Tegucigalpa, Honduras
November 13, 1998

Dear Mr. Camdessus:

1.  Honduras is facing an unprecedented national crisis caused by hurricane Mitch, which struck on October 26, 1998, and remained on Honduran territory until October 30. The effects of the hurricane have been catastrophic. The number of deaths is estimated to be close to 7,000, more than 10 thousand people are reported missing, nearly 2 million persons have been displaced, and several towns and villages have been destroyed. Despite prompt assistance from the international community, shortages of food, medicine, fuel, electricity, and water continue to affect large segments of the population. Damage to the infrastructure and the economy has been extensive. Several main roads and bridges have been destroyed, most schools, as well as hospitals and administrative centers have been closed, and basic public services damaged seriously. Flood waters in populated areas are giving rise to concerns about public health.

2.  Efforts are well under way to provide immediate relief to those affected by the crisis, and undertake repair and reconstruction work so that the economy could begin to recover as quickly as possible. The international community has responded promptly and generously to help meet these priorities, but the process will require a considerable amount of time and resources. Accordingly, and given the scope of the devastation, the government of Honduras requests a purchase equivalent to SDR 47.5 million (50 percent of quota) under the Fund’s guidelines for emergency assistance related to natural disasters. The purchase will help meet the immediate foreign exchange needs stemming from the crisis, thereby easing pressure on the central bank’s international reserves and contributing toward maintaining confidence in the external position.

3.  As soon as the most urgent needs are addressed, the government intends to work closely with the Fund in continuing to pursue those policies that had been discussed with the staff in the context of a program that could be supported under the Enhanced Structural Adjustment Facility (ESAF). The government expects that the staff will visit Tegucigalpa in early 1999 to assess more fully the effects of the hurricane, and on that basis, help finalize a revised program that could be supported under the ESAF.

4.  Hurricane Mitch interrupted almost two years of sound economic performance under the economic program for 1997 which was monitored by the Fund staff, and during the first nine months of the new administration. GDP growth accelerated, inflation fell markedly, the fiscal position improved, and the balance of payments strengthened. Also, real wages in the manufacturing sector rose significantly and the unemployment rate was reduced.

5.  Moreover, during 1997–98 the pace of reform picked up, especially in the areas of tax administration, privatization and private investment, the regulatory framework for public sector tariffs, and supervision of the financial system. Details of the macroeconomic performance and these reforms are set out in the September 1998 staff report for the Article IV consultation.

6.  At the time of the hurricane, government representatives had been finalizing discussions with the staff of the Fund and the World Bank on a policy framework for 1999–2001 that could be supported under the ESAF, with the expectation that the request for an arrangement under the ESAF would be presented to the Executive Board by mid-December 1998. The objectives in that framework included (i) maintaining a rate of real GDP growth of about 5 percent a year; (ii) reducing inflation to 10 percent in December 1999 and 5–6 percent over the medium term; (iii) maintaining strong and sustainable fiscal and external positions; and (iv) implementing reforms in the areas of privatization, public sector modernization, financial sector supervision, and improvements in the quality and coverage of social services. Based on the economic performance in 1997–98, and the sound prospects for the economy over the medium term, private sector confidence increased notably, and the economy appeared to be on the brink of take off.

7.  Hurricane Mitch has been the most devastating natural disaster to affect Honduras. In addition to the social and infrastructure damage noted above, the economy has been seriously affected. Estimates indicate that real GDP growth could fall to 3–4 percent in 1998, and turn negative (by 2 percentage points) in 1999 as the effects of the damage to production would be only partly offset by those related to the reconstruction effort. Inflation is expected to reach 15–20 percent in 1998–99 (compared with 13 percent in 1997 and in the first nine months of 1998) owing to possible shortages of basic goods. Also, unemployment is likely to rise as workers in the agricultural and manufacturing sectors are laid off pending the rehabilitation of crops and factories.

8.  The central government deficit is expected to widen to 4½ percent of GDP in 1998 and 7–8 percent in 1999 in light of the needs for disaster relief, reconstruction of infra-structure, and a weakening of revenues (deficits averaging 2½ percent of GDP in 1998–99 had been contemplated in the pre-hurricane macroeconomic framework). These deficits are expected to be financed mainly by foreign grants, concessional loans, and debt relief.

9.  Central government current revenue is now expected to decline to about 16 percent of GDP in 1998 and 14½ percent in 1999, compared with 17½ percent a year contemplated prior to the hurricane, reflecting a marked reduction in receipts from income and sales taxes, as well as lower customs duties on imports of raw materials and equipment associated with reconstruction efforts. While initial efforts will focus on redirecting expenditure to emergency needs, it is expected that government primary expenditure could increase by 2½ percentage points of GDP in 1998–99 relative to the levels contemplated in the pre-hurricane budget. Most of the additional expenditure will be related to work on repairing and rebuilding key infrastructure, particularly bridges, roads, and the water supply system.

10.  The loan portfolios of several banks have been affected because of losses experienced by major borrowers. The banking commission, with the assistance of the MAE expert on bank supervision and the World Bank is carrying out an assessment of possible losses. Also, discussions are expected to take place in early December between Honduran banks and their overseas creditors on the need for a temporary restructuring of, and increase in lines of credit to help support the reactivation of the export sector.

11.  The external current account deficit is projected to widen to about 8 percent of GDP a year in 1998–99 (from the pre-hurricane estimate of 2½ percent a year) owing to the effects of the hurricane on exports of goods and services and on imports of food aid, equipment, and capital goods to be used in the reconstruction efforts. The weakness in the trade account in 1998–99 will be only partially offset by expected compensation payments by insurance companies and an increase in private remittances and foreign grants.

12.  The government’s overall strategy for dealing with the crisis is two-pronged. First, the immediate priorities being undertaken—with the assistance of donors—are to (i) provide food, shelter, and health care to the homeless and displaced persons; (ii) repair temporarily infrastructure (roads, bridges, airports), as well as services such as water, electricity, and telephones; (iii) take measures to preserve public health; and (iv) begin the immense clean up efforts. Second, the government, with the help of donor countries and multilateral agencies, will shortly develop a comprehensive plan aimed at reactivating the economy and addressing the large social needs.

13.  In the short run some emergency measures have been introduced to ease the economic burden stemming from the crisis. These measures include temporary (limited to 60 days) price controls on basic commodities. In the fiscal area, the date for the payment of year-end bonuses to public sector workers is being brought forward, and transfers of food and clothing are being made to persons affected by the hurricane. Also, the government has decided to defer scheduled payments of income and sales taxes¹ in 1998 to the first and second quarters of 1999, respectively, and to introduce temporary duty exemptions (for six months) on donated imports of essential food and some construction materials. Moreover, it is not feasible to raise electricity tariffs as scheduled on January 1, and this will now be phased in during 1999. To help ease the liquidity situation in the banking system, banks’ required holdings of central bank bonds have been reduced from 27 percent to 25 percent, effective November 9.

14.  As noted above, spending priorities in the public sector are being shifted to the needs arising out of the emergency, and the increased deficits will be financed in 1998–99 mostly by external grants, concessional loans, and debt relief—thereby avoiding undue pressure on interest and exchange rates. The government has started to prepare a revised budget for 1999 reflecting this approach, aimed at limiting exemptions and other tax concessions to the most affected sectors, and setting a time limit (which will be reviewed periodically) to the duration of these concessions. Also, temporary increases in subsidies, transfers, and other expenditure financed by domestic resources will be limited, and directed to the displaced and other most affected groups. Domestic financing of the revised budget for 1999 is not expected to exceed 1–1½ percent of GDP.

15.  Determined efforts are being made by the central bank to ensure an adequate supply of currency throughout the country; however, the growth in currency in circulation is expected to be limited to 16 percent in 1998-99, about the same rate contemplated prior to the crisis. Open market operations aimed at dampening inflationary pressures that might arise as a result of the projected large capital inflows are continuing. The central bank is to begin preparing shortly a revised monetary program for 1999 aimed at setting the basis for containing inflation. At this time, the central bank does not envisage granting credit lines to financial institutions to help them address the difficulties arising out of the crisis. Discussions are taking place with bankers on the treatment in their balance sheets of losses arising out of the hurricane.

16.  The government intends to maintain the existing arrangement that permits the exchange rate to fluctuate freely within the band. For these purposes auctions based on the export surrender requirement are continuing, and the central bank will aim to hold a minimum level of gross international reserves equivalent to three months of imports. Also, Honduras intends to maintain a trade system free of restrictions on current transactions.

17.  The government fully intends to regularize relations with Paris Club creditors in the first half of 1999 in the context of a revised economic program for 1999–2001 that could be supported under the ESAF. In this connection, proposals for debt relief by Paris Club creditors are expected to be discussed during a meeting scheduled for December 9. Arrears to a commercial bank also will be settled during 1999.

18.  All cash disbursements received from donors will be channeled through the ministry of finance to ensure adequate accounting and use of these resources. Also, to ensure control over the contracting of new external debt, all new external loans will require the prior approval of a committee comprising representatives of the ministry of finance and the central bank. During 1998–99, the government will not enter into new agreements for the contracting or guaranteeing of external debt (including private external debt) on nonconcessional terms.

19.  The government of Honduras attaches great importance to implementing its agenda of structural reforms aimed at achieving faster rates of economic growth and lower indices of poverty. As soon as the immediate priorities have been addressed, the government is determined to refocus its attention on pursuing the policies and reforms that could be supported in the context of a new ESAF arrangement. The government believes firmly that an ESAF-supported program, aimed at consolidating macroeconomic stability, increasing prospects for private investment, and deepening structural reforms that address constraints to growth, could play a key role in restoring confidence in the economy.

20.  The main priorities for reform will remain (i) giving the private sector a greater role in the economy and taking steps to encourage private investment; (ii) increasing (with assistance of the World Bank and the IDB) the efficiency of the central administration through reforms aimed at streamlining the sector, reducing waste caused by duplication of tasks and obsolescence, and improving the salary structure to retain and attract skilled staff; and (iii) increasing public sector saving over the medium term (through appropriate public sector tariffs, better targeting of subsidies, improved tax administration, and expenditure management) in order to meet the significant social needs, which have become more acute in the wake of the crisis caused by the hurricane.

21.  In the banking system, work on strengthening the regulatory framework for bank supervision and undertaking on-site inspection of banks on a consolidated basis is continuing with the assistance of the MAE expert. Efforts are being made to ensure better compliance with prudential regulations, and implement needed corrective actions and recommendations arising out of the findings of the ongoing inspections. Also steps will be renewed to set up a deposit insurance scheme, and improve the regulation of the stock exchange, pension funds, and insurance companies.

22.  It is hoped that the international financial community will support generously our efforts to repair and rehabilitate our severely damaged economy and the country’s social structure. We look forward to an early approval of the requested purchase under the Fund’s emergency assistance guidelines, and to accelerated and increased disbursements from other donors, in particular the IDB, the World Bank, and governments. As noted above, while the government may be forced by the effects of the crisis to temporarily accumulate arrears on debt-service payments to some creditors, all arrears will be settled during the first half of 1999.

23.  The government will continue to cooperate with the Fund in an effort to strengthen Honduras’ balance of payments situation and maintain economic stabilization. The government does not intend to impose new or intensify existing restrictions on the making of payments and transfers for current international transactions, introduce new or intensify existing trade restrictions for balance of payments purposes, or enter into bilateral payments agreements which are inconsistent with Article VIII of the Fund’s Articles of Agreement.