III. ECONOMIC TRENDS AND OUTLOOK A. KEY ECONOMIC INDICATORS (Est.) 1991 1992 1993 1994 Population (millions) 4.8 5.1 5.3 5.4 Population growth (percent) 2.9 3.1 2.9 2.7 Real GDP (millions of 1978 LPS.) 5,334.0 5,634.0 5,840.0 Real GDP growth (pct. chg.) 3.3 5.6 3.7 -2.0 Per Capita GDP (pct. chg.) 0.4 2.5 0.8 Consumer Price Index (pct. chg.)/3/ 21.4 6.5 13.0 33.0 Labor Force (thousands) 1,429.7 1,476.9 1,520.5 Unemployment (pct.)/4/ 14.8 15.5 15.8 14.7 Underemployment (pct.)/4/ 40.0 41.0 38.0 36.0 Government Deficit (pct. chg.) 3.3 5.1 10.4 Balance of payments (USD millions): Exports (FOB) 834.7 833.1 846.0 904.0 Imports (CIF) 912.5 990.2 1,079.5 1,217.0 Trade Balance -77.8 -157.1 -233.5 -313.0 Current Account Balance -172.5 -258.1 -353.4 Overall Balance 47.8 55.1 -142.3 Foreign Exchange Reserves/2/ 93.4 180.1 67.7 Foreign Debt (USD millions):/2/ 3,262.0 3,403.0 3,607.0 3,612.0 --As Pct. of GDP 106.4 100.2 107.9 --Debt Service 345.6 331.6 296.0 --As Pct. of Exports 42.0 40.0 35.0 Foreign Exchange Rate (LPS./USD): --Average Market Rate 5.63 5.75 6.82 --Year-end Market Rate 5.80 5.92 7.31 U.S.-Honduran Trade (USD millions) Exports To U.S. (FOB) 403.3 431.9 433.4 Imports From U.S. (CIF) 460.1 539.7 563.0 Bilateral Trade Balance -56.8 -107.8 -129.6 U.S. Share of Honduran imports 48.2 52.1 49.8 U.S. Assistance (fiscal years) 157.3 95.7 57.0 Source: Honduran Central Bank /1/ Preliminary /2/ Year-end Values /3/ Official GOH Index /4/ GOH Ministry of Labor Estimates B. BACKGROUND Since the early 1980's Honduras has been taking important steps toward modernization. Political stability has been strengthened by the holding of four consecutive democratic elections. The most recent presidential election, in November 1993, was won by Liberal party candidate Carlos Roberto Reina. President Reina ran on a moral revolution platform pledging to combat corruption and increase government efficiency. Honduras remains among the poorest countries in the hemisphere, with a per capita income of USD 630, and health, nutritional and educational levels that, while improving, are low. However, Honduras has made significant progress on the economic policy front. Important measures have been taken to reduce barriers to trade, and liberalize prices, the exchange rate and interest rates. A modern national investment law was enacted in 1992. The law provides equal treatment for national and foreign investors and eliminates restrictions on repatriation of profits. The reforms have engendered positive results; since 1991, Honduras has experienced a rise, albeit small, in living standards and foreign investment levels have increased significantly. A rising fiscal deficit, however, threatens to derail the economic gains made. The massive fiscal deficit is exerting upward pressure on prices and is undermining the currency. The Government of Honduras needs to take decisive measures to tackle the deficit and restore economic stability. Assuming orthodox deficit reduction measures are implemented and market-based economic policies continue to be pursued, we can expect the country's ample resource, climate, wage and geographic advantages to provide a solid foundation for high growth and rising living standards. C. GROWTH, OUTPUT AND EMPLOYMENT In general growth terms, the Honduran economy has responded well to the market-based price and exchange rate liberalization measures begun in 1990. In 1992, real GDP expanded an impressive 5.6 percent. In 1993, the pace of economic recovery slackened, with real GDP growing 3.7 percent. In 1992, the growth numbers were led by a surge in construction activity (up 34 percent). In 1993, a relative scarcity of cement constrained growth in this sector to a far more modest 4.8 percent. Agricultural production, which eked out 1.1 percent growth, was hurt by a combination of unfavorable weather and price (domestic and international) conditions for key crops such as coffee, bananas, rice and basic grains (corn, beans, and sorghum). Rising real commercial bank loan rates in the second half of 1993 also reduced overall investment demand and dampened the recovery. With the exception of the disappointing construction and agricultural numbers, the economy advanced on a broad front in 1993. Manufacturing kept pace with the general expansion growing 3.7 percent. Electricity, gas and water production jumped 7.7 percent, reflecting strong investments in maquila and rural electrification programs. The transport, commercial and services sectors grew a solid 6.8 percent, 3.2 percent and 3.9 percent, respectively. The liberalization of interest rates buoyed bank profits and the financial services sector grew by 5 percent. Finally, rising levels of public investment -- in key infrastructure sectors such as roads and telecommunications -- boosted the public sector's contribution to GDP (up 4.5 percent). In per capita terms, GDP grew 0.8 percent and hardcore unemployment was reduced modestly to 14.8 percent. The outlook for 1994 is clouded by the onset of a major energy crisis caused by a combination of rising electricity demand, insufficient rains and dropping water levels at Honduras' primary hydroelectric dam project -- Francisco Morazan. In the second quarter of 1994, electricity output is down 20 percent from normal capacity. In 1994, the loss to business, particularly manufacturing and services, could shave 1.5 percent from GDP performance. Also, major sales of cement to neighboring countries, caused by more favorable prices in these other markets, will, in the absence of a domestic cement price increase, continue to hurt construction activity. Finally, an evident downturn of investment flows to the maquila industry will dampen growth in output and employment in this key sector of the economy. On the up side, we expect rising investment in telecommunications and a more favorable agricultural panorama for export commodities and basic grains to mitigate an economic contraction. We estimate real GDP growth to slow to 2 percent in 1994. D. INFLATION In the first three years of the previous Callejas administration the government waged an effective war on inflation -- cutting consumer price increases from 36.6 percent in 1990, to 6.5 percent in 1992 -- the lowest in Latin America. Rigid monetary/fiscal policies were decisive factors in braking inflation. In 1993, a major deterioration in the fiscal accounts, induced by exorbitant public sector capital account spending and current account expenditure levels, increased inflationary pressures. The problem was aggravated by a rapid depreciation of the Lempira of 19 percent vis-a-vis the U.S. dollar, which induced major jumps in import prices. In 1993, the Consumer Price Index (CPI) rose 13 percent (on a point-to-point basis). A 12.7 percent increase in food prices, compared to 6.2 percent in 1992, was a major factor fueling the inflationary spiral. There were jumps in prices of basic food items such as beans (143.7 percent), corn (19.2 percent), powdered milk (27.6 percent), eggs (27.4 percent), tomatoes (35.4 percent), and chicken (13.4 percent). The CPI also revealed annual increases in housing prices/rents (9.3 percent), alcoholic beverages and tobacco (11.6 percent), and education (13.3 percent). E. MONEY, CREDIT AND BANKING In recent years, Honduran bank earnings were bolstered by a series of financial reforms. Beginning in 1990, the Central Bank began to promote more efficient financial intermediation by gradually phasing-in interest rate deregulation. Interest rate ceilings were gradually removed, and in 1992 the Central Bank moved to a free interest rate regime. Another positive development was the creation of stock exchanges in San Pedro Sula (in 1990) and Tegucigalpa (in 1993). These stock exchanges have quickly matured into an active market for the trading of debt instruments and offer future prospects for the raising of equity through the issuance of publicly traded shares. On the down side, Honduran commercial banks have faced steep reserve requirements, which in 1993 hovered in the 36-42 percent range. The onerous reserve requirement has forced banks to keep average loan rates in 1993 at a high 27 percent, or approximately 14 percent in real terms. In 1993, the deterioration in the fiscal accounts was partially reflected in the monetary aggregates. M1 (currency in circulation and demand deposits) grew an expansive 14.1 percent, which shadowed the rise in price levels. The bank credit numbers continued to track the money supply figures. Central Bank credit to the public sector jumped 18.6 percent. The public sector's thirst for financing crowded-out private sector players. Central Bank credit to the private sector was up a meager 1.3 percent. Total banking credit expanded 14.7 percent in 1993. In 1993, commercial banks suffered an 8 percent real (inflation- adjusted) drop in total deposit liabilities. Honduran private and public sector entities withdrew nearly 1 billion Lempiras in demand, time and savings deposits. The selloff reflects savers' preference for dollars -- a traditional hedge in periods of rising inflation -- and higher non-commercial bank rates (such as those of finance companies), over the relatively unattractive terms offered on commercial bank local currency deposits. According to Honduran economists, to bolster the commercial banking system's deposit base, the Honduran authorities will need to strengthen public confidence by adopting anti-inflationary fiscal and monetary policies. They feel the commercial banks also must demonstrate a greater willingness to compete for domestic savings. Enactment of a proposed financial sector reform law is sorely needed to promote banking system efficiency and competitiveness. F. FISCAL OPERATIONS The significant deterioration of the fiscal accounts is the principal threat to economic stability in Honduras. The fiscal crisis was induced by the adoption of highly expansionary expenditure policies. In 1993, public sector investment spending rose 46 percent to 2.5 billion Lempiras. Surging capital account spending and a high 24 percent increase in current account expenditure levels (due to wage hikes for public sector employees) ensured a 40 percent jump in total public sector spending. These spendthrift policies overwhelmed a respectable 15.3 percent increase in government revenues nearly doubling the public sector deficit to 2.3 billion lempiras. The consolidated public sector deficit --as a percent of GDP-- widened from 5.0 percent in 1992 to 10.7 percent in 1993. Honduras badly missed the IMF program target of cutting the consolidated public sector deficit to 3.8 percent of GDP. The fiscal imbalance is a primary factor driving higher inflation, currency depreciations and a weakened balance of payments. A successful reduction program will require the immediate adoption of major cuts in expenditure levels and measures to increase public sector revenue inflows. G. THE BALANCE OF PAYMENTS In 1993, Honduras' balance of payments continued to weaken. Unfavorable world prices for key export commodities constrained export growth to a negligible 1.6 percent (to USD 846 million). Banana exports fell 10.1 percent (to USD 230.5 million), principally due to the European Union's adoption of a restrictive banana import regime. Coffee export values declined 15.7 percent as a result of weak international prices and lower volume output. Combined, bananas and coffee accounted for 42 percent of total export receipts. The move to a free market exchange rate regime in 1992 continues to bolster many export industries. Wood, beef, shrimp, lobster, tobacco and non-traditional exports all reported gains. Maquila operations, calculated in the services account, continued to be a bright spot in the export equation --reportedly up 23 percent in 1993. Economic growth and lower import tariff duties supported the rise in imports, which grew a solid 9 percent --reaching USD 1.1 billion. Rising import demand and negative net accounts for services, shipping and interest payments on short-term debt contributed to record merchandise trade/services and current account deficits of USD 525.3 million and USD 353.4 million, respectively. Honduras' capital account performed well in 1993, recording a hefty surplus of USD 205 million. In recent years, the capital account has been bolstered by a combination of Paris Club debt rescheduling and international lending. However, the overall balance was minus USD 142.3 million and Central Bank reserves sank USD 101.8 million to USD 68.4 million. For 1994, we expect slowing maquila investments and an inadequate recovery of traditional exports to forestall any significant improvement in the balance of payments. H. THE EXTERNAL DEBT In recent years, Honduras has benefited from more than USD 500 million in debt forgiveness granted by the United States and other creditor countries. However, Honduras has continued to take on new debt and in 1993 total external debt obligation rose USD 200 million to USD 3.6 billion. On the year, debt service (principal and interest) was USD 295 million, or 35 percent of total exports. While Honduras has managed to remain current on debt service payments to its multilateral creditors, there are small but growing arrears on bilateral commitments. I. ECONOMIC REFORM AND POLICY ISSUES Honduras' economic reform initiatives have received strong support from the multilateral development banks. In July 1990, the IMF Board approved a 12-month stand-by arrangement that was later extended for seven months. The stand-by provided Honduras USD 30 million in balance of payments support funds. The IMF program paved the way for favorable debt rescheduling terms from the Paris Club countries on September 14, 1990. The Paris Club strengthened Honduras' capacity to service its debt with a number of other bilateral creditors. In July 1992, the IMF approved a three year (1992-95) Enhanced Structural Adjustment Facility (ESAF), allowing Honduras to obtain a Paris Club agreement in October 1992. The terms Honduras received --called "Trinidad Terms" -- were some of the most generous accorded to any country. In July 1993, the ESAF was renegotiated for a second year and Paris Club terms were secured in late 1993. Subsequently however, Honduras missed some of the IMF targets and the country's Paris Club arrangement is in technical suspension. Unfortunately, the previous government's failure to meet the fiscal deficit reduction targets established under the ESAF requires the new government to renegotiate program terms in 1994. Therefore, a policy priority of the new government will be to adopt a credible deficit reduction package that ensures a continuation of ESAF and Paris Club terms for Honduras. A number of other major World Bank and Inter-American Development Bank sectoral loans will hinge on continued Honduran reform in the financial, agricultural, environmental and energy policy areas. J. MAJOR INFRASTRUCTURE PROJECTS Ports: Honduras has ports on both the Atlatnci and Pacific oceans that are served by a number of shipping companies that link the country with Asia and Europe, as well as the rest of the Western Hemisphere. The northern port of Puerto Cortes, Honduras' principal seaport, operates 24 hours a dya and is used for shipment of goods from El Salvador and Nicaragua. A recently completed project to expand Puerto Cortes will provide it with greater dock facilities and cold storage installations. Honduras has three other ports on the Caribbean and one on the Pacific. Roads and Highways: Honduras has a 14,000 KM official road networking connecting the ports and airports with the secondary cities and rural areas of the country. The country ahs good surface communication with the rest of Central America. The Ministry of Communicaiton, Transportation and Public Works (SECOPT) plans to upgrade approximately 2,000 kilometers of secondary roads during the next three years, which will improve the connection of small towns and rural farming areas to the main road system. Airports: Three international airports serve the capital Tegucigalpa, the commercial center San Pedro Sula, and the coastal city of La Ceiba. Air freight services are reliable and efficient. Three gateway cities (Houston, Miami, and New Orleans) are only 2 1/2 hours flying time from Honduras. Direct flights between Honduras and cities in North and Central America are provided by the following international airlines: American, Continental, COPA, LACSA, IBERIA, and TACA. Islena Airlinees, a domestic air carrier, connects Tegucigalpa with the north coast and the Bay Islands. Charter service and aircraft rentals (small single- and twin-engine equipment) are available from private flying services operating out of Tegucigalpa, San Pedro Sula, and La Ceiba. Electrical generating systems: Honduras is facing a severe energy crisis caused by rising electricity demand and output shortfalls at the country's largest hydroelectric plant. By a Presidential Decree in April 1994, the National Electric Company (ENEE) has been authorized to engage in direct contract negotiations with firms that offer thermal electric generating systems. Over the next two years, estimated investment in this area will reach USD 150 million. Telecommunications: In 1993, the Honduran Telephone Company (HONDUTEL) awarded two contracts, valued at USD 155 million, for the installation of 220,000 telephone lines. HONDUTEL also awarded a USD 30 million leasing arrangement for private cellular telephone services. The Government of Honduras is close to making a final decision on the privatization of HONDUTEL. Construction: Even though the construction sector in Honduras has been suppressed by high interest rates, the erection of industrial parks in most of the secondary cities has kept this sector from total collapse. The demand for residential housing is greatly under-supplied. The Reina government has announced plans to implement a program for the construction of low cost housing. The estimates are between 30-50 thousand units of social housing. The project will be executed in the next three years. K. NATURE OF LOCAL AND THIRD COUNTRY COMPETITION The U.S. is Honduras' chief trading partner, accounting for about 50 percent of the country's total exports and imports. Honduras' other leading trading partners include Mexico, Japan, Taiwan, Korea and the other Central American countires (El Salvador, Guatemala, Costa Rica and Nicaragua.) Traditionally, Hondurans have maintained a preference for products "Made in the USA." In General, receptivity to U.S. products and services is high, there is little competition for U.S. exporters from local domestic suppliers, and competition for u.S. exporters from third-country suppliers is medium to heavy. Competition varies on a sector-by-sector basis. Increasingly, developing and emerging countries are challenging the U.S. exporters in many sectors. Japanese vehicles dominate the new car market, but U.S. manuracturers are beginning to make a serious effort to regain lost ground in previous years. U.S. firms still dominate areas such as electrical pwoer system, construction equipment, forestry and woodworking equipment, automotive parts & service equipment, agricultural machinery and equipment, building products, hotel and restaurant equipment, comoputers & peripherals and software, and telecommunication equipment. However, competition from Asian and European firms is growing.