Document of The World Bank

FOR OFFICIAL USE ONLY AJ pŽcg-44t Public Disclosure Authorized

ReportNoYP-4376-PAN

Public Disclosure Authorized REPORI AND RECOMMENDATION

OF THE

PRESIDENTOF THE

INTERNATIONAL RANK FOR RECONSTRUCTION AND DEVELOPMENT

TO THE

EXECUTIVE DIRECTORS

ON A

Public Disclosure Authorized PROPOSED SECOND STRUCTURAL ADJUSTMENT LOAN

IN AN AMOUNT EQUIVALENT TO US$100 MILLION

* TO

THE REPUBLIC OF PANAMA

Public Disclosure Authorized November 13, 1986

This documenthas a restricted distribution 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. CURRENCY EQUIVALENTS

Currency Unit = Balboa (B/.) US$1 = B/.1

Note: The issue of Balboas is restricted to coins. The US Dollar (US$) is accepted as currency.

Fiscal Year

January 1 - December 31

WEIGHTS AND MEASURES Metric System

GLOSSARY OF ABBREVIATIONS

BDA - Banco de Desarrollo Agropecuario (AgriculturaJ Development Bank) BHN - Banco Hipotecario Nacional (National Mortgage Bank) BNP - Banco Nacional de Panama (National Bank of Panama) ZALV - Corporacion Azucarera La Victoria (La Victoria Sugar Corporation) CFF - Compensatory Finance Facility COFINA - Corporacion Financiera Nacional (National Finance Corporation) CSS - Caja de Seguro Social (Social Security Agency) ENDEMA - Empresa Nacional de Maquinaria Agricola (State Farm Equipment Services Company) ENASEM - Empresa Nacional de Semillas (State Seed Company) IDAAN - Instituto de Acueductos y Alcantarillados Nacionales (National Water and Sewerage Institute) IDB - Iater-American Development Bank IFARHU - Instituto para el Fomento y Adiestramiento de los Recursos Humanos (Human Resources Development Institute) IMA - Instituto de Mercadeo Agropecuario (Institute of Agricultural Marke; ng) IMF - International Monetary Fund IRHE - Instirito de Recursos Hidraulicos y Electrificacion (Hydroelectric Resources Institute) MIDA - Ministerio de Desarrollo Agropecuario (Ministry of Agricultural Development) MIPPE - Ministerio de Planificacion v Politica Economica (Ministry of Planning and Eccnomic Policy) MIVI - Ministerio de Vivienda (Ministry of Housing) PAHO - Pan American Health Organization UNDP - United Nations Development Programwe USAID - U.S. Agency for International Development FOR OFMICL USE ONLY PANAMA

SECONDSTUCTURAL ADJISTHT LOAN

LOANSUMMARY

Borrower: Republic of Panama

hAunt: US$100 million equivalent

Terms: 15 years, including 3 years of grace, at the standard variable interest rate

Loan Description: The proposed loaa would continue to support the Government's strategy of structural adjustment and economic recovery. The strategy aims at creating a more open, export-oriented ecoaomy ia which the efficieacy of the productive sectors is enhanced through exposure to greater iateraatioaalcompetition and through refocused public services. The major components of the program iaclude: (i) improving the efficiency of the public sector; (ii) reorientingthe incentive structure in the iadustrialsector; (iii) removing some rigidities ia the labor market; and (iv) reduciag distortionalinterventions in agriculture.

Benefits & Risk: The economic program supported by the proposed loan is expected to result in substantiallyhigher levels of economic growth and employment than would otherwise occur. To realize its potential the program requires a favorable internationalenvironment: contiaued growth in the industrializedcountries, recovery in Latin America, low interest rates and oil prices, aad opea international markets. The main domestic risk associated with this SAL concerns the Government'sability to continue the program despite political pressure. This risk is, however, diminiahed by some recognitionamong policy makers that the strategy adopted represents the most likely alternative to avoid contiaued stagnation and increasing unemployment. Moreover, the program will be closely monitored, and the Government'sperformance will also be a key factor in maiataining Panama's creditworthinesswith commercial banks. Therefore, the risk Is considered acceptable.

Disbmrseinn- Estimates: Bank FY87 US$100 million

Appraisal Report: None

IBRD 19092

This document has a restricteddistribution and may be used by recipientsonly in the performance I of their officialduties Its contents may not otherwise be disclosedwithout World Bank authorization| UnINRATIO Bas FOL nCNSTRUCnoO AND

REPORTAND RECOIHENDAXIOOF THE PRESIDENTOF THE BRED TO T EXECUTIVEDIRECIORS ON A PROPOSEDSECOND S3TUCTURAL ADJUSTNT LOAN IN AN AMOUNT aQwvALNT TO US$100 MxnIOu TO THE REPUBLIC OF PANS

1. I submit the following report and recommendation on a proposed Second Structural Adjustment Loan (SAL II) to the Republic of Panama for the equivalent of US$100 million. The loan would have a term of 15 years, includingthree years of grace, with interest at the standard variable rate.

PART I - THE ECONOMY

2. An Economic Memorandum entitled "Panama: Structural Change and Growth Prospects- (5236-PAN)was distributedto the Executive Directors on February 28, 1985. This, together with the policy frameworkestablished by the Governmentin 1983 and supported by SAL I, has formed the basis of a dialogue between the Government and the Bank. This dialogue has continued despite some interruptions caused by domestic political uncertainty, and has led to the current program of economic reform, begun in February 1986. An appraisal mission for the proposed loan visited Panama in April/May 1986, and its conclusionsare reflected in this report. Country data are given in Annex I.

Main Features of the PanamanianEconomy

3. Situated strategically on a narrow isthmus joining North and South America, Panama functionedas an important ceater for Spanish colonial trade for more than two centuries. The constructionof the Panama Canal in 1904-14 consolidatedits entrepot role, and provided the most importantsource of economic growth until the early 1970s.

4. Panama has capitalizedon its geographic location,its use of the US dollar as currency, and its canal to build up strong export-oriented services, largely geared to the markets of Central and South America. The main areas of expansion have been in banking, travel and international commerce. With the stimulus of favorable banking legislationpassed in 1970, the banking sector grew by 11 percent per year during the 1970s. By 1984, 130 banks employing over 7,000 people were establishedin Panama. The number of visitors coming to Panama grew by four percent annually in the 1970s, while the activitiesof the Colon Free Zone-warehousing, display and trAnsshipmentof merchandise,mainly towards the markets of Latin America-expanded by 14 percent annually. By 1985, these and other private services accounted for nearly 60 percent of GDP, and contributedto a per capita income of US$2,080, more than twice the average for Central America. Agricultureand manufacturingeach contributedonly about 10 percent of GDP. * -~~~~~~~~~~~~~2-

Background: 1960-1981

5. The 1960s saw rapid economic growth in Panama. Canal-related activities,agriculture (led by grass-fed beef production and bananas), and import-substitutionindustry as well as constructionand services contributed to GDP growth rates averaging eight percent. The benefits of this rapid development were, however, concentrated in relatively few hands. Income distributionwas highly skewed, social services and infrastructure, particularly in rural areas, were inadequate, and acute poverty persisted.

6. A major political watershed came in 1968, when the National Guard replaced the civilian Government with an administrationcontrolled by General Omar Torrijos. The new Government strove to increase national economic sovereignty, particularly over the Panama Canal. It achieved this goal in 1979 with the signing of two treaties -withthe United States which established a timetablefor the reversionof the Canal and its related assets to Panama, culminatingin December 1999. To broaden the development process to include the rural poor and urban workers, the Torrijos Government also undertook major social reforms. Distributionalobjectives were to be achieved through investments in education, health, and improved rural transport, as well as agrarian reform and a new labor code. Ambitious public investment in infrastructureand productive activities, together with rapid growth in the internationalfree zone, an internationalbanking and re-insurancecenter, commerce, and other export services, were to enhance entrepot-basedgrowth. Private investment flourished in constructionand services linked to internationaltransportation.

7. Although this strategy was initially successful,real GDP growth fell from seven percent per year in 1968-73 to five percent in 1973-82. Externally, the increase in world oil prices was contractionaryfor the regional economy, and canal activities slowed after the peak traffic during the Vietnam war. Moreover, Canal Treaty negotiationscreated uncertaintyin the private sector, and policies such as the highly restrictiveLabor Code (1972),price and rent controls, and export quotas also undermined private sector confidence. Private investment fell, but large public investments partially offset the decline. During the 1970s the public sector accounted for over 80 percent of the new jobs created. High spending levels resulted in sharp increases in the public sector deficit and the public debt, which climbed to nearly 80 percent of GDP by the end of the 1970s.

8. The favorable resolution of the canal issue in 1979 reduced uncertainty and increased the popularity of the Government,enabling it to modify economic policy. A sustained effort began to reduce the deficit through increased taxes and tighter controls on expenditures. By 1981 the deficit had fallen to about five percent of GDP from nearly 12 percent in 1979. Investmentand employment incentives were introduced to encourage private investment and new exports. Despite the partial restorationof private sector confidence, private investment did not recover to the levels of the 1960s and early 1970s. Furthermore,agriculture and industry continued to be hindered by the policy and institutionalenvironment. -3-

9. During the 1970s the quality of life for most Panamanians, includingmany of the absolute poor, improved. Infant mortality, a key indicatorof maternal health and the health of the general populace, fell from 59 infant deaths per 1000 live births in 1965 to 21 in 1981. The number of doctors per inhabitantincreased more than 60 percent in the 1970s, and secondaryschool enrollment rose from 39 percent of the eligible population in 1970 to 63 percent in 1981. By the late 1970s, the level of absolute poverty had declined to about 26 percent of the population.

Economic Situationand Policy: 1981-1986

10. The accidentaldeath of General Torrijos in July 1981 unleashed a turbulentperiod in Panamanianpolitics and uncertaintyin economic policy as new leadership developedand civilian-militaryrelations took new forms. In July 1982, PresidentAristides Royo resigned and was replaced by Vice-PresidentRicardo de la Espriella, and subsequentlyby Mr. Jorge Illueca. A new constitution,adopted in May 1983, paved the way for elections a year later. Panama's first elected governmentin 16 years took office with the inaugurationof PresidentNicolas Ardito Barletta in October, 1984. Nonetheless,widespread doubt about the legitimacyof the election and the slim margin of victory weakened the Governmeatand stalled the progress of economic reform.

11. In 1982, the world recessionand the deepening financialcrisis engulfingLatin America convergedwith domestic politicaluncertainty to plunge Panama into recession. Net earnings from banking, travel and the Colon Free Zone declined sharply. Private investmentfell in real terms followingcompletion of a transisthmianoil pipeline. In an attempt to offset the contractionand in response to politicalpressures, fiscal coatrols were relaxed and several public sector agencies exceeded their budgets by wide margins. The consolidatedpublic sector deficit rose back to 11 percent of GDP, almost double the 1980-81average. Net foreign borrowing by the public sector amounted to about US$500 million, and the outstanding public medium-termdebt reached US$3.1 billion at the end of 1982, equivalent to 73 percent of GDP. Interest on the debt absorbed over 30 percent of total public sector revenues.1/

12. The Government implemented an IMF-supported stabilization program in 1983 and 1984, which cut the deficit of the nonfinancialpublic sector to an average of just under six percent of GDP for both years. At the same time, the authorities undertook a program of structural reforms, supported by the Bank through SAL I, laying the groundworkfor trade liberalizationand cutting back some inefficientoperations of the public sector. But several factors contributedto the continuingstagnation of the economy: the

1/ Defined as the current revenues of central governmeatand autonomous agencies plus the current surplus of the public sector enterprises. Since Panama uses the US dollar as its currency, this ratio is more revealing than normal debt service ratios. The ratio of service on public debt to exports of goods aad noufactorservices was 35.4 percent in 1982, equivalent to 14.4 percent of GDP. -4-

reductionin deficit spending reduced aggregatedemand; the continued recessionin Latin America cut into offshore leadlg of commercial banks and depressed the activitiesof the Colog Free Zone; and the completion of the La Fortuna hydroelectricproject togetherwlth declines in housing demand reduced employment in constructionby one-third. GDP contractedby 1.5 percent in 1983 and 0.4 percent in 1984; unemploymentrose to over 15 percent in the metropolitan areas; this undoubtedly has meant worsening poverty.

13. The Ardito Barletta Governmentadopted a broad-basedpolicy of economic reforms,particularly aimed at the industrialand agricultural sectors, and began in 1985 to discuss a Second StructuralAdjustment Loan with the Bank in support of this program. The Government also concluded a standby arrangement with the IMF, and rescheduled 1985 and 1986 payments on Panama's external debt to both commercialbanks and official creditors. However, the external financing package for the year founderedwhen the Governmentwas unable to sustain its economic reform program. A severe fiscal squeeze then easued, together with some excess internal borrowing. However, the economy began to show some recovery in 1985, with GDP growth at about 3.0 percent and employment up by 2.6 percent.

14. In September 1985, PresidentArdito Barletta resigned and Vice-PresidentEric Delvalle assumed the Presideacy. The new President reacted to the coatinuing financialcrisis by drawing up a new development program in January and February 1986 based upon extensivediscussions with affected interest groups, political parties, and the armed forces. In March, the Governmentreembarked on its program of structuralreforms. The authoritiesalso renewed a financialstabilization program with IMP support.

15. Growth prospects for 1986 and immediatelybeyond are somewhat brighterbecause of the combined programs, the fall in oil prices and interest rates, aad the continuing (if weak) recovery in the OECD countries. Prelimiaaryindicators suggest growth of GDP may approach three percent because of reaewed activity in the Coloa Free Zone, increased canal traffic aad partial recovery in manufacturing and nontraditional exports.

Short Term Stabilization Measures

16. To provide the necessarycontext of financialstability for its new developmentstrategy, the Governmentis continuingits fiscal austerityby keeping the public sector deficit to a very low level in 1986. This has allowed continued IMF support under the standby arrangement,signed in July 1985 and running through March 1987. The Iff Board approved the 1986-87 compoaentsof the standby on July 2, 1986, which provide for purchasesof about US$52 million in 1986 and US$13 million in 1987. The main conditions attached to the standby are a public sector deficit of no more than 1.2 percent oi GDP in 1986 and a reduction in the recently expanded public debt -5- to the government-owned Banco Nacional de Panama (BNP). The saving and gross borrowing requirements of the public sector implied by the program are shown in Annex I.

17. Because Panama uses the US dollar as domestic currency, the Government cannot expand the money supply. It also has relatively restricted access to domestic sources of credit, and therefore cannot sustain a deficit much above the net external financing available. Since the 1982 financial crisis, external commercial funding has been almost unavailable, and the deficit has been largely financed by bilateral and multilateral ageacies. (An exceptionalsituation arose in 1985 with the loss of expected external financing, aad the Government undertook temporary and uasustaiaable borrowingsfrom the BNP). While the Government could reduce the deficit through increasing taxatioa or cutting expenditure,the high tax burden (23 percent of GDP) and large share of the public sector in the economy (40 percent of formal sector employment) limits the gains that can be achieved through revenue increases. Capital expenditure has already been cut extensively,as have t'.enon-wage componentsof recurrentexpenditure, to the point where the efficiency of the remaining expenditureis threatened. Government policy therefore concentrateson the orderly cuttiag back of recurrent expenditureby reducing public sector employment and improving efficiency in resource use.

18. In late 1985 Panama's external creditorsand the Governmenthad agreed to reschedule amortizationowed to private commercialbanks in 1985 and 1986. This amounted to US$579 million, refinancedover 12 years (of which 3.5 are grace), and at an interest rate of LIBOR plus 1 3/8 percent. The agreement included a new money facility worth US$60 million of medium-termcredits, which the banks tied to the successful implementation of the IMF standby and the Government'sstructural adjustment program supported by the World Bank; because of delays in carrying out these programs, these funds only began to be disbursed in July 1986. Twenty-one million was disbursed in July followingthe SAL appraisalmission and IMF Board presentation;the remaining US$39 million is linked to the progress of the adjustmentprogram through 1986. In addition, the agreement included short-term credit lines for working capital for some public enterprises (US$56 millioa), a money market facility for the BNP (US$133 million) to bring its placements up to the December 1984 level, and a short-term petroleum import credit of US$28 million. In September 1986, the Paris Club also agreed to reschedule at various interest rates 50 percent of all maturities falling due with Paris Club bilateraldonors for the period September 15, 1985/December31, 1986; these amounted to US$18 million. The terms included eight years maturity,with three of grace. -6-

19. Despite the burden of its external debt, Panama remains creditworthyfor Bank lending. It should be able to meet its external interest obligationsif it continues to exercise prudent financial management,although the Governmentwill have to reach agreementwith commercial banks to reschedule amortizationdue in 1987-90 (para 50). As a result of its debt-managementpolicies there has been an important shift in the structure of service toward longer maturitiesassociated with the rise in the proportionof Panama's external debt owed to preferred creditors in recent years. The share of multilateralorganizations rose from 14 percent in 1980 to 23 percent in 1985; the Bank's share rose from six to nine percenc in the period, and is projected to be 11 percent in 1990. The generallymore favorableterms of such borrowing have contributedto easing the servicing burden.

PART II - E SfRUCTURALADJUSTMhEN PROGRAM

20. Since 1983, the Government has sought to promote the international competitiveness of Panama through major efforts to increase the efficiency of the public and private sectors. Public sector efficiency was to be achieved by concentratingservices on much-neededactivities that would enhance national productivityand by scaling back ancillary activities that increased public consumption;private sector efficiencywas to be achieved through changing the structure of incentivesembodied in the tariff and pricing system, thus channelingprivate investment into more productive activities. Taken together, these efforts were aimed at increasing growth, creating new jobs, and reducing poverty.

The Accoqplishants of the SAL I Program

21. The Government's 1983-84 structural adjustment measures had three main aims: first, to begin the process of increasing the efficiencyof the public sector; second, to commence the reorientationof the incentive structure in the urban, industrial sector towardsexports and employment generation;and, third, to take measures to increase productivityand output in the agriculturalsector. The First StructuralAdjustment Loan was approved by the Board on November 15, 1983; the first tranchewas released by the end of the year, and the second and final tranche in July, 1984.

22. Much was achieved during the SAL I period. In the public sectors several loss-sakingenterprises were sold, restructuredor shut down (para. 23), marking an important reduction in subsidiesto state entities. Current and capital cash transfersfrom the central government to public enterprises and decentralizedagencies fell from an average of B/.25 million per year in 1980-82 to BI.16 million in 1983-84. Controls over public investmentand debt management were strengthened,and capital expenditureswere reduced selectivelyin accordancewith fiscal constraints. They fell from a high of B/.518 million in 1982 to B/.245 million In 1985. In public housing, the -7-

Social Security Agency phased out its costly interventionas a direct promoter of construction. In trade policy, three quarters of the quantitativerestrictions on imports were replaced with tariffs. In agriculture,there was a slight reduction in the rice support price, liberationof beef from export controls,establishment of an intermediate price for medium grade milk, and lifting of domestic price supports and controls on potatoes.

23. In 1982, a state-ownedbanana corporation,COBAPA, was closed, generatingsavings of about B/.1.5 million in subsidiesper year. In 1983, the Government closed the Felipillo sugar mill, the most inefficientof the state owned La Victoria Sugar Corporation(CALV) complex, which accountedfor about 30 percent of La Victoria's total oaillingcapacity. The mill's losses in 1982 had amounted to B/.15.5 million (39 percent of the corporation's total); idle land and equipment at Felipillo have since been offered for sale. At the beginning of 1983, the Government announced that state subsidies for the Bayano Development Corporation (BDC) and the Chiriqui Citrus Company would cease, involving a saving of just over B/.1 million per year. The National Finance Corporation(COFINA) was closed in 1985, putting a stop to its loss-makinglending operations. All these reforms are importantand remain in place.

24. The program, however, did not achieve all of its goals. Progress began to falter in late 1984, primarily because the turbulentpolitical situationundermined the consensusfavoring reforms. In trade policy, the Governmentdid not replace all quotas with tariffs. Although a draft law was prepared that would have set new maximum and minimum tariffs and abolished the protectionistand discretionary Contractswith the Nation", it was never put before the legislature,and, in fact, the number of contractsincreased. In agriculture,the Governmentremoved price controls only slowly; it did liberalizeprices on higher cuts of beef, but then reversed itself. In public finance, the Governmentpayroll continued to increase.

25. A Technical AssistanceLoan (TAL) accompaniedSAL I and financed technicalassistance and studies of further public sector reforms, including major actuarial studies for the social security programs,studies on industrialprotection, agricultural pricing policy and management studies of key agriculturalinstitutions and enterprises. The studies laid the analyticalgroundwork for subsequentnew policies toward state enterprises, social security, industry, and agriculture.

The SAL II Program

26. The grave financial situationaffecting Panama as the financial program became unravelled by end-1985 eventually created a new momentum to enact reforms. In early 1986, the Government formulated a new medium-term development program of reform that builds on the prior SAL I program. It recognizes that new growth and employment opportunities can no longer be sought through further public sector expansion, an import-substitution -8- process in industry,and an agricultureheavily subsidizedthrough the trade and price control regimes (includingquotas and state price supports). Moreover, the excess costs of industrial,agricultural and public sector inefficiencyput additional burdens on the service sectors in which Panama's comparativeadvantage lies. Since increasedwage competitivenesscannot be achieved through adjusting the exchange rate, inefficienciesmust be attacked directly in each sector of the economy. Opportunitiesare also being sought in external markets through the acceleratedproduction of goods for export and more efficient import substitutionbased upon Panama's comparative advantages. Greater efficieacy In agriculture and industry will also help to improve competitivenessand reduce upward pressureson prices and wage rates. The strategy also recogaizes the importanceof an incentiveframework to stimulateprivate investment in internationallycompetitive activities.

27. The policy measures designed to give practical shape to the Government'smediumrterm development strategy may be divided into four main areas: first, improving the efficiency of the public sector; second, reorientingthe incentivestructure in the industrial sector towards exports and more efficient import substitution;th'rd, removing some rigidities in the labor market; and fourth, reducing distortionalinterventions in agricultureto increase productivityand output.2 / In financialservices, there is less urgent need for structural reforms as the sector already benefits from a favorable legislativeregime. In the energy sector, pricing policy is generallyadequate to reflect scarcity, although the Governmenthas been cautious in passing on price declines to consumers. Ia June 1986 the Government introduced a differentialbetween the es-refineryprices of refined petroleum products and the prices at which the refinery sells these products in order to increase governmentrevenue from the petroleum sector. The Government is also negotiatingwith the country's single refinery to change the profit-sharingcontract.

2B. In the face of considerablepolitical opposition,the Government has sought to build a domestic constituencyfavoring reform. It has already moved forward on several politically sensitiveissues: closings and divestituresof more state-ownedentities, opening the issue of social security reform, reducing tariffs to industry, enacting revisionsto the labor code, and reduciag levels of subsidies and protection to domestic agriculture. In confrontingthese several problems over the last six moaths with a relativelycoherent program, the Government has demonstrated its capacity for action, staved off financial crisis, and put in place a program to rekindle broadly shared growth. The followingsections review the progress achieved and describe further actions which the proposed loan supports.

Public Sector Efficiency

29. The financial constraintson the public sector reveal the need for increasedefficiency. The Government'sstructural adjustment program is concentratingon reforming those activitieswhich most hamper the efficiency of the public sector. The major componentsinclude: (i) closing or

2/ The measures supported by SAL II are summarizedin Annex IV. -9- divesting several money-losingpublic enterprises;(ii) gradual reductionof public employment; (iii) reform of the social security system; and (iv) an investment program for the period 1986-1987consistent with the prioritiesof the new developmentstrategy.

30. Public Sector Enterpriseu. Panas's public sector is made up of about 40 decentralized agencies and state-owned enterprises in addition to the central government. Together these entities account for somewhat lese than half of the public sector's employment and wage bill. The decentralized agencies account for only about five percent of consolidatedpublic sector revenue and mainly depend on Governmenttransfers. The consolidatedaccounts of the decentralizedagencies showed an operatingdeficit of about B/.26 million in 1985, roughly one-half the level of 1982. Followinga comprehensivefinancial review of all entities carried out in February 1983, concentratingon the most heavily subsidized,efforts were made to control costs, raise revenues where appropriate, and phase out loss-making activities. Revenues rose from B/.67 million in 1982 to B/.80 million in 1985 while current expendituresfell from B/.113 million to B/.106 million in the same years.

31. The public sector enterprisesare much larger. Their consolidated accounts have also Improved; their operating surpluses (before transfers) rose threefoldafter 1982 to B/.125 million in 1985. The closings cited above (para. 23) helped eliminate operating losses; similarly, the financial performanceof HydroelectricResources Institute (IRHE),the state electricityfirm, and National Water and Sewerage Institute (IDAAN),the water authority,have improved, though both still have high costs relative to comparableorganizations in the region, due to overstaffingand high debt servicingobligations.

32. To continue these financial improvements,the Governmenthas taken the following actionB:

The Las Cabras sugar mill of the La Victoria Sugar Corporation tCALV) was closed in July 1986. This was CALV's oldest and least efficient operating mill and had the lowest yields and highest maintenancecosts in the complex. Since CALV has to sell its excess productionon world markets at very depressed prices, the marginal savings from shutting the Las Cabras mill are correspondinglylarge. On the basis of recent production costs and likely world prices, the savings are estimated to be 'on the order of US$1.1 million per year. The closure involved laying off 250 workers employed year round and reducing purchasesof cane from an additional 250 out-growers. The Governmentsold the plant in Septemberto a private group, which intends to convert the plant to alcohol production. The buyer is expected to rehire part of the former labor force. -10-

The Government closed the state seed compaay, ENASEM, in July 1986. Seed stocks and the company's research program were transferredto the State AgriculturalResearch Institution (IDIAP). ENASEM employed 60 persons as of December 31, 1985 and recorded losses of B/.158,000 during the year, or about 20 percent of sales; about 40 of its workers were transferred to IDIAP.

The Governmeat has sold the state-owned farm equipment servizes company, ENDEMA (whose assets are mainly rice harvesters) to a newly created private firm. As with other divestitures, it will receive no subsidies from the Government. ENDEMAemployed about 400 workers oa December 31, 1985. The firm's sale will end subsidies amounting to over B/.1.6 million in 1985, and losses of about a further BI.0.2 million. It is expected that about three quarters of the former employees will be employed by the new firm.

- The Government has sold the domestic airline Aeroperlas and the Contadora Hotel. The new owners of the hotel plan to remodel and upgrade the facility and open two casino operations; these will generate an additional B/.10 million in revenues for the Government over the next five years. In additioa, the Government is committed to selling either the Chiriqui Citrus Company or the Alanje sugar mill by March 31, 1987.

33. The total recurrent saving to the public sector from selling these four enterprises is estimated at around US$12 millioa per year. In addition, the treasury will benefit from any funds received from the asset sales (estimated at B/.4-8 million). The sales would transfer about 1,300 permaneat staff out of the public sector, and a total of around 3,200 at the height of the sugar harvest. Ending of sugar production at Alanje would have additioaalexternal benefits, which could be passed on either to private sector producers as lhigherprofits, or to consumers by reducing the domestic sugar price. Selling the Conradora/Aeroperlascomplex would open the way for the development of the facility as a more attractive tourist destination. Similarly new investment could well be undertaken at the Citrus Company to eahance its efficiency and expand production.

34. Reducing Public Sector Eploy-ent. The Government also intends to reduce the public sector labor force by two percent ±n 1986 (in addition to the closings and divestitures),mostly through attrition. At year end 1985, total public sector employment,including municipal workers, temporary workers and those working on investmentprojects, stood at 152,000, some 11 percent above the total two years before, and about a quarter of total employment in the country. Excluding municipal employees over whom the Central Government has no authority, the workforce was 146,800. A two percent phased-in reduction implies eliminating about 2,900 jobs and would save about US$8 million in wage payments in 1986 and about twice this much in each subsequent year. This should help the reallocationof spending towards capital and non-wage recurrent expenditures,while enabling fiscal discipline to be maintained. The Go!'ernmentintends to continue its program-of reducing public sector employment through attrition into subsequentyears. - 11 -

35. Social Security. The Social Security Agency (CSS) is responsible for various programs: a pension program for almost all formally employed workers, the special pension (Leyes Especiales)program of government workers, and a health program. Social insurance contributionsfor these programs form a significantand rising compooent of labor costs, adding aearly 13 percent to the direct cost of employing a worker. The CSS also occupies a large place in public finance (with cash income equal to nearly eight percent of GDP). In 1982, the CSS had a total cash income of nearly B/.320 million, generated cash savings of B/.52 million and was responsible for nearly one fifth of the total public sector capital expenditure. However, the savings of the CSS fell to B/.18 million in 1983 and then turned sharply negative in 1984 and 1985. This reflected both aa urgent near-term liquidity problem and deeper structuralproblems.

36. The near-term liquidity problems stem from the failure of the Governmentto pay in cash its contributionfor public sector workers and interest obligationson CSS-held governmentbonds, skewed cost-sharing arrangementsbetween the Ministry of Health and CSS for health services, excessive costs in the health system, and the large deficits of special pensions for selected public employees,notably the military and school teachers. The special pensions have unrealisticallylow contributionrates and high benefits, and the program's demographicsmean that benefitswill become unsustainablyexpensive within the next few years. The program for health and the special pensions were in deficit by B/.20 million in 1985. A relativelylow rate of return on its portfolio (6.3 percent in 1985) also contributed to the weak cash flow of the CSS. While the Governmenthas become current on its interest payments to the CSS, it paid only about 54 percent of the B/.142 million due the pensioa subprogramia 1985. Finally, the administrationof the CSS requires improvement;employment increased by 27 percent between 1983 and 1986 (nearly all in 1983/84);internal decision-makingstructures are unclear; actuarialestimates are not routinely made; internal financial informationis inadequate;and the investmentpolicy of the CSS is not sufficientlyflexible to provide maximum returns consistent with low risk.

37. Long-term structuralproblems also plague the pension program of the CSS. First, demographictrends toward an older populationstructure meaa the number of pension recipientsper contributoris rising. The ratio of beneficiariesto contributorshas risen by one-fifth between 1981 and 1984 and it will likely double in two decades. Secoad, the peasion payments are too generous to be sustained. Many retired workers are eligible for pensions virtually equal to their last salary. To maintain the current level of benefits at the system's present level of capitalizationwould require an increase in the contributionrate for workers and their employers from 8.2 percent of salaries in 1984 to 17.9 percent in two decades and rise to 24.3 percent by the end of three. Third, the optional ages of retirementwith full benefits (55 foc meL and 50 for women) are unrealisticallylow in view of Panama's high life expectancy (over 71 years) and health standards.

38. Addressingthe social security issues is one of the most politicallyvolatile and difficult componentsof the reform program. Yet - 12 - addressiag these quickly is essential for improving the medium and long-term finances of the public sector. Siace any reform law must phase in changes gradually,the effects of social security changes will be slow. Nonetheless, reform is vital to slow the rate of growth in wage costs that would otherwise be necessary to fund excessive pension levels; rising pension costs could jeopardizethe employment and efficiencygains made in other sectors and undermine their positive impact on Panama's relative wage costs. The proposed changes are the most extensive reform of the system siace its fouading ia the 1940s.

39. With the guidance of studies fiaanced uader TAL I, the Government iatends to revise the pension system, reform the special pension program, and undertake administrativemeasures to improve the efficiency of the CSS. Reforms of the main pension program include gradually ending the early retirement option, reducing the pension rate, and extending the number of years used to calculate the pension base. Normal retirement for a male worker wil' be at age 60 with a pension of 65 percent of average salary (reduced from the present 100 percent). If he elects to continue working, he could receive a pension increasing by aa additioaal three percent of salary for each year worked beyoad age 60. Anaalgous provisionswill apply to women, whose retirement age would be 55. This reform is being put into legislativeform; the Goverameat expects the legislaturewill consider it by year end 1986. The special pension programs will be transferred to the general budget begilning in fiscal 1987, and will be reformed in March 1987 reflecting Government'sdecision on which groups will continue to receive the extra benefits implied by these almost unfuaded programs. Finally, the management of the CSS has agreed to undertake administrative reforms that will, among other things, reduce the workforce by 120 positions in 1986.

40. In the short term, the administrative measures, the gradual elimination of early retirement, and the reduction of early retirement pensions to the minimum set by law may achieve some savings, estimated to be about B/.50 millioa over the next few years. The balance sheet of the CSS itself will improve substantiallywith the continued cash payment of the Government'sinterest obligations,the contributionsof public workers, and relief from funding of the special pensions.

41. The most significanteconomic benefits are loag-term: the main pension system will again be viable, the threat to workers' savings posed by the integrationof the special pensions into the CSS is removed, and the prospect of redistributingincome away from contributingworkers to the unfunded pensioas is minimized. Also, the threat that pensions of today will decapitalizethe system is reduced. Most important, this means that contribution rates will not have to rise at the same rapid rate as in the recent past to support high pensions, and so Panama's relative wage cost will not escalate and erode its internationalcompetitive position.

42. Public Investment. Overall public investmenthas fallen from aa average of over 13 percent of GDP in 1970-82 to 9.3 percent in 1983 and then - 13 - to an estimated five percent (B/.245million) in 1985. The Government is estimating a similar level (B/.253 million) in 1986, but delays in arranging financing might, as in previous years, hold investmentexecution below planned levels, perhaps to about 4.5 percent of GDP.

43. Investment spending was cut back in 1983-85 primarily in power, where a major expansion of generating capacity was completed, transport infrastructure,where the roads program has been curtailed,and industry, where the state-owned industrial finance company COFINA ceased operations. Major cutbacks also occurred in investmentswith heavy dependenceon domestic financiag. The only sector in which investment has increased is telecommunications, where the state-owned entity INTEL is profitable enough to finance its own expenditures, and where investment has been low relative to the country's needs for a number of years. Areas such as agriculture, health and housing have suffered modest cutbacks.

44. Panama's present investment strategy gives a higher priority to on-going projects, especially those with foreign financing, and to the maintenance and rehabilitation of existing assets rather than major new works. Investment is envisaged to recover slightly to reach B/.350-400 million over 1987-90. About half of public investmentwill be focused on infrsztructure,and about one-fifthwill be devoted to the social sectors, up slightly from 19Y5 levels in recognitionof their importance to low income groups. Both of these features are consistent with the policy orientation being pursued under the structural adjustment program.

45. In 1987, the share of investment devoted to infrastructure will fall relative to 1985 (Annex V). In power, priority is now being given to transmissionand distribution,although it is also planned to raise the Fortuna dam and rehabilitatethe country's thermal generating capacity which should guarantee adequate supply through the early 1990.. The next large-scalehydroelectric plant, either Changuinola or Teribe, is now planned to come into operation in 1998, implying that constructionneed not start until after 1990. As a basic transport network is in place, priority is given to road rehabilitationand maintenance. Several major projects, in particular for a second bridge over the Panama Canal and for a road from Punta Pena to Alairante, are in suspension for lack of funds, and more modest alternativessuch as widening the approaches to the existing bridge subst'tuted. Major port improvementsare underway, which are of great importance to Panama in realizing the potential its geographicalposition gives it as an entrepot for merchandisetrade. A modest (US$5 million) investment is planned in 1987 to rehabilitatethe Panama Railroad, which links the ports. Finally investment underway in civil aviation is to replace the obsolete beacons and other navigationalequipment handed over with the reversion of the canal zone. Telecommunication investmentshave been restrictedduring the last few years, but the Governmentnow seems willing to let INTEL carry out a larger fraction of the works it has programmed,mainly converting the urban telephone network to digital switching, but also expanding the network into rural areas. - 14 -

46. The share of the social sectors in investment has increased since 1985. The Ministry of Education has a modest program of school rehabilitationand expension,with relativelylittle constructionof wholly new schools. The University,which made only very small investmentsin 1985-86,will start a larger program of works next year, mainly related to graduate and scientific courses. Demand for student loans from the Human Resources DevelopmentInstitute (IFARHU),has fallen because of increased economic insecurity. Unlike the Ministry or the University,IFARHU enjoys an independent income from a payroll tax. Its simultaneous existence in a sector with extreme scarcity of local funds for fined investment implies a possible misallocationof resources. The nation's public bealth system is jointly administeredby the Ministry of Health and the CSS. Present investments are mainly in remodelling and small improvements at hospitals and clinics, but larger works are planaed for 1988 and beyond. Major efficiency improvementsare needed if this is to be financiallyfeasible. Other health investmentsmainly consist of IDAAN's water supply aad sewerage expansioa. The entity has ambitious plans, but does not have the financial capacity to undertake them, with water losses around 40 percent and few connections metered. Until this situationis improved, major expansions should be deterred for another few years. In housing, public sector involvement is mainly through two leading agencies, the Natioaal Mortgage Bank (BHN)O-which concentrates on small loans-and the Savings Bank (Caja de Ahorros), while the Ministry of Housing carries out emergencyworks and low income housing construction. The CSS is completing the few remaining houses started under its collectivehousing program, and plans no further direct housing programs.

47. Investment in the social sectors will have a positive impact on low income groups, and levels are budgeted to rise considerablyfrom 1986 levels (though falling somewhat as a proportion of total investment). The major effects on low income groups, however, come through the recurrent budget, where both health and education have received favorable treatment. The Ministry of Educationhopes to be able to include a reasonable maintenance budget in recurrentexpenditure for the first time in 1987. The quality aad availabilityof health services will be directly affected also by the improvementunderway in the CSS, as well as by actions to improve health service administration,now under study for possible support in a future Bank operation.

48. Most of the Government'sinvestment in the productive sectors is in agriculture. It takes the form of projects in forestry, watershed protection and technical improvements,but also research into improvingseeds and other aspects of agriculturalpractice is increasinglyimportant. These programs are strongly supportedby USAID, and are consistentwith the new policy direction being taken by the Government. The same is also true in industry, where the emphasis is on exports and on encouraging small businesses. 15 -

49. While its sectoral priorities seem sound and the investment program is free from major uneconomic projects, the main problem confroatingthe Governmentis how to maintain and evea increase investmentlevels in an era of constrainedforeign resources. The Governmeatwill, if its 1986 financing package is completed as expected,eater 1987 with a much better position than in either 1985 or 1986. But it must continue to implementits policy reforms to increase public savings through expenditurerestraint and enhance its creditworthiness.

50. In 1987-90, the Governmentenvisages annual investmentsof B/.350-400million. With public savings averaging B/.250-280million, the Government could finance as much as 65-75 perceat of its program; an additional 10-15 percent would have to come from commercial banks (in addition to reschedulings) and a like amount from multilateraldevelopment institutions and the remainderfrom supplierscredits and bonds. Ia September 1986, Panama approached its commercial bank creditors, seeking a nilti-year rescheduling arrangement for amortization due in the period 1987-1990. The Government submitted the preliminary outlines of a financial plan for this period, in which it is asking the 180 commercial creditors of Panama to put up new money towards filling its financiag requirement. The details of the financing program will become clearer when the Government finishes these discussions. Having a financial plan in place for 1987 is a condition for disbursemenlt of the second tranche of the SAL II.

Industrial and Trade Policy

51. While Panama's previous policies encouraged the developmentof a large, internationally competitive service sector, they did not promote efficient manufacturing activities directed either to exports or competitive productioa. Manufacturingaccounts for oaly about 10 percent of CDP and employs about the same percentageof the labor force. Productioahas been orieated almost entirely to a protecteddomestic market and consists mostly of constructionmaterial, food processing and light industriessuch as chemicals and furniture. In 1981, manufactured exports were only 2.6 percent of industrial output. Ia the 1960s, growth in manufacturingvalue added was slightly faster than that of GDP; since 1970, however, the sector has lagged behind, with output growing at only 60 percent of the rate for the economy as a whole. Employment in the sector doubled from 24,000 in 1960 to 48,000 in 1970; since then, it has grown slowly to just over 60,000 in 1984. Firms have become increasiaglycapital-inteasive, and many manufacturingplants operate well below full capacity.

52. These trends were consistentwith prevailing iacentives. The usual iacentivemechanism for manufacturiag,tourism aad some commercialinvestment was a system of protection that provided maximum security from foreign competition. Firms usually were granted protectionvia strictly eaforced quotas oa final products or excessivelyhigh tariffs; to guaraatee low-tariff inputs, investorssought a Coatract with the Nation under which the Goverament granted exemptions or reductions from income taxes and import - 16 - duties. Quotas or high tariffs on final products and contractuallyprotected low tariffs on inputs combiaed to produce excessivelyhigh rates of effective protectionon final goods produced for the local market. These incentives have diverted entrepreaeurialand financial resources away from exports or nonprotectedactivities. Exonerationsfrom payment of Import duties on machinery and accelerateddepreciation allowances also favored the intensive use of capital relative to labor.

53. As part of its new program, the Governmenthas embarked upon a liberalizationof its industrial and trade policies aimed at improving competitiveness. The first steps in this process-the substitutionof most quantitativerestrictions with tariffs, the adoption of Brussels Nomenclature,and enactment of certaia customs reforms-were supported by SAL I. The second step in the current program iavolves (a) eliminatingall but 20 quota restrictions,(b) the substitutioaof Contractswith the Nation with a simple industrialregistry, (c) loweriag present tariff levels on existing final products, while restrictiagtariff protectioaon new final products to 20 percent and 30 percent for industrial aad agroindustrialproducts, respectively,aad (d) according greater emphasis to ad valorem tariffs. Many of these actions were embodied in the new Industrial IncentivesLaw passed on March 21, 1986.

54. Conversion of QuantitativeRestrictions Into Tariffs. The vast network of quotas, a maia element of the prior trade regime, will be virtually ended under the program. In mid-1983, the Government's survey of all forms of quantitative restrictions produced a list of 457 8-digit tariff categories; 368 of these were eliminated in 1983. Progress slowed in 1984-85, however, as the more politicallyentrenched quotas were reached. Then in 1986, the Government uadertook as part of its new program the removal of 19 quotas in April aad another 50 in June, leaving oaly 20 in place. The remaining quotas are concentrated oa agricultural products. The Goverament believes they are necessary to protect against imports in areas (such as milk and sugar) where internationalprices are highly distorted, products on which an import tariff cannot effectivelybe levied because of prior Contractswith the Natioa (such as oils, timber) and a few industries of particular politicalsensitivity (salt and fishmeal).

55. Contracts with the Nation and the IndustrialRegistry. Under the provisions of prior legislation, industrialists could sign Contracts with the Nation which afforded them exemptionsfrom tariffs on inputs and tax payments for periods of up to 20 years. (The Contracts,however, did not provide guaranteesof tariffs or quotas oa the final product.) Nearly all major industrialfirms used this mechanism to secure favorable tariff treatmentfor iaputs and preferentialtax treatment. The contracts eventually became part of the documentationbanks required to extend firms credit. Nonetheless,the contractshad several drawbacks: they inherently involved administrative discretionsince they were issued on a company-by-companybasis, reflectiag the negotiatingpower of the investor rather than the rate of return to the - 17 -

project; the contracts increased dispersion in the tariff structure; they exempted firms from payment of any minimm tariff; and they provided continuousfiscal benefits for selected industrialenterprises. 3 /

56. As of the date of enactment of the new IndustrialIncentives Law, a total of 570 industrialfirms (most of the largest firms) had contracts in force; about 75 percent of these will expire by 1990 and about 90 percent by 1993. The balance are mostly contracts that have been granted for 20 years to investment projects located in less developed areas. While the existing contracts provide for tariff exonerationsfor raw materials, equipment and machinery,with the abolition of quotas, protectionon fiaal products is subject to the tariff reduction schedule which began to be applied on August 2, 1986.

57. While existing contractswill be honored, the new law abolishes the practice of Contracts with the Nation for the future. The Government has instead created an industrialregistry, and firms eligible for the benefits may simply sign up at the Ministry of Commerce and Industry and obtain the benefits for ten years. Benefits include exemption from taxes and tariffs on imported inputs for a limited period. The registry eliminatesthe administrativediscretion and concomitaatlegal fees involved in the contract system, and opens the system up to smaller firms which previously had difficulty in obtaining Coatracts. As a second modification,the registry will extead exemptions on payment of the minimum tariff only uatil 1990. While firms caa register under the terns of the new law for new products, they will be subject to any subsequentlegislatioa should the Government elect to change the tariff and tax systems to provide these incentives directly rather than through the IndustrialIncentives Law.

58. Maxi-m and Minima Tariff Leweis. The overall level of protection in Panama is low by Latin American standards. The uaweighted average level of tariffswas estimated to be 30 percent in 1985, and when weighted by the value of imports, the level was estimated to be only nine percent. But these figures are misleading;because averages disguise the high levels of protectionafforded virtually all import-substitutionindustries and the low or zero tariffs on many other imported products not produced in the country. There is thus a huge variation in protection,as tariffs ranged from zero to 385 percent; of 19 major import categories, 10 had maximum tariff levels in excess of 100 percent. For the whole tariff code, the standard deviatioa around the 30 percent mean was 33 percent.

59. Aside from its distortingeffects on resource allocation,the tariff system is highly regressive, since many products consumed by the relatively wealthy are imported free of duty or at relativelylow rates, including notably automobiles (26.3 percent on the first US$5,600), or video cassette recorders (7.5 percent),and air conditioaers(27.5 percent). On the other hand, products of greater importance to the relatively poor,

3/ This mechanism is not limited to the industrialsector; other laws provide for similar contracts and benefits to firms in agriculture,retail trade, and tourism, although the number of such contracts is relativelylow. - 18 - includingmany food products and textiles, have ad valorem equivalent protectioncommonly ranging from 50 to 200 percent; local industriessupply these to the domestic market at prices well above internationallevels. According to 1983 data, food products, domestic soaps and detergents, textiles, clothing,cemeat, and other building materials were sold on the local market anywhere from 14 to 114 percent above the landed import price, while prices for luxury goods are so competitivethat Panama attracts shoppers from throughout the Region.

60. The new Industrial IncentivesLaw will reduce these high levels. Effectiveupon passage of the law, aew products receive a maximum of 20 percent nominal tariff protection,except for agroindustrialactivities, which to compensate for higher input costs will be eligible for up to 30 percent protection. Existing industrieswith higher tariffs will have their tariffs reduced in five equal steps to a maximum of 60 percent over five years. The only exceptions are 18 products which will have maximum tariff protectionof up to 90 percent; these amount to less than one percent of products currently imported and represent about five percent of output. As with the remaining quotas, these exemptions reflect a variety of special circumstances;for example, the Governmentwishes to protect regional producer interests in the case of tomato products. The first tariff reductionof 20 percent occurred on August 2, 1986. The new law also enacts a minimum tariff of three percent on all imported inputs aad capital goods, many of which were previously duty-exempt. In addition, the Government is committed to systematicallyreviewing protectionafforded all industry,and will seek to reduce excessive levels.

61. Specific and Ad Valorem Duties. The Panamaniantariff code has historicallyrelied on specific duties, which have been periodicallyadjusted upwards, leading to variable and unpredictablerates of nominal protection and lack of transparency. The Government is reluctant to abandon specific duties because it is concerned that importers may underinvoicetheir products to reduce payment, a problem accentuatedby Panama's dollar curreacy and entrepot role for an abundance of traded goods. Nonetheless,the Government has decided to apply ad valorem, rather than specific duties, for new products. Moreover, it will not raise specific duties for existing products, and will reduce them by the same proportion as the reduction in overall nominal tariffs. Since the customs authoritywill charge whichever duty provides the greater fiscal resources, increases in the general world price level should lead most specific duties to fall eventually below their ad valorem counterparts,eventually providing for a more modern tariff system. Moreover, the Governmentand the Bank are discussing the implementationof GATT-like antidumpingand safeguards procedures,which should allay traditionalfears of underinvoicingto escape ad valorem duties.

62. The total effect of these measures will be to reduce the currently high level of protectionafforded a select group of industries. The maximum tariff will drop from 385 percent to 60 percent (except for the 18 products - 19 - that will have tariffs up to 90 percent). The unweighted average tariff will fall from 30 percent to 26 perceat. More important,the degree of dispersion in the tariff system will be cut in half; the average deviation from the mean will fall from 33 percent to 15 percent. These numbers understate the distortion reduction for several reasons. All new productioa will have a maximum tariff of 20 perceat (or 30 percent if they are agroindustrial). The coaversioaof quotas to tariffs will ensure that almost all industrieswill have only levels of protection explicitlyprovided under the tariff code. The implied gradual phase out of specific duties associated with increases in the world price level will enhance the efficiency of the tariff system. Fiaally, the terminationof the Contractswith the Nation will contribute markedly to a more efficieat tariff system by reducing administrative discretionand making iacentives transparent.

63. Reducing the implicit subsidies to industry through the tariff system implies sustained industrialgrowth as investmentand labor resources are channeled toward more economicallyappropriate activities rather than to inefficientactivities with high levels of protection. Real incomes will increase through lower prices. Also, to the extent that high tariffs affect items that absorb a large share of expendituresof the poor, low-income groups will benefit directly; perhaps more importantly,the poor will benefit from more rapid growth in job opportunitiesin efficient import-substitution and export industries.

Employment Policy

64. Panama has high urban wages in comparisonwith neighboring countriesaad even with some of the newly industrializingnations. One of the reasons has been the high wage structure of the former Canal Zone, which in 1983 had an average wage three times that in the rest of the Republic. The average real wage level, however, has remained about constant since 1970, while wages in the Canal area rose in real terms by over 40 percent. The stagnationof real wages is presumably attributableto the increasinglyhigh level of unemployment. Open unemploymenthas risen from 6.4 percent in 1975 to 9.7 percent in 1983 and 11.8 perceat ia 1985, a trend which is likely to continue because of demographicpressures. Concealedunemployment may also be increasinglyprevalent. That wages have not fallen further in response to this level of unemploymentis probably due to the dominant influenceof the high wages in the Caaal segment of the labor market and the rigid structure of the urban labor market in the non-Canal segments.

65. The market outside the Canal is unduly rigid because of Panama's Labor Code. Effectivein 1972, the Code made important advances in protecting employee rights, and is widely regarded by employers as important in maintaininggood labor relations. However, the Code, which was expressly designed to strengthen the position of labor, introducedrigidities into the labor market, increasing the costs of dismissal significantlyand thus restrainingemployment creation. The Code made it difficult to reward productivity,to pay for piecework,or to vary the workforce iLnline with economic need because of the high indemnitiesto be paid in case of dismissal. The Code also segmented labor markets. While it applies in - 20 - principle to all employed workers, the most restrictiveof its provisionsare largely confined to the unioaized sector of the labor force, which includes about 100,000mainly urban and industrialworkers, about 14 percent of the labor force.

66. In recognitionof these problems, the Governmentamended the Code in 1976 and 1981; a further reform was approved by the legislaturein March 1986. This recent law has several substantiveprovisions. The first is to expand the definition of "small" enterprisesto include retail businesses with six to ten employees. The main importanceof this is that such enterprisesare, under the 1981 reform, exempt from the stabilityprovisions of the Code (Articles 211 and 212), under which employees may not be dismissed at the discretionof the employer. Enlarging the definitionof small" retail enterpriseswill decrease the proportion of the workforce covered by the Code by about six percent. Taken together with the existing exemption of firms producing solely for export and the exemption of seasonal workers in agriculturalenterprises from the stability regime, the March 1986 reform will help the most vulnerable and labor-intensivebusinesses to achieve more flexibilityin labor use.

67. The second change concerns overtime. In agriculture,livestock, export-orientedand small enterprises,the reform allows the employer to require his employees to work overtime,subject to daily and weekly limits. Moreover, the overtime premium is fixed at a flat 25 percent. This provision replaces higher rates under which overtime pay depended on the shift worked, with special premia for weekends and holidays.

68. Flexibilityin the use of labor has also been enhaaced by changes to the articles o2 the Code governing piecework. The reforms open up to all employers the possibility,hitherto restricted to agriculture,of establishingproductivity pay schemeswithout the explicit agreementof the trade unions. With such schemes employers avoid the effects of the old Article 159 of the Code, under which salaries,once enhanced by productivity bonuses, could never subsequentlybe reduced. Though potentiallyimportant, this change seems unlikely to have a rapid effect on the Panamanianlabor market, as productivityagreements are complex to design and slow to put into force.

69. The reforms also allow work at home on a subcontractingbasis, placing it outside the scope of the Labor Code. Another change is the extension of the probationary period for new employees from two weeks to three months. This should have a positive effect on youth employment,as it allows for a realisticperiod of training and familiarizationduring which an employer runs no risk of being locked into employing an unsuitableworker.4/

4/ Another (less consequential)change was to increase slightly the payments to be made to workers on dismissal,by removing the age qualificationfor receiving long-servicebenefits. However, its effect seems likely to be small, since less than one percent of the amount paid out in court settlementsof labor disputes, and only about 2.5 percent of the amount paid out in individualsettlements, involved such long-servicebenefits. In many collectivebargaining agreements, these age limits probably had already been waived by mutual agreement. - 21 -

70. The Ministry of Labor has also changed the administratioaof the Code with a view to reducing abuses. Two administrativechanges are embodied in the 1986 reform: first, the assets of small businesses are now protected from sequestrationby employees during the adjudicationof a labor dispute; and second, aa appeal mechanism is instituted in labor court cases involving sums of more than B/.2,000. Furthermore,to speed up the decision process in adjudicated labor disputes, three new labor courts are to be set up in 1986, and the Minister of Labor has uadertaken to resolve within 60 days all cases where labor is being dismissed for economic cause.

71. The recent trend of settlements of labor disputes has been towards more out-of-courtsettlements (43 percent ia 1985 as against 31 percent in 1983 and 21 percenc iA 1979-82). Since 1982, moreover, the proportioaof adjudicatedcases settled in favor of the employer or resulting in the worker withdrawing his case has risen from 43 percent to 79 percent ia 1985. While such changes in the interpretationof the law are reversible,they indicate that the former bias of the system against employers has recently been decreasing.

72. Overall the modificationof the Labor Code has made a modest contributionto the economic reform program, though it has not yet resolved the high cost of dismissal facing medium and large firms in the organized sector. Even so, it has proved to be highly controversial,occasioning a 22-day general strike and other protests. The reform certainly will benefit more small businesses and introduce some flexibilityinto the labor market. The effects of other aspects of the Code (such as productivity-basedpay schemes) could also be significant,but will depend on the manner in which employers and workers take advantage of the new prov'isions.

AgriculturalPolicy

73. During the 1970s, the agriculturalsector was the least dynamic of the Panamanian economy, with average annual growth from 1970-72 to 1980-82of only 1.7 percent, compared with 5.7 percent for noa-agriculturalGDP. During the early 1980s, agriculturalproduction continued to grow slowly, at around 1.5 percent. This slow growth occurred despite heavy protection and the investmentof substantialpublic resources, both in terms of direct subsidies and personnel.

74. Ia the early 1970s the Government undertookan ambitious land reform; over 16 percent of Panama's laad changed haads in five years. The lending of the state-ownedagricultural bank was increasedrapidly, primarily to land-reformsettlers. The Government also made major investments in three - 22 - new sugar mills, took over a fiaaaciallyweak citrus firm, and opened new state enterprises for bananas and other export crops. It also financed progressivelyhigher support prices for an increasing range of grains, especiallyrice and maize. Unfortunately,these actions resulted in many unrecoverableloans, uneconomicoutput expansioa, an inflexibleprice support system, poorly managed state enterprises,and a bloated state sector. In 1985, the total number of public employees in the sector was nearly 9,800, about seven percent of the total agriculturallabor force. The 1986 budget for the Ministry of AgriculturalDevelopment (MIDA),and the autonomousand semi-autonomousagencies operating in the sector, is about B/.155 million, nearly one third of agriculture'svalue added.

75. There is no agronomic reason why considerablyhigher agricultural growth--perhapsas much as double historical rates--cannotbe reached. Such a goal would require that productioabe based more on Panama's long-term comparativeadvantages and less on protectionagainst foreign competition. Because Panama's arable land is usually not very fertile, these advantages seem to lie principally in: (a) forestry in the central mountain areas, based on reforestationwith fast growing pulp species; (b) dual purpose semi-intensivecattle raising in the ceatral and western coastal plains and foothills; (c) where good land is available, small scale, labor-intensive production of tropical export crops (e.g., coffee and cacao), and of temperate zone vegetable and fruit crops in the upper altitudes; and (d) equally small scale, labor-intensivegrowing of selected vegetable and fruit crops with irrigationnear the rivers of the central provinces.

76. The Governmenthas recogaized that this developmentstrategy requires a fundamentalchange in agriculturalpolicy to orient the sector towards higher productivityand output, to increase productive employment, to reduce the costs of basic foodstuffs,and expand exports. The Government has decided to take specific measures to achieve these goals, including (a) new agriculturallegislation to more clearly set forth public objectivesand iacentives;(b) revising the role and scope of public institutionsin agriculture;and (c) price actions to reduce distortingsubsidies and protection.

77. AgriculturalLegislation. The Government has uadertaken a sweeping revision of the Agricultural IncentivesLaw which had encapsulatedthe philosophy of past agriculturalpolicy. According to the former law, imports of foodstuffswere quantitativelyrestricted and annual percentage targets were establishedfor their replacementby domesticallyproduced goods. Price controls on a basic food basket were maiatained (though often at high levels relative to internationalprices), and the law permitted and encouraged state interventioain factor and input prices, capital markets and agricultural production. New legislationpassed in March 1986 gives greater emphasis to efficiencyand comparativeadvantage as guiding principles of agricultural policy, and removes mandated quantitativegoals of self-sufficiencyfor import substitutionin the former law. This is an importantchange in itself, but to be fully effectivewill have to be accompaniedby appropriate institutionalactions (paras. 78-80) and changes in pricing and trade policy (paras. 81-87). - 23 -

78. Public Sector Institutions. The institutionalreforms in agriculture focus on closing or divesting inefficientpublic sector activities and redefiaing the role of the AgriculturalMarketing Institute (IMA) in pricing and marketingpolicy. As outlined above, ENDEMA, ENASEM, and the Las Cabras sugar mill of CALV are now being closed or sold, and other agriculturalentities, namely the Chiriqui Citrus Company or the Alanje sugar mill, are slated for divestiturein 1987. In addition to the decrease in subsidy cost to the treasury, these changes can also be expected to produce a more efficient allocation of resources. The closure of the Las Cabras mill reduces the need for sugar sales in the extremely depressed world market, and thus the need for cross-subsidiesfrom domestic consumers. The divestiture of ENDEMA will eliminate the top-heavy administrationof the enterpriseand allow a commerciallyviable enterpriseto perform the harvesting services under the discipline of the market; the provisionof more timely and improved services tD rice growers could well increase productivityin the trop. The divestitureof Chiriqui Citrus Company may well lead to improvementsin productivitysufficient for the enterprise to be more profitable.

79. A second set of institutionalreforms concerns IMA. In 1984-85, IMA supported the domestic prices through direct subsidies from the treasury worth B/.0.6 million and cross-subsidiestaken from the profits of importing maize under quota estimated at a further B/.1.1 million. These subsidies were used to support the price of rice, salt, oaions, beans, and domestic maize and sorghum. All of these products were under some form of quota restriction.

80. The Government annouaced on August 1, 1986 that IMA will restrict its future activitie. to warehousiag,price and market information,setting standards, and exceptionalmarket interventionsin times of national emergency. IMA will not otherwise purchase or hold inventoriesof its own. Most important,it will receive no further transfersnor increase its capitalizationor net borrowing. IMA has sold off virtually all its rice and salt inventoriesand is now leasing many of its warehouses. These policies will allow the Government to provide for coaceras over price stabilityand food security (since IMA's price and production analysis will be used in setting future tariff rates) while markedly reduciag the price-distorting effect of IMA. When coupled with the new trade and price policy discussed below, these policies will introducenew flexibilityinto agriculture and improve efficienciesin resource allocation.

81. AgriculturalTrade and Pricing Policy. The principal objectiveof the Government'snew trade and pricing policy for agricultureis to reorieat price signals and incentivestoward areas where new o-atputcan expand real incomes and employment. The previous pricing policy of achieving self-sufficiencyhad been oriented towards providingincentives for certain basic products (rice, mai-, beans and sugar), the further production of which would be an economic burden. To subsidizedomestic consumption,price controls were imposed and restrictionsplaced on exports of other products (notably,beef and coffee, and, until recently, fishmeal and cocoa). This has led to the over-concentrationof resourcesin areas where Panama's - 24 - comparative advAntage is weak while providing disincentives for producing efficiently for domestic and export markets. Support prices have been high, especially for rice and maize, and this has encouraged overproductionand given an incentive for contraband imports from neighboring countries. To finance its losses on rice, IMA used its monopoly profits on imports of maize, and to a lesser extent, onions and beans. Since mid-1982, however, these profits have nDt sufficed, and IMA's financial situationworsened considerablydue to the large volume of surplus rice accumulated.

82. A new pricing and trade policy to emphasize eff±ciency over self-sufficiency,therefore, implies bringing domestic prices closer to internatiDnalprices and less restrictivetrade measures. Concom'tantly,the new policy entails a reduction of the state's role in agriculturalmarketing, and a greater reliance on market forces. This does not mean a complete disappearanceof the state's role in agriculturalpricing; but it does imply changing both the price and tariff regimes.

83. The domestic price support system will be effectively eaded by the cessation of IMP.purchases; the Government has already ended its purchases of rice, onions, salt, and beans; maize and sorghum purchases will be ended by February 1, 1987, the date the current crop-pledgingsystem for these commodities arranged through the BDA is set to expire.

B4. In addition, the Governmeat has removed controls oa domestic prices of most agriculturalproducts at the retail level, a major chaage in Panama's agricultural price regime. In June 1986, the Office of Price Regulation ended price controls on rice, sugar, coffee, milk, pork, chicken, live fowl, cream of cereals, wheat flour, juices, dried and fresh vegetables aad pulses, maize, butter, shortening, margarine, mayonnaise, honey, fish, cheese, salt, and canned tomatoes. In September 1986, the Government removed controls on edible oils, eggs, and all beef cuts. These product categories embraced over 600 discretely specified products, and their liberation from price cow.-rols is expected to introduce more flexible prices to consumers and more accurately transmit price signals and incentives to producers.

85. The import regime has also been changed. The quotas regulating imports of IMA-supportedproducts - maize, sorghum, onions, beans and lentils - as well as on certain other commodities,such as butter, butter oil, tallow and margarine. were replaced by specific tariffs effective August 1, 1986. Tariffs on the forme-ly price-supportedproducts were set at levels designed to avoid sudden farm price declines in mid-season, based on latest estimates of probable frontier price of competitive imports. This implies tariffs equivalent to 133 percent of the CIF import cost for rice, 88 perceat for maize, 74 percent for sorghum, 25 percent for onions, and 20 percent for beans.

86. - To bring prices closer to international levels for the next crop year, these tariff levels are to be reduced on Februiry 1, 1987 by 22 percent in rice (to a 104 percent ad valorem eluivalent), 18 percent in maize (to 66 percent), seven percent in sorghum (to 66 percent), and 50 percent in beans (10 percent). Since internationalprices of rice are especially - 25 - volatile,the Governmenthas agreed to review rice tariffswith the Bank in . the event that & sharpprice rise mitigatesthe intendedeffect of the tarife reductions.

87. Finally, the Government inteads to offer greaterincentives to beef producersto expand productionand exports. Not only were domesticprice controlson the more expeasivecuts of beef liberatedin April 1986, but all price controlsincluding those on live animals were removedon October 1. This, togetherwith new land availablefrom crops currentlydevoted to high-costproduction of rice, maize, sorghumor sugar cane, is expectedto lead to increasesin qualityand quantityof beef production.

PART III - TIE PROPOSEDLOAN

88. The proposedloan would supportthe Government'sstrategy of structuraladjustment and economicrecovery. The loan was preparedduriag an intensivedialogue with the Government,reaewed in early 1986,and in close consultationwith the IMF. It was appraisedin April-May1986 and negociationsheld in Spptember1986. The Panamaniandelegation was led by Dr. RicaurteVasquez, Minister of Planningand EconomicPolicy. Annex III containssupplementary loan data.

89. The proposedloan of US$100 millionwould meet about 10 percentof Panama'stotal gross externalcapital requirements for 1986 and 1987. The loan would be in two tranches;the first of US$50million equivalent would be eligiblefor disbursementupon effectivenessof the Loan Agreement,and the second,also of US$50 million,some six months later. Proposedtranching will enable the Bank to review the implementationof agreedpolicy measures and providethe Goveramentwith sufficienttime to undertakefurther difficultreforms.

90. The specificactions supported by the proposedSAL were reviewedin detail during appraisalaad are summarizedin Annex IV. These include actionsalready taken by the Governmentin each of the four main policy areas addressedby its program,which are actionsthe first tranchewould support.

ActionsAlready Undertaken

91. PublicSector Efficiency. To increasethe efficiencyof the public sector,the Governmenthas alreadyundertaken the followiagactions: (a) closureof ENASEMand sale of ENDEMA.,Las CabrasSugar Mill, ContadoraHotel, 2nd Aeroperlas;(b) beginninga programto reduce the publicsector workforce by approximatelytwo percentby year-end;(c) cabinetapproval of a new draft law to restorefinancial viability of the socialsecurity pension system by eliminatingearly retirement,lengthening the pensionbase averagingperiod, loweringthe pensionrate, changingthe pensionrate for specialgroups, and transiferriagthe financingof the specialpeasioas to the nationalbudget; and {d) agreementwith the Bank on the publicinvestmeat program for 1987. - 26 -

92. Industrial Policy and Trade Liberalization. In March 1986, the Goverament passed the Iadustrial lacentives Law described in paras. 53-63 above, under which Contracts with the Nation were replaced by the Industrial Registry and a first rouad of tariff cuts were made on August 1, 1986. All but 20 quota restrictions were removed by Juae 30, 1986, and tariffs substituted for them.

93. Labor Policy. The Goverament passed in March 1986 amendments to the Labor Code, described in paras. 66-72.

94. Agricultural Policy. In March 1986, the Government passed the Agricultural Incentives Law, described ia para. 77. In addition, the Government sold the agricultural enterprises noted in para. 32. Finally, the Government (a) liberalized the retail price of most food products; (b) ceased purchases and storage of rice, onioas, beans, salt and other products; (c) replaced quotas and embargoes on these products (except salt) with tariffs; (d) sold IMA's inveatories of rice, onions, and half of its salt; (e) announced that there would be no future export quotas oa beef; and (f) anaounced the aew role for IHA to limit its activities to warehousing, price iaformation, analysis aad emergency stabilization.

Second Tranche Actions

95. Besides continuing its stabilization and adjustment programs, several further actions are to be undertaken by the Goverament by various dates up to April 1, 1987, or prior to the second tranche. These will include further major reforms to improve public sector efficiency and agricultural policy.

96. Public Sector. The Government will (a) complete the two percent reduction of the public sector workforce (i.e. about 2,900 jobs) ia caleadar 1986; Cb) complete the sale of the Chiriqui Citrus Company or Alanje sugar mill; (c) make fully effective its reform of the maia CSS pension scheme; (d) implement the new special peasioa scheme and; (e) improve the efficiency of the CSS, including reducing administrative staff by 120; and (E) have in place a financial plan for 1987.

97. Agriculture. By April 1, 1987, the Government will undertake further actions, including: (a) the revision of IMA's charter to limit its role formally; (b) lowering the implicic support prices for rice, maize, sorghum, and beans through lowering the tariffs by specified amounts; (c) ending the BDA crop-pledging system to finance maize purchases; and (d) the sale of the remaining salt inventories.

Economic and Social Prospects with the Program

98. The Government's structural adjustment efforts will position the economy to renew growth after four years of aear-stagnation, relieviag the crisis of public fiaanLe and alleviating poverty. As a small, trade-dependent country, Panama relies heavily on the iaternational economy. The program will have maximum benefit for Panama if growth of the OECD economies is strong, the Latin American region recovers, and the price of oil - 27 - and iate.est rates continue to fall. Moderate growth of two perceat is forecast for the industrial economies in 1986 with a mild acceleration to three percent for the rest of the decade; and the price of oil, after its abrupt fall in 1985-86, is projected to rise only slightly in real terms.

99. The structural adjustment program would permit Panama to take advantage of this envirooment,and attain a more rapid sustainable rate of growth toward the end of the decade. The reforms in public finaace will have multiple, mutually-reiaforcingeffects: divestituresand closings reduce subsidies as well as recurrent costs by reducing inefficienciesand excessive employment; reforms in social security uill aot only have a sustained impact on reducing public expeaditures,they will-over time-increase labor generation by moderating the rise in the cost of labor. Together, these efforts imply a sharp reversal of negative public savings, so that even after paying the onerous debt service, more resources would be available for investment. Taken together, these would permit greater efficiency and a higher level of public iavestment,which could interact to increase productivityand output.

100. Efforts in industrial and labor reform would also promote growth. Reducing levels of effective protection through tariff reductions and eliminatingnontariff barriers will alter price signals for producers, change profit rates among industries in favor of internationallycompetitive activities,and so stimulate export production and more efficient import-substitution. This will induce capital to flow from inefficient to more efficient industries,while the reforms in the labor market will permit more flexible allocation of labor resources. Firms, especially small enterprises,the retail trades, and exporters, will be able to avail themselves of new provisioas in the Labor Code. These permit rewarding productivity,facilitate employers hiring workers with reduced fear of being locked into rigid contractualobligations, and reduce, if oaly partially, the segmentationof the labor market between a relatively highly paid, tenured minority of workers and the rest. By restrainingprices and labor costs, these changes should also help enhance the competitivenessof the service sector. The interaction of tatesereforms could help channel private investmentand labor into internationallycompetitive, labor-iatensive sectors with high growth potential.

101. The reforms in agriculturewould also stimulate growth and employment. They would introduce new elements of flexibility and efficiency in resource allocation. As IMA withdraws from its former role as price setter, internationalmarket forces will assume greater importancein discipliningdomestic prices and production. As with industrialists,farmers will face relative prices that will reward them for producing internationally competitive crops and compel them to adjust to changing world price signals. This will leave IMA free to concentrateon the functions of managing its warehouses efficiently and providing producers with price and market information,and should progressivelyallow output growth in the sector as it escapes from the constraints imposed by the small size of the domestic market. Since Panama has no control over its currency or its exchange rate, and it has fully tapped its borrowing capacity, the only way it can grow in a sustainable fashion is through productivity-enhancingreforms such as these. - 28 -

102. Impact oanthe Poor. The program can also be predicted to have a positive impact on the real incomes of low-income groups over time. The most important factor will be the increased employment associated with aew growth. A more rapid growth in employment would also occur because labor costs would be lower than in the abseace of the program: the social security reform will mitigate the rise in social insurance contributionsof employers and workers, the labor reforms will make it attractive for employers to increase their employment at the margin, and, over the long run, cheaper food and coasumer goods will reduce upward pressure on wage rates.

103. IQ addition to employment effects, low-income groups will beaefit directly from lower prices of food and manufacturesbrought about by the shift from the policy emphasis on high cost self-sufficiencyin agriculture to aa emphasis on the efficiency of productionand the tariff reform in industry. In the past, policy had emphasized import-substitutionin many products that absorb the bulk of expendituresof the poor: processed food and clothing. This meant that key basic needs items had high tariffs and usually a correspondinglyhigh price in the domestic market while luxury goods had low tariffs aad prices. The tariff reform will place a downward pressure on domestic prices of processed food products and many categories of clothing. Fiaally, ensuring the financial viability of the social security system will aid the increasing proportion of old people in the population;if the Government were to fail to take corrective measures, a great many lower-paidworkers might reach retirement with inadequate pensions or savings and little prospect of gainful employment.

104. Although the net distributionaleffects of the program are expected to be progressive,unavoidably some groups will be hurt. As inefficieat sectors contract, some workers will become dislocated and some firms and farms will go out of busiaess. Some social security beneficiarieswill suffer lower pensions than they had expected. Besides attempting to maximize the growth opportunitiesgenerated in the program, the Government has sought to mitigate the problem by reducing public employment through attrition, by gradually changing relative prices over several years or, in the case of social security, phasing in the new pension levels over five years while protecting the acquired rights of potential beneficiariesclose to retirement. In the case of industry, tariff reductions will occur over five years; in agriculture,the price reductions will occur in the second year of the program. The fact that the Government is aanouncing these actions in advaace gives farms, firms, and workers an opportunity to adjust.

105. All of these actions should enhance the country's creditworthiness, which in Panama is mainly a fiscal matter in the short term, but in the longer run depends on the growth of the productive sectors of the economy.

Economic Projections: With and Without Adjustment

106. The expected economic effects of the program can be described quantitatively by comparing scenarios of the country's developmentwith or without a program of adjustment. Ia both cases a relatively supportive - 29 - internationalenvironment is assumed of the kind outlined in para. 98. The main features distinguishingthe scenarios involve differencesin the level of public savings and investment,growth in agriculturaland industrial production and exports, rates of job-creationin the economy, and external financing.

107. Both scenarios recognize that, in the absence of a central bank and powers to independentlyexpand domestic credit to the public sector, the Government'sinvestment resources are closely constrainedby its own immediatelyavailable savings and foreign resources. In the "without program scenario, the Covernment does aot curtail public sector consumption but relies on compressed levels of public investment to contain the overall public deficit. External resources are limited to possible reschedulings. As a result, the shrunken public investment program fails to recover, hampering growth.

108. Growth in GDP is considerablyhigher in the "with-program"scenario than in the "without" case, 4.1 percent annually compared to 2.1 percent (Table 1). The driving force of the "with-program"scenario is the higher investment levels attributable to improved public savings, increased foreign and domestic private investment in agriculture and industry associated with the improved business climate (including clearer rules of doing business and improved debt management), aad expansion of aontraditional exports and services. The rate of job-creatioa accelerates with the impetus of labor reform and social security; unemployment even with the program will probably still rise slightly because of demographicpressure, perhaps to 13 percent in 1990, but not nearly as high in the absence of the program, where rates might easily approach 16 percent.

109. The improvement in public savings associated with the closings/divestitures, social security reforms, and improved operation of public enterprises has direct implications for the growth of the public sector, public investment and debt management. The real public sector wage bill declines by 0.5 percent per annum reflecting the contraction of Government employment, compared to a growth of 1.2 percent in the absence of a strong program. Public sector employment in the reform case is assumed to decline by two percent annually over the 1986-88 period; without this policy public employment is assumed to rise by two percent for the next three years (after which any further increase is financially not possible). The squeeze on the public investment program abates under the program, allowing for much needed new investment in productive infrastructure and human resources; this in turn increases the productivity of private sector investments. Gross national savings grow at more than twice the rate of the without-program scenario, fueling the higher levels of total investment and growth ahown in Table 1.

110. Measures of creditworthiness also improve as total debt as a share of GDP falls to 54 percent and the ratio of debt service to public sector revenues falls also. This debt service ratio, although still high as a share of public sector revenues, begins to fall toward the end of the decade as reschedulings provide debt relief and higher public savings permits some - 30 -

Table 1: SELECTEDECONMaC NDICATORS

ActUal With Program - Lthout Program 1980-1985 1986-1990 1986-1990

Amal Crowth Rates (constant 198S prices)

GDP at Malket Prices 2.0 4.1 2.1 ConsumLp 3.6 2.9 2.4 GCross Dome.tic Inwstuzet -7.4 7.3 1.1 Esports of GElS -1.5 4.5 1.7 Iports of CUPS -6.0 3.4 1.9

Agriculture 2.5 3.0 2.4 Tndus,try -0.2 4.6 2.1 Gvernmnt Services 5.4 -0.5 1.2 3thar 1.6 3.9 2.2

Other Indicators

Investment as percent of CDP 23.8 18.9 17.9 PubLis Invustuman as percent of GDP 7.6 5.4 4.3 Public Sector DeficLt as percent of GDP 5.8 0.9 1.1 Public Sector Outstand External Debt as percent of GDP C(ed of period) a/ 67.4 53.9 63.8 Interest Payamets an Public External Debt as percent of Publle Sector Rswenuas (end of period) sI 15.0 15.4 16.2 Seryics an Public Eaternal Debt as parent of Public Sector RIvens (end of period) *l 28.2 22.4 24.3 aI Include- flow. and payment. a*socoated with presumd rescheduLing to fill gross borroving ruquir.mentg eclcudeslU. - 31 - amortization. Interestpayments as a share of public sector revenues (the critical indicator of creditworthinessin the case of Panama) holds steady at 15 - 16 percent in both cases; in the reform case this reflects a slightly lower interest rate on a slightly higher amount of external credits borrowed over the period.

111. Growth performancewith the program is much improved in part because exports become a leading sector, permittinghigher rates of imports aad consumptionthan would occur without the program. Exports grow by 4.5 percent on average in 1986-90 with the more favorable policy eavironment. Shrimp, meat, maaufacturers,and other nontraditionalgoods have higher growth rates among merchandiseexports; in additioa, nonfactorservices, including travel, could grow at slightly higher rates in the program's supportiveenvirooment. These permit much higher rates of growth for imports, 3.4 percent annually compared to 1.9 percent.

Benefits and Risk

112. The main benefits of the SAL programwould be the expected reorientationof economic activity and incentivestowards areas of Panama's comparativeadvantages in agriculture,industry and services,and the redirectionand strengtheningof public agencies towards supporting these activities. The investmentclimate would be improved and incentivesprovided for the private sector to invest in areas of Panama's comparativeadvantage. This should pave the way for sustained, broadly-shareddevelopment, and would increase job opportunities,resource inflows, aad coatributeto alleviating poverty.

113. A main risk is the internationalenvironment: if the international ecoaomy weakeas or becomes more protectionist,Panama's exports will grow less rapidly, Canal traffic will fall with slower world trade, and Colon Free Zone activity will drop. The main domestic risk is that the Governmentmay not coasistently follow up the program and make it credible through clear announcements and effective administrative actions. This applies especially to the social security reforms, which will require bold political leadership as well as competentadministrative direction to carry through successfully. It also applies to the later phases of the reductions in industrialand agriculturalimport tariffs. There is, however, some recognitionthat the Government's strategy represents the best alternative to continued stagnation and increasinguaemployment. The program, including budgetaryand public investment targets, would be closely monitored and release of the second tranchewould be conditionalupon agreed actions beiag taken (paras. 96 and 97). In the short-term the continuity of the adjustmentprogram would also be reinforcedby the IMF standby arrangementwhich runs until the end of March 1987. Moreover, the Government'ssatisfactory performance under the program is a conditionfor release of the remaining tranches of the commercialbank's new money facility through 1986.

Disbursement and Procurement

114. Disbursementswould be made against Statementsof Expenditures backed by Customs Declarationsevidencing the CIF cost and importationof - 32 - goods and their countries of origin. The Statemeatsof Expenditureswould be audited by indepeadent auditors acceptable to the Bank. Customs Declarations would be kept ia Panama and be available for review by supervisionmissions. Retroactive financing of up to US$50 million would be allowed for imports after August 1, 1986. Imports of military equipment and luxury consumer goods would not be eligible. All purchases,other than petroleum products, of US$5 million equivalent or more each would be procured through incernatioaalcompetitive bidding. Petroleum products would be procured according to Panama's normal procedures. Imported petroleum products and foodstuffs would be limited to US$20 million equivalent each. Public sector imports under contracts below US$5 million equivalentwould be ia accordance with standard government practiceswhich ensure adequate competition. Private sector imports under contracts below US$5 million equivalent would follow normal commercial practices.

Monitoring

115. The progress of the measures supported by the Government's structural adjustment program will be closely monitored through regular supervision. Contiaued supervisionwill determine compliancewith the conditions for release of the second tranche. The Governmentwill submit to the Bank progress reports from time to time, and these will form the basis for an exchange of views. The first of these consultationswill take place no later than February 28, 1987 (Section 3.01(c) of the draft Loan Agreement).

PART IV - BANK GROUP OPERATIONS

116. The Bank has to date made thirty loans and one supplementary loan to Panama totalliag US$572.7 million (net of cancellations). Of these, 21 loans for US$325.3 million net of cancellationsare fully disbursed, three for roads totalling US$25.1 million; one for an airport project for US$20 million; four for agriculture totalling US$13.1 million; two for fisheries totalling US$8.2 million, five for power for US$141 million; two for development banking for US$21 million; one each for ports (US$24 million), water supply and sewerage (US$12 million); structuraladjustment (US$60.2 million); and energy planaing and petroleum exploration (US$0.6million). Ongoing operations include one each for livestock credit, developmentof tropical tree crops and road rehabilitation;three in the power sector (for generation, transmissionand distribution);a project to help develop the water supply and sewerage sector; one for the urban developmentof Colon; one for port developmentand one for technical assistance. The most recent loan to Panama, a seventh powe- project, was approved by the Executive Directors oa March 19, 1985.

117. IFC has made four investmentsin Panama. The first was in 1971 to acquire US$0.3 million of equity in, and lend US$1.2 millioa to, the Corporacioa de Desarrollo Botelero, S.A., to build a new international hotel. The second was ia December 1977 to lend US$2.4 million to, and - 33 - acquire US$1.4 million in equity in, Vidrios Panamenos, S.A., a glass containerfactory. In June 1986, the original investment in Vidrios was sold and a standby loan of US$0.7 million made. The third and fourth were commitmentsin 1979 and 1985 to acquire US$2.5 million in equity in, and lend US$21.3 million to, the Banco Latino-Americanode Exportaciones(BLADEX), a regioaal export bank located in Panama.

118. While there are some difficulties,satisfactory overall progress in the implementationof ongoing projects was reflected in the steady increase in Bank disbursementsfrom US$29.5 million in FY81 aad US$39 million in FY82 to US$39.6 million in FY83. Disbursementsunder SAL I raised the total to US$94 million ia FY84. The decline to US$27.5 million in FY85 and US$29.5 million in FY86 was due to the severe Government fiscal situationand the delay in the Government'sstructural adjustment program. Annex II contains a summary statement of Bank loans and IFC investments as of September 30, 1986.

119. Bank lending to Panama is designed to support the Government's medium-term economic reform program described above and the further development of supporting infrastructureand service industries,the diversificationof production and exports, and the creation of employment opportunities. Specifically,the Bank assists those sectors in which it can make a special contributioain terms of: (i) developingpolicies and institutions;(ii) removing remaiaing iafrastructurebottleaecks; and (iii) better utilizing the country's natural resources, including its geographic location. In addition to the proposed loan, projects under active considerationfor Bank lending include the Balboa Port project, an urban transport project for Panama City, a health sector project, a road improvement aad maintenance project (which would include the substantial rehabilitationof the TransisthmianHighway) and a technicalassistance project to help the Government in carrying out its reform program.

120. Both USAID and the Inter-AmericanDevelopment Bank (IDB) have invested substantialamounts in agriculture,social services, infrastructure, and technicalassistance. The IDB also participatedwith the Bank and bilateral aad commercial sources in financing the Fortuna Hydroelectric Project and is financingrural electrificationand water supply. USAID is lending for alternativesources of energy (other than petroleum). USAID expects to continue its efforts in manpower training and projects oriented toward environmentalprotection. USAID and UNDP are also providing additional techaicalassistance to increase the planning capacity of MIPPE and MIDA and to carry out additional studies to assist the Government in its policy reorientationefforts.

121. The Bank's share of Panama's medium-termpublicly-guaranteed external debt outstanding and disbursedwas 9.3 percent at the end of 1985 and the Bank's share of public external debt service was 7.4 percent in 1985. These percentagesare expected to increase slightly in the late 1980s; the Bank share of outstanding and disbursed debt is expected to rise to just over 12 percent in 1987-88and end the decade at 11 percent. - 34 -

rmT v RBWHNTION

122. 1 am satisfied that the proposed structuraladjustment loan would comply with the Articles of Agreement of the Bank and recommend that the Executive Directors approve the proposed loan.

Barber B. Conable President

Attachments November 13, 1986 - 35 -

ANLE I Page 1 of 5

PANA.A: PUBLIC SECTOR FINANCIALINDICATORS

-Actual ------Projected cI ------1983 1984 1985 1986 1987 1989 1989 1990

- I I. Operations

.* A. In MlLlons of US Dollars

Current Revenues a/ 1385.5 1424.6 1523.3 1604 1735 1844 1980 2152 Current Expenditures 1243.0 1333.6 1373.9 1407 1519 1581 1681 1776 Publlc Savings 142.5 91.0 149.4 197 216 263 299 376 Capital Expenditure bi 407.2 365.4 242.5 265 292 313 351 393 Consolidated Deflict -264.7 -274.4 -93.1 -6a -76 -49 -52 -17

-. As a Percentageof GDP

Current Revenues a! 31.7 31.4 31.7 31.6 31.7 31.2 30.8 30.8 Current Expenditures 28.4 29.4 28.6 27.7 27.8 26.7 26.1 23.4 Public Saving. 3.3 2.0 3.1 3.9 3.9 4.4 4.7 5.4 Cepital Expenditure bl 8.2 6.9 5.1 5.2 5.3 5.3 5.5 5.6 Consolidated Deficit -4.9 -4.9 -1.9 -1.2 -1.4 -0.8 -0.5 -0.2

II. Nediin and Long Tem Ezxrernal Debt (USS mllion) di

Interest Payments 301.2 321.6 323.1 358 346 350 347 341 Amortization 189.4 241.4 159.6 219 149 170 184 171 Total Debt Service 490.6 563.0 482.7 577 495 520 530 511 Debt Outstnding 3330.4 3485.9 3544.0 3608 3694 3733 3785 3902

Debt Service (Z of GDP) 11.2 12.4 10.1 11.4 9.1 8.8 8.2 7.3 Interest (1 of Current Revenue) 21.7 22.6 21.2 22.3 20.0 19.0 17.5 15.5 Debt (t of GDP) 76.1 76.8 73.9 71.0 67.3 63.1 58.9 54.4

aI Coneral gn t currnt revemns plus current surplusesof public enterprisesexcludlng the ncnoonsolidated public sector. bi Capital expendltures are net of investets financed by the revennes of public sector fci-iL agencies. cj WLth SAL 13 scenario assuemptios (see text). di Includes IlU, and nev flovs ad interestpayments associatedvith additional capital requirements. -36-

ANNEXI Page 2 of S

Real. Annual Grankh Rates CZ)

Amount (USt SLlion) ------A ctual------Projectd A/1------1385 1981 1932 1913 1984 1985 1986 1937 1968 1969 19900

National. Accounts

Gramm Domestic Product 4,798.3 4.2 4.? -1.5 -0.4 3.1 2.9 3.5 4.0 4,.5 4.5 AarcLultusre 493.3 83. -1.5 4.9 -1.3 2.5 2.6 3.0 3.2 3.2 3.2 In,duatcy 460.4, -2.9 2.3 -1.9 -0.1 1.8 2.3 4.0 3.0 5.5 3.5 Other 3,3sibi.6 4..7 5.8 -2.3 -0.4 3.3 2.9 3,5 4.0 4.5 4.5

* Coc@usptit@ 3,920.2 2.8 6.0 1.1 0.9 6.5 4,3 2.9 2.8 3.4 2.5 * Cross Domestic Investaent 320.9 13.1 -3.7 -23.3 -13.2 -3.2 8.2 &.9 6.4 6.8 11.0 Export. of CR75 1,793.8 1.3 -1.1 -5.2 -6.5 4.4 0.1 4.0 4.4 4,8 4.5 IE9orts of CR73 1,690.0 4.5 -3.8 -13.1 -4.4 -2.5 6,0 3.4 2.8 3.6 3.8

Prices

GDP Deflator (1985-100) 100.0 85.5 90.1 93.5 97.5 100.0 103,0 107.1 111.4 115.9 120.5 Exchange Rate (DaLboas par US$2 1.0 1.0 1.0 1.0 1.0 i.a l.a i.e i.e i.0 i.0

Share of GDP at Market Prices CZ) Average Annual Increase (2) ------(At current prices)------(at Constant 1985 Prices) --- 1970 1975 1980 1995 1990 Al 1970-75 1975-80 1980-85 1985-90 at

Grams Doewstie Product 17.3 87.0 89.3 90.4 39.9 4 7 5.9 2.0 3.7 AMrlcuLture 14-.6 11.2 10.0 10.3 9.9 1.2 2.3 2.5 3.0 Other 72.7 75.8 79.3 80.1 30.0 5.7 4.8 1.6 3.8

Consuiqtton 75.5 76.5 75.5 31.7 30.8 4.6 4.2 3.6 3.2 Gross Domestic Iv3tvestnt 27.8 30.9 27.7 17.1 20.3 6.0 0.2 -7.4 7.5 Exports of 097S 30.0 47.0 4.4.4 36.9 42.2 3.9 8.9 -1.5 3.6 Imports of GNE'S 41.4 54.3 47.T7 35.7 33.0 4.6 5.0 -4.0 3.9

ml With SAL II senamrio asskqutlons. - 37 -

ANNEXI Page 3 of 5

PAYMANA BALANCE OF PAYMENTS ;USS mIllLon at cuurrnt prLoes)

------Actual------Projected a/------1981 1982 1983 1984 1985 1986 1917 19B0 19;^ 1990

Exports of Goods and Non Factor Service. 1734 1770 1774 1705 1794 1843 2063 2315 2611 2950 of whlch Merchandlse f.o.h. 46 4f88 426 419 *11 427 495 573 tA2 767 Imports of Goods and Non Factor Services 1855 1871 1697 1693 1690 1733 1929 2140 2383 2654 of whlch Merchandise f.o.b. 1470 1496 1353 1343 1339 1376 1535 170Z 1£93 2106 Net Transfers 31 46 *4 79 83 79 84 92 97 101 Investuant Income -271 -350 -324 -350 -427 -413 -409 -422 -429 -434

Current Account -360 -405 -203 -239 -240 -223 -191 -15A -105 -37

Capital Account 386 360 207 153 34 223 191 154 105 37

Official Capital (let) 205 510 302 214 32 108 130 125 1I0 75 Amortization -240 -305 -232 -266 -375 -535 -586 -579 -'98 -296 Disbursement 445 815 534. 431 l18 289 214 220 235 183 Nescheduling% b/ 225 354 501 484 312 184 Other Official Bank Transactlons (Not) -40 0 -b7 -13 135 S -54 -76 -58 -So Dlrect Investment (Net) 171 1 55 37 91 44 53 58 64 70 Other Private CapLtal (Met) 50 49 -63 -e; -223 66 63 47 -li -50

Net Errors and XLssions -26 -155 -5 102 205 0 0 0 0 °

at WLth SML I1 scenario assumptions (see text). bi ReschedulLnss of conbereLaX bank and Parils Club d4bt (1985-86), and additional capital requiremants (1987-90) (sec text).

Source: Ministry of PlannLng and Economic Policyl IMF, and World Bank - 38 -

ANNEXI Pose 4 of 5

PANAMAsPUOLIC OlTfuL CAIPTAL AND DO3T rJ (USS mIlILon at aurnt prices)

---- ru------1Wl 1an2 19is 1am4 ins 19u6 is; zosa 1S89 1960

Grees Dlsbmrsinm £73 779 527 £96 467 6" 734 714 616 379 OffLCLl Cicamrt 5 5 3 3 57 7 7 10 * 7 Loms 467 774 523 491 409 687 726 704 605 372 OaffcIlal. 3tLateral 81 91 62 45 21 45 30 £2 40 36 OfficLL IuLtieatoral 73 91 147 139 90 16 153 166 185 141 lUND 3 £C 77 52 26 to Lo 10£ 10i 57 Other PaLtilatAeal 34 51 70 a8 64 73 53 62 76 *4 *PWrint. 225 592 197 204 262 £30 12 11 11 9 lrU 39 0 116 103 36 44 11 0 0 0 AMLialeI equyired Capital bt 501 £s3 372 14

Debt Outstanding Iblsusg Ubdisbursed 330£ 3591 £147 3393 3931 4120 4136 4277 £269 4272 Outstandlng and Dlsburse 2533 3011 330 34386 3544 363 3634 3733 3785 3102 OfflaaL 776 915 1133 1343 1433 1305 1545 1564 1606 1594 Privat 1759 2096 2136 2143 2106 2103 2139 2170 2179 2207 UndI.buzred 769 53S 317 407 437 512 44£ 543 453 £69

Total Debt ServLce of 516 631 £91 563 483 577 495 520 330 511 Interest 236 344 301 322 323 353 3U6 350 347 341 * seNiaatia 229 237 189 241 160 219 149 170 13£ 171 Servi Payrents eas I of ampors MS 29.7 35.7 27.7 33.0 26.9 31.3 24.0 22.5 20.3 17.3

LAmizg. Ixner Naze a Debt Outstanding 11.9 12.4 9.5 9.4 9.2 10.0 9.5 9.4 9.2 9.0 Official 6.4 5.7 5.5 6.0 6.5 7.9 7.9 7.6 7.9 7.9 Print.: 14.1 15.4 11.3 11.5 11.0 11.5 10.7 10.6 10.2 9.3

Aeage maturity efer fLos 12 11 10 29 i 3 14 17 16 17 17 Offbvicl 22 20 14 29 . .. .n . n.S.- .n.- n.-. -- ri st- 9 9 7 5 S.& a.&. U.-. .S. IL.&. u.&.

00 IDS 162.7 190.7 253.4 207.3 291.3 352.5 416.4 £29.4 429.8 426.4 snnITots CZ) 6.7 6.3 3.1 1.9 9.0 10.7 12.2 12.1 11.7 11.£

atInludes fDV. W Includes -m disbusemes associated wlth fillng grose capital borrowing rezAiXmmontS through possible resebadulin end mm y facilitie. ol Includes adtitis-l seorve asseciated wIth fillsa grass capital berfowiLru req _rements-

5eeres. World Desk Debt Reporting Sexvice nd staff satLates of fusru Lnflows F.3 - 39 - ANNEX I Page 5 of 5 PAMAMMA EXTER1AL TRADE

Amount Annual Growth Rates (Z) (USS mIllion) Cat constant 1985 prices) -- -Actual------Projected------4 1985 &I 1983 1984 1985 ad 1986 1987 1988 1989 1990

Merchandise Exports F0B 410.9 -14.0 2.1 -1.2 153 4.7 4.8 5.0 S.1 Primary 176.9 18.2 0.8 2.8 2.9 3.1 3.2 3.3 3.5 MarnufacturesL Other bI 233.9 -36.3 3.4 -4.0 24.7 5.7 5.8 6.0 6.1

MerchandLse Lmports FOB 1339.4 -11.9 -4.4 1.2 8.9 3.3 2.6 3.4 3.7 Petroietas 298.8 -6.3 -1.8 -12.5 16.2 2.1 4.0 1.8 2.4 Machinery & Equipment 266.2 -28.0 -13.0 -0.6 8.2 4.9 4.7 6.8 8.4 Manufactures 659.0 -25.4 -1.5 9.8 6.4 3.5 1.1 2.9 2.8 Other 115.3 0.7 -1.5 2.5 5.1 2.6 1.9 2.2 1.1

Price IndLees (1985-LO0) Export Price Index 100.0 95.7 t'9.2 100.D 102.5 110.4 118.9 128.1 138.2 Import Price Index 100.0 o05.0 00.9 100.0 96.7 104.1 112.3 120.8 129.6 Terms of Trade Index 100.0 91.1 98.3 100.0 106.0 106.0 105.9 106.1 106.7

Camposition of Merchandise Trade CZ) Average Annual Increase (2) Cat current prices) (et constant :985 prices) 1970 1973 1980 1985 af 1990 1970-75 1975-80 1980-85 1985-90

Exports 100.0 100.0 100.0 100.0 100-0 n.a. 2.5 0.2 5.6 Primary 74.2 46.6 39.0 32.9 46.3 n.a. 1.3 0.8 3.1 Others bI 25.8 55.4 61.0 67.1 53.7 n.a. 2.B -6.0 7.4

Imports 100.0 100.0 100.0 100.0 100.0 n.a. 7.5 -3.1 3.8 Petroleum 19.0 34.4 31.1 29.6 14.4 n.a. 12.1 -5.5 Z.3 Machinery EEquipment 27.5 29.0 19.' 21.8 25.0 n.a. 98 -3.7 5.9 Others 53.5 36.6 49.5 48.6 60.6 n.a. 5.9 -1.8 3.0

Share of Trade vith Share of Trade with Share of Trade wLth Direction of Trade Industrialized Countries (2) Developing Countries (1) Capital Surplus OlI Exporters CZ) 1960 1970 1975 1980 1960 1970 1975 1980 1960 1970 1975 1980

Exports 99.0 89.6 74.8 79.0 1.0 10.4 24.6 20.0 0.0 0.0 0.6 1.0 Primary h.a. U.&. 96.7 n.a. n.a. n.a. 2.3 n.a. n.a. n.a. 1.0 c.a. Manufactures m.a. n.a. n.a. n.a. n.e. n.-. n.a. n.a. n.a. a.-. n.e. n.a.

Imports 7&.9 61.3 41.4 63.7 24.7 20.7 18.9 6.5 0.4 18.0 39.7 29.8

at Stlmated. bl Includins petroleum products. - 40 - ANM= II Page 1 of 2

THE STATUS OF BANK GROUP OPERATIONS IN PANAMA

A. STATEMENTOF BANK LOANS AND IDA CREDITS (as of September 30, 1986)

Amount in US$ million (less cancellatioas) Loan or Fiscal Undis- Credit No. Year Borrower Purpose Bank IDA bursed

21 loans fully disbursed 325.3

1397-PAN 1977 BNP Livestock II 8.0 0.8 1470-PAN a/ 1977 IRHE Power IVa/ 31.3 8.7 1672-PAN 1979 BNP Tropical Tree Crop Dev. 19.0 9.4 1878-PAN 1980 Republic of Paaama Urban 35.0 13.1 2020-PAN 1981 Republic Road of Panama Rehabilitation 19.0 6.4 2182-PAN 1982 APN Secoad Port 24.4 15.3

2222-PAN 1983 IDAAN Water Supply II 21.6 16.0 2313-PAN 1983 IRHE Power VI 32.1 25.4 2356-PAN 1983 BNP Livestock III 9.0 7.3 2358-PAN 1983 Republic Technical of Panama Assistance 5.0 1.2 2506-PAN 1985 IRHE Power VII 51.0 50.9

TOTAL 572.7 of which has been repaid 131.6 TOTAL aow held by Bank 441.0 Amount sold 9.2 of which repaid 9.2

TOTAL undisbursed 145.1 at Supplementary loan - 41 -

ANNEX II Page 2 of 2

PANAMA

B. STATEMENT OF IFC INVESTMENTS (as of September 30, 1986)

Investment Fiscal Types of Number Year Obligor Business Loan Equity Total --- ($1US millioa)-

202-PAN 1971 Corp.Des. Tourism 1.2 0.3 1.5 Hotelero

393-PAN 1978 Vidrios Glass 2.4 1.4 3.8 Panamenos Factory

427/783/PAN 1979/85/86 Bco. Latino Money & 42.3 2.5 44.8 Amer.de Expor- Capital taciones S.A. Market

Total gross commitments 45.9 4.2 50.1

Less cancellations, terminations, repayment, and sales 28.4 0.3 28.7

Total commitments now held by IPC 17.5 3.9 21.4

Total undisbursed - 0.1 0.1 - 42 -

ANNEX III Page I of 2

PANAMA

SECOND STRUCTURALADJUSTMENT LOAN

I. Timetable of Key Project ProcessingEvents

(a) Time taken to prepare: Two years

(b) Prepared by: Goveramentwith IBRD assistance

(c) First IBRD mission: October 1984

(d) Appraisal mission departure: April 1986

(e) Negotiations: September 8, 1986

(f) Planned Date of Effectiveness: Mid December 1986

II. Special Bank ImplementationActions None contemplated.

III. Special Conditions

Prior to disbursementof the second tranche, the following conditions should be met (paras 96 and 97):

(a) completionof program to reduce the public sector workforce by two percent;

(b) adoption of all necessary measures to strengtheathe administrative capabilitiesof the CSS, including a reduction of 120 in administrativestaff;

(c) reform of the CSS IVM program in a manner consistentwith an actuarially sound financial basis;

(d) adoption of necessary measures to reduce the long-term financial burden of pensions under the Leyes Especiales; - 43 - ANNEX III Page 2 of 2

(e) reduction of tariffs on agriculturalproducts to agreed levels;

(f) reorganizationof IMA, including ending the BDAs maize pledging scheme and sale of all crop and salt inventories;

(g) complete divestiture of three of four specified public enterprises;and

(h) ensure the Government'sexternal financing needs for 1987.

- -44 - *A w

PAK- SECIX S1URTMAL 'Aun IM R2

SEMER AND MCY ISSUE Fn TRNE SEMD RAU .~ ~~I REICf L EUM ElCr9=R 1. Closes of BlblIc Entities

a) ENASI (Seed Gmpany) Seserch ftnctioos transferred to MDIP. Quare of CAlial operatimrs axd -disposa of assets. b) HIDI. (Agriculural Draft sale reseoluo co Pyol) Cabint. Disposl of assets.

c) Azuer &1gar Mil M'lM dstoed ard Ca3ut nagr~iaitto disposal of assets. Final disposal of assets.

2. Divsmats of Ebblic Eatities Sale of na of these Sale by April 1, 1987 of t enterprises. Jfurterenerprises on this (i) Cttr1o d Chriqui list. (it) Aeroperlas Assts sold. (ili) IHtel ontalora Assets sold. (iv) Alaaje Sugpr MIM Intenaoa aantd.

3. A*lic Sector Workforce It percent redmction dring 1966. 4. Social Security Fund (i) Transfer leyes (i) iactmnt of new Eapeciales to Pension 1aw, including: hxget; (a) Reidctim of early (ii) initiate measres retiresnt pensions aad to iprowe administra- gradal elimdnadon of early tlve efficieacy; rer1nr; (iii) Cab t approval (b) ncw srale of pension of draft La govening rights; pens se; (c) lo1r averaging period (iv) understasdiog on for pension Fase; reform of leyes Cd) inflation adjustmnot of -nles:, pensions; (e) maiaterance of captalzatonlevel. Cii) Redaction of CSS wcrkforce. (iii) Refom of layes Espedales.

5. Financial stabilization Pt in place aa accept- Satsfactory cculiaoc with able stabilization staRih1elon progra. yprogra6

6. Ebblic nvestment program Aguenet with Bark Satisfactory financial pla. prelindnary 1987 invest- mat program -45 - ANNE IV Pow 2 of 3

PNMN - SEN SIUCRA ADJMlMr IDANPR1XAM

SECIIR ANDHLICY ISSUE FDlT IRNE SECOID IRANDE

IL INDUIS4ALAND RA1DEF.LCI 1. lndustrial Incentives 1 New l passed, March 1986, inhxd1r. (a) disaoidnatain of Contracts with the Nktica; (b) nxdma tariff protection of 20 percent for new inristrtal products, 33 percent for Lew agroustrial products. (e) reductim of existilg prtection; *d) those percent ugniam tariff. leduction of exlsting ariff Aigust 1, LW986, as the first of 5 equal acts to a adimn of 60 percent (90 percent for a few exceptional products).

2. Geral incentives and All bit Z import quotas protec-tive struca re med before June 30, 1986.

3. Thriff AdLinistration B1Nsystem and CIF tariff base aiopted.

eci c duties to be supplaeted with ad-valorem duties for all cmwdities; no specific duties to be raised.

III. IABDCLVLICIES l passwdM i 1986, 1. Labor Cods mDdifying the Gode to: (1) permit plecewk; (ii) encurag rewards for productivity;(iii) rationalize overtime provisioas for satll, export and agro-based firms; (iv) remov subcantract- ing frmmthe scope of tie CGle.

Imrovements ia the adadaistration of the labor CQe, including quidoar decisiocs, appeals, etc. - 46 -

ANNEXIV PaE 3 of 3

BOM - SEUND SWICIUR&LADtrfh IfMANFAM

SO IN)P ISSUE FIRST RE SEC D

IV. AIaJiaM1R ANDRUtAL

1. Incnitives NaIW LOW passed, March TPgLlat1m 1986. (i) replacing self-suf- ficLer-y aim wLth the purstdt of amparative advatare; (ii) aboklishing iqport ubstitutim targets; (ii) ablsR g automatic quntitativie -restrictime c agriaditwal imports.

2. Promher Prices and biuort End of support prices Reduction of import dutie co Tariffs for rice, crzimxs, bems rice, anize, anions, and a salt. bens. hibort quotas on rice. En- of support price for mime, oxiiis, and beans . i! lifted and replaced with eqtivaUmt tariffs.

3. Qnsumer Pfle Hading of price controls cz 20 categories of foods. Baling of price cztrols on faor further items.

4. Rbbic Sector RPle e of end to En of UI crcp-pledgL:g 1D crop pirdasing, systen. incling salt. Revisim of mA's charter. kM30LMcemetOf 1m3ch Sale of remsinirg salt red role for NAL. imentories. Sale of rice aid part of salt lnentories. - 47 - ANEX v

FIXED INVESTMENTS: SECTORALALLOCATIONS FOR 1985-87 (percent)

1985 1986 1987 Actual EstimatedPreliminary

Agriculture 7.5 8.2 10.0 Industry 1.2 2.8 1.9 ProductiveSectors 8.7 11.0 11.9

Education 3.3 6.5 6.2 Health 8.2 15.3 12.2 Housing 3.5 3.0 2.0 Social Sectors 15.0 24.8 20.4

Energy 37.7 21.6 26.3 Transport 26.1 19.1 17.9 Telecommunication 7.8 11.0 10.3 Infrastructure 71.6 51.7 54.3

Multisectorala/ 4.7 12.5 13.2

Total 100.0 100.0 100.0 Memo: Public Investment(B/.million) Total Capital Expenditures 243 265 292 Fixed 203 220 242 Net Lending and Ocher 40 45 50 at Includes integratedrural developmentprojects, preinvestuent studies and a group of small non-cacegorizableinvestments.

Source: MIPPE and World Bank staff. S

MAP SECTION *1-~~~~~~~~~~~~~~S El. P A N A M A

OIL PIPELINE . NATIONAL PORTS PORTSAND DOCKING LOCATIONS SURFACEDROADS GRAVEL ROADS PAN-AMERICANHIGHWAY UNDER CONSTRUCTION RAILRDADS *t AIRPORTSI LANDING STRIPS RIVERSF PROVINCE BOUNDARIES INTERNATIONAL BOUNDARIES

ur ;, - -.-

ELEVATIONS IN METERS _y>= ' f-- _1~~~~~~~~~~~~~~~~~~~---

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IL

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n h _ L.W.A HE R R d ___. ( AC ,1-' t A .r f F6C

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JULY1985 I1