Honduras. Country Report. Honduras at a glance: September Key changes from last month

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1 Country Report Honduras Honduras at a glance: OVERVIEW Manuel Zelaya Rosales of the Partido Liberal (PL), who has two-thirds of his four-year term as president to run, appears increasingly beleaguered. The PL s lack of a simple majority in Congress leaves the government reliant on the support of other parties. The Economist Intelligence Unit expects limited progress in , despite an assertive stance by Mr Zelaya. Economic policy will focus on targets agreed under a likely policy support instrument (PSI) yet to be agreed with the IMF. Honduras will benefit from debt relief granted under the heavily indebted poor countries (HIPC) initiative. Annual GDP growth will slow to 5.6% in 2007, reflecting a forecast softening of US import demand, and average 5.4% in Improved monetary policy tools will help to keep inflation below the historical trend, in the absence of external shocks, but there is a heightened risk that oil prices will rise above current forecasts. The exchange rate will continue to appreciate gradually in real terms against the US dollar. A wide trade deficit stemming from rising import spending, associated with relatively high oil prices and buoyant domestic demand, will be only partly offset by rising remittances. Key changes from last month Political outlook With parties (including the PL) already focusing on their presidential candidates for the 2009 election, Mr Zelaya has sought to quell rumours that he wants to amend the constitution to allow for presidential re-election. Economic policy outlook Following a 25-basis-point rise in the short-term policy interest rate on August 28th, we expect monetary policy to be tightened further in the remainder of 2007 as the BCH struggles to meet its 5-6% year-end inflation target. Economic forecast We have revised upward our estimate for real GDP growth in 2007, to 5.6%, and our forecast for 2008, to 5.4%, as a result of indications that private and public consumption, and increasing investment growth are underpinning an ongoing firm economic performance, despite slower US growth. September 2007 The Economist Intelligence Unit 26 Red Lion Square, London WC1R 4HQ United Kingdom

2 The Economist Intelligence Unit The Economist Intelligence Unit is a specialist publisher serving companies establishing and managing operations across national borders. For 60 years it has been a source of information on business developments, economic and political trends, government regulations and corporate practice worldwide. The Economist Intelligence Unit delivers its information in four ways: through its digital portfolio, where the latest analysis is updated daily; through printed subscription products ranging from newsletters to annual reference works; through research reports; and by organising seminars and presentations. The firm is a member of The Economist Group. London The Economist Intelligence Unit 26 Red Lion Square London WC1R 4HQ United Kingdom Tel: (44.20) Fax: (44.20) london@eiu.com Website: New York The Economist Intelligence Unit The Economist Building 111 West 57th Street New York NY 10019, US Tel: (1.212) Fax: (1.212) newyork@eiu.com Hong Kong The Economist Intelligence Unit 60/F, Central Plaza 18 Harbour Road Wanchai Hong Kong Tel: (852) Fax: (852) hongkong@eiu.com Electronic delivery This publication can be viewed by subscribing online at Reports are also available in various other electronic formats, such as CD-ROM, Lotus Notes, online databases and as direct feeds to corporate intranets. For further information, please contact your nearest Economist Intelligence Unit office Copyright 2007 The Economist Intelligence Unit Limited. All rights reserved. Neither this publication nor any part of it may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of The Economist Intelligence Unit Limited. All information in this report is verified to the best of the author's and the publisher's ability. However, the Economist Intelligence Unit does not accept responsibility for any loss arising from reliance on it. ISSN Symbols for tables n/a means not available; means not applicable Printed and distributed by Patersons Dartford, Questor Trade Park, 151 Avery Way, Dartford, Kent DA1 1JS, UK.

3 Honduras 1 Outlook for Political outlook Domestic politics Manuel Zelaya Rosales of the Partido Liberal (PL) has just under two-thirds of his four-year term as president left to run. With just 62 of the 128 seats in Congress, compared with 55 for the opposition Partido Nacional (PN), the government lacks a clear majority, so will remain reliant on the support of the three minority parties, which together hold 11 seats, to pass legislation. Given high public expectations, the Zelaya administration is struggling to maintain public support in the face of failure to achieve tangible results on key commitments, such as tackling high levels of corruption and crime, reducing poverty and unemployment, and countering the effects on the cost of living of sustained high oil prices. Lack of progress has seen public support for Mr Zelaya fall to 50% in an early May CID-Gallup poll, down from 66% in a similar poll in January. A measure of the president s loss of momentum is that political parties (including the PL) are already focusing on candidates for the 2009 presidential election. Introducing far-reaching reform will be difficult in the face of an opposition buoyed by lack of government progress and reinvigorated by the approach of party primary elections in An increase in protests by environmental groups and indigenous communities, and demands for land reform, will also test the government. Central to Mr Zelaya s commitment to developing a participatory democracy and restoring trust in state institutions will be his success in implementing the Ley de Transparencia y Acceso a la Información (transparency law), passed by Congress in November 2006, which aims to increase scrutiny of public officials through greater access to official records. Soaring crime rates will continue to test the government. Honduras s murder rate is among the highest in Central America, and maras (criminal youth gangs) present a potent challenge to a police force with limited resources. Mr Zelaya has pledged a comprehensive approach to combating crime. Nevertheless, security measures introduced by his government to date have focused on a more traditional approach to crime prevention, including plans to increase the number of police by 1,000 officers each year. An effective strategy against violent crime will need to include a comprehensive reform of the penal system, which is permeated by corruption, as well as the investigation and eradication of the links between the trade in illegal drugs, public officials and the police. However, passing such legislation through an obstructive Congress increasingly focusing on the 2009 elections will prove difficult. International relations Honduras s historically close relations with the US have come under strain as a result of concerns over foreign policy under Mr Zelaya in particular moves to strengthen ties with Venezuela and controversy over the new international bidding system for fuel imports introduced by the government. However, the extension in May of Temporary Protected Status (TPS), covering undocumented Honduran immigrants living in the US for a further 18 months, has improved sentiment on both sides. Given that the US is by far the most

4 2 Honduras important trade partner for Honduras, accounting for around 40% of merchandise exports and almost all maquila (offshore assembly for re-export) goods, Honduran trade relations will centre on promoting the benefits to investors of the Dominican Republic-Central American Free-Trade Agreement (DR- CAFTA), which makes permanent the beneficial access to the US for Honduran (and other Central American) exports. Following the signing of a trilateral freetrade agreement (FTA) by Honduras and El Salvador with Taiwan in May, trade policy in the forecast period will focus on negotiations towards closer economic co-operation, including an FTA between the EU and Central America. Economic policy outlook Policy trends Fiscal policy Although the Economist Intelligence Unit expects the Zelaya administration to continue to follow a broadly prudent, market-oriented policy, the government s weak position in Congress makes it inclined to garner public support through populist measures. This will place in sharp focus the new economic programme, to be agreed with the Fund before the end of 2007, to replace the three-year poverty reduction and growth facility (PRGF) that expired in February. The successful meeting of targets set out in the PRGF agreed with the Fund by the previous (PN) administration led to debt relief under the IMF- World Bank heavily indebted poor countries (HIPC) initiative. Under a likely policy support instrument (PSI), the Fund would provide advice and support, but Honduras would not have access to a credit line as under the PRGF. A PSI would provide greater flexibility for the government than a PRGF in setting targets. However, manoeuvrability in terms of fiscal policy is limited by spending rigidities; over one-half of government revenue is allocated to spending on wages and salaries. Moreover, although more flexible fiscal targets would provide the government with greater room to fulfil campaign pledges, such as job creation and increased expenditure on healthcare and education, the shift would raise concerns over fiscal discipline owing to a lack of institutional capacity to step up such spending in an efficient manner. A sharp deterioration in the fiscal position in the first quarter of 2007, when the central government recorded a deficit of La468.3m (US$24.7m), compared with a surplus of La766.2m in the same period of 2006, has raised concerns over the pace of government spending. The 2007 budget envisages a 17% year-on-year nominal increase in total central government spending. However, current spending in the first five months of 2007 was 37% higher year on year, driven by a 34% increase in spending on wages and salaries and a doubling of spending on goods and services. Despite a 12% public-sector pay increase agreed in 2006, the government will come under pressure for further salary increases in , given the disparities between public- and private-sector pay. Tax revenue in will be supported by moderate growth in domestic demand, but tax revenue from import duties will fall in line with tariff reductions under DR-CAFTA. This, combined with an easing of the fiscal stance on the part of the government in the face of wage increase demands and transfers to poorly performing state-owned enterprises, will result in substantially wider fiscal deficits in than the 1.3% of GDP deficit

5 Honduras 3 recorded in Given the demands on the public finances, and assuming that the government meets its capital spending targets, we expect the central government deficit to reach 2.6% of GDP in 2007, narrowing slightly to an average of 2.3% of GDP in , as spending to meet election promises and government efforts to meet calls from public-sector bodies for pay increases continue to weigh on the public purse. Monetary policy In line with commitments agreed with the IMF, improvements have been made to the monetary policy framework. The Banco Central de Honduras (BCH, the Central Bank) has moved away from targeting monetary aggregates towards a greater reliance on the use of short-term interest rates and a stable exchange rate as policy tools for keeping inflation in check, giving the Central Bank greater flexibility to achieve its policy goals. The BCH raised the Tasa de Política Monetaria (TPM, the short-term policy interest rate) by 25 basis points to 6.25% on August 28th in the face of above-target inflation and rapid credit expansion. New credit to the private sector increased by 38% in the 12 months to June, almost double the target rate in the authorities monetary programme for We expect monetary policy to be tightened in the remainder of 2007 as the BCH struggles to meet its 5-6% year-end inflation target. Pressures may build to move towards a more flexible exchange rate regime if the implicitly fixed rate currently in operation results in a significant drop in international competitiveness, although this is not currently our central forecast. Given concerns of inflation overshooting Central Bank targets, a deteriorating external balance as a result of strong import demand and the risk of a reduction in asset quality in the financial sector as GDP growth slows, a tightening of monetary policy by the Central Bank will be aimed partly at moderating the accelerating trend in commercial and consumer credit growth. Economic forecast International assumptions International assumptions summary (% unless otherwise indicated) Real GDP growth World US EU Exchange rates US$ effective (2000=100) :US$ US$: Financial indicators US$ 3-month commercial paper rate US$ 3-month Libor Commodity prices Coffee (Arabica; US cents/lb) Oil (Brent; US$/b) Food, feedstuffs & beverages (% change in US$ terms) Industrial raw materials (% change in US$ terms) Note. Regional GDP growth rates weighted using purchasing power parity exchange rates.

6 4 Honduras Although our central assumption is that the rate of global growth will remain robust in , at an annual average of 4.7% (on a purchasing power parity basis), this forecast carries downside risks. Slowing growth in the US in 2007 will result in a fall-off in demand for Honduras s exports. The US currentaccount deficit remains a weakness, and the risk of a rapid depreciation of the US dollar persists. On a positive note, some of Honduras s principal export commodities will continue to benefit from high prices in Crop shortfalls for coffee have resulted in considerably tighter market conditions, and we now expect prices for Honduras s main export commodity, Arabica coffee, to fall more slowly than previously forecast. On the downside, Honduras s exports to Europe could be adversely affected by the EU s new tariff for bananas the country s second-largest agricultural export commodity of 176/tonne (US$220/tonne), if challenges brought before the World Trade Organisation (WTO) by the US and Latin American producers to the introduction of the tariff prove unsuccessful. Economic growth Available indicators for the first quarter of 2007 confirm our expectations that, after picking up to 6% in 2006, Honduras s real GDP growth is slowing this year (we forecast a slowdown to 5.6%) as slower growth in the US leads to a fall in demand for Honduran exports. This will be offset by firm, albeit slowing, growth of remittances, which will continue to support brisk private consumption growth, underpinning overall growth, and are estimated to reach US$2.7bn in 2007, the equivalent of 26.7% of GDP. The maquila industry and the tourism sector will continue to be major drivers of growth of exports and investment. Honduras s participation in DR-CAFTA is also expected to attract higher foreign investment inflows and opportunities for export-oriented business in , sustaining relatively strong GDP growth, despite slower growth in the US. Infrastructure projects, such as the long-awaited inter-oceanic road, the dry canal connecting Puerto Cortés on the Atlantic coast with ports on the Pacific, are also likely to benefit. The telecommunications and energy sectors would also attract foreign direct investment (FDI) potentially boosting investment above forecast levels if further sectoral liberalisation is achieved, but progress will depend on the government s ability to move ahead with restructuring and reform to address the parlous financial position of the state energy and telecoms providers. A recovery in US demand, the benefit to maquila exports provided by DR-CAFTA and slowing import demand will result in the external balance becoming less of a drag on growth by the end of the forecast period. On the supply side, agricultural output in will slow from the strong return to growth in 2006, influenced by falling coffee prices, but it will continue a moderate recovery. Construction activity will play an important role in supporting real output, stimulated by historically low interest rates notwithstanding expected tightening in the remainder of 2007 and into 2008 and increased mortgage lending. With property-related financial services contributing strongly to the performance of the sector, financial services which have been expanding rapidly will continue to perform robustly, barring an unexpected fall in the property market.

7 Honduras 5 Inflation Exchange rates External sector Annual consumer price inflation, which edged outside the upper limit of the target range of 5-6% in March, stood at 6.3% in July, marking the fifth consecutive month that 12-month inflation has been above target. Although fuel and energy subsidies have eased pressures associated with high oil prices and the government s stalled energy policy, increased food prices (especially for maize) resulting from strong demand and poor harvests in Asia, and demand for grains to make biofuels, have emerged as a new source of price pressure. We expect ongoing food and oil-price-related inflationary pressures and relatively robust domestic demand to contribute to the authorities narrowly missing their inflation target in However, ample levels of foreign exchange, buoyed by high remittance levels, and the support provided by HIPC debt relief will underpin the currency and support efforts to contain inflation in Consequently, after ending 2007 at 6.4%, we expect inflation to ease to 6% by end-2008, just within the Central Bank s target range, and to 5.8% by the end of 2009, on the assumption of stable oil prices and a stable exchange rate. Nevertheless, there is a heightened risk that higher oil prices and the government s stalled energy policy could lead to prolonged petrol price disruptions affecting the supply chain. The Central Bank will continue to maintain an implicit peg of L18.9:US$1 as a means of providing an anchor for inflation in , as it has since mid-2005, since when the currency has appreciated by 4.3% in real terms against the US dollar. Multilateral aid, debt-service relief and rapidly increasing remittances from Hondurans working in the US have boosted international reserves to record levels, providing support for the currency. Official reserves (as measured by the IMF) reached a record US$2.7bn in April 2007, equivalent to 4.8 months of projected imports of goods and services in Our forecast is for firm growth in international reserves to continue in , on the back of increasing levels of workers remittances and international official loans. However, given strong import growth, our forecast growth in reserves will not result in a significant increase in import cover. And, with inflation higher than in the US, the lempira will appreciate moderately further in real terms against the US dollar, implying a reduction in international competitiveness. Nevertheless, the lempira does not currently appear overvalued, and even remaining at its current level will still be 6% below its long-term average by the end of the forecast period. The deficit on trade (excluding maquila) widened by 40% year on year in the first half of 2007, to US$12.1bn, up from US$1.5bn in the same period of 2006, as a 26% increase in import spending, led by increased spending on consumer goods, dwarfed a 6.1% rise in export earnings, led by non-traditional agricultural goods exports. Firm domestic demand supported by investment and growth (albeit slowing) in remittances from expatriate Hondurans will see import spending continuing to outweigh export earnings in the forecast period, although at a slower pace in 2008 as domestic demand moderates. Growth in remittances slowed to 1% year on year in the year to July 26th, to US$1.4bn (down from growth of 40% in the same period of 2006), but

8 6 Honduras they still account for more than double maquila earnings and more than total earnings from merchandise exports. In the forecast period gains made in the services account from the maquila industry and tourism sector will only partly offset the effect of continued strong demand for imports. As a result, we estimate that the current-account deficit will widen to 4.3% of GDP in Rising services and transfers surpluses, resulting from the maquila industry and tourism sector, and falling income deficits will outweigh a continued widening of the trade deficit to bring about a narrowing of the current-account deficit to an average of 3.2% of GDP in Honduras will finance its external imbalance mainly with aid and FDI inflows. We expect international reserves to average around US$3.3bn in (equivalent to five months of imports of goods and services), supported by still high levels of remittances and other capital inflows. Forecast summary (% unless otherwise indicated) 2006 a 2007 b 2008c 2009c Real GDP growth Gross agricultural production growth Gross fixed investment growth Unemployment rate (av) 27.9 b Consumer price inflation (av) Consumer price inflation (year-end) Weighted average local currency lending rate Central government balance (% of GDP) Exports of goods fob (US$ m) 1, , , ,000.4 Imports of goods fob (US$ m) 5, , , ,200.3 Current-account balance (US$ m) Current-account balance (% of GDP) External debt (year-end; US$ bn) 3.9 b Exchange rate La:US$ (av) Exchange rate La:US$ (year-end) Exchange rate La: (av) Exchange rate La:SDR (av) a Actual. b Economist Intelligence Unit estimates. c Economist Intelligence Unit forecasts. Editors: Ian Emery (editor); Martin Pickering (consulting editor) Editorial closing date: September 1st 2007 All queries: Tel: (44.20) london@eiu.com Next report: Full schedule on