8a, Y rl H a g HONDURASTable 6. BALANCE OF PAYMENTS (US$millions) 'EARS hrrent Account 3xports of goods & services 2.600.6 I 2.510.7 Exports of goods Shipping and insurance Travelers expenses Dividend and interest Government transactions T'alue ;idded h I a q d a Others mports of goods & services Imports of goods, f.0.b. Shipping and insurance Travelers expenses Retribution to foreign investments Interest paidon external debt Government transactions Others Jet trade in goods & services ( ~ ~ ~ 1: ~ ) Il I Jet current transfers :urrent Account Balance (194.0) (169.9) (128.2) (240.9: :spital& Financial Account Jet total private investment inflows 146.0 250.6 184.1 272.9 LongTerm Direct Investment Loans hrrears Other ShortTerm Jet total financial inflows LongTerm Loans Arrears Other Short Term Jet official inflows LongTerm Loans Arrears Other Short Term lapita1Account Balance ,rrorsand omissions ilobal Balance .eserves, net change I iegative sign indicates increase) kher Series [et reserves (end of period, incl. gold) 1,490.4 1,637.7 eserves as month's imports 5.0 5.3 ;DP ( d o n s of US$) 5,956.1 6,327.9 3urce: www.bch.hn -- n HONDURASTable 7. Trade ( illions of I? ' E A R S - 1995 1996 1997 Preliminar Prelimina t. EXPORTS 11.Exports (fob, US$) 'oralPrimary Commodities Bananas Coffee Shrimps hher commodities 'oral 'rices (current S) Bananas (40 Ibs) Coffee (46 Kgs) Shrimps (kg) 1.2 Exports (constant prices- 1993) .oral PrimaryCommodities Bananas (1993: 6.21) 197 240 205 7 Coffee (1993: 89.28) 209 239 200 E Shrimps (1993: 11.05) 102 118 115 i.IMPORTS 1.1Imports (cif, US$) hnsumer Goods Durables Nondurables Law LIaterials Agriculture hfanufacturing ubricants and fuels zapitalGoods Agriculture Xlanufacturing Transport Construction Ither .'oral 8.( 3.2 Imports shares IonsumerGoods 27% 27% 27( Law materials 29% 29% 30' ,ubricants and fuels 13c 13O 119 8% 10% 13' kpitalGoods 31% 30% 25' Ither 4% 4' iources: CentralBank and Honduras statisticalannex IhIF 9 9 9 9 9 0 9 9 9 9r 9 9 9 9 9 9 9 9 9 2 2 2 h l m n n c . 1 b * c o r - m * m d o"hl- r - o o b ~ * * i o d m * W c o h l " " O \ h l W d (h, d c . 1 h l i 32v v 3 2 v HONDURASTable 11.Vulnerability Indicators ----- YEARS 1999 2000 2001 2002 2003 A. Market Indicators Annual percent change in average exchange rate 6. 4.1 4.3 6. 5. Annual change in T-Bdlrates (short-term) Average spread on Eurobonds (basis points) B.RiskRatings ICRGcomposite (1-100, bad to good) Euromoney (1-100, bad to good) Institutional Investor (1-100, bad to good) C. Financial Annual growthin real domestic credit ("/o) -6. 15: 12.t 0. 15. Foreign currency to total deposits (YO) Non-perfm. loans of commercial banks (% of total) I 0.1 C D. Reserve Cover Indicators Reserve cover of imports (months of imports) 5.1 5.1 5.3 5. 5. Reserves to short term debt 5.1 5.' 6.E 8. Reserves/M2 0. 0.. 0.5 0. 0. E.Prices Annual change in terms of trade (YO) 0. -1.: -8.3 2. 0. Annual appreciation REER (`YO) 21.1 3.. -46.8 -190. 63. F. External Current account balance (YOof GDP) -4. -4. -4.1 -3. -3. Extemal D e b t (% of GDP) 79. 71.1 68.C 64. 66. G. Fiscalsustainability indicators I/ Total net public debt (% of GDP) n.a. n.a. n.a. n.a. n.a. Overall public sector balance (% of GDP) -0. -0.1 -3.4 -4. -3. - Primary balance (Overall ba1.-interest; O/Oof GDP) -0. -0.1 -3.4 -4. -3. I/ Note: These numbers are from Table 4A, the aumentedpublic sector table. Sources: IFS, WDI, IMF, Datastream. HONDURASTable 12: Millennium DevelopmentGoals Indicators I 3 Promote gender eaualitv 2005 target = education ratio to 100 - 1 Under 5 mortality rate (per 1,000) Contraceptive prevalence rate (Yo of women ages 15-49) Xumber of chddren orphaned by H I V / A I D S I 7 Ensure environmental sustainabilitv 2015 tarpet 1 I @.' I I Fixedline and mobile telephones (per 1,000 people) Personal computers (per 1,000 people) Source: World Development Indcators