Updating Report On

Report No. 1066a-PAN FILEtS,! Y UpdatingReport on the Economyof Panama

(In Two Volumes) Public Disclosure Authorized Volume 1:Main Report May 13, 1976 Latin America and the CaribbeanRegional Office Country ProgramsDepartment I P 'L q FOR OFFICIAL USE ONLY Ll UtuJ Lk - J Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of the World Bank

Thisdocument has a restricteddistribution and may beused by recipients oniy in the performanceof theirofficial duties. Its contentsmay not otherwisebe disclosedwithout WorldBar!k authorization. CURRENCYEQUIVALENTS

1.00 Balboa = 1.00 US$

1.00 US$ = 1.00 Balboa

Fiscal Year: January 1 to December 31 FOR OFFICIALUSE ONLY

UPDATINGREPORT ON THE ECONOMYOF PANAMA

Volume I

TABLEOF CONTENTS

Page No.

COUNTRYDATA

MAP

SUMMARYAND CONCLUSIONS

I. INTRODUCTION 1

II. THE ECONOMYIN 1975 2

A. General Trends 2

B. Trends in Output 11

(i) Agriculture 11 Poverty and Agriculture 11 Recent Trends 12 (a) Basic Grains 12 (b) Livestock 16 (c) Export Crops 18 Policies 18 Future Needs 20 (ii) Fisheries 21 (iii) Manufacturing 21 (iv) Other Sectors 25

III. THE GOVERNMENT'SPROGRAM 29

A. Short-TermProgram 29

This Economic Updating Report is based on the findings of an economic mission in September/October1975, comprisingMessrs. Luis Landau (MissionChief), John Kendall (PublicInvestment Analyst), Alberto Eguren (GeneralEconomist), Francisco Ravecca (IFC CMD Consultant, Banking and Finance), Jose German Cardenas (Consultant,Public Sector Finance) and Helmut Wieseman (Power). In April 1976, Messrs. Roberto Fernandes and Luis Landau discussed a draft of this report with the authorities.

This document has a restricteddistribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. - 2 -

TABLE OF CONTENTS (Cont'd.)

III. THE GOVERNMENT'S PROGRAM (Cont'd.) Page No.

B. The Government's Development Strategy 30

(i) Agriculture 31 (ii) Sugar 33 (iii) The Bayano Cement Plant 34 (iv) Copper Mining 35 (v) Tourism 36 (vi) Transport 37 (a) The Transisthmic Oil Pipeline 37 (b) Roads 37 (c) Ports 39 (d) Aviation 40 (vii) Telecommunications 40 (viii) Power 40 (ix) Education 41 (x) Health 42 (xi) Housing 45 (xii) Overall Aspects 45

C. Financing Public Expenditures 47

(i) Recent Trends 47 (ii) Central Government Financial Operations 50 (iii) The System of Budgeting and Control 53

IV. STRATEGIES FOR GROWTH 55

A. Introduction 55

B. The Government's Preliminary Financial Program 57

C. An Alternative Financial Program (Medium Growth Case) 59

D. The Low Growth Case 65

E. Conclusions 69

ADDENDUM 70

VOLUME II - STATISTICAL APPENDIX

Note: Tables 1 through 24 are inserted in the Main Report. Tables 1.1 through 10.4 are included in the Statistical Appendix. Page 1 of 2 pages

COUNTRYDATA

GROSS NATIONALPRODU5T IN 197J ANNUALRATE OF GROWTH(%, constant prices)

US$ Mln. % 1963 -68 1968 -73 1974

GNP at Market Prices 1649.7 100.0 7.0 7.2 1.9 Gross Domestic Investment 448.3 27.2 10.5 11.1 -5.2 Gross National Saving 186.3 11.3 15.3 7.1 -30.2 Current Account Balance -259.6 -15.7 Exports of Goods, NFS 734.6 44.5 8.2 4-5 9.0 Imports of Goods, NFS 906.1 54.9 6.5 7.5 11.9

OUTPUT, LABOR FORCE AND PRODUCTIVITYIN 1973

Value Added Labor Force-/ V. A. Per Worker US$ mln. ,g Thou. % US$

Agriculture 250.9 17.0 154.7 31.0 1622.0 55.0 Industry 366.8 24.9 81.3 ]6.3 4512.0 153.0 Services 254.8 58.1 25).5 51.0 3359.0 113.8 Unallocated 8.5 1.7 Total/Average 1jS72.5 100.0 49 9. 0 100.0 {z 100.0

GJ0VERN1ENTFINANCE NGeneral Government2/ Central Government ( Mlni.) % of GDP ( Mln.) of GDP 197 _197 19.2-7h 19715 1-97 i 1, '-- 7!

Current Receipts 478.9 27.5 25.5 267.3 15.4 15.4 Current Expenditure l1o9.4 23.5 22.5 263.)5 15.1 15.3 Current Surplus T5 75 -S75 3.0 3.9 - 0.3 Capital Expenditures 193.0 11.1 9.9 59.2 5.1 5.5 External Assistance (net) 83.3 5.8 5.9 62.7 3.6 4.1

MONEY, CREDIT and PRICES 1969 1970 1971 1972 1973 1974 (3!lillion outstanding end period)

Moncy and Quasi Moneyi/ 217.4 284.7 339.9 I50.15 506.5 596.4 Bank credit to Public Sector 22.1 31.2 U8.2 75.7 75.2 132.6 Bank Credit to Private Sector 306.1 407.9 520.7 703.5 965.1 1259.0

(Percentages or Inclex Numbers)

Money and Quasi Money as % of GDP 23.0 27.2 29.1, 33.9 34.4 34.3 General Price Index (1961 = 100) 109.7 112.0 113.1 128.1 151.6 185.4 Arnual percentag3 changes ins General Price Index (wholesale) 1.2 3.0 5.5 8.5 10.5 30.2 Bank credit to public Sector 106.5 51.2 54.6 57.1 -0.7 76.3 Bank credit to Private Sector 22.0 33.3 29.6 33.1 3702 30.,

NOTE: All conversions to dollars in this table are at the average exchange rato prevailing during the period covered.

1/ Total labor force; unemployed are allocated to sector of their norrnal occupation. "Unallocated" consists mainly of unemployed workers seeking their first job. j Consolidated puhl ic sector P ;imand, time .nd savinrs dcpo0its only. The aciutoit of US dollars in cir-culetion ia un1luowrl. ildboa issue_ rue lr!dte.l to coins. Page 2 of 2 pages

CUXJNTRYDATA

BALANCEOF PAYMENTS MERCHANDISEEXPORTS (AVERAGE1970-73)

1969 1973 1974 US $ Min % (Millions US $) Bananas 63.0 52.3 Refined Petroleun& 23.1 19.2 Exports of Goods, NFS 276.3 427.6 622.4 Shrimp 13.3 11.0 Imports of Goods, NFS -360.7 -587.0 -891.5 Sugar 6.5 5.4 Resource GaP (deficit = Beef and meat 2.1 1.7 -84.4 -159.la -269.1 1Alother commodities 12.4 10C.4 Interest Payments (net) -25.6 -42.4 -90.6 Workers' Remittances 79.8 92.4 97.8 Other Factor Payments (net) - - - Net Transfers 1.2 0.2 2.3 Balance on Current Account -29.0 -109.2 -6 Total 120.4 l)0.0

Direct Foreign Investment 21.5 35.5 23.6 EXTERFALDEBT, DECEMBER31, 19,74 Net MLT Borrowing Disbursements 39.9 156.8 171.2 US.$ Mln Amortization 8.5 .&3 f.o Subtotal 31.4 98.5 108.2 Public Debt, incl. guaranteed 472.2 Capital Grants - - - Non-Guaranteed Private Debt Other Capital (net) _ - _ Total outstanding & Disbursed 1472-T Other items n.e.i -140.2 -109.8 Increase in Reserves (+)2 -i0.4 -115.14 -237.6 DEBTSERVICE RATIO for 19 /

Public Debt, incl. guaranteed .7 Non-Guaranteed Private Debt Fuel and Related Materials Total outstanding & Disbursed .7 Imports 58.6 91.3 277.4 of which: Petroleum .. 88.1 271.2 Excports 39.8 75.9 227.5 of which: Petroleum 39.8 75.9 227.5 IBRD/IDA LENDING, ( 12/31/1975 ) (Million US $)

RATF, OF EXCHLVNGE IBRD IDA Outstanding & Disbursed 64.3 Thro-ch -= . 71 Since - 1971 Undisbursed 61.7 u 1.00 - I-O US $ TB1 00-7 .00 Outstanding incl. Undisbursed 126.0

I/ Ratio of Debt Service to Exports of Goods and Non-Factor Services plus workers' remittances . Debt service in 19714 eXcludes $145.6 rillion prepayment of loans. 2/ Net foreign transactions of the banking systeJn Ex .cludes sale of bunker oil

Country Programs I Latin America and the Caribbean Regional Off ice

February 12, 1976 IBRD 12082

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SUMMARY AND CONCLUSIONS

Recent Trends

1. In the 1960's, the Panamanian economy expanded rapidly with limited government participationand an efficientuse of investment. Many factors made this fortunate situation possible. World trade flourished during that decade and Panama was able to benefit from its unique geographic location,owing to liberal trade legislation,free use of the U.S. dollar as the domestic currency,and limited investment of high economic yield, such as the Colon Free Zone. The domestic market offered opportunitiesfor small-scaleindustrialization, and there still was much accessiblevirgin land that could be brought under production. The situation changed in the present decade. There are fewer opportunitiesfor import-substitution.Further expansionof agriculturerequires more capital and specializedmanpower, whether to improve yields and cropping patterns or to extend the frontier to new less accessible lands. The recessionwhich is affectingworld trade has lowered the growth of the export-orientedservice sector. World inflationand high interest rates have been transmittedto the open Panamanian economy, at a time when slackening aggregatedemand made it particularlydifficult to pass on to consumers the full cost increases. The impact of these unfavorable developmentswas compoundedby the end of a boom in private construction of high income housing and office buildings. The rate of GDP growth, which averaged 8 percent in 1959-71, fell to 6.4 percent in 1972-73, to 3.5 percent in 1974 and to less than 2 percent in 1975. The unemployment rate is estimated to have risen from 7 percent of the labor force in 1973 to 8.5 percent in mid-1975. Despite a rising level of public fixed investment (which increased from 6.9 percent of GDP in 1968-72 to 9.1 percent in 1974) total investment declined from 26.9 percent of GDP to 25.8 percent, as private investment fell from 20 percent of GDP in 1968-72 to 16.7 percent in 1974.

2. The drop in private investmenthas been accompaniedby an even faster drop in private savings from 22 to 10.2 percent of GDP between 1972 and 1974. There are indicationsthat three factors have contributed to the drop: declining retained business earnings, capital flight, and a drop in real per capita income not matched by a drop in consumption. While private savings were declining faster than private investment,public savings increased in 1973 and 1974 but were outpaced in 1974 by the expansionof fixed and financial public investment. On balance, the country'sresource gap widened to the unprecedentedlevel of 9.9 percent of GDP in 1974, and the current deficit of the balance of payments continued the rapid growth which started in the late 1960's reaching $260 million, or 15 percent of GDP.

3. These trends in resource gap and current-accountdeficit were made possible by the unique role that the banking system plays in Panama. - ii -

Because of the openness of the economy, the absence of a central bank, the use of the U.S. dollar as currency and liberal banking legislation,the banking system has channelledincreasing foreign resources into the country and thus simultaneouslyfinanced domestic expendituresand any resulting foreign deficits. By pursuing liberal credit policies until 1974, the commercialbanks contributedto finance the boom in construction-- much on rather short maturities-- and financed the working capital needs of Panamanian firms at a time when these needs soared owing to rapid inflation and rising inventories. The situation changed in 1975. Commercialbanks experienceddelays in repayments. In 1975 there was a contractionin real terms in bank credit to the private sector, reflectingboth greater caution by banks and reduced demand for credit by business. (A continuationof this contractioncould hinder recovery from the present recessionby reducing the money supply.) But it seems realistic to expect that banks will respond to a revival in profitable lending opportunitiesby expanding their domestic loans. In the longer run, it would be in Panama's interest to reduce the great dependence of the whole economy (both private and public) on banking flows which can be reversed in the future for reasons outside of Panama's control such as changes in foreign banking regulations. To reduce this dependence it will be necessary to strengthenPanama's balance of payments through export promotion policies and measures aimed at striking a better balance between domestic aggregatedemand and supply.

Agriculture

4. Despite the relative smallness of the sector -- which comprises less than one-third of the labor force -- agriculturecontinues to receive much attention from the authoritiesfor two main reasons. First, a serious problem of poverty still affects over 40 percent of the rural population and, second, with appropriatepolicies the sector could make a greater contribution to output, the balance of payments and employment. Since 1968, public policy in agriculturehas aimed at improving the productivityand living standards of peasant groups by organizingthem into collectivesettlements or cooperatives,by providing them with land, abundant credit and technical assistance,and by facilitatingmarketing of their crops. Public sector outlays for agriculturerose from 1.1 percent of GDP in 1968 to over 4 percent in 1974, an annual increase of 26 percent in real terms. Initially,these efforts were oriented towards land acquisition and settlement,peasant organization and the provision of social and economic services such as education, health and feeder roads. The emphasis on land redistributioncreated uncertainty among medium and large scale farmers regarding their own tenure stability. At the same time, the authoritiesmaintained price ceilings on food staples which discouragedprivate investmentin basic crops.

5. Since 1973, the emphasis has shifted towards the consolidationof settlementefforts in lands already acquired and the expansion of production. Many collectivefarms have been successfullygrowing rice in newly cleared low land. As part of the efforts to increase production, the - iii -

authoritieshave increased support prices for basic grains and other products and expanded their marketing activities. These measures brought about a reversal in the declining trend in basic grains and a return to self-sufficiencyin rice. Trends in beef production on the other hand have worsened in recent years. There has been a decline in investmentin cattle despite large increases in bank credit for livestock,from B/. 55 per additonalhead of cattle in 1969 to B/. 743 in 1974. This suggests that credit may have been diverted by ranchers to uses other than cattle expansion,to take advantage of credit on softer terms. Major causes of the decline in beef have been the maintenance of low domestic price ceilings and export quotas, continuing uncertaintyregarding the Government's land reform programs and, more recently,weakened world demand.

6. Spurred by increased world sugar prices and farm-gate cane prices, sugarcane has become the most dynamic crop in Panama. Most of the expansion has been associated with the new mills operated by the state-owned CorporacionAzucarera La Victoria. While the high internationalprices prevailing in 1974/75 meant good profits for La Victoria, preliminary indications are that its costs for refined sugar have been on the high side in relation to costs in other major producing countries. To be profitable in the long run, La Victoria will have to lower costs as it expands its scale of operations and develops new cane varieties.

7. Further improvementsand coordinationof pricing policies are needed to bring about the full developmentof Panamanian agriculture. Farmers are not likely to improve land use unless they feel confident that future prices for their output will be remunerative. Recent price increaseswere not enough to fully reverse the previous adverse movement in internal terms of trade of agriculture,which dropped steadily between 1968 and 1974. The creation of the Marketing Institutehas established the mechanism for a coherent, long-run agriculturalpricing policy as well as related credit and marketing activities.

8. At prevailing agriculturaltechnology levels, Panama only seems to have clear absolute advantage in the production of bananas, beef and shrimp. Production for the internal market has been protectedby import quotas and subsidies for most agriculturalproducts. Since rural wages in Panama are higher than in neighboring countries (the average weekly farm wage is B/. 12), and resource endowments for agricultureare not superior, there is a need for measures to redress the lack of international competitivenessof the sector. For example, a special export incentive coupled with higher generalizedimport duties and relaxation of import quotas would facilitateagricultural expansion.

Manufacturingand Services

9. Manufacturingis sufferingfrom the general slowdown in economic activity. The decline in residentialand office constructiondirectly - iv -

affects the demand for furniture and constructionmaterials, which together account for one-third of manufacturingvalue added. The smallness of the internal market limits the scope for future growth based on import substitution. On the other hand, it is difficult to export Panamanian industrial products because labor costs are too high compared to countries which would export competing products. In the first place industrialwages are higher than in other countries in the region. Second, fringe benefits and payroll taxes add substantiallyto labor costs (20 percent in 1972 and more in 1975). Third, there is a generalizedfeeling among employers that some Labor Code provisionshave led to increased absenteeismand reduced productivity. Implementationof the Code appears to have been biased against employers, and to have unduly restricted their rights to reassign or dismiss workers and to impose discipline. Together with representativesof the industrial- ists and the workers, the authoritiesare exploring possible ways to reverse the unfavorabletrends in productivity.

10. In the long run, expansion of manufacturingwill require additional measures or a more effective applicationof existing export subsidies. The need for high protection for domestic sales and the lack of international competitivenessof industrial exports are indicationsthat special incentives are needed for manufacturing,as they are for agriculture.

11. In late 1974 the Governmentpassed Law 108, which creates an export subsidy in the form of a tax payment certificate (CAT) equivalent to 20 percent of the national value added of eligible (non-traditional)exports. The CAT is not transferable,and can be submitted in payment of taxes after a 12-monthwaiting period. This waiting period reduces the CAT's present value considerably,and the authoritiesmay in the future find it useful to eliminate or substantiallyshorten this period. The non-transferability feature also reduces the CAT's attractiveness. This could be correctedby making CAT negotiable or by indexing them to maintain their real value over time. An alternativeapproach for improving the internationalcompetitive- ness of manufacturing,which may also yield a fiscal surplus, could consist of imposing a uniform ad valorem import duty on all imports, relaxing import quotas and liberalizingthe export subsidy to apply it to the full value of all exports.

12. The Colon Free Zone continues to be a good source of employment and export-earnings. The contrast between the successful expansionof service activities in the Colon Free Zone and the slow growth of domestic manufacturing suggests that a comparativestudy of both sectors and their environ- ments may yield useful insights for future policy. Until 1975 the expansion of the Zone's activitieswas limited by lack of space, but in March 1975, the U.S. Government turned over to Panama 216 hectares in the old France Field Air Base. The authoritiesare making preparationsto expand the Zone into the new land, and are also consideringcreating another Free Zone near the new airport at Tocumen. If past liberal policies continue these two Free Zones could expand fast. In planning these extensions,the authorities may wish to consider carefullyways to minimize possible contraband of goods into Panama. The value of the Zone's surplus of re-exports over imports has been declining steadily as a proportion of imports. In part this trend might be explainedby changes in the compositionof traded products leading to a lower value added in the Zone. Nonetheless,the possibilitythat part of the Zone's merchandiseis being smuggled into the territorydeserves investigation.

13. Panama has become an importantcenter for financialactivity in Latin America. Approximately17,000 people are employed by the financial sector and it accounts for 5.6 percent of Gross Domestic Product. The absence of exchange controls, the fact that the dollar constitutes the only paper currency in circulation and good communicationfacilities, all add to the attractivenessof the country's geographiclocation in promot- ing its developmentas a regional financialcenter. The expansionof the banking system is reflectedby the large increase in the number of banks authorizedto operate in Panama, from 39 in January 1973 to 73 in December 1975. By December 1975, total foreign deposits were approximately $7 billion, more than ten times the level of only four years before.

14. Despite the weakening in world trade, other internationallyoriented service activities,such as transport,warehousing, and tourism have continued to expand at a good pace. Tourist arrivals in 1974 were 16 percent higher than the year before, and estimated tourist expendituresin current prices expanded by over 30 percent in the same period. This confirms the Government'sassessment that Panama's comparativeadvantage lies in the provision of services using the country'sunique geographic location.

Public Sector Program

15. The Government has responded to the slackening of economic growth by formulatinga short-termprogram to reactivate the economy and a bold development strategy, embodied in the Draft National DevelopmentPlan, 1976-1980.

16. The principal elements of the Government'sshort-term program include, in addition to the export subsidy for non-traditionalexports: (a) creation of a National Development Bank to promote and finance private investmentand to manage government holdings in commercial ventures; (b) subsidization of bank credit to agricultureand industry; (c) a scheme to guarantee commercialbank mortgage loans for low and middle-incomehousing and a facility to rediscount these loans after eight years; (d) lowering of commercial banks' capital and reserve requirements;(e) fiscal incentives to promote investment;and (f) special income tax deductions for firms which increase the number of low-incomeworkers on their payrolls. The Govern- ment has also stepped up the pace of public investmentin ongoing projects.

17. For the longer term, the Government has concluded that Panama needs to develop new investment opportunitiesif the economy is to resume a satisfactorygrowth rate. The Government has identifieda number of large - vi -

projects in infrastructureand in directly productiveactivities to take better advantage of the country's potential for providing services to internationaltrade and to develop more intensivelynatural resources This includes projects to improve transport facilitiesacross the Isthmus of Panama (an oil pipeline, a container port, and improvementsof the transisthmichighway), a large open pit copper mine at Cerro Colorado, three sugar mills with related field investments,a 6,000 ha. rural developmentproject in the undeveloped eastern part of the Colon Free Zone and smaller projects for tourism, transport,and urban development. The following table shows the compositionand level of public investment. The preliminaryplan calls for public investmentmore than twice as large as during the past five years for the 1976-80 period.

PUBLIC DfV&MTVW(NPROQRAM 1971-75 AND 1976-80 (Annual Averages in Millions of 1975 Balboas)

Percentage Change in Annual Averages between 1971-75 % 1976-80 % 1971-75 and 1976-80

DirectlyProductive Sectore Agriculture 21.8 14.1 o.9 2.o n Commerce, Industry, and Miming v 20.8 10.2 121.4 29.0 484 Tourias 1 0.7 5.0 1.0 2 fl.1 2960 18T7.3 M-.0- 7' Infrastructutre Transport 35.3 17.3 69.2 16.3 96 Telecommunications 4.0 2.0 9.4 2.2 135 Power 21.7 58.4 13.7 63.6 Ul-0 137.0 32.2 3 SocialService H1ealth 26.5 13.0 25.4 6.0 -4 Eaucation 174 8.5 19.8 4.6 1i4 Housing 17.2 8.4 4S.6 10.7 6 ri.I 29.9 9o.e 21.3 vfitisector(local and regional development) 8.5 4h1 10.2 2.5 20 Total of all sectors 204.3 100.0 425.3 100.0 108

L Includes Oil Pipeline, Container Port and La Victoria sugar program. Sourca: Tablc 5.L0

18. The proposed transisthmicoil pipeline project is based on the assumptionthat a surplus of crude oil production over consumptionwill emerge in the Pacific Coast of the Americas, as production is initiated or increased in Alaska, Ecuador, Peru, and Bolivia. This surplus could be sold in the East Coast of the United States. For the project to be - vii -

economicallyfeasible, firm commitmentsfrom petroleum producers and carriers would be necessary so that enough throughput (300,000barrels/ day) could be assured (see para. 67). In addition to carrying out the Punta Vacamonte fishing port project, the Government intends to construct a containerport in old France Field, east of the Caribbean end of the Canal Zone. The port would serve as a transshipmentpoint for containers which would be transportedin bulk to Panama for distribution in smaller lots to destinationsin Central and South America. Panama's unique geographicposition as a crossroad to world trade is favorable for a containerport's success (see para. 73). According to the feasibilitystudy, the global benefits are sufficient to justify this investment. The Government intends to sign a turnkey agreement for construction. An economic and financial evaluation of the benefits accruing to the Panamanian economy remains to be worked out. Constructionof a new internationalairport at Tocumen was initiated in 1973; investment costs have risen substantiallysince the project was undertaken,and the expected completion date has been delayed by two years, to 1977. This new facility should enable Panama to improve its earnings from international services (see para. 74).

19. INTEL, the Government-ownedtelephone corporation,has prepared a National TelecommunicationsPlan which establishesas main goals for the sector: (a) extension of telephoneservices to rural areas, (b) direct dialing services between metropolitanand rural areas, (c) installationof an internationalexchange which would permit INTEL to handle international services now provided by privately-ownedcompanies, and (d) a national and internationaltelex service to replace the telegraph and telephone service now provided by the Direccion General de Telecomunicaciones. INTEL intends to obtain suppliers' credits and commercialbank loans to finance the bulk of its investment costs. An increase in telephone rates would be required to permit INTEL to service its resulting debt adequately. The authorities are consideringthis matter (see para. 76).

20. Over 90 percent of electric power consumed in Panama is of thermal origin and petroleum imports for power generation are large. To prevent the fuel bill from increasing further, and to reduce dependence on foreign oil supply for power generation,the Government intends, in addition to completing the Bayano project, to install hydroelectricfacilities at several suitable sites to meet power requirementsthrough the 1990's. A preliminary Master ElectrificationPlan recommends that in order to meet projected power requirements,generation capacity should be increasedby bringing an 80 MW hydropower project (La Estrella-LosValles) on stream in 1980 and a 255 MW hydropower project (La Fortuna) into service in 1982. The major question relating to the feasibilityof this program is IRHE's ability, in the absence of electricityrate increases in 1975-76, to make a significantcontribution from internal cash generation after meeting its mounting debt service obligations. It is clearly essential that substantial electricityrate increasesbe effected in the near future and IRHE is planning to proceed accordinglyin 1977 (see paras. 77 and 78). - viii -

21. A turnkey contract has been signed with a supplier to construct a 330,000 ton cement plant to begin operations in 1978. The Government feels that the project is justified on the grounds that the cement plant will generate enough financial resources to cover operation costs and debt service payments. However, the investmentcost per ton of the project would be high, and this may lead to increases in cement prices. Even so, revenues may be inadequate to cover debt-serviceobligations in the first five years of operationsowing to the relativelyshort repayment periods of the proposed financing (see paras. 60-62).

22. By far the largest investment in the Government'sprogram is the Cerro Colorado copper mining project. The mineral deposit lies in the western part of Panama and contains proven and probable ore reserves of about 1,500 million metric tons with an average copper content of 0.6 percent. Reserves would be sufficientto maintain productionat an annual rate of 150,000 metric tons of blister copper for over 20 years, according to a pre-feasibilitystudy prepared in 1973. A detailed feasibilitystudy is now required before investmentsare initiated. The deposit's remote location, absence of infrastructurein the region and the ore's compara- tively low mineral content are factors which may offset in part the advantage offered by the deposit's size. The inherentlyrisky nature of mining operations requires that they be financed with an adequate amount of equity capital and that the debt structurebe such as to permit uninterrupted debt service under unfavorablemineral market conditions. If production costs are in line with long term world prices and if the capital! debt structure is sound, the project could make significantcontributions to public savings, employmentand the economic developmentof the western region (see paras. 63-65). 23. The overall strategy of the Draft National DevelopmentPlan is well conceived with its emphasis on projects which would provide new sources of growth and of foreign exchange earnings. The plan is, however, highly ambitious and its administrativeand financial implicationswill require careful attention by the Government.

24. There are three major areas of concern. First, while economic priorities have been well determinedand project identificationhas on the whole been good, in some cases there has been insufficientdetailed project planning, as suggested by the preceding discussion. Investmentsin the productive sectors require detailed examinationto establish operating costs, ensuring that the enterprisescan be competitiveinternationally over the long run. Since the profitabilityof several important projects hinges on volatile future commodity prices, analysis of risk deserves explicit con- sideration. In making specific investment decisions in the past, the authoritiesmay have given greater weight to the terms of financing provided by suppliers of investmentgoods than to the above considerations. Commercialbanks which have provided project financinghave not required adequate long-term financial analyses. The authoritieshave recently - ix -

taken steps to strengthenproject analysis and it is expected that the recently created National Development Bank will contribute towards this objective.

25. Second, as noted above, the volume of public investmentplanned for the rest of the decade is more than twice as large in constant terms as in the 1971-75 period. This considerableincrease in the Government'spartici- pation in the national economy will require a much expanded professional capacity which will no doubt put a strain on the country'sprofessional resources. The authoritiesare aware of the constraint and have taken steps to attract qualified Panamaniansliving abroad and to train local professionalsin the new skills required. These measures may prove insufficient to meet the demand for professionalskills which the pace and diversity of the investment program would require. There are already signs that project implementationhas been delayed and large cost overruns incurred owing to an insufficientnumber of qualified domestic managers, e.g., in housing, power, and some transportprojects. The authoritiesare therefore resorting to turnkey contractsin some cases, but this adds considerably to the cost of projects. They have now determined to adopt a more gradual approach to investmentsin some activities,to enable personnel to experimentwith techniques suitable to conditions in Panama before undertakingprojects on a large scale.

Public Finance Prospects

26. The third major area of concern is the need for soundly financing the investmentprogram. With the major expansion in social and economic programs started in 1968, total public sector outlays have risen steadily. The authoritieshave made efforts to raise the level of public sector savings in order to finance these expanded programs. Following a disappointing outcome in 1972, when the ratio of public savings to GDP fell to 1.4 percent, the ratio has risen steadily to about 4 percent in 1974 and it is estimated to have been higher in 1975. Nonetheless,despite the adoption of several new taxes, of improvementsin tax administration,and of measures to restrain the growth of current outlays, public savings have not kept pace with investment outlays and the Governmenthas increasingly relied on external borrowing, much of it in the form of commercialbank loans. (In the case of Panama, practicallyall borrowing is considered external owing to the use of the U.S. dollar for all transactions.) The followingtable shows that gross external borrowing requirementsof the public sector have risen from 1.4 percent of GDP in 1965 and 6.6 percent in 1970 to 9.7 percent in 1974 and 11.0 percent in 1975. As of December 1974, the disbursed external public debt reached US$ 472 million, almost four times more than five years earlier, and equivalent to US$ 290 per capita, one of the highest in the world. x

SUMMARY OF OPERATIONS OF PUBLIC SECTOR, 1965, 1970-1975

(Percentof GDP)

1965 1970 1971 1972 1973 1974 1975 (Est.)

Public Savings 2.5 2.2 2.7 1.4 3.2 4.0 4.2

Capita Revenues, net 0.1 -0.3 -0.3 -0.2 0.3 0.2 0.3 Capital Expenditures 4.1 6.6 6.0 7.4 10.7 11.1 15.2 (Fixed Investment) (3.3) (5.8) (5.0) (6.9) (7.5) (9.1) (10.5)

Overall Public Deficit -1.5 -4.7 -3.5 -6.1 -7.1 -6.9 -10.6

Gross External Borrowing 1.4 6.6 6.9 8.7 11.6 9.7 11.0 Gross Internal Borrowing 0.7 0.9 1.1 1.0 0.6 1.4 1.1 Amortization 1.0 2.9 4.9 3.9 5.0 5.4 2.4

Change in Assets and Discrepancy (-increase) 0.4 - -0.5 -0.6 - 1.2 0.9

Source: Table 16

27. The draft financial program of the Government implies that these trends would continue. Since public savings (beforeinterest) in 1976-80 would be less than one-half of public investment,public sector borrowing (excludingthe National Bank of Panama and the Savings Bank) would average $530 million per year in current prices, about one-half of which from commercialbanks. This is three to four times higher than in 1971-74. Debt-servicepayments on the public debt would average nearly $250 million per year, 3.5 times higher than in 1971-74 and equivalent to 94 percent of public sector savings before interest payments. In view of these implicationsof the draft program, the authoritiesmay conclude that the risks would be excessive as regards the magnitude of debt service and availabilityof loans. It may be very difficult to borrow the amounts expected from private sources. Commercialbanks in the United States are coming under increasing public scrutiny as regards the quality and diver- sification of their portfolios;they may tend to be more restrictive in their lending policies in the future. Should it prove impossible to obtain the required commercial loans at acceptable terms once the major investment - xi -

programs have been launched, the authoritiesmight find themselves in a very difficult liquidity situation.

28. To reduce these risks, the authoritiesmay choose a financial program relying more extensivelyon internal efforts, such as the one outlined below. Sound financing of the Public Investment Program requires a determined internal savings effort, which may have to be achieved at the expense of some loss in GDP growth and in consumptiongains, with respect to the preliminaryprogram's targets. Public savings (beforeinterest payments) in 1976-80 would have to finance about 60 percent of public investment (i.e., B/. 1.6 billion, compared to B/. 0.3 billion in 1971-74)which would require a combinationof fiscal action and incomes policy.

29. The needed fiscal measures could aim at simultaneouslystrengthen- ing public finance and the balance of payments. Output growth in agriculture and manufacturingis hampered by lack of internationalcompeti- tiveness at present exchange rates. The export-orientedservices sector, on the other hand, continues to thrive because of Panama's clear comparative advantage. Panama could achieve a more balanced developmentand utilize more fully its labor and natural resourceswith a lower effective exchange rate for the goods-producingsectors. It may be possible to accomplish the necessary changes by replacing the existing system of quotas and specific import duties by a generalizedsurcharge, applicable to all merchandise imports, of between 20 and 25 percent of the value of imports. This measure could be accompaniedby the establishmentof a generalized export subsidy of the same proportion,on the value of all exports. These two actions would be tantamount to a partial devaluation,and would have a large positive fiscal effect. As merchandise imports exceed merchandise exports by about US$ 350 million, the initial fiscal surplus could be as high as B/. 80 million. If not defeated by price controls, this partial "devaluation"would tend to stimulateproduction of goods for the domestic market and for export by reducing the internationalcost of Panamanian products. It would also have the needed effect of reducing the growth of private consumptionexpenditures, thus moving aggregate supply and demand towards equilibriumand reducing the resource gap.

30. Other tax measures which would have the desired side effects of improving resource allocation and/or increasing domestic savings include a general sales tax, a tax on automobile ownership, and more effective enforcementof taxes on urban and rural land, as well as improving certain aspects of the income tax. The scope and timing of specific measures would depend on business conditions,administrative readiness for implementation and other circumstances,but the needed efforts would be broadly equivalent to annual tax packagesof B/. 15 to B/. 20 million (1975 prices) in 1976-80. It would be desirable to make public enterprisesof a commercial nature (e.g., in cement, sugar, copper) subject to payment of corporate income taxes. This would help ensure that they are run efficientlyand would give the Central Government more effective command over savings generated in the - xii -

the rest of the public sector. Altogether these measures would raise the tax burden (excludingSocial Security taxes) from about 12 percent of GDP in 1970-74 to about 17 percent of GDP by 1980. Current outlays would need close monitoring to keep their annual growth around 5 to 5.5 percent in real terms. If this is done, Central Government savings before interest payments could well reach 8 percent of GDP by 1980.

31. This financialprogram would strengthen public sector finances. By restricting the growth of private consumption,the program would also open up possibilitiesfor some lending from the Panamanian private sector to the Government (US$ 15 million per annum). Overall gross borrowing requirements of the public sector would be around US$ 450 million per year, of which about US$ 175 million from commercialbanks. Under these assumptions, total debt service on the public debt would average $225 million per year and by 1980 it would drop to 75 percent of public sector savings before interest. Such a situationwould still require delicate management and close attention,but would not be out of line with that in other developing countries of similar income levels.

32. If it should turn out that the tax effort outlined above cannot be made, or that the Eurodollarmarket is tighter than expected, the investment program would have to be scaled down. The authoritieshave expressed their intention to interpret their DevelopmentProgram with flexibility, and to adjust their expendituresto the availabilityof financing. They may prefer to delay launching some investmentprojects to allow for better appraisal, preparation,and implementation. Alternatively,ways may be found to allow private capital to participatemore fully in large projects. Because of Panama's open exchange system, little is known about the extent to which Panamanian residents are holding foreign financial assets, but the amounts may be considerable. Part of these savings could be reinvested in Panama, if conditionsare favorable. This would reduce the need for large tax increases,while allowing Panama to develop its growth potential.

33. In spite of the ongoing recession,medium-term growth prospects remain favorable. In a country that relies on trade and services, economic growth entails the full participationof both the public and private sectors. Therefore, success of the Government'songoing efforts to encourage private investmentwill greatly strengthen these prospects.

34. The authoritieshave never defaulted or unilaterallyrescheduled any external debt. They are in good standing with internationalagencies and with private banks. The future ability of the public sector to meet debt service payments as they come due will hinge mainly on a resumption of fast economic growth and on the following actions:

(a) timely adoption of taxes and public utility tariff measures to ensure that public savings (net of interest payments) exceed amortizationpayments on all public debt; and - xiii -

(b) prudent timing of new investmentprojects so that total public sector gross borrowing from private banks does not exceed, on average, around US$ 175 million per year -- in current prices -- in 1976-80, including possible refinancing.

35. In April 1976 the authoritiesrevised the PreliminaryDevelopment Plan and decided to introduce some importantchanges. First, they postponed the timing for the executionof certain projects and changed the scope of others to reduce their cost. The crude oil pipeline will not be initiated in the period 1976-80 and will be carried out only if throughput agreements are reached. The housing program was significantlyreduced, although it still would be much larger than in the past. Other projects displaced or recast are in agriculture,industry and commerce, and other sectors. As a result of these changes in the scope and timing of projects, the total investmentplanned for the period 1976-1980has been reduced from B/. 2.7 million in the PreliminaryPlan to B/. 2.1 million (in 1975 prices). The authoritieshave also recognized that it will be necessary to adopt additional tax packages to raise the buoyancy of public revenues with respect to GDP growth, to restore aggregate equilibriumand to stimulate investment and production. In addition, they have started a process of adjustment of public utility rates. All these measures should permit to raise the contributionof public savings to financingpublic investment, to reduce accordinglyadditional borrowing from commercialbanks, and to strengthen the country's creditworthiness. The revision of the Plan was still under way as of late April 1976. For this reason this report does not include the revised public sector financial program.

I. INTRODUCTION

1. This document reports on developmentsin Panama since the last com- prehensive economic report (275-PAN),which was based on a Bank mission to Panama in April 1973. Report 275-PAN examined the Government'sefforts, first, to encourage rapid economic growth in the Panama-Colonmetropolitan areas and, second, to channel the public resourcesgenerated by this growth to improve the living standards of urban and rural poor as well as to integrate more closely the heretofore neglected rural areas of Panama with the more prosperous urban areas. The report concluded that the chief problem facing the Panamanian authoritieswas a fiscal one, and it suggested a public expenditureand financingprogram.

2. During the last three years the Governmenthas made progress towards improving the output of the rural poor and extending social services to the rural and urban poor. The economic situation,however, has worsened as a result of three causes: first, the open Panamanian economy was severely affected by external factors such as internationalinflation, high interest rates and world trade recession; second, new investmentsin extensive agriculture and import-substitutingmanufacturing have been declining as the more profitable projects were completed; third, private investment was adversely affected by uncertaintiesrelating to the applicationof controls on low and middle-incomerents and on prices of cement, food and pharmaceu- tical products and of labor legislation. With the purpose of compensating for the fall in private investmentand also to create new opportunitiesfor profitable private investment in the future, the Draft National Development Plan contemplates -- in addition to incentive legislation already adopted -- a large Public InvestmentProgram for 1976-1980,more than twice the size of public investment in 1971-1975.

3. This report consists of two volumes. The first examines the financial and macroeconomicimplications of the Draft Public Investment Program, and the options open to the authorities. Three strategies are presented to illustrate the possible range of policies. The report concludes that, if the major investment effort which is planned is to be successful and financially sound, it must be accompaniedby a strong effort to raise public and private savings. Because the program will continue to require a large amount of borrowing from commercial banks, the future availabilityof which is by no means assured, it will be necessary to maintain flexibilityin order to adjust the levels of future public expenditureto the availabilityof financial resources. In the long run, Panama's creditworthinessdepends on a resumption of sustainedhigh economic growth. This in turn entails the full participationof the initiative,ingenuity and productivityof both the public and private sectors. To that extent, success of the Government'sefforts to restore private confidencewill greatly influence the viability of the National Development Plan. -2-

4. A second volume, the StatisticalAppendix, presents the economic and social data used in the report. The StatisticalAppendix also presents a note with a proposed adjustmentto the investment estimates in the nationaL accounts, to help understand the recent behavior of private investment.

II. THE ECONOMY IN 1975

A. General Trends

5. After more than a decade of rapid expansion, the Panamanianeconomy has been slowing down. The rate of real GDP growth, which was on average 8 percent in 1959-71, fell to 6.4 percent in 1972-73 and to 3.5 percent in 1974 (provisionalestimates, see Table 1); it may have been around 2 percent in 1975. This deceleration,which is particularlyserious because populatior. continues to grow by nearly 3 percent per year, is a consequenceof the ero- sion of some important sources of growth, not fully compensatedby the emer- gence of new leading sectors. It has been aggravated in recent years by unfavorable internationaleconomic conditionsand by a climate of uncertainty among private investors.

6. This combinationof factors has led to a drop of the Private Invest- ment/GDP ratio from 23 percent in 1972 to 19.8 percent in 1973 and to 16.7 percent in 1974 (Table 2). Private investmentwas hurt by the serious glut in high-incomehousing and in the commercialconstruction market, attributable to excessive constructionin recent years (See Section B). Another factor in 1974 was the sharp rise in the price of imported inputs and in financial costs; these could not be fully passed on to consumersowing to weakening demand and, in the case of certain activities,to the enforcement of price controls on rents and wage goods. Thus, the consumer price index rose by only 17 percent in 1974, 13 points less than wholesale prices.l/ This suggests that a profit squeeze may have contributedto discourageinvestment. The profit squeeze continued into 1975 because of a further weakening of demand. Also, organizedbusiness groups have expressed concern regarding the Government'sincreasing involvement in directly productiveventures. In addition to the above, the way in which the provisions of the 1972 Labor Code have been implementedappears to have tended to reduce labor productivity and to increase absenteeism. As a consequence,business firms are reported to be substitutingcapital for labor, notwithstandinga decline in wages relative to capital after 1972. Thus, despite the absolute fall in total private investment,average private investment in machinery and equipment per new job created increased from an average B/. 7,300 in 1970/71 to B/. 20,000 in 1972-74, expressed in 1960 prices (see Table 3). Employment has been growing at a declining rate, and the urban unemploymentrate is estimated to have reached 8.5 percent in July 1975.

1/ The wholesale price index, which until 1970 moved closely in line with the consumer price index, has increasinglyexceeded the latter since 1971. There are some important differencesbetween the two indices, however, which limit their comparability. Table 1: GDP GROWTHBY SECTOR

Value Added in: Composition Annual Growth Rates (%) in 1974 (%) 1960-70 1971 1972 1973 1974

Agriculturej 15.5 5.3 3.7 2.9 3.4 - 0.8 - Bananas ( 2.8) ( 9.7) (-2.7) (-8.2) (-24.9) - Other 1/ (12.7) ( 1.5) 55.2) ( 7.7) ( 6.8) Manufacturing2/ 16.9 10.8 8.6 6.2 4.7 2.0 Construction 7.0 8.9 18.7 12.0 6.3 3.9 Transport, Warehousing, Communications 8.0 11.9 14.t 6.2 ii.4 13.8 Commerce 14.3 8.1 7.3 6.2 6.4 5.7 Banking, Insurance, Financial 5.3 12.9 14.7 13.0 21.3 ii-0 Public Administration 2.5 7.4 8.1 7.9 1-5 2.5 Public and Private Services 2/ 24.6 5.9 8.2 6.9 4.2 3.6 Services Sold to Canal Zone 5.9 8.9 4.3 -2.7 4.9 -9.8

Total GDP 100.0 8.0 8.7 6.3 6.5 3.5

1/ Includes Fishing and Forestry. 2/ Includes snall value of mining. 3/ Includes electricity,water and sewerage, ownership of dwellings.

Source: Direccion de Estadistica y Censo - 4 -

Table 2: EXPENDITUREON GROSSDOMESTIC PRODUCT (Percentages of GDP)

1970 1971 1972 1973 19714

CONSUMPTION 76.9 78.2 75.2 814.1 Private 62. 6. 7;7 62.8 69.0 Public 114.3 14.2 114.8 14.5 15.1

INVESTMaTT 26.4 25.7 30.0 27.3 25.& Private 20.7 20.7 23.0 917 Public 1/ 5.7 5.0 7.0 7.5 9.1

EXPORTS 37.3 37.3 36.0 36.2 L2.2

IDPORTS 40.6 141.2 41.2 14o.8 52.1

GROSSDOMESTIC SAVINGS 23.1 21.8 24.8 22.7 15.9 Private 20.2 8.1- 22O0 10.2 Public 2/ 2.9 3.7 2.8 4.7 5.7

RESOURCEGAP .3 3.9 5.2 14.6 9.9 Private 0.5 2 1.0 1.5 Public 2.8 1.3 14.2 2.8 3.4

1/ The national accounts concept of public sector investment differs from the public finance concept (Table 13) because it includes only fixed investment, and it considers that public sector financial investment is a part of private sector investment.

2/ "Gross domestic savings - public" is gross of interest payments abroad and therefore exceeds the public savings estimates shown in Table 13.

Source: Mission estimates from data provided by the Office of the Controller General, the Ministry of Planning and by decentralized autonomous public agencies and corporations, based on current price series.

Note: Official national accounts estimates (expenditure side) are summari7ed in Tables 2.3 and 2.4. These estimates have been revised as explained in Table 2.7; the revised figures, which are summarized in Tables 2.8 and 2.9,, are used throughout this report. The revision has affected mainly the figures for total investment in construction. Public fixed investment also has been adjusted in line with the consolidated public sector estimates (Table 5.1 ); the largest adjustment was made for the year 1972, by subtracting from the official estimate of fixed public investment the value of the fixed assets of Fuerza y Luz (B/.56.9 million in current prices and B/.114.4 million in 1960 prices). The value of the net Fuerza y LaAzassets 031.35.7 in curreuit prices) was iricluaeo as financial investment of the public sector in 1973 (the year in which the transaction was recorded by IRHE). - 5 -

Table 3: PRIVATE SECTORINVESTMENT AND EMPLOYMENT

1970 1971 1972 1973 1974

New Jobs Created in Private Sector (000)- 10.2 15.0 2.4 5.7 4.5

Private Investment in Machinery and Equipment (B/ millions) 2/ 90.2 94.8 76.2 90.7 84.5 Investment Per New Job (B/000) / 8.8 6.3 31.8 15.9 18.8 Index of Nominal Wages (1970=100)1/ 100.0 108.6 110.4 115.8 140.3

Index of Nominal Interest Rates (1970=100) 100.0 80.3 69.1 110.0 132.3

Relative Cost Labor/Capital(1970=100) 100.0 135.2 159.8 105.3 106.0

Cost of Living Index (1970=100) 100.0 102.2 107.3 114.2 133.8

Index of Real Wages (1970=100) 100.0 106.3 102.9 101.4 104.9

I/ Includes banana growing zones.

2/ In 1960 prices.

2/ This index incorporatespart of the 13th month bonus in 1971, 10 cents/hour minimum wage increase in 1971/72, 5 percent collectivebargaining gains in 1973 and part of the general wage and salary increase decreed in March 1974. The effective cost of labor to employershas increased by more than this series indicates because of rising payroll taxes, such as the EducationalInsurance and Social Security contributions,and because this index does not take into accowit thLecEct of Qe".es irlion-pecurxiary fringe benefits, such as paid vacation.

Source: Tables 2.5, 9.3, 9.4 and Banking Commission. - 6 -

7. The drop in private investment has been accompanied,since 1972, by an even faster drop in private savings from 22 to 10.2 percent of GDP in two years. 1/ Not enough is known about the behaviour of private savings, but there are indicationsthat three factors have contributed to the observed drop: declining retained business earnings, capital flight, and a drop in per capita real income.

8. Retained business earnings fell from 9.8 percent of National Income in 1972 to 6.4 percent in 1973 (Table 2.6). Preliminaryestimates indicate a further drop in 1974. The resulting decline in working capital was compensated by increased short-term borrowing from commercial banks (Table 6). The extent of recent private capital outflows is suggestedby balance of payments estimateswhich show a total net outflow of over US$ 250 million in 1972-74 (see Table 7). Nominal wages in Panama have moved broadly in line with the cost of living, although the general wage and salary increases decreed in March 1974 probably led to modest gains in real wages (see Table 3). In 1974, however, real per capita national income fell by over 3 percent, when account is taken of increased interest payments abroad and worsening terms of trade (see Table 4). The combinationof significant, albeit modest, gains in employment (Table 1.5) with some increase in real wages at a time of falling real national income per capita thus allowed private consumptionto outpace national income and contributed to the observed fall in private savings. 2/

9. While private savings were declining faster than private investment, public sector savings increased in 1973 and 1974 but were outpaced in 1974 by the expansion of public investment,including financial investment. On balance, the overall resource gap widened to the unprecedentedlevel of 9.9 percent of GDP, and the current deficit of the balance of payments continued the rapid growth which was started in the late 1960's (see Table 5).

10. The large current account deficit of 1974 reflects the higher cost of petroleum products (aboutUS$ 50 million), a decline in banana exports due to an export tax dispute with the exporting company (US$ 14 million), higher interest payments (US$ 50 million) associated with the peak in Eurodollar rates and the growing reliance of the economy on foreign bank credit, as well as an increase in the value of imports of goods and non-factor services owing to sharply higher prices and to an increase in real terms of almost 12 percent over 1973 (Table 2.4).

1/ It seems that the national accounts statistics tend to exaggerate the extent of fluctuationsin savings and investment. An attempt has been made to adjust these apparent errors, as explained in StatisticalAppen- dix Table 2.7. 2/ National account statisticsare subject to wide margins of error as regar,ls the measurement of consumptionand savings (see Table 2.7 for a discussioii and partial adjustment.) Furthermore, the observed decline in private savings is in part also due to the recent absorption into the public sector of profit-makingenterprises such as Fuerza y Luz and INTEL. This is discussed in Chapter III, Section C. Table 4: PER CAPITA GROSS NATIONALINCOME (In millions of 1960 Balboas)

Average Annual Growth Rate 1972 1973 1974 1972-74

1. Gross Domestic Product 1033.8 1100.6 1139.6 5.0 2. Net Factor Income Payments -28.7 -31.7 -50.3 32.5 3. Gross National Product loo5.1 1068.9 1089.3 4.1 4. Terms of Trade Effects 52.1 37.9 13.7 -48.7 5. Gross National Income 1057.2 1106.8 1103.0 2.1 6. Per Capita Gross Nat'l. Income 685.4 697.8 676.2 -0.7

Source: Mission estimates from data provided by the Office of the Controller General. - a -

Table 5: BALANCEOF PAYMENTS- CURRMNTACCOUNT DEYICITS

Year ($ Million)

Average 1961-1968 20 1969 29 1970 64 31971 75 1972 97 1973 109 1974 260

Source: Table 3.1 - 9 -

Table 6: BANKINGSYSTEM - FLOW OF FUNDS (In B/Millions)

1972 1973 1974 1974 I/ 1975 l/

Uses 166 26 393 223 Changes in Credit to Private Sector (175) (262) (295) (179) (-11) Changes in Credit to Public Sector (- 1) (-10) ( 58) ( 20) ( 65) Unclassified (_ 8) (-16) ( ho) ( 24) (-19)

Sources 166 D6 393 223 5 Foreign Net Contribution T4t) (139) (022) (1772) Increase in Donestic Deposits (102) ( 65) ( 94) ( 29) (- 3) BanksI Capital and Domestic Reserves ( - ) ( 32) ( 47) ( 12) (-6)

P/ January-June

Source: IMF - 10 -

Table 7: FINANCING OF THE BALANCEOF PAYMENTS CURRENTACCOUNT DEFICIT (In $ Millions)

1972 1973 1974

Current Account Deficit 97 109 260

Net ContributionBanking System 64 139 252

Net Public Sector Long-termBorrowing 84 100 83

Net Private Capital 2/ - 51 - 130 - 75

1/ Includes funds for the public sector. L/ Includes "Errors and Omissions"

Note: There are differencesof classificationbetween this table and table 3.2

Sources: Table 3.2 and IMF. - 11 -

11. These trends in resource gap and current-accountdeficit were made possible by the unique role that the banking system plays in Panama. Because of the openness of the economy, the absence of a central bank, the use of U.S. dollar as currency and liberal banking legislation,the banking system has channelledincreasing foreign resources into the country and thus simultaneouslyfinanced domestic expendituresand any resulting foreign deficits (see Table 7). By pursuing liberal credit policies until 1974 the commercialbanks contributedto finance the boom in construction -- much on rather short maturities -- and financed the working capital needs of Panamanian firms, at a time when these needs soared owing to rapid inflation and growing inventories.

12. The situation changed in 1975. Commercialbanks experienced delays in repayments.1/ In 1975 there was a stagnation in bank credit to the private sector and a contractionin real terms, reflectingboth greater caution by banks and reduced demand for credit by business (Table 6). A continuationof this contractioncould hinder recovery from the present recessionby reducing the money supply. But it seems realistic to expect that, as long as banks continue to enjoy a favorablebusiness environment, they will respond to a revival in profitable lending opportunitiesby expanding their domestic loans. In the longer run, however, it would be in Panama's interest to reduce the great dependence of the whole economy (both private and public) on banking flows which might be reversed in the future for reasons outside of Panama's control such as changes in foreign banking regulations. To reduce this dependenceit will be necessary to strengthen Panama's balance of payments through export promotionpolicies and measures oriented towards striking a better balance between domestic aggregate demand and supply, such as those suggested in Chapter IV, Sec- tion C.

B. Trends in Output

ti) Agriculture

Poverty and Agriculture

13. The importanceof agriculturefor Panama is less than for most Latin American countries. Under one-third of the labor force derives its primary income from agriculture,the sector's share in GDP was only 15.5 percent in 1974 and its contributionto total exports of goods and non- factor services in the same year was 13.5 percent. Despite the relative smallness of the sector, agriculturecontinues to receive much attention from the authoritiesfor two main reasons. First, there still is a serious problem of poverty in rural areas and, second, with appropriatepolicies the sector could make a greater contributionto output, the balance of payments and employment,as discussed below.

1/ It is not possible to quantify the magnitude of this problem or the extent to which it was confined to constructionloans. - 12 -

14. While agricultureis not always associatedwith low incomes (Chi- riqui province is a prosperous agriculturalzone) the poorest districts in Panama are primarily agricultural (see Table 8, Part II). These districts are located in remote areas of difficult access and their population is so dispersed that it would be very costly to provide significant levels of public *-ervices.The physical isolation of these farmers restricts opportunitiesto market crops and results in heavy dependence on subsistenceagriculture which, combined with poor cropping practices and low input levels, leads to low productivity. A recent government study l/ defined as extreme poverty a total annual family income of less than B/. 200 per person. This study found that 58 percent of rural families were below this income level in 1970, compared to less than 15 percent of families in the metropolitanarea (see Table 8, Part I). Living conditions of many farmers, however, have been alleviatedby government programs to extend health and education services to low-income districts, and welfare indicators other than income suggest that conditions of extreme poverty affect about 300,000 persons, i.e., 40 percent of the rural population or 20 percent of Panama's total population (those resid- ing in the 27 districts classifiedin the two lowest welfare levels). (See Table 8, Part II). Since virtually all the rural poor have some land there is no open unemploymentin agriculture,although low productivity and the seasonalityof crops lead to substantialunderemployment.

Recent Trends

(a) Basic Grains

15. Since 1968, public policy in agriculture has aimed at improving the productivity and living standards of peasant groups by organizing them into collective settlementsor cooperatives,by providing them with land, abundant credit and technical assistanceand by facilitatingmarketing of their crops. In support of this policy, public sector institutionswere strength- ened and budgetary allocations increasedsharply. Public sector outlays for agriculturerose from 1.1 percent of GDP in 1968 to 4.1 percent in 1974, an annual increase of 26 percent in real terms. Initially, these efforts were not oriented towards increasedproduction but rather towards land acquisitionand settlement,peasant organizationand the provision of social and economic services such as education,health and feeder roads. Between 1969 and 1972, the Government acquired 330,000 hectares -- one-sixth of the total land in farms in 1970 -- of which 80 percent through expropriationor tax auction. 2/ The emphasis on land redistributioncreated uncertainty among medium and large scale farmers regarding their own tenure stability. At the same time, the authoritiesmaintained price ceilings on food staples which discouragedprivate investment in basic crops (rice, corn and beans). Thus, production of these crops fell sharply in 1969-1972 (the drought of 1972 intensified the production decline). (See Table 9).

1/ Ministry of Planning and Economic Policy, "Radiografiade la Pobreza," unpublished,Panama, 1973. 2/ 150,000 hectares belonged to a largely undevelopedplantation owned by a foreign firm. Most of it was occupied by squatters. Table 8 (Part I): DISTRIBUTION OF FAMILY INCOME: METROPOLITAN AREA AND REST OF ThE COUNTRY, BY DECILE GROUP OF FAMILIES (1970) (Population figures in thousands, Income figures in Balboas)

Lowest Second Third Fourth Fifth Sixth Seventh Eighth Ninth Tenth Total Decile Decile Decile Decile Decile Decile Decile Decile Decile Decile

Republic of Panama

Total Population 113.1 140.0 133.1 134.8 140.0 140.0 138.5 148.2 152.2 154.0 1,395.1 Average Annual Family Income per capita 36.5 61.0 109.8 175.7 247.8 335.1 449.1 578.5 846.6 2,043.4 519.3

Metropolitan Area

Population 17.0 26.0 30.0 42.7 60.o 75.0 83.5 100.0 111.6 129.4 675.6 Average Annual Family Income per capita 41.9 70.4 137.0 228.1 279.6 379.3 478.0 611.0 875.1 2,110.5 790.0 Proportion of Income in kind (%) 33.0 19.2 12.1 3.8 1.6 0.5 0.6 0.5 0.4 0.5 0.7 Adjusted Average Annual Family Income per capita - 55.7 83.9 153.6 236.8 284.1 381.2 480.9 614.1 878.6 2,121.1 795.5

Rest of the Country

Population 96.0 114.0 103.1 92.1 80.0 65.0 55.0 48.2 40.6 24.6 719.5 Average Annual Family Income per capita 35.4 58.9 101.9 151.3 223.4 281.6 403.1 502.4 766.7 1,734.8 265.1 Proportion of Income in kind (%) 48.3 40.4 22.3 11.5 5.4 7.4 9.1 3.4 2.8 1.1 7.4 Adjusted Average Annual Family Income per capita 1/ 52.5 82.7 124.6 168.7 235.5 302.4 439.8 519.5 788.2 1,753.9 284.7

Composition of Decile 21

Metropolitan 15.0 18.6 22.5 31.7 42.9 53.6 60.3 67.5 73.3 84.0 48.4 Rest of Country 85.0 81.4 77.5 68.3 57.1 46.4 39.7 32.5 26.7 16.0 51.6

Note: Totals may not add up owing to rounding. Each decile group includes 28,500 families.

1/ Family Income was adjusted upward assuming that the market value of income in kind is twice the imputed value. 2/ Percentage of Population (%)

Source: Derived from Contraloria General-Direccionde Estadistica y Censo - Encuesta Especial Sobre Ingresos - Afio1970, and staff estimates. Table 8 (Part II): INDICATORSOF WELFAREBY INCCMELEVELS OF DISTRICTS (1970)

Lowest welfare Highest 'welfare Level Second Level Third Level Fourth Level Fifth Level Level (13 Districts) (14 Districts) (14 Districts) (11 Districts) (9 Districts) _(5 Districts)

Population(000) 147.0 150.2 139.1 238.8 178.9 57___ (Percent) (10.3) (10.5) T 9.7) (16.7 (12.5) (40.3) Proportionof Labor Force in Agriculture (%) 84.2 81.4 72.2 58.9 47.4 14.9

Proportionof Populationunder 5 years of age (%) 18.3 18.7 18.3 16.8 14.8 14.7

Crude Birth Rate (0/oo) 42.2 40.6 40.8 36.5 34.2 34.2

IlliteracyRate (%) 53.8 42.9 31.6 21.7 19.3 6.4 a

Primary School Enrollment (%) (Population5-14) 60.3 59.0 60.0 72.4 68.2 74.5

SecondarySchool Enrollment (%) (Population15-19) 0.9 7.7 8.1 28.9 42.9 60.9

InfantMortality (0/oo) 51.7 43.9 36.3 33.1 26.8 30.7

OverallMortality ( 0/oo) 10.2 8.1 8.o 6.2 6.5 5.3

Population/Physician(000) 24.4 11.9 5.1 3.2 2.4 0.9

Population/HospitalBed (000) 3.7 1.0 0.8 0.4 0.3 0.2 Population/Km2 9.3 13.0 18.9 34.5 44.0 399.2

Source: Contraloria General. Dirennion de yst.d!i54eij-Cnso - iiio'ryof P-flanningand Economic Policy. - 3.5-

Table 9: BASIC GRAINS - RECENTTRENDS (Yearly Averages)

1966-68 1970-72 1972-74 1975

Rice Area (1000 has) 130 98 108 112 Production (1000 metric tons) 151 131 155 186 Yield (cwt/ha) 25.7 29.4 31.8 36.6 Imports (1000 metric tons) 0.1 9.4 1.9 0

Corn Area (1000 has) 107 65 70 76 Production (1000 metric tons) 86 52 53 63 Yield (cwt/ha) 17.6 17.6 16.7 18.3 Imports (1000 metric tons) 0.1 13.5 26.1 N.A.

Beans Area (1000 has) 19 12 13 16 Production (1000 metric tons) 6.4 3.2 3.6 4.4 Yield (cwtAha) 7.4 6.o 6.2 6.1 Imports (1000 metric tons) 1.9 2.2 2.0 N.A.

a/ Harvest year 1975/76. Preliminary estimates.

Sources: Tables 3.6, 5.6, USDA-FASand mission estimates. - 16 -

16. Since 1973 the emphasis shifted towards the consolidation of settlement efforts in lands already acquired and the expansion of production. Since March 1973, the Government acquired less than 90,000 hectares, most of which in connection with the rural development project in the Bayano area in the Darien jungles. Although a small proportion of the farmers resettled eventually left the asentamientos, by mid-1975 over 8,000 families remained established in 200 collective farms and 300 other coopera- tive units. Many collective farms have been successfully growing rice in newly cleared low land, using capital-intensive methods made possible by the availability of subsidized government credit. In 1974/75 organized farm groups produced nearly 25,000 metric tons of rice at an average yield of 42.4 cwt/ha, 20 percent higher than the nationwide average yield. As part of the efforts to increase production, the authorities have substan- tially increased support prices and expanded their marketing activities. All these measures brought about increases in the production of perishable vegetables, a reversal in the declining trend of basic grains (see Table 9) and a return to self-sufficiency in rice.

(b) Livestock

17. Unlike the situation in basic grains, trends in beef production have worsened in recent years. The nation's herd, which had expanded at an annual rate of 4.5 percent in 1965-71, grew by only 1.9 percent annually in 1971-74. Since 1970, over 40 percent of cattle slaughtered have been females, compared to less than 20 percent in countries which are building up their stocks. This decline in investment occurred in spite of large increases in bank credit for livestock, fror B/. 55 per additional head of cattle in 1969 to B/. 743 in 1974 (see Table 10). This suggests that livestock credit may have been diverted by ranchers to other uses outside of agriculture, to take advantage of the credit on softer terms. Major causes of the decline have been the maintenance of low domestic price ceilings and export quotas, uncertainty regarding the Government's land reform programs, and more recently, weakened world demand.

18. Most livestock is raised in animproved grasslands with a low stock- ing ratio (one head per hectare). With improved technology and substantial investments, Panama could greatly increase beef production and exports (particularly to the United States, because Panama is free of hoof-and- mouth disease). But private investment is only likely to be renewed on a large scale if domestic price controls on meat are lifted and if producers are assured that they will be allowed to export when world demand improves.

19. The maintenance of artificially low beef prices is also adversely affecting poultry production, which is stagnating. Milk production declined in 1970-74 because higher feed costs were not fully passed on to prices. (Imports of milk and milk products are equivalent to 100 million liters/ year.) Raw milk purchases by dairy products factories dropped by 25 percent in 1969-1973, reportedly owing to inadequate raw milk supplies (see Table 10: LIVESTOCK TRENDS

Year Increase Credit Net Flow Net Credit Beef Milk Purchases End in for of per Exports by Processing Stocks Stocks Livestock Credit Additional Head Factories (Millions (Millions of (000) (000) (B/Millions) (B/Millions) (B/) M. Ton) liters)

1969 1,157 38 17.4 2.1 55 1i3 26.6 1970 1,188 31 19.9 2.5 81 2.1 28.5 1971 1,260 72 32.8 72.9 179 1.2 26.7 1972 1,289 29 42.6 9.8 338 2.4 24.2 1973 1,312 23 55.2 12.6 548 1.0 19.9 1974 1,333 21 70.8 15.6 743 1.1 22.1

Source: Based on the data obtained from Ministry of Planning and Economic Policy and Contraloria General. - 18 -

Table 10); there have been cases of informal rationing.There are indications that milk productionhas increasedsince 1974 as milk prices were allowed to rise and as technologicalimprovements helped to reduce costs. In the long run, the interestsof Panamanianconsumers will be better served by allowing food prices to rise to remunerativelevels.

20. Spurredby increasedworld sugar prices and farm-gatecane prices, sugarcanehas become the most dynamic crop in Panama. The 1974/75harvest was 1.7 millionmetric tons, 20 percenthigher than the previousyear, at an averageyield of 50 metric tons/hectare(compared to about 65 metric tons/hectareon average in the most efficientCaribbean islands). Most of the expansionhas been associatedwith the new mills operatedby the state- owned CorporacionAzucarera La Victoria,as discussedin Chapter III. While the high internationalprices prevailingin 1974/75meant good profits for La Victoria,preliminary indications are that its costs of raw sugar have been around 15 cents/lb (includinginterest), which is on the higher side in relation to costs in other major producingcountries. La Victoria should be able to improve its efficiencyas it expandsits scale of industrialoperations, develops new cane varietiesand initiatesproduc- tion in areas with expectedhigher yields.

21. Panama's agriculturehas been traditionallydominated by bananas, which in the mid-1960'saccounted for three-fourthsof all agricultural exports. Employmentand real earningsrose rapidly in the 1960's (Table 9.10). Although the importanceof this crop has diminishedin recent years, thanks to the emergenceof other exportssuch as coffee,beef, shrimp and, especially,sugar, in 1973 bananas still accountedfor two- thirds of agriculturalexports. In 1974, owing to an export tax dispute with the foreignfirm that controlledthis trade, these exports dropped sharply. There was a partial recovery in 1975. The Governmenthas recentlyreached an agreementwith the company,under which Panama will purchase the company'sland, lease parts of it back to the company,and the companywill undertaketo market the production. Taking into account the weak foreign demand outlook, it appearsunlikely that banana exports can expand rapidly in the future,but it should be possible in 1976 to return to the 1973 export levels (32 million cases) and maintain some modest growth thereafter.

Policies

22. In the past, most increasesin agriculturalproduction were achieved by bringing virgin land under cultivationor pasture. Capital requirements were low because this land was easily accessibleand requiredlittle infrastructure. Becauseof poor soil management,however, large areas were allowed to erode and eventuallyabandoned (about500,000 hectares since 1950). As this process continued,it has been necessaryto expand into - 19 -

land that is either more remote or less productive,thus requiringgreater capital investment. This is reflectedin a decliningrate of expansionof -landin farms, which was 56 percent in the 1950-60decade but only 16 percent in 1960-70. As of 1970, 2.1 million hectares,equivalent to 29 percent of Panama's total land area, were in farms. With greaterphysical and human investment,there remainsconsiderable scope for increasingpro- ductionwithin this area, if appropriatepolicies are implemented.

23. About one-thirdof the land in farms is suitable for intensive field crops, but much of it is tnderutilizedas extensivecattle pasture. Yields of all crops could be increasedwith better managementand additional investments. To stimulatemore productiveuse of land in farms it would be desirableto take action as regardsland titles, land taxation and price incentives.

24. Only 28 percent of farmersin Panama have legal titles to the land they use. The process to obtain titles is costly and time consuming, requiringa journey to Panama City. Farmerswould be more willing to improvetheir land if they had the securityof tenure provided by a title. The authoritiescould assist by facilitatingand decentralizingtitling procedures.

25. Taxationof rural land is extremelylow, in part a consequenceof the lack of titles,although a rural cadasterwas completedin 1969. Timely enforcementof a substantialtax based on the productivepotential of the land could serve the dual purpose of raisingrevenues and discourag- ing land underutilization.

26. Farmersare not likely to improve land use unless they feel confident that future prices for their outputwill be remunerative. In recogni- tion of this fact, the authoritieshave recentlyincreased support and ceiling prices for certainproducts. Betweenmid-1973 and mid-1975 the following increasesin averageprices receivedby farmers took place: rice (firstclass) from 5.9 to 8.9 cents/lb;corn, from 5 to 8 cents/lb;beans, from 13 to 24 cents/lb,fresh milk (specialquality) from 14 to 17 cents/ liter; and sugar cane (unburnt,top grade), from 8.25 to 13 B/. short ton. Price ceilingsfor tomatoes,fresh produce and certain fancy cuts of beef were also raised. These measures stimulatedincreases in output of vegetables, grains and cane, as noted above, but failed to reverse the adverse movement in internalterms of trade of agriculture,which dropped steadily between 1968 and 1974 (Table9.2). Between 1970 and 1974, this index dropped 15.6 percent,but it recoveredsomewhat in 1975. The retail food price index increasedmore rapidly than wholesaleagricultural prices in 1974, reflectingmainly prices of importedfoods and beverages.

27. Further improvementsand coordinationof pricingpolicies are needed to bring about the full developmentof Panamanianagriculture. Decisions that affect agriculturalprices are taken by many governmentalagencies, - 20 -

without apparent coordination: (a) the MarketingDirectorate established supportprices, bought, stored, imported,and retaileda wide range of products. Its 1974 purchasesrepresented 15.6 percentof all marketed rice, 11 percent of domesticcorn and beans; (b) the Office of Price Regu- lation establishesprice ceilings on essentialitems; and (o) the Ministry of Trade and Industrycan establishimport quotas and in this way affect domesticprices of traded goods. The independentdecisions frequently adoptedby these agencieshave created uncertaintyamong producersand, by giving wrong price signals,have led to cases of alternatingperiods of shortages - requiring imports -- and gluts -- leading to spoilage. The recent creation of the MarketingInstitute, which replaced the Marketing Directorate,has establishedthe mechanismfor a coherent,long run agriculturalpricing policy as well as relatedcredit and marketing activities.

28. At prevailingagricultural technology levels, Panama only seems to have clear absoluteadvantage in the productionof bananas, beef and shrimp. At world prices prevailingin late 1975, exportsof rice would require a subsidy. Unless sugar productioncosts are substantiallyreduced (see para. 20) sugar exportswould also require subsidization,given prospective world sugar prices. (Recentsugar exports benefittedfrom recordworld prices.) The supply of beef is fairly inelasticin the short run, but presentworld prices may be inadequateto stimulatenew investmentin cattle. Productionfor the internalmarket has been protectedby import quotas and subsidiesfor most agriculturalproducts. Although domestic prices have not been sufficientto greatly stimulateproduction -- with the recent exceptionof grains and cane -- they have been generallyhigher than internationalprices and food is being smuggled in from Costa Rica. Since rural wages in Panama are higher than in neighboringcountries (the averageweekly farm wage, excludingbanana workers, is B/. 12), and resource endowmentsin agricultureare not superior,a special export incentive coupledwith higher generalizedimport duties and relaxationof import quotas would facilitateagricultural expansion. Panama could thus export more tobacco,fruits and vegetablesand reduce importsof milk, meats, fish products,vegetable oils and other foodstuffs. This issue is discussedin a broader contextin Chapter IV.

Future Needs

29. Even if yields are improvedin existing farms, it will be necessary to expand the area under cultivationto feed the rapidlygrowing population, to strengthen-exportsand to create new jobs. The bulk of known remaining virgin land with good agriculturalpotential is in the jungle area of Darien; little is known about the humid Atlantic (north)slopes. Develop- ment of these areas will requireheavy investmentsin roads, drainage, sanitationand social services.The Government'sprogram for these areas is analyzed in Chapter III. - 21 -

(ii) Fisheries

30. Panama's locationon the istbmusseparating the Caribbeanfrom the Pacificprovides clear advantagesin developinga domestic fishingindus- try and in servicingthe internationaltuna fleets operatingoff the Pacific coast. On the Pacific side, the waters are rich in seafood, especially in the Gulf of Panama which supportssizable stocks of commercially valuable speciessuch as shrimp. Foreign tuna fleets which, in accord- ance with the regulationsof the Inter-AmericanTropical Tuna Commission, can only fish in the easternPacific tuna grounds during the first quarter of the year, are increasinglytransshipping their catch in Panama Bay in order to avoid time-consumingtrips to their home ports.

31. The main fishing activitiesin Panama are shrimp trawling and processing, reductionto fishmealof anchovyand herring, inshore fishing, and servicingof the internationaltuna fleets. The industryemploys about 4,600 people or about one percent of the economicallyactive population and its shrimp exportsrank second (afterbananas) among merchandise exports. Although the fishing industryhas grown vigorouslyover the last two decades, it is still far from having realizedits potentialboth as an earner of foreign exchange and as a source of food for domestic consumption. The main obstaclesto furtherdevelopment have been (a) obsolescenceof the local fishing fleet; (b) lack of adequateport facilities;(c) lack of knowledgeon fish resources;and (d) inadequatelocal distributionand marketing facilitieswhich contributeto a relativelylow per capita consumption of fish.

32. The Governmenthas taken a number of measures to deal with the first three of the above-mentionedconstraints. It has providedcredit facilitiesfor the modernizationof the shrimp fleet and has obtainedexter- nal financingfor a project to developinshore fishing. Panama,which par- ticipatesin the UNDP/FAO Regional Project for Central American Fishery Development,has obtained assistancefor resourcesurveys and for strengthen- ing the distributionand marketingof food fish. The resource surveyshave already led to the discoveryof promisingnew deepwatershrimp grounds,but the extent of these resourceshas not yet been determined. The Government is also building a fishingport at Punta Vacamonte,and it has taken some measures to protect the fishing resourcesfrom depletion. Enforcementof some fishingregulations, including restrictions on the horsepowerof shrimp trawlersin operationin Panamanianwaters, has been fairly satisfactory. Effectivecontrol of fishinglicenses, however, is also essentialto avoid overfishing,especially of high-pricedshrimp varieties. In additionto the measures alreadytaken, new efforts to improve fish distributionand marketing facilitieswould contributeto the fuller utilizationof this resource.

(iii) Manufacturing

33. Constrainedby slow growth of demand and higher costs, the slackening of industrialexpansion which began around 1970 has continuedin recent - 22 -

years. The annual growth of value added in the sector fell steadily from over 10 percent in the 1960's to 2 percent in 1974, and preliminaryindi- cators point to an absolutedecline in 1975 (Table12).

34. Manufacturingis sufferingfrom the general slowdown in economic activity. The decline in residentialand office construction,for example, directlyaffects the demand for furnitureand constructionmaterials, which togetheraccount for one-thirdof manufacturingvalue added. This demand contractionhas served to heighten the basic dilemma facing Panamanianindustry. The smallnessof the internalmarket limits the scope for continuinggrowth based on import substitution. The authorities have recognizedthat a viable long-termstrategy for the sector must rely on foreignmarkets and have taken some first steps to improve the international competitivenessof the sector. (Seebelow).

35. The impressiveexpansion that industrialproduction experienced in the 1960's (over 10% per annum),was based on the substitutionof imports. Although import dutieswere generallylow (the average ratio of import duties collectedto total imports is below 10 percent),effective protection has been quite high for many products. This protectionwas granted through restrictiveimport quotas,and was complementedby high tariffson some final products such as prepared foods, beverages,cosmetics, clothing, furniture, paper products and constructionmaterials (see Table 3.5). The practice of protectingdomestic industrythrough import quotas is continuing. In the period October 1974 throughApril 1975, the authoritiesissued fourteennew resolutionsrestricting imports of specificgroups of articles. The authorities,however, feel that it is not desirableto continuethese policiesbecause they tend to raise the cost of living and thereforedis- couragepotential manufactured exports.

36. It is difficultto export Panamanianindustrial products because labor costs are too high compared to countrieswhich would export competing products. In the first place industrialwages, which in 1974 averaged over one Balboa/hour(excluding technical personnel), are higher than in other countriesof the region. Second,fringe benefits and payroll taxes add substantiallyto labor costs (20 percent in 1972 and higher in 1975). Third, it is a generalizedfeeling among employersthat some Labor Code provisions have led to increasedabsenteeism and reducedproductivity. The Labor Code has greatly strengthenedurban workers' tenure,benefits and bargaining power. The dismissalof a worker can become a lengthyprocess. Implemen- tation of the Code appears to have been biased againstemployers, and to have restrictedemployers' rights to reassignworkers to new tasks or to impose discipline. The authoritiesare exploring,together with represen- tatives of the industrialistsand the workers, possibleways to reverse these unfavorabletrends in productivity.

37. In the long run, expansionof manufacturingwill require additional measures,such as the one discussedbelow. The need for high effective - 23 -

Table 11: MANUFACTURINGINDUSTRY - RECENT INDICATORS (Metroplitan Area)

First Semester Change 197k 1975 %

Number of Employees 21,589 20,622 -4.5

Wages paid (B/million) 5.4 5.6 +4.0

Total Sales (B/million) 54.6 60.6 +11.1

Sales/Employee(B/000) 2.53 2.94 +16.2

Sales/Wages(B/) 10.2 10.8 +6.4

New InvestmentContracts:

- Number 26 13 -50.0

- Investment(B/million) 3.6 3.9 +8.9

Source: Direccionde Estadisticay Censo and Ministeriode Planificacion y Politica Economica. - 24 -

protectionfor domestic sales and the lack of inter-nationalcompetitive- ness of industrialexports are indicationsthat special incentivesare needed for manufacturing,as they are for agriculture. The authorities have tried to correct the problemby protectingdo-mestic sales and, more recently,bv subsidizingexports.

38. In late 1974 the Governmentpassed Law 108, which createsan export subsidy in the form of a tax payment certificate(CAT) equivalentto 20 percent of the national value added of eligible (non-traditional)exports. The CAT is not transferable,and can.be submittedin payment of taxes after a 12-monthwaiting period. As of year-end 1975, the authorities were processingCAT applicationsfor about B/. 7 million of exports (tobacco, clothing,rum and plastics). If the new subsidyis administeredspeed- ily, with a minimum of red tape, it may contributeto compensatefor the cost disadvantageof Panamanianindustry and stimulatenew exports. The requiredwaiting period, however, reducesthe CAT's presentvalue considerably, and the authoritiesmay in the future find it suitable to eliminate or substantiallyshorten this period. The non-transferabilityfeature is also of questionablevalue, because it reducesthe CAT's attractiveness, especiallyfor new firms which may not expect to have to pay substantial taxes in their early years of operations,and thereforemay have no use for CAT's. This drawbackcould be correctedby making CAT's negotiable or by indexing them to maintain their real value over time. To the extent that the CAT is effectivein stimulatingnew exports, it is not likely to have undesirablefiscal consequences,because the expansionin economic activity generatedby the additionalexports would yield enough new fiscal revenues to probably offset most of the foregonetax payments (see Chapter IV, SectionC).

39. In additionto liberalizingthe export subsidy,the authorities could considerother measures to favor the expansionof industrialand non-traditionalexports. It may be possible to liberalizethe applica- tion of certainprovisions of the Labor Code for export-orientedactivi- ties -- as was recently done for construction (see para. 51) -- to make these activitiesmore competitivewith other countries. The newly created NationalDevelopment Bank (see para. 51) could give specialemphasis to the promotionand financingof exports. New effortscould be made to attract foreignfirms into these activities. Also, it may be useful to appoint a high-levelofficial who would be responsiblefor promotingexports. This officialwould identifyexport opportunities,distribute information on foreignmarkets and proceduresto potentialexporters and act as inter- mediarybetween Governmentand private sector to facilitatetheir operations.

40. At under B/. 5 million, industrialexports accountfor less than 1 percent of the value of industrialproduction. They consist of few lines such as a Kraft paper products,clothing, rum and plastics and are primari'lydestined to the Central American countrieswith which Panama - 25 -

maintainsbilateral trade treaties (CostaRica, El Salvador,and Nicara- gua). The smallnessof present exports is not a good indicatorof Panama's potential,should cost disadvantagesbe corrected. A recent survey of 32 firms prepared for the Ministry of Trade and Industryindicates that these firms were "ready to export" l/ over 30 products in 1975, for a value of almost $20 million,but could not do so owing to high costs, shortages of inputs and inadequatetransportation facilities. Insufficientcredit to financesales was also mentionedas an obstacle in several cases. But all these apparentconstraints could be relaxed throughappropriate policies. If producerswere assuredof stable and adequateincentives, they would probably be able to ensure adequate raw material supplies and make suitable transportationarrangements. In fact, the availabilityof excellenttransport facilitiesconstitutes one of the possible comparativeadvantages of Panamanianindustry. With adequateincentives, Panama should be able to export larger amountsof agroindustrialproducts, forestry products, high quality clothingunder franchiseof well known designersand other high- valued assemblyproducts to take advantageof Panama's skilledlabor, excellentinfrastructure and trade connections.

(iv) Other Sectors

41. The recessionaffecting world trade has led to a reductionin the volume of traffic crossingthe Panama Canal and, thus, to a reductionin the employmentof Panamaniansin the Canal Zone in 1975. This situation is unlikely to improve in the near future.

42. The importanceof constructionas a determinantof recent economic trends is far greater than indicatedby its 7 percent share of GDP and 6.3 percentshare in total employment. As mentionedabove, one-thirdof manufacturing output -- almost 6 percent of GDP in terms of value added -- consistsof constructionmaterials and furniturewhich are directlylinked to constructionactivity. The sector has also importantlinkages with commerce, warehousing,transport, services and banking. A recent study estimated that each B/. 1 million of additionalbuilding permitshas generated a B/. 2.5 million incrementin GDP and 475 additionaljobs. 2/

43. Growth of value added in constructionis decliningin spite of an expandingpublic investmentprogram. In recent years privateconstruction of high income residential,office and commercialbuildings had boomed, fueled by abundantbank credit and a rapidly growingdemand. In the absenceof informationor guidance from the Government,the BankingCommis- sion or trade associations,supply outpaceddemand and the number of unsold

1/ "Ready to export"means that these firms had the physical capacity to produce items for which an exportmarket was known to exist. 2/ "El Mercado de Viviendasen el Area Metropolitana,Sector Pacifico", INDESA,Panama, July 1975. - 26 -

finishedunits soared in 1974. (This number is estimatedto have reached 2,900 in early 1975 for a total value of B/. 62 million; it may take two to three years for the market to absorb it). As a result,new construction of high-risebuildings has nearly stopped. This has probably been the most importantcause of the present recession. In October 1973, the authoritiesestablished controls on rents of up to $250 per month; while this factor has undoubtedlycontributed to discouragenew investmentin rental housing, it has not been the main determinantof the present problem. Finally,commercial banks, faced with growing arrearsin their constructionloans, have become more cautious in their lendingoperations in other sectors as well.

44. The Colon Free Zone continuesto be a good source of employment, export-earningsand public sector savings. Since its establishmentin 1953 with 10 companieson 14 acres it has grown to over 300 companieson 110 acres. Employmentis about 6,000 in activitiessuch as warehousing raw materialsand finishedproducts, book printing and binding,packaging and repackaging,and light manufacturing. Principalproduct lines are pharmaceuticals,electronic and radio components,cameras and film supplies, laboratoryequipment, automotive and other spare parts, bicycles, books, chemicals,textiles, toiletries and perfumes,jewelry, watches, tobaccoand liquor. The Free Zone combinesseveral advantages for international firms: (a) a well trained, skilledand largelybilingual labor force, and experiencedmanagers, at a cost that, while higher than in other neighboringcountries, is not excessivein relation to high-valuedpro- ducts; (b) strategicgeographic location with excellenttransport facilities, ideal for transsbipmentoperations. Most goods arrive by sea, in bulk shipments,and are later re-exportedto Latin American countriesin small parcelsby surfaceor air; the possibilityof fillingorders quickly helps reduce inventoriesin the countriesof final destination;(c) fast deliverieshelp to reduce financialcosts to importersin countrieswhich require a prior deposit in their Central Bank for the value of the merchandise between issue of an import licenseand receiptof the merchandise. The profits of the Colon Free Zone Company,which is part of the public sector,have grown form B/. 400,000 in 1970 to B/. 920,000in 1974. The contrastbetween the successfulexpansion of activitiesin the Colon Free Zone and the slow growth of domesticmanufacturing suggests that a comparative study of both sectorsand their respectiveenvironments may yield useful insights for future policy to the authorities.

45. Until 1975 the expansionof the Zone's activitieswas limitedby lack of space, but in March 1975, the U.S. Governmentturned over to Panama 216 hectares in the old France Field Air Base. The authoritiesare making preparationsto expand the Zone into the new land, and are also consideringcreating another Free Zone near the new airportat Tocumen. If past liberalpolicies are continued,these two Free Zones could expand at annual rates in excess of 10 percent. In planning these extensions, the authoritiesmay wish to considercarefully ways to minimize possible - 27 -

contrabandof goods into Panama. The figuresin Table 13 suggest that the value of the Zone's surplus of re-exportsover importshas been declining steadilyas a proportionof imports. In part this trend might be explainedby changesin the compositionof traded products,leading to a lower value added in the Zone, and also by a greatershare of freighton imports. Nonetheless,the possibilitythat part of the Zone's merchandise are being smuggledinto the territorydeserves investigation.

46. Panama has become an importantcenter for financialactivity in Latin America. The expansionof the banking system is reflectedby the large increase in the number of banks authorizedto operatein Panama, from 39 in January 1973 to 73 in December 1975. Of the 69 private banks, 44 are licensed to carry out domesticand offshoreoperations; 21 are licensed only to maintain representativeoffices. In addition,there are 2 officialbanks licensedfor domesticand offshoreoperations. Approxi- mately 17,000 people are employedby the financialsector and it accounts for 5.6 percentof Gross Domestic Product.

47. The country'sadvantages as a regionalfinancial center derive from its liberalbanking and exchange legislationand its strategicgeographic location. There are no reserve requirementsor interest rate restrictions on foreigndeposits. Income on foreignloans and investmentsis tax free. Regulationson domesticbanking operationsare fairly liberal. These advantagesare complementedby the absence of exchange controlsand the use of the U.S. dollar as the only paper currency in circulation. Total bank depositsfrom abroad have increasedrapidly. By December 1975 they exceededUS$ 7 billion,more than ten times the level of only four years before.

48. In contrast to the generallyliberal banking legislation,there is a 4.5 percent ceiling on interestrates paid by commercialbanks on small and medium size savings accounts -- up to B/. 14,000 -- which discourages financialsavings and may stimulatecapital flight. In view of the need to increase the contributionof domestic savingsto financinginvestment it would be desirableto substantiallyraise or eliminatethis ceiling. Such action may also require to raise the interestrate currentlypaid to savers by the government-ownedsavings bank from the present 5.5 percent, and to raise accordinglythe lending rate on mortgages.

49. Despite the weakeningin world trade, other internationallyoriented serviceactivities such as transport,warehousing, and tourismhave continued to expand at a good pace. Tourist arrivalsin 1974 were 16 percent higher than the year before, and estimatedtourist expenditures in current prices expandedby over 30 percentin the same period. This confirms the Government'sassessment that Panama's comparativeadvantage lies in the provisionof servicesusing the country'sunique geographiclocation. - 28 -

Table 12: COLON FREE Z01NE- IPORTS AND REEXPORTS

($ millions and %)

Year Imports (FOB) Reexports Balance Balance as (Apparent % of Imports value added)

1965 93.4 148.8 55.4 59.3 1966 120.0 171.9 51.9 43.3

1967 120.3 185.9 65.5 54.4 1968 130.4 188.8 58.4 44.8

1969 153.7 214.1 60.4 39.3

1970 191.2 249.4 58.2 30.4

1971 216.5 255.2 38.7 17.9

1972 245.5 312.7 67.2 27.4

1973 309.9 376.1 66.2 21.4 1974 (P) 462.7 479.7 17.0 3.7

P: Preliminaryfigures.

Source: Contralorla General, Direcci6n de Estadistica y Censo. - 29 -

III. THE GOVERNMEN'T'SPROGRAM

50. Faced with a serious recession, the Government is in the process of implementing both a short-term program to reactivate the economy and a bold public investment program to create new sources of growth in the medium and long term.

A. Short-Term Program

51. The principal measures adopted during the last twelve months to stimulate a revival of private investment include:

(a) accelerating the pace of public investment in ongoing projects and in new low-income housing programs;

(b) an export subsidy equivalent to 20 percent of the value added for non-traditional exports;

(c) a fund to subsidize bank credit to agriculture and industry; the subsidy varies from 3 to 4 points and is financed through a 1/2 point surcharge on all loans for commerce or consumption;

fd) a scheme to guarantee long-term mortgage loans made by commercial banks for middle-income housing and a facility to rediscount these loans in the National Mortgage Bank after eight years;

(e) lowering of commercial banks' capital and reserve requirements from 5 percent of domestic earning assets to 4 percent;

(f) selective licenses to export beef for private producers;

(g) a series of fiscal incentives to promote investment, including accelerated depreciation, investment credits, income tax exoneration for reinvested corporate profits and temporary real estate tax exoneration for new buildings;

(h) creation of a National Development Bank (COFINA) to promote and finance private investment and to manage government holdings in commercial ventures;

(i) reduction of import duties on selected products to stimulate tourist-oriented trade; and - 30 -

(J) specialincome tax deductionsto firms which increase the number of low-incomeworkers employed.

The Governmentis also seeking to restore the confidenceof the private sector, through improvedcommunications and consultationswith it. The authoritieshave recognizedthat it is necessaryto improve labor productivity. They have taken measures to expedite the processingof labor disputes,and have created an unemploymentinsurance scheme for the con- structionindustry, to be financedout of a new tax on payrolls. This mechanismwill give employersgreater flexibilityto dismissand reassign workers. The Governmentis now consideringthe extensionof similarmecha- nisms to other sectors. A revision of certain aspectsof the Labor Code would go a long way towards improvinginvestors' confidence.

B. The Government'sDevelopment Strategy

52. For the longer run, the Governmenthas concludedthat Panama needs to developnew sources of growth if it is to return to annual GDP growth rates of at least 7 percent. It has identifieda number of large projects, in infrastructureand in directlyproductive investment, to take better advantageof the country'spotential for providingservices to international trade and to developmore intensivelynatural resources,including the coun- tryis minerals,hydroelectric capacity and the Darien virgin forest area. Although the Governmentintends to carry out these large investments directly and the ratio of public investmentto GDP in the next few years is likely to remain below historicallevels, the Governmentexpects that its programwill open up new investmentpossibilities for the private sector in the next five years and that Panamanianbusinessmen will respond favorablyby steppingup their investmentexpenditures. 1/ The public investmentprogram is also aimed at continuingthe ongoing processof income redistribution through the provision of services to the poor and the adoption of measures to increase productivity of low-income farmers.

53. Individual projects corresponding to almost 64 percent of the investment program are expectedby the Governmentto be financiallyself- liquidating. In the case of some directlyproductive projects, the Govern- ment is willing in the near term to preempt the role of the domestic private sector on the grounds that the private sector lacks the initiative and entrepreneurialcapacity to undertakethe large (andperhaps risky) projects that are required. The Government'snew involvementin diverse and large projectsin the productivesectors will doubtlessput a strain on its managementresources, even though it is making efforts to attract

1/ An econometricsimulation study prepared at Wharton EFA tentatively found that public investmentin Panama has a high multipliereffect. - 31 -

well-trained Panamanians, mar.y of whom are retuniing from abroad, and to use foreign expertise to the extent possible without relinquishing control. The macroeconomic and financial implications of the Government's development strategy are examined in Chapter IV, Section B below.

54. A shift in favor of the directly productive sectors was already evident in the 1969-74 period when investment in agriculture, commerce, industry, and tourism increased from 11 percent of total public investment in 1969 to 22 percent in 1974. The auth.oritiegplan to devote 44 percent of public investment during the 1976-80 period to projects in these sectors but, as in the past, increased investments in the productive sectors are not intended to occur at the expense of investment in other fields. Thus, if the progiam is fully implemented, public investment would more than double on average, compared to the 1972-75 period (see Table 13).

55. The investment projections summarized in Table 13 are based on the Government's preliminary Investment Program, which has been adjusted in some cases to reflect the Bank's estimate on the timing of some major projects. Investments in the Cerro Colorado mining project, for instance, have been projected to starr in 1978, one year later than the Government expects them to start, and to be completed in 1982 instead of 1980. Changes in projected amounts are noted in the sector discussion below. Shifts in timing of some projects and other changes bring total investment during the 1976-80 period down from B/. 2.7 Lillion in the Prelimi- nary Program to B/. 2.1 billion in 1975 prices, still more than twice the amounts invested in 1971-75.

(i) Agriculture

56. In addition to ongoing programs to improve production techniques and marketing methods through the Ministry of Agriculture, and to provide credit for livestock, farmer cooperatives and fishing activities, the Gov- ernment intends to carry out projects aimed at developing twelve selected rural communities and to invest in the development of newly opened lands in the Bayano region, east of Panama City. These new programs, the cost of which is expected to average about US$ 20 million per annum, would provide technical and financial assistance to five asentamientos and form four cooperatives comprising 1,300 families, and would expand the role of State farms in the Bayano Region. In the latter area the authorities intend to carry out drainage projects on 6,000 ha of government-owned land, primarily to increase production of sugar cane to be processed by the Pacora mill (see para. 59).

57. The availability of physical facilities for marketing has recently become a major constraint to the expansion of agricultural production. The ability of the Marketing Directorate QMercadeo) to buy large quanti- ties of products at the official support prices -- 15 percent of marketed basic grains -- has been a most important factor in the recent expansion Table 13: PUBLIC INVESTMENTPROGRAM 1971-75 AND 1976-80 (Annual Averages in Millions of 1975 Balboas)

Percentage Change in Annual Averages between 1971-75 % 1976-80 % 1971-75 and 1976-80 Directly ProductiveSectors Agriculture 28.8 14.1 60.9 14.0 111 Commerce, Industry, and Mining 20.8 10.2 121.4 29.0 484 Tourism 1.5 0.7 5.0 1.0 2 71TT -2$0 1T7T3 hh.0 2 Infrastructure Transport 35.3 17.3 69.2 16.3 96 Telecommunications 4.0 2.0 9.4 2.2 13-5 Power 44.3 21.7 58.4 13.7 2 83.6 hl.0 137.0 32.2 63 Social Service Health 26.5 13.0 25.4 6.o -4 Education 17.4 8.5 19.8 4.6 14 Housing 17.2 8.4 45.6 10.7 6 61.1 29.9 90.7 21.3 S9 Multisector(local and regional development) 865 4.1 10.2 2.5 20

Total of all sectors 204.3 100.0 425.3 100.0 108

/ Includes Oil Pipeline,Container Port and La Victoria sugar program.

Source: Table 5.h0 - 33 -

of basic grains and other products for domesticuse. But this success has been achieved at a substantialcost in spoilageand waste of perishl- able products. Mercadeo'slosses in 1974 are estimatedat B/. 2.5 million, only a small part of which is attributableto price supportoperations per se. The Governmerthas launcheda B/. 10 millionmedium-term investment program to strengthenthe newly created autonomousagency (*ara.27).

58. The primary emphasisof the Public InvestmentProgram in agriculture is to increaseproduction, although the Program also aims at a more balanced regionaldevelopment and improvedliving conditionsin rural areas through increasedincomes. This is a rationalpriority, given the nation'surgent need for economicgrowth and exports. As indicatedin Chapter II, Panama's agriculturehas reacheda point at which further production gains can only be attainedwith significanteffort and outlays. There is a danger,however, that this emphasis on productionmight lead to the adoptionof too capital-intensivetechnologies. Even when economic growth resumes, the urban sectorsmay not be likely to fully absorb the rapidly growing labor i-orce.Although fiscal considerationsimpose the need to curtail the growth of public sector operatingexpenditures, it is necessaryto strike a sound balancebetween capi'taland current outlays to ensure that the investment is fully used. This will require, therefore,a reevaluationof the agriculturaldevelopment programs with a view to providingmore extensionworkers (the present ratio of one middle level agriculturaltechnician per 200 farm families,while not low by internationalstandards, could still be increasedto permit a full utiliza- tion of the capital stock),to adopt better price and land tax pcliciesand to extend land titlingthroughout the rural areas. The Governmentis aware of these needs. It has initiatedprograms to train middle level technicalpersonnel and to expand and reorient agriculturalresearch.

(ii) Sugar

59. Increasesin the world price for sugar over the recent past and a desire to make better use of Panama's land resourceshave led the authorities to expand sugar productionfor export markets. The Governmenthas owned and operateda sugar companysince 1972 (CorporacionAzucarera La Victoria)which produced 33,000 tons of sugar in 1974. Three additional sugar mills are in constructionand expected to begin productionin 1977; these would increaseCorporacion Azucarera's capacity to about 230,000 tons of sugar per annum by 1980. Most of the new productionis intended for export markets. The sugar expansionprogram is ro be carriedout on both state-ownedland, and in cooperationwith private farmers. La Vic- torta mill at Santiago, for instance, would purchase 70 percent of the cane it processesfrom privatefarmers, as would the Chiriquimill, while the Pacora estate would obtair most of its own cane from state-owmedland. The present price paid to independentfarmers for cane is B/. 12.95 per short ton and providessufficient incentive to clear new land for cane. Planting is proceeding well in preparaticn for added mill capacity. Since - 34 -

wage rates in Panama for skilled farm workers (B/. 0.50 an hour, plus about 30 percent in social benefits) 1/ are higher than in other sugar producing countries and it is difficult to find cane cutters in sufficient numbers, wherever physically possible, mechanical harvesting machines will be used. Experiments with such machines have reportedly been carried out successfully. As indicated above (para. 21) production costs will vary from mill to mill, but could be as high as l51/lb at present scales of productiont (including interest on debt), which is higher than in countries with established sugar industries. Total investment costs of the sugar expansion program have not been accurately determined, but will probably amount to US$ 170 million for both factory and field installations in all three mills. La Victoria's investments to June 30, 1975, amounted to B/. 68 million, of which B/. 27 million were financed by equity capital. It is expected that the bulk of new investments will be financed through retained earnings and suppliers' and bank credits. Because of the wide swings in world sugar prices and the relatively high present costs of La Victoria, there is a risk that in years of low prices the company may suffer losses. Over the medium-term, however, costs are expected to fall as better cane varieties are developed and economies of scale are obtained (see para. 20).

(iii) The Bayano Cement Plant

60. Traditionally, Panama has been a net importer of cement since domestic production by two privately-owned firms now in operation has usually failed to meet demand which grew at around 10 percent annually. In order to supplement domestic production, notably for the Government's hydroelectric expansion program as well as for the housing and other construction programs, the Government, in 1975, decided to construct a 330,000 ton cement plant to be located at Calzada Larga, near Panama City. A turnkey contract has already been signed with a foreign equipment supplier to construct the mill so as to begin operations in 1978. However, because of delays in preparation, production could be postponed at least by one year.

61. The cost of the project can be expected to be about B/. 70 million including working capital and interest during construction, to be financed by a government contribution of about B/. 15 million and the rest by suppliers' credits and borrowing from commercial banks. The Government feels that the project is justified on the grounds that the cement plant will generate enough financial resources to cover operation costs and debt service payments. However, the initial investment cost per ton of the project would be B/. 180 (excluding working capital and interest during construction) which compares unfavorably with about B/. 90-170/ton plants of somewhat larger size. These investment costs are so high because: (a) they include oversize equipment (washers, mills, etc.) which could expand to double capacity at low additional cost in the 1980's, and (b) the turnkey contract adds about 20 percent to the cost.

1/ Source: Ingenio La Victoria, October 1975. This corporation, because it is government-owned, is not subject to the new labor laws which apply only to the private sector and can retain workers under the Civil Service Code on a seasonal basis. - 35 -

62. Production could begin in 1979 at an initial capacity of 275 thou- sand tons per year, reaching a level of 330,000 tons pet year by 1981. Cement prices, which are controlled by the Government, are assumed to remain around B/. 47 per ton in constant terms during the 1979-1985 period. Since total production capacity will not be achieved uintil 1981, production costs will be higher during 1979-1981 than in later years when the plant can take advantage of economies of scale. The projected production cost/ ton of cement -- before interest payments -- ranges between BI. 23 and E/. 21.50 in the 1979-1985 period. During 1979-1983, some profits could be generated but at the projected cement prices, debt amortization payments could not be ful:Lycovered. In later years, the overall financial situation of the plant could improve with revenues covering all operational costs including debt amortization payments.

(iv) Copper Mining

63. By far the largest investment in the Government's program is the Cerro Colorado copper mining project. The mineral deposit lies in the mountainous watershed in the western part of Panama and contains proven and probable ore reserves of about 1,500 million metric tons with an average copper content of 0.6 percent. Ongoing tests suggest that this content may be in the order of 0.6 to 1.0 percent; this would be comparable to the content of similar mines being planned elsewhere, but lower than in established minies. Reserves would be sufficient to maintain production at an annual rate of 150,000 metric tons of blister copper for over 20 years. At present copper prices 1/ the mine could generate about US$ 240 million a year in gross new export earnings. The mine concession, which up to the beginning of 1975 was held by a foreign corporation, has now reverted to the Government, which has created a Corporation to carry out the project. Investment costs were estimated at US$ 450 million in a 1973 pre-feasibility study prepared for the previous concessionaires; in 1975 prices, the investment required would be in excess of US$ 650 million. A detailed feasibility study is now required before investments are initiated. The deposit's remote location, absence of infrastructure in the region and the ore's com- paratively low mineral content are factors which may offset the advantage offered by the deposit's size. If the project is feasible, experienced personnel will be required to implement it and to manage the operation; there is no previous experience with mines of this nature or magnitude in Panama. The Government has reached an agreement with a foreign mining company which would manage the mining project subject to satisfactory completion of feasibility studies now being carried out by that company. The inherently risky nature of mining operations requires that they be financed with an adequate amount of equity capital and that the debt structure be such as to permit uninterrupted debt service under unfavorable mineral market conditions. If Cerro Colorado is to avoid financial dependence on the Government under adverse conditions, its investments would have to be financed by a substantial equity capital

1/ 73¢/lb in late April 1976 (CIF, London Metal Exchange). - 36 -

contribution(perhaps larger than the US$ 200 million visualizedby the Government)and long-termcredits with stuitableperiods of grace.

64. Investmentcould begin in 1978 continuingthrough 1982, thus allowing the.project to be fully operationalby 1983. Operating-costsare now estimatedby the Governmentat 53/11.bof copper produced excludingcapital service,but this seems low when account is taken of the deposit'sdiffi- cult location,absence of infrastructurein the region,the mineral content of the ore, and relativelyexpensive energy sources. A more realistic productioncost estimate that takes these factorsinto considerationwould imply a figure higher than 80f/lb, in constant1975 prices,by 1983 when large-scaleextraction operations begin. By 1985, the productioncost/lb could well drop as a consequenceof added infrastructurein the region, a larger scale of productionand the substitutionof local technicians for foreign ones. l/

65. The price of copper,which had been depressedduring the 1971-1972 recession,rose sharply in the 1973 boom and continuedto rise in the first quarter of 1974, reachingthe historicpeak of 152l/lb in April. With the onset of the current recession,the price steadilydeclined through the rest of 1974, falling to 52-55l/lb in early 1975. Assuming a gradualrecovery in world economicactivity in the coming years, the price in constant 1975 prices is expectedto rise to 94¢/lb in 1985. 2/ On these assumptions,the copper mine could generategross revenuesof about B/. 800 million in 1983-1985,which after covering operatingexpenditures would leave cumulativegross earnings of Bl. 85 million. The overall financialsituation could improve after 1985. Thus, the project could make significantcontributions to public savings,employment and thieeco- nomic developmentof the western region.

(v) Tourism

66. It is the Government'sintention to furtherdevelop export earnings from tourismby investingan averageof B!. 8.6 million per annum in new tourism facilities. Liberal tradingpolicies already attractvisi- tors who wish to take advantageof shopping,banking and business opportunities in Panama, and the number of visitors could perhapsbe increasedby

1/ Copper exports of 90 thousandmetric tons per year might be realized when operationsbegin in 1983 and ar,export productionof 150 thou- sand metric tons per year might be possibleby 1985, 21 IBRD Report No. 814, Price Forecastsfor Major Primary Commodities, Julv 1975 and updating tables dated November 26, 1975. All prices are c.i.f.,London Metal Exchange, It is expected that Panama would receive the full c.i.f. p rice, the differential between c.i.f. and f . o.b. would te tia-1 for by thJ refiners in exchange for small amounts o-hhigh-value metaL6 fioundwith the ore. The IBRD price terecasts are in 1973 prices. The price index used to convert to 1975 prices is 133 (1,973= 100). - 37 -

investmentin new facilities. Panama's comparativeadvantage ln the tour- sim trade appears to be in its geographiclocation. as a stepping stone between North and SoutlhAmerica, and moderate investments(around B/. 5 million per annur) designed to exploit th:s location,such as the business conventioncenter ;ovi being startedbv the authorities,should yield good results.

(vi) Transport

(a) The Transist.amcOil P.te±tiTne

67. The Governmenthas been cousideringthe constructionof a transisthmic oil pipeline. W'ile at prasent the volume of petroleumcrossing the Canal is not large (see Table 10.4) a potenLialmarket for the pipeline may exist. Toward the end of the 1970's,it is possiblethat a surplus of crude oil poodction over consuvmptionwill emerge in the Pacific Coast of the Americas,as productionis initiatedor increasedin Alaska, Ecuador,Peru and Bolivia. This surpluscould be sold in the East Coast of the United States. Possible alternativetransport modes from Pacific to Atlantic could be: (a) conventionaltankers (under50,000 tons) cross- ing the Canal; (b) super-tankerstoo large for the Canal, going around Cape Horn; and (c) pipelines. At a volume of over 300,000barrele/day, the Panama pipeline would be viable. It is still not kRown how large the PacificCoast surpluseswill be. The Governmenthas concluded.that, for the project to be economicallyfeasible, firm commitmentsfrom petrcleum producersand carrierswould be necessaryso that enough throughp:utcould be assured.

(b) Roads

68. Although Panama has a fairly well developedroad system, in the past road constructiondid not respond to clearlyestablished economic priorities. The creation of the PlanningOffice of the Ministry of Pub- lic Works in 1971 and of the Ministry of Planningand Economic Policy in 1973 establishedthe institutionsfor designinga rational investment program, and the recently completedNational TransportSurvey (NTS) provides the basis for sector planning. The Survey has identified76 links of exlstingor proposed roads which qualify for early investment. This includesrehabilitation, reconstruction to higher standardsanad the constructionof some nevwroads. These links have in turn been grouped accordingto priority (see Kta)). The PreliminaryPublic InvestmentPro- gram for roads allocatesBo/. 165 million in the 1976-80period. This includes 218 km of feeder roads (B/. 43 million),the 22 km Arraijan- Chorreraroad (W/.21 million) and wldening of the 10 km San Miguelito- Tocumenroad (B/. 10 million). These projects are broadly in li.e with the prioritiesestablished in the NTS &Bcause of financialconstraints some parts of the Penonome-Colon-- outewill have to be postponeduntil after 1980 althr.ueii:his is a hig. pr40rity project ahich would open up - 38 -

valuablenew agriculturalland. The Panama-Colonhighway, a high priority project, is includedin the Program. Practicallythe whole of this road needs rehabilitationand some parts must be reconstructed. While this road fits well with the Government'sstrategy to fully utilize Panama's potentialfor transisthmictransport, careful design is needed to avoid overinvestmentthrough excessively high standards.

69. Extendingthe Pan AmericanHighway all the way across the Darien Region is the main projectwith undeterminedeconomic benefits included in the Program, accordingto the NTS. This road would pass throughone of the most inhospitableareas in the hemisphere,where low lying lands combinewith high rainfall to form dense tropicaljungles. Road sections totalling172 kilometersto the east of Panama City have either been con- structedor are being constructedto sub-base level (i.e.,without paving) and plans are to continue constructionto Canglon, a town some 82 kilo- meters from the Colombianborder with financingalready obtainedfrom the U.S. Government(grants covering the equivalentof 2/3 costs), IDB, Eximbank,and commercialbanks. The remainingsection to the Colombian border would not be built until the Colombianauthorities complete a program to controlhoof-and-mouth disease among livestockin their territory, in a sanitary cordon on the Colombianside of the border. In 1975, a U.S. Federal Court ordered the suspensionof U.S. aid for completionof new sections of this road, on the grounds that environmentalstudies have not been completedand that the projectmay threatenthe U.S. cattle industry. Because the earmarkedforeign assistance for this road cannot be trans- ferred to other projects,discontinuing work on the ongoing sectionswould only releaseabout B/. 10 million of investiblefunds in 1976-80.

70. The NTS also recommendsto place much greateremphasis on road main- tenanceand to implementa systematicprogram to prevent highway deteriora- tion. High rainfall,improper surfaces and, more important,truck overload- ing, have already combined to cause prematuredeterioration of important sections of the Pan American Highway. To reduce investmentand maintenance requirements,secondary road design criteriacould be lowered to a maximum 18,000 pound axle loading; this would requirea parallel loweringof regulations which now permit 10-ton axle loadings for these roads. Furthermore, it is necessaryto ensure enforcementof existing truck-loadregulations. These policies and others recommendedby the NTS could be implementedmore readily if the Ministry of Public Works were reorganized,upgrading its PlanningOffice and the Departmentresponsible for maintenance.

71. Although road user charges in Panama are not negligible,there is much scope for improvementin the systemwith the double objectiveof raising additionalfiscal revenuesand ensuringbetter resourceallocation. These charges consistof license fees, import duties and usage taxes (taxes on gasolineand on tires). The NTS suggests increasinglicense fees and/or import duties to discouragefurther additions of vehicles and stimulatea more intensiveuse of the existingmotor vehicle fleet. In particular,the - 39 -

NTS found that cars should bear a larger burden of taxation. Buses we-e found to be overtaxed in relation to trucks. 1/

72. Final engineering studies are under way for the B/. 36 million fisb&- ing port at Punta Vacamonte, Panama's first deep-water fishing port. This port will accommodate large shrimp trawlers capable of tapping presently unutilized resources (see para. 32). The project also aims at providing transshipment facilities to the international tuna fishing fleets which operate off Panama's Pacific coast. An additional important benefit would be derived in Panama City, by freeing for urban redevelopment important areas of the business district, now occupied by shrimp processors who would move to the new port area.

73. In addition to carrying out the Puerto Vacamonte fishing port project at an estimated cost of B/. 36 million, the Government intends to construct a container port in the old France Field area, within the projected expansion of the Colon Free Zone, to the east of the Caribbean end of the Canal Zone. The port would serve as a transshipment point for containers which would be transported in bulk to Panama for distribution in smaller lots to destinations in Central and South America. According to the pre-feasibility study, the global benefits are sufficient to justify this investment. Panama's unique geogra,phicposition as a crossroad to world trade and the existing related infrastructure appear to be favorable for a container port's success. However, a detailed economic and financial evaluation based on benefits accruing to the Panamanian economy still has to be worked out. This evaluation should take into account the fact that other similar ports are under construction in Central America and the Caribbean and that a container facility has recently been provided at the port of Balboa. The Government intends to sign a turnikeyagreement for construction, with suppliers' credits and commercial bank financing being provided for full costs. Apart from the fishing and container ports, other investments totalling no more than US$ 4 million are needed to improve ports on the Pacific coast serving the agricultural regions of Veraguas and Chiriqui.

1/ The problem of traffic congestion at peak hours in the city of Paniamaand in other areas suggests the possibility of using road user charges for the added objective of reducing congestion. Panama could profit from a system of area licensing as a form of congestion pricing. After delineat- ing the zone with the greatest congestion problems, the authorities would require all private vehicles to display a special area license sticker in this restricted zone during peak hours. Licenses could be sold for about B/. 1.50/day or B/. 30/month. In addition charges for parking within the restricted zone could be increased to discourage all-day perking. At the same time the Government could build parking lots in the suburbs a-id ctc- ate a fast shuttle bus system into the restricted zone. (A similar scheme has been successfully implemented in Singapore and is belxg intre- duced in Kuala Lampur.) In addition to relieving congestion and a?r pol- lution, lowering fuel imports and benefitting lower income groups through improved public transportation, this scheme could also generate - fiscal surplus. - 40 -

(d) Aviation

74. Constructionof a new internationalairport at Tocumenwas initiated in 1973; investmentcosts have risen substantiallysince the project was undertaken. The remainingexpenditures, estimated at B/. 34 million, would be disbursedduring 1976, 1977 and 1978, enabling the airport to initiateoperations in 1977. This new facilityshould enable Panama to improveits earningsfrom internationalservices. In addition to this investment,capital expenditureswill be required to improve and upgrade a number of provincialairports which handle local traffic. These investments, which could be undertakenbefore 1980, would total about B/. 7.5 million.

(e) ProgrammedInvestment

75. The Government'sinvestment program for transportin the period 1976-80has been increasedby US$ 40 million to allow for the recommended completionof the Penonome-Colonhighway, initiationof a road maintenance and rehabilitationprogram, especiallyfor the Pan American Highwayeast of Panama City and of programs to improveprovincial ports and airports.

(vii) Telecommunications

76. INTEL, the Government-ownedtelephone corporation, has prepared a National TelecommunicationsPlan which establishesas main goals for the sector: (a) extensionof telephoneservices to rural areas (b) direct dialing servicesbetween metropolitan and rural areas, (c) installation of an internationalexchange which would permit INTEL to handle international servicesnow provided by privately-ownedcompanies, and (d) a national and internationaltelex serviceto replace the telegraphand telephone servicenow providedby the DireccionGeneral de Telecomunicaciones. These programswill require investmentsof B/. 47 million in 1976-80and INTEL intendsto obtain suppliers'credits and commercialbank loans to finance the bulk of its investmentcosts. An increasein telephonerates would be required to permit INTEL to service its resultingdebt adequately. The authoritiesare consideringthis matter.

(viii) Power

77. Over 90 percent of power consumed in Panama is of thermalorigin and petroleumimports for power generationare large. To prevent the fuel bill from increasingfurther, and reduce dependenceon foreign oil supply for power generation,the Governmentintends to installhydroelec- tric facilitiesat severalsuitable sites to meet electricpower requirements through the 1990's.

78. The Bayano hydroelectricproject, initiatedin 1970, is about 80 percent completedand is expected to begin productionby the end of 1976. In its first stage, the project consists of a main dam, an auxiliarydam, - 41 -

a powerhouse with two 75 MW units, 80 km of transmission lines to Panama City, and a receiving substation. In full production, this project is expected to save about 1.8 million barrels of petroleum imports per year. Because of techrncal difficulties and administrative constraints, construction is about 18 months behind the original schedule; total costs are 60 percent higher than est:imatedat the time of appraisal. A Preliminary Master Electrification Plan recommends that in order to meet projected power requirements, assuming that consumption increases at about 10.5 percent per annum up to 1982, generation ctipacityshould be increased by bringing the La Estrella-Los Valles project (80 MW) on stream in 1980 and the La Fortuna Project (225 MW) into serUice in 1982. Should the Cerro Colorado Mining Project be undertaken, capacity would have to be increased by a further 120 MWby 1982. Since the La Estrella-Los Valles project (now beginning construction) would take about five years to be completed and the La Fortuna project (now in preappraisal preparation stage) would take not less than taree years for completion (including the associated transmission system), the Government proposes that IRHE, the national power corporation, initiate their execution as soon as possible. Invest- ments up to 1980 are estimated at B/. 375 million and IRHE proposes to o'tain suppliers' credits for about 85 percent of the cost of the La Estrella-Los Valles project (estimated at BI. 75 million) and to finance the balance of the investment program with assistance from officil lending agencies, suppliers' credits, commercial bank loans and from Govern- ment contributions and IRHE's own cash generation. The major question relating to the feasibility of this program is IRHE's ability, in the absence of electricity rate increases in 1975/1976, to make a slagnificant contribution from internal cash generation after meeting its mounting debt service obligations. It is clearly essential that substantial electricity rate increases be effected in the near future and IRRE is planning to proceed accordingly in 1977. There is no doubt that the proposed run-of-river hydroelectric facilities at Estrella-Los Valles would result in lower energy costs when ccmpared to fuel-based thermal generation. Preliminary studies indicate that a purely hydroe'ectric program compares favorably with a purely thermal.program (between Bl. 82 million and B/. 105 million lower discounted total cost, dependirig on the assumptions about shadow prices, with a discount rate of 12 percent).

(ix) Education

79. The Thovernment has made strong efforts to improve the quality and reach of public educatioa. While public outlays for the sect2r Increased from 5.1 percent of GDP in 196.8-72to 5.5 percent irn i972-75 (Table 5.44), the number of students erneclledin puDiic schools at al. educational levels increased by aimost 60 percent between 1967 and 1973. The largest gains were at the secondary le-vel, where enrollments rose by 80 percent. At the same time there were lIprovements in the quality of education, as suggested b-y changes in the ratirs of students per teacher and teachers per school (see Table 14). ?rimn.ary educaticr has been made generally available to - 42 -

even the poorest,more remote districts(see Table 8, Part II), and adult educationand literacycampaigns have been intensified.

80. While these effortshave improvededucational opportunities for the lower income groups, they have been costly. Current costs per students have risen fast at the universityand primary levels (Table14). A recent comparisonof educationindicators for 23 Latin American and Caribbean countries1/ suggeststhat currentcosts per student,relative to GNP per capita,are very high in Panama. The Governmentmight move towardsimprov- ing the efficiencyof public educationby exploringthe adequacyof provisions for materialsand supplies (the 1975 budget for primary education allocated95.5 percent of currentoutlays forisalaries,1.5 percent for administrativeexpenses and only 3 percent for materialsand supplies), and the scope for better trainingof teachers (withbetter teacher training and more intensiveuse of teachingmaterials it may be possible to increase the student/teacherratio without loss of quality). It may also be possible to reduce the future need for capitaloutlays by improvingmaintenance and upkeep of school facilities;because of poor maintenancein the past, the life expectancyof existing facilitiesis low. For this purpose, it would be desirableto expand the ongoingstudent and parent self-help maintenanceprogram. To enhance the equity of the system, it may be desirableto raise the fees paid by universitystudents (who currentlycon- tributeonly about 10 percent of their educationalcosts and who would be eligiblefor scholarshipsin case of need) and to reduce accordinglythe Government'ssubsidy to the University.

81. Though the Governmentintends to continueits programs to extend and improve ducation,no major increase in the level of investmentsin this sector is contemplated. The Governmentintends to expand its program of loans to universitystudents working in Panama and abroad. This program would account for 46 percent of investmentsin the sector. It also intends to start a program to improvethe quality and relevanceof trainingfor industrialand serviceneeds. For this purpose it has contractedthe constructionof 19 fully equipped schoolsof the basic cycle (grades6 to 8) and 4 buildingsfor middle-levelprofessional and technicaleducation. The Governmenthas also launchednew programs to train teachersand administra- tors for technicalschools and to reorganizethe educationalsystem at the professionaland technicallevels includingthe creationof a post-secondary "ipolytechnic"level.

(x) Health

82. Considerableprogress has been made in improvingwater and sewerage facilitiesin Panama in the last 15 years, but these are still inadequate to meet the needs for the rapidlygrowing population. Investmentsincreased rapidly, particularlyin the seventies,totalling US$ 44.1 million in the 1971-74period. These resulted in substantialincreases in transmission and distributionfacilities, and in theinstallationof the Chilibre Plant

1/ IBRD study in preparation. - 43 -

Table .h: PUBLIC EDUCATION INDIGATORS

Primary Secondary University 1960 1973 1960 1973 1960 1923

Enrolment as % appropriate age group 85 93 24 36 n.a. n.a.

Students/Teachers 30 30 23 20 27 27

Teachers/School 4 .1 13.4 5.0 23.6 96 335

Current Cost per Student (B/.) 49 92 141 182 286 652

Cost per Student (Index, 196o0100) 100 188 100 129 100 228

n.a. Not applicable J Includes Private Schools

Source: Tables 1.6, 1.7 and 1.9 - 44 -

to supply Panama City, the first major government-owned plant. (In the past, a large portion of the water distributed by TDAAN has beenibought from the Panama Canal Comparny. TLe percentage of the population served by piped water increased from 48 percent in 1960 to 70 percent in 1974. In 1974, more than 90 percent of the urban population had access to piped water, and somewhat l5ss than 50 Dercent of the rural. population in communiti s of less than 2,000 inhabitants received piped water. About 72 percent of the urban populaticn but less than 1 percent of the rural populatio:ihias access to sewerage services, Althouglr the expansion of water supply and sewerage systems in the urban centers-11as been rapid during the 'ast 15 years, most of the poor and rural migrants to urban frirngeareas still. do not have direct access to these servrces.

83. The Government's effort to impro-vewater supply has been costly, partly owing to overinvestment, which results in high average operating costs. At present) overcapacity in portions of the system, particularly in Panama City, co-exists with shortages in others. Further, the rapid expanisionhas led to production and supply probiems. Water losses in the networks and household wastage account for a high percentage of water produced, and much of the water distributed is not billed. The full extent of the problem cannot be measured because over 40 percent of cornnections are not metered. The organizational structure and management systems of the national water supply agency, the Instituto de Acueductos y Alcanta- rillados Nacionales (IDAAN) was not changed to meet the demands imposed on it by the expanded network. Largely because water rates have not been adequately adjusted and much of the water used was not paid for, IDAAN's contribution to investment has been negligible, and its financial viability impaired.

84. The Government is making efforts to correct these problems and has orepared a national sanitation programr, which has as an objective the provision of water to at least 85 percent of the populacion by 1980. The program aims at bringing water to poor urban areas to meet requirements resulting from the inflow of rural migrants; increasing service in rural areas, and providing adequate service to the rapidly expanding industrial and commercial sectors. Investments in water services will be geared not only to expanding capacity and distribution, but also to optimizing the use of existing capacity, inter alia through national metering and leek detection programs. In carrying out its program, the Government intends to improve sectoral planning as well as to strengthen IDAAN's organization, management and operations, with a view to making it a more effective agency in project preparation and execution. Finally, the Government has taker.action on water pricing, so that a reasonable proportion of new works can be financed from water sales, while maintaining cross-subsidization from high to low income consumers.

85. A major portion (54 Derceiat) of public investmeuts in health would be narried out througn IDAkN. T" ese include a 4 million gallonsiday water treatment plant and reilabilitacio of the distribution system in the ci-y - 45 -

of Colon, rehabilitation and expansion of distribution networks in low income districts of Panama City and in several.towns of the interior. The Social Security Institute, wthich is financially self-sufficient, would continue to invrestin improving hospital facilities in maj',orvopula- tion centers and to integrate its services with the Ministry of 'Heaith throughout the country. Preventive services in rural areas are to be expanded through the constructionaof rural clinics. The Ministry of Health is also to continue a program ol providing potable water and latrine facilities to small rural communities; these projects are in many cases carried out by using conmunity self-help techlniqueswhich noc only reduce capital costs but improve community response.

(xi) Housing

86. The results of the Government's ambit'ous program for low-cosL housing construction were disappointing in the early 1970's, malniy owing to administrative difficulties which lead to the transformation in 1973 of two housing institutes into the Ministry of Housing and its financial branch, the Banco Hipotecario (Mortgage Bank). There was a marked accel- eration in execution of the program in 1975. The Government is confident that institutional problems have now been largely overcome and that a higher rate of low-cost housing construction can be achieved and maintained in the future. In the short run, a large volume of construction would undoubtedly help revitalize the econom3y,but given the recent over- production of middle and high-income housings careful market studies are needed. Given past performance, it is probable that budgeted inviestments in low-cost housing for 1975-77 are on the optimistic side. Resources available for low-cost:housing construction have been increased by means of a new tax on payrolls; it is also expected that external agencies will continue providing assistance in this sector. The Ministry of Housing and Mortgage Bank have improved their rent collection and loan recovery methods and it is expected that this will further strengthen the financial position of these institutions in the future.

(xii) Overall Aspects

87. The general strategy of investments appears well conceived. Empha- sis is being given to productive sectors and to projects which would alter the structure of economic activity to provide new sources of growth and of foreign exchange earnings. There are two areas of concern, however. Firstly, while econom:icpriorities have been well determ.inedard project identification has on the whole been good, in some c?ses there is an absence of detailed project planning. The long-term eroncmic well-being of Panama might be endangered if large new projects are undcertakenwithout sufficient analysis of their econr_micand financial viability l!ndercon- servative assumptions. Inivestmentsin the nroductive sectors should be sibject to detailed examination to establish operating costs, so as to ensturethat the enterprises can be competitive internationally over the - 46 -

long run, that the size of installations contemplated is optimal, so as to avoid unnecessary investments, that the full cost of investments have been taken into account, including contingencies, working capital needs and interest costs during the period of construction, and that the capital structure of the autonomous agencies undertaking investment projects is adequate, so as to avoid unexpected burden3 on the Treasury in the future. Since the profitability of several important projects hinges on volatile future commodity prices, analysis of risk deserves explicit con- sideration. In making specific investment decisions the authorities seem in the past to have given greater weight to the terms of financing provided by suppliers of investment goods than to the above considerations, and commercial banks which have provided project financing have not required adequate long-term financial analyses. The authorities have taken steps to strengthen their project analysis and it is expected that the recently created National Development Bank will contribute towards this objective.

88. Secondly, the volume of public investment planned for the rest of the decade is more than twice as large in constant terms as in the 1971-75 period. In some activities the planned increment is many times higher and in relative terms proposed investments would be large by the standards of any country. This considerable increase in the Government's participation in the national economy will require a much expanded professional capacity which will no doubt put a strain on the country's professional resources. The authorities are aware of the constraint and have taken steps to attract qualified Panamanians living abroad and to train local professionals in the new skills required (for instance through the University loans and scholarship program). They are also making use of foreign expertise wherever it is possible to do so without relinquishing domestic control over the projects being undertaken. These measures may prove to be insufficient to meet the demand fox professional skills which the pace and diversity of the investment program would require. There have already been signs that project implementation has been delayed and large cost overruns incurred owing to an insufficient number of qualified domestic managers (e.g. in housing, power, and some transport projects), as well as to inadequate sector financial policies. To reduce this constraint, the authorities in some cases are resorting to turnkey contracts, but this adds considerably to the cost of the projects. They have now determined that they should adopt a more gradual approach to investments in some activities, thus permitting personnel to experiment with techniques suitable to conditions in Panama before undertaking projects on a large scale. - 47 -

C. FinancingPublic Expenditures

(i) Recent Trends

89. The major expansionin social and economicprograms started in 1968 is continuing. Total public sector outlays rose from under one-fourthof GDP in 1968-71to almost one-thirdof GDP in 1972-74and total public investmentrose from 6 percent of GDP to 10 percent of GDP in the same period. Preliminaryestimates point to a further rise in 1975. Starting from a very low base the authoritiesmade significantgains in savings to finance these programs. Followingthe disappointingyear of 1972 when the ratio of public sector savings to GDP fell to 1.4 percent, this ratio has risen steadilyto about 4.0 percent in 1974 and may be somewhathigher in 1975 1/ (see Tables 15 and 16). In spite of these gains, this savings ratio is not high by internationalstandards (an internationalcomparison of some 100 countriessuggests that a country of Panama'spopulation, income per capita and size normally has a ratio of public savingsto GDP rangingbetween 5.7 percent and 10.7 percent 2/) and given the large increase in capitalexpenditures, the overallpublic sector deficit rose to 6.7 percentof GDP in 1972-74and is estimatedby the Bank to have reached a record 10.6 percent of GDP in 1975. Part of the increasein public savings,moreover, has not originatedfrom an improvementin fiscal performancebut from the absorptioninto the public sector of revenue- earning agenciessuch as IRHE (power),INTEL (telecommunications)and La Victoria (sugar). These three agenciesaccounted for over one-fifthof public sector savings in 1972-74 (Table5.41).

90. The widening gap between public capital expendituresand savings has led to an increasedreliance on externalborrowing. 3/ Despite continuing improvementsin projectpreparation, which have lead to an accel- eration in disbursementson officialproject loans, the latter have not kept pace with growing capitaloutlays and the authoritieshave continued resortingto commercialbank loans, inter alia to financecounterpart fund contributions.As of December 1974, the externalpublic debt (excluding

1/ This public finance conceptof public sector savings differs from the national accountsconcept (seeTable 2) because it includes as current expendituresinterest payments on the public external debt, whereas the national accounts conceptof domesticsavings is gross of external interestpayments. In addition,the public financeconcept of public capitalexpenditures includes financial investment, which in the national accounts is consideredprivate investment. 2/ "A Handbookof ExpectedValues of StructuralCharacteristics," IBRD Staff Working Paper No. 154, June 1973, prepared by N. G. Carter. 3/ In the case of Panama,almost all public borrowingis considered external owing to the use of the U.S. dollar for all transactions. Table 15: CONSOLIDATED PUBLIC SECTOR ACCOUNTS 1960 AND 1965-75

(Thotusandof Balboas)

1960 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 (Estimate)

Current Revenues 66,795 114,621 132,708 149,368 158,448 180,998 220,318 257,227 301,945 370,145 478,898 549,433

Current Expenditures 56,603 92,724 106,476 123,058 134,872 153,546 180,905 212,478 265,100 314,947 398,423 459,762

Current Savings before Transfers 10,192 21.897 ~2623226,310 23.576 27,452 39.413 44,749 36,845 55.198 8Cj75 89,671

Net Transfers to Private Sector 5,492 5,222 6,628 8,395 9,061 10,074 16,125 13,620 17,945 8,635 10,996 6,423

Current Savings after Transfers 4.700 16.375 19,604 17,915 14,515 17,378 23.288 31,129 18,900 46.563 69.479 83,248

Capital Transfers net of Capital Revenues - 935 1,100 1,299 -447 -5,303 -3,024 -2,944 -2,515 5,040 3,985 6,520

Non-borrowed Funds for InYvstmerit 4,700 17,310 20,704 19,214 14,168 12,075 ZO,264 28,185 16,385 51,603 73,464 89,768

Capital Expenditures 16,236 27,161 32,057 43,314 39,908 58,039 68,699 69,273 97,393 156,877 193,023 297,430 Fixed Investment ( ) (22,106) (27,480) (37,100) (36,143) (52,071) (59.612) (57,472) (90,250) (110,512) (158,773) (206,082) Purchase of Fixed Assets ( ) ( - ) ( 20) ( 262) ( 208) ( 191) ( 645) ( 25) ( 454) (25,610) ( 1,654) (27,800) Lending to Private Sector (net) ( ) ( 5,025) ( 4,519) ( 4,925) ( 2,536) ( 5,029) ( 6,177) (10,646) ( 5,248) (19,934) (31,080) (62,348) Other ( ) ( 30) ( 38) ( 1,027) (11,021) ( 748) ( 2,265) ( 1,330) ( 1,141) ( 821) ( 1,516) ( 1,200)

Over-all Surplus () or Deficit (-) -10.536 -9,851 -11.353 -2_3.10 -25,740 -45,964 -48,435 -41.088 -81,008 -105.274 -119.559 -207,662

Gross External Borrowing 7,775 9,052 12,929 12,028 19,028 42,244 68,873 68,873 114,223 170,618 169,444 215,586 AID (5,000) (5,249) (8,655) (5,616 (6,436) (5,258) (5,705) (14,361) (6,213) (16,493) ( - ) ( 9,114) IDB ( - ) (1,230) (1,205) (3,472) (5,603) ( 553) (5,799) (13,146) (7,374) ( 5,686) (10,045) (10,372) IBRD ( - ) ( 706) (1,880) ( 289) ( 786) ( - ) ( 912) ( 2,187) (11,747) ( 8,222) (15,034) (25,500) Other (2,775) (1,867) (1,189) (2,650) (6,203) (36,433) (56,457) (49,959) (88,889) (140,217) (144,365) (170,600)

Gross Internal Borrowing 6,089 4,903 4,553 13,274 18,284 15,081 9,821 13,158 25,528 8,527 23,634 21,768

Amortization (-) 1,467 6,197 7,525 6,535 9,848 12,320 29,896 46,677 51,361 74,310 94,324 47,169

Discrepancy and Change in Assets (-increase) -1,861 2,813 1,396 5,333 -1,724 959 -362 -5,047 -7,382 439 20,805 17,477

Source: Tables 5.6 to 5.17. Table 16: CONSOLIDATED PUBLIC SECTOR ACCOUNTS, 1960 AND 1965-75

(Percent of GDP)

1960 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 (Estimate)

Current Revenues 16.1 17.4 18.5 18.7 18.4 19.1 21.1 22.2 23.0 25.1 27.5 28.0

Current Expenditures 13.6 14.1 14.8 15.4 15.7 16.2 17.3 18.4 20.2 21.4 22.9 23.4

Current Savings before Transfers 2.5 3.3 3.7 3.2 2.7 2.9 3.8 3.9 2.8 3.7 4.6 4.6

Net Transfers to Private Sector 1.3 0.8 0.9 1.0 1.0 1.1 1.5 1.2 1.4 0.6 0.6 0.3

Current Savings after Transfers 1.1 2.5 2.7 2.2 1.7 1.8 2.2 2.7 1.4 3.2 4.0 4.2

Capital Trabafer net of Capital Revenues - 0.1 0.2 0.2 -0.1 -0.6 -0.3 -0.3 -0.2 0.3 0.2 0.3

Non-borrowed Funds for Investment 1.1 2.6 2.9 2.4 1.6 1.3 1.9 2.4 1.2 3.5 4.2 4.6

Capital Expenditure 3.7 4.1 4.5 5.4 4.6 6.1 6.6 6.0 7.4 10.7 11.1 15.2 Fixed Investment (.) (3.3) (3.8) (4.6) (4.2) (5.5) (5.8) (5.0) (6.9) (7.5) (9.1) (10.5) Purchase of Fixed Assets (.) - ) ( - ) ( - ) ( - ) ( (- ) ( - ) ( - ) ( - ) (1.7) (0.1) (1.4) Lending to Private Sector (Net) (.) (0.8) (0.6) (0.6) (0.3) (0.5) (0.6) (0.9) (0.4) (1.3) (1.8) (3.2) Other (.) - ) ( - ) (0.1) (0.1) (0.1) (0.2) (0.1) (0.1) (0.1) (0.1) (0.1)

Over-all Surplus (+) or Deficit (-) -2.5 -1.5 -1.6 -3.0 -3.0 -4.8 -4.7 -3.5 -6.1 -7.1 -6.9 -10.6

Gross External Borrowing 1.9 1.4 1.8 1.5 2.2 4.5 6.6 6.9 8.7 11.6 9.7 11.0

Gross Internal Borrowing 1.5 0.7 0.6 1.7 2.1 1.6 0.9 1.1 1.9 0.6 1.4 1.1

Amortization 0.4 1.0 1.0 0.8 1.1 1.3 2.9 4.0 3.9 5.0 5.4 2.4

Discrepancy and Change in Assets (-increase) -0.4 0.4 0.2 0.6 -0.2 0.1 - -0.5 -0.6 0.2 1.2 -0.9

GDP (B/.M) 415.8 659.9 719.2 800.7 861.4 945.4 1,045.8 1,157.0 1,311.7 1,472.5 1,740.2 1,960.9

Source: Table 5.1 - 50 -

undisbursed)reached US$ 472 million, almost four times more than five years eariter and equivalent to US$ 290 per capita, one of the highest i-r the world.

91. As a consequenceof the high debt and the large proportion of private bank credits (60 percent of total public external debt in 1974) debt-serviceobDigations mounted. Tn 1974, amortizationon public debt reached US$ 94 million, 17 percent more than public sector savings, and total debt-serviceon public debt exceeded US$ 140 million. 1/ Until now, it has been possible to-avoid a liquidity problem by having recourse to refinancingof loans, as the authoritiesdid successfullyin 1973. After the large prodtuctiveprojects in the National Development Plan are completed, the authoritiesare determined to ensure that public sector savings should increase faster than debt service obligations. This will require strengtheningthe Central Government revenue structure and making the decentralizedrevenue-earning agencies more profitable,so as to reduce their dependence on capitaL transfers from the Central Government.

(ii) Central Government Financ-alOperations

92. The root of the problem of low public savings lies in the inadequate elasticity of the tax system with respect to income and to inflation. This low elasticity has made it necessary to increase taxes periodicallyto keep pace with expenditures. Thus, since 1969 the Governmenthas adopted a number of tax changes, including; (a) increase in both personal and corporate income tax rates and of the tax on dividends in 1970; (b) increase in eadas- tral valuation for the urban property tax, only partially implementedin 1971; (c) rate increase in the business net worth tax in 1970; (d) near doubling the ad valorem import surcharge rate (from 3.5 percent to 6 percent) in 1970; (e) steep increases in excise duties on beer, domestic liquor, domestic cigarettes and gasoline, and on import duties on liquor, in 1972 (the increased taxes on liquor and beer were soon rescinded after disappointing revenue results); (f) further increaseson gasoline taxes in 1974 and in 1975; (g) increased export taxes on bananas and sugar in 1974; (h) an excise tax on non-alcoholicbeverages in 1974; (i) further increase in the import surcharge rate from 6 to 7 percent of the value of imports in 1975; (j) a B/. 5 consular fee on air invoices in 1975; (h) a 10 percent increase in the cost of lottery tickets in 1975; (i) further increase in the banana export tax in 1976, from 35 to 40 cents/case;and (k) new increase in the ad valorem import surcharge to 7.5 percent in 1976. Tax collection and administrationhas also been strengthenedsince 1969 through increases in the numbers of inspectors and withholding agents, more systematic auditing and cross-checkingof individual incomes, completion of a cadastralsurvey for the City of Panama and other measures. Despite all the tax changes and improvementsin tax administration,the rato of tax revenues to GDP has

1/ The debt-serviceburden is inflated in 1974 because in this year the authoritiesprepaid debts for US$ 48 million, as part of the 1973 refinancing operation. - 51 -

remained around 12.3 percent in 1970-74. This ratio is not high by international standards. The comparative study of 100 developing countries suggests thbt a country of Panama's size and income level would normally have a ratio of taxes to GDP ranging between 15.4 and 20.5 percent. 1/ The true tax burden in Panama is probably heavier than indicated by these ratios, however, because of the highly developed and expanding Social Security System. Contributionsto the System and other earmarked payroll taxes in 1974 were equivalent to about 6 percent of GDP and a part of this should be considered as a tax.

93. If the authorities are determined to continue expanding the Govern- ment's role in the economy, there is a need for further increases in tax effort. This could be accomplishedin a number of ways. It is possible to continue introducingad hoc measures periodicallyto recover the ground lost to inflation. Or the authoritiesmay prefer to overhaul the tax system so as to make it buoyant. While perhaps more difficult to implement in the short run than small new taxes, a tax reform, once implemented, would set the base for sound financing of the public investmentprogram, and allow policy makers to concentratein the future on the development effort. A tax reform could also serve to improve resource allocation, help restore equilibriumbetween aggregate demand and supply and lead to output growth. The most promising areas for tax improvementsare import duties, taxes on property (mainlyland and automobiles),taxes on consumption (or sales taxes) and tax administration.

94. Most import duties are specific rather than ad valorem. As the general price level increases, the ratio of tax collectionsto the value of import goes down. Including the import surcharge, this ratio has fallen from around 12 percent in the mid-1960's to 7 percent in 1974. As noted in paragraph 36 above, protection from imports is obtained not so much from duties as from quotas. The authorities,recognizing the advantages of ad valorem duties, intended to reform the system in 1974 but then decided to postpone the implementationof these measures because of the recession. To be effective, any increase in import duties would have to be accompaniedby more rigorous enforcement,particularly in the Colon Free Zone (see para. 45).

95. As indicatedin Section B, road user charges could be increased. If accompaniedby improvementsin public transport facilities,greater taxation of private vehicle ownership and of their use -- including gasoline sales -- would help reduce traffic congestion and possibly slow down imports of vehicles, parts and fuels. Furthermore,by making the property tax progressivelyhigher for newer vehicles, it may be possible to encourage owners to keep their vehicles longer, thus expanding demand for maintenance and repair work. As of 1971 almost 45,000 small and 8,000 large automobileswere registered,paying annual fees of B/. 26 and B/. 36, respectively,with a total yield of B/. 1.4 million which accrued to the

1/ Ibid. - 52 -

municipalities. Without undesirableinflationary or redistributiveeffects, these fees could be complementedby a graduated property tax, at aulaverage B/. 200 and B|. 500, respectively,for a total yield of Bl. 13 million, which would accrue to the Government. As mentioned in paragraph 25 above, in the area of property taxes enforcementof taxation on rural land would provide a needed incentive for better land use. A graduated tax, based on the productivepotential of the land (ratherthan on its actual use) could possibly yield on average B/. 3 per farm hectare, or a total of B/. 6 to 7 million. Better enforcementof the urban property tax, in line with recent increases in urban land prices, could yield a further Bj. 15 million. To help collect this tax, the authoritiescould request mortgage l-endersto act as withholding agents.

96. The need for some type of taxatian of consumptionin Panama has been identified for many years. In the present circumstancesin which private consumptionis increasing faster than national income and the resource gap has approached 10 percent of GDP, it becomes urgent to restrain ttiegrowth of consumption. Of the various forms of consumptiontax that have been recommended for Panama, the easiest to implementmay be a tax on consumption or a hybrid wholesale-retailsales tax. 1/ This could initially yield about B/. 20 million. There is also scope for additional revenues by taxing sales of restaurantsand bars. Certain provisions of the income tax law could be modified to make this tax more equitable and to raise revenues. Thus, the authoritiescould usefully consider eliminatingthe deduction from taxable income of interest payments on mortgages of owner-occupieddwellings The allowance for medical expenses (5 percent of taxable income) has encouraged travel abroad for medical reasons, and could be reduced. The progressive scale for corporate income taxes, which encourages the artificial fragmenta- tion of firms, could be transformedinto a flat rate.

97. In the last few years, tax administrationhas improved, but further gains could be made by strengtheningthe resources available to the General Tax Directorate. Major improvementsare needed, particularlyin the areas of import duties, personal income taxes (paymentarrears on these taxes are estimated to exceed 40 percent of tax liabilities),land taxes, and the tax on Panamanian flag ships.

98. During the past few years the authoritieshave restrained :he expansion of operating outlays and the ratio of current expenditures (excluding interest payments) to GDP fell from the peak of 1972 (13.3 percent) to 12.8

1/ To implement a hybrid wholesale-retailsales tax, all firms -- whether wholesalers or retailers-- with sales above a specified amount (e.g. B/. 100,000 per year) would be registered. The tax would then be col- lected only on sales made by registered firms to unregisteredbuyers, i.e. to smaller firms or to the public. By this technique, sales would only be taxed once, either at the retail level by the registered seller, or at the wholesale or manufacturinglevel on sales made to small, unreg- istered retailers. The profit margins of small retailers and artisans would therefore remain outside the tax base. In this way liability for the tax would fall on only a limited number of larger taxpayers. - 53 -

percent in 1974 and an estimated 12.1 percent in 1975 (see Table 17). While there is scope for further economies by streamliningand making certain activities such as education, agriculture,and central administrationmore efficient, in the medium term these outlayswill have to increase to ensure that the rapidly growing public fixed capital stock is properly maintained and utilized to capacity.

(iii) The System of Budgetingand Control 1/

99. The Central Government'sbudget is divided into Ordinary and Capital Budgets. Both are prepared within the Ministry of Planning and Economic Policy. Ordinary Budget expenditureincludes most current outlays, debt service and minor capital outlays. In the past, numerous items of expenditures were excluded from the Ordinary Budget. Some items, such as the work brigades for road maintenance,were transferredto the Capital Budget, and there have been instances in which major government expenditureswere excluded from both budget and financed by issue of government notes. Obliga- tions to the Social Security System, for example, were not recorded as a current outlay and were settled by occasionallyissuing promissory notes. The Capital Budget is prepared on a project by project basis, with specific sources of financing identified for each project. The Capital Budget is almost wholly financed by borrowing; all borrowing is earmarked for individual projects, even minor ones. The authoritiesare improving the system of recording expenditures. The work brigades, for example, are now included in the ordinary budget.

100. This budget system tends to understate current expendituresand thus to overstate current savings. Central Government savings have averaged less than 1 percent of GDP for the last four years. The earmarkingof some capital funds makes efficient cash management difficult. Until recently, authorized domestic bond placements remained unissued while fresh borrowing was being undertaken for other projects, but this practice has now been corrected. The budget system, while offering the appearance of complete and up-to-date information,has in fact allowed for extra-budgetaryexpendi- ture and thus has not permitted effective informationand control. The extent of capital transfershas often been unknown because it only showed up in the details of government debt.

101. The ComptrollerGeneral's Office keeps very close track of the Cen- tral Government'sdirect debt obligations,both foreign and domestic,but it has some difficulty in getting external debt informationfrom autonomous public agencies. The Office has only limited informationon private sector debt guaranteed by the Government and on internal debt of autonomous agencies. There is no systematic tallying of debt under Central Government guarantee and no assessment of which contingent liabilitiesmight have to be met by the Central Government. Because of inadequate informationon contingent debt-serviceobligations, financial planning is less than optimal.

1/ This Section draws on the report "Public Borrowing in Panama," IMF/IBRD Joint Mission, February 19, 1975. Table 17: CENTRALGOVERNMENT OPERATING EXPENDITURES (CASH BASIS)

Central Government Total Interest Operating Expenditures Operating Expenditures Payments Net of Interest Payments Year in current prices (B/Millions) Current Prices (B/Million) (B/Millions) As Percent of GDP

1971 167 17 150 13.0

1972 194 22 172 13.3

1973 204 29 175 11.9

1974 266 43 223 12.8

1975a/ 279 43 236 12.1

Price Indices Net Operating Expenditures Index of Real Net (1971 = 100) in Constant Prices, Operating Expenditures Year Implicit GDP Adjusted by: Adjusted by: Wholesale Deflator Wholesale Prices GDP Deflator Wholesale GDP (B/Millions, 1971 Prices) Prices Deflator

1971 100l 0 100.0 150 150 100 100 1972 108.5 105.6 159 163 106 109

1973 119.9 112.4 146 156 97 104

1974 156.1 128.4 143 174 95 116

1975 a/ 180.9 141.2 130 167 87 111

a/ Preliminary estimates Source: ContraloriaGeneral - 55 -

102. The authoritieshave taken steps to strengthenbudgetary control. The authority of the Financial Commission,which was created in late 1973, has been strengthenedby institutionalizingits functions and operating procedures. Although budgeted financing is approved in the formal budgetary process, all public sector loans have to be individuallyapproved by the Commission before formal negotiations. All Central Government expenditures not included in the budget and all public sector capital expendituresmust be approved by the Commission. Significantmodifications to budgeted current expendituresin the rest of the public sector must also be approved.l/ The ComprollerGeneral's Office has improved its reporting on capital outlays and is obtainingmore informationon borrowing by autonomousentities. In addition, it has extended to most of the public sector an advanced com- puterized data processing and informationsystem. These recent improvements lay the foundation for further improvementsneeded in financialmanagement and control. The budget should show all financial obligationsto be incurred by the Government over the year. Such a system would give policy makers a clear picture of the Central Government'sfinancial operations. It would greatly improve control over floating debt, since all floating debt would then be registered. It would permit identificationof the true size of the Government'sdeficit and allow for a more systematicapproach to its financing. It would, in sum, facilitate the understandingof the Government's true financial position.

1/ The Financial Commission is presided over by the Minister of Planning and Economic Policy and has the followingmembers: Minister of Finance, ComptrollerGeneral, Director of the National Bank, designated member of the LegislativeCommission and the Director of the Budget. It has a supporting technical staff. - 56 -

IV. STRATEGIES FOR GROWTH

A. Introduction

103. In the 1960's the Panamanian economy expanded rapidly with minimum government participation (total public expenditures were equivalent to less than 15 percent of GDP) and an efficient use of investment (the average incremental capital-output ratio was 2.94). Many factors made this fortunate situation possible. World trade flourished during the decade and Panama was able to benefit from its unique geographic location because of its liberal trade legislation, unrestricted use of the U.S. dollar as currency and some limited investments of high economic return, such as the Colon Free Zone. The domestic market offered opportunities for small-scale industrialization and there was still much virgin land that could be brought under extensive production with small investment and effort. This fortunate combination of circumstances enhanced the productivity of capital and labor. A study suggests that less than 60 percent of the growth that took place in the decade was due to investment and the growth of the labor force, while 40 percent was attributable to improved productivity (including education).l/

104. Panama cannot unfortunately rely on a continuation of these trends in the decade ahead. While a resumption of growth in world trade would benefit Panama as much as it did in the past, further expansion of agriculture will require more capital and specialized manpower, whether to improve yields and cropping patterns or to extend the frontier to new, less accessible, virgin lands. Large investments will be also needed to develop mineral resources, to exploit more fully the hydroelectric potential and to expand the export-oriented service industries.

105. The Government plans to create the conditions necessary for a resumption of sustained economic growth. This is needed to provide enough work opportunities for the rapidly growing labor force and to generate fiscal resources which will be used to continue to improve living standards in poorer rural areas and in the growing urban slums. As noted in the preceding Chapter, the Government plans to take the lead in carrying out the required investments. The following sections examine the macroeconomic and financial implications of the public investment program outlined in Chapter III, and consider two other patterns of public finances in the light of the probable availability of domestic and foreign savings.

1/ Plan Nacional de Desarrollo, Version Preliminar, Panama, 1975 (page 64). - 57 -

B. The Government'sPreliminary Financial Program

106. In 1975 prices, the PreliminaryPublic Investment Program 1976-80, adjusted as noted in Chapter III, would amount to B/. 2.1 billion (see Table 5.40), or B/. 425 million per annum in 1976-80, compared to B/. 204 million per annum in 1971-75. This increase -- from 10.8 percent of GDP in 1971-75 to 20.4 percent in 1976-80 -- is largely due to the inclusion of four large projects of a commercial nature: the copper mine, pipeline, sugar mills and cement plant, which together are expected to average B/. 120 million per annum -- or 5.9 percent of GDP -- in 1976-80. When these four large commercialprojects are excluded,public investmentin 1976-80 is projected at an average annual level of B/. 300 million, practically the actual estimated 1975 level. Assuming that future price movements in Panama will continue to follow internationalinflation and that the average annual rate of inflation in 1976-80 will be 7.8 percent, the projected public investmentprogram in current prices would amount to B/. 2.7 billion, or B/. 540 million per year. By stimulatingeconomic activity in the short run and creating productiveinfrastructure in the medium term, the program could lead to an annual rate of GDP growth of 6.8 percent in 1975-80 and over 7 percent in 1980-85.

107. To finance this large investment the PreliminaryProgram projects a substantialincrease in public savings, primarily in the decentralized public sector agencies (see Table 5.41). The greatest contributionto savings would come from IRHE, the State power company, which intends to set its tariffs at levels high enough to yield an 8.75 percent return on its revalued assets and thus generate in 1976-80 savings (before interest payments) equivalent to about 40 percent of the total decentralized public sector savings. Another 25 percent would originate in the Social Security System, from recent increases in payro]l taxes. Part of the higher payroll taxes will also benefit the National Mortgage Bank, which could thus contribute 13 percent to the decentralized agencies' savings. INTEL, the telecommunicationscompany, assuming that it adjusts its tariffs by 10 percent (in 1975 prices) in 1977, would contribute 12 percent of savings. The large new commercial ventures (e.g., La Victoria, the Copper Mine, the Pipeline)would not be able to make a large contributionto public savings during this period, although their importance is expected to increase greatly in the 1980's. The Program does not contemplatemajor new tax measures, but Central Government tax revenues are projected to increase with an income elasticityof 1.2 with respect to GDP. Recent studies have shown, however, that in the absence of new tax measures the elasticity of the Panamanian tax system has been somewhat less than unity. In the following projectionsit has been assumed that without new tax measures, Central Government tax revenues would grow at the same rate as GDP, reflecting expected improvementsin tax enforcement. Altogether, public - 58 -

sector savings (before interest payments) could be B/. 1.0 billion in 1975 prices, or about 48 percent of public investment in 1976-80 (see Table 17) compared to 51 percent in 1971-75 (Tables 5.40, 5.41 and 5.43).

108. The many investmentprojects under preparationwill offer opportunities for expanded drawings on project-relatedloans, includingnot only loans from official developmentfinance agencies but also suppliers' credits, buyers' credits (e.g., in the cases of copper and the pipeline) and possibly special financial packages for individualprojects through cofinancing,consortia or other arrangements. After tapping all these sources of capital, a large financial gap would remain which the Pre- liminary Program expects to fill by borrowing from private banks (see Table 18). On the basis of average terms of five years maturity (includingtwo years of grace) and a 10 percent interest rate, the public sector would need to borrow an average of about US$ 270 million per annum (gross disbursements)from private banks, compared to US$ 91 million per annum in 1971-74. On the other hand, if Panama were able to obtain seven-yearaverage maturities on private bank loans, gross annual requirementsfrom these sources could be reduced to about US$ 250 million. Total external borrowing by the public sector in 1976-80 would average about US$ 530 million per year gross and US$ 400 million net. Allowing for a fairly rapid growth in private consumption (7.3 percent per year, about the same as in 1970-74) and a resumptionof growth in private investment in response to the demands to be generated by the public investment program, the resource gap would be in the order of 14 to 15 percent of GDP by 1980. The current-accountdeficit of the balance of payments would average US$ 675 million per year in 1976-80 and approach US$ 1 billion by 1980 (current prices).!! This would imply average annual borrowing requirementsby the private sector of about IJS$275 million net, of which about US$ 50 million might be direct private investment,and US$ 225 million commercialbank loans.

109. It might be very difficult to borrow the amounts expected from private sources. Commercial banks in the United States are coming under increasing public scrutiny as regards the quality and diversifi- cation of their portfolios; they may tend to be more restrictive in their lending policies in the future. Should it prove impossibleto obtain the required commercialloans at acceptable terms once the major investmentprograms have been launched, the authoritiesmight find themselvesin a very difficult liquiditysituation (debt service obligationswould average US$ 247 million annually, up from US$ 46 million during each of the past three years). Although this appears to be the Government'sPreliminary Financial Program, the authoritiesmay

1/ For details of the projectionssee Tables 2.12, 3.8, 3.9, 3.12, 3.13, 4.7 and 5.45. - 59 -

conclude that the risks would be excessive as regards the magnitude of debt service and availability of loans. To reduce these risks, the authorities may choose an alternative financial program relying more extensively on internal efforts.

C. An Alternative Financial Program (Medium Growth Case)

110. The sound financing of the Preliminary Public Investment Program requires a determined internal savings effort, at the expense of some loss in GDP growth and in consumption gains, with respect to the Pre- liminary Program's targets. Public savings (before interest payments) in 1976-80 would be needed to finance about 60 percent of public investment, i.e., B/. 1.2 billion, compared to B/. 0.5 billion (both in 1975 prices) in 1971-75 (see Tables 5.41 and 5.43). The principal elements of the Program could be a combination of fiscal action and incomes policy.

111. The needed fiscal measures could aim at simultaneously strength- ening public finance and the balance of payments. This report has suggested that further output growth in agriculture and manufacturing is hampered by lack of international competitiveness at present exchange rates. The export-oriented services sector, on the other hand, continues to thrive because of Panama's clear comparative advantage. Panama could achieve a more balanced development and utilize more fully its labor and natural resources with a lower effective exchange rate for the goods-producing sectors. It may be possible to accomplish the necessary changes by replacing the existing system of quotas and specific import duties by a generalized surcharge, applicable to all merchandise imports, of between 20 and 25 percent of the value of imports. This measure could be accompanied by the establishment of a generalized export subsidy of the same proportion, on the value of all exports. These two actions would be tantamount to a partial devaluation, and would have a large positive fiscal effect. As merchandise imports exceed merchandise exports by about US$ 350 million, the initial fiscal surplus could be as high as B/. 80 million. If not defeated by price controls, this partial "devaluation" would tend to stimulate production of goods for the domestic market and1 for export by reducing the international cost of Panamanian products.- It would also have the effect of raising the cost of living. If not compensated by general wage and salary increases, this increase in prices would have the needed effect of reducing the growth of private consumption expenditures, thus moving aggregate supply and demand towards equilibrium and reducing the resource gap. The nation's external deficit could also be reduced by adopting the export- promotion policies outlined above (see para. 39).

1/ Export-oriented service activities (e.g., tourism, banking) would not benefit directly from this scheme. Inasmuch as these are sectors in which Panama enjoys strong comparative advantage, they can continue to expand without special incentives. - 60 -

112. Other tax measures which would have the desired side effects of improving resource allocation and/or increasing domestic savings have been discussed in paragraphs 93-9'. Tite implementationof at least some of those measures would tend to raise the buoyancy of the tax system, closer to the 1.2 projectedby the Government, For-example, the proposed sales tax could yield B/. 20 million per year, the tax on automobileownership Bj. 13 millioriper year, better enforcementof taxes on urba,-nland B/. 15 million per year, and the foreign trade t.axes suggested in the preceding paragraph up to B/. 80 million per year. The scope and timing of specific mea.;,ireswould depenidon business conditions, administrative readiness f or implementatioin and other circumstances,but the needed efforts would be broadly equivalent to annual tax packages of B/. 15 to S!. 20 million (1965 prices) in 1976-80. It would be desirable to make publi.centerprises of a commercial nature (e.g., in cement, sugar, copper) subject to payment of corporate income taxes. This would help ensure that they are rur. efficientlyand would give the Central Governmentmore effective command over savings generated in the rest of the public sector. Alto- gether these measures would raiso the tax burden (excludingSocial Security taxes) from about 12 percent of GDP in 1970-74 to about 17 percent of GDP by 1980. Current outlays would need close monitoring to keep their annual growth around 5 to 5.5 percent in real terms. If this is done, Central Governmentsavings before interest payments could well reach 8 percent of GDP by 1980 (see Tables 5.42 and 18).

113. These measures would be likely to allow for a rapid rate of growth of GDP (about o percent per year) and tne resource gap could be reduced to 6 percent of GDP by 1980 (Table 19). They would also permit private consumtptionto grow at an annual rate of about 4.7 perceut in 1976-80, compared to over 7 percent in 1970-74. Thus, the current-account deficit of the balance of payments could be kept at an annual average of US$ 445 million in the five-year period (in culrrentprices) still a large, but more manageable level. To finance this current-accountdeficit, net public capital could contributeUS$ 315 million per annum (of which US$ 80 million net would have to be borrowed from commercial banks) and net private direct investmentUS$ 40 million; the net borrowing needs of the private sector from commercia-ibanks would thus be about US$ 90 million, a level in line with recent experience (Table 20).

114. This financial program would strengthen public sector finances. By restrictingthe growth of private consumption,the program wovld also open up possibilitiesfor some lending from the Panamanien pr.ivate sector to the Government (US$ 15 mil1ion per ar um). Overall gross borrowing requirementsof the public sector wzouldbe around US$ 450 million per annum, of which about US$ 175 mlllion from co.mmercial banks, assuming again 5-yeat maturities and 10 percent interest rate (Table 21). If a7e-ragevvtlrities could be stretched to seven years, Table 18: SUMEARYPUBLIC SECTOROPERATIONS - MEDIUM GROWTHCASE (In US$ Million)

Total 1975 - 1976 1977 1978 1979 19&0 1976-1980 1985

Public inve3st:ent 297.4 380.l) 460.4 527.9 655.9 706.2 2730.8 716.0

Total Debt Service 102.4 98° 22._2 2 93.4 1131.7 599.6 Amortiza!Aon 47.24.3 69.5 127.0 175.9 228.3 645.o 406.6 Interest 55.2 54.0 73.7 96.2 117.5 116.3 h867 193.0 Total FinancingRequired 399.8 076.7 603.6 751.1 949.3 1079-. 3862.5 1315.6

Public SavingsL' 138.4 167.4 238.5 308.8 403.3 493.9 1611.9 1372.9

Total Grcss m.sbursements 261.4 31 3 353.1 4275 528.0 28.021.176.5 Official 71.1 110.1 10.-9 1E -125.9 16I1 l 629.1 21.42 CommercialBanks 135-. 127.7 159.0 152.9 221.1 223.7 884. -182.7 Other TPrivateCreditors 54.9 63.53 8r.2 108.2 181.0 224.1 662.1 40.8

Private Sector InternalNet Transfer - 10.0 12.0 15.0 18.0 20.0 75.0 -133.8

Total 2ossibleFiiancing 399.8 478.7 603.6 '61.1 949.3 1079.8 3862.5 1315.6

i4ero:

Assumed InflationIndex 100.0 108.8 217.6 126.4 135.9 145.5 204.0

1/ Fixed and financial 2/ Before interest payments of public debt. 3/ Also includesUS$21.8 million of InternalBorrowing, US$17.5 million of Discrepancy-and Change in Assets, US$6.5 million of Capital Revenues and US$8.6 million of statisticaldiscrepancy. , Preliminaryestimate.

Source: Mission estimates. Table 19: BASIC MACROECONOMICMAGNITUDES - MEIUM GROWTHCASE (Millions of 1974 Balboas)

1975 / 1976 1977 1978 1979 1960 1985

Gross Domestic Product (GDP) 1769.8 1849.4 1951.1 2068.2 2213.0 2367.9 3321.1

Consumption (C) 1463.4 1529.2 1601.1 1678.0 1758.5 1846.4 2482.7 Private (1201.2) (1258.7) (1315.6) (1376.8) (1140.8) (1511.2) (2044.5) Public (262.2) (270-5) (285.5) (301.2) (317-7) (335.2) (436.2)

Investment (I) 447.9 461.0 506.6 579.5 619.6 663.0 868.6 Private (254-9) (237.7) (227.3) (287.4) (265.4) (304.3) (657.6) Public (193.0) (243.3) (279.3) (292.1) (354.2) (358.7) (231-0)

Exports of Goods and NFS (X) 800.1 842.5 884.9 926.1 961.6 1021.2 1439.2

Imports of Goods and NFS (M) 941.6 1003.3 1041.5 1115.4 1126.9 1162.7 1489.4

Resource Gap (RG = M - X) 141.5 160.8 156.6 189.3 165.1 141.5 50.2 a

Gross Domestic Savings (GDP - C) 306.4 320.2 350.0 390.2 454.5 521.5 838.4 Private (161.5) (181.4) (167.0) (169.7) (186.6) (214.9) (607-3) Public (124.9) (138.8) (183.0) (220.5) (267.9) (306.6) (231.1)

Net Factor Service Payments (FSY) -101.1 -111.5 -124.3 -139.3 -157.1 -175.4 -268.5

Gross National Product (GDP + FSY) 1668.7 1737.9 1826.8 1928.9 2055.9 2192.5 3052.6

Terms of Trade Effects (TOT) 18.2 -1.2 -10.8 -21.7 -21.3 -20.1 -34.2

Gross National Income (GNP + TOT) 1686.9 1736.7 1816.0 1907.2 2034.6 2172.4 3018.4

Memo GDS + TOT 324.6 319.0 339.2 368.5 433.2 501.4 804.2 RG - TOT 123.3 162.0 167.4 211.0 186.4 161.6 84.4

/ Preliminary estimate.

Source: Mission estimates. Table 20: BALANCEOF PAYMENTSPROJECTION - MEDIUMGROWTH CASE (In US$ Million)

19757 19 16 1977 1978 1979 1980 1985

Exports of Goods and NFS 882.5 985.3 1109.6 1238.8 1380.0 1569.2 3100.8 Imports of Goods and NFS 1015.5 1174.9 1321.9 1527.5 1653.5 1822.4 3287.0

Resource Balance -133.0 -189.6 -212.3 -288.7 -273.5 -253.2 -186.2

Interest Payments - Net -100.7 -118.8 -141.7 -169.7 -205.0 -244.4 -514.3 /Interest on Public Debt7 -34.7 /797.27 68.17 F-914 /g1217 g 171414g7 /190.27 DirectInvestment Income -11.4 -15.6 -20.1 -25.3 -31.4 -38.0 -92.0

Current Account Balance -245.1 -324.0 -374.1 -483.7 -509.9 -535.6 -792.5

Direct ForeignInvestment Net 28.3 30.0 35.0 40.0 45.0 50.0 125.0 Private Borrowingfrom Commercial Banks (Net) 46.7 24.3 45.4 132.5 104.0 139.2 989.6

Public Capital: Gross Disbursements (207.0) (301.3) (353.1 (427.3) (528.0) (565.9) (76.5) Amortization (-36.9) (-31.6) (-59.4) (-116.1) (-167.1) (-219.5) (-398.6) Net Disbursements 170.1 269.7 293.7 311.2 360.9 346.4 -322.1

E/ Preliminary estimate.

Source: Mission estimates. Table 21: PROJBCTION OF EXTERKAL PUBLIC DEBT - MEDIUM GROWTH CASE (In US$ Million)

1975 / 1976 1977 1978 1979 1980 1985

Gross Disbursements 207.0 301.3 353.1 427.3 528.0 565.9 76.5 Official- 71.1 110.1 10. : 125.9 llo.1 210. Commercial Banks 135.4 127.7 159.0 152.9 221.1 223.7 -182.7 Other Private Creditors 0.5 63.5 85.2 108.3 181.0 224.1 40.8

ATfordEizationPayments 36.9 1 6 116.1 167.1 21.5 6 Official 7.1 .6. .1 10.2 9.2 Commercial Banks 19.9 20.3 46.6 102.7 141.8 179.3 221.5 Other Private Creditors 9.9 4.7 4.7 3.8 15.1 31.0 142.5

Net Disbursements 170.1 269.7 29-.7 311.2 360.9 36.4 -32221 Official 64.0 103 . 5- 115.7 108.9 i83.8 ConmercialBanks 115.5 107.4 112.4 50.2 79.3 44.4 -404.2 Other Private Creditors -9.4 55.8 80.5 104.5 165.9 193.1 -101.7 Interest_ayments 34.4 47.9 68.1 91.1 112.9 141.1 190.9 Official 6.3 9.9 3 19.2 31.7 84.2 Commercial Banks 25.3 35.7 46.3 57.5 63.2 71.7 40.3 Other Private Creditors 2.8 2.3 7.5 14.4 23.3 37.7 66.4

Service Payments 71.a 9 127., 207.2 280.0 36o.6 5&5-5 Official 16.5 22. -275 36.6 40.9 t5T7 Commercial Banks 45.2 56.0 92.9 160.2 205.0 251.0 261.8 Other Private Creditors 12.7 7 12.2 18.2 38.4 68.7 208.9

Disbursed Amount Outstandin6 882.9 1167.2 1471.2 1831.3 2177.7 2186.7 Official 1 196.2 274.o 365,4 514.7 629 738.5 1503.7 Commercial Banks 398.3 505.7 618.1 668.3 747.6 792.0 - Other Private Creditors 44.4 103.2 183.7 288.2 454.1 647.2 683.0

I/ Exmludes US$43.1 million of grant and grant-like flows during 1976-1980. E/ Preliminary estimate.

Source: Mission estimates. - 65 -

the gross borrowing from commercialbanks could fall to US$ 150 million per year. Under these assumptions,by 1980 total debt service on the public debt would have dropped to 75 percent of public sector savings before interest, and amortizationto 65 percent of public savings net of interest payments. Such a situationwould still require delicate management and close attention, but would not be out of line with that in other developing countries of similar income levels.

D. The Low GrowthiCase

115. The strong tax effort necessary to undertake the financial program discussedabove and the somewhat uncertain prospects in Euro- dollar markets make it necessary to consider these projectionswith caution. The authoritieshave expressed their intention to interpret their DevelopmentProgram with flexibility,and to adjust their expendituresto the availabilityof financing. This paragraph illus- trates the possible macroeconomicand financial implicationsof a drastic reduction in the availabilityof public savings and foreign credit. If it were necessary to contract spending in relation to the Government'sprogram so as to keep the resource gap below 3 percent of GDP -- a level consistentwith a continuationof the present level of savings -- the large revenue-earningventures would have to be postponed and public investmentcurtailed. Under these conditions, aggregate demand would probably take longer to recover from the current recession and domestic private investmentmight remain at about the same levels as in 1975. Private investmentmight be primarily directed towards export-orientedservice activities in the metrop6litanarea and, provided the authoritiescontinue to improve price policy, towards selected agriculturalactivities. Completion of the Penonome-Colon road would open up good crop and pasture land. Altogether, the annual rate of GDP growth might not exceed 5 percent, probably not enough to maintain unemploymentrates from rising above present levels, but enough to allow private consumptionto expand at an annual rate of over 4 percent (Table 22). In the absence of special corrective measures, the current-accountdeficit would still be substantial,an average US$ 275 million per annum, one-third of which might be financed by private sector borrowing from commercial banks, and perhaps 60 percent by net official borrowing (Table 23). In this case, it would become particularlyimportant to concentrateon measures to attract private capital for the developmentof commercialventures and to center public investrnenton infrastructureto complement private investment.l/

1/ For a summary of the three alternativesconsidered, see Tlble 24, Table 22: BASIC MACROECONOMICMAGNITUDES - LOW GROWTHCASE (Millions of 1974 Balboas)

F~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 1975 v 1976 1977 1978 1979 1980 1985

Gross Domestic Product (GDP) 1769.8 1831.7 1914.1 2009.9 2110.3 2215.9 2828.1

Consumption (C) 1463.4 1514.6 1582.8 1662.0 1745.0 1832.3 2338.5 Private (1201.2) (1244.0) (1298.7) (1363.6) (1431.8) (1503.4) (1918.7) Public ( 262.2) ( 270.6) ( 284.1) ( 298.4) ( 313.2) ( 328.9) ( 419.8)

Investment (I) 447.9 421.8 401.4 411.5 422.1 443.2 565.6 Private (254.9) (228.8) (208.4) (218.5) (229.1) (250.2) (319.3) Public (193-0) (193.0) (193-0) (193.0) (193.0) (193.0) (246.3)

Exports of Goods and NFS (X) 800.1 842.7 868.4 897.7 927.0 959.3 1125.7

Imports of Goods and NFS (M) 941.6 947.4 938.5 961.3 983.8 1018.9 1201.7

Resource Gap (RG=M-X) 141.5 104.7 70.1 63.6 56.8 59.6 76.0

Gross Domestic Savings (GDP-C) 306.4 317.1 331.3 347.9 365.3 383.6 489.6 Private (181.5) (190-9) (181.7) (180.7) (184.5) (195.4) (263.1) Public (124.9) (126.2) (149.6) (167.2) (180.8) (188.2) (226&5)

Net Factor Service Payments (FSY) -101.1 -111.5 -119.7 -126.5 -133.0 -141.3 -193.2

Gross National Product (GDP+FSY) 1668.7 1720.2 1794.4 1883.4 1977.3 2074.6 2634.9

Terms of Trade Effects (TOT) 18.2 0.1 -o.6 -6.o -4.0 -2.8 -0.5

Gross National Income (GNP+TOT) 1686.9 1720.3 1793.8 1877.4 1973.3 2071.8 2634.4

Memo: GDS+TOT 324.6 317.2 330 7 341.9 361.3 380.8 489.1 RG -TOT 123.3 104.6 70.7 69.6 60.8 62.4 76.5

E/ Preliminary estimate. Source: Mission estimates Table 23: BALANCEOF PAYMENTSPROJECTION - LOWGROWTH CASE (In US$ Million)

1975 - / 1976 1977 1978 1979 1980 1985

Exports of Goods and NFS 882.5 985.2 1098.6 1217.1 1349.8 1494.8 2476.7 Imports of Goods and NFS 1015.5 1107.5 1188.0 1312.2 1438.6 1,92.3 2645.2

Resource Balance -133.0 -122.3 -89.4 -95.1 -88.8 -97.5 -168.5

Interest Payments - Net -100.7 -118.8 -135.7 -152.1 -170.9 -193.8 -368.3 /Intereston Public Debt7 -534.7 /-47.27 559 .7 570.17 /-79.7 /-89._7 1:158.17 DirectInvestment Income -11.4 -15.6 -20.1 -24.9 -29.2 -33.8 -68.0 CurrentAccount Balance -245.1 -256.7 -245.2 -272.1 -288.9 -325.1 -604.8

DirectForeign Investment Net 28.3 30.0 30.0 30.0 30.0 30.0 75.0 0o

Private Borrowingfrom Commercial Banks (Net) 46.7 52.8 53.6 85.9 109.6 143.2 238.2

Public Capital: GrossDisbursements (207.0) (205.5) (220.9) (260.0) (279.5) (306-4) (554.9) Amortization (-36.9) (-31.6) (-59.3) (-103.8) (-130.2) (-154-4) (-263.3) Net Disbursements 170.1 173.9 161.6 156.2 149.3 151.9 291.6

E/ Preliminary estimate.

Source: Mission estimates. Table 24: BASIC MACROECONOMIC INDICATORS

Value in Millions of 1974 us$ Composition (%) Rate of Increase 1975 1_980 1975 1980 1975-1980 High Medium Low High Medium Low High Medium Low

GDP 1769.8 2458.8 2367.9 2215.9 100.0 100.0 100.0 100.0 6.8 6.0 4.6

Consumption 1463.4 2052.5 1846.4 1832.3 82.7 83.4 78.0 82.7 7.0 4.8 4.6 Private (1201.2) (1707.6) (1511.2) (1503.4) (67.9) (69.4) (63.8) (67.9) (7.3) (4.7) (4.6) Public ( 262.2) ( 344.9) ( 335.2) ( 328.9) (14.8) (14.0) (14.2) (14.8) (5.7) (5.0) (4.6)

Investument 447.9 770.2 663.0 443.2 25.3 31.3 28.0 20.0 11.5 8.2 0.0 Private (254.9) (411.5) (304.3) (250.2) (14.4) (16.7) (12.8) (11.3) (10.0) (3.6) (0.0) Public (193.0) (358.7) (358.7) (193.0) (10.9) (14.6) (15.2) ( 8.7) (13.2) (13.2) (0.0)

Exports GNFS 800.1 983.6 1021.2 959.3 45.2 40.0 43.1 43.3 4.3 5.0 3.7 cD (Excluding Petroleum) (517.1) (704.1) (739.1) (672.8) (29.2) (28.6) (31.2) (30.4) (6.4) (7.4) (5.4) Imports GNFS 941.6 1345.7 i162.7 1018.9 53.2 54.7 49.1 46.0 7.5 4.3 1.6 (Excluding Petroleum Exports) (658.6) (1066.2) (880.6) (732.4) (37.2) (43.3) (37.2) (33.1) (10.1) (6.0) (2.2) Resource Gap 141.5 362.1 141.5 59.6 8.0 14.7 6.0 2.7 20.5 0.0 -16.0

Gross Domestic Savings 306.4 406.3 521.5 383.6 17.3 16.6 22.0 17.3 5.8 11.2 4.6 Private (181.5) (180.1) (214.9) (195.4) (10.3) (7.4) (9.1) (8.8) (0.0) (3.5) (1.5) 1 Public / (124.9) (226.2) (306.6) (188.2) ( 7.0) (9.2) (12.9) (8.5) (12.6) (19.7) (8.5)

Net Factor Service Payments -101.1 -220.8 -175.4 -141.3 -5.7 -9.0 -7.4 6.4 16.9 11.7 6.9

Gross National Product 1668.7 2238.0 2192.5 2074.6 94.3 91.0 92.5 93.6 6.1 5.6 4.4

Terms of Trade Effects 18.2 -22.9 -20.1 -2.8 1.0 -0.9 -0.8 -0.1 - - -

Gross National Income 1686.9 2215.1 2172.4 2071.8 95.3 90.1 91.7 93.5 5.6 5.2 4.2

, Bel'ore interest payments of external public debt

S.uice: Mission estimates - 69 -

116. This alternative illustratesa rather extreme case. A more likely developmentwould be a combination of the Medium and Low alternatives,i.e., some additional internal savings effort, considerable public external borrowing from private sources and a pragmatic approach to public investment. The launching of some individual projects could usefully be delayed to allow for better appraisal, preparation,and implementation,as suggested in paragraphs 84 and 85. Ways may be found to aLlow private capital to participatemore fully in large projects. Because of Panarm.'sopen exchange system, little is known about the extent to which Panamanian residents are holding foreign financialassets, but the amounts may be considerable(see paragraph 8). It can be expected that part of these savings will be reinvested in Panama, if conditionsare favorable. Under these assumptions,GDP growth could be around 5.5 percent per year in 1976-80 and somewhat more thereafter.

E. Conclusions

117. Report 275-PAN argued that, because of its use of the U.S. dollar as currency, the creditworthinessof Panama's public sector should not be measured by the usual relationshipbetween public external debt service and projected export receipts, or by the stock of foreign exchange reserves. The re'levantcriteria, instead, were found to be the overall growth prospects of the economy, and the expected ability of the public sector to repay its debt service as it came due. These continue to be the main aspects of creditworthiness.

118. In spite of the ongoing recession, medium-term growth prospects remain favorable. In a country that relies on trade and services, economic growth entails the full participationof both the public and the private sectors. Therefore, success of the Government'songoing efforts to encourage private investmentwill greatly strengthen these prospects.

119. By emphasizinginvestment in productive sectors the Preliminary National DevelopmentPlan aims at stimulating future growth. This could be strengthenedif objective criteria for selection of public investmentprojects were spelled out. Because of the Government's excellentrelations with the banking community, it has been able to borrow for practicallyall its needs at real interest rates well below 6 percent. It might appear, therefore, that the opportunity cost of capital is aLso of the order of 6 percent in real terms but it probably is much higher. Since the public sector cannot undertake in 1976-80 all the investment projects in its preliminaryprogram owing to managerial and financial constraints,the opportunitycost of includinga project in the program is given by the economic rate of return of another project that may be displaced. Analysis of the Preliminary DevelopmentPlan suggests that this may be of the order of - 70 -

10 to 12 percent. The authorities could, therefore, consider selecting only projects backed by thorough feasibility studies, with expected economic yields at least that high.

120. The authorities have never defaulted or unilaterally rescheduled any external debt. They are in good standing with international agencies and with private banks. Nevertheless, because of its substantial reliance since 1968 on debt with relatively short maturities, the public sector is burdened with heavy debt service obligations. This situation has not led to major difficulties in the past because the Government has been able to successfully refinance its debt to commercial banks as, for example, in 1973. The future ability of the public sector to meet debt service payments as they come due will hinge mainly on the following actions:

(a) timely adoption of taxes and public utility tariff measures to ensure that public savings (net of interest payments) exceed amortization payments on all public debt; and

(b) prudent timing of new investment projects so that total public sector gross borrowing from private banks does not exceed, on average, around US$ 175 million per year -- in current prices -- in 1976-80, including possible refinancing. - 71 -

ADDENDUM

121. In April 1976, the authorities revised the Preliminary Develop- ment Plan and decided to introduce some important changes. First, they postponed the timing for the execution of certain projects and changed the scope of others to reduce their cost. The crude oil pipeline will not be initiated in the period 1976-80 and will be carried out only if throughput agreements are reached. The housing program was significantly reduced, although it still would be much larger than in the past. Other projects displaced or recast are in agriculture, industry and commerce, and other sectors. As a result of these changes in the timing of projects, the total investment planned for the period 1976-1980 has been reduced from B/. 2.7 million in the Preliminary Plan to B/. 2.1 million (in 1975 prices). The authorities have also recognized that it will be necessary to adopt additional tax packages to raise the buoyancy of public revenues with respect to GDP growth, to restore aggregate equilibrium and to stimulate investment and production. In addition, they have started a process of adjustment of public utility rates. All these measures should contribute to raise the contribution of public savings to financing public investment, to reduce accordingly additional borrowing from commercial banks, and to strengthen the country's creditworthiness. The revision of the Plan was still under way as of late April 1976. For this reason this report does not include the revised public sector financial program.