Mission Concluding Statement 

Panama: Staff Concluding Statement of the 2017 Article IV Mission

March 17, 2017

Panama’s economy is expected to remain among the most dynamic in the region. The economic outlook is favorable, albeit set against the backdrop of heightened external uncertainty. Panama’s growth model relies on its ability to remain a competitive and attractive destination for international financial, business, and transportation services. Continued progress with tax transparency and financial integrity are essential to preserve this growth model. Commitment to fiscal discipline and efforts to strengthen the fiscal framework and enhance institutional capacities contribute to ensuring sustainability, and need to be complemented by a comprehensive monitoring of fiscal risks. As a regional financial center, the comprehensive monitoring of systemic risks and a strong macroprudential and crisis management framework are important to safeguard financial stability.

The economic outlook remains favorable

Growth is expected to remain among the highest in the region, with stable and low inflation, sustainable public debt, and a declining current account deficit:

• Economic growth is projected to pick up slightly to 5.1 percent in 2017 and about 5.5 percent over the medium term, supported by the expanded Canal and the wide range of investment projects.
• Inflation is projected to pick up to about 2 percent in 2017 from 0.7 percent in 2016 as fuel prices continue to normalize and economic activity strengthens somewhat.
• Fiscal consolidation is projected to continue in line with the Social Fiscal Responsibility Law (SFRL) deficit targets, which would imply a gradual reduction of the non-financial public sector (NFPS) deficit over the medium term and would place NFPS debt as a share of GDP on a downward trajectory.
• The current account deficit is projected to further narrow to about 3 percent of GDP over the medium term, driven by a diversification of exports into primary commodities, and to continue to be financed by broad-based foreign direct investment.

Key risks relate to the external environment and progress in strengthening tax transparency and measures for anti-money laundering and combatting the financing of terrorism (AML/CFT). Weaker-than-expected global growth or a shift toward increasing trade restrictions could lead to a slowdown in Canal activity, which could dampen Panama’s growth and government revenue. A faster-than-expected tightening of U.S. monetary policy and continued appreciation of the U.S. dollar could put continued appreciation pressure on Panama’s REER and erode external competitiveness. Panama needs to address deficiencies in tax transparency, exchange of tax information, and AML/CFT to preserve its role as an international financial and business center. Pressures on correspondent banking relations could adversely affect Panama’s international financial center.

Strengthening tax transparency and financial integrity should remain at the top of the policy agenda

Progress needs to continue to ensure compliance with international requirements on tax transparency and exchange of tax information. The authorities completed several important policy actions over the past year. Panama committed to implement automatic exchange of tax information by 2018, ratified the OECD’s Multilateral Convention on Tax Matters, and adopted key pieces of domestic legislation that form the legal basis for automatic exchange of tax information, strengthen the revenue administration’s powers, and reinforce the accounting requirements for companies and foundations registered in Panama. To obtain a positive assessment under the Global Forum’s fast-track procedure in mid-2017 it is essential to address the remaining deficiencies, including strengthening the revenue administration’s human, procedural, and ICT capacities to ensure effective exchange of tax information.

Effective implementation of the AML/CFT framework to enhance financial integrity is a critical complement to strengthening tax transparency. The AML/CFT framework has been strengthened, but it will be important to address remaining gaps, of which the most critical is to make tax crimes a predicate offence to money laundering. The completion of the national risk assessment in January 2017 is an important milestone to advancing further reforms and its findings should be addressed in the national AML/CFT strategy being developed. Panama will also need to demonstrate effective implementation of the framework to receive a positive assessment in the Financial Action Task Force of Latin America’s assessment later this year.

Support fiscal sustainability with a stronger fiscal framework

The planned medium-term consolidation path, that is in line with the Social Fiscal Responsibility Law’s fiscal rule, is needed. The consolidation efforts amid slower growth demonstrate the authorities’ commitment to fiscal discipline and help strengthen the credibility of the fiscal framework, which was negatively affected by a series of waivers and amendments several years ago. Such an approach should put the NFPS debt-to-GDP ratio on a downward path, and help build buffers in light of possible fiscal risks.

Public sector fiscal risks and contingent liabilities need to be better monitored. Publishing additional information in the fiscal accounts about the different stages and accrued obligations for turnkey projects would enhance transparency and accountability. In addition, the reserves of the exclusively defined-benefit pension subsystem are expected to be depleted in a decade. Without a parametric reform (e.g. to the retirement age or replacement rate), these shortfalls would put expenditure pressures in subsequent years and crowd out other components of public spending. A comprehensive assessment of all contingent liabilities of the consolidated public sector is necessary to be assured that the Social Fiscal Responsibility Law’s debt target results in adequate buffers to face fiscal risks.

Establishing a fiscal council could strengthen the fiscal framework. By publicly assessing and monitoring fiscal assumptions and results, including performance under the fiscal rule, such a body could improve transparency, promote accountability of the fiscal framework, and encourage an informed public debate. Ensuring legal and operational independence of the fiscal council, and endowing it with adequate resources, are indispensable for its role as a candid assessor of fiscal assumptions and results.

Continued progress in strengthening revenue administration would help generate resources to finance strategic public investments. Recent improvements in tax administration, enhancement of human resources, the introduction of partial VAT withholding and an upgraded tax filing system contributed to the strongest tax performance over the last three years. Building on this progress, further measures should aim to strengthen the tax administration’s institutional capacity, upgrade its IT system, and strengthen incentives for tax compliance. In addition, the customs administration needs to address weaknesses in institutional capacity, advance trade facilitation, reform control processes, and improve its data collection and management. Measures to strengthen the capacity of the revenue administration agencies need to be complemented by policy actions to review and streamline the complicated scheme of tax incentives and exemptions, starting by publishing a list of the estimated fiscal cost of each of these measures.

Financial sector oversight, macroprudential policy and crisis management should be strengthened to build resilience

Monitoring of systemic risk should be strengthened. The Financial Coordination Council has taken steps to enhance oversight of financial conglomerates and deepen information exchange across financial supervisors. Nevertheless, given the decentralized nature of financial supervision in Panama, it will be desirable to further expand coordination to monitor system risk of the overall financial system. Enhanced data is also needed to appropriately assess systemic risk, particularly on household and corporate balance sheet vulnerabilities, as well as on residential and commercial property prices. The recent efforts of the Superintendencia de Bancos de Panamá along these lines are welcome. Increased information exchange with home supervisors of foreign institutions remains imperative to help monitor systemic risks from the regional financial center’s cross-border exposures. Improved supervision of non-bank financial institutions will be critical to assessing systemic risk within this segment of the financial sector.

A framework for macroprudential policy should be established. Macroprudential policy can be an important policy tool to address identified emerging risks to financial stability, especially since Panama does not have a central bank or lender of last resort. As a priority, macroprudential policy tools applicable to the Panamanian context should be developed. Given the importance of financial conglomerates with international presence, additional capital buffers could also be considered. At the sectoral level, the build-up of household credit appears to present the most pressing macrofinancial risk and the priority should be to develop macroprudential policy tools targeted at the household sector to address this risk. Based on enhanced data collection and monitoring, limits on loan-to-value ratios, maximum debt-to-income and debt service-to-income ratios could be introduced.

As a regional financial center, Panama needs a robust crisis management framework. While the liquidity of Panama’s banking system appears high according to the official definition, it appears low relative to comparable countries and Basel III requirements. Financial regulations should be aligned with Basel III to ensure banks maintain sufficient liquidity. A temporary liquidity facility for banks to address systemic shocks should be established as a complement to the facility recently put in place by the Banco Nacional de Panamá. The coverage of that system appears inadequate to handle systemic shocks. The bank resolution framework should be upgraded to provide the bank superintendency with sufficient powers to effectively resolve financial institutions. Deposit insurance remains an important gap in the financial safety net and could be considered to provide protection to depositors in the event of a financial crisis. Finally, a crisis management plan should be elaborated to coordinate the response of supervisory agencies. The Financial Coordination Council should be tasked with preparing and maintaining such a plan, including through undertaking hypothetical simulation exercises.

Education reforms and effective social safety nets are essential for making growth more inclusive

Continued focus on education reform is essential for promoting inclusive growth.

In line with the authorities’ priorities stipulated in the Government Strategic Plan, measures to strengthen technical education, upgrade vocational skills, revamp language training, and improve qualifications of teachers have the potential to address skill shortages, improve competitiveness, and put growth on a more inclusive trajectory. Enhanced assessment and accountability at different stages of the education process is needed to help translate reform priorities into outcomes. Efforts to strengthen the targeting and effectiveness of social assistance programs will also be important. A continued focus on public services that aim to tackle the specific needs of indigenous groups can strengthen their economic inclusion. Finally, public investment toward projects with high social returns that raise productivity, enhance competitiveness, and open new growth opportunities should be prioritized.

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The mission would like to thank the Panamanian authorities for their excellent cooperation, kind hospitality, and candid and open discussions.