Public Information Notice No. 01/56

Public Information Notice: IMF Concludes Article IV Consultation with Guatemala

May 25, 2001

On May 14, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Guatemala.¹

Background

Despite some improvement in economic performance and structural reforms since the early 1990s, Guatemala continues to face serious problems of poverty and income distribution. Nearly 60 percent of the population lives below the poverty line, the income received by the richest quintile is 30 times the income of the poorest quintile, and 2½ percent of farms take up 65 percent of agricultural land. The 1996 Peace Accords set a social agenda to address ingrained inequalities, institutional failures, and social barriers, through a substantial increase in public sector investment in social and basic infrastructure to be financed by higher tax revenue and donor support. However, implementation of the Accords has suffered from weak execution capacity and lack of domestic resources due to insufficient political support. The main problem has been the insufficient tax revenue effort with the tax rate currently around 9¾ percent of GDP, well below the 12 percent of GDP for 2002 targeted in the Accords.

Since assuming office in January 2000, the administration of President Alfonso Portillo has sought to restore macroeconomic stability and advance the implementation of the donor-supported Peace Accords. Real GDP growth slowed to 3 percent in 2000 (3½ percent in 1999) reflecting the tight stance of monetary policy, cuts in public sector investment, and the effect of adverse terms of trade. Inflation remained at about 5 percent-the lower end of the central bank's target range of 5-7 percent-as the effect of a deceleration of aggregate demand and currency stability, noted below, more than offset rising oil prices. The external current account deficit narrowed to 4½ percent of GDP in 2000 (5½ percent in 1999) owing to slower economic activity and, the effect with a lag of the large real quetzal depreciation in 1999. The capital account surplus rose to 8¼ percent of GDP on the strength of private capital inflows attracted by high domestic interest rates and renewed confidence in the quetzal, and on account of the second installment of receipts from the privatization of the state telecommunication company.

The overall deficit of the combined public sector (including the central bank) narrowed to 2½ percent of GDP in 2000 (3 percent of GDP in 1999) due mostly to cuts in central government capital outlays to 3¾ percent of GDP (5¼ percent of GDP in 1999). Public sector savings fell to 2 percent of GDP in 2000 (2.8 percent of GDP in 1999), mostly on account of rising current expenditure associated with a 10 percent across-the-board increase in wages, a higher interest bill (including on open market operations), and the cost of the subsidy on electricity consumption. Tax revenue rose to 9.6 percent of GDP (9.3 percent in 1999) reflecting improved tax administration and the effect of tax measures introduced in June 2000. Such measures included: increasing the top income tax rate from 25 percent to 31 percent; widening the VAT base to include customs duties; and phasing out some exemptions.

The central bank has maintained a tight stance of monetary policy initiated in August 1999. In early 2000, the central bank stepped up its placement of open market securities to strengthen the international reserves position. Thereafter, as confidence in the quetzal improved, higher private capital inflows prompted the central bank to buy U.S. dollars and to mop up the resulting liquidity through open market operations. As a result, usable net international reserves rose by US$725 million in the year, bringing the stock to the equivalent of 117 percent of base money in December 2000 and the quetzal appreciated by about 5 percent in both nominal and real effective terms. Private sector financial savings rose by about 23 percent in the year, but credit to the private sector rose moderately.

The financial sector remains fragile and there is an urgent need to cope with various weaknesses and vulnerabilities, which result from inadequate prudential regulations and supervisory oversight. Nonperforming loans stood at 13 percent of total loans at end-2000, with a substantial underprovisioning. Furthermore, capital adequacy ratios and profitability have deteriorated. The recent World Bank-Fund Financial Sector Assessment Program (FSAP) mission found that a few financial institutions were insolvent. The size of the problem is probably larger as an important segment of the financial sector consisting of offshore and off-balance-sheet operations (estimated to be about the same size of the regulated system) are outside the reach of official supervision and regulations. In addition, deposits from the public sector, especially the social security system, are supporting financial institutions. After the FSAP mission, the authorities intervened three small banks in early 2001 and the monetary board approved new drafts of laws of the central bank, banking sector, and banking supervision.

Executive Board Assessment

They welcomed the strengthening of macroeconomic conditions in 2000, highlighting improvements in the fiscal and balance of payments position, and continued single-digit inflation. Directors noted that the tight stance of monetary policy has helped maintain inflation under control and stabilize the exchange rate. At the same time, they underscored that continued reliance on tight monetary policy could affect negatively the achievement of high and sustained economic growth, and urged the authorities to rebalance the policy mix by reducing the fiscal deficit. Concern was expressed about the acceleration of government expenditure during the first four months of 2001, and the authorities were encouraged to take corrective measures to assure macroeconomic stability and avoid putting further strains on the financial system.

Directors stressed that the major challenge facing Guatemala was to increase the tax effort from its very low level in order to raise social expenditure and make room for the costs of bank restructuring. In this regard, they commended the authorities for their plan to improve tax administration, including through modifications in the tax and penal codes. However, Directors noted that more was needed to strengthen significantly tax revenue in 2001 and set the stage for achieving the tax ratio of 12 percent of GDP in 2002, as targeted in the Peace Accords. They therefore urged the authorities to introduce additional revenue-raising measures, including increasing the value-added tax rate and eliminating exemptions to the value-added tax. Directors also highlighted that expenditure should be kept at budgeted levels, and emphasized the importance of eliminating unproductive outlays and replacing these with well-targeted programs to benefit the poor.

Directors broadly supported the authorities' intention to maintain a monetary stance that would achieve the targets for inflation and international reserves. They noted that the authorities should monitor closely developments in monetary aggregates and in the exchange market, owing to the legalized use of foreign currencies alongside the quetzal in domestic transactions, and in financial assets in the domestic banking system. Directors encouraged the authorities to recapitalize the central bank to enhance its conduct of monetary policy.

Noting weaknesses in the financial sector, Directors commended the authorities for undertaking an FSAP, and for the steps taken to improve the health of the financial system and to intervene three insolvent banks. They welcomed efforts to build a new legal and institutional framework for monetary and financial policies and introduce prudential regulations limiting banks' exposure to exchange risks in line with the Basel Committee. Nonetheless, Directors recommended that a comprehensive examination of banks should be undertaken promptly to deal with any other insolvent financial institutions, liquidate nonviable institutions, and strengthen the capital base of weak, but viable banks. They also urged the authorities to adopt measures to raise to international standards the regulatory and supervisory framework, improve the quality of banking supervision, and enhance the effectiveness of the payments system, along the lines recommended by the FSAP mission. The authorities should also take steps to enhance transparency and good governance. Directors urged the authorities to act expeditiously to put in place anti-money-laundering legislation.

Directors encouraged the authorities to carry out with determination their policy of allowing the exchange rate to reflect market conditions and to refrain from intervening in the foreign exchange market, except for market smoothing. Keeping the fiscal position under control, strengthening human capital, and expanding the country's infrastructure were viewed as crucial for maintaining competitiveness over the medium term.

Directors commended the authorities for the progress made with structural reforms. Looking ahead, they encouraged the authorities to reform the social security system, to privatize ports and airports services, and to consider privatizing the remaining government shares in the power company (EGSSA).

Directors underscored the need to strengthen the statistical base, particularly in the areas of public sector revenue and expenditure, balance of payments, and the banking sector.