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