Honduras—Letter of Intent, Memorandum of Economic Policies, and Technical Memorandum of Understanding

Tegucigalpa, February 2, 2004

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

Dear Mr. Köhler:

1. We enclose with this letter the Memorandum of Economic Policies (MEP) that underpins our economic program and poverty-reduction strategy during 2003–06, and sets out specific objectives and quarterly financial and structural targets for 2004.

2. To strengthen our efforts to alleviate poverty in Honduras, we need a stable macroeconomic framework to revitalize growth while keeping inflation low and improving our external position. Given the importance of ensuring that the macroeconomic adjustment in the program is acceptable to the Honduran public, our government has made every effort to reflect social concerns in the program, following an ample participatory process to update the poverty reduction strategy and the establishment of a National Dialogue. The updated PRSP, which is the key policy document underpinning this program, was sent to the Fund on December 11, 2003. The participatory strategy aims at establishing strong ownership of the goals of the program.

3. The key components of the program are:

• A medium-term macroeconomic framework consistent with an increase in sustained growth and achievement of the targets in the updated poverty reduction strategy;
  
  
• A strong fiscal adjustment that will contain the wage bill and strengthen the revenue effort, while allowing a steady increase in anti-poverty spending;
  
  
• A far-reaching reform of the financial system to strengthen its financial health; and
  
  
• Improvements in governance and transparency.

4. To support these objectives and policies, Honduras hereby requests a three-year arrangement under the Poverty Reduction and Growth Facility (PRGF) in a total amount equivalent to SDR 71.2 million (55 percent of quota), to be provided in seven equal semi-annual disbursements. The Government of Honduras also requests the resumption of interim assistance under the Enhanced HIPC Initiative in an amount equivalent to SDR 4.3 million, which will cover 42.8 percent of principal obligations falling due to the Fund between February 18, 2004, and February 17, 2005, assuming Board approval of the proposed PRGF arrangement by mid-February 2004, and that Honduras will reach the completion point in March 2005.

5. Our government believes that the policies set forth in the attached Memorandum of Economic Policies (MEP) are adequate to achieve the objectives of its program, but it will take any further measures that may become appropriate to this purpose. Honduras will consult with the Fund on the adoption of these measures, and in advance of the revisions to the policies contained in the MEP, in accordance with the Fund's policies on such consultation. Honduras will provide the Fund with all necessary data on a timely basis for monitoring purposes. During the program period, the government will not introduce or intensify any exchange rate restrictions or multiple currency practice, conclude any bilateral payment agreements that are inconsistent with Article VIII of the Fund's Articles of Agreement, or introduce or intensify import restrictions for balance of payments purposes. Consistent with its intention to keep the public informed about its policies and objectives, the government will publish the MEP and will report periodically on progress under the program.

6. We propose that the Fund carry out reviews under the 2004 program in September 2004 and March 2005 based on the observance, respectively, of end-June and end-December 2004 quantitative and structural performance criteria established in Tables 1 and 2 of the attached memorandum.

7. We are confident that the program will deliver sustained growth and substantive poverty-reduction, and hence that it deserves the support of the international community.

Sincerely yours,

MEMORANDUM OF ECONOMIC POLICIES
OF THE GOVERNMENT OF HONDURAS

I. INTRODUCTION

1. The Government of Honduras has decided to implement a three-year program for poverty reduction and growth that can be supported by the International Monetary Fund and will give Honduras access to further debt relief from the international community under the enhanced HIPC Initiative.

A. Program Objectives

2. A main goal of the program will be to address the rising fiscal pressures the government has been facing since it assumed office in January 2002. The elimination of these pressures is the only way to make adequate funding available for programs which support growth and fight poverty, the two basic objectives of Honduran society, as reconfirmed by the participatory process for the updated Poverty Reduction Strategy.

3. The government, conscious of the need to ensure that such a program is acceptable to the Honduran public, has supplemented the unavoidable adjustment measures in the program with reforms which respond to social concerns raised in the National Dialogue. The aim is to ensure the program is one which goes beyond a narrow resolution of our fiscal problems by broadening and strengthening the commitment to fighting poverty, sharing resources more equally among social groups, escalating the struggle against corruption, fortifying the financial system, and articulating the government's macroeconomic strategy for increasing growth. The program deserves the financial support of the international community, not only because of the courageous adjustment measures it contains, but more importantly because its fundamental goal is to raise the living standards of the Honduran people.

B. The Economic Background

4. When President Maduro took office in January 2002 the fiscal situation was very weak. The consolidated public sector deficit, which had averaged 1.8 percent of GDP in 1995–2000 rose to 3.2 percent of GDP in 2001, and the quality of expenditure deteriorated markedly with increasing current expenditure, particularly from generous salary increases granted beginning in 1998, and low investment in social sectors. Furthermore, the new government inherited substantial wage demands that had not been incorporated in the 2002 budget. As a result, the deficit widened further to 3.6 percent of GDP in 2002 despite a package of revenue measures adopted midyear. For 2003, the wage bill would have grown to more than 11 percent of GDP (from 6½ percent in 1997) if the government had not begun to take remedial action.

5. In addition, the Honduran economy had been hurt by numerous external shocks, some of which continue to have repercussions. These include natural disasters, the slowdown of the U.S. economy, and a persistent decline in the terms of trade caused by unprecedentedly low coffee prices and rising world oil prices. This situation has put severe pressure on the external current account deficit, and, despite large aid inflows, on the financing needs of the balance of payments. Real GDP per capita declined by an average ½ percent a year over the last five years, while two-thirds of the population remains poor-with half in extreme poverty.

C. The Social Framework for the Program

6. The government's ability to implement the program will critically depend on the public support that can be assembled.

• In the first half of 2003, the government asked civil society and the international community to review the Poverty Reduction Strategy Paper (PRSP) completed in 2001. Based on that review, a Progress Report on the implementation of that strategy was completed in November 2003. This exercise has served to reconfirm and clarify society's priorities and commitment to the PRSP process. The prioritization of programs in the progress report, and the macroeconomic framework presented in it, serve as the basis for the economic program described in the rest of this Memorandum. By using the Poverty Reduction Strategy as the framework for the program, the program's policies aim to respond to the needs of the population (and in particular of the less privileged) as fully as public financial resources permit without endangering fiscal sustainability.
  
  
• The encouraging participatory process that evaluated and updated the Poverty Reduction Strategy has been followed by two complementary consultation processes, the National Dialogue and the Fiscal Responsibility Pact, in which all sectors of society have been invited to participate. These ongoing discussions have served to develop understanding of the nature of the adjustment problem, while drawing attention to the more deep-rooted concerns of society which need to be taken into account if the adjustment is to be socially acceptable. We believe that these consultations have established the social legitimacy of the program we propose to implement, and we will maintain and deepen ownership over the period of the program.

II. STRATEGY AND TARGETS FOR THE PROGRAM

7. The program contains the following major components: (1) a medium-term macroeconomic framework reflecting the debt relief and other international financial support associated with the program, consistent with a reactivation of growth and with the targets in the updated Poverty Reduction Strategy; (2) detailed fiscal, monetary, and external sector policies and structural reforms; and policies intended to respond to social concerns, including strategies for (3) reforming the financial sector, and (4) improving governance and transparency in other areas of the economy.

A. The Medium-Term Macroeconomic Framework

8. In line with the goals of the updated Poverty Reduction Strategy, the program aims to raise growth to an annual 4½ percent by 2006, targets a gradual decline in inflation to the level in trading partners by 2008, and provides funds considered sufficient to lower the incidence of poverty to 42 percent of the population by 2015. The external current account deficit will widen temporarily to reflect large investments of vital importance to the government's growth strategy, while gross international reserves will be accumulated to a level consistent with maintaining import coverage of four months to ensure external sustainability.

Macroeconomic Framework
	2003	2004	2005	2006
(Annual percentage changes)
GDP at constant prices	3.0	3.5	4.0	4.5
Consumer prices, end of period	6.8	6.7	6.0	5.0
(In percent of GDP, unless otherwise noted)
Combined public sector savings	1.4	3.9	4.8	5.9
Anti-poverty spending	7.5	8.1	8.7	9.4
Combined public sector balance	-4.6	-3.0	-2.5	-1.7
Of which:
Central government balance	-5.5	-3.5	-3.0	-2.5
External current account balance	-5.2	-7.1	-4.5	-3.8
Gross international reserves (months of imports)	4.0	4.0	4.1	4.1

B. Growth

9. The strategy for revitalizing growth has several elements. First, public investment will increase to meet key infrastructure needs and complement private investment. For 2004, the public investment program focuses on road construction and low-income housing (particularly in rural areas), and the expansion and upgrading of the telephone network. Second, large private investments are expected, in particular, in electricity generation, telecommunications, tourism, textiles (maquila), and agriculture. The monetary program has been designed to allow adequate provision for financing potential private sector investment. Third, recent and pending reforms in governance and transparency (e.g., of the judicial system and of the property cadastre and titling) are expected to improve the investment climate and attract further new investment-as will the consolidation of price stability and external sustainability. Fourth, structural reforms to improve the efficiency of the public sector and the soundness of the financial system should provide a stronger institutional backdrop for growth. Fifth, a successful conclusion of the Central American Free Trade Agreement is expected to open additional markets and create pressures to enhance efficiency. And finally, the government is committed to maintaining competitiveness in the more open environment through its exchange rate policy, and enhancing it through improvements in productivity.

10. The government sees participation in the Central American Free Trade Agreement (CAFTA) as a key element of its strategy for boosting Honduras' growth potential. Participation in CAFTA is expected to make access to the U.S. market more permanent and grant exporters and investors a fuller set of protection and dispute resolution rules. Furthermore, the agreement will motivate us to upgrade existing rules and institutions regarding investment and trade (e.g., involving intellectual property rights, and labor and environmental regulations). These changes are expected to lead to higher foreign and domestic investment. Also, the government plans to review, with support from IDA, the potential impact of CAFTA on the poor and most vulnerable members of society, in order to prepare timely compensatory actions.

11. The objective of the National Competitiveness Plan, launched in May 2002, is to improve the climate for private investment over the next five years, thereby ensuring that Honduras captures all potential benefits from CAFTA. The plan places priority on the development of agribusiness, forestry, maquila, and tourism, which are areas with particular growth potential. It contains actions to increase factor productivity, foster a more competitive business environment, and promote export growth. With a view to upgrading regulatory practices and encouraging private sector investment, the government will seek passage of a competition-promotion law during 2004, changes in the framework law for telecommunications by mid-2004, of a new framework law for transportation by end-2004, and possibly also a framework law for the electricity sector. With these laws, the private sector will be able to obtain concessions to operate Puerto Cortes, and carry out projects to increase the number of telephone lines, and broaden the power sector network. To facilitate the goals of the National Competitiveness Plan, the Government will: (1) implement the administrative simplification law passed in 2002 to shorten the time required to start up new businesses; (2) merge by June 2004 the land registry and cadastral functions into a single agency to enhance land tenure security; and (3) improve the public vocational training system, through the reorganization of INFOP (the National Institute for Vocational Training) and separation of the provision and certification of training activities. Furthermore, within the context of the annual minimum wage negotiations, the government will encourage containment of minimum wage increases in real terms to what is justified by productivity.

12. One of the measures taken to cushion the social impact of the program, especially on lower-income groups, is a selective price freeze until June 30. The government is aware of the distortions associated with price controls and the likely negative implications for growth. Hence, in agreement with the private sector, the price freeze has been limited to a few basic products of most importance to the poor, and the June 30 expiration date will be strictly observed. Moreover, the government will seek to accelerate the approval of the competition-promotion law to before June 30 if possible-upon which the price freeze would automatically expire. No further price freezes will be introduced during the program.

C. Poverty Reduction and HIPC Goals

13. In line with the priorities established in the consultation process for the Poverty Reduction Strategy, anti-poverty spending for 2004–06 will focus on projects to: (1) broaden the quality and coverage of education and health; (2) improve basic rural infrastructure (water and sanitation, roads, electricity, and telecom networks); and (3) enhance the social safety net for the poor, particularly ethnic minorities and women.

14. The updated Poverty Reduction Strategy redefines eligible poverty-reduction spending to cover a broader range of priorities than in the original version (including, for instance, the hiring of teachers for rural areas as well as the investment projects previously emphasized). The broader definition of such spending should help ensure that the budget devotes enough resources to anti-poverty programs-and allows these to be sufficiently flexibly targeted-to make reaching the Poverty Reduction Strategy goals feasible.

15. To ensure these resources are spent as promised, the government will continue enhancing its mechanisms to track anti-poverty spending. All poverty-reduction spending under the new definition will be identified by budget code before the program is approved, so that it can be fully monitored under the program. To minimize the possibility of misuse of the spending, monitoring according to the revised definition will be fully automated by end-2004. Automation of the reporting process will be developed over the year, with expected deadlines of March 2004 for automated reporting of poverty-reducing spending financed by external funds, May 2004 for the linking of spending, debt and grant data (under an UNCTAD contract), and full operation of the automated system by September 2004. For monitoring purposes under the revised definition, the database recording the number of teachers will be maintained up to date.

16. The government intends to maximize the debt relief available to Honduras by attaining the HIPC completion point as soon as possible (in early 2005). This will require maintaining a track record of compliance with the program and successful implementation of the PRSP, as well as implementing the structural and social reforms laid out in the decision point document. The government has already implemented most of these reforms but will continue to make reforms in relevant areas during 2004. Specifically: (1) a comprehensive participatory anti-corruption strategy has been presented to the national and international community, and implementation has begun; the abolition of immunities for officials will strengthen the program in 2004; (2) the Social Security Law has been reformed to increase contributions by a factor of eight, permitting the IHSS health program to expand coverage; IHSS pension and health funds have been separated; and work is underway to strengthen the regulatory capacity of the health secretariat with support from the World Bank and IDB; (3) to strengthen basic health services for the poor, a package of services has been delivered to 181,000 people in 749 communities as of November 2003, almost double the targeted figure of 100,000; (4) to improve the quality of education, 1,700 PROHECO (community managed) schools have been established as of November 2003, well above the targeted 1,350 schools; (5) to improve the efficiency and targeting of social safety nets, FHIS has continued to base its programming on participatory planning methodologies, and a national model for participatory municipal-level planning is being developed; and (6) to strengthen the financial sector, the financial sector reform includes a timetable for compliance with Basel principles.

D. International Financial Support

17. The government is confident that this program will be backed by the support of the international community. International financial support (including debt relief) will help pay for poverty-reduction programs and will allow the pace of fiscal adjustment to be more gradual than would otherwise be possible.

18. The government envisages that the fiscal financing gaps in the program can be closed through the combination of: (1) a flow rescheduling by Paris Club creditors of the debt service falling due in 2004 and early 2005, and of the stock of arrears incurred in 2002–03; (2) program grants and loans from bilateral donors and multilateral creditors for poverty alleviation and reforms in the financial system and the public sector; and (3) debt relief upon reaching the HIPC completion point. The government will also explore with Paris Club creditors options to obtain additional debt relief (beyond HIPC) and will seek additional support from donors in the context of the upcoming Consultative Group Meeting tentatively scheduled for the first half of 2004.

19. The combination of domestic adjustment and external debt relief should, according to the medium-term policy framework, make the public debt manageable. Total public debt is expected to decline to 51 percent of GDP by 2006, down from 72 percent of GDP in 2003 and 82 percent in 1999, before Honduras reached the HIPC decision point in 2000 and first began to receive HIPC debt relief. Specifically, the NPV of external debt could be reduced gradually to 29 percent of GDP by 2006 (47 percent in 2003), to 151 percent of government revenue (248 percent in 2003), and to 77 percent of exports of goods and services (127 percent in 2003). Domestic debt will remain small over the medium term.

III. ECONOMIC AND FINANCIAL POLICIES

A. Fiscal Policy

20. The fiscal program will decisively tackle the imbalances that have threatened sustainability, but with a mix of adjustment measures chosen by the government to be least painful to society and to spread the adjustment burden as broadly as possible.

The fiscal strategy for 2004–06

21. The deficit of the combined public sector will be limited to 3 percent of GDP in 2004, 2½ percent in 2005, and 1¾ percent in 2006. The central government deficit will be targeted at 3½ percent of GDP in 2004, 3 percent in 2005, and 2½ percent in 2006. Meeting these goals will result in a significant increase in public sector savings to close to the level of the late 1990s by 2006.

22. To attain the needed increase in public sector savings, it will be necessary to slow the rate of increase of public sector wages, and ensure that wages are equitable across different groups of public sector workers. To avoid putting an intolerable adjustment burden on government wage-earners, the government has also made savings in other areas of non-poverty-reducing spending, and has taken the difficult step of restoring fuel tariffs. The need to raise taxes has been lessened by the elimination of numerous tax exemptions outside the basic consumption basket, and measures to improve the operating balance of public enterprises. The government will also pursue a long-term strategy of pursuing noncompliant taxpayers, recovering assets from sectors which received taxpayer-financed support, and prohibiting new bail-outs, with a view to raising significant additional resources which can be used to improve the equity of spending over the medium term.

23. The increase in public savings will allow poverty-reduction spending to rise by 0.6 percent of GDP in each year of the program, from 7.5 percent in 2003 to 9.4 percent in 2006. In light of the need to demonstrate progress in poverty reduction, the government has agreed that the poverty-reduction spending target should be subject to program conditionality.

24. If fiscal deficits can be contained to the targeted levels, the need for domestic financing of the central government will sharply decline (from 4 percent of GDP in 2003) and be eliminated by 2005—assuming that sizable financing gaps (close to 5½ percent of GDP in 2004 and 2-2½ percent a year in 2005–06) can be filled by external support. If this additional support falls short of what is estimated, the government will implement further measures to preserve poverty-reduction spending and investment, while maintaining the combined public sector deficit at financeable levels throughout the program.

25. During the period of the program, the government commits to the contracting of external debt only on concessional terms-with the exception of up to US$3.3 million for the purchase of a building for the diplomatic missions of Honduras in Washington, D.C. The government will make every effort to maintain the deficit of the central government at a level consistent with concessional external financing starting in 2005.

The 2004 fiscal program

26. The combined public sector deficit will be reduced by 1.6 percent of GDP to 3 percent in 2004, and the central government deficit by 2 percent of GDP to 3½ percent (5½ percent in 2003); central government domestic financing will be limited to ½ percent of GDP. The adjustment will be reinforced by structural reform to achieve a sustainable government wage policy, the termination of government sectoral support including to agricultural debtors, and steps to improve fiscal governance and transparency. The expenditure envelope for the 2004 budget will be set in line with that of the program.

• To achieve the fiscal targets of the program, the government will reverse the sharp upward trend in the wage bill. No nominal wages will be cut, but no new salaries above L 60,000 a month will be granted. Mid- and high-level civil servants will receive no increase in 2004 and others will receive an adjustment depending on expected inflation—according to a new permanent salary determination formula developed in consultation with employees. Employees in decentralized agencies (including public enterprises) will be subject to the same wage policy in 2004 to the extent that the resources of these agencies permit and excepting any agreements covering the period which were concluded before mid-November 2003.
  
  
• The wage reform eliminates all special wage regimes by end-2006, broadening the scope of wage policy to cover all government employees, and allowing the government to set wage bill ceilings in line with fiscal objectives and financial constraints. The reform fully incorporates the wage bill of medical doctors into the wage policy from the beginning of 2005 (with the only distinction being an annual inflation catch-up from 2006 onward) and that of teachers (half of total wage outlays) by January 2007, with salaries in 2004 maintained constant for doctors and with a lower than previously envisaged increase for teachers in 2004 and 2005. Existing supplementary payments to teachers will be set at end-2003 nominal values, and new supplementary payments will be capped through 2006 as described in the 2004 budget law. These measures will permit the wage bill to continue to grow but at a slower pace than in recent years, thereby causing it to decline in terms of GDP.
  
  
• Though the wage containment strategy described above is gradual, the government is strongly committed to re-establishing an affordable and equitable wage system, and to that end will take additional rationalization measures. The government has already begun a process of 're-engineering' the public sector, with a view to merging and streamlining institutions, and expects that savings from this process will amount to 0.2 percent of GDP in 2005 and 0.4 percent in 2006. The ongoing first step includes detailed analytical work and implementation of restructuring strategies in the three largest ministries: education, health, and agriculture, to be concluded by March 2005. The process of identifying ghost workers and eliminating them from the payroll will be widened, and the likely savings will be taken into account in the first review. The government intends to pursue a more far-reaching human resources reform in the context of a World Bank credit, to be agreed before April 2004.
  
  
• The government will also contain expenditure by around 0.3 percent of GDP relative to the draft budget submitted to congress in September 2003, by maintaining some current transfers constant in nominal terms and other efficiency savings. On the tax side, besides the significant reduction in tax exemptions, the government has fully implemented tax measures approved in April 2003 by raising the excise tax on cigarettes and collecting sales taxes on credit card transactions. These measures, together with the restoration of fuel tariffs, are projected to increase tax revenue from 16.6 percent of GDP in 2003 to 17½ percent in 2004, though this projection is subject to risks from tax administration constraints and the potential impact of lower import duties following the implementation of CAFTA (more likely in 2005). In the case that deviations from the fiscal projections start to emerge, the government will take prompt corrective steps to ensure the deficit target for the central government.
  
  
• The government is committed to enforcing current tax laws to the fullest extent, to minimize the need for further tax measures. Since 2002, 1,600 businesses were sanctioned with temporary closure for noncompliance with the sales tax law, and the DEI will build on this achievement through an action plan for improving tax and customs administration in 2004 and beyond. The Tax Code will be modified (by September 2004) to strengthen the collection and enforcement powers of the DEI (inter alia by the introduction of appropriate payment facilities, and more realistic penalties against tax fraud and evasion). The National Tax Register will be overhauled by the second quarter of 2004. Filing, control, and audit procedures for large taxpayers will be improved, including by extending the coverage of electronic filing to 100 percent of large taxpayers by September 2004, by training of auditors, and by the establishment of a new tax office in San Pedro Sula. The DEI intends to more than double the number of audits in 2004. The government intends to introduce two chambers of specialized tax courts before end-2004, to streamline the appeals process.
  
  
• The customs administration will be made more efficient by the elimination of internal customs facilities and transit procedures, and the concentration of resources at points of entry by June 2004. Control of trade will be much enhanced by requiring all large exporters and importers (including depots, industrial parks, those eligible for special customs regimes, customs agents, shipping companies, transport agencies, etc.) to complete import/export procedures on line from March 2004. To limit the undervaluation of imports, the government is negotiating, in tandem with other governments in the region, with pre-shipment companies to have prices of imports valued at origin, starting in 2004.
  
  
• The program contemplates steps to contain the deterioration in the operating surplus of public enterprises in 2004, to help finance the pro-poor capital outlays identified in the Poverty Reduction Strategy. These steps comprise the implementation before end-2003 of the modification in the formula for adjusting electricity tariffs defined in note CNE00155-2003 of the National Energy Commission, and a wage increase of up to 6.7 percent in all public enterprises, in line with the wage policy outlined above. Two large thermal projects by the private sector are scheduled to come on stream this year, which will result in important savings in operating outlays (by 0.4 percent of GDP in 2004 and a further 0.4 percent in 2005) for the state electricity company. In the case that the envisaged operating savings do not materialize as planned, the authorities will implement further corrective measures in 2004 to ensure that the targets on the public enterprises' operating balance and the combined public sector overall balance can be met, while taking into account any impact from the investment adjuster described in paragraph 46.
  
  
• During 2003 the government awarded a second mobile concession to a private operator and launched the program Telephones for All, that opened up the fixed telephone market to private operators without tariff regulation. With these actions, significant private projects will be carried out to expand the fixed telephone network, new operators will interconnect through HONDUTEL, and telephone lines are expected to expand by at least 50 percent over two years. International calls will be opened to private operators starting in December 2005. In preparation, the National Telecommunications Commission will take steps to rebalance tariffs on local calls (these are among the lowest in the region) starting in 2004 to offset the impact of an expected significant decline in international tariffs. HONDUTEL will limit its investment spending to maintenance of the current network and rural expansion, which will keep investment at about 1¼ percent of GDP for 2004 and 2005.

The fiscal program in 2005–06

27. To achieve the fiscal goals of the program for 2005–06, the government will extend the income tax surcharge (5 percent) through 2006, and as noted below, eliminate those tax exemptions supported by the fiscal pact and the national dialogue. Moreover, it is the government's policy to prevent any decline in the real value of specific excises. Adjustments on the basis of these policies will need to more than offset the potential impact of CAFTA on revenue. In addition, we anticipate savings of 0.2 percent of GDP in 2005 and 0.4 percent of GDP in 2006 from our plans to downsize the central administration through the restructuring of the ministries of education and health, and closure of redundant offices. Increases in public investment in each year of the program are a high priority for the government, but such increases will be maintained consistent with overall program goals. Measures to close any remaining fiscal gaps will be identified during the first and third reviews of the program. The government will take all measures necessary to ensure that the deficit targets of the program are met.

B. Monetary and Exchange Rate Policy

Targets and strategy

28. In the context of the existing crawling band arrangement, monetary policy will aim at reducing inflation to 6.7 percent in 2004, 6.0 percent in 2005, and 5.0 percent in 2006, and in the medium term to the levels of Honduras' main trading partners. To this end, the central bank will conduct cautious policies during the program period. The stock of net domestic assets will be limited to L -14,075 million at end 2004, while the floor on the stock of net international reserves of the central bank (NIR) will be set at US$1,205 million. This floor should allow end-2004 gross international reserves to remain at 4.0 months of imports, and provide more than 100 percent coverage of short-term liabilities (including money base and CAMs).

• The improved fiscal stance expected for 2004 will facilitate meeting the targets specified above. This, in turn, will be consistent with private sector credit growth faster than inflation. The quantities of CAMs placed at the auctions will be consistent with the achievement of the quarterly NIR targets, and interest rates on CAMs will be allowed to increase if necessary to clear the auctions.
  
  
• While the central bank's weekly auctions of CAMs will remain its main monetary policy instrument, the central bank recognizes the importance of developing further defenses to protect its NIR. The central bank will use technical assistance to develop these defenses, and will ensure that the rate of crawl and other aspects of the band regime remain appropriate over the period of the program.
  
  
• The central bank will continue to take steps to discourage the dollarization of financial system operations, and in this connection, will maintain reserve and liquidity requirements for foreign currency deposits at the current levels. It will also maintain the present limits on foreign currency credit to the private sector.

Strengthening monetary management

29. To enhance the effectiveness of monetary policy, the central bank will, with the assistance of an MFD technical assistance mission in early 2004, (1) make the use of indirect instruments of monetary management more effective; (2) improve interest rate signaling to the market; and (3) define the appropriate limit on open market operations denominated in dollars. The central bank will implement these modifications within a timetable to be finalized by end-September 2004. Prior to agreement on the appropriate limit for dollar-denominated open-market operations, the ceiling on these operations will be US$65 million.

30. To improve the lender-of-last-resort facility, the central bank will seek to redefine the legal framework for its liquidity support to the financial system by June 2004, and fully implement the framework by the first review, so as to ensure that this support takes the form of quick-disbursing short-term loans with the highest interest rates in the market. Central bank liquidity support will be provided only to illiquid, but solvent banks and clear limits will be set on it, not to exceed the recipient bank's capital. While the government does not anticipate supporting insolvent banks, if, in an extreme case, such support were necessary to avert a systemic crisis, these funds will be provided by the government, and offset by compensatory measures in the fiscal program.

31. In consultation with the ministry of finance, the central bank will design a mechanism through which the government will capitalize the central bank for past operating losses, and will gradually assume all future central bank cash losses. The MFD technical assistance mission will provide recommendations on this front and the timetable of actions will be agreed during the first review of the program. The fiscal implications of these operations will be reflected in the central government accounts.

32. The central bank will upgrade the payments system. Plans will be prepared by December 2005 to separate large-value and low-value payments. Large value payments will be moved to a parallel payments system with adequate risk management mechanisms. The securities settlement infrastructure will be modernized to support the development of an efficient interbank market.

33. The central bank will improve transparency in monetary policy by keeping the public informed about monetary developments, and publishing the full set of financial statements, including the opinion of the external auditor and the explanatory notes, beginning with the 2003 Annual Report. It will complete the process of appointing the external auditor by end-September each year. It will expand the scope of the Internal Audit Department's audit plan from 2004 on, to include audits of the process of reporting monetary data to the IMF and audits of controls over central bank investments.

34. The central bank will seek congressional approval by June 2004 of reforms to the Central Bank Law to redefine the lender of last resort mechanism, will require the government to capitalize the bank and assume cash losses in the future, and will adopt provisions to prohibit the central bank from guaranteeing debts of other entities and to preclude distribution of unrealized profits.

C. Financial Sector Reform¹

35. To improve the soundness of the Honduran financial system, the government has embarked on a comprehensive reform program that includes actions to: (1) improve the prudential regulatory framework and ongoing supervision, and (2) enhance the efficiency and effectiveness of the financial safety net. The reform will also strengthen mechanisms to prevent money laundering and financing of terrorism and deter domestic financial crime. Critical elements of this reform will be implemented in 2004, as the current universal deposit scheme is scheduled to expire by October 2004.

Prudential regulation and supervision

36. Strengthening supervision and prudential regulations means giving the National Banking and Insurance Commission (CNBS) the tools to guarantee that all financial institutions reach and maintain healthy solvency and liquidity indicators. The main actions will include:

• The introduction of legal changes by June 2004, and, by December 2004, of the regulatory reforms necessary for the implementation of consolidated supervision, followed by the training of supervisors to conduct consolidated supervision in pilot exercises from June 2005 onward, with the goal of having consolidated statements of the entire sector by December 2006.
  
  
• Finalization by the CNBS of a timetable to comply with new regulations on capital adequacy, loan classification, and provisioning (including for investment in FONAPROVI bonds) by end-June 2004.
  
  
• Implementation of regulations issued in December 2003 to bring the calculation of the capital adequacy ratio in line with Basel standards.
  
  
• A strengthening of loan loss provisioning, as provided by the new regulations issued in December 2003. At the time of the first program review, the CNBS will discuss with the Fund a timetable for each bank to bring provisioning requirements into full compliance by December 2006. Meanwhile, the CNBS will continue to reinforce compliance with existing provisioning requirements. Provisioning requirements will also apply starting from January 2004, to the banks' investments in FONAPROVI bonds that resulted from the debt relief to agricultural producers.
  
  
• A gradual reduction in banks' related lending and the share of banks' equity in nonfinancial firms as mandated by congress in August 2002.
  
  
• Establishment of the legal basis for better risk management practices in the financial system through a set of new regulations by June 2004. In June 2004 and June 2005 the CNBS will conduct surveys to follow up on the compliance with these new measures, to ensure full compliance by December 2006.
  
  
• A regulation to reinforce governance requirements for banks' boards of directors, with clear accountability rules (June 2004).
  
  
• By the time of the first review, the CNBS will have put in place mechanisms to improve the breadth and quality of, and access to, credit bureau information.

37. By the time of the first program review, the CNBS will provide the Fund with a list of required capital increases by bank resulting from the enforcement of the new regulations described above, and will agree on a timetable for the increases, to be completed by December 2006. The modalities governing resort to the recapitalization fund will be agreed with the Fund during the first program review.

38. The CNBS will also by June 2004 introduce legal reforms to (1) strengthen its autonomy and accountability and take over some functions that correspond to the supervisory authority but are now carried out by the central bank; (2) strengthen sanctions against institutions not complying with regulations; and (3) introduce a special supervision framework for weak banks. The CNBS will train staff to enhance on- and off-site inspections, and will continue to enforce the requirement that banks publish quarterly financial statements.

Financial safety net

39. Action will be taken to make the financial safety net more effective and efficient, and to limit moral hazard. The authorities have recently taken resolute actions to deal with troubled banks². In dealing with these cases, the CNBS has realized that it is imperative to upgrade the financial safety net-the deposit insurance system and the bank resolution framework, as well as the lender of last resort function already discussed in paragraph 29. The government intends to address these issues, in line with IMF recommendations.

• The government will improve the financial position of FOSEDE, by recapitalizing FOSEDE through the recovery of past government loans to troubled financial institutions, by US$10 million in 2004 and a further US$10 million in 2005. FOSEDE will also be recapitalized by an additional US$10 million from IDB resources, currently scheduled for early 2006. Bank premia will remain at 0.25 percent of total bank deposits until banks are adequately recapitalized. The adequacy of the premia will be revisited at the second review. By June 2004 the government will introduce legal changes to adapt FOSEDE to its new exclusive role of manager of the deposit insurance scheme. Thus, its capacity to resolve stressed banks through intervention and recapitalization will be discontinued.
  
  
• An improved bank resolution framework will be put in place by June 2004. It will put more emphasis on early detection, to minimize the cost of bank resolution to government while preserving debtor discipline. The new framework will allow the CNBS to request, at an early stage, rehabilitation plans from weak institutions, and will bring the resolution mechanism under the CNBS' authority to expedite intervention. By December 2005, the CNBS will take action to resolve any non-viable institutions based on this new framework.
  
  
• In June 2002 congress approved a Law for Money Laundering Prevention and in September 2003 made the financing of terrorism a criminal offense. During 2004 the CNBS will improve multilateral and bilateral cooperation to combat these offenses; upgrade regulations on confiscation, freezing and seizure; and begin on-site verification of the supervised entities' policies for accepting clients. It will also introduce software systems to control unusual transactions, train specialized investigators, and apply for EGMONT membership.
  
  
• The government continues to be concerned about domestic financial crime. Hence, it will introduce amendments to the Penal Code by June 2004 to make such a crime a punishable act, and define adequate sanctions. Besides its inherent value, this measure will meet a main concern of the public—that financial wrongdoing leading to bank failure should not go unpunished.
  
  
• To achieve the changes mentioned above, the government will submit to congress a set of legal reforms that will be approved before June 2004. These include a new Financial Institutions Law, as well as amendments to the Deposit Insurance Law, the National Banking and Insurance Commission Law, and the Penal Code.
  

IV. GOVERNANCE AND SOCIAL EQUITY

40. The government is aware that social concerns about governance could undermine support for the needed reforms in the economy. Moreover, Honduras' disappointing standing in the recent Transparency International Index of Perceptions of Corruption risks damaging prospects for investment, both local and from abroad. The government has always been committed to fighting corruption and improving governance in Honduras. An Anti-Corruption Commission was established in 2001. The government has recently taken fundamental reform measures to address perceived shortcomings, and will continue to pursue an agenda for enhancing the transparency and probity of the public sector.

41. Recent governance and anti-corruption measures include fundamental judicial and political reforms and transparency measures.

• As regards judicial reform, (1) the independence of the Supreme Court has been strengthened by extending judges' terms of office beyond the election cycle and making reappointment possible; (2) a new Penal Procedures Code has been adopted, providing for open process; (3) judges are to be evaluated by an independent international company; and (4) plaintiffs may choose their own lawyers to handle foreclosure cases (an important anti-corruption measure). Before end-2004, the government intends to take further far-reaching measures to: (5) eliminate immunities from prosecution of congressmen and public officials; (6) strengthen the Penal Code to ensure that sanctions against financial crime are adequate and comprehensive; and (7) adopt a Civil Procedures Code to complement the Penal Procedures Code.
  
  
• Recent political reforms expected to improve governance include: (1) a reduction in the campaign cycle (to the last year of every presidential term)—a measure also expected to greatly improve economic management; (2) a more direct congressional election process; and (3) electronic voting in congress so that all voting records are known.
  
  
• In the area of fiscal transparency: (1) a large share of government procurement has been delegated to the UNDP (which has cut costs as well as limiting corruption) and an independent auditing process has been established for procurement; (2) the Comptroller General's office and Office of Public Ethics have been merged into an independent Superior Accounting Tribunal; (3) more than 1,200 businesses have been temporarily closed for nonpayment of tax and other fiscal fraud; and (4) the annual budget was submitted in full and in good time to congress, together with quarterly execution reports (for the first time in Honduran history). The government intends to build on these achievements in 2004 by: (5) strictly limiting the number of political appointments to the public sector and establishing a system of advancement based on merit; (6) incorporating in a permanent law the prohibition of intra-year unfinanced expenditure appropriations; (7) preparing finalized reconciled fiscal accounts as a prerequisite for the eventual goal of submitting audited fiscal accounts to congress; (8) enacting a new law to enhance control over National University decisions; and (9) establishing specialized tax courts.
  
  
• The government is particularly committed to reducing red tape to help improve the investment climate. A Simplification Law was approved by congress in 2002, and the Competitiveness Commission is pursuing further simplification of procedures. This reform, together with the adoption of a new property law facilitating the titling of land, will reduce transaction costs and speed up the process of starting a new company.

42. The government is also aware of concerns that bail-outs (condonaciones) and support for depositors in failed banks have pre-empted scarce public resources that could otherwise have contributed to poverty-reduction programs. The government has decided to abstain from all possible bail-outs over the period covered by the program. When bail-outs are unavoidable, their cost will be fully reflected in the budget and offset by compensatory fiscal measures—with a view to ensuring full public scrutiny of the bail-outs and congressional prioritization of the use of public resources.

• Successive support plans for agricultural loans approved in recent years have resulted in large fiscal cost, unfair distributional impact, and weakened incentives for creditors to remain current with loan obligations. To demonstrate its commitment to discontinuing bail-outs, the government has decided to prioritize the eligibility for support under the Agricultural Decree to small beneficiaries. Access to relief under the decree will terminate on December 31, 2003, and no further support to the agricultural sector will be extended over the course of the program.
  
  
• A limited amount of future public support for weak banks is provided for under the program as described above, to resolve previously identified problems in banks without unnecessary losses to savers. However, the government is committed to recovering as much as possible of the public resources used to support banks, with the goal of recovering L 360 million by December 2005. The strengthened sanctions against financial crimes referred to above should both limit misappropriation of bank assets and help enforce their recovery.
  

43. A goal of the government is to spread the tax burden as equitably as possible across society, to minimize its impact on any single group. The reduction in tax exemptions and measures to enforce tax collection described above represent the government's commitment to minimize tax increases by ensuring that existing taxes are fully collected. If consensus from the Fiscal Pact and the National Dialogue support a further elimination of tax exemptions, the government will submit these proposals for congressional approval before end-2004.

44. The government is committed to improving transparency in every domain. Honduras has participated in all evaluations of standards and codes for which the IMF takes lead responsibility. By the first review, the government will develop an action plan to improve Honduran statistics according to a prioritized list of reforms, with a view to participating in the IMF's General Data Dissemination Standards (GDDS).

V. PROGRAM MODALITIES

45. The program will have semiannual quantitative performance criteria, for end-June and end-December, and indicative targets for end-March and end-September, on (1) the stock of central bank net domestic assets and net international reserves; (2) the central government wage bill; (3) the overall deficit of the central government; (4) the overall deficit of the combined public sector; (5) net domestic financing of the combined public sector; (6) the non accumulation of external payments arrears; and (7) the contracting or guaranteeing of nonconcessional external debt. These are specified in Table 1. Quarterly indicative targets will be set on the operating balance of public enterprises and on (the new definition of) poverty-reduction spending.

46. Given the importance of a rapid implementation of key public sector investments to growth and the public finances, the program for 2004 envisages an adjustment of some of the fiscal targets (up to ¼ percent of GDP) to accommodate a higher execution rate of telecommunications projects than currently anticipated. In particular, the target on the combined public sector deficit and its domestic financing will be adjusted upward by up to L 335 million, in the event that investment by HONDUTEL exceeds the amount of L 1,543 million (1¼ percent of GDP) envisaged in the program.

47. Structural conditions (performance criteria and benchmarks) will focus on progress with the social objectives of the program and in particular with financial sector reform. These are listed in Table 2.

48. The program will be subject to semiannual reviews, to assess observance of performance criteria and benchmarks, and ensure that future targets remain viable. During the first review, scheduled for September 2004, the government will agree with the Fund on any measures needed to meet the fiscal targets for 2005, any reforms needed to enhance monetary and exchange rate management, and the timetable for complying with new rules for capital adequacy, loan classification, and provisioning. The review will also assess the consistency with understandings under the program of the regulations issued to implement the conclusions of the special wage commission created by Decree 220-2003. The second review, scheduled for March 2005, will include a focus on the adequacy of anti-poverty expenditure tracking, as well as on reforms in tax administration, governance, and transparency. The third review will, inter alia, address fiscal policy for 2006. The fourth and fifth reviews will address progress with the financial sector reform and with re-engineering of the public sector; the fourth review will also address the appropriateness of the monetary targets for 2006.

49. Access under the PRGF arrangement is requested in an amount of SDR 71.2 million (55 percent of quota), with seven equal semiannual disbursements. Outstanding IMF credit to Honduras would peak at 100 percent of quota in 2006, which would amount to a projected 5½ percent of exports of goods and nonfactor services and 11 percent of gross official reserves.

TECHNICAL MEMORANDUM OF UNDERSTANDING

1. This technical memorandum sets out the understandings between the Honduran authorities and the Fund for the monitoring of the first-year program during 2004 supported under the Poverty Reduction and Growth Facility (PRGF) arrangement. It defines the concepts used to assess observance of quantitative performance criteria and benchmarks specified in Tables 1 and 2 of the Memorandum of Economic Policies (MEP). It also specifies the frequency of the data to be provided to the Fund for monitoring the program.

A. Fiscal Targets

2. For the purposes of the program, the deficit of the combined public sector (CPS) will be measured from the financing side, which corresponds to the net borrowing requirements of the combined public sector, from both external and domestic sources. The combined public sector comprises the nonfinancial public sector (NFPS) and the operating result (quasi-fiscal balance) of the central bank. The NFPS covers the central government (including deconcentrated agencies), local governments and decentralized agencies, the social security institute (IHSS), the pension institutes for executive branch staff (INJUPEMP) and teachers (IMPREMA), and the public enterprises.

3. The deficit of the central government will also be measured from the financing side. The central government includes the executive, judicial, and legislative branches of government. It also consolidates the operations of the trust fund created by decree no. 68-2003 approved in April 2003 to support agricultural loans.

4. The central government wage bill is defined as all central government wages and salaries including severance payments, plus employer social security and pension contributions.

5. Anti-poverty spending comprises all spending on programs and projects of the Poverty Reduction Strategy (whether financed by domestic savings, HIPC debt relief, grants, and external loans), as presented in the relevant annex of the PRSP, approved in December 2003. Programs and projects in the PRSP will be labeled in the 2004 budget and tagged through the SIAFI. Anti-poverty spending will be presented by economic classification, type of program, and source of financing.

6. The operating surplus of the public enterprises is the difference between the operating revenue (excluding interest earnings and transfers) and the operating expenditure (excluding interest payments and transfers) of the enterprises. For the purposes of the program, the public enterprises comprise the state electricity company (ENEE), the state telecommunications company (HONDUTEL), the state water and sewerage company (SANAA), and the state ports company (ENP).

7. Net domestic financing of the CPS comprises the operating result of the central bank and the change relative to end-2003 in the stocks of: (1) outstanding indebtedness of the NFPS (direct bank credit plus bank holdings of public sector bonds less deposits) to the domestic financial system (central bank, commercial banks, and other financial institutions); (2) outstanding public sector bonds held outside the financial system; (3) outstanding deposits held abroad; and (4) outstanding suppliers' credit and floating debt (uncashed and undelivered checks, and unpaid invoices and orders) of the central government, and unpaid orders of the rest of the NFPS (all domestic debt is in domestic currency).

8. Discrepancies. The authorities will undertake periodic reconciliations to minimize potential discrepancies between above-the-line and financing data. If needed, these reconciliations should be carried out prior to completion of the first and second reviews under the program.

9. Adjustor. The ceilings on the cumulative CPS deficit and its net domestic financing will be adjusted upwards by up to L 335 million, in the event that investment by HONDUTEL exceeds the program amount of L 1,543 million.

B. Monetary Targets

10. Net international reserves (NIR) of the central bank. For program purposes, NIR will be measured as gross international reserves that are readily available (excluding the zero coupon bonds related to the CABEI rescheduling and contributions in gold/foreign exchange to international organizations other than the Fund) minus short-term reserve liabilities (including purchases and credits from the Fund) and minus foreign currency deposits of financial institutions at the central bank for reserve requirements, as described in the international reserves table of the weekly executive summary prepared by the central bank. Readily available reserves also exclude those that are pledged or otherwise encumbered, including but not limited to reserve assets used as collateral or guarantee for a third-party external liability. NIR excludes (1) any conversion of short-term reserve liabilities; (2) foreign assets stemming from foreign currency deposits of financial institutions at the central bank; and (3) transfer to the central bank of foreign currency deposits of HONDUTEL, INJUPEMP, and IHSS held abroad, which amounted to US$85 million at end 2003. NIR will be valued at current exchange rates.

11. Net domestic assets (NDA) of the central bank will be measured as the difference between currency issue and NIR, both measured on the basis of end-of-period data.

12. Open market bills. The monetary program assumes that foreign currency open market bills (CADDs) will not exceed US$65 million during 2004. This assumption will be reassessed in line with the conclusions of the MFD technical assistance mission scheduled for the first quarter of 2004.

C. External Targets

13. Stock of external debt arrears. For the purpose of the program ceiling, external debt-service arrears are defined as overdue debt service arising in respect of obligations incurred directly or guaranteed by the public sector, except on debt subject to rescheduling or restructuring as indicated by the respective creditors.

14. Borrowing on nonconcessional terms. For the purposes of the program, this ceiling applies to the contracting or guaranteeing of nonconcessional external debt by the CPS or any other agencies on their behalf—with the exception of up to US$3.3 million for the purchase of a building for the diplomatic missions of Honduras in Washington, D.C. The ceiling applies not only to debt as defined in the Point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt adopted by the Fund on August 24, 2000, but also to commitments contracted or guaranteed for which value has not been received.

15. External debt definition. The definition of debt set forth in Point No. 9 of the guidelines noted above reads as follows: "(a) For the purpose of this guideline, the term "debt" will be understood to mean a current, i.e., not contingent, liability, created under a contractual arrangement through the provision of value in the form of assets (including currency) or services, and which requires the obligor to make one or more payments in the form of assets (including currency) or services, at some future point(s) in time; these payments will discharge the principal and/or interest liabilities incurred under the contract. Debts can take a number of forms, the primary ones being as follows: (i) loans, i.e., advances of money to obligor by the lender made on the basis of an undertaking that the obligor will repay the funds in the future (including deposits, bonds, debentures, commercial loans, and buyers' credits) and temporary exchanges of assets that are equivalent to fully collateralized loans under which the obligor is required to repay the funds, and usually pay interest, by repurchasing the collateral from the buyer in the future (such as repurchase agreements and official swap arrangements); (ii) suppliers' credits, i.e., contracts where the supplier permits the obligor to defer payments until some time after the date on which the goods are delivered or services are provided; and (iii) leases, i.e., arrangements under which property is provided which the lessee has the right to use for one or more specified period(s) of time that are usually shorter than the total expected service life of the property, while the lessor retains the title to the property. For the purpose of the guideline, the debt is the present value (at the inception of the lease) of all lease payments expected to be made during the period of the agreement excluding those payments that cover the operation, repair, or maintenance of the property. (b) Under the definition of debt set out in Point No. 9(a) above, arrears, penalties, and judicially awarded damages arising from the failure to make payment under a contractual obligation that constitutes debt are debt. Failure to make payment on an obligation that is not considered debt under this definition (e.g., payment on delivery) will not give rise to debt."

16. Concessionality will be based on a currency-specific discount rate based on the
10-year (6-month) average of the OECD's commercial interest reference rates CIRR for loans or leases with maturities greater (less) than 15 years. Maturity will be determined on the basis of the original loan contract. Under this definition of concessionality, only debt with a grant element equivalent of at least 35 percent (relative difference between nominal value and present value of debt) will be excluded from the debt ceiling.

17. Excluded from the debt ceiling are: (1) the use of Fund resources; (2) debts classified as international reserve liabilities of the central bank; (3) short-term import financing (with a maturity of less than one year); (4) debts to restructure, refinance, or prepay existing debts; and (5) central bank instruments placed in the domestic market held by nonresidents.

D. Structural Reforms

This section provides further technical detail on structural reforms, mainly the changes in government wage policy and the financial sector actions.

Government wage policy

18. The measures below will permit the wage bill to continue to grow but at a slower pace than in recent years, thereby causing it to decline in terms of GDP to 10.4 percent of GDP in 2004 and to 9.6 percent in 2006.

• Civil servants. No new salaries above L 60,000 a month will be granted to civil servants. Civil servants with salaries higher than L 30,000 a month will receive no increase in 2004. Henceforth, civil servants outside special regimes will receive wage increases equivalent to expected inflation.
  
  
• Special regimes. Increases in teachers' base salaries originally agreed for 2004–05 will be spread over 2004–06, and salaries will rise by expected inflation from 2007. All existing supplementary payments will be set at their end-2003 nominal values through 2006 and incorporated into the integral salary in 2007. New supplementary payments will be calculated on the basis of the base salary for 2003 and capped through 2006 at 1,200 teachers for seniority and 300 teachers for academic qualifications. The reform also freezes high-paid wages for medical doctors in 2004, allows them to increase by expected inflation in 2005, and by expected inflation adjusted for any difference between the previous year's expected and actual inflation from 2006 onward. No supplementary payments will be granted to doctors.
  
  
• Human resources reform. Measures envisaged include the issuance of regulations to professionalize the civil service by promoting competitive hiring practices, merit-based promotion, and administrative separation between civil servants and political appointees; the implementation of a new salary scale for central government employees and the development of a performance evaluation system for civil servants. The human resource information system will be strengthened, and, as an input to the re-engineering, public posts and personnel functions will be redefined.

Financial sector reform

19. Consolidated supervision and reporting. The new Financial Institutions Law (to be passed by June 2004) will introduce the concepts of financial groups and financial holding companies as well as the responsibility for groups to calculate capital in a consolidated way. The law will also empower the Commission for Banking and Insurance Supervision (CNBS) to undertake consolidated supervision and require reporting on a consolidated basis. Intensive training of CNBS staff and establishment of new internal systems for consolidated supervision will start in 2004. The related regulations will be issued by December 2004, with pilot exercises starting in June 2005. A first set of consolidated financial statements of each group will be ready by December 2006.

20. Stricter calculation of capital adequacy ratio. Regulations issued in December 2003 bring the calculation of the capital adequacy ratio (both the capital base as well as risk-weights attached to different asset categories) in line with the Basel standards.

21. New regulation on loan classification and provisioning. Regulations issued in December 2003, deal with: (a) new guidelines for loan classification on the basis of credit risk (rather than quality of collateral); (b) a reduction from 8 to 5 loan categories according to quality; and (c) an increase in required provisioning from 1 to 2 percent for Category II loans; from 10 to 15 percent for Category III loans; and a unification of various rates (ranging from 25 to 75 percent) to a single rate of 50 percent for Category IV loans¹.

22. Provisioning for investment in FONAPROVI bonds. At end-2003, banks swapped their agricultural loans eligible under decree 68 of April 2003 for bonds issued by the FONAPROVI trust fund. Banks will be required by CNBS (by special regulations) to classify in January 2004 the loans that are represented by those bonds guaranteed by the banks in Categories III and IV, and provision them accordingly by end-2006. Banks will also fully provision the losses incurred in the settlement of liabilities to FONAPROVI with government-guaranteed bonds.

23. Limit on related lending. A timetable has been agreed for those banks whose related lending exceeds the new ceiling of 40 percent of capital. The timetable sets quarterly targets leading to full compliance by December 2005. For monitoring purposes, the timetable has been provided to the Fund.

24. Limit on ownership of banks in nonfinancial firms. This limit was set at 20 percent of banks' capital. For those banks currently in breach, a timetable with quarterly targets has been agreed to attain full compliance by December 2005. For monitoring purposes, the timetable has been provided to the Fund.

25. Risk management regulations. By June 2004, the CNBS will issue a set of regulations to manage risks (i.e., credit, interest rate, foreign exchange, conglomerate, liquidity, and operational risks), as well as to introduce stricter standards for financial institution corporate governance.

26. Reform of the lender-of-last-resort facility. Amendments to the Central Bank of Honduras Law will be adopted by June 2004 to ensure that this facility can be used more flexibly. By September 2004, the central bank will prepare regulations to: (1) shorten the maturity of loans under the facility; (2) define conditions for granting the loans and possible rollover; (3) ensure rapid disbursements by the central bank; and (4) define the interest rate conditions. Interest rates should be the highest in the market. For monitoring purposes, the regulations will be provided to the Fund before issuance.

27. Revision of the mandate of FOSEDE and its recapitalization. The Deposit Insurance Law (to be approved by June 2004) will: (1) narrow the mandate of FOSEDE to the collection, management, and pay-out of funds related to deposit insurance; and (2) define the terms of a recapitalization of FOSEDE, which will be completed in 2006 when the second IDB tranche has been received. After that date, FOSEDE will no longer have any access to credit from the central bank.

Governance

28. Unfinanced appropriations. Intra-year appropriations will be deemed financed only if ordinary revenues (i.e., not borrowing) are identified to pay for them, or compensating expenditure savings are made elsewhere.

E. Monitoring and Reporting Requirements

29. The information required to monitor the compliance with quantitative and structural performance criteria and benchmarks specified in the MEP will be supplied to the Fund monthly (and electronically, to the extent possible) within 45 days of the end of the previous month (unless otherwise noted) according to the following sources:

30. The ceilings on the deficit of the central government and of the CPS will be monitored below-the-line on the basis of the monthly reports Financiamiento del Gobierno Central and Honduras: Financiamiento del Sector Público no Financiero, respectively, prepared by the central bank, which contain:

• Net external financing of the central government and the NFPS, respectively, with detailed information on disbursements, amortizations, exceptional financing, zero-coupon bond, and accumulation of arrears. This information is prepared by the central bank and reconciled with the ministry of finance.
  
  
• Net domestic financing of the central government and the NFPS, respectively, with detailed information on: (1) net domestic financing from the central bank and the rest of the financial system to the central government and the NFPS, as contained in the Panorama Financiero monthly report; (2) net placement of bonds (including stabilization bonds) by the central government and the NFPS outside the financial system, as reported by the central bank with data from the Public Credit Directorate of the ministry of finance; (3) change in foreign currency deposits held abroad by the central government and the NFPS; and (4) change in the outstanding stock of suppliers' credit and floating debt of the central government, as reported by the Treasury, and the rest of the NFPS as reported by the central bank. To monitor the net domestic financing to the CPS, the central bank will provide the Fund with detailed data on a cash basis on the operating revenue and expenditure of the central bank.

31. The ceilings on the wage bill of the central government will be monitored monthly on the basis of the ministry of finance report: Información institucional por objeto de gasto - servicios personales y aportes patronales.

32. To complement the monitoring of fiscal performance, a breakdown of tax revenue by type of tax will also be provided monthly to the Fund.

33. The floors on the operating surplus of the public enterprises and on anti-poverty spending will be monitored quarterly on the basis of the information provided by the ministry of finance. Anti-poverty spending will be obtained from the detailed central government report: Cuenta Financiera. The ministry of finance will also provide the breakdown between poverty and non-poverty reduction spending by expenditure category (i.e., wages and salaries, goods and services, current transfers, fixed capital formation, and capital transfers).

34. The floor on NIR and the ceiling on NDA of the central bank will be monitored on the basis of monthly information included in the Panorama Financiero and Resumen de Cuentas del Banco Central produced by the central bank. This monthly information will be provided within two weeks of the end of the previous month.

35. The ceilings on the contracting of non-concessional external debt and on the non-accumulation of external payments arrears will be monitored with information provided by the central bank. The accounting of nonreschedulable external debt-service arrears by creditor (if any), with detailed explanations, will be transmitted by the central bank on a monthly basis within four weeks of the end of each month. Moreover, a loan-by-loan accounting of all new loans contracted or guaranteed by the public sector, including detailed information on the amounts, currencies, and terms and conditions, as well as relevant supporting materials, will be transmitted by the central bank on a quarterly basis within four weeks of the end of each quarter.