Guatemala: Concluding Statement of the 2014 Article IV Mission
July 7, 2014
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
This note summarizes preliminary findings and recommendations of the mission that visited Guatemala during June 24-July 7 to conduct the 2014 Article IV consultation. The mission thanks the Guatemalan authorities for their excellent cooperation and open dialogue.
Recent developments, Outlook, and Risks
1. The Guatemalan economy continues its solid expansion. Emerging from the 2008-09 global financial crisis, activity rebounded quickly. Strong domestic demand, rising export prices, and counter-cyclical policies supported the recovery. Growth has now eased back to potential and the output gap is closed. Prudent macroeconomic policies have helped maintain relatively low inflation and a strong foreign reserve position. The financial system appears robust, the current account deficit is stable, and the macro outlook is broadly positive.
2. Economic developments since the 2013 Article IV Consultation have been positive.
- Growth has returned to trend. After decelerating somewhat in 2012 following the powerful bounce back from the global crisis in earlier years, real GDP expanded by 3¾ percent in 2013, slightly higher than the estimated long-run rate, thus lifting supply to capacity. Growth was supported by buoyant private consumption and credit, despite less favorable external conditions and the roya coffee disease.
- Inflation stayed within the target range and has declined in early 2014. Headline inflation edged up in 2013 owing to fast rising food prices, but remained within the target range of 3-5 percent. Once these temporary pressures subsided, inflation (including core measures) decelerated markedly in the first half of 2014, driven mainly by declining commodity prices and a positive domestic food supply shock.
- The balance of payments was stable in 2013 and competitiveness continues to be broadly adequate. The current account deficit was virtually unchanged in 2013 and remains comfortably financed by steady FDI and public sector borrowing. In contrast to other countries in the region, Guatemala did not experience pressures in the foreign exchange market since the Fed’s announcement of tapering. Quantitative indicators point to comfortable levels of international reserves. The mission also assesses competitiveness to be broadly adequate, though with some signs of erosion, including a loss of world market share by exports over the last decade.
- The fiscal deficit declined in 2013, amid revenue and financing shortfalls. Revenue underperformance induced by the disappointing results of the 2012 tax reform were more than offset by expenditure cuts driven by delays in Congressional approval of external loans. As result, the overall deficit of the central government, slightly above 2 percent of GDP, fell below the budget target of 2½ percent of GDP.
3. The economic outlook remains benign. The mission expects growth to remain broadly in line with its trend rate of 3½ percent, supported by buoyant domestic demand, while inflation converges toward the center of the target range. The external current account deficit, largely financed by FDI, is expected to stay at about 2½ percent of GDP over the medium term, underpinned by relatively stable trade balance and remittances. Modest fiscal expansion through the 2015 election cycle is projected to be followed by measured consolidation, with the central government deficit stabilizing at 2 percent of GDP by 2019 and public debt rising slowly to about 27 percent of GDP.
4. However, risks are tilted to the downside, owing both to global uncertainties and domestic policy constraints. The mission views external risks related to the normalization of U.S. monetary policy as balanced. If exit is orderly, the net impact of faster U.S. growth and tighter global financial conditions should be positive in the short term. At the same time, extreme bouts of volatility in world financial markets could still inflict serious damage on Guatemala. Other external risks to growth include a deeper-than-anticipated slowdown in emerging markets, less favorable than expected developments in Europe, and disruptions in commodity markets due to geopolitical tensions. On the domestic front, lasting difficulties in implementing the tax reform and a continuation of the political impasse on the budget may endanger much needed government programs. Conversely, if further possible revenue shortfalls were not met with spending cuts, the hard-won fiscal consolidation could be derailed, lowering Guatemala’s resilience to shocks. In the longer term, persistent problems in revenue mobilization and entrenchment of the serious security situation could deter growth and threaten social cohesion.
Near-term Policy Mix
5. Fiscal policy is broadly adequate, but consolidation of the tax reform, timely approval of multilateral loans, and adoption of a budget for 2015 are critical. With the output gap essentially closed, a broadly neutral fiscal stance, as envisioned in the “continuing resolution” 2014 budget currently in force, is appropriate. However, efforts to address implementation setbacks to the 2012 tax reform are urgently needed, notably by strengthening taxpayer compliance, particularly in customs. Timely approval of multilateral loans will also be important to support effective spending execution. Passing the 2015 budget in a timely manner will facilitate adequate targeting of outlays. In our view, this would help safeguard priority social programs and investment in the event of continued revenue shortfalls. Eliminating the stock of domestic spending arrears (not legally recognized) will require a reliable and audited estimate of their outstanding amount and a transparent strategy for their clearance. While important steps have already been undertaken, further improvements in public financial management are also called for to avoid incurrence of new arrears.
6. Monetary policy is slightly accommodative after the recent policy rate cuts, calling for heightened vigilance for any incipient inflationary pressures. Headline inflation is currently close to the bottom of the target range, inflation expectations have lately declined close to the mid-point of the target range, and core inflation remains low. After the cumulative cuts of 75 basis points in the last nine months which have brought the policy rate to 4½ percent, the mission assesses the monetary stance to be somewhat supportive, though still generally appropriate. ith the domestic output gap closed, food prices starting to rise in the region, and increasing risks of an upturn in import prices, the mission considers that under current conditions there is no room for additional cuts to the policy rate. Moreover, the authorities should stand ready to increase the rate promptly to anchor better expectations, if signs of an inflation upswing emerge.
Increasing Resilience to Shocks
7. The 2013 budget outcome was generally consistent with long-term sustainability but is unlikely to be maintained once financing constraints are resolved. After rising steadily since the 2008 crisis, the debt-to-GDP ratio nearly stabilized in 2013 at a relatively low level by international standards. This was the result of a lower-than-expected deficit driven not by structural fiscal consolidation, but rather by the political impasse in Congress that delayed loan approval and thus forced spending cuts. Unless revenues pickup more than anticipated, deficits will once again expand and debt ratios resume their steady ascent once these artificial funding problems are resolved.
8. The mission stresses that continued increases in the burden of public debt are a source of vulnerability. In our view, Guatemala could not comfortably rely on borrowing to support prolonged expansionary counter-cyclical policies. Funding risks could rapidly escalate, especially given the country’s low government revenues and fairly high debt-to-revenue ratios. An increase in risk aversion in international capital markets may render government and bank funding more expensive.. A shallow domestic financial market and political rigidities that curtail access to multilateral lending provide thin coverage against spikes in global risk aversion.
9. Hence, fiscal sustainability should be gradually bolstered over the medium term. Stabilizing the debt-to-GDP ratio at its current level would require a permanent improvement in the primary balance of about ½ percent of GDP—the sustainability gap. This gap would be larger if the actuarial deficit of the social security system were taken into account. With no pressing cyclical need for tightening and risks to growth weighed to the downside, the mission recommends a moderately paced and modestly frontloaded adjustment beginning in 2015. This would strike the right balance between reducing the sustainability gap and limiting the negative impact on growth.
10. The mission urges additional efforts to mobilize revenue beyond budget consolidation needs in order to support social and growth objectives. Guatemala needs not only to achieve long-term fiscal sustainability, but also to maintain macro stability while addressing pressing social needs and enhancing growth potential. Meeting these objectives will depend upon raising the currently low level of government revenues to support priority public spending. In particular, we advocate improving tax administration, reducing tax expenditures, and realigning VAT rates with those prevailing in the region. Lowering the currently high degree of revenue earmarking will also be important to widen the fiscal adjustment toolbox. Regarding the draft competitiveness law (Ley de Inversión y Empleo), the mission is concerned that tax exemptions and other special treatments included in the current proposal could threaten fiscal revenue. More generally, developing a deeper social consensus on the urgency of critical spending needs will be critical to overcome strong political resistance to revenue increases.
11. In addition, it will be essential to reinforce budgetary management and improve the efficiency of public expenditure. Delays in Congressional endorsement of multilateral loans in 2013 highlighted the need to streamline such approvals to prevent expenditure under-execution and provide greater room for counter-cyclical policies, if needed in the future. The mission believes that a key element of this reform would be a requirement for Congress to approve all government financing—including external loans—as part of any overall budget package. The recently approved amendments to the Organic Budget Law, canenhance transparency and efficiency of public spending, and help reallocate resources toward high priority areas. In turn, this would strengthen the credibility of government policies and break the widespread culture of tax avoidance.
12. The mission calls for further strengthening of the monetary policy transmission mechanism, not least by continued progress towards exchange rate flexibility. Guatemala’s annual inflation has been relatively low and within the central bank’s target band for several years now. Nonetheless, the transmission channels of monetary policy remain feeble, while pass-through effects from commodity prices continue to influence inflation heavily. In order to reinforce inflation as the primary objective of monetary policy, the mission supports a gradual enhancement of exchange rate flexibility. This would also contribute to de-dollarizing credit by forcing agents to internalize FX risks. Development of public debt and private securities markets would also be helpful, not least to facilitate monetary operations. To this end, it is important to finalize the draft capital markets law in compliance with IOSCO best practices and enact it. In addition, the mission recommends that the central bank balance sheet be strengthened by refunding the bank’s operational losses.
13. The fast rise of private credit, though it has now moderated, calls for greater vigilance. In particular, the slant of new loans toward foreign currency and consumer financing cause some concern. While credit expansion above that of nominal GDP is consistent with desirable financial deepening, continuation over a long period of very high rates of credit growth could eventually undermine financial stability. The mission stresses that macro-prudential measures, notably higher capital requirements for FX loans to non-exporters, should be considered to guard against these risks, if signs of deterioration in credit quality emerge. Extension of the loan register system to non-bank lenders would improve monitoring of household leverage.
14. Efforts to bolster regulation and supervision of the financial system should progress further. Guatemala’s financial system is shallow and its deepening will require moderate but sustained growth of credit over that of nominal GDP, which in turn calls for upgrading the regulatory and supervisory framework. The mission appreciates that significant administrative and legislative reforms have been undertaken,, but notes that additional improvements are still needed.
- Although capital levels seem adequate, there is a need to strengthen consolidated supervision and supervision of financial entities that pose material risks to conglomerates, as well as to tighten definitions of related parties, in order to mitigate risks of overestimating capital levels. Moreover, it would be desirable to step-up the ring-fencing of on-shore banks with respect to the operations of off-shore banks, (acting in Guatemala but incorporated in other countries).
- Preliminary estimates of core tier 1 capital in the banking system, its high profitability, and excess systemic and individual liquidity levels indicate that the time is ripe to require capital and liquidity buffers that could raise resilience to adverse shocks. In this regard, a phased move to Basel III standards appears the right course of action. Filling in data gaps and adopting robust methodologies for financial stability analysis should be a priority in the policy agenda.
- Ongoing financial integration among CAPDR countries can bring important economic benefits but also poses challenges for consolidated and transnational supervision. To capitalize on the opportunities, it is hence critical to implement regulation and supervision arrangements that minimize regulatory gaps, arbitrage, and cross-border contagion.
15. Enhanced social spending, structural reforms, and greater regional integration would pave the way toward high inclusive long-term growth. Notwithstanding the progress made toward meeting the Millennium Development Goals targets, poverty remains widespread and security concerns are very serious. In our view, higher social spending would not only help reduce poverty but also build a skilled and productive labor force, thereby fostering competitiveness and sustaining growth. There is also scope to enhance productivity through structural reforms to improve the business climate, reduce anti-competitive practices, limit the influence of vested interests, and combat crime. Greater regional integration through the completion of the customs union, harmonization of trade rules, and further integration of services and factor markets would also boost Guatemala’s growth potential.