Honduras at a Glance: 2007-08

Country Report

Honduras

HondurasHonduras atat aa glance:glance: 2007-082007-08

OVERVIEWOVERVIEW CRManuel Overview Zelaya summary Rosales hereof the Partido Liberal (PL) took office as president of Honduras for a four-year term on January 27th 2006. The PL’s failure to gain a Keysimple changes majority from in the last Congress month leaves the government reliant on the support of other parties in order to pass legislation. The Economist Intelligence Unit Politicalexpects broad outlook policy continuity in 2007-08, focusing on goals agreed under an • IMF-World CR Political Bank outlook poverty text reduction here and growth facility (PRGF). Honduras will Economicbenefit from policy debt outlook relief under the heavily indebted poor countries (HIPC) •initiative during 2007-08. Annual GDP growth will average 3.9% in 2007-08. The CR exchange Economic rate policy will outlook stay broadly text here stable in real terms against the US dollar. EconomicRapid growth forecast in the import bill, associated with high oil prices and relatively •strong CR Economic domestic forecastdemand, text will here result in a widening trade deficit, keeping the current-account deficit relatively wide.

Key changes from last month Political outlook • Existing tensions within the government have been exacerbated by Mr Zelaya’s perceived desire to foster closer relations with the administration of Hugo Chávez in Venezuela. Failure on the part of Mr Zelaya to change the direction of his foreign policy in response to the misgivings of some ministers could lead to a cabinet crisis in the coming months. Economic policy outlook • Following a strong improvement in the public finances in the first half of the year, we have revised down our estimate for the budget deficit in 2006. We expect the central government deficit to narrow to 0.3% of GDP in 2006, before increasing to an average of 0.6% of GDP in 2007, and further to 1.1% of GDP in 2008 as government expenditure is stretched to meet spending commitments. Economic forecast • After estimated growth of 5.2% in 2006, we expect growth to slow in 2007- 08, to an annual average of 3.9%, in line with slower growth in the US. Relatively robust domestic demand and high oil prices will result in strong import growth, keeping the current-account deficit wide.

October 2006

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Honduras 1

Contents

Honduras

3 Summary

4 Political structure

5 Economic structure 5 Annual indicators 6 Quarterly indicators

7 Outlook for 2007-08 7 Political outlook 8 Economic policy outlook 9 Economic forecast

12 The political scene

15 Economic policy

18 The domestic economy 20 Agriculture 21 Manufacturing 22 Financial services

24 Foreign trade and payments

List of tables 9 International assumptions summary 12 Forecast summary 16 Central government finances 19 Monthly index of economic activity (IMAE) 20 Consumer price inflation 22 Selected industrial production 23 Credit to the private sector 24 Merchandise trade

List of figures

12 Gross domestic product 12 Consumer price inflation

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Honduras 3

Honduras October 2006 Summary

Outlook for 2007-08 Manuel Zelaya Rosales of the Partido Liberal (PL) took office as president of Honduras for a four-year term in January 2006. With just 62 of the 128 seats in Congress, compared with 55 for the Partido Nacional (PN), the government is reliant on the support of other parties to pass legislation. A government priority in 2007-08 will be to agree an IMF-World Bank poverty reduction and growth facility (PRGF) to replace the PRGF that expires in early 2007. Honduras will benefit from debt relief under the heavily indebted poor countries (HIPC) initiative during 2007-08. Annual GDP growth will average 3.9% in 2007-08, while inflation is forecast to average 4.8%. The exchange rate will stay broadly stable in real terms against the US dollar. An increasing trade deficit as a result of strong, investment-driven import demand will cause the current-account deficit to remain wide in 2007-08, although gains made in the services account from the buoyant maquila (offshore assembly for re-export) and tourism industries will help to offset the effect of continued strong demand for imports.

The political scene After nearly eight months in office, Mr Zelaya is facing a deteriorating political environment, in which the government’s lack of a majority, confrontation with political allies, a controversial foreign policy and growing social tensions threaten to disrupt government effectiveness.

Economic policy The public finances underwent a sharp year-on-year improvement in the first half of 2006, with the central government recording a surplus as a result of expenditure restraint and strong revenue growth. Despite the improved fiscal performance, there are concerns over the potential impact on the public finances of government fuel subsidies and public-sector pay increases.

The domestic economy In the first six months of 2006 the Indice Mensual de la Actividad Económica (IMAE, the monthly index of economic activity), a proxy for GDP growth, expanded by 5.4%, compared with 3.8% in the same period of 2005, led by growth in the construction and banking sectors.

Foreign trade and payments In the first seven months of 2006 the merchandise trade deficit widened by 23.2% year on year, as growth in import spending continued to outstrip increases in export earnings. Remittances by Honduran workers abroad and value-added earnings by the maquila (offshore assembly for re-export) industry helped to offset much of the trade deficit.

Editors: Ian Emery (editor); Martin Pickering (consulting editor) Editorial closing date: September 22nd 2006 All queries: Tel: (44.20) 7576 8000 E-mail: [email protected] Next report: Full schedule on www.eiu.com/schedule

Country Report October 2006 www.eiu.com © The Economist Intelligence Unit Limited 2006 4 Honduras

Political structure

Official name Republic of Honduras

Form of state Unitary republic

The executive President, elected for a four-year term

National legislature National Congress, comprising one member and one substitute member elected for every 35,000 people or fraction over 15,000

Legal system US-style Supreme Court system

National elections November 2005 (legislative and presidential); next elections due November 2009 (legislative and presidential)

National government Following his victory in the November 27th 2005 election, Manuel Zelaya Rosales of the Partido Liberal (PL) took office as president on January 27th 2006

Main political organisations Government (from January 27th 2006): Partido Liberal (PL) Opposition: Partido Nacional (PN); Partido de Innovación Nacional y Unidad-Social Demócrata (PINU-SD); Partido Demócrata Cristiano (PDC); Partido de Unificación Democrática (PUD)

President Manuel Zelaya Rosales

Vice-president Elvin Santos

Key ministers Agriculture Hector Hernández Culture & sports Rodolfo Pastor Fasquel Defence Arístides Mejía Economy, industry & commerce Lizzy Azcona Bocok Education Rafael Pineda Ponce Finance Rebeca Santos Foreign affairs Milton Jimenez Puerto Health Jenny Meza Interior & justice Jorge Arturo Reina Labour & social security Riccy Moncada Natural resources & environment Mayra Mejía del Cid Presidency Yani Rosenthal Hidalgo Public security Alvaro Romero Public works, transport & housing José Rosario Bonano Technical co-operation Karen Zelaya To u r i s m Ricardo Martínez

Private secretary to the presidency Raúl Valladares

Central Bank president Gabriela Núñez

National Congress president Roberto Micheletti

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Economic structure

Annual indicators 2002a 2003a 2004 a 2005 a 2006b GDP at market prices (La bn) 108.1 120.5 137.2 157.7 172.9 GDP (US$ bn) 6.6 6.9 7.5 8.4 9.1 Real GDP growth (%) 2.8 3.5 5.0 4.2 5.2 Consumer price inflation (av; %) 7.7 7.7 8.1 8.8 5.7 Population (m) 6.7 6.9 7.1 7.2 7.4 Exports of goods fob (US$ m) 1,364.3 1,380.1 1,603.3 1,765.4 1,947.1 Imports of goods fob (US$ m) 2,806.1 3,035.0 3,676.7 4,187.5 4,860.3 Current-account balance (US$ m) -240.9 -259.8 -399.4 -42.3 -160.1 Foreign-exchange reserves excl gold (US$ m) 1,524.1 1,430.0 1,970.4 2,327.2 2,766.2 Total external debt (US$ bn) 5.4 5.6 6.3 5.9 b 5.6 Debt-service ratio, paid (%) 12.1 11.5 7.7 6.5 b 8.0 Exchange rate (av) La:US$ 16.43 17.35 18.21 18.83 18.93 a Actual. b Economist Intelligence Unit estimates.

Origins of gross domestic product 2005 % of total Components of gross domestic product 2005 % of total Agriculture 13.9 Private consumption 76.5 Mining 1.7 Government consumption 13.6 Construction 4.4 Fixed investment 23.2 Electricity, gas & water supply 5.0 Stockbuilding 6.9 Manufacturing 20.1 Exports of goods & services 41.0 Services 54.9 Imports of goods & services -61.2

Principal exports 2005 US$ m Principal imports 2005 US$ m Bananas 252.7 Manufactures and industrial raw materials 1,848.7 Coffee 334.9 Machinery and transport equipment 991.5 Shrimp & lobster 184.1 Food and animal products 715.4 Gold 63.3 Minerals and fuels 928.0

Main destinations of exports 2005 % of total Main origins of imports 2005 % of total US 36.8 US 38.0 El Salvador 10.5 Guatemala 9.0 Guatemala 7.9 El Salvador 5.9 Germany 8.5 Costa Rica 5.5 Belgium 5.4 Mexico 5.3

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Quarterly indicators 2004 2005 2006 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr Prices Consumer prices, Tegucigalpa (2000=100) 139.2 141.7 145.2 148.5 151.7 153.0 154.9 157.2 Consumer prices, Tegucigalpa (% change, year on year) 8.8 9.0 9.6 9.1 9.0 8.0 6.7 5.9 Financial indicators Exchange rate La:US$ (av) 18.33 18.54 18.72 18.84 18.87 18.90 18.90 18.90 Exchange rate La:US$ (end-period) 18.44 18.63 18.78 18.86 18.89 18.90 18.90 18.90 Deposit rate rate (av; %) 11.0 10.9 11.0 11.0 10.9 10.8 10.6 9.8 Government bond yield rate (av; %) 11.4 10.9 11.2 11.6 11.3 11.2 10.8 n/a Lending rate (av; %) 19.7 19.6 19.3 19.0 18.6 18.5 18.3 17.8 Savings rate (av; %) 6.0 6.0 6.0 6.0 6.0 6.0 6.1 5.3 M1 (end-period; La m) 16,595 20,019 20,351 20,374 20,312 24,093 24,480 24,430 M1 (% change, year on year) 25.1 16.0 22.6 24.8 22.4 20.4 20.3 19.9 M2 (end-period; La m) 74,667 80,945 84,462 87,705 89,595 97,495 103,537 106,400 M2 (% change, year on year) 17.5 20.7 19.6 20.1 20.0 20.4 22.6 21.3 Sectoral trends Coffee production (annual totals; ‘000 tonnes)a ( 185 ) ( 191 ) n/a n/a Foreign trade (US$ m) Exports fob 369.1 348.8 442.1 500.3 376.1 379.4 487.6 518.6 Imports cif -983.7 -1,078.2 -999.0 -1,132.6 -1,135.2 -1,216.9 -1,187.6 -1,332.4 Trade balance -614.6 -729.4 -556.9 -632.3 -759.1 -837.5 -700.0 -813.8 Foreign reserves (US$ m) Reserves excl gold (end-period) 1,695 1,970 2,068 2,160 2,177 2,327 2,565 2,699 a Estimate for 2005. Sources: Food and Agriculture Organisation (FAO); IMF, International Financial Statistics Banco Central de Honduras.

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Outlook for 2007-08

Political outlook

Domestic politics Manuel Zelaya Rosales of the Partido Liberal (PL) took office as president of Honduras for a four-year term in January. With just 62 of the 128 seats in Congress, compared with 55 for the Partido Nacional (PN), the government is reliant on the support of other parties to pass legislation. Of the three minority parties—the Partido de Unificación Democrática (PUD) with five seats, the Partido Demócrata Cristiano (PDC) with four seats and the Partido de Innovación Nacional y Unidad-Social Demócrata (PINU-SD) with two—only the centre-left PINU-SD has lent its support to the PL. The PN has attracted the support of the remaining two parties, leaving Congress divided, with both the government and the opposition able to count on the support of 64 legislators. During his campaign, conducted under the slogan Poder Ciudadano (citizen power), Mr Zelaya promised a more inclusive government, stressing the need for Honduras to develop a participatory democracy. Central to his bid to restore trust in state and independent institutions will be his success in reducing corruption in both the public and the private sector. Mr Zelaya’s call for openness will be backed by the introduction of a Ley de Transparencia (transparency law). As well as a mechanism to monitor the performance of the central government, Mr Zelaya is seeking to promote a degree of decentralisation of power, with certain powers, including land development rights, being transferred to the local level of government. The task is challenging, given that local political structures are based on political clientelism, and widespread poverty and low educational standards discourage political participation at the local level. With security a prime concern in view of the upsurge in violent crime in recent years, expectation for improvement in this area is high. Mr Zelaya’s election victory was a rejection of the hardline stance of the PN candidate, Porfirio Lobo Sosa, whose campaign centred on the reintroduction of the death penalty. Mr Zelaya, who favours a comprehensive approach towards tackling crime, taking into account the social conditions that foster criminality, campaigned on a policy of reducing poverty and unemployment, as well as the introduction of an offender rehabilitation scheme. However, an effective strategy against violent crime will need to include a comprehensive reform of the penal system, which is badly affected by corruption, as well as the investigation and eradication of the links between the trade in illegal drugs, public officials and the police. Given high public expectations and its weak position in Congress, the Zelaya administration will struggle to maintain public support in the face of high levels of corruption and crime, widespread poverty and unemployment, and the effects on the cost of living of sustained high oil prices.

International relations The Zelaya administration will continue to foster Honduras’s close relations with its most important trading partner, the US, but recent moves to strengthen ties with Venezuela, motivated by economic considerations such as the purchase of oil on concessionary terms, have raised concerns regarding

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Mr Zelaya’s foreign policy. Honduras’s participation in the Dominican Republic- Central American Free-Trade Agreement (DR-CAFTA) with the US will make permanent the beneficial access to the US for Honduran exports enjoyed under the Caribbean Basin Initiative (CBI). DR-CAFTA will also help attract additional investment in the maquila (offshore assembly for re-export) industry, as efforts are made to diversify away from a reliance on garment assembly to a broader base of assembly products. Progress will be made in 2007-08 on bilateral trade agreements with countries such as Colombia, Panama and Taiwan.

Economic policy outlook

Policy trends Although the Economist Intelligence Unit expects the Zelaya administration to follow a prudent, broadly market-oriented policy, despite public opposition to the IMF-backed economic policy programme, the government’s weak position in Congress makes it inclined to garner public support through populist measures. A priority will be to agree on a poverty reduction and growth facility (PRGF) to replace the three-year PRGF that expires in February 2007. The PRGF agreed with the Fund by the previous (PN) administration, led to debt relief under the IMF-World Bank’s heavily indebted poor countries (HIPC) initiative. The Zelaya administration will try to negotiate a relaxation of some of the programme targets set out under the previous PRGF to release funds to fulfil campaign pledges such as job creation and increased expenditure on healthcare and education. Concerns will centre on the threat of such initiatives to fiscal discipline. The Fund will seek assurances that measures will be put in place to reduce the short-term fiscal impact of DR-CAFTA (resulting from reduced import duties), as well as measures to improve the financial health of state companies, such as the Empresa Nacional de Energía Eléctrica (ENEE, the state electricity company). Implementing a new energy policy will be a priority against a background of high global oil prices and expensive government subsidies. Government plans to introduce an international bidding mechanism to become the sole oil importer is proving difficult to finalise, while other measures intended to reduce fuel prices, such as the reduction of fuel duties, will prove difficult to sustain owing to budget constraints. The government will benefit from debt relief under the HIPC initiative, following a successful review of Honduras’s economic performance under the PRGF now nearing its end. Under HIPC, Honduras’s foreign public debt will be cut by around one-quarter over ten years. The freed resources will finance a poverty-reduction strategy, agreed with the Fund in 2004 by the previous administration.

Fiscal policy The central government deficit target for 2006 under the PRGF is 2.5% of GDP. First-half figures for 2006 showing strong revenue growth and expenditure restraint suggest that the outturn in 2006 will be better than targeted. Tax revenue in 2006-07 will be supported by firm domestic demand. However, failure to rein in expenditure, or further laxity on the part of the government in the face of demands for wage increases, would risk making fiscal targets unattainable. The announcement of several initiatives involving increases in public expenditure by Mr Zelaya during his first months in office have raised

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concerns about the government’s commitment to fiscal prudence. The IMF programme includes the government’s commitment gradually to reduce the heavy burden that the wage bill places on the public finances. However, despite a 12% public-sector pay increase in April, the likelihood is that the government will come under pressure for further salary increases in 2007-08, which if acceded to would result in a wider deficit than we are currently forecasting. Although the government has hinted at a reform of the state bureaucracy, such a comprehensive reform would probably be too politically costly. Given the benefits of debt relief and the need to avoid measures that would put the economic programme at risk, we expect government policy to include ad hoc measures to meet planned reductions in the fiscal deficit. Despite these, fiscal structural imbalances will remain unresolved. Furthermore, given the demands on the public finances in 2007-08, we expect a widening of the central government deficit as increased public spending to meet election promises and the need to react to calls from public-sector bodies for pay increases weigh on the public purse.

Monetary policy In line with commitments under the PRGF, measures have been taken to improve the monetary policy framework. The Banco Central de Honduras (BCH, the Central Bank) has moved away from targeting monetary aggregates and to a greater reliance on the use of short-term interest rates as a policy tool for keeping inflation in check. This will give it greater flexibility and should help it to achieve its policy goals in 2007-08. Following a gradual slowing in the rate of inflation since the start of 2006, the BCH has reduced the Tasa de Interés de Política Monetaria (TPM, the short-term interest rate that reflects the BCH’s monetary targets) by 100 basis points to 6.0% and suspended the issue of US dollar-denominated monetary certificates used as a sterilisation tool. The BCH has also reduced reserve requirements on lempira-denominated liabilities to 12% and eased foreign-exchange controls, following a sustained increase in international reserves.

Economic forecast

International assumptions International assumptions summary (% unless otherwise indicated) 2005 2006 2007 2008 Real GDP growth World 5.0 5.3 4.7 4.7 US 3.2 3.4 2.1 2.7 EU25 1.7 2.6 2.1 2.2 Exchange rates US$ effective (1995=100) 84.9 84.2 78.4 77.9 ¥100:US$ 1.10 1.15 1.02 0.98 US$:€ 1.245 1.255 1.363 1.338 Financial indicators US$ 3-month commercial paper rate 3.49 5.13 4.83 5.26 US$ 3-month Libor 3.56 5.20 4.90 5.33

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International assumptions summary (% unless otherwise indicated) 2005 2006 2007 2008 Commodity prices Coffee (Arabica; US cents/lb) 114.9 113.8 110.5 109.5 Oil (Brent; US$/b) 54.7 69.3 69.3 66.0 Food, feedstuffs & beverages (% change in US$ terms) -0.5 8.9 -4.5 0.7 Industrial raw materials (% change in US$ terms) 10.2 49.1 -3.7 -10.5 Note. Regional GDP growth rates weighted using purchasing power parity exchange rates. Although our central assumption is that the rate of global growth will remain robust in 2007-08, at an annual average of 4.7% (on a purchasing power parity basis), this forecast carries downside risks. High oil prices are threatening to drag down economic performance in oil-importing economies, with the US— Honduras’s main trading partner—particularly at risk, given that its economic output is more oil-intensive than that of most other OECD economies. Our forecast for oil prices (dated Brent) to average US$69/barrel in 2007 and US$66/b in 2008, reflect continued strong demand and ongoing capacity constraints in the industry. Slowing growth in the US in 2007 will result in a fall off in demand for Honduras’s exports. The US current-account deficit remains a weakness, and the risk of a rapid depreciation of the US dollar persists. On a positive note, some of Honduras’s principal export commodities will continue to benefit from high prices in 2007-08. Crop shortfalls for coffee have resulted in considerably tighter market conditions, and we now expect prices for Honduras’s main export commodity, Arabica coffee, to remain relatively unchanged in 2007-08. On the downside, Honduras’s exports to Europe could be damaged by the EU’s tariff for bananas—the country’s second-largest traditional export commodity—of €176/tonne (US$220/tonne), if challenges by Latin American producers to the introduction of the tariff prove unsuccessful.

Economic growth Our estimate is for real GDP growth to pick up slightly in year-on-year terms in 2006, to 5.2%. In 2007, however, economic growth will slow, in line with slowing external demand, and especially owing to slowing growth in the US, by far Honduras’s most important trade partner. Continued growth in inward remittances will support moderate consumption growth. On the supply side, agricultural output in 2007-08 should continue the recovery begun in 2006. The maquila (offshore assembly for re-export) industry and the tourism sector will continue to be major sources of growth. Honduras’s participation in DR-CAFTA in 2007-08 should attract increased investment inflows and opportunities for export-oriented business, helping to offset the slowdown in the US. Infrastructure projects, such as the long-awaited inter-oceanic road, which would connect Puerto Cortés on the Atlantic coast with ports on the Pacific, are also likely to benefit. The telecommunications and energy sectors would also attract foreign direct investment (FDI) if further sectoral liberalisation is achieved. Progress could take place in 2007-08, but this will depend on the new government’s ability to move ahead with reform, given its weak position in Congress.

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Inflation We expect the authorities’ efforts to reduce inflation to succeed in slowing year- end inflation to 5.7% in 2006, within the BCH’s monetary programme inflation target range of 5.5-6.5%. We expect further moderate success in stemming the rate in the outlook period to enable the authorities to meet their inflation targets, despite relatively robust domestic demand. After averaging 5.0% in 2007, we expect inflation to fall further in 2008, to an average of 4.5%, on the assumption of slowing aggregate demand. However, were an oil price shock to lead to any further upward revisions to our oil price projections for 2007-08, the risk of inflation overshooting our current forecast would increase.

Exchange rates Multilateral aid, debt-service relief and rapidly increasing remittances from Hondurans working in the US have boosted international reserves to record levels, helping to shield against the risk of currency instability. We estimate that official reserves will reach US$2.8bn at end-2006, a year-on-year increase of 19%. We forecast that strong growth in international reserves will continue throughout 2007-08, helping to support the value of the currency. The Central Bank is overhauling monetary management by adopting indirect instruments, the increasing use of which in the outlook period should lessen inflationary risks and underpin greater exchange-rate flexibility. Our baseline forecast is for the lempira to stay broadly stable in real terms against the US dollar in 2007, yielding a year-end rate of La18.9:US$1, before a strengthening in the value of the dollar causes the lempira to depreciate slightly, to 19.2:US$1 in 2008.

External sector Following a widening of the trade deficit in 2006 to US$2.9bn, we forecast a deceleration of export earnings growth in 2007-08 related to weaker US growth. With domestic demand still relatively strong, import spending will continue to outweigh export earnings, leading to a deterioration in the external position. Growth in imports is being driven by high international fuel prices and continued strong growth in investment-related imports of machinery and electrical equipment. Domestic demand will continue to be supported by investment and growth in remittances from expatriate Hondurans. Remittances are currently double maquila earnings and more than total earnings from merchandise exports. In 2007-08 gains made in the services account from the buoyant maquila industry and tourism sector will help to offset the effect of continued strong demand for imports. Consequently, we expect the current- account deficit, after widening to an estimated 1.8% of GDP in 2006, to narrow to 1.5% of GDP in 2007, moderating slightly further, to 1.1% of GDP in 2008. Honduras will finance its external imbalance mainly with aid and FDI inflows. We expect international reserves to average around US$3.5bn in 2007-08, equivalent to around eight months of imports of goods and services, supported by the high level of remittances and other capital inflows.

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Forecast summary (% unless otherwise indicated) 2005 a 2006 b 2007c 2008c Real GDP growth 4.2 5.2 3.8 4.0 Gross agricultural production growth 0.5 3.2 2.5 2.4 Gross fixed investment growth -6.8 5.8 3.8 4.2 Unemployment rate (av) 28.0 b 27.9 27.8 27.7 Consumer price inflation (av) 8.8 5.7 5.0 4.5 Consumer price inflation (year-end) 7.7 5.3 4.8 4.3 Weighted average local currency lending rate 18.8 17.7 19.1 20.6 Central government balance (% of GDP) -2.7 -0.3 -0.6 -1.1 Exports of goods fob (US$ m) 1,765.4 1,947.1 1,999.0 2,110.1 Imports of goods fob (US$ m) 4,187.5 4,860.3 5,222.9 5,573.4 Current-account balance (US$ m) -42.3 -160.1 -150.2 -121.0 Current-account balance (% of GDP) -0.5 -1.8 -1.5 -1.1 External debt (year-end; US$ bn) 5.9 b 5.6 5.5 5.3 Exchange rate La:US$ (av) 18.83 18.93 19.20 19.54 Exchange rate La:US$ (year-end) 18.90 19.03 19.36 19.71 Exchange rate La:€ (av) 23.44 23.76 26.16 26.14 Exchange rate La:SDR (av) 27.83 27.89 29.86 30.36 a Actual. b Economist Intelligence Unit estimates. c Economist Intelligence Unit forecasts.

Gross domestic product Consumer price inflation (% change, year on year) (av; %)

Honduras Latin America Honduras Latin America 6.0 11.0

5.0 10.0

4.0 9.0

3.0 8.0

2.0 7.0

1.0 6.0

0.0 5.0

-1.0 4.0 03 04 05 06 07 03 04 05 06 07 08 08 2002 2002

The political scene

Mr Zelaya faces a more After nearly eight months in office, the president, Manuel Zelaya Rosales, of the

difficult political environment Partido Liberal (PL), is facing a deteriorating political environment in which the government’s lack of a majority, confrontation with political allies, a controversial foreign policy and growing social tensions threaten to disrupt government effectiveness. Mr Zelaya, a landowner from the department of Olancho, campaigned on a populist policy platform, which included promises to reduce fuel prices and increase public-sector workers’ pay, yet these promises are proving difficult to fulfil given the high international cost of fuel and the government’s financial constraints. In order to avoid the political cost of acknowledging the difficulty of fulfilling campaign promises, Mr Zelaya has

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sought to shift the blame for the lack of movement in important policy areas onto the obstructionism of the political opposition. At the same time, Mr Zelaya has strengthened the political stance shown in his first few months in office, characterised by a strong leadership, with decision-making resting with the president and an inner circle of confidants. The president’s firm stance appears designed to compensate for the lack of a coherent government programme, and for the government’s weakness in terms of being able to pass legislation. However, the resulting confrontational style has served to generate frictions not only with political opponents, but with local business leaders, the international community, and even with political allies within the PL.

Fo re ig n p o l i cy fo rm s a fo c u s o f Differences within the PL have emerged most starkly over the issue of foreign

discontent policy. Mr Zelaya’s apparent willingness to foster closer ties with Venezuela has prompted dissent from more conservative elements of the party and stimulated a wider debate about Honduran foreign policy priorities. As an oil importer, Honduras has been suffering directly from the effects of high international oil prices. Mr Zelaya’s moves towards closer ties with Venezuela are motivated by the desire to improve access to oil resources. Petróleos de Venezuela (PDVSA, the Venezuelan state oil company) is expected to participate in the international bid for the purchase of fuels that the government intends to introduce in the second half of 2006, under which it will become the sole importer of oil into the country. However, many fear that any arrangement that would result in closer relations with the Venezuelan president, Hugo Chávez, could affect traditional ties with the US. Honduras has been an important political ally of the US in Central America for many years, as a result of which it has received substantial financial aid. Moreover, the US is the main destination of Honduran exports and a major source of remittances, Honduras’s main source of foreign exchange.

These concerns have prompted even the vice-president, Elvin Santos, to declare his opposition to closer ties, citing concern that the perception of political influence being exercised by Mr Chávez could put relations with the US under strain. Mr Zelaya and Mr Santos subsequently gave a joint press conference to stem rumours of a cabinet crisis. The US ambassador in Honduras, Charles Ford, has expressed his concerns about any moves by the Zelaya administration that could give the perception of ideological affinities with Mr Chávez. In June the US embassy stopped scheduling appointments to issue visas to Honduran citizens, only resuming normal scheduling ten days later following Mr Zelaya’s criticism of the move. The measure was said to be based on fears of irregularities in the issue of Honduran identity cards and passports. However, the sensitivity of the Venezuelan question was underlined by the belief among many in Honduras that the move was intended as a warning of the difficulties that could emerge in the US-Honduras relationship owing to approaches being made to Mr Chávez.

The government reaches an An increase in the already high level of public protest has added to the

agreement with teachers government’s difficulties. In its first seven months in office the Zelaya administration has faced around 20 protests per month. These protests usually involve the blocking of roads and government offices, and are often led by

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public-sector workers such as teachers, healthcare service workers and bureaucrats, as well as by environmental groups. At the end of July indigenous communities, together with environmentalist groups and church representatives, caused severe disruption when they blocked the national road system in the west and central region of the country in order to highlight their demands for the abolishment of the 1998 law that allows international mining companies to carry out open-air mining operations. However, the most significant protest the government has had to face in recent months was a strike by teachers in early August, which lasted for ten days and deteriorated into violence during one street protest. Teachers have long been campaigning for the annulment of the Ley de Reordenamiento Retributivo (Payment Restructuring Law), sanctioned during the presidency of Ricardo Maduro Joest (2002-06) of the conservative Partido Nacional (PN), under which teachers’ salaries were frozen, and the full implementation of the Estatuto del Docente (Teaching Statute) of 1997, passed under a PL government, which mandates annual salary increases and other economic benefits for teachers. Outside the teaching profession, the Estatuto del Docente is considered as over generous in terms of the benefits it provides for teachers regardless of their academic qualifications and performance. During the Maduro administration, as part of an effort to reduce the fiscal deficit and ensure that Honduras qualified for debt relief under the IMF-World Bank HIPC programme, many salary benefits enjoyed under the Estatuto were removed, resulting in frequent protests and strikes by teachers and the loss of school days. During his election campaign, Mr Zelaya promised to restore these benefits, but complying with this promise carries significant negative implications for the fiscal balance. Disagreement over the government’s ability to finance its reintroduction played a part in the resignation of the then minister of finance, Hugo Noe Pino, in mid- June. Although the fiscal implications have prevented the government from moving forward with its election pledge, in early August the government and teachers reached an agreement under which the government will gradually implement the measures of the statute (see Economic policy). The government appears to be calculating that the fulfilment of campaign promises and the prevention of further social tensions, currently outweigh the fiscal burden of the measure. Given the weak position of the government in the legislature, winning over the teachers, who have been the most effective militant groups under successive governments, could prove a boost for Mr Zelaya at a time when his own political allies are questioning the effectiveness of his presidency.

Mr Zelaya loses another In July, one month after the resignation of his minister of finance, Mr Zelaya lost member of his cabinet another of his cabinet members when Orizon Velásquez, the then minister of health, resigned in the middle of a corruption scandal involving irregularities over the purchase of medicines. In February 2006 the Zelaya administration had revoked the contract with the UN Development Programme (UNDP), through which the purchase of medicines was conducted, following accusations of irregularities under the mechanism during the Maduro administration. However, it later emerged that under the new system the Ministry of Health was favouring some companies to supply medicines even

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though they didn’t comply with the conditions stipulated by the government. This led to the resignation of the general secretary of health in April followed by that of Mr Velásquez. Apart from irregularities in the purchase of medicines, Mr Velásquez was also criticised for having presided over a 3,800 increase in the number of healthcare sector employees during his time in office, resulting in the ministry exceeding its budget. This caused some critics of the government to accuse it of using the health ministry (which, together with the education ministry, receives the largest share of the central government’s budget) as a vehicle for rewarding political supporters.

Criticism of the government’s One of the main concerns of the general public, and a central issue in the

security policy election, the issue of crime, has continued to dog the government. The minister for public security, Alvaro Romero, has been the subject of strong criticism. Although Mr Romero has admitted shortcomings in police response to the problem of violent crime and the need for police reform, he has also faced criticism from human rights organisations and civil society for allowing military officials accused of crimes committed during the last military regime in the security forces. The government’s plan to reform the Ley Orgánica de la Policía Nacional (National Police Force Law) as set out by Mr Romero has also been rejected by human rights organisations who fear that a resulting increase in co- operation between the police and military to stem rising crime would result in the militarisation of the police force. During the 1980s the police was subordinated to military forces, but in the early 1990s a process of demilitarisation was begun, which resulted in the police becoming a civil organisation administered by the public security ministry.

Opposition party legislators Despite the difficulties facing the government, infighting within the opposition

reposition themselves parties is preventing them from capitalising fully on the Zelaya administration’s weakness. Two legislators of the left-wing Partido de Unión Democrática (PUD), Doris Gutiérrez and Tomás Andino, have left the party, after accusing the party leadership of authoritarianism. However, the decision reflects discord within the PUD stemming from its leadership’s decision to support the main, right- wing opposition Partido Nacional (PN) during the election for president of Congress. Meanwhile, the decision at the beginning of August by two PN congresswomen, Ilsa Díaz and Nelly Jerez, to resign their posts on the board of Congress marks the first signs of PN members jockeying for position ahead of the next presidential campaign in 2009. They were replaced by PL legislators who, leaving one legislator from the Partido Demócrata Cristiano (PDC) as the only opposition member on the board of the Congress.

Economic policy

A strong surplus in the first According to recently published figures from the secretary of finance, the public half of 2006 finances underwent a sharp year-on-year improvement in the first half of 2006. The central government recorded a non-financial public-sector (NFPS) surplus of La2.9bn (US$153.7m) during the period, compared with a deficit of La606.6m (US$32m) in the first half of 2005. A nominal increase in total receipts of around 12% was underpinned by tax receipts, which reached La16bn, driven by

Country Report October 2006 www.eiu.com © The Economist Intelligence Unit Limited 2006 16 Honduras

the strong performance of income tax, which grew by over one-third and accounted for more than one-half of the increase in total tax revenue. Receipts from sales tax, which accounts for one-third of all tax revenue, increased by around 15%, reflecting the positive impact on the government finances of firm domestic demand, as consumer confidence has been bolstered by falling interest rates and slowing inflation. The improved outlook for the public finances was also owing to governmental spending restraint. Total spending by the central government (including interest payments on public debt) narrowed by just over 10% in the first half of 2006, to La14.8bn, driven by a reduction in capital expenditure, which fell by over one-half as a result of a sharp fall in the level of capital transfers. Although current expenditure remained practically unchanged in nominal terms, spending on salaries increased by 11%, close to the rate of increase of nominal GDP, leaving the ratio between public salaries and GDP at around 8%. A 16% increase in interest payments on public debt highlights the burden on the sovereign that its large debt stock represents and the importance of debt relief between Honduras and its multilateral and bilateral creditors. At the end of June 2006 foreign public debt reached US$4.4bn, just 0.2% (US$35.2m) lower than a year earlier. This reduction was the net result of debt relief of around US$155m, new disbursements totalling US$90bn, and the effect of the revaluation of the US dollar against other currencies in which Honduras’s debt is also denominated.

Central government finances (La m) 2005 2006 % change Total revenue & grants 15,855.3 17,697.9 11.6 Current revenue 14,771.8 16,900.5 14.4 Donations 714.2 274.9 -61.5 HIPC donations 348.4 522.5 45 Total expenditure 16,461.9 14,806.8 -10.1 Current expenditure 13,162.6 13,262.7 0.76 Wages 6,486 7,203.3 11.1 Interest on debt 780.7 908.6 16.4 Overall balance -606.6 2,891.1 -

Sources: Secretaría de Finanzas; Banco Central de Honduras.

Concerns over subsidies and Despite the improved fiscal performance in the first half of the year, there are public salary increases concerns over the potential impact on the public finances of the government’s commitments. Fuel subsidies in place to prevent the increase in international prices from feeding through to consumer prices, carry an estimated fiscal cost of La600m in 2006, assuming oil prices stay at current levels. The government believes that the increase in tax revenue during the period it has been in office will enable it to maintain these subsidies until its planned international bid for the purchase of oil takes place later in 2006. Despite these reassurances, however, the IMF has expressed its concerns over subsidies, recommending that they be targeted at the most vulnerable groups in society to contain their fiscal impact. Furthermore the agreement reached with teachers, under which the government has agreed to grant salary increases based in the controversial Estatuto del Docente (see The Political Scene), will have a substantial negative fiscal impact from 2007, when the pay increases begin.

Between 2006 and 2009 teachers’ basic hourly pay will increase by 72%, from La33.4 (US$1.80) to La57.5. The first increase will take place in 2007, when the hourly rate will increase by 24%. From 2009 teachers’ salaries will increase in line with adjustment in the minimum wage. Teachers will also be compensated for back-dated payments that they would have received had the Estatuto del Docente been in operation in recent years. The Ministry of Finance estimates that the agreement will cost around La7.2bn in 2007-09, to be funded from a combination of government resources and funds from international donors. Given the need for a disciplined fiscal stance, the increase in teachers’ pay will absorb resources that would otherwise have been channelled to other social areas. The settlement is also at odds with the reduction in the wage bill agreed with the IMF under its poverty reduction and growth facility (PRGF).

Negotiations with the IMF An IMF mission visited Honduras in May for a fourth review under the three-

stagnate year PRGF arrangement agreed with the previous government in February 2004. As well as expressing concerns over the effects of energy subsidies and public salaries’ increases on the public finances, the Fund did not complete the review owing to the government’s lack of plans to strengthen the financial situation of two public enterprises, the Empresa Nacional de Energía Eléctrica (ENEE, the state-owned electricity company) and Hondutel (the state telecommunications company). The ENEE is estimated to lose around La2bn yearly, owing to failures in electricity distribution, and is severely indebted with thermal generators (which are in private hands), while Hondutel is suffering from the liberalisation of long-distance calls. Hondutel’s revenue fell by La1.2bn in 2006 as a result of the opening up of the long-distance call market to private competitors. Since the current IMF programme concludes in the first quarter of 2007, negotiations on a new agreement need to begin before the end of 2006, placing the emphasis on the government to move ahead with developing strategies to restructure its loss-making state enterprises. When they do take place, part of the government’s aim in the negotiations will be to highlight improvements in the macroeconomic fundamentals (with robust economic growth and inflation under control) to argue for a relaxation of some of the targets included in the PRGF.

A plan to recuperate the ENEE Given the problems highlighted by the Fund in relation to the ENEE, in July the government took a significant step when it intervened to appoint a board with the task of rescuing the company from its virtual bankruptcy. At present the company’s deficit totals La3.2bn (around US$170m), and its short-term debt amounts to US$150m. In addition, around 25% of electricity is lost owing to failures in the distribution system. The board has already presented a four-year plan to recuperate the ENEE, called “Plan de Acción para la Recuperación del Subsector Eléctrico 2006-10” (Plan for the recuperation of the electricity subsector 2006-10), which aims to turn the current budget deficit to a surplus by the end of the period. The plan includes a proposal to raise electricity tariffs (by 15% in 2006 and 10% in 2007), to target energy subsidies to the most vulnerable sectors, and to improve the interconnection system. This would allow the ENEE to disconnect automatically the electricity supply to its debtors. It is estimated that the private sector owes La15bn in outstanding bills to the ENEE. The plan also includes the goal of increasing electricity coverage to 80% of the

population by 2010. Although the government is thought to agree in principle with most of the suggestions put forward by the board, tariff increases are unlikely to be adopted given the unpopularity of the move with the public and the opposition to such a move by most of Congress.

Fuel bidding system to take Given that 70% of electricity is generated by thermal power plants, high

place in last quarter of 2006 international oil prices have direct implications for the cost of energy generation. Mr Zelaya’s strategy to introduce a sustainable energy policy is a plan to introduce an international bidding process for the purchase of oil. This is likely to happen in the last quarter of 2006, having been approved by Congress. The government hopes that by putting the fuel import contract out to international tender, with the company offering the best bid winning the right to be the sole supplier, it can achieve a significant reduction in domestic fuel prices, with annual savings of US$40m-US$60m for the economy. At present, Honduras consumes 15.5m barrels of oil per year. For the last 80 years, fuels have been imported by four companies: Esso, Texaco, Shell and the Honduran oil distributor, DIPPSA. The publication of the basis for the international bidding process was expected in the first week of September, but difficulties in finalising the text delayed its publication. Once the document is published, the government will have 15 days to analyse the different proposals. According to government sources, there are 60 companies interested in the bidding process; Petróleos Mexicanos (PEMEX, the Mexican state oil company), Petróleos de Venezuela (PDVSA, the Venezuelan state oil company) and Petróleos de Brasil (PETROBRAS, the Brazilian state oil company) are thought to be the main contenders. Concern among the business community over the plan has resulted in warnings that the legal text of the international bid could violate some of the international treaties signed by Honduras, such as the Dominican Republic- Central American Free-Trade Agreement (DR-CAFTA). According to a study prepared by the Consejo Hondureño de la Empresa Privada (COHEP, the Honduran national business council), the bidding process does not comply with articles of the DR-CAFTA treaty that refer to the transparency of government procurement processes. There have also been threats from current importers that legal challenges against the Honduran government for an estimated US$300m in lost earnings could be lodged if the government pushes ahead with its plan.

The domestic economy

Strong economic growth In the first six months of 2006 the Indice Mensual de la Actividad Económica recorded in the first half (IMAE, the monthly index of economic activity), a proxy for GDP growth, expanded by 5.4%, compared with 3.8% in the same period of 2005. With the exception of mining and public administration, all sectors that comprise the IMAE showed a positive performance. The increase in the IMAE was led by growth in the construction and banking sectors. Electricity and water, agriculture, forestry and fishing, and transport and communications all expanded at a higher than average rate.

Monthly index of economic activity (IMAE) (Jan-Jun, 1986=100) 2005 2006 % change Agriculture, forestry & fishing 175.7 187.5 6.7 Mining 725.4 717.9 -1.0 Manufacturing 282.5 289.5 2.5 Electricity & water 358.7 386.2 7.7 Construction 184.0 242.8 32.0 Transport & communications 317.3 338.3 6.6 Commerce 323.4 336.1 3.9 Banking & insurance 185.0 229.2 23.9 Public administration 144.3 135.0 -6.4 Other services 158.8 168.1 5.9 IMAE 236.1 248.9 5.4

Source: Banco Central de Honduras.

Construction activity was driven by private-sector demand. Private-sector construction activity expanded by 32% (compared with a reduction of 10.9% in the same period of 2005), with new commercial construction (particularly new shopping centres) growing by 50.6%, followed by residential construction, which expanded by 26.9%. Activity in the sector is being stimulated by the improved sentiment stemming from macroeconomic stability, increased access to credit, lower interest rates, and investment in the maquila (offshore assembly for re-export) industry, which has led to a 15.6% increase in maquila-related industrial construction. Increased demand for construction-related credit was reflected in the strong performance of the banking industry. A 24% increase in the banking and insurance sector was almost entirely the result of a 29.5% in banking sector activity—the insurance sector expanded by just 1.8%. With construction growing rapidly, demand for utilities has also been rising. Activity in the electricity and water sector was led by 8.1% growth in electricity generation. Growth in agriculture, forestry and fishing was underpinned by a 9.9% increase in agriculture, which offset a 3.4% contraction in fishing activity. Commercial trade growth was helped by growth in the agricultural sector and, to a lesser extent, by manufacturing, which slowed slightly year on year. Growth in transport and communications was accounted for by the entrance of new fixed-line telecoms companies, a reduction in tariffs for international calls since early 2006 and increasing demand for mobile-phone services. Within the transport and communications sector, growth of 18.2% in telecoms outweighed a 2.1% contraction in maritime transport activity owing to a fall in international trade.

Inflation continues to trend Contributing to an improvement in confidence in the economy has been the downward authorities’ success in reducing inflation even at a time of oil-price-related inflationary pressures. In the first eight months of 2006 annual inflation maintained the downward trend observed since the last quarter of 2005. In August the monthly inflation rate reached 0.4% (half the rate of the same month of 2005), taking year-to-year inflation to 4.8%, the lowest rate since 1988, and well below the 5.5%-6.5% target established in the 2006 monetary programme. The main drivers of this downward trend are exchange-rate stability (supported by a sustained increase of international reserves), fuel price

controls, a sufficient supply of staple foodstuffs such as grains, and adequate liquidity management by the BCH to offset inflation pressures.

Consumer price inflation (% change unless otherwise indicated) 2004 2005 2006 Monthly Annual Monthly Annual Monthly Annual Jan 0.9 6.9 0.8 9.0 0.4 7.3 Feb 1.1 6.7 1.2 9.1 0.7 6.8 Mar 0.4 6.7 0.8 9.5 0.2 6.2 Apr 1.1 7.3 0.9 9.4 0.5 5.8 May 0.8 7.9 0.4 9.0 0.7 6.1 Jun 0.6 8.3 0.7 9.0 0.3 5.7 Jul 1.3 9.3 0.9 8.6 0.5 5.3 Aug 0.3 8.7 0.8 9.1 0.4 4.8 Sep 0.1 8.4 0.4 9.3 - - Oct 0.9 8.8 0.1 8.5 - - Nov 0.9 9.1 0.2 7.7 - - Dec 0.4 9.2 0.4 7.7 - - Annual average - 8.1 - 8.8 - -

Source: Banco Central de Honduras.

The lempira remains stable By the end of August 2006 the nominal exchange rate was only 0.2% above its year-earlier level. Since November 2005 the exchange rate has remained virtually fixed at La18.90:US$1, aided by the sustained growth of international reserves. In July 2006 net international reserves held by the Banco Central de Honduras (BCH, the Central Bank) reached US$2.3bn (a 16% rise since the start of the year), driven by remittances from Hondurans working abroad and by growing export earnings. Officially, the Central Bank maintains a competitive exchange rate so as to encourage export-oriented sectors. However, with domestic inflation higher than in the US, the lempira is appreciating in real terms against the dollar. The real effective exchange-rate index, which measures Honduran competitiveness against its main trade partners, showed an appreciation of 1.5% in the first half of 2006.

Agriculture

Strong growth in the According to the IMAE, the agricultural sector—including agriculture, forestry, agricultural sector livestock, poultry and fishing—expanded by 6.7% in the first half of 2006, compared with a contraction of 0.5% in the same period of 2005. Growth was led by agriculture, which expanded by 9.9% after a contraction of 1.6% in 2005. Relatively high prices and strong demand for coffee, coupled with increasing production of one of the major non-traditional crops, African palm, output of which expanded by 16.3% year on year, played a major part in the recovery. The Instituto Hondureño Del Café (Ihcafe, Honduran Coffee Institute) estimates that the 2005/06 (Sep-Aug) coffee year harvest could reach a historical record, with around 4.5m 46-kg bags, compared with 3.1m in 2004/05. Despite high international prices, coffee output narrowed during the previous year's harvest owing to financial difficulties faced by producers, which had led to the abandonment of many cultivated fields. However, coffee growers have reacted

to the favourable prices by implementing intensive fertilisation programmes, resulting in the projection of a record harvest for 2005/06. Sugar cane production also grew strongly in the first half of the year, by 12.5%, but the damage caused by tropical storms towards the end of 2005 continued to affect the production of bananas, which contracted by 22.7%. Aided by improvements in capacity utilisation and the adoption of new technologies, poultry production grew by 5.5% year on year in the first half of the year. By contrast, fishing output, hit by a 50% reduction in shrimp extraction and a 2.7% fall in the cultivation of shrimp, contracted by 3.4%.

Mr Zelaya launches a four- In line with commitments made during his election campaign to increase year agricultural sector plan opportunities for the agricultural sector, at the end of August Mr Zelaya announced a four-year plan to boost agricultural output, guarantee food security, reduce poverty and increase exports through the Dominican Republic Central-American Free-Trade Agreement (DR-CAFTA). The “Plan Estratégico Operativo para el Sector Agroalimentario 2006-10” (Operative strategic plan for the agroalimentary sector 2006-10) aims to reduce imports of basic grains (in particular corn), improve yields by implementing irrigation systems, increase livestock numbers (which have fallen to around 2m head from a high of 3m) by 20,000 animals each year. The programme’s estimated La2bn (US$100m) cost will be met from a combination of government resources, foreign loans and donations. The government also intends to submit a financial assistance package for farmers. It is thought that this would make available medium-term loans for around La7.0bn (US$370m) to assist producers in different subsectors, such as coffee, fishing, African palm and sugar cane. This element of the government’s plan for the sector has raised fears that, as with similar assistance to the sector in the past, the largest producers benefit more from the measure than those smaller producers whom the package is intended to benefit.

Manufacturing

Growth in the manufacturing Despite the general improvement in the economy in the first half, sector slows manufacturing output growth lagged that of other sectors. The strongest performance was recorded by basic metal products, the production of which more than doubled, non-metallic minerals, which increased by 14.8%, paper products (5.0%) and the food, beverages and tobacco subsector (3.2%). The performance of the basic metals industry was the direct result of the recent increase in demand in Central America for basic hand mills. Non-metallic minerals production benefited from the expansion of cement production (20.8%) as the rapid pace of private-sector construction activity drove up demand for building materials. A resulting increasing demand for cement bags boosted the paper industry, which also benefited from an increasing activity in the publishing industry, offsetting the adverse effect of a fall in demand for cardboard boxes for bananas. The positive performance of food, beverages and tobacco was accounted for by robust demand in a number of areas such as animal food (with an increase of 13.9%), tobacco (6.2%), poultry (5.5%) and pasteurised milk (4.7%). In contrast, textile production expanded by just 1.1%, affected by a slowdown in the production of fabrics, owing in part to strong

competition from China. The metals industry, production of which increased by 9.1% in the first half of 2005, contracted by 14.9% as a result of a fall in production of iron rod and office furniture.

Selected industrial production Jan-Jun Jun 2005 2006 % change 2005 2006 % change Sugar (46-kg bags) 7,190 7,335 2.0 185 278 50.6 Wheat flour (46-kg bags) 1,405 1,418 0.9 275 195 -13.7 Pasteurised milk (litres) 50,618 52,996 4.7 8,365 8,668 3.6 Vegetable oil (lbs) 82,444 83,610 1.4 16,200 20,795 28.4 Soft drinks (12-oz bottles) 653,611 663,942 1.6 116,125 119,685 3.1 Beer (12-oz bottles) 132,586 129,471 -2.3 23,433 25,762 9.9 Rum & distilled spirits (litres) 5,153 7,093 37.7 721 1,153 60 Cigarettes (packets of 20) 162,636 172,766 6.2 30,923 33,254 7.5 Fabric (yards) 106,073 105,275 -0.8 18,237 18,337 0.5 Cement (42.5-kg bags) 15,756 19,036 20.8 2,731 3,133 14.7 Fibre cement sheets (sq metres vol) 3,081 3,200 3.9 523 528 0.9 Newspapers (copies) 31,815 33,276 4.6 5,455 5,675 5.3

Source: Banco Central de Honduras.

During the first half of 2006 value-added earnings by the maquila industry reached U$S406m, an increase of 13% compared with the same period of 2005. Maquila producers estimate that in 2006 value-added by the sector will grow by 14.2%, while employment in the maquila industry will increase by 5.6%. As Honduran maquila producers are mainly concentrated in the textile sector, they are facing increasing competition from Asia in the US (their main export market). As a result, the industry is engaged in diversifying into the manufacture of medical instruments, construction materials, electronics, computer assembly, home appliances, and automotive parts. Initial indications are favourable, although a great deal of further progress is necessary to reduce the current reliance on textiles.

Financial services

Increasing dollarisation of the Moderate inflation rates and positive real interest rates (with a weighted loan portfolio average nominal interest rate of 7.9% for new Lempira-denominated deposits) have encouraged an increase in domestic savings. In June total deposits of the private sector in commercial banks showed a year-on-year increase of 26.3%, up to La84.2bn (around US$4bn). Lempira-denominated deposits, which reached La57.4bn and accounted for 68.2% of total deposits, increased by 34.1% year on year, while foreign currency-denominated deposits increased by 12.3% to reach La26.7bn. The faster pace of growth in lempira-denominated deposits resulted in a reduction in the share of dollar-denominated deposits to 31.8% of total deposits in June 2006, compared with 35.8% in the same month of 2005, reflecting a de-dollarisation trend driven by confidence in Honduras’s macroeconomic fundamentals, including exchange rate and price stability, as well as a pick up in economic growth in 2006.

New credit by commercial banks to the private sector increased by 42.6% year on year in the first half, to La38.7bn (US$2.0bn). The expansion was led by consumer lending (up by 76.7%) and loans related to property purchases (66%), followed by loans to the services sector (58.3%). The weighted average interest rate on new lempira-denominated loans reached 15.7%, 1.2 basis points lower than the year-earlier record. The total stock of credit to the private sector recorded a 25% year-on-year increase. The participation of foreign currency- denominated loans in the total loan portfolio reached 35.2% in June 2006, compared with 33.8% in the same month of 2005, driven by a 51.6% increase in new dollar-denominated loans by commercial banks to the private sector, compared with a 38.4% increase of new loans in domestic currency. The increasing dollarisation of the loan portfolio has been encouraged by measures implemented by the BCH, such as the reduction of reserve requirements on foreign currency-denominated deposits, the removal of the limit on financial entities’ foreign debt, and the elimination of the restrictions placed on foreign currency loans for debtors in the non-tradeables sector.

Credit to the private sector (La m unless otherwise indicated; from commercial banks) New credit Total stock of credit Jun 2005 Jun 2006 % change Jun 2005 Jun 2006 % change Agriculture & livestock 1,478.4 1,606.8 8.7 6,002 5,699.8 -5.0 Industry 5,102.1 4,844.6 -5.0 9,853 13,120.2 33.2 Services 3,417.0 5,409.5 58.3 6,182 8,801,8 42.4 Real estate 2,968.2 4,927.1 66.0 11,883.4 15,291.7 28.7 Commerce 8,410.6 11,750.0 39.7 13,450.4 15,941.1 18.5 Consumer 5,732.4 10,128.8 76.7 7,363 9,553.5 29.8 Other 0.0 0.8 - 1.7 1.5 -11.8 Total 27,108.7 38,667.6 42.6 54,735.5 68,409.6 25.0 Source: Banco Central de Honduras.

The strong pace of credit expansion is being encouraged by historically low interest rates. With inflation following a downward trend, in September the Central Bank continued its gradual process of monetary easing and reduced the Tasa De Interés de Política Monetaria (TPM, the short-term monetary policy interest rate that reflects the BCH’s monetary targets) by 50 basis points to 6%. Since the beginning of the year, the Central Bank has cut interest rates by 1 percentage point, reflecting the authorities’ policy goal of encouraging economic growth through easing access to credit to the private sector.

Banks’ balance sheets improve In June 2006 total assets of the financial system (including commercial banks, saving and loans institutions, and financial societies) reached La149.1bn (US$8bn), a 23.8% year-on-year increase. Among the main asset items, investment was the most dynamic category, increasing by 32.9% over the period to reach La33.2bn, led by investment in public entities. The loan portfolio expanded by 25%, reaching La71.3bn, while liquid assets increased by just 4.9% to La15.7bn. Liabilities totalled La118.5bn (US$6.3bn), up by 23.7% over June 2005, while total capital and reserves increased by 15.8% to La12.3bn. Total deposits grew by 25.1% to La92.9bn, leaving the gap between deposits and loans unchanged, with loans representing 77% of total deposits. Balance sheets of commercial banks continued to improve in the period. Liquidity is high, with

liquid assets accounting for around one-half (48.3%) of short-term liabilities. Banks are also well capitalised, with capital reserves at 13.3%, above the minimum of 10% set by the authorities, while overdue loans followed their downward trend, falling to 5.2% of the total loan portfolio, from 5.8% at the start of the year.

Foreign trade and payments

Import demand result in a In the first seven months of 2006 the merchandise trade deficit widened by widening trade deficit 23.2% year on year, to US$1.8bn, as import spending increased by 16.7% (compared with a 15.6% expansion in 2005), while export earnings grew by only 8% (compared with an 11.2% increase in 2005). The fall-off in export earnings came despite the benefit being enjoyed by Honduras of higher international prices for 12 of Honduras’s top 17 export commodities. Higher prices encouraged increased export volumes of zinc (up 19%) and tilapia (up 23.5%). Export earnings from coffee (Honduras’s main merchandise export) grew by 19.6%, as a 19.9% increase in export volumes outweighed a 0.2% decrease in prices. Despite a price increase of 16.1%, export earnings of bananas (Honduras’s second main merchandise export) declined by 6.9%, owing to a 19.8% contraction of volumes, which were affected by tropical storms at the end of 2005, and by the implementation of quotas by the EU: export volumes to Europe fell from 1.28m 40-lb boxes in the first seven months of 2005 to only 542,211 in the same period of 2006.

Merchandise trade (US$ m) Jan-Jul Jul 2005 2006 % change 2005 2006 % change Merchandise exports fob 1078.6 1,164.6 8.0 136.4 158.3 16.1 Banana 152.6 142.1 -6.9 8.9 13.9 56.2 Coffee 290.1 347.1 19.6 26 41.2 58.5 Shrimp 70.3 59.8 -14.9 33.2 20.4 -38.6 Merchandise imports cif 2,517.2 2,937.1 16.7 385.7 447 15.9 Consumer goods 661.3 814.5 23.2 102.8 118.5 15.3 Fuels & lubricants 514.6 669.5 30.1 92.6 90.9 -1.8 Capital goods 398.1 444.9 11.8 53.9 70.5 30.8 Raw materials & intermediate goods 779.2 806.3 3.5 109.4 135.8 24.1 Trade balance -1,438.6 -1,772.5 23.2 -249.3 -288.7 15.8

Source: Banco Central de Honduras.

The 16.7% increase in the import bill was led by higher spending on consumer goods, which accounted for 36.5% of the increase of total imports, as a result of strong domestic demand and increased consumer confidence. Consumer goods imports were driven by food, medicines and vehicles. Purchases of fuels (the second-largest component of the import bill) rose by 30%, driven by an increase of 31.9% in prices, far outweighing a decrease in import volumes of 1.5%. The Banco Central de Honduras (BCH, the Central Bank) estimates that higher oil prices prevailing in 2006 inflated the import bill by 11% in the period. The boom in construction has also pushed up the import bill, with a 36% increase

in the purchases of construction materials reflected the strong growth in this sector. Remittances by Honduran workers abroad and value-added earnings by the maquila (offshore assembly for re-export) industry have helped to offset much of the trade deficit. Maquila earnings reached US$406m in this period, up by 13.1% over the same period of 2005, while remittances reached US$1.1bn, a 41.1% increase over the first half of 2005. Workers’ remittances have been the main driver behind a sustained growth in international reserves, which, according to the BCH, has placed Honduras in a favourable position in relation to other countries in Central America, with a total reserves to imports ratio equal to 6.3 months of import cover, the highest in the region.