Panama City, Panama
June 12, 2000

Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431
USA

Dear Mr. Köhler,

1. Since taking office in September 1999, the Moscoso Administration has been guided by two basic objectives in formulating its economic policies: the paramount importance of fiscal consolidation; and the need to ensure that the fruits of Panama’s economic growth are distributed more equally. This letter describes the program of economic and financial policies the government will follow in order to realize these two basic goals.

2. Panama’s economy continues to grow at moderate rates and to enjoy low inflation. The consumer price index increased by only 1.8 percent in the 12 months ending in March  2000, despite the substantial increase in the prices of petroleum products over the past six months. Real GDP growth declined from 4.1 percent in 1998 to 3.2 percent in 1999, mainly because of the depressed demand for the reexport and processing activities of the Colon Free Zone (ZLC) resulting from the economic difficulties of neighboring countries. Growth in construction remained strong because of the demand stemming from a number of large projects as well as a boom in residential construction related to the reversion of Canal Area properties. Credit-financed consumer purchases also contributed to the growth in demand. The rate of unemployment dropped from the level of about 13½  percent of the work force at which it had been stuck for several years to 11.6 percent in 1999.

3. The low level of activity in the ZLC and the high level of domestic investment resulted in a further increase in Panama’s external current account deficit from 13.3 percent of GDP in 1998 to about 14 percent in 1999. Foreign direct investment financed a significantly smaller share of the current account deficit in 1999 than it did in 1998, although part of the decline may represent recording problems. The bulk of Panama’s external financing took the form of a reduction in the net external positions of Panamanian banks to finance domestic lending.

4. The borrowing requirement of the nonfinancial public sector (PSBR) declined from 2.9 percent of GDP in 1998 to 1.4 percent of GDP in 1999, only slightly above the revised target of 1 percent of GDP. The decline in the PSBR, which took place in spite of the fact that previous privatizations had transferred entities enjoying a financial surplus to the private sector, was due in large part to the efforts of the new administration to control expenditure. The central government’s overall deficit declined from 5.0 percent in 1998 to 2.4 percent in 1999. Nonetheless, the Administration recognizes that there are some problems of expenditure control that remain to be addressed, in spite of the progress achieved in implementing an automated and integrated system of financial management.

5. The transfer of the Panama Canal from the Government of the United States on December 31, 1999 was the culmination of the process set in motion by the Carter—Torrijos Treaty of 1977. The end of the U.S. military presence and the transfer of the Panama Canal Commission (renamed the Panama Canal Authority) results in only a small loss of income from employment on the bases and purchases of domestically-produced goods and services, since the bases' contribution to the economy had been declining for some years. The reversion should increase Panama’s GDP substantially over time, however, inasmuch as the transfer of the Canal Area and its assets entails a very large increase in Panama’s capital stock. The increase in investment that has taken place since 1997 is largely a result of the opportunities created by the reversion, and will substantially increase the size of Panama’s tourist industry, transportation infrastructure, and various industries related to the Canal, such as transshipment and storage.

6. The economic outlook for 2000 is for a continuation of recent trends. Real GDP growth is projected to increase somewhat to 3½–4 percent, based on recovery in ZLC and a rebound in pisciculture (mainly shrimp farming), which will offset the impact of a decline in investment from the high levels reached in 1998–99 and some decline in credit-financed consumer expenditure. The partial recovery in the ZLC and the decline in investment are expected to lead to a decline in the external current account deficit to 9.2 percent of GDP. Inflation is likely to increase temporarily, to around 2 percent, in response to the increase in oil prices over the last six months, since changes in the international price of oil are automatically passed through to domestic prices. The stance of fiscal policy should be approximately neutral in 2000, but will be tightened in 2001 (see below). In 2001–04, the growth of real GDP is projected to increase further to 4.5 percent in 2001 and 5 percent thereafter, given the increased capacity for export entailed by the reversion and the investments it is stimulating, a further recovery in activity and margins of the ZLC, and the lower interest rates expected to result from fiscal consolidation. The external current account deficit should continue to decline, and inflation should revert to its current rate of 1½ percent.

7. In keeping with the overriding importance the Administration attaches to fiscal consolidation, the principal goal of fiscal policy will be a substantial, progressive decline in the debt to GDP ratio, with a view to reducing the interest spread between Panama and the United States. The PSBR is projected to decline from 1.4 percent of GDP in 1999 to 1.0 percent in 2000, and to zero thereafter. The programmed decline in the PSBR over 1999–2001 and the maintenance of a balanced position thereafter, together with the projected increase in economic growth will result in a substantial decline in the ratio of net public debt to GDP, exclusive of the assets of the Trust Fund.

8. The modified budget for 2000 projects a deficit of 4.2 percent of GDP. The increase in the deficit of the modified budget for 2000 with respect to the outturn for 1999 is largely the result of additional social expenditure projects that were approved by the legislature after the budget for 2000 had been ratified at end-1999. The Government of Panama is committed to achieving the targeted deficit of 1 percent of GDP in 2000. To this end, the Government will establish ceilings on investment expenditures by ministry and agency, freeze vacant positions in the civil service and reduce unnecessary current expenditures.

9. The projected decline in the PSBR of about 1¼ percentage points of GDP from 1999 to 2001 will result almost entirely from the central government’s own adjustment efforts. The tax reform to be implemented in the course of 2000 should generate additional revenues of about ½  percent of GDP in 2001. An increase in revenue from the Panama Canal Authority (PCA), in part due to savings from the elimination of expatriate benefits passed on by the PCA, will offset the impact of privatization on dividend payments from public enterprises. On the expenditure side, a decline in wage and salary expenditure resulting from the elimination of exceptional severance payments made in 1999 to employees of privatized enterprises will also contribute to the programmed adjustment. In addition, capital spending in 2000 and 2001 will be substantially restrained in relation to the modified budget for 2000. Fiscal restraint will not be at the expense of well-targeted social expenditure, however, and the share of such programs in the budget will increase, as described below.

10. Panama is not a high tax country. Apart from social security contributions, tax revenues of the central government amount to about 12 percent of GDP. This relatively low tax burden results from the combination of moderate or even low tax rates and tax bases that have been narrowed by a proliferation of preferences and exemptions. Consequently, there is scope for increasing the ratio of revenue to GDP without introducing undue distortions into the economy or burdening the poor. In particular, the base of the value-added tax (ITBM) will be significantly broadened by including a number of luxury goods and services. In addition, the effective rate of taxation of bank income will be significantly increased. The Administration plans to submit legislation embodying these changes by September 30, 2000. In addition to excessive exemptions, the tax yield has been reduced by a less than fully effective administration. The government plans to strengthen the General Tax Directorate by increasing its budgetary-allocation in 2001.

11. Considerable progress has been achieved in the development of the automated system of integrated financial management ( SIAFPA). Regarding the budgetary module, with the exception of expenditure financed by regional and international development agencies and expenditure carried over from previous budgets, the central government’s expenditure can be tracked from the authorizations to the checks-issued stage with a lag of 24 hours. For some five ministries, expenditure is tracked on a real time basis. The administration recognizes the importance of extending SIAFPA to include both that part of expenditure which is financed by multilateral agencies and expenditure carried over from previous budgets. The Ministry of Economy and Finance, which is the agency now responsible for SIAFPA, has set itself the goal of including these expenditure categories within the system by December 31, 2000. Similarly, the real time system will be progressively expanded over the next 18 months until it covers all central government spending agencies.

12. Panama’s social security system (CSS) , because of its substantial financial reserves, runs a small cash-flow surplus. Contributions are already insufficient to cover expenditure, however, and with the aging of the population the system can be expected to incur deficits by the second decade of the new century. The Administration wishes to take preemptive action to prevent a latent problem from creating serious difficulties in a few years. The pension system bestows generous pensions, entailing very high replacement rates, for persons who have worked most of their lives. Consequently, there is scope for a change to the benefit formula of the pension system that will address the system’s tendency to deficit without entailing hardship for the retired or elderly. Changes can be phased in gradually, and will have no substantial impact on persons about to retire. These reforms will not affect the PSBR in either 2000 or 2001, but would have a cumulative impact over time. The Government will nominate a high-level commission to seek solutions along these lines to the CSS’s problems by October 31, 2000.

13. The Agricultural Development Bank (BDA) and the National Mortgage Bank (BHN) were established by earlier administrations in order to channel credit to farmers and would-be home-owners who did not have access to loans from conventional commercial sources. Neither entity has been efficiently run, however, and their loans have not been well targeted. The Administration will present legislation to close the BHN to the legislative assembly by December 15, 2000 at the latest. The law, which the Administration expects to be passed by January, 2001, will establish a deadline of 12 months following its approval for the sale of the BHN’s performing loans, the release of its employees and its liquidation. The BDA will remain in operation, but the Administration will take action to make it more efficient. To this end, the Administration will commission an external audit of the bank, which will begin in July and will be completed by October 31, 2000.

14. The privatization program of the mid-late 1990’s transferred the bulk of the assets of Panama’s nonfinancial public enterprise sector to the private sector. The only enterprises of any size that remain are ETESA, the electricity transmission company, IDAAN, the water company, and Tocumen airport, which are traditional public sector utilities. Both ETESA and Tocumen airport are profitable. The Administration proposes to invite bids from appropriately qualified companies interested in operating the airport as a concession, once it has been subject to a thorough valuation, so that an appropriate reservation price may be set. IDAAN incurred losses averaging $12 million per year in 1998–99, in part because of system leakages—water is effectively free in certain areas—and because of an excessive payroll. To address these problems, a plan will be prepared by October 31, 2000 to overhaul IDAAN’s billing and accounting systems, and to allow it to contract with private sector operators for services in the areas of billing, collections, metering, construction and other areas. IDAAN will also review its tariffs.

15. Real progress has been achieved with reform of bank regulation and supervision in Panama. The Superintendency, which was established in 1998, issued regulations governing liquid asset ratios in February, 2000. To complete the formal regulatory framework, it will issue regulations governing asset quality and provisioning by June 30, 2000. The Superintendency’s regulatory and supervisory powers are substantially greater than those of the Banking Commission, the supervisory body it replaced. In particular, it has enacted and will enforce uniform standards of accounting and provisioning for doubtful loans; is able to audit the consolidated financial statements of offshore and general license banks owned by the same company; may require the publication of all audited financial statements; and may actively intervene to liquidate a troubled financial institution. The Superintendency has also standardized the basic reporting system that Panamanian banks use. Some of the banking system’s reduction in external exposure in 1999 resulted from a move out of emerging market securities, in line with the Superintendency’s guidelines on risk exposure. With the regulatory framework in place, the Superintendency plans to audit 30 percent of the banks in the system by end-December 2000. By the same date, the Superintendency will have started a formal review of its performance during the past 18 months with the aim of assessing the quality of its audits and the training needs of its auditor corps.

16. With Panama’s accession to membership in the World Trade Organization (WTO), virtually all of the country’s nontariff barriers were eliminated and a maximum tariff rate of 30 percent was adopted, which applied to all but a small number of sensitive goods—mostly agricultural products and foodstuffs. Maximum tariffs on all but four products were lowered at a stroke to 15 percent. This rapid reduction has caused some dislocation in the import-competing industries, and in late 1999 and early 2000 the Moscoso Administration raised the tariffs on some of these products to the maximum rates agreed with the WTO. The Administration’s action was not intended to provide permanent protection to local agriculture, but to allow it more time to adapt to liberalization. Accordingly, the government has decided that the tariffs will be reduced to their levels of mid-1999 by end-2004. This rate of reduction is noticeably more rapid than that stipulated by the decrees of late 1999–early 2000, which would not have returned the rates to their mid-1999 levels. With this decision, the Administration affirms its commitment to trade liberalization.

17. For a country with a per capita income of $3,400, Panama suffers from a high rate of poverty. Some 37 percent of Panamanians are estimated by the World Bank to live below the poverty line, and some 19 percent to live in extreme poverty. The Administration believes that continued moderately rapid rates of growth are necessary to reduce poverty. However, it also believes that the administration must help the poor by making a substantial investment in human capital; increasing their access to land and credit; and improving basic services such as the provision of potable water. The social investment program accordingly emphasizes educational and health expenditure, low-income housing, and water provision. The targeting of expenditure will be improved by using the new poverty map, which identifies particularly vulnerable groups and regions within the country, and by expanding the coverage of primary health care and basic education. As part of its efforts to combat extreme poverty and malnutrition in rural communities, the Administration plans to introduce the Sustainable Farm Program, with the aim of establishing 400 multi-family farms by 2000 and a total of 3000 farms by 2004. The nongovernmental organization (NGO) in charge of the farm program will receive only a small subsidy from the government. Further financial support is to come from private donors and developed countries. In addition, a program to address the serious problem of lack of proper titling of land is underway with assistance from the multilateral agencies.

18. Panama is blessed with great biodiversity. This gift of nature has been threatened by uncoordinated development and the lack of a coherent policy of environmental protection. The establishment of the National Environmental Authority (ANAM) in 1998 was an important first step towards addressing the problem of environmental degradation. The government will complete the regulations necessary to allow the effective application of General Environmental Law 41, and strengthen the institutional capacity of ANAM to allow it to make good use of the powers the law has conferred on it. Finally, the Administration has recently conferred responsibility for protecting the Canal Area watershed on the Panama Canal Authority, which has set aside an annual budget of $3.5 million for this purpose.

19. Panama’s statistical apparatus is not commensurate with the country’s status as an emerging market economy. The national accounts are in need of major improvement: quarterly national accounts are constructed only from the supply side and published with a long delay; the base year, 1982, is badly out-dated; and the measure of value-added in a number of sectors is flawed. Balance of payments statistics are affected by reporting problems, and the compilation of both the balance of payments and national accounts needs to be modified to take the effects of the reversion fully into account. The Administration will make a concerted effort to upgrade the national accounts, which will include rebasing them to a recent year, and to address the other shortcomings just described. For this purpose the Statistics Directorate (part of the General Audit Office) has requested technical assistance from the Fund’s Statistics Department. The Administration will also increase materially the allocation of the Statistics Directorate in the 2001 budget.

20. In support of the economic and financial program described in this letter, the Government of Panama requests a stand-by arrangement with the Fund for a period of 21 months in an amount equivalent to SDR 64 million. It intends to treat the stand by arrangement as precautionary. The Government also requests that the extended arrangement approved on December 11, 1997 be cancelled. The quarterly performance criteria under the stand-by arrangement requested by the Government of Panama comprise limits on the net borrowing requirement of the nonfinancial public sector; sublimits on the net borrowing requirement of the central government; limits on the contracting of nonconcessional public and publicly guaranteed external debt; and sublimits on the contracting of nonconcessional public and publicly guaranteed debt with original maturity of strictly less than one year. These quarterly limits are set out in Tables 1 and 2. The issue of regulations on asset quality and provisions by the Superintendency in line with Basle standards by June 30, 2000; the submission of legislation to broaden significantly the base of the value added tax by including a number of luxury goods and services and increase significantly the effective rate of tax on bank income to the legislative assembly by September 30, 2000; and the presentation of legislation to close the BHN by December 15, 2000 are structural performance criteria. During the period of the stand-by arrangement, Panama will not incur any external payment arrears. In addition, during that period, the Government of Panama will not impose or intensify restrictions on payments and transfers for current international transactions, introduce or modify multiple currency practices, conclude bilateral payments agreements that are inconsistent with Article VIII or impose or intensify restrictions for balance of payments reasons.

21. The Government of Panama believes that the policies and measures described in this letter will achieve the objectives of the program but will take additional measures and seek new understandings with the Fund, if necessary, to keep the program on track. During the period of the arrangement the Government of Panama will remain in close consultation with the Fund, in accordance with the Fund’s policies on such consultations, on the progress made in implementing the policies described in this letter. In any event, the Government of Panama will complete review discussions by end-December, 2000, at which time quarterly performance criteria for 2001 will be set. It will publish this letter in its entirety.

Sincerely yours,

Attachments

Panama—Technical Memorandum of Understanding

This technical memorandum of understanding (TMU) defines and explains the basic policy targets and related terms used in the Letter of the Government of Panama dated June 12, 2000.

1. The quarterly performance criteria under the agreement with the Fund that the Government of Panama requests in its letter of June 12, 2000 comprise: (i) a limit on the nonfinancial public sector (NFPS) net borrowing requirement; (ii) a sub-limit on the net borrowing requirement of the central government (CG); (iii) a limit on the contracting of public-and publicly-guaranteed external debt; and (iv) a sub-limit on the contracting of public-and publicly-guaranteed external debt of original maturity of strictly less than one year. The limits are all measured cumulatively from December 31, 1999, and will apply for June 30, 2000, September 30, 2000 and December 31, 2000. Limits for these policy variables measured from December 31, 2000 will apply for December 31, 2001 and will be indicative targets. The values of these performance criteria and indicative targets are set out in Tables 1 and 2 attached to the letter of intent. The coverage of the NFPS and that of the CG are defined in the attached Annex.

2. At the time of the review provided for in the letter, quarterly performance criteria comprising limits on the policy targets specified in Paragraph 1 and measured cumulatively from December 31, 2000 will be set for March 31, 2001, June 30, 2001, September 30, 2001, and December 31, 2001.

3. The net borrowing requirement of the NFPS will be defined as the sum of its: (i) net foreign borrowing; (ii) net domestic borrowing; and (iii) the net proceeds from asset sales under the privatization program, which will be invested in the Trust Fund for Development.

a. Net foreign borrowing of the NFPS will be defined as the sum of (i) disbursements less amortization of medium- and long-term foreign obligations by the NFPS (that is, maturities of one year or more); (ii) the change in net short-term foreign liabilities of the NFPS; and (iii) the change in NFPS deposits abroad (including those of the Trust Fund for Development).

The calculation of net foreign borrowing of the NFPS will be based on the following understandings and guidelines:

• Transactions denominated in currencies other than U.S. dollars will be converted into U.S. dollars at the exchange rate prevailing at the time of the transaction;

• Any accumulation of external arrears will be included in external financing;

• The use of released collateral will be counted under the ceiling on the public sector borrowing requirement.

b. Net domestic borrowing of the NFPS will be defined as the change in the respective stocks of: (i) net credit (credit minus deposits) of the domestic banking system to the NFPS; (ii) domestic public debt (securities issued by the monitored NFPS entities) held by the nonbank private sector and the nonmonitored NFPS; (iii) uncashed checks issued by the CG; and (iv) financial resources held by the United Nations Development Program under the "dinamización" project.

The calculation of net domestic borrowing of the NFPS will be based on the following understandings and guidelines:

• The domestic banking system will include the National Bank of Panama (BNP), commercial banks, and the Savings Bank.

• Domestic bank deposits will include domestic deposits of the Trust Fund for Development.

• Any accumulation of official domestic payment arrears, defined as amounts still payable 15 days or more after verification (that is, the issuing of payment orders) by the Comptroller General's Office will be included in domestic financing.

4. The net borrowing requirement of the CG will be defined as the sum of its (i) net foreign borrowing; (ii) net domestic borrowing; and (iii) the net proceeds from asset sales under the privatization program, which will be invested in the Trust Fund for Development.

a. Net foreign borrowing of the CG will be defined as the sum of net disbursements (adjusted for up-front borrowing costs) less amortization of medium-and long-term foreign obligations (maturities of one year or more) by the CG and the change in net short-term foreign liabilities of the CG; and the change in CG deposits abroad (including those of the Trust Fund for Development).

The calculation of net foreign borrowing of the CG will be based on the following understandings and guidelines:

• Transactions denominated in currencies other than U.S. dollars will be converted into U.S. dollars at the exchange rate prevailing at the time of the transaction;

• Any accumulation of external arrears will be included in external financing;

• The use of released collateral will be counted under the ceiling on the public sector borrowing requirement.

b. Net domestic borrowing of the CG will be defined as the change in the respective stocks of: (i) net credit (credit minus deposits) of the domestic banking system to the CG; (ii) CG debt held by the nonbank private sector and the rest of the public sector (monitored and nonmonitored entities); (iii) uncashed checks of the CG; and (iv) financial resources held by the United Nations Development Program under the "dinamización" project.

The calculation of net domestic borrowing of the CG will be based on the following understandings and guidelines:

• The domestic banking system will include the National Bank of Panama (BNP), commercial banks, and the Savings Bank.

• Any accumulation of official domestic payment arrears, defined as amounts still payable 15 days or more after verification (that is, the issuing of payment orders) by the Comptroller General's Office will be included in domestic financing.

• Domestic bank deposits will include domestic deposits of the Trust Fund for Development.

5. Public or publicly guaranteed external debt will include the flows accumulated from the relevant date over the relevant period of nonconcessional external debt contracted or guaranteed by the public sector. The coverage of debt includes financial leases and other instruments giving rise to external liabilities, contingent or otherwise, on noncessional terms.

The calculation of the value of public external debt or publicly guaranteed debt that is contracted will be based on the following understandings and guidelines:

• External debt will be expressed in U.S. dollars using the prevailing exchange rate at the time the contract is signed.

• Debt contracted on concessional terms will be excluded from the limits on external debt.¹ The concessionality of loans using currency baskets will be assessed on the basis of the U.S. dollar interest rate. For loans with interest rates based on the internal policy of the creditors, the relevant interest rate to define concessionality will be the interest rate for each creditor at the moment of the commitment.

• Debt contracted to carry out debt exchange operations that reduce the net present value of the external public debt also will be excluded.

Panama—Nonfinancial Public Sector

I. Entities Comprising Monitored Nonfinancial Public Sector

Asamblea Legislativa
Contraloría General de la República
Ministerio de la Presidencia
Ministerio de Gobierno y Justicia
Ministerio de Relaciones Exteriores
Ministerio de Hacienda y Tesoro
Ministerio de Educación
Ministerio de Comercio e Industrias
Ministerio de Obras Públicas
Ministerio de Desarrollo Agropecuario
Ministerio de la Juventud, la Mujer, la Niñez, y la Familia
Ministerio de Salud
Ministerio de Trabajo y Desarrollo Laboral
Ministerio de Vivienda
Ministerio de Planificación y Política Económica
Consejos Provinciales
Corte Suprema de Justicia
Procuraduría de la Nación
Tribunal Electoral

B. Caja del Seguro Social (Including Fondo Complementario)

C. Decentralized Agencies

Universidad de Panamá
Instituto para la Formación y Aprovechamiento de los Recursos Humanos (IFARHU)
Banco de Desarrollo Agropecuario (BDA)
Instituto de Mercadeo Agropecuario (IMA)
Banco Hipotecario Nacional (BHN)

D. Public Enterprises

Empresa de Transmisión Electrica Sociedad Anónima, (ETESA)
Instituto de Acueductos y Alcantarillados Nacionales (IDAAN)
Zona Libre de Colón
Dirección de Aeronaútica Civil
Instituto Panameño de Turismo
Autoridad Portuaria Nacional

II. Entities Comprising Nonmonitored Nonfinancial Public Sector

Autoridad de la Región Interoceánica
Autoridad del Canal de Panamá
Autoridad Maritima Nacional
Centro de Conferencias Atlapa
Bingos Nacionales
Lotería Nacional de Beneficencia
Corporación para el Desarrollo Integral del Bayano
Instituto Nacional de Deportes
Autoridad Nacional del Ambiente
Corporación Financiera Nacional
Dirección Financiera Nacional
Dirección Metropolitana de Aseo
Universidad Tecnológica
Instituto de Seguro Agropecuario
Instituto Panameño Autónomo Cooperativo
Instituto Nacional de Cultura
Instituto Panameño de Habilitación Especial
Instituto de Investigaciones Agropecuarias de Panamá
Instituto Nacional de Formación Profesional
Seguro Educativo
Comisión de Libre Competencia y Protección al Consumidor
Ente Regulador de los Servicios Públicos
Universidad Autónoma de Chiriquí
Defensoría del Pueblo
Superintendencia de Bancos