## _cr06130

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---

### Background
- Panama is fully dollarized (since 1904) and relatively open; the service sector accounts for about 80 percent of GDP, including the Panama Canal, the Colon Free Zone, and a large banking system integrated with international financial markets.
- Annual output growth averaged 3.7 percent over the decade to 2002.
- Public debt was over 60 percent of GDP, motivating the fiscal responsibility law enacted in 2002, which limits the NFPS deficit to 2 percent of GDP and targets a gradual reduction in public debt to 50 percent of GDP.
- Key structural priorities: overhaul of the social security system and flexible labor markets.

### Recent economic developments
- Growth and inflation
  - Real GDP growth: 0.8 percent (2002), 3.9 percent (2003, estimated).
  - Inflation: 1.8 percent (2002), 1.2 percent (2003), 1.3 percent (projected end-2004).
  - Recovery in 2003 led by construction (stimulated by a December 2002 tax law), the primary sector (notably fishing), and a late-year rebound in export-oriented services (Colon Free Zone and ports).
  - Unemployment remained above 13 percent in 2003.
- Public finances
  - NFPS balance shifted into a deficit in 2001 and widened in 2002.
  - Tax reform of December 2002 yielded an estimated 0.4 percent of GDP in additional revenue in 2003.
  - Preliminary 2003 data suggest the fiscal deficit reached 2½ percent of GDP, exceeding the 2 percent of GDP statutory limit.
  - Capital revenues in 2003 were much lower than in 2002; expected buybacks of Brady bonds and associated capital gains did not take place.
- Financial sector
  - Banking stress in 2002 from regional market turbulence; large withdrawals of nonresident deposits by foreign banks and curtailed foreign credit operations.
  - Recovery in 2003: private sector credit and bank deposits resumed slow growth; deposit spreads fell.
  - Banking fundamentals as of November 2003: capital adequacy ratios exceeded 17 percent on average; liquidity ample; nonperforming loan ratios decreased to less than 3 percent on average as of end-September 2003.
  - Banks improved profitability in 2003 through rebound and cost-cutting.
  - Interest rates trended downward since 2000; foreign banks lowered deposit rates faster than local banks.

### Political context
- Government holds a thin majority in the Assembly and emphasizes consensus-building (national dialogues on economic recovery and social security reform).
- Presidential and congressional elections scheduled for May 2004; change of government in September 2004.
- Main presidential candidates did not signal departure from market-friendly policies.

### Outlook and macro projections (staff)
- Real GDP growth: 0.8 (2002), 3.9 (2003), 4.2 (2004).
- Inflation (end of period): 1.8 (2002), 1.2 (2003), 1.3 (2004).
- External current account: -0.8 (2002), -3.2 (2003), -3.6 (2004).
- International reserves: $1.2 (2002), $1.0 (2003), $1.1 (2004) (in billions of U.S. dollars).
- International reserves (months of imports): 3.6 (2002), 3.0 (2003), 3.1 (2004).
- NFPS primary balance: 2.3 (2002), 1.9 (2003), 2.8 (2004).
- NFPS overall balance: -1.9 (2002), -2.4 (2003), -2.0 (2004).
- Public debt: 63.6 (2002), 65.4 (2003), 63.4 (2004).

### Baseline and staff-recommended fiscal scenarios
- Baseline (through 2008)
  - Assumptions: fiscal deficit maintained at 2 percent of GDP; real GDP growth at 3¾ percent a year.
  - Outcome: public debt declines to 57 percent of GDP by 2008; gross fiscal financing needs remain large in later years, raising rollover risk and leaving virtually no room for countercyclical policy if the 2-percent ceiling is treated as an annual target.
- Staff-recommended scenario
  - Assumption: average deficit of 1 percent of GDP and implementation of growth-oriented structural reforms.
  - Outcome: public debt about 50 percent of GDP by 2008, substantially reduced gross financing needs, and room for automatic stabilizers.

### Risks and vulnerabilities
- Downside risks: slower-than-expected regional recovery; weaker rebound of Colon Free Zone net exports; sizeable slippage from fiscal deficit limit undermining confidence and investment.
- Upside potential: stronger-than-expected strengthening of service sectors; buoyant private consumption in 2004; a stronger construction boom.
- Vulnerabilities: high public debt; full dollarization (absence of monetary and exchange rate policy and no lender of last resort); openness/integration with the global economy requiring productivity and labor market reforms.
- Mitigants: strong fiscal policy and a sound banking system with ample liquidity and contingency plans for liquidity needs.

### Policy discussions and recommendations — fiscal stance and reforms
- 2004 fiscal policy
  - Measures yielding about 1 percent of GDP are needed to meet the 2 percent of GDP fiscal deficit limit in 2004.
  - Authorities decided on measures that would cover about half of this gap and are working to identify additional measures.
  - Staff recommended adoption of a quarterly program to guide fiscal policy during the political transition.
- Fiscal reform priorities
  - Improve tax administration.
  - Civil service reform.
  - Deepen the 2002 tax reform by broadening the tax base.
- Pension reform
  - Comprehensive reform of the pension system is needed to ensure viability; authorities are taking administrative steps to reduce the deficit, but comprehensive reform will need to be undertaken by the new government.
- Financial sector policy
  - Prudential framework strengthened and fully compliant with Basel Core Principles.
  - Authorities prefer not to establish formal lender-of-last-resort and deposit insurance schemes, citing a focus on crisis prevention and ample liquidity cushions in banks.
- Medium-term growth strategy
  - Further develop Panama as a hub for transportation, communication and related export-oriented services.
  - Policy initiatives include further trade liberalization and legislation for special economic zones to allow greater flexibility in terms of employment.

### Sensitivity analysis and public debt dynamics
- If no measures are taken to reduce the fiscal deficit (deficit rising to 4 percent of GDP in 2008), the public debt ratio would decline only marginally (to 60 percent of GDP), with significantly increased gross financing needs.
- The fiscal responsibility law limits the growth rate of nominal debt (to 80 percent of the growth in nominal GDP) if real GDP growth exceeds 1.5 percent; effectively, the debt limit constrains the deficit when real GDP growth is in the range of 1½–3 percent.
- Example from the law: if nominal GDP growth is 5 percent, implying a maximum 4-percent increase in nominal debt, the deficit limit of 2 percent of GDP would likely be the binding constraint on fiscal operations.

### Panama Canal expansion scenario
- A proposal may be ready by mid-2004; a decision to proceed would be taken only on the basis of a national referendum; the project would be completed in the next decade.
- Investment cost could range up to 50 percent of GDP.
- Financing strategy would aim to obtain an investment-grade credit rating for the Panama Canal Authority, and seek private sector financing that does not rely on a government guarantee.

### Debt management and sovereign issuance
- Authorities’ debt management strategy aims to improve debt maturity structure and deepen the domestic capital market.
- Three- and five-year treasury notes began to be issued in 2002 to help define a Panamanian yield curve.
- Global bond issues totaling US$3.7 billion since 1999 have been used to meet fiscal financing needs and retire Brady bonds.
- Authorities decided that all future sovereign bond issues would include collective action clauses (CACs), starting with a bond issue of US$250 million in January 2004.
- The latest buyback of Brady bonds (US$400 million, in January 2004) reduced the stock of Brady bonds to less than US$400 million.

### Social security (CSS) — status and reform
- Financial status
  - CSS balance deteriorated from a surplus of US$133 million in 1999 to a deficit of US$18 million in 2002; the deficit is expected to have widened further in 2003.
  - ILO 1998 estimate: uncovered obligation US$2.1 billion (16 percent of GDP).
  - Total unfunded obligations (including contributors not yet retired) estimated at 56 percent of GDP (unofficial estimate from 1998).
  - Reserve depletion projections: 1998 ILO study—reserves depleted by 2023; revised 2001 ILO study—reserves depleted by 2018.
  - Personnel and operating costs increased sharply owing mainly to a 60-percent increase in employees from 1999 to 2002.
- Structural causes and benefit rules
  - Pay-as-you-go contributions do not cover current benefits; deficit will widen without comprehensive reform.
  - Benefit rules: minimum contribution period of 15 years yields a pension of 60 percent of the reference wage; each additional year adds 1¼ percentage points.
  - Retirement age: men 62 years; women 57 years.
  - Nonbinding ceiling of US$1,500 a month applies for most pensions; average pension about US$500.
- Reform process
  - National dialogue with UNDP facilitation; task forces for CSS’s four programs.
  - Consensus reached on aspects of three programs; pensions (IVM) task force has reached no conclusions.
  - Proposals: employers favor higher contribution rates, longer minimum contribution period, changes in retirement age; workers favor preservation of existing benefits.
  - An actuarial model is being developed with UNDP assistance; unofficial estimates from 1998 suggest unfunded obligations are over 50 percent of GDP in NPV terms.

### Structural reform priorities — labor market, tax, and competitiveness
- Labor market
  - Unemployment persistently above 10 percent; 2003 unemployment revised to 12.8 percent (August measurement); 2004 Household Survey: unemployment 11.8 percent at end-2004.
  - Recommended reforms: institute part-time and evening work schedules; test periods for employees; decrease severance packages.
  - Authorities propose initial labor flexibility in special economic zones.
- Tax reform (2002)
  - Projected net revenue yield of 0.4 percent of GDP in 2003 (authorities’ proposal envisaged 0.8 percent of GDP).
  - Main components preserved verbatim:
    - Annual exemption under personal income tax raised from US$3,900 to US$10,400.
    - Banks’ income became taxable.
    - Some fiscal incentives phased out over five years (including tax exemptions for construction).
    - Corporate income tax rate lowered from 30 percent to 28 percent.
    - VAT base widened to include selected services, with many exceptions.
    - A 5-percent consumption tax levied selectively, mainly for luxury goods.
    - Tax exemptions for the housing sector modified for better targeting to low-income housing.
  - Recommendations for future reform: broaden the VAT to encompass a wider range of services; close loopholes and reduce poorly targeted tax expenditures; provide the tax administration authority with required legal framework to enforce the law and reduce tax evasion.
- Competitiveness
  - Real effective exchange rate declined sharply since 2002.
  - Panama ranked 59th out of 85 countries in a World Economic Forum competitiveness study, with strengths in international services and weaknesses in public institutions, labor market rigidities, licensing requirements, and laws that discourage investment.
  - IDB-supported competitiveness project to remove sector-specific barriers to foreign investment and enhance transparency.

### Balance of payments and external sector statistics
- Improvements in compilation and coverage since STA missions (1996–2001); International Investment Position data for 1995−2002 compiled.
- Most recent balance of payments statistics pertain to June 2003 (in the excerpt).
- Revisions: merchandise imports and transportation services revisions in 2003 lowered current account deficit for 2000 and 2001 by 1.8 and 2.9 percentage points of GDP, respectively.
- Revised FDI data modified previous estimates by more than 1 percent of GDP during 1999−2002.
- Data gaps: nonfinancial private sector debt and transactions involving financial derivatives not yet available.
- CPIS participation supported by a STA mission in September 2002.

### 2003–2004 updates and 2005 outlook (selected figures and developments)
- Real GDP growth: rebounded at over 6 percent of GDP in Q1 2004; reached 6.2 percent by end-year 2004, compared to 4.1 percent in 2003.
- Inflation: consumer price inflation 1.7 percent during 2003 (staff estimate was 1.3 percent); end-of-year inflation projected at 1.5 percent for 2004, compared to 1.7 percent at end-2003.
- External current account: deficit 3.2 percent of GDP for 2003; at end-2004 external current account deficit reached 8 percent of GDP compared to 4 percent at end-2003; almost totally covered by foreign direct investments that reached 7.3 percent of GDP.
- Foreign direct investment: US$792 million in 2003 (staff estimate US$654 million).
- Panama Canal Authority (ACP) revenues increased 15.8 percent in FY2004, breaking the one billion dollar level; Canal serviced 14,035 ship-crossings in 2004, a 6.7 percent increase compared to 2003; at present rate of growth canal capacity may be reached by 2012; a referendum expected late this year to authorize expansion; estimated construction time of eight years.
- Public finances and fiscal measures
  - Minister announced NFPS deficit for 2003 was 1.9 percent of GDP on March 11; SM/04/65 reported 2.4 percent of GDP for 2003.
  - As the administration took office on September 1, 2004 the NFPS deficit reached 5.0 percent of GDP at end-2004.
  - Immediate expenditure restraint of US$225.8 million; non-renewal of personnel contracts; plan to gradually reduce unpaid arrears with suppliers.
  - 2005 budget envisages fiscal deficit of 3.8 percent of GDP with controls on current public expenditures; revenues-to-GDP ratio expected to increase to 15.4 percent from 14.6 percent.
  - Law no. 6 (approved February 2, 2005) provisions include scaling down public payroll to about 165-170 thousand by early 2008 from over 180 thousand; ceilings on current expenditures; reduction by 60 percent the number of vacancies within the next three years; increases operating fees; eliminates industrial incentive law of 2004 and exports incentives certificates (CAT’s) (expire end-2005); taxes a share of Panamanians’ foreign income; widens the income tax base; envisages an anticipated withholding tax of 10 percent.
  - A fiscal reform yielding 1 percent of GDP has been approved; a social security reform package under discussion.
- Public debt level increased to US$9.98 billion at end-December 2004.

### Financial sector updates (2004)
- Banking system assets: US$33.2 billion, a 4.5 percent increase compared to 2003.
- Liquid assets to deposit ratio: 42 percent (last September).
- Capital adequacy ratio: 18.6 percent (regulatory required CAR 8 percent).
- Return on capital: 16.2 percent.
- Return on assets: 2.3 percent.
- Non-performing loans: 1.8 percent (down from 2.7 percent in 2003).
- Domestic credit: grown steadily, driven by foreign private banks and public banks.
- Supervision: SoB enhancing consolidated and cross-border supervision; steps to meet Basel II risk requirements by 2008.
- MFD mission planned to complete a Model 2 OFC review (AML/FT, insurance sector legislation, domestic stock market framework).

### Investment activity and mega-projects
- Canal and reverted areas: second bridge over the Panama Canal (US$200 million public investment); ACP investment and maintenance program nearly US$170 million in 2004.
- Private investments: over US$300 million in maritime sector, tourism, commercial services and infrastructure in 2004.
- PPC-Hutchison Wampoa port expansion cost over US$200 million in 2004.
- Other projects: new shopping mall and hotel US$100 million; Tocumen airport expansion begun end-2004; Bayano hydroelectric US$40 million investment increased capacity by 20 percent; La Fortuna hydroelectric US$225 million expansion to 150 megawatts.
- Electricity production: slightly over 5,000 megawatts at end-2004, with 58 percent produced by hydroelectric plants.
- Mega-projects under consideration:
  - New sets of locks in the Panama Canal: approximate investment of over US$4.5 billion.
  - Gas pipeline estimated cost US$200 million (operation in 24 months).
  - Colombian electricity interconnection: two routes 571 km and 514 km costing US$169 million and US$139 million respectively.
  - Venezuela considering transport of oil in trans-Panama oil pipeline (Petroterminales) with pumping capacity of 860,000 bbl per day.
  - Pacific coast port construction: investment of US$600 million.
  - PPC-Hutchinson Wampoa and MIT port operator to invest US$500 million in 2005 for Atlantic-side port expansion; MIT already invested US$300 million; PPC-Hutchinson Wampoa invested US$340 million in Balboa Port to date.

### Statistics, data coverage, and technical assistance
- National accounts revision: base year changed from 1982 to 1996; accounts now include resident banks and enterprises operating in the Colon Free Zone; revised data available by productive sector for 1996−2002; demand side of new GDP series not yet available.
- CPI weights: current CPI weights from 1983/84 household budget survey; new CPI index planned in first half of 2004 based on 1997/98 survey; consumer price data available through November 2003.
- Government finance: central government finances compiled on a cash basis; monthly and quarterly central government data available through September 2003; migration to GFSM 2001 planned with STA mission scheduled in February 2004 and preliminary report by March 2004.
- Monetary accounts: monetary data available monthly through November 2003; joint effort improved timeliness and reduced errors; wider coverage of financial soundness indicators.

### Staff appraisal — key judgments and recommendations
- Recovery of the economy is under way; the recovery gathered strength in 2003 and is expected to continue in 2004.
- The fiscal responsibility law provides a sound framework for fiscal policy and has helped maintain prudence and expenditure restraint.
- Main fiscal focus for 2004: ensure observance of the fiscal responsibility law; meeting the deficit limit this year is essential for credibility and will require additional measures.
- Staff encourages preparation of a quarterly fiscal program for the election year to guide fiscal policy during the political transition.
- Comprehensive pension reform is needed to restore solvency; staff encourages improving social security finances via staff rationalization and improved portfolio management, but stresses more fundamental reforms are needed to cover direct and contingent liabilities.
- Sustained compliance with fiscal rules will require structural reforms: improve tax administration, civil service reform, and deepen the 2002 tax reform by broadening the tax base and reducing exemptions.
- Staff welcomes progress in strengthening bank regulation and supervision; current arrangements focused on crisis prevention, transparency, and ample liquidity cushions have served the financial system well.
- While recognizing the preference not to introduce deposit insurance, staff recommends considering protecting the social safety net for small depositors by inflation-adjusting the size of deposits with priority status in the event of a bank liquidation.

*Source: Executive Summary and selected excerpts of IMF Staff Report _cr06130*

### Executive Summary ......................................................................................................

### _cr06130 - Executive Summary

### Background
- Panama is fully dollarized (since 1904) and relatively open; the service sector accounts for about 80 percent of GDP, including the Panama Canal, the Colon Free Zone, and a large banking system integrated with international financial markets.
- Annual output growth averaged 3.7 percent over the decade to 2002.
- Public debt was over 60 percent of GDP, motivating the fiscal responsibility law enacted in 2002, which limits the NFPS deficit to 2 percent of GDP and targets a gradual reduction in public debt to 50 percent of GDP.
- Key structural priorities: overhaul of the social security system and flexible labor markets.

### Recent economic developments
- Growth and inflation
  - Real GDP growth: 0.8 percent (2002), 3.9 percent (2003, estimated).
  - Inflation: 1.8 percent (2002), 1.2 percent (2003), 1.3 percent (projected end-2004).
  - Recovery in 2003 led by construction (stimulated by a December 2002 tax law), the primary sector (notably fishing), and a late-year rebound in export-oriented services (Colon Free Zone and ports).
  - Unemployment remained above 13 percent in 2003.
- Public finances
  - NFPS balance shifted into a deficit in 2001 and widened in 2002.
  - Tax reform of December 2002 yielded an estimated 0.4 percent of GDP in additional revenue in 2003.
  - Despite that, preliminary 2003 data suggest the fiscal deficit reached 2½ percent of GDP, exceeding the 2 percent of GDP statutory limit.
  - Capital revenues in 2003 were much lower than in 2002; expected buybacks of Brady bonds and associated capital gains did not take place.
- Financial sector
  - Banking stress in 2002 from regional market turbulence; large withdrawals of nonresident deposits by foreign banks and curtailed foreign credit operations.
  - Recovery in 2003: private sector credit and bank deposits resumed slow growth; deposit spreads fell.
  - Banking fundamentals as of November 2003: capital adequacy ratios exceeded 17 percent on average; liquidity ample; nonperforming loan ratios decreased to less than 3 percent on average as of end-September 2003.
  - Banks improved profitability in 2003 through rebound and cost-cutting.
  - Interest rates trended downward since 2000; foreign banks lowered deposit rates faster than local banks.

### Political context
- Government holds a thin majority in the Assembly and emphasizes consensus-building (national dialogues on economic recovery and social security reform).
- Presidential and congressional elections scheduled for May 2004; change of government in September 2004.
- Main presidential candidates did not signal departure from market-friendly policies.

### Outlook and risks
- Staff macroeconomic projections (in percent of GDP, unless otherwise indicated)
  - Real GDP growth: 0.8 (2002), 3.9 (2003), 4.2 (2004).
  - Inflation (end of period): 1.8 (2002), 1.2 (2003), 1.3 (2004).
  - External current account: -0.8 (2002), -3.2 (2003), -3.6 (2004).
  - International reserves: $1.2 (2002), $1.0 (2003), $1.1 (2004) (in billions of U.S. dollars).
  - International reserves (months of imports): 3.6 (2002), 3.0 (2003), 3.1 (2004).
  - NFPS primary balance: 2.3 (2002), 1.9 (2003), 2.8 (2004).
  - NFPS overall balance: -1.9 (2002), -2.4 (2003), -2.0 (2004).
  - Public debt: 63.6 (2002), 65.4 (2003), 63.4 (2004).
- Baseline and alternative scenarios
  - Baseline (through 2008) assumes the fiscal deficit is maintained at 2 percent of GDP and real GDP growth at 3¾ percent a year (equal to the average over the last decade). Under this scenario public debt declines to 57 percent of GDP by 2008, but gross fiscal financing needs remain large in later years, raising rollover risk and leaving virtually no room for countercyclical policy if the 2-percent ceiling is treated as an annual target.
  - Staff-recommended scenario: average deficit of 1 percent of GDP would bring public debt to about 50 percent of GDP by 2008, substantially reduce gross financing needs, and provide room for automatic stabilizers; the scenario assumes implementation of growth-oriented structural reforms to raise the growth path.
- Risks
  - Downside risks: slower-than-expected regional recovery, weaker rebound of Colon Free Zone net exports, and sizeable slippage from the fiscal deficit limit undermining confidence and investment.
  - Upside potential: stronger-than-expected strengthening of service sectors, buoyant private consumption in 2004, or a stronger construction boom.
  - Vulnerabilities: high public debt, full dollarization (absence of monetary and exchange rate policy and no lender of last resort), and openness/integration with the global economy requiring productivity and labor market reforms.
  - Mitigants: strong fiscal policy and a sound banking system with ample liquidity and contingency plans for liquidity needs.

### Policy discussions and recommendations
- 2004 fiscal policy
  - Measures yielding about 1 percent of GDP are needed to meet the 2 percent of GDP fiscal deficit limit in 2004.
  - Authorities decided on measures that would cover about half of this gap and are working to identify additional measures.
  - Staff recommended adoption of a quarterly program to guide fiscal policy during the political transition.
- Fiscal reform
  - Sustained compliance with the fiscal responsibility law requires structural reforms: further improvement of tax administration; civil service reform; and deepening the 2002 tax reform, in part by broadening the tax base.
- Pension reform
  - Comprehensive reform of the pension system is needed to ensure viability.
  - Authorities are taking administrative steps to reduce the deficit, but comprehensive reform will need to be undertaken by the new government.
- Financial sector policy
  - Prudential framework strengthened and fully compliant with Basel Core Principles.
  - Authorities prefer not to establish formal lender-of-last-resort and deposit insurance schemes, citing a focus on crisis prevention and ample liquidity cushions in banks.
- Medium-term growth strategy
  - Authorities intend to further develop Panama as a hub for transportation, communication and related export-oriented services.
  - Policy initiatives include further trade liberalization and legislation for special economic zones to allow greater flexibility in terms of employment.

*Source: Executive Summary of IMF Staff Report _cr06130*

### 18.      Sensitivity analysis shows that the public debt dynamics are vulnerable to policy

### 18.      Sensitivity analysis shows that the public debt dynamics are vulnerable to policy

### Public debt dynamics and sensitivity analysis
- If no measures are taken to reduce the fiscal deficit (implying a departure from fiscal rules, with the deficit rising to 4 percent of GDP in 2008), the public debt ratio would decline only marginally (to 60 percent of GDP), with significantly increased gross financing needs.
- This fiscal-path scenario would leave the country vulnerable to shocks, particularly to growth and interest rates.
- The fiscal responsibility law also limits the growth rate of nominal debt (to 80 percent of the growth in nominal GDP) if real GDP growth exceeds 1.5 percent; effectively, the debt limit constrains the deficit when real GDP growth is in the range of 1½–3 percent.
- Example from the law: if nominal GDP growth is 5 percent, implying a maximum 4-percent increase in nominal debt, the deficit limit of 2 percent of GDP would likely be the binding constraint on fiscal operations.

### Panama Canal expansion scenario
- A potentially large expansion of the Panama Canal is being studied; a proposal may be ready by mid-2004.
- A decision to proceed would be taken only on the basis of a national referendum; the project would be completed in the next decade.
- Investment cost could range up to 50 percent of GDP.
- Financing strategy would aim to obtain an investment-grade credit rating for the Panama Canal Authority, and seek private sector financing that does not rely on a government guarantee.

### Fiscal policy — stance, rules, and measures
- The fiscal responsibility law: core goal is lowering the debt-to-GDP ratio gradually to 50 percent.
- Staff view: projections based on the approved budget for 2004 imply a need for measures equivalent to about 1 percent of GDP, in order to meet the 2-percent GDP deficit limit.
- Staff recommended steps to improve the social security balance and to postpone some of the budgeted increases in government employment (with a projected total impact of 0.6 percentage point of GDP).
- Additional measures to close the remaining gap could include further restraint of low-priority expenditure.
- Authorities reported some measures already being taken; they believed cuts in nonessential spending could close the remaining gap.
- Staff recommended preparing a quarterly fiscal program consistent with the annual fiscal rules to guide policy implementation during the political transition and avoid a repeat of the stop-go pattern of 2003.
- Staff suggested refinements to the fiscal responsibility law, such as rules to guide policy implementation during political transitions and defining debt limits to permit pre-funding of deficits; authorities noted changes could only be effected by the next government.
- The projections in Tables 2 and 3 include the measures the government already decided upon (lowering operating expenditure in the social security sector and raising the yield of the social security fund’s portfolio), leaving some 0.7 percent of GDP of measures to be adopted.
- While the budget projects a deficit of 2 percent of GDP, it is based on over-optimistic assumptions for capital revenue.

### Debt management and sovereign issuance
- Authorities’ debt management strategy aims to improve debt maturity structure and deepen the domestic capital market.
- Three- and five-year treasury notes began to be issued in 2002 to help define a Panamanian yield curve.
- Global bond issues totaling US$3.7 billion since 1999 have been used to meet fiscal financing needs and retire Brady bonds.
- Authorities decided that all future sovereign bond issues would include collective action clauses (CACs), starting with a bond issue of US$250 million in January 2004.
- The latest buyback of Brady bonds (US$400 million, in January 2004) reduced the stock of Brady bonds to less than US$400 million.

### Social security and pension reform
- Authorities and staff agreed on the need for comprehensive pension reform to restore solvency and ensure medium-term fiscal sustainability.
- Short-term approach: improve finances through gradual staffing reductions and steps to raise the yield on the social security fund’s portfolio.
- Second stage: a comprehensive reform to be implemented after the September 2004 change in government.
- An actuarial model is being developed with assistance from the UNDP to estimate uncovered liabilities; unofficial estimates from 1998 suggest unfunded obligations are over 50 percent of GDP in NPV terms, including future obligations to contributors who have not yet retired.
- Participants in the national dialogue (government, business, labor) have presented a variety of proposals for reducing the large actuarial deficit.

### Structural reform priorities
- Steps to sustain compliance with fiscal rules include:
  - Improve tax administration.
  - Rationalize government expenditure through civil service reform (better aligning staffing levels with needs and improving the public sector wage-setting mechanism).
  - Deepen the 2002 tax reform by broadening the tax base and reducing exemptions.
- Directors had urged implementation of a revenue-enhancing tax reform; a tax package approved in late 2002 yielded about ½ percent of GDP in 2003.

### Financial sector policies and stability framework
- Supervisory framework strengthened since the Module 2 OFC report of 2001, addressing Basel Core Principles compliance (improving offsite and onsite inspections and regulation of banks’ equity investments).
- Implemented recommendations include enhanced legal protection for supervisors, strengthened procedures for bank mergers and acquisitions, and progress with consolidated supervision of financial entities involving cooperation with regulators in other jurisdictions.
- Authorities’ view: no formal lender-of-last-resort scheme is needed; banking system strength derives from strong regulatory and supervisory framework and market discipline.
- Liquidity statistics: liquidity ratio (liquid assets in relation to deposits) averaged 28 percent as of end-November; the average liquidity ratio that includes marketable securities is over 40 percent for both foreign and domestic banks.
- More than half of the securities are marketed outside Panama, and one third of the total comprises investment-grade securities.
- Authorities see no clear need for deposit insurance; protection of small depositors provided by giving priority over most other claims to the payment of deposits up to US$5,000.
- Staff emphasized importance of maintaining strong supervisory framework, crisis prevention, transparency, market discipline, ample liquidity cushions, and sound fiscal policy.
- Staff encouraged considering inflation-adjusting the ceiling on small deposits with priority over other creditor claims in the event of bank liquidation (in accordance with provisions in the Banking Law).
- Authorities attach high priority to combating money laundering and the financing of terrorism; Panama has a comprehensive legislative framework and has ratified the UN International Convention for the Suppression of the Financing of Terrorism. Draft legislation is being prepared to criminalize the financing of terrorism.

### Trade policy, competitiveness, and labor market
- Government strategy to raise growth: further develop Panama as a hub for transportation, communication, and related services.
- Free trade agreements are central to the strategy for boosting investment and growth; a free trade agreement with Taiwan Province of China was concluded in the second half of 2003, and discussions on an agreement with the United States are to begin in April.
- Based on the economic integration treaty with Central American countries in 2002, a trade agreement with El Salvador has been concluded; negotiations with Costa Rica and Nicaragua are under way.
- Panama’s trading system: relatively open, with a low average tariff but prohibitively high tariffs on selected agricultural products (300 percent for certain poultry products).
- The unweighted average tariff is 8.6 percent; Panama has a rating of 1 (i.e., open) on the Fund’s 1–10 trade restrictiveness index.
- Some import tariffs and subsidies on nontraditional exports would be phased out by end-2005 under the terms of accession to the WTO; authorities expect to replace export subsidies with more general tax incentives for manufacturing through a law on industrial policy effective February 2004 (authorities estimated the law’s fiscal impact to be neutral).
- Competitiveness: real effective exchange rate declined sharply since 2002; Panama ranked 59th out of 85 countries in a World Economic Forum competitiveness study, with relative strengths in international services and weaknesses in public institutions, labor market rigidities, licensing requirements, and laws that discourage investment.
- A competitiveness project supported by the IDB includes reforms to remove sector-specific barriers to foreign investment and enhance transparency of the legal framework for foreign investors.
- Labor market: labor code poses obstacles to job creation (difficulty of laying off employees, high nonwage labor costs, inhibits temporary employment). Authorities propose legislation for special economic zones near the Panama Canal to allow greater employment flexibility as pilot projects.

### Other issues and statistics
- Progress on recommendations from the last Article IV consultation: focus on debt and deficit sustainability consistent with Directors’ recommendations; a tax package was approved in late 2002 yielding about ½ percent of GDP in 2003; draft law for flexible employment terms in special economic zones follows recommendations to facilitate job creation.
- Limited progress where consensus is required, notably pension reform.
- Economic statistics: timeliness and coverage generally adequate; a recent revision of national accounts extended GDP coverage to include the canal and some informal sector activities; GDP for 2002 was revised upward by 18 percent.
- Statistics gaps: need to reduce reporting lags for fiscal data and improve frequency and coverage of labor market statistics.

### Staff appraisal — key judgments and recommendations
- A recovery of the economy is under way; the recovery gathered strength in 2003 and is expected to continue in 2004.
- The fiscal responsibility law provides a sound framework for fiscal policy and has helped maintain prudence and expenditure restraint.
- Main fiscal focus for 2004: ensure observance of the fiscal responsibility law; meeting the deficit limit this year is essential for credibility and will require additional measures.
- Staff encourages preparation of a quarterly fiscal program for the election year to guide fiscal policy during the political transition.
- Comprehensive pension reform is needed to restore solvency; staff encourages improving social security finances via staff rationalization and improved portfolio management, but stresses more fundamental reforms are needed to cover direct and contingent liabilities.
- Sustained compliance with fiscal rules will require structural reforms: improve tax administration, civil service reform, and deepen the 2002 tax reform by broadening the tax base and reducing exemptions.
- Staff welcomes progress in strengthening bank regulation and supervision; current arrangements focused on crisis prevention, transparency, and ample liquidity cushions have served the financial system well.
- While recognizing the preference not to introduce deposit insurance, the authorities should consider protecting the social safety net for small depositors by inflation-adjusting the size of deposits with priority status in the event of a bank liquidation.

*Source: _cr06130 - 18.      Sensitivity analysis shows that the public debt dynamics are vulnerable to policy*

### 46.      The staff supports the emphasis in the government’s growth strategy on

### The staff supports the emphasis in the government’s growth strategy on exploiting the country’s comparative advantage in the export-oriented service sector.

### Growth strategy and competitiveness
- Staff support for policies focusing on:
  - providing the needed economic infrastructure,
  - promoting good governance,
  - strengthening the environment for productive investment and job creation.
- IDB-supported competitiveness project is welcomed as a contribution to designing and implementing reforms.
- Reducing labor market rigidities highlighted as particularly important.
- Staff encourages authorities to seek consensus for labor market reforms, initially through greater flexibility in the terms of employment in special economic zones.

### Trade liberalization
- Staff supports the authorities’ plans for further trade liberalization.
- In pursuing bilateral and regional trade agreements, authorities should ensure agreements are:
  - broad-based,
  - comprehensive,
  - consistent with multilateral trading arrangements being pursued under the Doha Round.

### Medium-term outlook and prospects
- Medium-term outlook described as sound, conditional on:
  - continued pursuit of prudent fiscal policies,
  - growth-enhancing structural reforms.
- Prospects noted:
  - sustained growth with a declining public debt burden,
  - a possible expansion of the Panama Canal could give a significant further boost to Panama’s longer run growth potential.

### Article IV consultation timing
- It is proposed that the next Article IV consultation with Panama take place on the standard 12-month cycle.

### Box 1. Tax Reform — Reforms in 2002 (findings)
- The 2002 tax law included a combination of tax reductions and increases with a projected net revenue yield of 0.4 percent of GDP in 2003 (the authorities’ proposal envisaged a yield of 0.8 percent of GDP). Main components:
  - The annual exemption under the personal income tax was raised from US$3,900 to US$10,400.
  - Banks’ income, previously largely exempt, became taxable.
  - Some fiscal incentives are being phased out over five years (including tax exemptions for construction).
  - The corporate income tax rate was lowered from 30 percent to 28 percent.
  - The VAT base was widened to include selected services, albeit with many exceptions.
  - A 5-percent consumption tax was levied on a selective basis, mainly for luxury goods.
  - Tax exemptions for the housing sector were modified for better targeting to low-income housing.
- A law to reform the main tax agency was approved in 2002, supported by regional technical assistance to improve tax administration.

### Box 1. Tax Reform — Agenda for future reform (recommendations)
- Broaden the VAT to encompass a wider range of services.
- Close loopholes and reduce poorly targeted tax expenditures.
- Provide the tax administration authority with the required legal framework to enforce the law and reduce tax evasion.

### Box 2. Sources of Growth — Historical context and challenges
- The collapse in output resulting from the political crisis of the 1980s was followed by broad recovery, particularly in the service sector, which accounts for almost 80 percent of GDP.
- Growth of export-oriented services facilitated by Panama’s integration into the world economy and anchored around:
  - the Panama Canal,
  - the Colon Free Zone,
  - an open and well regulated banking system.
- Strong growth in the 1990s was followed by the regional slowdown of 2000-01.
- Despite strong 1990s growth, total factor productivity growth has been stubbornly low.
- Key reforms needed to boost productivity:
  - reducing labor market frictions,
  - improving education, e.g., promoting skills relevant to service exports such as language training.

### Box 2. Panama: Contribution to Growth (Average, in percent)
- Factor Contribution / Sectoral Growth Rate (table entries preserved verbatim):
  - 1981-1985: GDP 3.5, Capital -4.4, Labor 1.4, Productivity 6.5, Primary 5.1, Secondary -0.6, Tertiary 5.0
  - 1986-1990: GDP -0.4, Capital -8.0, Labor 1.3, Productivity 6.3, Primary 0.8, Secondary -3.1, Tertiary -0.9
  - 1991-1997: GDP 5.4, Capital 8.6, Labor 1.3, Productivity -4.5, Primary 2.8, Secondary 8.7, Tertiary 4.6
  - 1998-2002: GDP 3.5, Capital 2.2, Labor 1.2, Productivity 0.0, Primary 2.8, Secondary -1.1, Tertiary 4.3
  - 2003-2008: GDP 3.8, Capital 2.4, Labor 1.3, Productivity 0.1, Primary 4.2, Secondary 4.6, Tertiary 3.7
- Notes excerpted from table:
  - growth given by change in real investment, and a five year moving average for growth of labor post-2002.
  - Domestic investment for 1989-1990 is averaged to control for political instability.
  - The tertiary sector is comprised of services.
  - Estimates are based on a Cobb-Douglas production function (with 0.6 capital share).

### Box 2. Unemployment and labor participation (findings and recommendations)
- Panama’s unemployment rate has persisted above 10 percent for many years, exacerbated by a rising labor participation rate.
- High structural unemployment may be partly attributable to overregulation and labor market frictions.
- Recommended labor market reforms include:
  - instituting part-time and evening work schedules,
  - test periods for employees,
  - decreasing severance packages.
- Political difficulties in implementing labor reform have led authorities to focus initially on changes in labor market conditions in special economic zones (para. 37).

*Source: IMF staff report text provided in the content unit.*

### Box 3. Social Security Reform

### Box 3. Social Security Reform

### Fiscal and financial status of the CSS
- The balance of the Social Security Fund (CSS) deteriorated from a surplus of US$133 million in 1999 to a deficit of US$18 million in 2002. The deficit is expected to have widened further in 2003.
- The reserves of the CSS are well below the legal requirement (to cover obligations to current pensioners).
  - An ILO study in 1998 estimated the uncovered obligation at US$2.1 billion (16 percent of GDP).
  - The total unfunded obligations, taking into account the claims of current contributors, were estimated at 56 percent of GDP.
- Projections of reserve depletion:
  - 1998 ILO study: reserves would be depleted by 2023.
  - Revised ILO study in 2001: reserves would be depleted by 2018.
- The financial imbalance has been exacerbated by a sharp increase in personnel and operating costs, owing mainly to a 60-percent increase in employees from 1999 to 2002.

### Structural causes: benefits versus contributions
- The financial problems are rooted in the imbalance between pension benefits and contributions to the pay-as-you-go pension system; contributions do not cover current benefits and the deficit will widen without comprehensive reform.
- Benefit rules and parameters:
  - For a minimum contribution period of 15 years, a worker receives a pension of 60 percent of the reference wage, and for every additional year of contribution payments, 1¼ percentage points is added.
  - Retirement age: men 62 years; women 57 years.
  - A nonbinding ceiling of US$1,500 a month applies for most pensions (with the average pension being about US$500).

### Reform process and policy options under consideration
- A reform of the social security system is needed to ensure its sustainability.
- Government actions to date:
  - Promoted a national dialogue on social security reform.
  - Anchored the dialogue by task forces for each of the CSS’s four programs: disability, old age, and death benefits (IVM); maternity and health care; workmen’s compensation; and the CSS administration.
  - Engaged UNDP to assist as a facilitator of the debate and a compiler of proposals presented by the government, employers, workers, and civil society.
- Outcomes and remaining disputes:
  - Consensus has been reached on aspects of three programs.
  - The task force on pensions (IVM) has reached no conclusions.
- Proposals tabled in the debate:
  - Employers: higher contribution rates, a longer minimum contribution period, and changes in retirement age.
  - Workers: preservation of existing benefits.

*Box 3. Social Security Reform — content as provided in the source document.*

### 1. Real sector

### _cr06130 - 1. Real sector

### 1. Real sector — revisions, coverage, and price indices
- Authorities are completing a revision of the national accounts with a change in the base year from 1982 to 1996, based on the 1993 SNA.
- The revision entails:
  - an update on the measurement of certain activities;
  - implementation of a new sectoral classification system;
  - extension of coverage to activities that did not exist in 1982 and are now included in the calculations.
- The accounts now include resident banks and enterprises operating in the Colon Free Zone (ZLC) by strictly applying the residency criterion of the balance of payments and national accounts recommendations.
- Financial services are now allocated to users, including exports.
- The revised data are available by productive sector for the period 1996−2002.
- At present the demand side of the new GDP series is not available.
- CPI weights:
  - Current CPI weights were derived from a household budget survey conducted in 1983/84.
  - Authorities plan to introduce a new CPI index in the first half of 2004 based on weights of the 1997/98 household survey.
- Consumer price data are available through November 2003.

Pending issues
- The time series of GDP by use for the 1996 base has not been published.
- Preliminary estimates of real GDP volume remain unreliable and untimely, in part because of delays in data collection.

Technical assistance
- The United Nations Economic Commission for Latin America and the Caribbean is supporting the development of a supply-use table.

### 2. Government finance — coverage, timeliness, and migration to GFSM 2001
- Data on central government finances, public enterprises and agencies are compiled only on a cash basis.
- Monthly and quarterly data for the operations of the budgetary central government are currently available through September 2003.
- Data provision to STA:
  - last month available for IFS data is April 2003;
  - the latest annual data submitted for publication in the Government Finance Statistics Yearbook 2003 are for 2001.
- Issues identified for improved monitoring:
  - provide data on an accrual basis and more timely;
  - improve consistency of information on intrapublic sector transfers;
  - make the coverage of the investment program complete.
- The authorities’ 2003 decision to include the operational balance of the Panama Canal Authority within the non financial public sector statistics will require a consistent and timely flow of information on a calendar basis.
- SIAFPA developments:
  - SIAFPA coverage of the central government accounts was completed in 2003;
  - work is under way to incorporate decentralized agencies such as the Social Security Agency.
- There is a need to address unrecorded expenditures, some likely due to accumulation of arrears.
- Authorities requested technical assistance from the Statistics Department to implement the 2001 Government Finance Statistics Manual 2001 (GFSM 2001) for a comprehensive review of coverage and methodology in the fiscal accounts.
- A STA mission is scheduled to be in Panama City in February 2004.
- A preliminary report, including a tentative timetable for a migration to the GFSM 2001, would be ready by March 2004.

Technical assistance
- Training related to the GFSM 2001 was provided to Panamanian officials during the six-week course offered at Headquarters during March–April 2003.

### 3. Monetary accounts — data flow, coverage, and recent improvements
- Provision of data by the monetary authorities has been regular and reasonably current.
- Monetary data are available monthly through November 2003.
- Data on operations of commercial banks are prepared by the Superintendency of Banks with a lag of one to two months, although they are reported for publication in IFS with somewhat longer lags.
- There is a lack of consistent data prepared on the financial positions of the National Mortgage Bank and the Agricultural Development Bank.
- In the last two years a joint effort of the banking system and the Superintendency of Banks:
  - improved the timeliness of monetary statistics production;
  - minimized errors through better information technology.
- The wider coverage of financial soundness indicators improved the transparency of the banking system statistics.

*Source: _cr06130 - 1. Real sector*

### 4. Balance of payments

### 4. Balance of payments

### Improvements in compilation and coverage
- STA technical assistance missions during 1996–2001 helped improve the compilation procedures and systems, reduce lags in data collections, and develop procedures for quality control.
- Authorities provided additional budgetary and staff resources to deal with administrative problems and the lack of adequate data processing equipment.
- These efforts led to significant improvements in the quality and timeliness of external sector statistics, including through periodic reconciliation of external debt statistics discrepancies with multilateral lenders.
- International Investment Position data for 1995−2002 have been compiled.
- The most recent data on balance of payments statistics pertain to June 2003.

### Pending issues and data revisions
- Despite substantial progress, data are still subject to sizeable revisions.
- Revised estimates of merchandise imports and transportation services released in 2003 resulted in a lower current account deficit over the period 1999–2001 relative to previously reported calculations.
  - The revised current account deficit for 2000 and 2001 were revised down by 1.8 and 2.9 percentage points of GDP, respectively.
- Revised foreign direct investment data modified previous estimates by more than 1 percent of GDP during the period 1999−2002.
  - These revisions may reflect improvements in coverage, but they also suggest that there is room for improvement in quality control procedures.
- The authorities are currently working on a full reconciliation between data of the banking sector and balance of payments capital flows consistent with the compilation method introduced by the Superintendency of Banks in 2002.
- Data are not yet available on nonfinancial private sector debt or on transactions involving financial derivatives.

### Technical assistance and surveys
- In September 2002 a STA mission visited Panama to support their participation in the Coordinated Portfolio Investment Survey (CPIS).

*Source: _cr06130 - 4. Balance of payments (excerpt).*

### 2.2 percent.

### _cr06130 - 2.2 percent.

### Economic performance and labor market
- Real GDP growth:
  - Rebounded at over 6 percent of GDP in the first quarter of 2004.
  - Real GDP growth reached 6.2 percent by end-year 2004, compared to 4.1 percent in 2003.
- Sector contributions: strong construction activity, agricultural exports, tourism and entertainment, Panama Canal operations, and the Free Zone.
- Inflation:
  - Consumer price inflation was 1.7 percent during 2003 (staff estimate was 1.3 percent).
  - End-of-year inflation projected at 1.5 percent for 2004, compared to 1.7 percent at end-2003.
- Unemployment:
  - The unemployment rate for 2003 (measured each year in August) was revised to 12.8 percent, compared with a preliminary figure of 13.4 percent (and 13.5 percent in August 2002).
  - According to the 2004 Household Survey, the unemployment rate decreased to 11.8 percent at end-2004, compared to 13.1 percent at end-2003.
- Outlook: Prospects for 2005 are favorable, with GDP growth expected to remain well above the last decade’s average.

### External sector and balance of payments
- Current account and FDI:
  - The external current account deficit was 3.2 percent of GDP for 2003, in line with the estimate in the staff report.
  - Foreign direct investment was US$792 million in 2003, compared with the staff estimate of US$654 million.
  - At end-2004 the external current account deficit reached 8 percent of GDP compared to a 4 percent deficit at end-2003; it was almost totally covered by foreign direct investments that reached 7.3 percent of GDP.
- Trade and services:
  - Preliminary 2003 balance of payments data confirm rebound of export-oriented services in latter part of year, notably trading activity in the Colon Free Zone and ports.
  - Exports grew at a faster rate than imports in 2004.
- Panama Canal:
  - Revenues of the Panama Canal Authority (ACP) increased 15.8 percent in FY2004, breaking the one billion dollar level.
  - In 2004 the Canal serviced 14,035 ship-crossings, a 6.7 percent increase compared to 2003.
  - At present rate of growth in cargo and ship-crossings, canal capacity may be reached by 2012.
  - A referendum is expected late this year to authorize expansion; estimated construction time of eight years.
  - Main users: the U.S., China, Japan, Taiwan, and Chile.

### Fiscal policy and public finances
- 2003 and 2004 fiscal outcomes:
  - On March 11, the Minister of Economy and Finance announced that the nonfinancial public sector deficit for 2003 was 1.9 percent of GDP, compared with the limit of 2 percent of GDP under the Fiscal Responsibility Law.
  - SM/04/65 reported a 2003 deficit of 2.4 percent of GDP (staff could not yet ascertain reasons for difference versus 1.9 percent).
  - As the administration took office on September 1, 2004 the non-financial public sector deficit reached 5.0 percent of GDP at end-2004.
- Government actions and 2005 budget:
  - Immediate expenditure restraint of US$225.8 million; non-renewal of personnel contracts; plan to gradually reduce unpaid arrears with suppliers.
  - The 2005 budget envisages a fiscal deficit of 3.8 percent of GDP, with stiff controls on current public expenditures.
  - Authorities committed to protect outlays for key social sectors and improve targeting of subsidies for electricity, water, cooking gas, and preferential interest rates for low-income housing.
  - Continuation of priority infrastructure projects related to water distribution, electricity, and irrigation.
  - Proposal of new norms to be included into the Fiscal Responsibility Law to enhance fiscal transparency, provide for clear enforcement of fiscal policy, and promote healthier public finances.
  - Staff considered the authorities’ fiscal policies and targets appropriate and in line with the Fund’s recommendations.
- Public debt and reforms:
  - Public debt level increased to US$9.98 billion at end-December 2004.
  - A fiscal reform yielding a 1 percent of GDP has been approved; a social security reform package is under discussion in addition to tighter government expenditure controls.
- Fiscal law (Law no. 6, approved February 2, 2005) highlights:
  - Public payroll to be scaled down by early 2008 to a range of about 165-170 thousand from the existing over 180 thousand, taking into account exceptions in health, education and security services.
  - Imposes ceilings on current expenditures, professional service contracts; reduces by 60 percent the number of vacancies within the next three years.
  - Increases operating fees, eliminates the industrial incentive law of 2004, and the exports incentives certificates (CAT’s), which will expire at end-2005.
  - Limits tax breaks on donations, taxes a share of Panamanians’ foreign income, widens the income tax base (including representation expenses), and envisages an anticipated withholding tax of 10 percent.
  - Implementation timing: representation expenses measure took place last February; Free Zone new operating fees will take effect in June of 2005; other tax measures in January 2006.
  - Revenues to GDP ratio expected to increase to 15.4 percent from the present 14.6 percent level.
  - Strong fiscal discipline and prospect of a social security (SS) reform may bring the investment grade up on Panama’s sovereign rating.

### Financial sector
- Banking system indicators:
  - Banking system assets at US$33.2 billion, a 4.5 percent increase compared to 2003.
  - Liquid assets to deposit ratio was 42 percent last September.
  - Capital adequacy ratio stood at 18.6 percent, compared to a regulatory required CAR of 8 percent.
  - Return on capital for the banking system was 16.2 percent.
  - Return on assets was 2.3 percent, slightly higher than in 2003.
  - Non-performing loans declined to 1.8 percent from 2.7 percent in 2003.
  - Domestic credit has grown steadily, with both foreign private banks and public banks accounting for most of the growth.
- Supervision and international standards:
  - SoB enhanced consolidated and cross-border supervision and is taking steps to meet Basel II risk requirements by 2008.
  - Banking system surveys in progress to evaluate future capital requirements, risk supervision, and legal framework for Basel II adoption.
  - An MFD mission is to travel to Panama shortly to complete a Model 2 OFC review, looking into AML/FT, insurance sector legislation, and domestic stock market framework vis-à-vis international standards.

### Structural reforms and trade policy
- Social security reform:
  - Consultations aimed at SS reform started in mid-2001 under UNDP sponsorship; discussed during 2003 Article IV consultation.
  - Reforms may entail changes in contributions, retirement age, services coverage, and replacement payments to ensure long-term fiscal sustainability.
  - An information campaign on the precarious fiscal situation of the SS system was launched in mid-February.
  - Reform package will reach the legislature after consultation with civil society and stakeholders; retains full ownership by the authorities.
- Other structural measures: judicial reform, deregulation, governmental restructuring, attracting foreign investments, and promoting exports.
- Free trade agreements and trade issues:
  - Panama negotiating trade agreements with Costa Rica, Mexico, Nicaragua, Singapore, and the United States.
  - Interest in joining the G-3 Group (Mexico, Venezuela, Colombia).
  - Joined Ecuador, Honduras, Guatemala, Costa Rica, Colombia, and Nicaragua on efforts to curb EU proposed “tariff only” for banana imports to be in effect in January 2006.
  - EU proposed a US$300 dollar tariff per ton --from the present US$75 per ton-- when the 2.6 million-ton quota system expires.
  - Panama exports 80 percent of its production to the EU and competes with duty-free banana from the Africa, Caribbean, and Pacific group (ACP).
  - U.S. FTA negotiations started April 2004 and have gone through eight rounds; remaining areas for a ninth round include agricultural products, access to Panama Canal procurements, and textiles.

### Investment activity and mega-projects
- Canal and reverted areas:
  - Second bridge over the Panama Canal: US$200 million public investment; access routes in final conclusion.
  - ACP implemented an investment and maintenance program of nearly US$170 million in 2004.
  - Private investments surged at over US$300 million primarily in the maritime sector, tourism, commercial services and infrastructure.
  - PPC-Hutchison Wampoa concluded a port expansion in 2004 at a cost of over US$200 million to service Panamax ships.
  - Evergreen and Manzanillo International Terminal (MIT) upgraded port facilities.
- Other investments:
  - New shopping mall and hotel in Panama City costing US$100 million now in service.
  - Expansion of Tocumen international airport began at end-2004.
  - Bayano hydroelectric plant increased capacity by 20 percent after a US$40 million investment.
  - La Fortuna hydroelectric starting a US$ $225 million expansion program to increase capacity to 150 megawatts.
  - At end-2004, total electricity production stood at slightly over 5,000 megawatts, with 58 percent produced by hydroelectric plants.
- Mega-projects under consideration:
  - Construction of new sets of locks in the Panama Canal: an approximate investment of over US$4.5 billion.
  - Gas pipeline and electricity inter-connection with Colombia:
    - Gas pipeline estimated cost of US$200 million and could be in operation in 24 months.
    - Colombian electricity 300 megawatts interconnection has two alternate routes of 571 km and 514 km costing US$169 million and US$139 million respectively.
  - Venezuela considering transport of oil in the trans-Panama oil pipeline (Petroterminales) with pumping capacity of 860,000 bbl per day.
  - Construction of a port in the Pacific coast with an investment of US$600 million; interested firms include Evergreen, PSA, COSCO, Maersk Sealand, and P& O.
  - PPC-Hutchinson Wampoa and MIT port operator will invest US$500 million in 2005 for expanding Atlantic-side port facilities.
    - MIT has already invested US$300 million in its port facilities.
    - PPC-Hutchinson Wampoa has a total investment to date of US$340 million in the Balboa Port on the Pacific side.

### Conclusion and governance
- Key challenges: enhance economic growth potential, improve government finances, and strengthen transparency and accountability.
- Anti-corruption measures:
  - Strong commitment to zero-tolerance policy on corruption.
  - An Anti-Corruption Council was established; audits of specific government institutions are underway.
  - UN Convention Against Corruption sent to the Legislature for approval.
- Private sector and competitiveness:
  - Authorities aware of need to enhance private sector environment and pursue policies to strengthen foreign investments.
  - Reactivation of the “Compete Panama” program, in partnership with the IDB, to reduce red tape and enhance business creation, investments, and employment generation.
- Social policy: Authorities express strong determination to improving social conditions for the poor and the most vulnerable groups, supported by the strong political mandate of the May 2004 elections.

*Source: _cr06130 - 2.2 percent.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06130.pdf_