Report No. 13977-PAN

PanamaA Dual Economy in TransitionJuly 20, 1995

CouLntry Operations DivisionCountylv Depxartmenit 11

Latin America and the c(arribein Re,'ion

Document of the World Bank

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CURRENCY EQUIVALENTS

USS I = I Balboa

FISCAL YEAR

Januarv 1 - December 31

ACRONYMS AND ABBREVIATIONS

ACP Panama Canal AuthoritvAPN National Ports AgencyARI Interoceanic AuthorityBDA Agricultural Developmcnt BankBHN Nationial Mortgage BankBNP National Bank of PanamaCBI International Banking CenterCBN National Banking CommissionCSS Social Securitv AgencyECLAC U.N Economic Commission for Latin America and the CaribbeanERL Economy Recovery LoanGATT General Agreement on Tariffs and TradeICOR Inlcreenicital Capital Output RatioIDAAN National Water and Sewvage AgencyIFIs International Financial InstitutionsIMA AgriCLultural Marketing InstituteINTEL National Telecommunications AgencyIRHE National Power ConipanvITBM Value Added TaxIVM Invalidity, Old Age and DeathMIPPE Ministry, of PlanningMOP MinistrN, of Public WorksNAFTA North American Free Trade AgreementNFPS Non-finanicial Public SectorNT Neutrality TreatyPCC Panama Canal CommissionPERL Public Enterprise Reform LoanSAL Structural Adjustment LoanTCC Tax Credit CertificateWTO World Trade OrganizationZLC Col6n Free Zone

COUNTRY DATA SHEET1994 unless otherwise indicated

General

Area (square kilometers) 75,520Population 2,585,000

Growth Rate from 1980 to 1993 2.0%Density (per square kilometer) 34.2

Social Indicators

Population CharacteristicsBirth Rate (per 1,000 people) 24.5Death Rate (per 1,000 people) 5.3

HealthInfant Mortality (per 1,000 live births) 24Physicians per 1,000 people 2.8 (1988)Hospital Beds per 1,000 people 7.3 (1985)

Household Income DistributionHighest Quintile 59.8 (1989)Lowest Quintile 2.0% (1989)

Access to Safe WaterPercent of Urban Population 100% (1991)Pecent of Rural Population 66% (1991)

NutritionCalorie Intake 2291 (1990)Per Capita Protein Intake (grams per day) 59.3 (1990)

EducationAdult Literacy Rate 88.1% (1990)Primary School Enrollment (percent of relative age group) 106% (1992)

Gross Domestic Product in 1994Average Annual Growth Rate (%)

US$ BILLION GDP Shares(%) 1980-85 1985-90 1990-94GDP at Market prices $6.9 100.0 6.6 0.2 8.6Gross Domestic Investment $1.6 24.0 -5.3 2.7 18.1Gross National Savings $1.2 17.7 2.4 -6.8 16.8Current Account Balance $-0.4 -6.3 33.7 -25.0 -22.5Exports GNFS $2.5 39.4 3.4 0.2 5.1Imports GNFS $2.7 36.3 -3.0 0.2 11.9

I

PANAMAA DUAL ECONOMY IN TRANSITION

TABLE OF CONTENTS

EXECUTIVE SUMMARY ................................................................. i-viiiRESUMEN EJECUTIVO ................................................................. i-xiv'

CHAPTER I: DUALITY, GROWTH AND POVERTY .................................................................. 1A. HISTORICAL PERSPECTIVE AND RECENT DEVELOPMENTS ........................................... 1B. A DUAL ECONOMY IN TRANSITION .................................................................. 4C. INVESTMENT, SAVINGS AND PRODUCTIVITY .................................................................. 5D. POVERTY AND INEQUALITY .................................................................. 5

CHAPTER II: EXPORT SERVICES: OUTLOOK AND CHALLENGES ..................................... 9A. THE FINANCIAL SECTOR ................................................................. 10B. THE PANAMA CANAL ................................................................. 14C. THE COLON FREE ZONE ................................................................. 16D. OTHER EXPORT SERVICES ................................................................. 17E THE REVERTED AREAS ................................................................. 17

CHAPTER III: CONSTRAINTS TO SUSTAINED GROWTH ..................................................... 18A. THE STATE AND THE ECONOMY ................................................................. 19B. BASIC SERVICES AND INFRASTRUCTURE ................................................................. 20C. LABOR MARKET ................................................................. 22D. TRADE AND PRICE POLICIES ................................................................. 24

CHAPTER IV: THE REFORM AGENDA AND GOVERNMENT ECONOMIC PROGRAM ..27A. THE REFORM AGENDA ............................................................... 28B. THE GOVERNMENT'S MEDIUM-TERM ECONOMIC REFORM PROGRAM ....................... 32

TEXT TABLESTable 1.1: Summary Macroeconomic Indicators, 1986-94 ................................................................. 2Table 1.2: Savings and Investment, 1986-94 .................................................................. 6Table 1.3: Poverty and Inequality, 1979-89 .................................................................. 6Table 2.1: Leading Export Services in the Economy, 1993 ................................................................. 10Table 2.2: The Financial System .................................................................. 11

TEXT FIGURESFigure 1.1: Poverty and Inequality .................................................................. 7Figure 3.1: A Simple Picture of the Unemployment Rate ................................................................. 22

The Spanish version of the Executive Summary is more comprehensive than the English version.

TEXT BOXESBox 2.1: The National Banking Commission ................................ 11Box 2.2: Labor Issues in the Canal ................................ 15Box 3.2: Leather Exports ................................ 25Box 3.3: The Food Exporting Industry ................................ 26

BIBLIOGRAPHY

TECHNICAL ANNEXESAnnex I: The Panamanian Business Cycle2

Annex II: Determinants of Growth'Annex Ill: Statistical Appendix and Macroeconomic Projections'

Thi rite by Rihard L ' G - 'nd ' fi M d (Co o t ,nds, ofeonomic msions e 1 d r t edtby

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2hvailable onsultingrS Tt are avai f Wol request.h MILADESteam ws compsed a Felip MOThIC6(ea lede) Ane rr mcOecOMicise) RodriodeI

(labor markets) large Quiraz growth prospecs);..o...Migue SAce L PanamA Caa adbsi evie)GoozalVarga (trade poliy); and O..tinAedo(soialsetors).Temsiosadti rdprt der sPerieby Ricard L Groud, ta Bannn andJos6 opez-Mix (A2COy Gustve Arecta and Beariz Arb.a(IZAZCO) also eonuiuted to this repor The Department Dirctor.i...d..be.to. . .egu ... the . .iiso Chie.... . s......Daita Doweet-Coiro ..a an th Lead ..onomist is.Ian.B.mion

2 Available on request.4~1 ev W

EXECUTIVE SUMMARY

A Dual Economy in Transition

1. Structure and Past Sources of Growth. With a per capita GNP of US$2,580 and lowinflation, the Panamanian economy is among the most prosperous and stable in the region. Butthe economy is highly segmented, as between the internationally-oriented services sector and thedomestically-oriented sector, beset with policy-induced rigidities and low productivity. Likewise,factor markets are segmented by policies which drive-up the cost of labor and cheapen the cost ofcapital. The poor performance of the economy has impeded job creation, swelling the ranks ofthe poor to two-fifths of the population and exacerbating extreme poverty and income inequality.Panama's peculiar structure and pattern of growth stem, in part, from its privileged geographicalposition. The Panama Canal and the monetary regime anchored in the use of the US dollar as legaltender spurred the rapid development of a wealthy services economy. Creation of the Col6n FreeZone (ZLC) in the late 1940s coincided with the intensification of restrictive trade policies in theregion and generated substantial growth during the following three decades. Panama also tookadvantage of its location, unique monetary regime and the prevalence of restrictive policieselsewhere, by creating the International Banking Center (CBI), which grew rapidly throughout the1970s. Substantial rents were garnered through the construction of the trans-isthmian oil pipelineand by licensing the Panamanian flag to merchant ships from around the world. The economygenerated growth of more than 6% per annum during 1950-81. Although serious distortionswere introduced beginning in the 1970s, their growth-inhibiting effects were masked by themassive inflow of extemal finance. In the aftermath of the second oil shock and the debt crisis,these distortions depressed growth to 2.5% annually during 1981-93.

2. Distortions and Stagnation. Over the past twenty-five years, the segmentation of theeconomy by Government policies and inefficient state enterprises has kept output growth farbelow potential. As public expenditure mounted relative to GDP and policy interventionsproliferated, domestic prices rose faster than international prices despite the monetary regime,most resources were channeled into rubrics in which the economy has a comparativedisadvantage, productive investment was crowded out, foreign investment dried up, and thecompetitiveness of international services was eroded. During the early 1980s, these distortions,together with the international debt crisis, pushed the economy into recession. The Governmentceased to service its external debt in 1987. The political crisis in the late 1980s and the impositionof external economic sanctions, led to a 16% contraction of economic activity during 1988-89.

3. Poverty and Inequality. Despite Panama's relatively high per capita income, two-fifthsof the population live in poverty. Two-thirds of the poor reside in the countryside, and over one-half of rural Panamanians live in poverty. The distribution of income is highly skewed and hasbecome much more regressive in the past decade. In 1979, the poorest 20% of the populationreceived 4% of income; in 1989, that share had plunged to 2%. In 1989, Panama had one of themost unequal distributions of income in the hernisphere. Moreover, in 1989 the average realincome of the poorest 40% of the population was one-third lower than in 1979.

4. Structural Duality? A declining growth trend, mounting unemployment, and widespreadpoverty are symptoms of exhaustion of Panama's 'tdual economy." The issue of duality is centralto understanding Panama's dilemma. Indeed, positive spillovers from the leading exports servicesto the rest of the economy are limited. The leading sectors generate large shares of GDP andespecially of exports, but little employment (3% of the labor force) or fiscal revenue. At the sametime, they inject significant negative spillovers into the economy: the high wages paid in theenclaves, particularly in the Panama Canal, where the U.S. minimum wage applies, sharply raisewage expectations relative to the opportunity cost of labor in the rest of the economy. The keyquestion from a policy perspective is to what extent duality is "structural," that is, generated bythe technological nature of the leading export services sectors, and to what extent it is fostered bydomestic institutions and policies.

Executive Summary ii

5. In response to the apparent inability of the economy to generate productive jobs insufficient quantity to absorb a growing labor force, many claim that the appropriate policyprescription is state-promotion of new activities, through state enterprises, tax exemptions andprice subsidies. This gives rise to what some call the "Panamanian approach to growth," based ondevelopment of "enclaves" like the ZLC and CBI that tend to replicate the basic concept of thePanama Canal itself. The heavy protection of industry and traditional agriculture, and restrictivelabor legislation, also are by-products of this approach. More recent examples are laws thatpromote tourism and export-processing zones through discriminatory policies. This approach alsorelates to the crucial issue of how best to develop the former Canal Zone.

6. Policy-Induced Duality. Structurally-induced duality, while important, should not beoverstated. For one thing, a direct consequence of economic specialization in conjunction withthe small size of the country will always be the predominance of a few sectors in internationaltrade. The duality problern, rather, stems largely from the ways in which the society attempts tocapture and redistribute part of the suroluses generated in the leading sectors. Such surplusescould be captured through nondistortionary taxation, and redistributed and invested throughgrowth-enhancing and poverty-reducing programs and policies. In the event, the relative weightof structural enclaves, and their adverse effects, would dwindle; instead, policies have capturedand redistributed surpluses through highly distortionary interventions, with the result that: (i) theyerode the natural positive spillovers of leading sectors and exacerbate the negative ones; (ii)undermine the growth potential of the leading sectors; (iii) waste these resources, and resourcesfrom the rest of the economy, by channeling them into activities in which the country lackscomparative advantage and into rent-seeking; (iv) reduce the employment-generating potential ofthe economy for any given level of output; and (v) redistribute income from the poor.

7. This report strongly emphasizes that duality should not be attacked through either publicsector involvement in new economic sectors, or through 'promotion" policies. Instead, dualityproblems should be redressed through broad reform that introduces a much more active role forprivate market forces and eliminates policy-induced market segmentation. Uniform, lessdistortionary taxation, as well as privatization and regulatory reform also would mitigate thestructural tendency to duality in Panama's economy, thereby reinvigorating the growth andemployment-creation potential of the economy.

8. Recent Economic Performance. The Govermment that assumed office following theouster of a mnilitary government in December 1989 launched a stabilization and adjustmentprogram supported by bilaterals and the IFIs (in the case of the World Bank, through the 1992Economic Recovery Loan, or ERL). During 1990-94, great strides were made in reducing intemaland extemal imbalances. Output rebounded 9.5% in 1991, and a further 8.6% in 1992. In 1993,the recovery slowed to 5.6%, and in 1994, to 4.7%, when the pre-crisis per capita income wassurpassed. Inflation remained below 2% per annum. Unemployment fell until 1993, but remainedseveral percentage points above that recorded prior to the crisis. GDP growth is expected tofurther decelerate, to 3 to 4%, in 1995. Although Panama normalized relations with the Paris Cluband the IFIs, it is unlikely that a current account balance of payments deficit of the magnituderegistered the past two years (about 6% of GDP) can be sustained in light of declining aid flowsand without debt relief During 1990-94, solid progress was achieved in shoring-up public sectorfinances, but it encountered political barriers to implementation of the medium-term adjustmentprogram required to achieve a sustainable fiscal position. Progress in carrying out other structuraladjustment measures also was slow.

9. Prospects for and the Challenge of Policy Reform. Following years of stop-go reformsand mounting frustrations, prospects for meaningful reform of the economy have brightenedconsiderably with the September 1, 1994 inauguration of President Perez Balladares. The

iii Executive SummarV

Administration has prepared a comprehensive economic reform program that addresses many ofthe distortions that have held back the expansion of the economy in the past, the complex externalchallenges to Panarn's traditional sources of growth, and many causes of widespread poverty.Nonetheless, the Government will have to overcome the widespread sentiment that the country'sunique position will somehow enable it to prosper without changing the status quo.

Growth Prospects of the Leading Sectors

10. Panama has based its prosperity on enclave and enclave-like activities; however, many ofthe niches exploited by Panama are experiencing symptoms of exhaustion, in part because theleading sectors are subject to increasing external challenges, but mainly because domestic inputsare costly and deficient. The growth prospects of the financial system are constrained byincreasing external pressure to disclose financial operations and by the preference of foreignintermediaries for operating in financial centers less affected by perceptions of money laundering.New regional financial centers and financial liberalization in the region also pose challenges.Domestically, regulatory pitfalls are hindering growth of international operations of the CBI andthe domestic financial market. The bright spots are the possibilities open to the CBI to enter intointermediation of bonds and stocks from other countries in the region.

11. Projections for traffic variables through the Panama Canal indicate growth of 1.5-2% peryear during the next two decades. These modest traffic growth projections are conditioned by theincreasing number of efficient transport alternatives to the Canal. The Col6n Free Zone (ZLC)has been expanding rapidly since 1990, in the train of trade liberalization in Latin America. In thelong run, however, trade liberalization may erode the ZLC's competitive advantage. Liberalizationof capital movements also could erode the competitive advantage of the ZLC. Domestically, highport fees and inefficient port services erode the competitive position of the ZLC. The oil pipelineis expected to expire by the end of the decade. And the legal representation business, like theC1I, is under external scrutiny for money laundering perceptions as well as for tax evasionconcerns. Against these rather gloomy prospects, many observers pin their hopes on the resourcesthe country will be able to obtain from the Reverted Areas--the land and facilities that are beinghanded back by the U.S. Key issues concern the real magnitude of the endowment and how bestto develop it. Estimates in this report indicate that the economic value of the Reverted Areascould be as low as US$4.3 billion--much less than the US$25 billion figure traditionally put forth.Moreover, this windfall needs to be measured against the reduction in value added stemming fromthe withdrawal of the U.S. Defense Department (about US$2 billion in present value terms).

12. In the absence of major reforms, and now that the economic recovery has run its course,growth likely will revert to the feeble trend registered during 1981-93, or rather less than 3% perannum. But comprehensive economic reform, along the lines recommended in this report, couldboost annual GDP growth to 5% or more over the medium-term, while enhancing the economy'semployment-generating potential.

What Are the main Constraints to Sustainable Growth?

13. Despite considerable progress in reducing imbalances, fiscal stability is jeopardized by theinexorable increase of state wage bill, and the mounting deficit of the social security system.Moreover, state finances will need to be adjusted to free-up resources to service the largecommercial bank debt and to finance essential maintenance and investments. At the same time,the tax burden, including social security taxes and implicit taxes garnered through excessivecharges by state utilities, is very high and deters private sector development. Private sectordevelopment also is hindered by the encroachment of state enterprises and limited effectiveness ofthe state in carrying out key public fuinctions. Furthermore, the state is large--its overallexpenditures are equivalent to 31% of GDP, and it employs 16% of the labor force. The high

Executive Summary iv

costs, low reliability and inadequate coverage of state-dominated basic services constraindevelopment of the country's internationally-oriented services. Telephone service is both restrictedrelative to effective demand, unreliable and expensive, while diffusion of new services is severelyretarded. Charges for phone calls from Panama to the U.S. are more than twice as much as callsto Panama from the U.S. The incidence of electricity shortages is increasing, there are long delaysfor new connections, and the price of electricity for industrial users is high (more than 40% higherin Panama than in the U.S). Port services are poor, and container handling costs are between 50and 160% higher in Panama than in competing ports. The road system is in an advanced state ofdeterioration--only 41% of paved roads are in good condition.

14. The labor market in Panami is sharply segmented. Following introduction of the LaborCode in 1972, the unemployment rate has climbed far above its historical trend and highunemployment has become chronic. Under prevailing policies, there is little reason to expect adecline in the unemployment rate from the current 13.7%. Indeed, under current policies,Panama would need to grow 12% per year to achieve a 5% unemployment rate by the year2000. Given the monetary regime, the capacity of the economy to adjust efficiently to evolvinginternational market conditions hinges exclusively on the downward flexibility of domestic prices.Consequently, the aim of remaining policies should be to foster market flexibility; instead, currentpolicies prevent domestic prices from adjusting. This was demonstrated graphically during 1988-89, when the price level did not recede in response to the drastic reduction in liquidity. The LaborCode curbs the ability of the economy to compete and create jobs because it: (i) stipulates thatwages cannot be reduced; (ii) mandates a large number of nonworking days; (ii) renders thedismissal of employees difficult and expensive; (iii) inhibits both piece rate pay and temporarycontracts; (iv) heavily involves the state in labor-management relations; and (v) prohibits privateemployment agencies. Fringe benefits added to the wage bill are high: in certain sectors such asindustry and construction, the Labor Code generates excess labor costs equivalent to as much as64% of the base wage bill. Other policies also drive-up the cost of labor and impede job creation.

15. The trade regime is highly distorted. Nominal tariffs range from 3 to 90%; tariffs on keyagricultural commodities are even higher once reference prices are factored in. About 50% ofimports are exempted from duties. In addition, formidable nontariff barriers riddle the economy.Indeed, the trade regime is the most distorted in the region. On top of this, the Cabinet exercisesdiscretionary control over trade policy instruments and frequently modifies them. At the sametime, a complex web of price controls affects a large number of products, while de jure and defacto regulations restrict entry and impede competition in a number of rubrics which have a largeimpact on the economy's competitiveness.

16. Human capital formation is lagging severely. The issue is not that the public sectorspends too little on education, health and nutrition, but that it spends badly. The efficacy of socialspending is reduced greatly by the misallocation and wastage of resources, and by the strong biasof social programs in favor of urban and higher income groups The bulk of the spending in theintegrated health care system is devoted to expensive curative care. Tertiary education receives adisproportionate and rising share of the education budget but the educational system is notresponsive to labor market demand, and the overall quality of education is poor. Many primaryschools lack educational materials and a large majority of primary school students are ill-preparedbecause of the low coverage of preschools. Although 40% of first grade students suffer frommalnutrition, spending on school-based feeding programs is meager.

17. Widespread poverty in a services economy like the Panamanian one is the legacy primarilyof the economic policies that militate against growth and employment creation, and which fosterthe concentration of income. The economic incidence of the Labor Code is higher incomes for

v Executive Summarv

those shielded by it at the expense of high structural unemployment, low wages and inferiorworking conditions for those not covered by the Code, and higher prices for consumers, poor andrich alike. Steep protection of food and other basic consumption goods directly reduces the realincome of the poor in particular as well as spawning inferior working conditions in penalizedsectors. At the same time, heavy protection keeps output and incomes low in rural areas becauseit diverts resources from their most productive use. The exorbitant prices charged for basicservices by state monopolies likewise aggravate poverty. In addition, much stronger incentives forrational resource use and conservation are needed. In 1991, more than two-thirds of agriculturalholdings, covering fully one-half of all land in use, lacked property titles. Three-fourths of smallfarmers did not have title to the land they occupied.

The Challenge of Policy Reform

18. In the absence of comprehensive policy and institutional reforms, Panama will not be ableto surmount external challenges nor solve its long-standing problems of "duality," insufficientemployment generation, and bad income distribution. The complex array of policy interventionsand distortions also points to the need for careful sequencing of policy reforms. Indeed, prevailingdistortions impose competitive disadvantages in the various sectors that must be removed in awell-coordinated sequence, to avert unnecessary welfare losses. Moreover, the political feasibilityof implementing such a reform program will hinge on sequencing the various policy reforms insuch a way that no one sector bears undue transitional costs. Finally, the active pursuit of anumber of reforms will have to be phased-in over a lengthy period simply due to the sheer volumeand weightiness of the issues.

19. Phase I: Fiscal Adjustment, Poverty Alleviation, Regulatory Reform andPrivatization. The reform program should be launched with public sector reform because thesuccess of the program likely will depend crucially on private sector perceptions that the state iscommitted to putting its own house in order before it cuts programs to the private sector's likingor raises its taxes; because the state is the most inefficient sector in the economy and the highcosts it imposes on the private sector will need to be redressed to enable the economy to better.compete in its traditional growth sectors and to develop new internationally competitive activities;because the state will need to retarget its spending to the poor and to provide transitional supportto those affected by the reform process; and because the timely conclusion of a debt restructuringdeal requires a prompt adjustment of public finances to release the resources needed to service it.

20. In this context, the following sequence of public sector refbrms suggests itself First,measures to effectively check the growth of the public sector wage bill should be adopted; clearly,such an initiative should precede any effort to augment taxes on the private sector. This meansthat at some point, the issue of the Special Laws will have to be addressed, albeit in the meantimevarious expedients can be used to continue to curb the growth of the wage bill. At the same time,social spending needs to be reallocated to programs that directly alleviate poverty, such as theSocial Emergency Fund. More far-reaching social sector reform probably should be carried out ina later phase. Second, a simpler, more equitable and less distortionary tax system should beintroduced; in particular, the value added tax (ITBM) should be extended to all services, whilelow uniform income and import tax rates should be instituted, and tax exemptions and subsidiesphased-out;' however, such a reform, to the extent that it raises the effective tax burden onbusinesses and individuals (e.g., by eliminating tax subsidies), should only be implemented intandem with price reforms in the electricity, telecommunications and port ser6ices.

A flat, all inclusiv:- ad valorem tariiT of 6% would gf nerate at least as much reve nue as the Plethora of tariff levels andexemptions currently in force; however, while trade relortn, e.specially targets aid timetable for tariff reductions should bepublicly announced at the beginning of the reform program, it should not be urndertaken in isolation froin goods and labormarket reforms. as descfibed in Phase I1 below.

Executive Summary vi

Contrariwise, such price reforms cannot be implemented to their full extent without offsettingrevenue measures along the lines suggested. Third, an external debt restructuring accord shouldbe implemented. Fourth, once regulatory reform is underway, privatization of basic servicesshould be vigorously pursued. Finally, the measures needed to eliminate the mushrooming socialsecurity deficit should be left for the last phase of public sector reform because of the fierceopposition it will spawn. As in the case of streamlining the bloated state wage bill, eliminating thisdeficit can be achieved solely by reforming the Special Laws. In the end, fiscal sustainabilitycannot be attained without these major reforms. Pension fund reform, if it entails private providerschemes, also could step up domestic resource mobilization and spur a revival of the financialsystem. Financial system reforn, while needed, is much less urgent, and could be delayed.

21. While the public sector reform is unfolding, the Government also needs to conclude theimplementation of the measures required for a smooth turnover of the Panama Canal and thedevelopment of the reverted areas. First, and foremost, the legal framework should grant theCanal Authority autonomy, financial solvency, immunity to political pressures, and freedom toapply out-sourcing policies. The 1994 amendment to the constitution that creates the CanalAuthority includes provisions of autonomy and immunity to political pressures, but alsointroduces ill-advised restrictions on Canal management in respect of the labor regime. Thisamendment has to be ratified by the current Legislative Assembly, which provides the opportunityto redress the anomalous wage scales prevailing in the Canal Commission. Second, although thepotential for cost reduction in canal operations exists, and an innovative approach to managementand toll policy could result in greater revenues for Panama, a precautionary strategy of sticking tothe status-quo, to guarantee a smooth transition of ownership of the Canal to Panamanian hands,with no negative effects on service reliability, will by itself be a success. Third, in order for thecountry to maximize the potential benefits of the reverted areas, the reversion process must beincorporated in the broader context of economic liberalization. This would require resisting thetemptation to create new enclaves and the past practice of handing-out reverted assets to stateentities, in the spirit of policy-induced duality.

22. Phase II: Trade Liberalization, Price Deregulation and Labor Code Reform. Theelimination of the major policy-induced distortions affecting the private sector will need toproceed on a broad front. The Labor Code needs to be overhauled. At the same time, a uniform,low ad valorem import tax should be introduced, and all nontariff barriers, export taxes,prohibitions and quotas eliminated. As trade barriers are dismantled, price controls should berescinded, and all discretionary authority to control prices repealed. Labor legislation reform,especially the reduction of excess wage costs in protected sectors, is essential for sustainable tradereform, as removal of wage-inflating restrictions is equivalent to a real exchange rate depreciation.But employees who benefit from the Labor Code clearly would be unwilling to countenancefundamental reforms to the Code unless the prices of food, housing and other necessities arebrought down, something which trade reform would accomplish, by raising real incomes of thepoor and reducing upward pressures on wages. Similarly, employers in protected activities clearlywould be unwilling to accept meaningful trade reform unless the Labor Code is greatly modifiedprior to or in conjunction with trade reform, and the prices of basic services simultaneouslyrationalized. At the same time, price deregulation would not be welcome by the public withouttrade reform. One reform in this area that could and should be instituted right away is theelimination of rent controls, because it will generate broad-based benefits.

23. Phase m: Social Sector and Governance Reforms. Other key public sector reforms,which could be initiated at any time, include education reform, health care reform, andjudicial reform. Nonetheless, the reform agenda is so formidable, and the need to reinvigoratethe economy so pressing, that it probably would prove advisable to postpone major social sector

vui Executive Summarv

reforms until the major economic reforms are well underway. In addition, economic policyreforms should raise real incomes of the poor in the short-run. Another reason for doing so is thateducation reform, like social security reform, is going to provoke considerable opposition. In thecase of education, much greater emphasis needs to be attached to improving its quality, especiallyat the pre-primary, primary and intermediate levels; and on expanding coverage of pre-primaryand intermediary education, targeting rural areas and the urban poor. All social spending needs tobe much more effectively targeted.

24. Phase IV: Land Tenure Reform. Trade reform is a necessary but insufficient conditionfor modernizing Panama's backward agricultural sector. Land tenure reform, as it pertains to landtitling, is also needed to provide the population economically active in agriculture with sufficientincentive to modernize, and to enable the rural sector to gain access to credit at more competitiveprices. This reform is also needed for soil conservation.

The Government's Medium-Term Economic Reform Program

25. The Government is well aware of the challenges facing the economy, and has takenimportant steps to implement its Medium-Term Economic Reform Program. The MTEPencompasses trade and pricing reforms; reforms to restore a viable medium-term fiscal frameworkand creditworthiness; privatization and rehabilitation of economic infrastructure; reform of theLabor Code; and expansion of social safety net mechanisms, health care reform; and educationalreform. In addition, a top priority of the Government is the successful transition of the Canal andthe development of the reverted areas.

26. Fiscal Policies. While the deficit of the CSS should diminish as the provisions of a 1991reform law are phased-in, a key priority of the Government is to undertake a more far-reachingreform of social security, opening it up to the private sector and reducing its adverse employmenteffect. In June 1995, the Legislative Assembly approved the Fiscal Incentives Harmonization Law,which gradually eliminates a large number of tax breaks and subsidies, for import-substitutingactivities and nontradeables, while enhancing fiscal sustainability and laying the groundwork fortrade regime reform. The Government is preparing a new public sector employment regime, withthe support of the ERL technical assistance component, that would replace the plethora of speciallabor laws affecting about 50% of state employment. Also, the previous Administration privatizedseveral goods-producing state enterprises and several more enterprises are slated for divestmentduring 1995-96. The Government has not yet announced plans to generalize the value added tax.

27. Basic Services and Infrastructure. The Government, with the support of the ERL andIDB's PERL, is pursuing a two track approach to redress deficiencies in basic services andinfrastructure. One centers on upgrading enterprise efficiency, rationalizing pricing policies andrehabilitation; the other, on strengthening enterprise autonomy, regulatory reform andprivatization. Under the first track, enterprises have cut physical and nontechnical losses;improved metering and billing; reduced accounts receivable and payable; and increased outlays formaintenance and investment. Procurement procedures have been streamlined and tariffs for somebasic services partially rationalized (international phone calls and some port services). Under thesecond track, the Government is focusing on regulatory reform and contestability by: (i)separating policy formulation, regulatory and service delivery functions within each subsector andrestructuring operating entities along commercial lines in accordance with private corporate law;and (ii) unbundling the operations of utilities and public works entities to enable competition inthose aspects of service delivery which do not possess natural monopoly characteristics.

28. To this end, the Legislative Assembly recently approved a law which provides for theincorporation and partial privatization of the telecoms firm. The Legislative Assembly alsoapproved an amendment to the state electricity company's charter law that opens the generation

E:xecutive Summary viii

of electricity to the private sector. In addition, concessions have been granted to the private sectorto develop the cellular telephone market, and build and operate new port facilities. APN broughtcontainer handling fees into line with those charged by the new private port at Manzanillo. In thetransportation subsector, the Government is focusing on rehabilitation, deregulation and out-sourcing. A concession has been awarded to a foreign firm to construct and operate a PanamaCity-Col6n tollroad. During the second semester of 1995, the Administration plans to submit tothe Legislative Assembly a bill that would establish the regulatory framework and entity for theelectricity sector, and another bill that would do the same for the telecommunications sector.

29. Trade Policies. The Government has launched another round of trade reforms, in thecontext of its incorporation in the World Trade Organization, focusing on elimination of allnontariff barriers, gradual reduction of tariffs to a range of 0 to 30% (but with many exceptionsfor basic grains and processed foods) and the phasing-out of fiscal subsidies (which has beenlaunched with the recent passage of the Fiscal Incentives Harmonization Law). While this clearlyrepresents a considerable improvement over present policies, such a tariff band, especially withthe much higher tariffs for agricultural and agroindustrial goods, is too wide to induce the majorreallocative response needed to energize the large nonenclave sector of the economy or tosignificantly reduce inflated domestic prices. Thus, it would continue to thwart the transformationof Panama's feeble agriculture and poverty-stricken rural sector, regardless of other policyinitiatives. With this in mind, the Government is exploring further trade reform initiatives.Remaining price controls are to be removed in tandem with further trade reform measures. A billthat would curb barriers to competition (by eliminating the Price Regulation Office, introducingantitrust statutes, and instituting antidumping norms) will be submitted to the LegislativeAssembly. In addition, legislation that would liberalize the housing market--but retain rentcontrols, is under consideration. These controls should be completely eliminated.

30. Labor Market Policies. The Administration submitted a far-reaching reform of the LaborCode to the Legislative Assembly that would: (i) soften the provision that prohibits employersfrom reducing wage rates, and allow new employees to be hired at any wage rate (equal to orhigher than the minimum wage); (ii) curtail dismissal costs; (iii) eliminate the disincentives to bothpiece rate pay and temporary contracts; (iv) substantially reduce the direct role of Government inlabor-management relations; and (v) rescind the ban on private employment agencies.

31. Poverty Reduction. The Government's strategy for mitigating poverty and inequalityconsists of four chief elements. The first is the introduction of conditions that will revivesustainable growth. In this context, the economic program emphasizes reform policies that willmitigate the bias against employment creation and reduce the high cost of the consumptionbasket. In addition, the incentive framework will be altered so as to encourage increasedagricultural production and employment opportunities in the countryside, where most of the poorare located. Second is the introduction of new mechanisms to protect those persons mostsusceptible to malnutrition and vector-transmitted diseases. The third facet is improving efficiencyand equity in social expenditures through sector reforms, especially in education and health;curbing growth in the wage bill; instituting cost recovery, and targeting subsidies to the mostvulnerable groups. The fourth is institutional modernization and capacity-building.

32. External Debt Strategy. Normalization of relations with external creditors forms a keyelement of the Government's medium term economic program. In May 1994, Panama reachedagreement with external bond holders on a refinancing arrangement, and in May 1995, achievedan agreement in principle on a debt and debt service reduction accord with its commercial bankcreditors. The Government also intends to resolve its arrears situation with Mexico andVenezuela. These efforts should cheapen the cost of foreign financing, reestablish Governmentaccess to the international capital market, and encourage foreign direct and portfolio investment.

RESUMEN EJECUTIVO'

Una Economia Dual en Transicion

1. Estructura y fuentes de crecimiento. La economia panamefia, con un PNB per capitade US$ 2,580 (1993) y baja inflaci6n, es una de las mas estables y de mayor ingreso en la regi6n.Sin embargo, es tambien una economia altamente segmentada con un sector de serviciosorientado internacionalmente y otro sector orientado hacia el mercado local, de bajaproductividad y plagado de distorsiones inducidas por las politicas publicas. De manera similar,los mercados de factores estan segmentados por politicas que encarecen el costo del trabajo yabaratan el costo del capital. Cerca del 14% de la fuerza laboral esta desempleada, a pesar de lapreponderancia de los servicios en la economia, de la desaceleraci6n del crecimiento de la fuerzalaboral y de una relativamente baja migraci6n del campo a la ciudad. El magro desempenio de laeconomia ha reducido la creaci6n de empleos, llevando a que la pobreza afecte a casi el 40% de lapoblaci6n, exacerbando la indigencia y aumentando la desigualdad en los ingresos.

2. La peculiar estructura productiva de Panama se deriva en forma importante de su especialubicaci6n geografica. El Canal de Panama y un sistema monetario anclado en el uso del d6lar deEE.UU. contribuyeron a un rapido desarrollo de una economia basada en servicios al inicio de larepuiblica. Ambos factores tambien influyeron en la creaci6n de la Zona Libre de Col6n (ZLC) afinales de los afnos 40, hecho que coincidi6 con la intensificaci6n de politicas comercialesrestrictivas en la regi6n. Ello ayud6 a que la ZLC contribuyera significativamente al crecimientode la economia en las siguientes tres decadas. Panama tambien aprovech6 su posici6n geografica,el uso del dMlar y restricciones en otros paises para crear el Centro Bancario Internacional (CBI)en 1970, el cual creci6 rapidamente durante la siguiente decada. La licencia de la banderapanamena a barcos de todo el mundo, labores de contaduria y representaciones legales a empresasextranjeras y el oleoducto transistmico tambien generaron rentas sustanciales. La economia creci6mas de 6% anual entre 1950 y 1981. Aunque durante la decada de los anios 70 y anossubsiguientes se introdujeron serias distorsiones a la economia, sus efectos negativos sobre elcrecimiento fueron ocultados por masivos influjos de capitales. Despues del segundo shockpetrolero y de la crisis de la deuda externa, las distorsiones deprimieron el crecimiento a 2,5%anual en el periodo 1981-93.

3. ,Dualidad estructural? El modelo de "economia dual" de Panama se ha agotado. Asi lodemuestran una tendencia hacia la disminuci6n del crecimiento econ6mico, niveles de desempleocrecientes por varios ainos y altos indices de pobreza. El tema de la dualidad es central paraentender el dilema que enfrenta Panama. Por un lado, los efectos positivos que ejercen losservicios de exportaci6n mas importantes sobre el resto de la economia son limitados. Dichossectores representan una porci6n importante del PI3 y en particular de las exportaciones, perogeneran poco empleo (3% de la fuerza laboral) y escasos ingresos fiscales. Por otro lado, los altossalarios pagados en los enclaves, particularmente en el Canal de Panama, donde se aplica el salariominimo de EE.UU., ejercen tambien efectos negativos sobre el resto de la economia pues elevansustancialmente las expectativas salariales respecto al costo de oportunidad del trabajo en otrossectores de la economia. La pregunta clave desde una perspectiva de politica econ6mica es hastaque punto la dualidad es "estructural", es decir, generada por la naturaleza tecnol6gica de lossectores de servicios de exportaci6n lideres y hasta que punto esa dualidad es alimentada porpoliticas e instituciones internas.

4. En respuesta a la aparente incapacidad de la economia para generar empleos productivosen una cantidad suficiente para absorber una fuerza laboral creciente, muchos argumentan que lareceta de politica econ6mica mas apropiada es la promoci6n de nuevas actividades por parte delestado, a traves de empresas estatales, exenciones de impuestos y subsidios. Esto da surgimientoa lo que algunos llaman el "enfoque panamefio del crecimiento", basado en el desarrollo de

1 La version en espaflol del Resumen Ejecutivo es mas extensa que la versi6n en ingles.

ii Resumen Eiecuiivo

t"enclaves" como la ZLC y el CBI, que tienden a replicar el concepto basico del Canal de Panamamismo. La fuerte protecci6n a la industria y la agricultura tradicional, asi como la restrictivalegislaci6n laboral son tambien subproductos de este enfoque. Ejemplos mas recientes en la mismalinea son la ley de fomento al turismo y la ley que establece zonas de procesamiento deexportaciones. Este enfoque tambien se relaciona con el tema crucial de cual es la mejor forma dedesarrollar las areas e instalaciones en las areas de la antigua Zona del Canal que revertiran alpais.

5. Dualidad inducida por politicas. Si bien la dualidad estructural es importante, no se ledebe poner mayor enfasis del necesario. El predominio de unos pocos sectores en lasexportaciones de un pais es una consecuencia directa y natural de la especializaci6n econ6mica deun pais pequeno. Este predominio se convierte en problema de dualidad cuando un pais no diseniaformas eficientes de capturar y redistribuir parte de los excedentes generados por los sectoreslideres. En efecto, esos excedentes pueden ser capturados a traves de impuestos nodistorsionarios y redistribuidos e invertidos a traves de programas (tambien no distorsionarios)que promuevan el crecimiento y reduzcan la pobreza. En tal caso, el peso relativo de los enclavesestructurales y sus eventuales efectos adversos, tenderan a desaparecer con el tiempo a medidaque la economia crezca. Esto no ha sucedido en Panama. Al contrario, las politicas publicasprimordialmente han capturado y distribuido los excedentes a traves de intervenciones altamentedistorsionarias, con resultados muy negativos. De esta forma han: (i) erosionado los naturalesefectos positivos de los sectores lideres sobre el resto de la economia y han acentuado los efectosnegativos; (ii) minado el potencial de crecimiento de los propios sectores lideres; (iii) malgastadoesos excedentes y recursos de otros sectores, al canalizarlos hacia actividades en las que el pais nocuenta con ventajas comparativas o directamente hacia grupos de presi6n; (iv) reducido elpotencial de generaci6n de empleo con politicas que favorecen tecnicas intensivas en capital; y (v)redistribuido ingreso desde los pobres hacia grupos de mayores ingresos.

6. El "enfoque panamefno del crecimiento" y el dilema de la dualidad puede ser ilustradoteniendo como referencia a la ZLC. La ZLC genera mas de una quinta parte de las exportacionesde bienes y servicios y 8% del PIB, pero emplea s6lo un 1% de la fuerza de trabajo,principalmente trabajadores de baja calificaci6n (s6lo un 25% del valor agregado de la ZLCrepresenta remuneraci6n al trabajo). Claramente, este enclave genera poca demanda por trabajo yuna distribuci6n del ingreso muy concentrada. Estos resultados, aunque en partetecnologicamente intrinsecos al tipo de actividad que envuelve la ZLC, son exacerbados por lasseveras distorsiones que se desprenden de las politicas de comercio exterior y laborales del pais,las cuales se traducen en un sistema de precios relativos adversos al factor trabajo, promoviendola adopci6n de tecnologias intensivas en capital en la ZLC (y en el resto de la economia). Dehecho, aunque parezca ins6lito, la economia panamefna es casi tan intensiva en capital como laeconomia de EEUU! Uno de los efectos positivos mas significativos de la ZLC sobre el resto dela economia es la generaci6n de una demanda sustancial por viviendas de alto valor. Sin embargo,tambi6n existen diversas intervenciones en los mercados del sector construcci6n y vivienda:salarios y beneficios a los trabajadores de la construcci6n artificialmente altos; altos aranceles deimportaci6n a los insumos de la construcci6n; y controles a los alquileres de las viviendas. Elresultado es que el efecto positivo de la ZLC se reduce ya que tanto la demanda por viviendascomo la demanda por trabajadores (en la construcci6n) son menores a lo que serian en ausenciade distorsiones. Ademas, los excedentes de los grupos de altos ingresos que compran lasviviendas caras, en lugar de repartirse a traves de la poblaci6n, se concentran en unos pocosprivilegiados: trabajadores, empresarios de los sectores construcci6n y proveedores, protegidospor la intervenci6n del estado. Finalmente, la poblaci6n de bajos ingresos termina pagando granparte del costo de las distorsiones a traves de precios mayores de las viviendas, menores salariospara trabajadores no calificados y mayor desempleo.

Resumen Eiecutivo iii

7. Ademas de lo anterior, las actividades de la ZLC, como todos los servicios, estan exentas delimpuesto al valor agregado en tanto que las tasas del impuesto a la renta a que estan sujetas lasempresas y personas que alli trabajan son particularmente bajas (8% versus el 30% que se aplicaen general). Esta es la raz6n por la que la Zona contribuye con solo el 2% de los ingresos fiscales.En compensaci6n, la ZLC es afectada por una forma de impuesto altamente distorsionaria, comoson los exorbitantes precios de los servicios publicos que cobran empresas estatales altamenteineficientes. Estas rentas son subsecuentemente redistribuidas a grupos de ingresos medios y altos,ya sea a traves de regimenes laborales especiales en esas empresas (puertos, telecomunicaciones yelectricidad), o por medio de politicas sociales muy mal orientadas y prebendas a la burocraciaestatal (altos salarios y pensiones muy generosas). Ademas, despues de que estos grupos de poderobtienen lo que quieren, el estado invierte lo poco que queda de los excedentes que recauda por lavia de altas tarifas de servicios publicos, tanto de la ZLC como de otros sectores lideres, pero lohace de manera ineficiente. Tanto es asi, que estudios econometricos preparados para esteinforme muestran que la inversi6n publica no realiza una contribuci6n estadisticamentesignificativa al crecimiento de la economia panamenia.

8. El presente memorandum hace enfasis en que la dualidad no debe ser combatida a traves de laparticipaci6n del estado en el desarrollo de nuevos sectores econ6micos "promisorios" ni a travesde politicas de promoci6n. Por el contrario, los problemas de dualidad deben ser enfrentados conun amplio programa de reformas, que incorpore a las fuerzas de mercado y al sector privado enun papel mucho mas activo eliminando asi la segmentaci6n de mercado inducida por las propiaspoliticas publicas. Para mitigar la tendencia estructural de la economia panamena a la dualidad, serequieren ademas estructuras tributarias uniformes y menos distorsionadas (incluyendo las tarifasa las importaciones), una legislaci6n laboral mas flexible, una reforma a la regulaci6n en general yun proceso de privatizaci6n de empresas publicas. Solo asi se podra revigorizar el crecimiento y elpotencial de generaci6n de empleo en la economia.

9. Perspectivas y desafios de las reformas. Despues de algunos anos de intentos y retrocesosde las reformas y de las respectivas frustraciones, especialmente de los sectores de menoresingresos, las perspectivas de que existan reformas mas permanentes en la economia han mejoradoconsiderablemente luego de la asunci6n al poder del Presidente Perez Balladares. Su gobierno hapreparado un programa comprensivo de reformas econ6micas que enfrenta directamente lasdistorsiones que han obstaculizado la expansi6n econ6mica en el pasado al enfrentar los desafiosexternos que presentan los servicios de exportaci6n tradicionales y las causas de la masivapobreza. Sin embargo, el gobierno tendra que combatir la difundidalcreencia en que la posici6ngeografica privilegiada de Panama le permitira progresar sin cambiar el status quo. Asimismo,debera superar la oposicion de los grupos de interes que se favorecen del status quo y la tentaci6nde reimpulsar el enfoque panamenio del crecimiento que se origina en la reversi6n de activos comoel Canal y las areas adyacentes. Para abordar estos desafios, el gobierno necesitara divulgar suestrategia de reformas, especialmente a quienes se benefician de ellas para contar con su apoyomasivo, a tiempo que debera realizar una secuencia cuidadosamente establecida tendiente aldesmantelamiento del complejo sistema de distorsiones prevaleciente. Esto con el fin de evitarperdidas de bienestar innecesarias y una mayor oposici6n al programa de reformas.

Antecedentes y Acontecimientos Recientes

10. Distorsiones y estancamiento. En los ultimos veinticinco anos, la segmentaci6n de laeconomia derivada de las politicas publicas y las ineficientes empresas estatales, han mantenido elcrecimiento de la economia muy por debajo de su potencial. Desde los inicios de la decada de losainos 70 se impusieron fuertes esquemas de protecci6n a la producci6n manufacturera y de granos,asi como un extensivo conjunto de controles de precios. En 1972, la promulgaci6n del C6digoLaboral gener6 grandes distorsiones al mercado laboral. Muchas empresas fueron nacionalizadas

iv ¢Resumen Eiecutivo

y se crearon nuevas empresas estatales tanto asi que el estado domin6 en poco tiempo losservicios basicos al tiempo que se cre6 un complejo aparato estatal para la agricultura. Durantelas decadas de los setenta y ochenta, el estado fue un empleador de primera instancia, generandodos terceras partes de todos los nuevos puestos de trabajo. Los servicios sociales fueronampliados significativamente, especialmente en lo que respecta al sistema de seguridad social delos empleados puiblicos y a la educaci6n terciaria. Los indicadores sociales mejoraronsustancialmente, pero la economia comenz6 a debilitarse, el desempleo aument6 persistentementey la pobreza empeor6. Mientras el gasto publico con respecto al PEB crecia, aumentaba laintervenci6n estatal y se destinaban recursos considerables a areas en que la economia teniadesventajas comparativas, la inversi6n privada era desplazada, desaparecia la inversi6n extranjeray la competitividad de los servicios de exportaci6n se erosionaba. La expansi6n del estado fuefinanciada con endeudamiento externo, al punto que en 1980, Panama tenia una de las deudas percapita mas altas del mundo con la banca comercial.

11. A principios de los an'os 80, el PIB cay6 como consecuencia de la crisis de financiamientopuiblico que sigui6 a la crisis de la deuda externa. El gobierno de la epoca emprendi6 un programade estabilizaci6n y reformas, con el apoyo del Banco Mundial y del FMI. A pesar que el primerPrestamo de Ajuste Estructural (SAL) se desembols6 completamente, el gobierno fue incapaz deprogresar substancialmente en su propio plan de reformas. El segundo SAL fue cancelado antesdel desembolso del segundo tramo, lo que coincidi6 con la reversi6n de varias de las reformasiniciadas anteriormente. Cuando se intensific6 la crisis politica de fines de los anios 80, el gobiernodej6 de servir su deuda externa (1987). La misma crisis y la imposici6n de sanciones econ6micaspor parte de EE.UU. llev6 a una contracci6n del 16% del PIB en el periodo 1988-89.

12. Pobreza y desigualdad. A pesar de su relativamente alto ingreso per capita, cerca de latercera parte de la poblaci6n vive en la pobreza (40.6% en 1989). Aunque existe pobreza absolutaen zonas urbanas, como la ciudad de Col6n--ir6nicamente al lado de la zona de libre comerciomas importante del hemisferio occidental--y en los alrededores de la Ciudad de Panama, lapobreza en Panama es principalmente un problema rural. Dos terceras partes de la poblaci6npobre de Panama vive en el campo y mas de la mitad de la poblaci6n rural es pobre. Ladistribuci6n del ingreso esta muy concentrada en los grupos de mayores ingresos y se ha vueltomas inequitativa en la iultima decada. En 1979, el 20% mas pobre de la poblaci6n recibia el 4% delingreso. En 1989, esa participaci6n habia caido al 2%. En este mismo anio, Panama tenia una delas distribuciones del ingreso mas desiguales del hemisferio de acuerdo con el coeficiente de Gini.Ademas, en 1989 el ingreso real promedio del 20% mas pobre de la poblacion era una terceraparte mas bajo que en 1979 (esto es en parte debido a la contracci6n econ6mica de 1988-89).

13. Desempeiio econ6mico reciente. El gobierno que sigui6 al derrocado regimen militar deNoriega en diciembre de 1989, lanz6 un nuevo programa de estabilizaci6n y ajuste. Esteprograma, apoyado por instituciones bilaterales y multilaterales (en el caso del Banco Mundial, atraves del ERL, o Prestamo de Recuperaci6n Econ6mica, en 1992), intentaba incrementar laeficiencia a traves de la apertura de la economia a la competencia extema y de la reforma al sectorpublico, al tiempo que pretendia restaurar la solvencia y credibilidad financiera del pais. El ERL yel apoyo de otros donantes le permiti6 al pais ponerse al dia en sus obligaciones atrasadas con lasinstituciones financieras internacionales (IFIs). En el periodo 1990-94 se avanzosignificativamente en la reducci6n de los desequilibrios internos y externos. Al mismo tiempo, ellevantamiento de las sanciones econ6micas extemas y la propia implementaci6n del programa deajuste elev6 la confianza en Panama, cuyo resultado fue una repatriaci6n de activos privados ygrandes flujos de ayuda bilateral que permitieron financiar un aumento en la inversi6n privada yconsumo. Este aumento en la absorci6n repercuti6 en una rapida recuperaci6n de la actividadecon6mica y un aumento importante en las importaciones. La producci6n global comenz6 a

Resumen Eiecutivo v

recuperarse, creciendo 9,5% en 1991, 8,6% en 1992, 5,6% en 1993 y 4,7% en 1994, alcanzandoen este ultimo anio el nivel de ingreso per capita prevaleciente antes de la crisis. La inflaci6npermaneci6 en niveles por debajo del 2% durante todo el periodo, en tanto que la tasa dedesempleo descendi6 hasta 13,7% en 1994, cifra que todavia es muy alta comparada con losniveles anteriores a la crisis.

14. A nivel sectorial, la construccion ha sido de lejos el sector mas dinamico despues de lacrisis. Aunque la construcci6n cay6 a niveles extremadamente bajos en 1989, su recuperaci6n fuevertiginosa, con un crecimiento acumulado de mas de 350% entre 1990 y 1993. El boom de laconstrucci6n tambien foment6 una fuerte recuperaci6n de la industria manufacturera. Laevoluci6n positiva del P1IB despues de la crisis se fundamenta en el gran dinamismo de la ZLC--eluinico sector en que el producto no se redujo en 1988-89. Ello se debe tanto a las altas tasas decrecimiento que el ZLC experimenta entre 1991 y 1993 (36, 28 y 13% respectivamente), como asus efectos positivos sobre otros sectores de la economia, especialmente la construccion. Laagricultura, por su parte, se recuper6 con la restauraci6n de la cuota de importaci6n de azucar porparte de EE.UU., pero su crecimiento disminuy6 en 1993. En general, el crecimiento de laeconomia continuo desacelerandose en 1994, con la excepcion del Canal, que registr6 el mas altovolumen de trafico de la historia ese anio. En 1995 se espera que el crecimiento econ6micocontinue desacelerandose un poco mas, a 3 o 4%. En efecto, aunque existen algunos grandesproyectos en ejecuci6n, el boom de la construcci6n esta cediendo. El segmento de viviendas dealtos ingresos esta saturado y los precios y alquileres estan comenzando a bajar. Ademas, seespera que el crecimiento en el trafico del Canal retomne a niveles normales. La inflaci6n, quenunca ha sido un problema en Panama, continuara siendo en 1995 menor a la internacional, aligual que en los u1timos siete ainos.

15. En el periodo 1990-93, una buena parte del crecimiento en la demanda interna fuesatisfecho con importaciones, que crecieron dos veces mas que el PIB. Las exportaciones, que serecuperaron rapidamente despues de la crisis, se estancaron en 1992-93, a pesar del sostenidocrecimiento de las exportaciones no tradicionales (18% en 1993). Como resultado, el balance derecursos extemos pas6 de un gran superavit (11% del P1IB en 1988) a un deficit del 2% en 1993.La expansi6n del deficit de la cuenta corriente se sostuvo en la recuperaci6n de los flujos decapital hacia el pais, la ayuda financiera bilateral y la repatriaci6n de capital privado. El deficitglobal en la balanza de pagos fue mas que compensado por la acumulaci6n de atrasos con iabanca comercial. Aunque Panama normaliz6 sus relaciones con el Club de Paris y las IFIs, esimprobable que deficits en la cuenta corriente como los experimentados en los ultimos dos afiospuedan sostenerse ante el descenso de los flujos de ayuda externa y sin alivio a su carga de ladeuda externa. Frente a esta situaci6n, PanamA acord6 con los tenedores internlacionales de susbonos una refinanciaci6n, en mayo de 1994, en tanto en mayo de 1995 alcanz6 un acuerdo enprincipio con la banca comercial para la reduccion de la deuda y su servicio.

16. Entre 1990 y 1994, se alcanzo un s6lido progreso en las finanzas publicas. En efecto,luego de un d6ficit de caja del 9%,o del PIB en medio de la contracci6n econ6mica de 1989, sealcanz6 un superavit de caja de mas de 5% del PIB en 1992. ElLo fue el reflejo no s6lo de unamayor recaudaci6n tributaria como consecuencia de la propia recuperaci6n econ6rmica y de unaumento transitorio en las tasas de los impuestos, sino de un freno a los gastos corrientes y elmantenimiento de los gastos de inversi6n a niveles minimos. El gobierno de la epoca cumplioconsistentemente con los criterios de desempeino requeridos por el FMI en sus programas definanciamiento, pero encontro serias barreras politicas para implementat algunos puntos claves deuna reforma fiscal de mediano plazo que permitiria establecer uria posicion fiscai financieramentesostenible. Tampoco hubo grandes avances en las reforrmas econ6micas estructtirales apoyadaspor el ERL del Banco Mundial y el Prestamo para la Reforma de las Empresas Publicas (PERL)del BID. Quizas como consecuencia de lo anterior, en 1993 el resultado de caja del sector publico

u Resumen Elecutiv

no financiero se torn6 en un deficit del 1% del PIB (cerca de 4% si se considera en terminos decausaci6n). Esta situaci6n se revirti6 a un superavit en 1994, a pesar de que nuevamente el avanceen las reformas estructurales fue reducido. Sin embargo, es elogiable que la posici6n financiera delsector publico haya sido superavitaria en 1994, durante un anio de elecciones presidenciales.

Perspectivas de Crecimiento de los Sectores Lideres

17. A lo largo de su historia, Panama ha basado su crecimiento en el desarrollo de enclaves ode actividades similares, todas ellas orientadas a los servicios de exportaci6n. En los uiltimos anios,muchos de los nichos explotados por Panama en el pasado estan experimentando signos deagotamiento. Ello se debe en parte a la liberalizaci6n de los mercados mundiales y los crecientesdesafios que generan para los servicios panamenos. Sin embargo, dicho agotamiento se debetambien al encarecimiento de los insumos dom6sticos y al deficiente nivel de los servicios basicosen el pais. Asi, por ejemplo, las perspectivas de crecimiento del sistema financiero estancondicionadas por factores externos y politicas dom6sticas. En el frente externo, se puedendestacar dos amenazas: (i) una presi6n creciente de EE.UW. y otros paises desarrollados sobrePanama para que abra las operaciones financieras del CBI, sobre la base de sospechas de lavadode dinero y (ii) la preferencia de los intermediarios financieros por operar en otros centrosfinancieros internacionales menos afectados por percepciones de lavado de dinero. El desarrollode nuevos centros financieros regionales y la liberalizaci6n financiera en la regi6n son tambi6ndesafios a considerar seriamente. A nivel interno, algunas deficiencias regulatorias (en particular elactual sistema de licencias bancarias) estan minando en cierta medida tanto el crecimiento del CBIcomo la eficiencia en el funcionamiento del mercado financiero domestico. Lo mas promisorioparecen ser las posibilidades que tendran los bancos del CBI para entrar en nuevas lineas denegocios, especialmente en intermediaci6n de titulos, bonos y acciones de otros paises de laregi6n. Sin embargo, los inadecuados servicios de telecomunicaciones en el pais constrinienseveramente esas posibilidades de crecimiento.

18. Las proyecciones de las variables de trafico a traves del Canal de Panama indican uncrecimiento de 1,5% a 2% anual en las proximas dos decadas. Las proyecciones son modestasdebido al creciente numero de formas de transporte alternativas al Canal. Sin mayores cambios enlas politicas de peaje, un crecimiento del 2% anual en los ingresos permitiria una contribuci6n de0,14% al crecimiento del PEB en los pr6ximos cinco anios. La Zona Libre de Col6n se ha venidoexpandiendo fuertemente desde 1990, lo que ha coincidido con el proceso de apertura comercialen America Latina. En el largo plazo, sin embargo, este mismo proceso de apertura puedeerosionar la ventaja competitiva de la ZLC. .Algo similar puede decirse del proceso deliberalizaci6n de los movimientos de capitales, que tambien esta teniendo lugar en la regi6n, en lamedida en que se traduce en una reducci6n en los costos financieros domesticos en los paises delcontinente hasta alcanzar niveles similares a los que obtienen las empresas de la ZLC. A nivelinterno, las altas tarifas portuarias y la ineficiencia de los servicios en los puertos restancompetitividad a las actividades de la ZLC. Esto por si s6lo constituye un fuerte argumento parala pronta reestructuraci6n de los servicios basicos en Panama. El oleoducto se espera que seextinga hacia fines de la decada, en tanto las actividades de representaciones legales, de la mismamanera que el CBI, estan bajo la mirada escrutadora de EE.WU. y paises desarrollados porsospechas de lavado de dinero y por consideraciones de evasi6n tributaria.

19. Contra estas perspectivas algo sombrias, muchos observadores tienen sus esperanzaspuestas en los recursos que el pais obtendra de las Areas Revertidas (la regi6n interoceAnica ylas correspondientes instalaciones que estan siendo devueltas por el gobierno de EE.UU. a laRepublica de Panama). Los dos temas mas importantes a este respecto son el valor econ6micoreal que tienen esas tierras e instalaciones y cual es la mejor forma de desarrollarlas. Lasestimaciones en este informe indican que el valor econ6mico de las Areas revertidas podria ser del

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orden de US$4.300 millones, mucho menos que la cifra de US$25.000 millones que usualmentese menciona en el debate publico panameno. Ademas, este incremento en el capital de Panamadebe ser contrarrestado por la reducci6n en el valor agregado que implica el retiro delDepartamento de Defensa de EE.UU. del area del Canal (proceso que tambien culmina a fines de1999), que se estima tiene un valor presente de US$ 2.000 millones calculado para el periodo1995 -2000.

20. Si no se producen cambios substanciales de politica econ6mica, respecto a la situaci6nprevaleciente en 1994, y dado que la recuperaci6n econ6mica post-crisis ya se complet6, elcrecimiento probablemente vuelva al mediocre registro promedio de 1981-93, es decir, algomenos del 3% anual. Al contrario, un plan de reformas coherente y comprensivo, en linea con losugerido en este informe y tambien en buena parte contenido en el programa del actual gobiemo,podria impulsar el crecimiento hacia niveles superiores al 5% anual en el mediano plazo.

,Cuales Son las Principales Restricciones que Enfrenta un Crecimiento Sostenible?

21. Panama enfrenta una serie de desafios externos de importancia: (i) el retiro de EE.UU. dela administraci6n del Canal y de las areas revertidas; (ii) los procesos de liberalizacion econ6micaen la regi6n y cambios tecnol6gicos en los servicios; (iii) la formaci6n de bloques comerciales; (iv)una fuerte caida en los flujos de ayuda bilateral; y (v) el aumento en las tasas de interesinternacionales y la depreciaci6n del dolar. No obstante, los impedimentos mAs relevantes para uncrecimiento sostenido son de naturaleza domestica.

22. A pesar del considerable progreso alcanzado en la reducci6n de los desequilibrios, laestabilidad fiscal sigue amenazada por el aumento inexorable en la masa salarial del sectorpublico (independientemente de consideraciones de productividad e incluso de compensacionespor perdida de poder adquisitivo) y el deficit creciente del sistema de seguridad social, ademas degrandes compromisos futuros no financiados. Adicionalmente, las finanzas puiblicas requeriran deun ajuste para liberalizar recursos con el fin de servir la gran deuda externa con la bancacomercial, asi como llevar a cabo inversi6n publica esencial. Al mismo tiempo, la elevada cargatributaria, que incluye las contribuciones a la seguridad social y los impuestos implicitos en lasaltas tarifas de los servicios publicos, frena la dinamica que podria imprimir el sector privado. Losexcesivos precios que cobran las empresas publicas de servicios basicos tendran inevitablementeque ser reemplazados por impuestos explicitos o rebajas de gastos. El desarrollo del sectorprivado tambien se ve afectado por el anquilosamiento de las empresas estatales y la limitadaefectividad del estado para llevar a cabo funciones publicas esenciales, como la administraci6n dejusticia. Ademas, el tamanio del estado es grande (el gasto es del 31% del PIB, y emplea el 16%de la fuerza laboral), lo que resta espacios al sector privado.

23. El alto costo, la baja confiabilidad y la inadecuada cobertura de los servicios bisicos einfraestructura, que en su mayor parte son provistos por empresas estatales, obstaculiza eldesarrollo de los servicios de exportaci6n. En telecomunicaciones, el servicio telef6nicotradicional no alcanza a satisfacer la demanda efectiva y es poco confiable, mientras la provisi6nde nuevos servicios esta sumamente atrasada. En la generaci6n de energia, los cortes en el fluidoelectrico son habituales y las nuevas conexiones presentan grandes demoras. El sistema decarreteras esta en un avanzado estado de deterioro (s6lo el 41% de las carreteras pavimentadasestAn en buenas condiciones). En terminos de tarifas y costos se destaca lo siguiente: en el caso depuertos, el costo de manejo de containers es entre 50 y 160% mas alto en Panama que en lospuertos competidores; los cargos por llamadas telef6nicas desde PanamA a los EE.UU. son masdel doble que los cargos por Ilamadas desde los EE.UU. a Panama; y el precio de la electricidadpara los usuarios industriales en PanamA excede en mas de un 40% el que se paga en los EE.UU.Los empresarios locales cada vez mas se ven forzados a buscar soluciones privadas paralelas paraafrontar las interrupciones y deficiencias de calidad de los servicios. Estas ineficiencias provienen

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de: (i) marcos regulatorios inadecuados y falta de autonomia de las empresas publicas; (ii) altoscostos de operaci6n, perdidas fisicas no tecnicas y pesadas obligaciones crediticias; (iii) barreras ala participaci6n del sector privado; (iv) uso masivo de los superavits operacionales de lasempresas estatales para financiar el presupuesto del Gobierno; y (v) engorrosos procedimientospara las compras y suministros.

24. El mercado de trabajo en Panama se presenta marcadamente segmentado. Posterior a laadopci6n del C6digo del Trabajo en 1972, la tasa de desempleo creci6 muy por encima de sucomportamiento hist6rico y el alto nivel de desempleo se ha vuelto cr6nico. Sin cambios en lalegislacion laboral, no se puede esperar un descenso significativo de la tasa de desempleo desde elactual 13,7%. Sin cambios en las politicas laborales, Panama necesitaria crecer 12% por aiiopara llegar a una tasa de desempleo del 5% hacia el ahio 2000. Debido al regimen monetario,la capacidad de la economia para ajustarse con eficiencia a las condiciones cambiantes delmercado internacional depende exclusivamente de la flexibilidad de los precios dom6sticos haciael descenso. Esta flexibilidad se ve seriamente restringida con la actual legislaci6n laboral y supeculiar aplicaci6n, lo que se vio demostrado en la recesi6n de 1988-89, cuando el nivel deprecios no cedi6, al menos no significativamente, como respuesta a la drastica reduccion deliquidez.

25. El C6digo del Trabajo reduce la capacidad de la economia para competir y crear empleosdebido a que: (i) estipula que los salarios no pueden ser reducidos bajo ninguna circunstancia; (ii)establece demasiados dias feriados; (ii) hace el despido de empleados dificil y costoso; (iii) inhibetanto la contrataci6n a destajo como la temporal; (iv) involucra demasiado al Estado en lasrelaciones empleado-administraci6n; y (v) prohibe agencias privadas de empleo. Los beneficiosaccesorios al salario basico son altos, En ciertos sectores, tales como la industria y laconstrucci6n, el Codigo del Trabajo genera un exceso de costo laboral por concepto de beneficiosequivalente al 64% del salario basico. Otras politicas tambien elevan el costo laboral e impiden lacreaci6n de empleos. La protecci6n excesiva infla los precios de los alimentos, las viviendas yotros bienes de consumo. Los monopolios estatales trasladan su ineficiencia a los consumidores atraves de precios altos en los servicios publicos. Los incentivos fiscales abaratan el capital. Lalegislaci6n sobre salario ninimo y la tradici6n de arreglos remuneratorios generosos en el sectorpublico incrementan las expectativas sobre las remuneraciones en el sector privado. Los altossalarios pagados en el Canal tambien incrementan las expectativas sobre remuneraciones. Elcosto laboral en Panama es alto en terninos de dMlares, pero el alto costo relativo de los bienes yservicios esenciales en el pais deprime los salarios reales en relaci6n con paises competidores. Porejemplo, los precios de la vivienda son 47% mas altos en Panama que en Costa Rica, aunque losdos paises tienen ingresos per capita similares.

26. El regimen de comercio es muy discrecional y distorsionado. Las tarifas nominalesvarian del 3% hasta el 90%. Alrededor del 50% de las importaciones estAn exentas de aranceles.Ademas, las barreras no arancelarias permean toda la economia e incluyen cuotas restrictivas,precios de referencia y restricciones sanitarias prohibitivas. En verdad, el regimen de comercio,con sus formidables barreras no arancelarias, es el mas distorsionado de la regi6n. Como si estofuera poco, el Consejo de Gabinete ejerce un control discrecional sobre los instrumentos depolitica comercial y los modifica con frecuencia.

27. Un complejo sistema de control de precios afecta un gran nuimero de productos.Ademas, tanto de hecho como de derecho, existen diversas regulaciones que restringen la entradade nuevos productores e impiden la competencia en varias actividades que a su turno tienen unimpacto grande en la competitividad de la economia. El impacto mAs importante se presenta enservicios basicos tales como telecomunicaciones, puertos y energia. Ademas, estA prohibida porley la venta de bienes al detalle a precios por debajo de los precios de lista estipulados por los

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productores manufactureros. La sustentaci6n de los precios de venta al detalle permea toda laeconomia. Es mis, no existe una legislaci6n anti-monopolios y la colusi6n es una practica muydifundida. Por ejemplo, el transporte de todo bien hacia y desde la ZLC esta concentrado en dossindicatos de trabajadores y una cooperativa de transportistas a la vez que existe una granlimitaci6n a la participaci6n de transportistas extranjeros en la movilizaci6n de exportaciones eimportaciones. Finalmente, el control de los alquileres restringe de manera muy importante laoferta de viviendas para los grupos de ingresos medios y bajos.

28. La formaci6n de capital humano se esta rezagando en forma severa. El problema no esque se gaste muy poco en educaci6n, salud y nutrici6n --de hecho, se gasta un monto de recursossignificativo en servicios sociales, en relaci6n al nivel de ingreso per capita-- sino que se gastaineficientemente. La eficacia del gasto social se reduce en forma importante por la malaasignaci6n y el desperdicio de recursos, y por los fuertes sesgos de los programas sociales enfavor de los grupos urbanos de mas altos ingresos. El grueso del gasto en el sistema integrado desalud se dedica a la costosa atenci6n curativa. La educaci6n terciaria recibe unadesproporcionada y creciente porci6n del presupuesto de educaci6n, el sistema educativo noresponde a las demandas del mercado laboral y en general la calidad de la educaci6n es pobre. Encontraste, muchas escuelas primarias carecen de materiales educativos y una gran mayoria deestudiantes de las escuelas primarias estan mal preparados a causa de la baja cobertura en la etapapreescolar. Aunque el 40% de los estudiantes de primer grado sufren de malnutrici6n, el gasto enprogramas de alimentaci6n provisto en la sede escolar es magro.

29. La masiva pobreza en una economia de servicios como la panamenia, es principalmente ellegado de politicas que atentan contra el crecimiento y la creaci6n de empleo y que favorecen laconcentraci6n del ingreso. La incidencia econ6mica de la legislaci6n laboral se traduce en altosingresos relativos para aquellos cobijados por esta, a costa de un alto desempleo, bajos salarios ycondiciones de trabajo inferiores para quienes no estan cubiertos por la legislaci6n laboral yprecios mas altos para los consumidores. La fuerte protecci6n a la producci6n de alimentos yotros consumos basicos reduce directamente el ingreso real, con efectos mas profundos entre losmas pobres, al tiempo que engendra inferiores condiciones de trabajo en los sectores penalizados(que son aquellos donde la legislaci6n laboral no se aplica de hecho). Simultaneamente, la fuerteprotecci6n mantiene la productividad y el ingreso bajos en las areas rurales porque desviarecursos de su uso mas productivo. Los precios exhorbitantes cobrados por los servicios basicosen manos de los monopolios estatales, agravan las condiciones de pobreza. En otro orden deideas, la pobreza en el campo tambien se relaciona con la precariedad de los derechos depropiedad de quienes ocupan y trabajan la tierra, lo cual tambi6n afecta su conservaci6n. Enefecto, en 1991, mas de dos terceras partes de las tierras agricolas en tenencia, que cubrian lamitad de toda la tierra en uso, carecian de titulos de propiedad. Tres cuartas partes de lospequenos granjeros no tenian titulo sobre la tierra que estaban ocupando.

El Desafio que Plantea la Reforma de las Politicas Publicas

30. Panama necesita emprender cambios profundos en sus politicas puiblicas. De otra forma nole sera posible remontar los nuevos retos externos ni resolver sus problemas endemicos de"dualidad", insuficiente generaci6n de empleo y mala distribuci6n del ingreso. La complejidad delensamble de politicas intervencionistas y distorsiones sefiala la necesidad de una cuidadosasecuencia en las reformas. En efecto, las distorsiones prevalecientes introducen desventajascompetitivas en los diversos sectores de la economia, algunas de las cuales son parcialmentecompensadas por otras distorsiones. Todas ellas deben ser removidas en una secuencia biencoordinada para evitar perdidas de bienestar innecesarias. Es mas, la factibilidad politica deimplementar tal programa de reformas dependera del ordenamiento de las reformas de manera queningun sector en especial deba sobrellevar cargas de transici6n en forma indebida. Ademas, la

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implementaci6n de una amplia gama de reformas requerira de cualquier manera un periodo detiempo mas que breve, simplemente debido al considerable volumen e importancia de los temas aabordar. Sin embargo, la secuencia de las reformas no es excusa para que no exista un programaclaro y conocido de antemano, con un cronograma y metas que son publicadas desde uncomienzo y respetadas a fin de afianzar la credibilidad en las reformas. Asimismo, una secuenciacomo la sugerida a continuaci6n no impide que reformas que pueden implementarse mas adelanteen el tiempo, no comiencen a ser disefnadas en sus detalles y discutidas en las instancias legalesque correspondan desde el comienzo

31. Fase 1: Ajuste fiscal, alivio de la pobreza, reforma al marco regulatorio yprivatizacion. El programa de reforma debe ser lanzado con una reforma del sector publicoporque el exito del programa depende crucialmente de la percepci6n del sector privado respecto aque el estado esta comprometido a poner su propia casa en orden. Ademas, es claro que el Estadoes el sector mas ineficiente de la economia y los altos costos que impone sobre el sector privadodeben ser minimizados para aumentar la competitividad intemacional de la producci6n nacional debienes y servicios. Es urgente tambien, que el Estado dirija mAs eficientemente su gasto socialhacia quienes realmente lo necesitan, los pobres, y a proveer apoyo transicional a aquellosafectados por el proceso de reformas. Por ultimo, es importante que el estado ajuste sus finanzasen el corto plazo para generar los recursos que demanda la impostergable reestructuraci6n de sudeuda externa.

32. En este marco, la siguiente secuencia de reformas al sector publico se considera la mAsrazonable. Primero, deberian adoptarse medidas para controlar efectivamente el crecimiento dela planilla del sector publico. Es claro que tal iniciativa deberia preceder cualquier esfuerzo deaumentar los impuestos al sector privado. Esto significa que en alguin momento, el tema de las"leyes especiales" tendra que ser abordado, aunque en el entretanto se puede recurrir a variasmedidas para continuar la reducci6n del crecimiento de la planilla. Al mismo tiempo, el gastosocial necesita ser reasignado a programas que alivien directamente la pobreza, tales como los quelleva a cabo el Fondo de Emergencia Social. Una reforma de mayor alcance en el sector socialdeberia ser implementada en una fase posterior. Segundo, se debe adoptar un sistema tributariomas simple, menos distorsionario y mas equitativo; en particular, el impuesto al valor agregado(ITBM) deberia ser extendido a todos los servicios, al tiempo que se establecen tasas deimpuestos a la renta y al comercio exterior mas uniformes y mas bajas y se eliminan las exencionestributarias y los subsidios injustificados2. Sin embargo, tal reforma en tanto eleve la cargatributaria del sector privado, debe ser aplicada en tandem con las reformas en las tarifas deelectricidad, telecomunicaciones y servicios portuarios. En sentido contrario, dichasmodificaciones a las tarifas de los servicios publicos no pueden ser aplicadas en su totalidad sinmedidas substitutivas de ingresos fiscales dentro de las lineas sugeridas. Tercero, el acuerdo dereestructuraci6n de la deuda externa deberia ser ejecutado. Cuarto, una vez que la reforma delmarco regulatorio este en marcha, la privatizaci6n de los servicios publicos deberia ser aplicadacon vigor.

33. Finalmente, la eliminaci6n del creciente deficit del seguro social requiere, al igual que en elcaso de la planilla del sector publico, de una reforma a las leyes especiales. Ello sugiere un espaciode tiempo mas prolongado. Sin embargo, es claro que, en definitiva, un panorama fiscal sostenibleno podria ser obtenido sin estas reformas profundas. La reforma de los fondos de pensiones, si

2 Una tarifa ad-valorem unica de 6% aplicada a todas las im,portaciones podria producir tantos ingresos como la pletora detarifas y exenciones actualmente en aplicaci6n. Sin embargo, si bien la reforma comcrcial debiera ser un objetivo claro ypublico (especialmente en lo que respecta a tarifas, metas y cronograma de rebajas), ella no deberia ser abordada en formaaislada de la desregulaci6n del mercado de bienes y del mercado de trabajo, tal como se describe en la fase II.

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contempla esquemas de provisi6n privados, podria incrementar la movilizaci6n de recursosintemos y estimular un mayor resurgimiento del sistema financiero en el mediano plazo.

34. Mientras se desarrolla la reforma del sector publico, el gobierno necesita ademas concluirla aplicaci6n de las medidas requeridas para un traspaso eficiente del Canal de Panama y eldesarrollo de las areas revertidas. En primer lugar y por encima de todo, el marco legaldeberia garantizar la autonomia de la Autoridad del Canal, su solvencia financiera, su inmunidadfrente a presiones politicas y su libertad para aplicar politicas independientes. La enmiendaconstitucional de 1994 que crea la Autoridad del Canal incluye provisiones sobre autonomia einmunidad a las presiones politicas pero ademas, incluye restricciones no aconsejables sobre laadministraci6n del Canal en relaci6n con el regimen laboral. Esta enmienda esta pendiente deratificaci6n por la presente Asamblea Legislativa, lo que brinda la oportunidad para reformar lasan6malas escalas de remuneraciones prevalecientes en la enmienda y que son heredadas de laactual Comisi6n del Canal. En segundo lugar, aunque existe potencial para reducir los costos enla operaci6n del Canal y un enfoque innovador en las politicas de admninistracion y peajes podriaresultar en mayores ingresos para Panama, es recomendable seguir una estrategia cautelosabasada en el mantenimiento del status quo de forma que se garantice una transici6n eficiente de lapropiedad del Canal a manos de Panama, sin efectos negativos sobre la confiabilidad del servicio.Finalmente, para maximizar el beneficio potencial de las areas revertidas, el proceso de reversi6ndebe ser incorporado a un marco de liberalizaci6n econ6mica mas amplio. Esto requeriria rompercon la tradici6n de la dualidad inducida, resistir la tentaci6n de crear nuevos enclaves y abandonarlas practicas pasadas de entregar los activos revertidos a entidades estatales.

35. Fase II: Desregulacion de los precios, reforma de la legislaci6n laboral yliberalizaci6n comercial. La eliminaci6n de las principales distorsiones que afectan al sectorprivado y que son inducidas por politicas publicas, requiere de un amplio espectro de reformas.El C6digo del Trabajo necesita ser revisado. Asimismo se deberia adoptar un impuesto a [asimportaciones, uniforme, bajo y ad-valorem, y eliminar todas las barreras no arancelarias,impuestos a la exportaci6n y las prohibiciones y cuotas. Al tiempo que las barreras al comerciointerracional son desmanteladas, los controles de precios deberian ser eliminados, y todaautoridad discrecional para controlar precios, abolida. La reforma de la legislaci6n laboral,necesaria para reducir los costos del trabajo especialmente en los sectores protegidos como laindustria, es esencial para una reforma comercial sostenible. Tal disminuci6n de los costoslaborales produce los mismos efectos que una depreciaci6n del tipo de cambio real. Es claro quelos empleados que se benefician de la aplicaci6n plena del C6digo del Trabajo no aceptarancambios fundamentales a dicho C6digo a menos que los precios de los alimentos, la vivienda yotros bienes esenciales se reduzcan. Esto es algo que las reformas comerciales podrian generar, atraves del incremento del ingreso real de los sectores de menores ingresos y de la reducci6n de laspresiones para incrementar los salarios. De forma similar, los empleadores en los sectoresprotegidos no aceptaran significativas reformas comerciales a menos que el C6digo del Trabajosea profundamente modificado con anterioridad o en forma simultanea a la reforma comercial, ylos precios de los servicios basicos sean racionalizados. Por otra parte, la desregulaci6n de losprecios no seria bien recibida por el publico sin una reforma comercial. No obstante lo anterior,una liberalizaci6n de precios que podria y deberia ser impulsada de inmediato, en formaindependiente de las medidas mencionadas con anterioridad, es la eliminacion de los controles alos alquileres de vivienda, porque no esta vinculada directamente al costo de ning[n otro sectorproductivo.

36. Fase m: Reformas al sector social y otras reformas institucionales y sectoriales.Otras reformas claves al sector publico, que podrian ser iniciadas en cualquier momento, incluyenla reforma educativa, la reforma del sector salud y la reforma judicial. En todo caso la

xii Resumen Eiecutivo

agenda es tan amplia y la necesidad de revitalizar la economia tan apremiante, que es probable quesea aconsejable posponer las grandes reformas del sector social hasta que las reformasecon6micas mas importantes esten bien adelantadas. Ademas, las reformas de politica econ6micadeberian elevar el ingreso real de los pobres en el corto plazo. En el caso de la educaci6n senecesita poner mucho mas enfasis en mejorar su calidad, especialmente en las etapas preescolar,primaria e intermedia, y en la extensi6n de la cobertura de la educaci6n preescolar e intermedia,llevandola hacia las areas rurales y a los sectores pobres de las ciudades. El Gobierno necesita: (i)adquirir mayor autoridad frente a los sindicatos de maestros en el disefio de las estrategias ypoliticas para el sector; (ii) introducir sistemas de manejo de informaci6n sobre el uso de losrecursos asi como de costos y resultados; (iii) instituir un sistema de evaluaci6n y control; y (iv)elevar rapidamente las matriculas en las universidades estatales. En terminos mas generales, elgasto social necesita ser orientado en forma mas efectiva y eficiente.

37. Fase IV: Tenencia de la tierra y conservaci6n de recursos naturales. La reformacomercial es una condici6n necesaria pero insuficiente para modernizar el atrasado sector agricolapanamenio. Se necesita ademas de la consolidaci6n de los derechos de propiedad sobre la tierra, atraves de un imprescindible proceso de titulaci6n, lo cual permitira a los agricultores tener unmejor acceso al credito, a menores costos y generara un mayor interes por conservar la tierra ysus recursos naturales.

El Programa de Reforma Econ6mica del Gobierno

38. El gobierno del Presidente Perez Balladares esta consciente de los retos que enfrenta laeconomia panameina, y ha dado pasos importantes para implementar un amplio programa dereforma econ6mica a mediano plazo (PREMP). El PREMP abarca reformas al comercio exteriory liberalizaci6n de precios; reformas para restaurar una estructura fiscal viable y sostenible en elmediano plazo y la credibilidad en el gobierno como recipiente de credito; la privatizaci6n yrehabilitaci6n de la infraestructura econ6mica; la reforma al C6digo del Trabajo; la expansi6n delos mecanismos de la red de seguridad social; la reforma de los servicios de atenci6n a la salud; yla reforma a la educaci6n. Ademas, el Gobierno le ha dado maxima prioridad a la exitosarecepci6n del Canal y el desarrollo de las areas revertidas.

39. Politica riscal. La Asamblea Legislativa aprob6 en junio de 1994 una ley que introduce unregimen de carrera para los funcionarios publicos que facilitara la modificaci6n de las leyesespeciales y ayudara a identificar las redundancias de fuerza laboral. Aunque el deficit de caja delSeguro Social (CSS) debiera disminuir en la medida que se aplican las reformas aprobadas en1991, una de las prioridades del Gobierno es emprender una reforma de mayor alcance al sistemade seguridad social, promoviendo la participaci6n del sector privado y reduciendo los actualesefectos adversos que el sistema tiene en el empleo. En adici6n, en junio de 1995, la AsambleaLegislativa aprob6 la Ley de Univerzalizaci6n de los Incentivos Fiscales, la cual elimina en formagradual un gran nuimero de exenciones tributarias y subsidios, tanto directos como indirectos, paralas actividades sustitutivas de importaciones y aquellas relacionadas con no transables, al tiempoque refuerza la sostenibilidad fiscal y prepara el terreno para la reforma de comercio exterior. Enmayo de 1995, el Presidente remiti6 a la Asamblea un proyecto de ley que flexibiliza el C6digo delTrabajo, y estA preparando un nuevo regimen de empleo para el sector puiblico con la ayuda delcomponente de asistencia tecnica del PRE. Este nuevo regimen reemplazaria la pletora de leyesespeciales que afectan alrededor del 50% del empleo estatal. Ademas, la administraci6n anteriorprivatiz6 varias empresas estatales productoras de bienes y todavia quedan algunas empresas cuyoobjetivo es privatizar en 1995-96. Se esta considerando una ley que estableceria la destinaci6n detodos los rcursos recibidos por las privatizaciones hacia los programas de infraestructura y

Resumen Eiecutivo xwi

reducci6n de la pobreza. El Gobierno no ha anunciado todavia planes para generalizar el impuestoal valor agregado.

40. Servicios baisicos e infraestructura. El Gobierno, con el apoyo del PRE y del prestamodel BID para la Reforma de las Empresas Publicas, esta intentando dos estrategias simultaneaspara corregir las deficiencias en servicios basicos e infraestructura. La primera tiene comoobjetivo elevar la eficiencia, racionalizar las politicas de precios y la busqueda de la rehabilitaci6n;la segunda, por su parte tiene como prop6sito el fortalecimiento de la autonomia de las empresas,la reforma de la regulaci6n y su privatizacion. A traves de la primera estrategia, las empresas hanreducido las perdidas fisicas y no-tecnicas, han mejorado la medici6n y la facturaci6n, hanreducido las cuentas por cobrar y han incrementado el gasto de mantenimiento e inversi6n.Ademas, los procedimientos de compras y suministros han sido reformados y las tarifas dealgunos de los servicios se han racionalizado en forma parcial (telefonia internacional y algunosservicios portuarios). En terminos de la segunda estrategia, el Gobiemo se esta concentrando enla reforma de la regulaci6n y la capacidad de respuesta, a traves de: (i) la separaci6n de lasfunciones de formulaci6n de las politicas, regulaci6n y suministro del servicio dentro de cadasubsector y la reestructuraci6n de las entidades operadoras dentro de criterios comerciales deacuerdo con la ley que rige a las empresas privadas; y (ii) la separaci6n de las operaciones alinterior de cada uno de los servicios publicos, para permitir competencia en aquellas actividadesque no tienen las caracteristicas de monopolio natural.

41. Con este prop6sito, la Asamblea Legislativa recientemente aprob6 una ley que autoriza laprivatizaci6n parcial de la empresa de telecomunicaciones. Un proyecto de ley similar presentadodurante la administraci6n anterior fue rechazado. Asimismo, la Asamblea L.egislativa aprob6 unaenmienda a la ley que regula las compaiiias estatales de electricidad, de manera que el sectorprivado pueda participar en la actividad de generaci6n de electricidad. Ademas, se han otorgadoconcesiones al sector privado para desarrollar el mercado de telefonia celular y para construir yoperar nuevas facilidades portuarias. Por otra parte, APN redujo en dos tercios las tarifas quecobra por el manejo de contenedores, con lo cual quedaron en niveles similares a las que cobraManzanillo, el nuevo puerto privado. En el subsector de transporte, el gobierno se estaconcentrando en la rehabilitaci6n, desregulaci6n y la promoci6n de inversi6n extranjera. Unafirma privada extranjera gan6 la licitaci6n publica de la concesi6n para la construcci6n yoperaci6n de la autopista entre las ciudades de Panama y Colon. Durante el segundo semestre de1995, la Administraci6n planea presentar a consideraci6n de la Asamblea Legislativa, dosproyectos de ley: uno que estableceria el marco regulatorio y la entidad a cargo del sectorelectrico y otro, que haria lo mismo para el sector de telecomunicaciones.

42. Politica comercial. La Administraci6n anterior inici6 un programa de reforma comercialcon el apoyo del ERL. El actual gobierno se ha comprometido a una nueva ronda de reformas alcomercio exterior, en el contexto de su incorporaci6n a la Organizaci6n Mundial de Comercio,concentrAndose en la eliminaci6n de la mavoria de las barreras no arancelarias, la reducci6ngradual de tarifas a un rango entre 0% y 30% (pero con muchas excepciones para granos basicosy alimentos procesados) y el desmantelamiento progresivo de incentivos fiscales (que ya se hainiciado con la aprobaci6n de la Ley de Universalizaci6n de Incentivos). Aunque estos hechosrepresentan un avance considerable respecto al sistema que existe actualmente, el margen tarifariomencionado y las numerosas excepciones que implican tarifas substancialmente mas altas paraproductos agricolas y agroindustriales, repercuten en que las distorsiones en los precios relativossubsistan y sean insuficientes para provocar una reasignaci6n de recursos significativa que permitael despegue de los sectores de la economia que no son enclaves. Esto no es aconsejabie porqueimposibilitaria de plano la transformaci6n de. d6bil sector agricola panamenio y la disminucion dela masiva pobreza del sector rural, aunque se intentaran otras iniciativas de politicas al respecto.

xiv Resumen Eiecutivo

Con esto en mente, el gobiemo se encuentra explorando reformas adicionales al sistemacomercial.

43. Politicas de precios. Se han dado pasos importantes para desregular la economia. Bajola administraci6n anterior se liberalizaron los precios del petr6leo, se eliminaron los controles deprecios en bienes agricolas para los cuales se sustituyeron las restricciones cuantitativas portarifas; y los requerimientos de informaci6n para el control de precios fueron eliminados. Loscontroles de precios que quedan seran removidos en tandem con la reforma comercial, en tantoque la Oficina de Regulaci6n de Precios se transformara en una agencia de protecci6n alconsumidor. En junio de 1995 se envi6 a la Asamblea Legislativa un proyecto que pretenderemover diversas barreras a la competencia (por ejemplo, la mencionada transformaci6n de laOficina de Regulaci6n de Precios, la introducci6n de estatutos antimonopolios y la instauraci6n denormas anti-dumping). Finalmente, la Asamblea ya se encuentra analizando un proyecto queliberaliza parcialmente el mercado de la vivienda. Lamentablemente, ese proyecto mantiene elcontrol de los alquileres, lo cual se considera altamente inconveniente.

44. Politicas laborales. El gobierno envi6 recientemente a la Asamblea un proyecto quemodifica en forma sustancial el C6digo del Trabajo. El proyecto propone: (i) suavizar la clausulaque prohibe a los empleadores reducir el salario y permitir que los nuevos empleados puedan sercontratados a cualquier salario superior al salario minimo; (ii) disminuir los costos de despido; (iii)eliminar los desincentivos a los contratos temporales y a destajo; (iv) reducir sustancialmente laintervenci6n directa del estado en las relaciones empresa-trabajadores, incluyendo la eliminaci6nde la clausula que requiere que los empleadores soliciten autorizaci6n al gobieemo para despedirtrabajadores; y (v) eliminar la prohibici6n de agencias privadas de empleo. Es posible, sinembargo, que las modificaciones que finalmente apruebe la Asamblea sean menos sustanciales.

45. Reduccion de la pobreza. La estrategia del gobierno para mitigar la pobreza y ladesigualdad contiene cuatro elementos principales. El primero es la introducci6n de condicionesque promuevan un crecimiento econ6mico sostenible. En este contexto, el programa de reformasenfatiza medidas destinadas a disminuir el sesgo contra la generaci6n de empleo y la reducci6n delcosto de la canasta de consumo. AdemAs, se intentarA alterar los incentivos prevalecientes en laeconomia de manera que se beneficie la producci6n agricola y se creen mayores oportunidades deempleo en el campo, donde se encuentra la mayor concentraci6n de pobreza. En segundo lugar,se introduciran mecanismos para proteger aquellas personas mas susceptibles de malnutrici6n yenfermedades epidemicas. El tercer elemento contempla el mejoramiento en la eficiencia y laequidad en el gasto social a traves de reformas ad-hoc en educaci6n y salud, la disminuci6n en elcrecimiento de la planilla publica, la instauraci6n de sistemas de recuperaci6n de costos y de laorientaci6n del gasto publico hacia los grupos mas vulnerables de la poblaci6n. El cuarto elementoes la modernizaci6n institucional. Muchas de estas medidas forman parte del programa global y yafueron comentadas.

46. Estrategia de la deuda externa. La normalizaci6n de las relaciones con todos losacreedores extemos es un elemento clave del programa econ6mico a mediano plazo del gobiemo.En mayo de 1994, Panama logr6 un acuerdo con los tenedores de bonos externos sobre un arregode refinanciamiento, y en mayo de 1995, logr6 un acuerdo de principio sobre un convenio dereducci6n de la deuda y de servicios de la deuda, con la banca comercial. El gobierno tambientiene la intenci6n de resolver la situaci6n de pagos en mora con los gobiernos de Mexico yVenezuela. Estos esfuerzos deberian disminuir el costo del financiamiento extemo, restablecer elacceso del gobiemo al mercado intemacional financiero, y estimular la inversi6n extranjera directay de cartera.

CHAPTER I: DUALITY, GRO WTH AND POVERTY

A. Historical Perspective and Recent Developments

1. Structure and Sources of Growth. With a per capita GNP of US$2,580 (1993) and lowinflation, the Panamanian economy is among the most prosperous and stable in the region. Butthe economy is highly segmented, as between the dynamic, internationally-oriented services sectorand the domestically-oriented sector, beset with policy-induced rigidities and low productivity.Likewise, factor markets are segmented by policies which drive-up the cost of labor and cheapenthe cost of capital. About 14% of the labor force is unemployed despite the preponderance ofservices in the economy, deceleration in the growth of the labor force and a relatively slow rate ofrural to urban migration. The poor performance of the economy has impeded job creation,swelling the ranks of the poor to over one-third of the population and exacerbating extremepoverty and income inequality.

2. PanamA's peculiar structure and pattern of growth stem, in part, from its privilegedgeographical position. The Panama Canal and the monetary regime anchored in the use of the USdollar as legal tender spurred the rapid development of a wealthy services economy. Creation ofthe Col6n Free Zone (ZLC) in the late 1940s coincided with the intensification of restrictive tradepolicies in the region and generated substantial growth during the following three decades.Panama also took advantage of its location, unique monetary regime and the prevalence ofrestrictive policies elsewhere, by creating the International Banking Center (CBI), which grewrapidly throughout the 1970s. Substantial rents were garnered through the trans-isthmian oilpipeline and by licensing the Panamanian flag to merchant ships from around the world. Theeconomy grew by more than 6% per annum during 1950-81. Although serious economicdistortions were introduced beginning in the 1970s, their growth-inhibiting effects were maskedby the massive inflow of external finance. In the aftermath of the second oil shock and the debtcrisis, these distortions depressed growth to 2.5% annually during 1981-93.

3. Distortions and Stagnation. Over the past twenty-five years, the segmentation of theeconomy by Government policies and inefficient state enterprises has kept output growth farbelow potential. Heavy protection was accorded to manufactured consumer products and basicgrains, and an extensive set of price controls was imposed. The 1972 Labor Code introducedmajor distortions in the job market. Numerous firms were taken over or established by the state,which came to dominate basic services, and an extensive governmental apparatus was establishedin agriculture. During the 1970s and early 1980s, the state was the employer of first resort,creating two-thirds of all new jobs. Social services also expanded, especially social security forpublic sector employees and tertiary education. Social indicators improved substantially but theeconomy began to falter, and unemployment and poverty worsened. As public expendituresmounted relative to GDP and policy interventions proliferated, domestic prices rose faster thaninternational prices despite the dollar-based monetary regime, considerable resources werechanneled into rubrics in which the economy has a comparative disadvantage, productive privateinvestment was crowded out, foreign investment dried up, and the competitiveness ofinternational services was eroded. The expansion of the state was financed by foreign borrowing;in 1980, Panama had one of the highest per capita commercial bank debts in the world.

4. During the early 1980s, these distortions, together with the international debt crisis,provoked a fiscal crisis and pushed the economy into recession. The Government embarked on astabilization and structural adjustment program, supported by the World Bank and the IMF. AStructural Adjustment Loan (SAL) was fully disbursed, but the Government was unable to sustainprogress. A second SAL was canceled before second tranche release, and several reforms werereversed. The Government ceased to service its external debt in 1987. The political crisis in the

Panama: A Dual Economy In Transition 2

late 1980s and the imposition of economic sanctions by the U.S., led to a 30% reduction in themoney supply and a 16% contraction of economic activity during 1988-89.

5. Poverty and Inequality. Despite PanamA's relatively high per capita income, two-fifthsof the population live in poverty. Although the abject poverty extant in Col6n and the peri-urbanareas of Panama City is striking, especially in the area adjacent to the Atlantic entrance of theCanal, where the poverty-ridden city of Colon is juxtaposed to the busiest free trade zone in theWestern Hemisphere, poverty in Panama is largely a rural phenomenon. Two-thirds of the poorreside in the countryside, and over one-half of rural Panamanians live in poverty. The indigenouspopulation (about 8% of the total) is the most destitute group in society. Income distributionincome is highly skewed and has become much more regressive in the past decade. In 1979, thepoorest 20% of the population received 4% of income; in 1989, that share had plunged to 2%. In1989, Panama had one of the most unequal distributions of income in the hemisphere, asmeasured by the Gini coefficient. Moreover, in 1989 the average real income of the poorest 40%of the population was one-third lower than in 1979 (in part due to the 1988-89 contraction).During the 1980s, tuberculosis cases doubled and malaria cases climbed tenfold.

Table 1.1: Summary Macroeconomic Indicators, 1986-1994

Acual Est PeriodAveraeesIndicator 1986 1987 1988 1989 1990 1991 1992 1993 1994 1980-86 1986-89 1990-94

Annual Real Growth Rates:

GDP 3.3 2.4 -15.6 -0.4 4.6 9.6 8.5 5.4 4.7 2.9 -2.6 7.0

Total Consiuniption per capita -3.0 -1.2 -24.5 11.5 -7.2 13.3 1.5 -2.1 9.5 1.4 4.9 5.5

Average Inflation Rate 0.4 0.9 0.3 -0.2 0.8 1.3 1.8 0.5 1.3 2.7 0.4 1.1

ExpoirsofGoodsandServices 4.3 -0.1 2.6 4.6 10.6 8.6 6.4 3.4 -2.8 1.9 2.0 3.8

Inports ofGoods and Services -2.3 4.6 -34.1 16.3 34.0 15.8 11.7 7.8 3.5 -0.5 -0.5 9.6

Ratios to GDP (%):Resource Balance 7 6 7.5 17.4 13.3 6.3 4.0 1.6 -0.3 -3.2 -0.1 10.4 1.7

Current Account Balance I/ -3.3 4.5 -1.2 1.6 -3.9 -0.8 4.3 -3.1 -6.3 -5.8 -2.2 -3.7

Grross Domestic Investment t 16.6 17.3 6.8 3.4 17.1 18.1 22.8 25.0 24.0 22.0 12.2 21.4

Public 3.3 2.9 2.2 1.6 1.4 3.4 3.7 3.8 3.5 3.3 2.3 3.6

Pivatl2/ 13.2 14.4 4.6 1.8 15.7 14.7 19.1 21.1 20.5 13.2 10.0 18.8

NFPSCunentRevenues 31.3 30.9 22.9 23.3 28.4 31.6 33.0 31.1 31.2 30.2 27.4 31.1

NFPS Current Expenditures 27.0 27.9 32.2 33.4 30.4 25.6 24.8 24.8 21.5 27.1 30.2 25.4

NFPS Deficit -0.2 -0.9 -10.5 -11.3 -2.6 4.0 5.2 1.8 6.6 -3.4 -5.1 3.1

UneniploymentRate(%/o) 10.5 11.8 16.3 16.3 16.1 16.0 14.7 13.2 13.7 11.0 14.2 14.4

Soutues: MIPPE, Contraloria and Bank staff estimates.

I! Dovs not include official transfers. 2/ Includes changes in stocks.

6. Recent Economic Performance. The Government that assumed office following theouster of a military government in December 1989 launched the National Economic Developmentand Modernization Program. This program, supported by bilaterals and the IFIs (in the case ofthe World Bank, through the 1992 Economic Recovery Loan, or ERL) aimed to increaseefficiency by opening the economy to external competition and reforming the public sector, and torestore financial soundness and creditworthiness. The ERI, and support from other donorsenabled Panama to clear arrears with the

3 Panamd: A Dual Economy In Transition

reducing internal and external imbalances. The lifting of economic sanctions and implementationof the adjustment program bolstered confidence, and resulted in repatriation of private assets andlarge bilateral aid flows that fueled private investment and consumption. The externally-financedupturn in absorption engendered a rapid economic recovery and a surge in imports. Outputstarted to recover in mid-1990, rebounded by 9.6% in 1991, and a further 8.5% in 1992 (Table1.1). In 1993, the rate of recovery slowed to 5.4%, and in 1994, to 4.7%, when the pre-crisispeak per capita income was surpassed. Inflation remained below 2% per annum throughout therecovery. The unemployment rate fell until 1993, but still remained very high (13.7% in 1994)and several percentage points above that recorded prior to the crisis. Reconstruction and theresurgence of domestic demand helped to bring about a spectacular upturn in constructionactivity. Value added more than doubled in 1991, rose 55% in 1992, and continued to increase(39%) more than any other sector in 1993. The construction boom, in turn, was largelyresponsible for the sharp upturn in manufacturing. But the recovery of GDP mainly reflected thedynamism of the ZLC--the only sector in which output did not contract in 1988-89. ZLC growthreached 36% in 1991 and 28% in 1992, before decelerating to 13% in 1993. Agriculturerecovered with restoration of the U.S. sugar quota, but slowed in 1993. Economic growthcontinued to decelerate across all sectors in 1994, with the exception of the Panama Canal, whichregistered its highest traffic volume ever. Although some big projects are underway, theconstruction boom is winding down. The market segment for upper income housing is saturatedand prices and rentals of apartments are falling. And growth of Canal traffic is expected to wanein 1995. Overall GDP growth is expected to further decelerate, to less than 4% in 1995. Theprice level scarcely rose in 1994, which marks the seventh consecutive year in which prices roseless in Panama than internationally.

7. Much of the growth in domestic demand was met by imports, which increased twice asmuch as GDP during 1990-93. Exports initially recovered at a brisk pace, but stagnated in1992-93; however, nontraditional exports continued to rise (18%) in 1993, thanks in part to afurther depreciation of the real effective exchange rate, which continued to depreciate in 1994.As a result of these trends, the resource balance switched from a large surplus (11% of GDP in1988) to a deficit of 2% of GDP in 1993. Bilateral aid flows, repatriation of private capital andlarge capital inflows brought about the expansion of the current account deficit. The overallbalance of payments deficit was more than offset by the accumulation of arrears to commercialbank creditors. Although Panama normalized relations with the Paris Club and the IFIs, it isunlikely that a current account deficit of the magnitude registered the past two years can besustained in light of declining aid flows and without debt relief. In May 1994, Panama reachedagreement with external bond holders on a refinancing arrangement, and in May 1995, reached anagreement in principle on a commercial debt and debt service reduction accord.

8. During 1990-94, solid progress was achieved in shoring-up public sector finances. At theheight of the economnic contraction in 1989, the cash deficit of the nonfinancial public sectorexceeded 11% of GDP. By 1992, this deficit had been transformed into a cash surplus of morethan 5% of GDP. This reflected much higher government revenues resulting from the recovery ineconomic activity, a transitory increase in tax revenues produced by modifications in the tax code,continued deferral of essential maintenance and investment, and containment of currentexpenditure growth during 1990-91. The Government consistently complied with the performancecriteria under successive IMF-backed programs, but encountered political barriers toimplementation of key elements of the adjustment program required to achieve a sustainable fiscalposition. Progress on other structural adjustment measures supported by the ERL and IDBthrough its Public Enterprise Reform Loan (PERL) also was slow. In 1993, the overall cashbalance of the nonfinancial public sector deteriorated to 1.8% of GDP, and registered a deficit of

Panama: A Dual Economy In Transition 4

about 4% on an accrual basis. During 1994, substantial progress was achieved in adoptingadditional short-term measures to stem the deterioration in public finances. Indeed, the publicsector registered an overall -,urplus on an accrual basis, but progress in implementing thestructural reforms, including those required for fiscal sustainability, was slight. The strong fiscalperformance is especially noteworthy as it was achieved while the governing coalition wascampaigning for and lost the general elections.

B. A Dual Economy in Transition

9. Structural Duality. A declining growth trend, mounting unemployment, and widespreadpoverty are symptoms of exhaustion of Panama's "dual economy." The issue of duality is centralto understanding Panama's dilemma. Indeed, positive spillovers from the leading export servicesto the rest of the economy are limited. The leading sectors generate large shares of GDP andespecially exports, but little employment (3% of the labor force) or fiscal revenue. At the sametime, they inject significant negative spillovers into the economy: the high wages paid in theenclaves, particularly in the Panama Canal, where the U.S. minimum wage is enforced, sharplyraise wage expectations relative to the opportunity cost of labor in the rest of the economy. Thekey question from a policy perspective is to what extent duality is "structural," that is, generatedby the technological nature of the leading export services sectors, and to what extent it is fosteredby domestic institutions and policies.

10. In response to the apparent inability of the economy to generate productive jobs insufficient quantity to absorb a growing labor force, many claim that the appropriate policyprescription is state-promotion of new activities, through state enterprises, tax exemptions andprice subsidies. This gives rise to what some call the "Panamanian approach to growth," based ondevelopment of "enclaves" like the ZLC and CBI that tend to replicate the basic concept of thePanama Canal itself. The heavy protection of industry and traditional agriculture, and restrictivelabor legislation, also are by-products of this approach. More recent examples are laws thatpromote tourism and export-processing zones through discriminatory policies. This approach alsorelates to the crucial issue of how best to develop the areas and facilities of the former CanalZone.

11. Policy-Induced Duality. Structurally-induced duality, while important, should not beoverstated. For one thing, a direct consequence of economic specialization in conjunction withthe small size of the country will always be the predominance of a few sectcrs in internationaltrade. The duality problem, rather, stems largely from the ways in which the society attempts tocapture and redistribute part of the surpluses generated in the leading sectors. Such surplusescould be captured through nondistortionary taxation, and redistributed and invested throughgrowth-enhancing and poverty-reducing programs and policies. In the event, the relative weightof structural enclaves, and their adverse effects, would dwindle over time as the rest of theeconomy expands. This has not happened in Panama; instead, public policies have strived tocapture and redistribute surpluses through highly distortionary interventions, with the result that:(i) they erode the natural positive spillovers of leading sectors and exacerbate the negative ones;(ii) undermine the growth potential of the leading sectors themselves; (iii) waste these resources,and resources from the rest of the economy, by channeling them into activities in which thecountry lacks comparative advantage and into rent-seeking; (iv) reduce the employment-generating potential of the economy for any given level of output; and (v) redistribute incomefrom the poor to higher-income groups.

12. The "Panamanian approach to growth," and the duality dilemma can be illustrated byreference to the ZLC. The ZLC generates more than one-fifth of exports of goods and servicesand 8% of GDP but employs merely 1% of the labor force, mainly unskilled workers; only 25% ofZLC value added represents remuneration of labor. Clearly, this enclave generates little labor

5 Panama: A Dual Economy In Transidion

demand and a highly skewed income distribution. These drawbacks, while largely engendered bythe production function appropriate to the ZLC, are exacerbated by economy-wide trade andlabor policy distortions that have turned the domestic relative price system against labor, fosteringthe adoption of overly capital intensive production techniques in the ZLC (as well as elsewhere inthe economy). Nonetheless, a natural positive spillover from the ZLC remains: a substantialdemand for high-income residential housing. But market interventions also abound in the housingsector, mainly through very high wages and benefits to construction workers, high import tariffson building materials, and rent controls. The result is that first, this positive spillover is reducedsince both the demand for construction and for labor in construction is less than it would be in theabsence of the distortions; second, the surpluses of the high-income groups who buy expensiveresidential houses, instead of accruing to a cross-section of the population, are diverted to a fewprivileged groups--labor and capital in the protected construction sector and supplying industries;and third, low income groups end up paying a large part of the cost of the distortions throughhigher prices for houses, lower wages for unskilled jobs, and unemployment.

13. Moreover, the ZLC, like all services, is exempted from the value added tax, while ZLCcorporate income is taxed at a special, low rate (8% versus the 30% corporate rate). This iswhy it contributes only about 2% of tax revenues; instead, the ZLC, is "taxed" in a highlydistortionary manner, through excessive prices charged by inefficient state utilities--rents that aresubsequently redistributed to middle- and high-income groups through poorly targeted socialspending, through special labor regimes in these enterprises (ports, telecommunications andelectricity), and through the bloated wage bill and lavish pension fund of the central govermnentbureaucracy. Furthermore, after these powerful clienteles are serviced, the state inefficientlyinvests what little remains of the surplus. Remarkably, results prepared for this report show thatpublic investment makes no contribution to growth.

14. This report strongly emphasizes that duality should not be attacked through public sectorinvolvement in new economic sectors, or through "promotion" policies. Instead, duality shouldbe redressed through broad reform that introduces a much more active role for private marketforces and eliminates policy-induced market segmentation. Uniform, less distortionary taxation, aswell as privatization and regulatory reform also would mitigate structural duality, therebyreinvigorating the growth and employment-creation potential of the economy.

15. Prospects for and the Challenge of Policy Reform. Following years of stop-go reformsand mounting frustrations, especially among low-income groups, prospects for meaningfuleconomic reform have brightened considerably with the September 1, 1994 inauguration ofPresident Prez Balladares. The Administration has prepared a comprehensive reform programthat addresses the distortions that have held back the expansion of the economy, the complexexternal challenges to Panama's traditional sources of growth, and the causes of poverty.Nonetheless, the Government will have to overcome the widespread sentiment that the country'sunique position will somehow enable it to prosper without changing the status quo; the powerfulinterest groups who have large stakes in the perpetuation of the status quo; and, in the end, thetemptation to revert to the traditional approach to growth, especially with the reversion of assetslike the Panama Canal and adjacent areas. In order to surmount these challenges, the Governmentwill need to consistently communicate its strategy and vision to the potential beneficiaries of thereform program and actively enlist their support, and to dismantle the complex array of distortionsin a carefully phased sequence, to avert undue welfare losses and opposition to the reforms.

C. Investment, Savings and Productivity

16. Although the current levels of investment suggest that the recent high GDP growth ratescould be sustained in the future, since the 1970s the qualitv of investment has been very poor

Panamd: A Dual Economy In Transition 6

(Table 1.2). During the 1970s and 1980s, Panama's Incremental Capital Output Ratio (ICOR) wasvery high, perhaps one of the highest in the region (Fernandez, 1993). This result is intuitivelyappealing if we consider that although the economy invested a larger share of GDP during the1970s than in the 1960s, GDP growth rates turned out to be lower than in the previous decade.Moreover, econometric estimates show two other striking and related facts: public investment hasnegligible effects on economic growth and total factor productivity growth made a negativecontribution to GDP growth during the last two decades (Annexes 1 and 2).

Table 1.2: Savings and Investment, 1986-1994(Percent of GDP)

Actual EsL PeriodAveraresIndicator 1986 1987 1988 1989 1990 1991 1992 1993 1994 1980-86 1986s90 1990-94

Total Investment 16.6 17.3 6.8 3.4 17.1 18.1 22.8 25.0 24.0 22.0 12.2 21.4

Public Fixed 3.3 2.9 2.2 1.6 1.4 3.4 3.7 3.8 3.5 2.0 2.3 3.2

Private Fixed 13.2 14.4 4.6 1.8 15.7 14.7 19.1 21.1 20.5 20.0 10.0 18.2National Savings 13.3 12.8 5.7 5.0 13.3 17.2 18.5 21.8 17.7 16.2 10.0 17.7

Public 4.3 3.0 -9.3 -10.1 -2.0 6.0 8.2 6.2 9.7 3.1 -2.8 5.6

Private 8.9 9.9 14.9 15.1 15.3 11.3 10.3 15.6 8.0 13.0 12.8 12.1

Foreign Savings 3.3 4.5 1.2 -1.6 3.9 0.8 4.3 3.1 6.3 5.8 2.3 3.7

ICOR 4.9 7.0 -1.1 -17.5 0.9 1.7 2.0 4.1 5.5 6.9 -44.1 3.0

Sources: MIPPE, Contraloria and Bank staff esimates.

17. The prevailing array of economic incentives that result from numerous Governmentregulations suggests that the low quality of investment and negative productivity growth arehallmarks of the Panamanian economy. For example, restrictions and distortions in the labormarket, by raising the private cost of labor far above its social cost, induce overinvestment inmachinery, with obvious consequences for the welfare effects of those investments. Leamer et.al.,(1994) show that the Panamanian economy exhibits a capital intensity similar to that obtaining inthe U.S! Moreover, policy distortions, together

.00

3.. mestic institutions, have greatly discouraged foreign direct investment. Over the last six years,and contrary to the trend in many Latin American economies, little direct foreign investment hasbeen made in the country.

Table 1.3: Poverty and Inequality, 1979-89 (%)

Unemploy-Income ment

Poverty Gini Coefficient Per Capita Rate

National Urban Rural Urban Rural

1979 37.9 31.0 45.0 0.40 0.35 100.0 8.8

1986 36.3 30.0 43.0 0.43 0.45 117.7 10.5

1989 40.6 34.0 48.0 0.46 0.43 95.1 16.3

Sources: ECLAC (1993) and Contraloria General.

D. Poverty and Inequality

18. Aggregate social indicators for Panama are relatively favorable and similar to those inother middle income countries, but poverty is high relative to its per capita income (Figure 1.1and Table 1.3). It is commonly asserted that as an economy grows, so does employment, wages,

7 Panamd: A Dual Economy In Transition

The consequent trend increase in unemployment, together with the deterioration of workingconditions in penalized sectors, has spread poverty to almost two-fifths of the population. Theabsence of a trickle down effect is not a structural phenomenon that calls for state interventionand massive social policies, but a direct consequence of policy-induced duality. Moreover, duringthe 1980s, the income of the poor declined sharply, as pervasive policy distortions dampenedgrowth, inhibited job creation and redistributed income from the poor to the wealthy.'

19. In 1989, about 41% of households in Panarna lived in poverty; in 1986, the correspondingfigure was about 36%, and in 1979, about 38% (Table 1.3). In rural areas poverty is about 14percentage points higher than in urban ones. While social indicators are relatively favorable byregional standards, they are low relative to the copious amount of resources Panama spends onbasic services and social programs. And in rural areas, social indicators are more similar to thosein much poorer countries (Figure 1.1). During 1979-86, per capita real income rose 17.5%, butthe percentage of poor households fell by only 1.6%. The associated poverty/growth elasticity isexceptionally low. To reduce the incidence of poverty by 10 percentage points would require18.5 years annual per capita income growth of 4%, and 25 years if the growth rate were 3%.Such growth rates are three to four times higher than those achieved during the last fifteen years.

20. Rural Poverty and Environmental Degradation. Although the abject poverty extant inColon and the peri-urban areas of Panama City is striking, poverty in Panama is largely a ruralphenomenon. In 1990, 47% of the population resided in rural areas, and over one-half of rural

Figure 1.1: POVERTY AND INEQUALITY

Social indicators have improved someWisat.. but mask ponounced regional d,ffermnces.

., I ~R-1

income dretributon 2heighly ekev,ad and vJole outcutlha eteagnaud and lhe income of

s deteriora3d0 te poor ha plunged

NO... 11 Percentege of children agied e eO 16 not ettendirig school. 2i Percentage of totl populator.

lThe high cost of the basic consumption boasketi,n Panambt is confimned in 'thie ECI.AC study. 1hi 1988, the cost of this basket(the poverty line) was the second highest in a sample of 10 Latin Americian countries, exceeding Argentina, Costa Rica,Mexico and Uruguay. Only Venezuela with a poverty line of USS70.6 surpassed Panhimm.

Panamd: A Dual Economy In Transition 8

Panamanians lived in poverty. The indigenous population (about 8% of the total) is the mostdestitute group in society. In the 28 poorest of the 68 administrative districts in the country,infant mortality ranges from 40 to 100 per one thousand (or from two to five times the nationalaverage and is similar to rates in low income countries). In these districts, the incidence ofmalnutrition in young children and breast-feeding and pregnant women is about 40%, and 40 to70% of children enter school suffering from growth retardation. About one-third of households inthese districts do not have access to safe drinking water and basic sanitation; more than half lacksufficient income to purchase minimum food requirements, and 40 to 50% do not have access toprimary health care.

21. The high incidence of poverty in Panama is not a consequence of scarcity of naturalresources; arable land and water are abundant relative to the population. Natural resourcemanagement and conservation, however, are highly deficient. Some 45% of the forest cover hasbeen eliminated by the encroachment of extensive cattle ranching and subsistence agriculture.Although there are areas suitable for livestock which currently are devoted to socially lessefficient uses, indigenous peoples in fragile areas are being gradually displaced from the flat landrain forests by cattle ranchers who are overexploiting these resources. In the past thirty years, thesurface affected by severe erosion has climbed from 0.5 million to 1.3 million hectares, or 18% oftotal land area.

22. Notwithstanding the abundance of water resources, major urban and rural centersperiodically suffer from water shortages. Moreover, the quality of these resources, includingthose for human consumption, have declined over the past two decades. In rural areas, over 75%of water supply systems lack disinfection facilities, the quality of tap water is not monitored andwaste waters rarely treated. Latrine use is not yet generalized among the 30% of the ruralpopulation lacking sewerage systems. As a result of these conditions, the level of morbidity fromwater-borne diseases is increasing and diarrhea is the leading cause of death in the countryside.The urban population also faces major environmental health problems as a result of inadequatesewerage treatment, chemical contamination and runoff, oil spills, and uncollected solid domesticand industrial waste. The direct outfall of raw sewage into Panama Bay has transformed this-once-beautiful natural resource into an open sewer. In some parts of the Bay contaminationreaches levels 500 times internationally accepted standards for fishing and bathing. In addition,the intermingling of sewage and stormwater runoff in an inadequate drainage system frequentlyblocked by uncollected garbage, results in extensive flooding throughout Panama City. Finally,deforestation affects 60% of the buffer zones and the Canal watershed proper. The resultingerosion and sedimentation already is limiting Canal operations in the dry season. Deforestationalso is seriously jeopardizing the operation of the Bayano hydroelectric plant, which suppliesabout 25% of all hydro power.

23. Much stronger incentives for rational resource use and conservation are needed. A majorimpediment to increasing rural incomes and sustainable development of natural resources issuesfrom the absence of land titles. In 1991, more than two-thirds of agricultural holdings, coveringfully one-half of all land in use, lacked property titles. Three-fourths of small farmers did nothave title to the land they occupied. The principal legislation dealing with natural resources isoutdated (i.e., the 1966 Forestry Law, the 1966 Water Resources Law, and the 1967 WildlifeLaw). The regulatory framework for the sector is ill-defined and contains many contradictorynorms. Institutional responsibility for natural resources management is widely dispersedthroughout the state; the resources devoted to natural resource management and conservation aremeager, and institutional capacity is very weak. Management plans have been prepared for only 4of the country's 51 hydrographic basins. Environmental laws rarely are enforced. In this context,the removal of the barrier to the further degradation of the Canal basin with the reversion of theCanal Zone raises the specter of the progressive destruction of this unique resource.

9 Panamd: A Dual Economy In Transition

24. Human Resources Development. Similarly, the untoward incidence of poverty inPanama does not stem from insufficient allocation of resources to the social sectors--socialspending as a proportion of GDP is among the highest in Latin America. But the efficacy ofsocial spending is reduced greatly by resource misallocation and wastage, and the strong bias ofsocial programs in favor of urban and higher income groups. The bulk of the spending in theintegrated health care system is devoted to expensive curative care, and the system is beset byduplication and the lack of a system to allocate costs between the facilities administered by theMinistry of Heath and those managed by CSS even though these serve an overlapping clientele.Tertiary education receives a disproportionate and rising share of the education budget but theeducational system is not responsive to the demand for skilled labor, technicians, professionalsand managers, and the overall quality of education is poor. Indeed, the University of Panama is amajor fiscal drain (tuition is US$20 per semester), the curriculum is inappropriate for the needs ofa modern economy, entrance is not based on appropriate examination standards and qualitycontrol is virtually nonexistent. Most students admitted to the University of Panama must firstattend remedial courses in basic skills. Many primary schools lack educational materials and alarge majority of primary school students are ill-prepared because of the low coverage ofpreschools. Although 40% of first grade students suffer from malnutrition, spending on school-based feeding programs is meager.2

25. Widespread poverty in a services economy like the Panamanian one is the legacy primarilyof the economic policies that militate against growth and employment creation, and which fosterthe concentration of income. The economic incidence of the Labor Code is higher incomes forthose shielded by it at the expense of high structural unemployment, low wages and inferiorworking conditions for those not covered by the Code, and higher prices for consumers, poor andrich alike. Steep protection of food and other basic consumption goods directly reduces the realincome of the poor in particular as well as spawning inferior working conditions in penalizedsectors. At the same time, heavy protection keeps output and incomes low in rural areas becauseit diverts resources from their most productive use. The exorbitant prices charged for basicservices by state monopolies likewise aggravate poverty.

CHAPTER II: EXPORTSERVICES: OUTLOOK AND CHALLENGES

26. Over the years, Panama has been able to develop a number of successful export niches(the Canal, the ZLC, the CBI, and the flag of convenience business). These activities produceabout a quarter of GDP and three-fourths of exports (Table 2.1). The official balance of paymentsrecords a very large amount of merchandise trade relative to GDP, with total goods exports ofUS$5.2 billion; substantial exports of transport services (US$611 million); investment income(US$924 million of credits and US$1,041 millions of debits); and unilateral official transfers(US$220 million). These figures, however, mask important features and are misleading. First,within the merchandise trade sector, it is necessary to disentangle ZLC exports and imports, andto treat the trade surplus of the ZLC as service exports. Second, within transport exports, it isimportant to highlight the role of two activities: the Canal and the Oil Pipeline. Third, withininvestment income we can disentangle the role of the CBI, which borTows from and lends abroad,generating a surplus in the current account. Finally, the disaggregation of unilateral transfersreveals the importance played by the U.S. Defense Department in the aggregate demand of theeconomy. Thus, a more appropriate accounting places exports of goods at only US$535 million,which are comparable to export services originating in the Canal (US$495 million) and the ZLC(US$460 million). Remarkably, service exports originating in various forms of legal representation

2 These issues are explored at length in the World Bank (1995).

Panama: A Dual Economy In 7ransition 10

of foreign corporations amount to about 27% of total goods exports, and exceed CBI serviceexports. Foreign income arising from the presence of the U.S. Defense Department is equivalentto about 57% of total goods exports (without the ZLC), or greater than banana exports (45%),the most important merchandise export.

Table 2.1: Leading Export Services in the Economy, 1993 (%)

Share of Total Exports as % of Share of TotalValue Added Goods Imports Employment

Col6n Free Zone 6.0 23.0 1.3

Panama Canal 7.1 25.0 0.7

Litemational Banking Center 7.7 6.0 1.1

Legal Fees from Foreign Corporations n.a. 7.0 n.a.

Source: Contraloria General de la Repuh]ica and Bank staff estimates

27. Exportable services are not labor intensive. Despite generating about one fourth of GDPand financing more than 60% of merchandise imports, they directly employ only slightly morethan 3% of the labor force. This dichotomy lies at the heart of the political and economic debateon "duality" and, by extension, of the country's growth prospects, ability to reduce poverty andimprove income distribution. In what follows, a closer analysis is made of the leading exportservices. As it turns out, growth prospects in these sectors are at best moderate, and major newexternal challenges loom. In light of this, the potential contribution of the reverted areas becomesmore critical, especially given the withdrawal of U.S. Defense Department personnel.

A. The Financial Sector

28. Background. In 1993, the financial sector accounted for 7.5% of GDP, but employedscarcely more than 1% of the labor force. Its contribution to fiscal revenues, essentially throughcorporate and personal income taxes, is hard to estimate but is presumed low because many of thesystem's operating profits are exempted from income taxes. Financial services, like all services,also are exempted from the value added tax (ITBM). The financial sector contributes US$130million in service exports (6.5% of total exports) and is the main vehicle through which foreignfunds are channeled to the private sector. The financial system comprises the CBI, insurance andreirisirance companies, finance houses, leasing companies and the stock market. The CBI is byfar the largest activity, accounting for more than 90% of the system's assets and net wealth(Table 2.2). Policies that have fostered the development of the CBI are use of the U.S. dollar aslegal tender; the liberal Banking Law enacted in 1970; and tax advantages and facilities granted toforeigners to set up companies. The most important regulatory elements are: (i) totalconfidentiality of banking operations; (ii) freedom of capital movements with accountingexemptions for amounts below US$10,000; (iii) exemption from taxes on interest earned onsavings and term deposits; (iv) freedom to withdraw capital and retained profits; (v) exemptionfrom taxes and restrictions on movements of foreign funds; (vi) broad freedom of operation forbanks; (vii) low costs arising from supervision; (viii) low minimum capital requirements for banks;and (ix) relatively low capital-asset ratios.

29. There are three types of bank licenses: (i) general (authorized to carry out bankingbusiness in the domestic market and abroad without distinction); (ii) international (authorized todirect, fiom an office established in Panama, transactions that are negotiated, carried out orproduce their results abroad); and (iii) representation (permitting establishment of representativeoffices, unable to operate directly in Panama). Banks with international licenses cannot receivelocal deposits or grant domestic loans, with the exception of credits to the public sector and

11 Panamd: A Dual Economy In Transition

interbank operations with general license banks. Regulation of the financial system is segmentedaccording to the type of institution. The National Banking Commission (CBN) is in charge ofsupervising banking institutions (Box 2.1).

Table 2.2: The Financial System (millions of Balboas)

Number of LoanInstitutions Total Assets Portfolio Net WVorth Deposits

L International Banking 110 28,513 16,734 1,620 23,040Centerl/

General License 62 23,753 14,627 1,370 18,802

Intemational License 28 4,760 2,107 250 4,238

Representation Office 18 na. na. na. na.

IL Financial Entities 2/ 105 353 n.a. 50 n.a.

Im Insurance Corporations 3/ 27 330 n.a. 96 n.a.

Sources: Comisi6n Bancaria Nacional and Supervisi6n de Seguros. 1/ June 1994; 2/ December 1993; 3/ December1991.

30. The state banking sector is made up of 4 institutions: the National Bank of Panama(BNP), the Savings Bank, the Agricultural Development Bank (BDA) and the National MortgageBank (BHN). The latter two are not included in the CBI as they do not take in funds from thepublic. The state banking system plays an important role in the financial system. BNP and theSavings Bank together grant 26% of all domestic credit, take in 30% of domestic deposits, andgenerate more than 36% of employment in the CBI. The state banking system is not supervised byCBN but by the Comptroller General. BNP is the largest banking institution in terms of domesticcredit, local deposits and saving deposits. It is entitled to offer a wide range of commercialbanking services through its 49 branches throughout Panama, although in practice many of thoseservices are carried out on a small scale. In the absence of a central bank, the BNP carries outseveral central banking functions such as managing a large part of legal deposits, conductingclearing house operations, and acting as the Government's financial agent. The Savings Bank is acommercial bank that concentrates its loans on mortgages for middle-income housing andpersonal loans. BHN and BDA obtain theirresources from the state and external sources, Box 2,1: THiE NATIONAL BANKING

and lend for housing in low income sectors and COMMSSIONfor small- and medium-scale farmers. The other The Banking Law assigns responsibility for

supervising banking institutions to the CBN; however,financial institutions are considerably less the LaWs limitations on access to infonnation, the

developed than the CBI, although they have prohibition on publicizing infornation on the situation of

been growing fast since 1990. The stock individual banks, a lack of human and material resources,the composition of the Conmission, and its dependencymarket began operating in 1990 and despite on the political authority prevent it from effectively

experiencing rapid growth, has a low level of fulfilling the objectives the Law defines for it. CBN is

transactions, highly concentrated in domestic made up of 7 members: 2 Ministers from the economicarea, 3 representatives from banks, the President of BNP,

fixed-income secufities. and a member chosen by the Executive from people not

31. Main Issues. The main feature of the connected to banking. The composition of the CBN gives31. . significant rights to the regulated, a principle which

CBI is its international orientation. Since the conflicts with the incentives that should prevail in aenactment of the Banking Law in 1970, which supervisory organization. Particularly sensitive are thefacilitated off-shore banking and further exercise of the CBN's license-granting attributions, its

powers to intervene and liquidate a bank, and approval ofderegulated financial flows, banking sector norms (Acucerdos) regulating and standardizingassets have grown by a factor of 32. However, supervision.the debt crisis of the early 1980s, changes in

Panamd: A Dual Economy In Transition 12

regulation in Japan in 1982 that made Japanese banks withdraw from Panama, and the politicalcrisis of 1987-89, significantly affected this growth trend. In effect, after a US$10 billion drop inassets following the debt crisis and a mild recovery subsequently, between 1987 and 1989, 23banks left the country--some of them big--and deposits declined by US$22 billion. Starting in1990, the CBI began growing again, although by mid-1994, total assets were still less than 60%of the mid-1982 peak. Thus, a critical issue is whether the CBI can regain the importance it hadin the early 1980s.

32. There are strong reasons to believe that the crises of the 1980s, especially the 1987-89one, had permanent effects on the CBI. Among them are the freezing of term deposits for morethan 2 years; money-laundering concerns and perceptions; and the development of majorinternational financial centers elsewhere that successfully attracted operations from Panama.Perhaps the most difficult to overcome are concerns related to money-laundering, becauseaddressing them would involve removing two features that have been at the core of Panama'ssuccess as an international financial center: the secrecy of banking operations and the legal easewith which foreigners can incorporate firms. In addition, most countries in the region have openedtheir financial markets to external capital. Thus, a fundamental question is whether in a financiallyliberalized environment, a regional financial center makes sense anymore.

33. A second issue concerns regulation of the banking industry. First, the current system ofseparating licensing between general and international is not appropriate for separating thedomestic and foreign operations of general license banks (the vast majority), and therebyencumbers the latter with regulatory pitfalls relating to the former. This could be seen as adisadvantage vis a vis other competing financial centers with more modern and simpler regulation.Second, several regulations work against efficiency and transparency in the domestic market: (i)financial institution intervention and liquidation procedures; (ii) control of credit portfolios; (iii)mechanisms established to deal with illiquidity; (iv) minimum capital and capitalizationrequirements for banks operating locally; (v) preference granted to Panamanian citizens inbankruptcy; and (vi) policies on legal deposits and their management.

34. A third issue relates to state banks, which have the potential to distort financial markets.BNP enjoys a privileged situation in competition with the rest of the banking system in itscommercial operations, although so far it has not exploited it much. These advantages stem from:(i) holding a monopoly on public sector deposits, in many cases without paying interest; (ii) freeand unremunerated management of a significant proportion of legal deposits; and (iii) not beingsubject to CBN supervision, thereby allowing it to operate in times of crisis with capital and debtratios completely outside the provisions of the Banking Law. Toward the end of the past decade,the financial situation of BNP was critical. However, a more efficient administration since 1990has managed to strengthen it. In recent years, the BNP has sorted out its relations with the publicsector, whose portfolio represents 72% of the total, through the documentation and fixing ofpayment plans for the great majority of the obligations of state institutions. The Government'soverdraft of US$932 million at the end of the 1980s was renegotiated, with BNP receiving a smallpayment in 1993, and a 25-year payment plan at an interest rate of 2% per year on the balance.The arrears index of the private portfolio decreased by 29.3 % between end-1989 and mid-1994,with the result that this index now stands close to 6%. The remainder of the state banking systemalso faced a deep crisis which peaked toward the end of 1980s; however, the recovery of theseinstitutions has not been as vigorous as in the case of BNP. In 1991, the Savings Bank obtained alegal modification allowing it to carry out commercial operations, a change that has helped toalleviate its critical financial situation. In light of this, there are also pressures to authorize BHNand BDA to enter commercial operations. The objectives for which these institutions werecreated have been only partially fulfilled, as a result of an inefficient administration together with ahigh degree of political interference in certain periods.

13 Panamd: A Dual Economy In Transition

35. A fourth issue relates to the CBI's failure to explore new lines of business, like corporatebanking, insurance, international intermediation of stocks and bonds or any other fee-for-servicetype of activity, as banks are doing all over the world. CBI has been a regional financial centersince its inception, concentrating on Central and South America. If it has not developed new linesof business beyond traditional banking, it is due to lack of interest on the part of its clients, firmsand governments in the region, which because of local regulations, underdevelopment of theirown financial markets and recurrent macroeconomic problems, have not demanded differentservices. In recent years, as most of the economies in the region have pursued financialliberalization, a more sophisticated financial demand is developing. It is not clear, however,whether the CBI will be able to meet these new demands. The development of the stock markethas been limited by: (i) the property structure of Panamanian companies; (ii) the close linksbetween bank shareholders and entrepreneurs in other sectors; (iii) the lack of the means to makeelectronic transactions; (iv) restrictive regulations regarding financial innovations; (v)cumbersome procedures for effecting securitizations; and (vi) absence of institutional investors.

36. Prospects and Policy Recommendations. While the financial system faces external anddomestic constraints, CBI banks could expand into new liner, of business, especiallyintermediation of bonds and stocks from other countries in the region. The use of the dollar asdomestic currency, freedom of capital movements, tax incentives, human capital connected mainlyto the CBI, as well as experience in financial operations, constitute important elements favoringgreater development of the financial system into these areas. For instance, the banks could moreactively participate in converting the stock market into a regional wholesale center of securityintermediation for Latin American firms which because of their size cannot or will not access U.S.markets. The CBI also could concentrate more on lending to the private sector in Latin Americathan to governments and public enterprises.

37. To improve the competitive position of the CBI vis a vis other financial centers, it isadvisable to redefine bank licenses, keeping banks operating internationally with as much freedomas they currently have. This would permit the isolation of international operations from anyregulatory hurdle designed for domestic operations. At the domestic level, key recommendationsare: (i) strengthen prudential norms for banks operating locally; (ii) establish appropriate bankintervention and liquidation procedures; (iii) eliminate the current mechanisms for dealing withilliquidity situations and define new ones according to bank licenses; (iv) redefine the policy andmanagement of legal deposits; (v) update norms and administrative procedures which limitbanking competition and efficiency; and (vi) modify CBN's legal charter to give it greaterautonomy, clarify its powers, and endow it with more resources. In addition, BNP could beprecluded from taking part in commercial bank activity, and encouraged to concentrate onmanaging the country's liquidity and its role as financial agent to the Government. Eventually, itcould be the depository for the banking system's legal deposits and act as a clearing house.

38. The stock exchange aims to become a market for Latin American securities, as analternative to the large markets of developed countries. Achievement of this objective, however,is constrained by inadequate regulations, the low volume of operations, especially in equities, andbackward technology. Regulation must allow prompt and low cost security listings, as well asfacilitate the development of financial products which respond to market needs. The NationalCommission for Financial Assets needs to be strengthened and given greater autonomy. It isdifficult to conceive of the development of a Latin American stock market in Panama without amodern regulatory framework, efficient and effective supervision, as well as swift and transparentjudicial procedures which engender confidence among dealers and investors. For its part, thestock exchange must incorporate the latest technology to allow for continuous transactions in a

Panama: A Dual Economy In Transition 14

transparent environment. For this, it needs electronic transactions media, reliable clearing andcustody, as well as investors capable of competing effectively with developed markets.

39. In the end, the recovery of Panama as a regional financial center and its growth prospectsare linked closely to the success of the country in addressing money-laundering concerns. Itssuccess will need to be built on the basis of an efficient and transparent financial intermediationsystem. In addition to the reforms suggested above, serious thought should be given to easingsecrecy clauses in financial operations and to making incorporation tougher for foreign firms inorder to improve transparency. This of course could have effects on the CBI and some money willleave Panama in the short run. But in the long run it could bring more business to the CBI.Adoption of the Vienna Convention could be a step in the right direction.

B. The Panama Canal

40. Background. In 1993, the Panama Canal accounted for 8.4% of GDP and employed,through the Panama Canal Commission (PCC), about 6,500 Panamanian workers, or 0.7% of thelabor force. The foreign revenues generated by the PCC were equivalent to 25% of imports. Itscontribution to fiscal revenues comes directly from a fee paid by the PCC to the Government(US$78 million in 1993 plus US$10 million for "public services") and indirectly from personalincome taxes (US$37 million in 1993). In 1993, these payments amounted to about 2% of GDP.The generation of value added in the Canal occurs with increasing returns to scale, with a positivetrend of tonnage shipments over the years in the context of a slight decline in labor use, withabout US$40 million in capital investments and US$100 million in maintenance expendituresannually. The PCC is an Agency of the Executive Branch of the U.S. Government. This agencywas envisaged in the 1977 Canal Treaty and established in 1979 through Public Law 96-70(Panama Canal Act). The PCC is charged with administering, operating and maintaining theCanal and its adjunct facilities, and with ensuring the orderly traffic of ships. The PCC will carryout these functions until noon on December 31, 1999, at which time Panama will assumecomplete responsibility for the Canal. At the end of 1993, PCC had 8,635 employees, of which7,420 were permanent; 88% of the permanent staff were Panamanian, and 11.2% U.S. citizens.The total payroll of the PCC in 1993 was US$236 million, of which US$184 million was paid tonon-American and US$52 million to American personnel. The direct contribution of the Canal tothe economy has been estimated at about US$380 million in 1993, including wages, pensions,services, and payments to the Government.

41. The 1977 Canal Treaty establishes that income from Canal operations (toll revenues)should just cover costs, although it leaves some discretion for the definition of such costs. Thetolls in force since October 1992, and which are expected to be maintained for at least anothertwo years, are: US$2.21 per Net Canal Ton for ships carrying cargo or passengers and US$1.76when a ship passes in ballast. These tariffs are applied to merchant ships, to military transportvessels, hospital ships, supply ships and yachts. Other vessels pay US$1.23 per ton ofdisplacement. Since 1979, when the Treaty came into effect, there has been a cumulative increaseof 30% in tolls, which implies an average annual increases of about 2%. The main variable themaritime community uses to evaluate the service provided by the Canal is the "Canal WatersTime" for ships in transit, which reflects the time waiting to enter, plus the time taken in passagethrough the Canal. On average, the Canal Waters Time has remained at 24 hours over the last 14years, which is considered very satisfactory.

42. Main Issues. First, the definition of an appropriate legal status for the Canal has beenaddressed by a recently approved reform to Panama's Constitution, which created an autonomousstate entity, the Panama Canal Authority (ACP) to manage the Canal. The ACP will have its ownbudget, with attributions appropriate to a commercial operation of the Canal, including powersfor the Executive Board of ACP to grant concessions for private agents to provide services to the

15 Panamd: A Dual Economy In 'Transition

Canal Authority; however, the special..labor regime established for the ACP Box 2.2: LABOR ISSUES IN TH1 CANAL

through this amendment presents Labor issues are potentially the most complexsignificant drawbacks (Box 2.2). ones for the new ACP. The creatiorn of a special labor

regime for the Canal whichI takes as a floor cwurent salary43. Second, the Neutrality Treaty, conditions and benefits-greatl) superior to those of thewhich will come into force at the end of rest ofthe economy and modeled on those prevailing in the1999, is not clear regarding the options U.S. Government--is inadvisable for several reasons. First,

1999, setting a high floor on labor benefits imposes cornsiderablePanama has for. setting toll rates. rigidity on the ACP's ability to inanage the Canal as aDebatable issues relate to the possibility of commercial operation. In addition, restrictions have beenobtaining profits from the operation of the placed on the contracting of foreigners. Experience with

assets that already have reveited to PananA, where wageCanal and the possibility of discriminating scales anid work conditions rulitg under the previous U.S.among users through the tolls. The administration have been preserved, clearly indicate thatinterpretation set out in the recent these soon becomes a straitjacket to an efficientl

ucommercial operationt Second, with such pronouncedconstitutional reform is that the Canal differences in salary and work conditions between theshould remain a nonprofit organization Canal and the rest of the economy, the pressures to obtainwhose toll policy is nondiscriminatory and a post in the ACP likely will tax the safeguards against

political intcrfercnce in Canal management. Furthermore,which produces sufficient income to cover: establishing a special labor regime for Canal personnel(i) the costs of maintaining and operating through constitutional means, on top of the already

the Canal; (ii) the capital needed for numerous special regimes in place, runs contrary to theireplacement, expansion and improvement niecessary dismantling of the special regimes that cause so

replacement, expansion many distortions in the economy.in plant; (iii) working capital requirements;and (iv) royalty payments to theGovernment.

44. The total costs and operating expenses of the PCC during 1993 were US$524 millior..However, some of these expense items will terminate at the turnover of the waterway to Panamasince they arise from accounting practices and special benefits to U.S. citizens working for thePCC which are not linked directly to the operation, administration or maintenance of the Canal.For this reason, these items represent possible cost reductions which could be made after thetransition. An estimate of expenses, currentlv recorded as operating costs in accordance with theTreaty and U.S. Federal norms, and which could cease to exist from the year 2000, amounts toclose to US$30 million per year. Some of these items will disappear totally, while others willdepend on what the new Canal administration decides to do.

45. The current cost structure includes payments by PCC to Pananim by virtue of the 1977Treaty (some US$94 million per year, which increases as traffic rises). If the interpretation bywhich the Canal cannot make profits and tolls should be fixed to cover operating costs prevails, apayment should continue to be included in the costs compensating Panama for the opporttinitycost, in terms of national resources, from operating the waterway. There is no estimate on whaitthat value should be, but at least it could continue under the current formnla, without facingprotests from the maritime community, unless there are significant toll increases Traffic and tollpolicies will depend in part on the interpretation of the Neutrality Treaty in order to clarify costconcepts and degrees of freedom in defining toll policy. It would seem legitimate to include in thecost structure certain items which could be quantitativelv important but which today ate notconsidered. Two which are under discussion include the maintenance of the hydrographic basin,and the protection and safety of the Canal area. Given the capacity of the Panamanian1s toteclnically operate and maintain the Canal Mn working order (somethin;, whict; is rot dlisputed),these issues point to the real challenge abead--to win the Confidence of the worldwide usercommunity that ii can count on a relidble an.d efficient service from dav one of the Panamanianadministration.

Panamd: A Dual Economy In Transition 16

46. Prospects. PCC traffic projections for 1990-2010, based on a 1989 study, indicateaverage growth of 1.5-2% per year for Net Canal Tons (the basis for calculation of the tolls). Thebulk of this growth, however, is expected to occur during 1994-2000. In fact, 1994 growth rateswere considerably above those anticipated for the long term i.e., a 1.8% growth in traffic, 8%growth in cargo passing through the Canal, 4% in Net Canal Tons, and an increase of 4.6% in tollrevenue. This last figure is noteworthy, because in 1993 it had already increased by about 9%over the previous year, as the result of a rise in tolls which took effect in October 1992. A 2%growth in revenues, which assumes no major change in toll policy or costs, would contribute0.14% to the economy's growth during 1995-2000. Beyond 2000, a projected increase of 1% intraffic, a toll policy that keeps revenues constant in real terms and no significant changes incosts, would permit the Canal to contribute 0.07% to overall economic growth. Under thisscenario, the contribution of Canal operations to Government income would rise at a similar pace.

C. The Colon Free Zone

47. Background. The ZLC, established in 1948, is the largest free trade zone in the WesternHemisphere, and the second largest in the world, after Hong Kong. It comprises 60.7 has. ofdeveloped areas and 43.3 has. of land for future development. There are more than 1,500 privatefirms in the ZLC, of which 700 are foreign. The ZLC generates about 8.8% of GDP (1993) anddirectly employs close to 12,000 people, or 1.3% of the total labor force. The volume ofoperations has grown significantly in recent years, from less than US$4 billion in 1982 to close toUS$10 billion in 1994. ZLC generated a trade surplus of US$459 million, close to 85% ofmerchandise exports. Hong-Kong, Taiwan, Japan and South Korea account for more than 50%of total imports, while Colombia, Venezuela, Aruba and Ecuador are the main export markets. In1993, its fiscal contribution was a little less than US$20 million. The ZLC is a state entity whichadministrates a number of buildings, facilities and land sites within its boundaries. It chargesrental fees to users of the facilities, as well as fees for services. All profits from ZLC operationsaccrue to the Government, which decides on investment plans. In 1993, divestiture of buildingsand facilities was initiated to raise funds for the Government, but in 1994, the new Administrationput this plan on hold. The ZLC performs three kinds of business: (i) "pure trade" i.e., imports inlarge quantities from other countries--mainly the Far East--and re-exports to third countries,mainly in Latin America; (ii) "distribution center" i.e., distribution of goods by transnationalcorporations who locate large stocks in ZLC to later distribute them to third countries; and (iii)"export processing zones" i.e., processing goods exclusively for export to third countries.

48. In addition to proximity to the Canal, the ZLC enjoys a number of competitiveadvantages, especially in the pure trade modality. The ZLC has an edge in terms of financing--itbuys in large quantities with credit from suppliers, and later re-sells--with no credit to thirdcountry buyers. The availability of credit from suppliers stems from: (i) the large quantitiesbought; (ii) use of the U.S. dollar as legal tender with freedom of capital movements; and (iii)collateral financing made available through the CBI. To these competitive advantages must beadded a process of dynamic scale economies, basically through learning-by-doing, which overtime has allowed ZLC entrepreneurs to develop special skills and knowledge of regional trade.Clearly, this is an advantage that no other country can quickly replicate without substantial entrycosts. As a center for distribution chosen by foreign multinationals, the competitive advantagesarises mainly from the geographical position and the free movement of capital and of goods underthe ZLC regime. But the maquila industries in Panama generate little value added due to highlocal cost, especially for wages and basic services, compared to other countries in the region.

49. Main Issues and Prospects. The ZLC confronts two major external challenges: tradeliberalization and liberalization of capital movements. Trade liberalization elsewhere in LatinAmerica, has been positive for the ZLC, especially in its "pure trade" and "distribution center"

17 Panama: A Dual Economy In TransiWion

modalities, as it has increased the demand for imported goods in Latin America. Much of thispositive effect, together with the economic recovery in Latin America explains, why the ZLC hasraised its value added at an average rate of 23% since 1989. In the future, however, part of thecompetitive advantage of the ZLC may be eroded, as growing trade volumes could enable thesecountries to secure financing advantages like those obtained by the ZLC. Liberalization of capitalflows, to the extent they imply a reduction in capital costs in third countries, also erode ZLC'scompetitive advantage. Domestically, the high port fees and service inefficiencies exert a negativeimpact on the competitive position of the ZLC. Indeed, the ZLC operates mainly in merchandisehaving high per-unit prices because handling, port and transport costs are high. Lowering thesecosts would enable the ZLC to expand into new products. A new private port facility being builtat Manzanillo and the privatization of the public ports will help Panama face these challenges.

DW Other Export Services

50. The Oil Pipeline was installed in the early 1980s as a result of distortions in theinternational oil market. Over the years it has produced significant income but currently is indecline. In 1993, the Pipeline contributed about US$30 million to current account receipts andabout 0.3% of GDP. Its activity is expected to expire by the end of the decade. In Panama, thelaw allows for corporations with bearer stocks, which over the years has generated an activebusiness of legal representation of foreign companies. In addition, Panamanian tax law makes itattractive for foreign shipping companies to establish in the country. This legal businesscontributes about US$145 million to the current account, or about 27% of export services. Likethe CBI, this source of foreign receipts flows is under U.S. scrutiny due to money laundering andtax evasion concerns.

E. The Reverted Areas

51. Background. The term reverted areas refers to about 147,000 has. surrounding thePanama Canal. These areas and facilities (military bases, airports, schools, hospitals, andhousing) formned the old Canal Zone, and they are being gradually handed back to Panama as aresult of the 1977 Canal Treaty. This process will conclude with the reversion of the Canal at theend of 1999. Although the reverted areas cover only 2% of the country, their location makesthem very valuable, as they are adjacent to 50% of the country's population and most of itseconomic activity. Lands and installations began to be handed back in 1979; among the mostimportant assets already reverted are the Canal terminal ports (Balb6a on the Pacific and Crist6balon the Atlantic), the Trans-isthmus Railway, the Mount Hope fuel deposits, the France Fieldairport near the ZLC, several office buildings, and about 3,000 houses.

52. In the past, the reversion process was conditioned by two phenomena preventing theirefficient utilization: the absence of a development policy for the assets that were being handedback--despite the various institutional and administrative arrangements that were created--and,perhaps due to this, the direct use by the public sector of a large part of the returned assets. Theresult was the nationalization of most of the properties, including houses which have been rentedat prices considerably below market, buildings which have been used as public offices, and poorlyadministered port facilities. In order to avoid repeating past mistakes, in 1993 the InteroceanicRegion Authority (ARI) was created with a mandate "...to organize, plan, guard, administer andmake use of all returned and to-be-returned assets..." ARI's principal characteristic isindependence from the political authorities, but a recent reform to its charter gives the Executivegreater influence.

53. Main Issues and Challenges. Great expectations exist in Panama regarding the value ofthe reverted areas and their facilities, and of the uses to which they can be put; however, theeconomic value commonly put on these areas, US$25 billion, is clearly an overestimate. A

Panamd: A Dual Economv In 7ransition 18

simple way to try to estitnate the value of the reverted areas is through the fiscal property register,which puts a price on the land approximating market values in comparable locations, and valuesimprovements to reflect current construction costs. The results of this exercise produce values ofUS$1,793 million for the land in the rnilitarv bases; US$2,160 rmillion for improvements; andabout US$320 million for other assets, or a total of about US$4.3 billion. This estimate does notinclude a value for the hydrographic basin in the Canal Area. While this estimate should betreated as an approximation, it suggests that the oft-quoted US$25 billion figure is too optimistic.

54- Putting the reverted areas to productive use is seen as a way of offsetting the economicrepercussions of the withdrawal of U.S. troops and their dependents. The Center for theExecution of the Treaty has calculated that direct and indirect expenditure in the nationaleconomy from the U.S. presence was of the order of US$383 million in 1994 (US$305 rillionexcluding pension payments). This contribution, exclusive of pensions to Panamanians, willdecline gradually until disappearing in the year 2000. Part of this expenditure, although fuelingaggregate demand, leaks out through imports so that in terms of value added, the U.S.contribution is somewhat lower. Assuming that two-thirds of these expenses eventually becomevalue added for the economy, with a discount rate of 10%, the "business value" of the revertedareas--that is, the difference between the total value of reverted areas as measured above and thepresent value of this contribution to value added--amount to about US$2.2 billion, or a figureequivalent to one year of merchandise imports.

55. For the economy to benefit substantially from the reverted areas, several challenges mustbe met. Above all, the institutional setup created to handle the reverted areas must work and workwell. By this is meant that it cannot be subverted by political pressures and that a frameworkmust be created for an efficient allocation of the reverted areas. ARI's decisions on the use of thereturned assets will be heavily influenced by the results that emerge from the study on the GeneralPlan for the Use, Conservation and Development of the Canal Area, which is supposed to becompleted in fourteen months, but whose start has been continuously delayed. This study shouldpresent partial reports on the use of certain facilities, helping in ARI's decisions in the meantime.Although ideally the Plan should basicaily be concerned with defining a general zoning of theareas, it is feared (and hoped by some) that the Plan will define in detail the sort of activities thatshould be carried out in the different areas and facilities. This leads to the temptation to apply anenclave-type arrangement to the reverted areas, in the tradition of policy-induced duality.Although the recent reforms to ARI could heighten the risk of political interference and rent-seeking activities, they are the result of a diagnosis that rates ARI's management record as pooranid slow. As a result of the reforms, it is expected that ARI will have a greater say in thedevelopment of the General Plan than initially anticipated.

ChiAPTER III: CONSTRIAITS TO SUSTAINED GROWTH

56 Panania confronts a series of external challenges: (i) the withdrawal of the U.S.Government from the administration of tihe Canal and the former Canal Zone; (ii) technologicalchange and economic liberalization; (iii) the formation of trading blocks; (iv) a sharp decline inbilateral aid flows, and (v) the rise in international interest rates and devaluation of the U.S. dollar.Nonetheless, the most formidable impediments to a revival of sustainable growth are domestic innature. 'This is clear from the negative contribution of total factor productivity growth to overallgrowth during the past two decades (Annex 2).

57, Policy-induced constraints retard growth through allocative distortions, and by renderingmacroeconomic adjustment much more costly. Given that the U.S. dollar circulates as legaltender, the Government cannot manage the economy through exchange rate or monetary policies.Thus, a disequilibrium in the relative price of nontradeables cannot be corrected indirectly (i.e., by

19 Panama: A Dual Economy In Transition

exchange rate movements). In particular, a real wage above the opportunity cost of labor can beadjusted toward a full employment level solely through a reduction in nominal wages. Butinstitutional constraints in the labor market limit wage flexibility, so such reductions are difficultand normally occur only after large increases in unemployment. The absence of price flexibilitydue to other policy distortions only adds to the unnecessary costs the adjustment process entails.As a result, macro management generates a more pronounced business cycle and moreuncertainty, to the detriment of investment and growth.

A. The State and the Economy

58. Background and Main Issues. Despite the considerable progress made in reducingimbalances, fiscal stability is jeopardized by the inexorable increase of the public sector wage billand the mounting deficit of the social security system. At the same time, the tax burden, includingsocial security taxes and implicit taxes garnered through state utilities, is very high and detersprivate sector development. Private sector development also is hindered by the encroachment ofstate enterprises and limited effectiveness of the state in carrying out key public functions such asthe administration of justice. Furthermore, the state is large (indeed, one of the largest in theregion)--in 1994, its overall expenditures were equivalent to 31% of GDP.

59. The public sector employs more than one-sixth of the labor force at an average wagesurpassing that in the private sector. The unsustainably large public sector wage bill is theoutgrowth of a patchwork of thirty-nine "special" laws that separately determine human resourcepolicies for different groupings of public employees. About 55% of public employees are coveredby these special laws, which grant major privileges in matters of salary and job security. Otherpublic employees come under an occupational regime characterized by instability of employmentand pay discretionality. The average salary of the sector covered by special laws exceeds that ofthe rest of the public sector by more than 30%. Furthermore, the special laws render fiscal policyinflexible by predetermining the payroll trend. During 1990-93 the payroll in the sector covered byspecial laws increased 14.2%, while in the rest of the public sector it increased 2.8%.

60. The social security tax is at a level that significantly inflates the cost of doing business andadversely affects employment but fails to generate the resources needed to cover the benefitsmandated under the system. In 1993, the current deficit of the social security agency (CSS)amounted to more than 2% of GDP. The insolvent government complementary pension fund,which provides public sector employees covered by special laws with an additional pension,registered an additional deficit of 0.5% of GDP. This deficit will expand progressively underexisting laws. Although the tax burden (including implicit taxes) is high, the tax system proper isinelastic. Services are not subject to the value added tax and tax incentives are used extensively.Moreover, the excessive prices charged by state monopolies and excessive transfers of theiroperating surplus to the central government eventually will have to be replaced by explicit taxesor expenditure reductions; and public finances will need to be adjusted to free-up resources toservice the large commercial bank debt and to finance essential maintenance and investments.

61. Public intervention through regulation is an essential determinant of the price system andresource allocation. Regulation occurs through four principal channels: (i) the tax system,characterized by discriminatory treatment; (ii) the structure of tariffs and other restrictions oninternational trade; (iii) the extended system of price controls (affecting about a third of theconsumption basket); and (iv) rigid labor laws which raise labor costs. State regulation isparticularly pervasive in the agricultural and industrial sectors, while leading export services arepractically free of regulations. State intervention has a high economic cost in Panama. The stateabsorbs considerable resources but provides inadequate and low quality services. Centraladministration is bureaucratic and bloated; the justice system is slow and ineffectual; and public

Panamd: A Dual Economy In Transition 20

safety has deteriorated. Services provided by public utilities are expensive and of poor quality,while social services are affected by serious efficiency problems. Public regulation has become acomplex web of penalties and compensations for different social groups impairing resourceallocation and economic efficiency.

62. At the same time, the state faces severe restrictions in the financing of its deficits. Thedomestic capital market is incipient, while external financing from private creditors is not availablegiven the Government's arrears situation and bilateral aid has declined sharply. The only majorsource of debt financing for the state is multilateral loans. With little financing flexibility,unexpected fiscal shocks are extremely disruptive, and lead to ad hoc cuts in already committedexpenditure, the bulk of which consistently falls on investment outlays. This partly explains whystate investment traditionally has contributed little, if anything, to growth. But a morefundamental problem is the lack of a state investment planning and assessment system to evaluate,prioritize and coordinate investment projects. There is no assurance that bad investment projectsare rejected or that those of greatest social benefit are implemented. The lack of executioncapacity in the public sector also contributes to the fact that only a fraction of budgetedinvestment actually materializes.

63. In December 1993, external public debt amounted to US$5.3 billion, equivalent to 82.7%of GDP. The public sector's principal foreign creditors are private banks, which hold more than70% of external liabilities, including arrears. The Central Government's domestic debt reachedUS$1.9 billion, almost all of it owed to Panamanian public sector creditors, notably BNP (45.6%of domestic debt) and CSS (42.5%). Thus, there is no national domestic debt as such, but thefinancial positions of BNP and CSS depend on the fulfillment of these payments. Moreover, acomplex system of cross subsidies impairs efficiency in each of these sectors: the BNP subsidiesthe Central Government, while the Central Government subsidizes the CSS.

B. Basic Services and Infrastructure

64. Background and Main Issues. Basic services are provided by state monopolies: IDAAN(water and sewage); INTEL (telecoms); and IRHE (electricity). These entities set tariffs, decideupon the provision of new services, and plan sector development. The fourth largest parastatal,APN, de facto a monopoly, is in charge of fifteen ports, the main ones having reverted to Panamafrom the former Canal Zone. These enterprises face a number of common problems: (i) lack ofautonomy of the Board of Directors and the Executive Director; (ii) rigid government controlsestablished in the Fiscal Code and the laborious ex-ante scrutiny of the Comptroller General; (iii)their use as a source of fiscal revenues, without regard for their investment requirements; (iv)highly restrictive labor regimes; and (v) poorly designed tariff schemes.

65. Transfers from INTEL, IRHE, and APN to the Treasury have been increasinglysignificant, and in some cases, have exceeded their net profits, forcing them to postponeinvestments and to withdraw funds from special reserves kept at BNP. IDAAN is the only one ofthe four that receives a net transfer from the Central Government, because of its weak financialsituation. Labor relations at INTEL and IRHE are governed by Law 8 (an old version of theLabor Code) which gives employees job and wage benefits superior to those established in theLabor Code, while severely restricting the personnel management. APN's labor relations aregoverned by a special Statute for Port Employees inherited from the U.S. Government, which isextremely inflexible and likewise guarantees employees a number of benefits even more generousthan those stipulated by the Labor Code. These experiences should serve as a warning against thetemptation of adopting special statutes for labor relations in other economic sectors. Althoughpublic service fees are generally high by international standards, certain groups are subsidized.These subsidies can be explicit, as in the case of the 25% reduction in electricity fees for retiredpeople, or implicit, by not metering or charging for consumption, as is the case of IDAAN.

21 Panama: A Dual Economy In Transition

66. Although telephone density and network digitalization are relatively high compared toother countries in the region, INTEL does not perform well on other indicators: (i) the backlog inline requests is high (20,000) and unchanged over the last several years; (ii) its productivity is low(74.1 lines per employee); (iii) its tariff scheme is uneconomic; and (iv) it has restricted thediffusion of new services. (Panama is one of the only countries in the region that does not have acellular phone system.) While national long distance rates are comparable to those in the region,local rates are relatively low. INTEL charges only a nominal fee for installation of new phonelines, and employs a flat rate system with an unlimited number and duration of local calls.International long distance rates are very high, especially when compared with rates in the maindestination countries. This has spawned rapid growth of the call-back system, which has resultedin a sharp increase in the imbalance of the international traffic. The decrease in INTEL's outgoingtraffic has important effects on its finances because the international service is the most lucrativepart of the business, generating over 50% of income.

67. The National Assembly recently approved legislation which provides for the incorporationof INTEL under private corporate law and the subsequent sale of up to 49% of the firm to aqualified strategic private investor. The new entity will enjoy a monopoly in international phoneservice for up to eight years and the right to operate cellular services. The state has retained theremaining shares, but 2% will form a trust for the benefit of INTEL workers. The state alsokeeps the right to exercise veto power over certain strategic decisions. The rights and limitationsof the different kinds of shares need to be well defined in order to assure the private investor-operator that it can control the company with 49% ownership. The precise definition of the initialconcession for the newly incorporated INTEL to operate basic telephone systems would have tobe clearly defined before it is offered for sale. Given that the Government has decided to go bystages, restructuring INTEL first and leaving the definition of a regulatory framework and thecreation of an independent regulatory body for later, there is still much to be done. In themeantime, however, some steps could be taken to achieve greater efficiency and promotecompetition, such as metering local service and tendering the cellular phone band.

68. IRHE is a vertically and horizontally integrated monopoly which operates and developspower generation, transmission and distribution. It has a solid financial position due mostly to itsmonopoly status. Productivity indicators are rather low, and power costs high, by internationalstandards. Recent studies prepared for a new fee structure based on marginal cost pricing showthat IRME incurs fixed costs of about US$100 annually per subscriber because of high expenses inoperation and maintenance for distribution, marketing and administration. Thus, although IRHE isfinancially sound there appears to be considerable scope for increases in efficiency that couldtranslate into lower rates. A recent amendment to IRHE's charter law will allow the generationand purchase of privately generated power. In addition, the current tariff structure, which has18 different fees, should be rationalized. A marginal cost-based fee structure would reduce powercosts for consumers if subsidies through the fees are removed, no direct transfers are made to theTreasury, and efficiency gains are obtained by reducing the excessive general, administrative andmarketing outlays.

69. APN ports, specially Crist6bal and Balboa, which account for more than 80% of itsincome, are high cost and low productivity operations (approximately one-third of internationalstandards in container operations). As a result its user fees are high. The cost of a containertrans-shipment at Crist6bal, for example, is between 50 and 150% higher than in Kingston,Jamaica. Recent studies have concluded that high costs and overstaffing at APN's main portsstem from the special labor statute for port employees. Thie Government plans to privatize APN'smain ports through concessions on cargo handling while retaining ownership of theinfrastructure. The biggest obstacle to implementing this plan stems from the substantial

Panamd: A Dual Economy In Transition 22

severance payments that would be due employees. APN is facing competition from a large,private sector facility, under construction near Col6n. Not only will this project alleviatePanama's transportation problems, but likely hasten the privatization of APN.

70. IDAAN's situation is precarious. It experiences water losses of 43%; meters a mere18.3% of water consumption; lacks adequate information systems; and suffers from low laborproductivity (8.5 employees per 1,000 water connections), and poor morale and workermotivation. As a result, it has incurred losses over the last four years despite having feescomparable to other water companies in the region. Although some reforms are underway to tryto improve IDAAN's efficiency, there is a need to explore the potential for attracting privatecapital and management to the sector.

71. The Ministry of Public Works (MOP) has road and highways investment plans amountingto US$577 million for 1994-97. About US$180 million would be financed by IDB and the WorldBank in support of the Road Rehabilitation Program, and MOP estimates that US$134 millioncould be financed by concessions. The first administrative concessions and bid process wasorganized by the new Government according to the 1988 Law of Administrative Concessions. AMexican group was chosen to design, construct and operate for 30 years a toll road complex thatincludes a 17 km urban road network, and an interoceanic highway.

C. Labor Markets

72. Background and Main Issues. The labor market in Panama is sharply segmented.Following introduction of the Labor Code in 1972, the unemployment rate has climbed far aboveits historical trend and high unemployment has become chronic. Under prevailing policies, thereis little reason to expect a decline in the unemployment rate from the current 13.7% (Figure 3.1).Indeed, under current policies, Panama would need to grow 12% per year to achieve a 5%unemployment rate by the year 2000. Given the monetary regime, the capacity of the economyto adjust efficiently to evolving international market conditions hinges exclusively on thedownward flexibility of domestic prices, but current policies prevent domestic prices fromadjusting. This was Figure 3.1: A SIMPLE PICTURE OF THE UNEMPLOYMENT RATE

demonstrated graphically during1988-89, when the price leveldid not recede in response to the Before the Labor Code ... after the Labor Code

drastic reduction in liquidity 18. 6Avg Unemipl.me,1rt 10.8%

while output and employment l. StGdXdDDviavJm 0.8 1 6 S.mui d 5 . ......... _ ..14. 14.

dropped precipitously. 12. - -- - . 12-

73. The Labor Code curbs 6-

the ability of the economy to 4. 462 63 64 65 86 67 68 69 70 7 72 73 75 77 79 83 86 87 89 93compete and create jobs because I.L_ _

it: (i) stipulates that wagescannot be reduced under any circumstance; (ii) mandates a large number of nonworking days; (ii)renders the dismissal of employees difficult and expensive; (iii) severely restricts worker mobilitywithin and among firms; (iv) heavily involves the state in labor-management relations; (v) inhibitsboth piece rate pay and temporary contracts; and (vi) prohibits private employment agencies.Fringe benefits and employer taxes collected on the wage bill are among the highest in the region.In certain sectors such as industry and construction, the Labor Code, in conjunction with social

security and other wage taxes, increase labor costs by as much as 64% of the base wage bill.

74. Other policies also drive-up labor cost and impede job creation. Steep protection inflatesthe prices of food, housing and other consumer goods. State monopolies pass on theirinefficiencies to consumers through high prices for basic services. Fiscal incentives cheapen

23 Panamd: A Dual Economy In Transition

capital. Minimum wage legislation (which mandate 12 different minimum wages, mo ,t well abovemarket clearing rates) and a tradition of generous pay settlements in the public sector covered byspecial laws raise wage expectations in the private sector as do high wages paid in the Canal Area.The cost of labor in Panama is high in dollar terms, but the relatively higher cost of necessitiesdepresses real wages relative to those in competing countries. For example, housing prices are47% higher in Panama than Costa Rica although the two countries have similar per capitaincomes.

75. The Labor Code was conceived for general application. In practice, it covers about 35%of the working population, because: (i) sectors which compete internationally would be severelyharmed if the Code were enforced in them; and (ii) even more generous labor laws protect manyworkers in the state sector. There are some fifty special labor laws for state employees (althoughabout 45% of state employees are not covered by any labor legislation). In addition, the PCCregime is being replicated for certain assets handed back to Panama (e.g. in ports). Smallcompanies and exporters are covered by a separate regime. In the CBI and the ZLC, the LaborCode is not operative because the Government has not allowed labor unions to form.

76. One of the most serious impediments to labor mobility imposed by the Labor Code is veryhigh dismissal costs. Although dismissal is permitted when the firm needs to adjust its labor forcefor economic reasons, it requires government approval. If the Ministry of Labor approves thedismissal, the firm must compensate the worker according to a rule which, in essence, taxes thecompany at a rate of one month per year of service.3 If the Ministry of Labor does not accept theeconomic reason for dismissal, the firm must either invoke a different reason and go to court, takethe worker back, or pay compensation at a rate of 1.5 months wages per year served. Thiscompares very unfavorably with other countries in the region (Gregory and Davila, 1993).Furthermore, an additional cost may be incurred if firms risk firing a worker for a justified reason.This is related to the so-called salarios caidos, i.e., retroactive wage payments a firm must makeif it fires a worker for a cause which, after a court hearing, is deemed invalid. These paymentsmay be considerable, thereby introducing a high degree of uncertainty for firms and perverseincentives to lengthen legal processes.

77. Available data indicate that, on average, 90% of workers fired claim wrongful dismissal.Hearings average one year but can take up to three. If the worker loses the judicial dispute,he/she does not have to pay costs. This is highly consistent with results of a sample of more than100 cases analyzed by Spinager (1983), where the average dismissal cost, in today's currency,amounted to US$4,500 and reached more than US$8,000 in the case of firms which fired thelongest-serving workers. Moreover, only 2% of cases were decided in the employer's favor,which means that the expected cost of dismissal is well approximated by the average cost.Mobility within the firm is mainly affected by the irrevocability of benefits obtained in pastnegotiations and the literal interpretation of the provision that every position should beremunerated equally.

78. Although the costs associated with high social contributions and rigidities are the mainproblems in the legislation, there are other costs which limit private investment and productivityimprovements. Most of these are related to a series of procedures which confer on the state avery large role relative to the negotiating parties. For example, the state intervenes actively in the

3 Some aspects of the way in which compessation is calculated, however, engendef greater complexitics. Thus, the benetit stuts with increases in thepayment for each three month period up to one year and two months (when an accumulated payment of 5 weeks is male). Afterwards, the increase isof one payment week for cverv two months up to one year and ten nmonths. TherL the payment is increased at the rate of one week per year. In addition,a one-month notice of disrmssal is r equired, which in most cases implies an extra month payment flr the firm.

Panamd: A Dual Economy In Transition 24

form the labor contracts must take, without giving freedom to the parties directly involved, evenin aspects which relate exclusively to each individual firm and cannot be considered at anaggregate level. The most illustrative case is that wage cuts for economic motives are notpermitted, even though dismissal is. Other aspects which should be determined according to thewishes of the parties are hours of work and overtime payments. The latter not only have a verycumbersome form of calculation, leading to a series of judicial conflicts, but are extremelyburdensome. The most prominent procedures which interfere in the way firms are run, are thelength-of-service benefit and the requirement that unions shall propose the method of fillingvacancies. Furthermore, Panamanian labor legislation, in its spirit of promoting unionization, endsup generating mechanisms which tend to make the unions undemocratic and nonrepresentative.The obligatory union fee is one. The biggest problem, however, is that by allowing negotiationsonly with the union which has majority membership, affiliation to a single union becomesobligatory.

79. A high degree of informality is a feature of the employment situation in many LatinAmerican countries. In Panama the incidence of informality is unusually high, mainly due to theintensity of policy distortions. The effect of informality and lack of coverage of the groups thatremain outside the legal regime was estimated on the basis of household surveys. The mostsuggestive results from estimating a Mincer-type model, adjusted for selectivity (lambda), indicatethat the informal sector accounts for about 45% of the labor force is Panama and that those whowork in that sector receive substantially lower wages than those in the formal sector. The resultsalso indicate that the stability norms do not manage to protect workers in the formal sector.Thus, the distribution of permanency at work in the formal sector shows that a substantialpercentage of workers are dismissed before completion of two years of service in order tocircumvent the provisions which make it extremely difficult and expensive to dismiss workers.

80. Informality also has important consequences on poverty. The most obvious effect is lowerwages in the informal sector due to protection in the formal one. However, there is a secondelement that may have even more important implications. Workers in the informal sector acquireconsiderably less training during their working life This is basically explained by the fact that amuch larger turnover is present in this sector than in the formal one. Indeed, the average tenure inthe formal sector is 6.7 years, 3.5 times the average in the informal sector. Estimates of aprobability model (Probit estimates) indicate a very close association between family poverty andwork status. As expected, the more education, the lower the probability of falling into poverty.The same is true for people with more work experience. Even though informal employment is inprinciple of lower quality than formal, it also helps to raise people out of poverty. Both thesignificance level and the size of the coefficient associated with the unemployment variable (0.86)clearly suggest that the employment-generating capacity of the economy could be augmented byreducing distortions in the labor market. In other words, it is equitable to reduce excessiveprotection to the employed workers in the formal sector not only because this will create moreemployment in this sector, but because it improves conditions in the informal sector.

D. Trade and Price Policies

81. Background and Main Issues. The trade regime is highly distorted. Nominal tariffsrange from 3 to 90%; tariffs on a number of agricultural commodities are considerably higherwhen reference prices are factored in. About 50% of imports are exempted from duties. Inaddition, formidable nontariff barriers riddle the economy, raising implicit protection far abovenominal levels. Indeed, the trade regime is the most distorted in the region. Moreover, trade andpricing policies are highly complex, the result of an array of instruments and measures ofdissimilar nature and objectives. On top of this, the Cabinet and individual Ministers exercisediscretionary control over virtually all trade policy instruments, and frequently modify them. This

25 Panamd: A Dual Economy In Transition

fosters instability, and at the same time, great susceptibility to political and interest grouppressures, resulting in intensive rent-seeking, a proliferation of special regimes and complexmarket segmentation.

82. The tariff regime itself is highly complex. It includes ad valorem and specific duties,reference prices and mixed duties. The specific duties are a combination of a tariff fixed byproduct unit and a percentage rate on the CIF import value; the mixed duty consists of applyingan ad valorem or a specific duty on affected items, whichever is greater. The great majority ofproducts with ad valorem or mixed duties above 50% are of agricultural origin. Those subject tomixed duties are concentrated in construction materials, cellulose, garments, footwear and foods.On the basis of this tariff structure, in 1993 the state collected US$225.6 million, of whichUS$144.6 million came from import duties, and US$81 million from ITBM (the discriminatorysales tax) on those imports. The weighted average duty exclusive of ITBM was 6.6% of the CIFvalue of imports; including ITBM, it was 10.3%.

83. Quantitative barriers take the form of quotas and prior import permits. In September1994, quotas affected 38 tariff categories, and prior permits covered 19 items, all of agriculturalorigin. Quotas and permits are established on a case-by-case basis by the Agricultural MarketingInstitute (IMA), in concert with producers; imports are authorized only when they do notcompete with domestic production. IMA collects an administration charge for servicing quotasand permits, which in most cases amounts to 4% of the CIF value of imported merchandise. Thisfee further increases protection. Goods subject to quotas and permits also face high tariffs, whichnormally have to be paid independently of the quotas or permits granted. Permits and quotas arecustomarily assigned on the basis of historical import precedents and purchases in the localmarket. Exports also are subject to taxes and controls: banana, scrap-iron, gold, silver andplatinum exports are taxed, and quantitative controls, imposed to ensure fulfillment of quotasgranted by the U.S., affect garment and sugar exports. Export quotas, applied to ensure domesticsupplies or to avoid harming areas of national economic activity, have affected beef, leather andcoffee (Boxes 3.2 and 3.3).

84. Panama's protectionistic trade regime shields domestic producers of basic grains, poultry,processed foods, beverages and tobacco, and construction materials from foreign competition.Tariffs, reference prices and quotas are set by commissions which include the responsible publicentities and producer associations; consumers are systematically excluded from this decision-making process. The high tariffs and quantitative trade restrictions severely curb competition inthese sectors of the economy, and have raised the prices of wage goods substantially aboveinternational levels, while the domestic prices of goods such as automobiles and wines are similarto international prices. In response, a complex web of price controls has been built up on such

Box 3.2: LEATHER EXPORTS

The regulatory policy for exports allows for the placing of restrictions on the export of certain goods, inorder to avoid domestic destocking, and shortages of essential products or damage to economnic activities consideredhigh-priority. As a traditional beef exporter, Panama generates a significant surplus of raw hides which is usedmainly as raw material for footwear. During certain periods the Foreign Trade Institute has restricted leather exports,to ensure supplies to the national industry. In this case, national industry enjoys access to raw material at prices farbelow interational ones, thereby generating a transfer from agricultural producers to industrialists. The latter havebeen opposed to the liberalization of leather exports, arguing that this would mean an increase in costs which wouldhave to be passed on to consumers, causing great harm especially to schoolchildren. But at the same time, footwearimports are subject to differential ad valorem duties, with lower-priced footwear enjoying the greatest protection. Inthis way not only does the industry enjoy access to cheaper raw materials, but it can also sell its own production atwell above international prices, thereby obtaining monopoly profits.

Panama: A Dual Economy In Transition 26

goods. Price regulation can be established directly through resolutions (Decree 60, 1969), orindirectly through the obligation to report changes in prices (Law 34, 1974). Within each categoryor type of service there may be two or more (in some cases hundreds of) items whose prices aresubject to controls. Since 1990, a number of price controls have been relaxed; but as of June1995, price controls continued to affect goods in 33 tariff categories and three types of services.Price controls invariably are based on domestic cost considerations, a policy that leaves wideroom for arbitrariness and fosters rent seeking. Prices also are regulated by varying import quotasand tariffs, when the Authorities fear that domestic production shortfalls threaten a sharp run-upin the domestic prices of foodstuffs. Thus, while these are the goods which receive the mostprotection, this protection drastically varies over time, leaving producers with little incentive toboost productivity.4

85. At the same time, de jure and de facto regulations restrict entry and impede competition ina number of rubrics which have a large impact on the economy's competitiveness. Notable amongthese are basic services like telecommunications, ports and energy. In addition, the retail sale ofgoods below the manufacturers' stipulated list price is prohibited by law. Retail price maintenancepermeates the economy. Moreover, there is no anti-trust legislation, and collusion is widespread.The transportation of all goods to and from the CFZ is concentrated in the hands of two laborunions and one truckers cooperative, and participation of foreign truckers in the transportation ofexports and imports is heavily restricted. Price controls also heavily restrict the supply of housingfor the poor and lower-middle income groups.

86. As the exports of goods have stagnated as a result of heavy protection, successiveGovernments have established a series of special incentive regimes to foster exports (e.g., theZLC, export processing zones, petroleum trans-shipment and tourism). In addition, theGovernment, through the Panamanian Institute of Foreign Trade, administers promotion systemsfor export development, among which are access to a discount window, subsidies for attendanceat trade fairs, technical support, and tax credit certificates (TCC). The TCC is a subsidyequivalent to 20% of the national value-added content of nontraditional exports, which are looselydefined. In 1992-93, TCCs amounted to US$21.5 million, representing an average subsidyequivalent to 15% of the FOB value of the exported goods.

Box 3.3: THE FOOD EXPORTING INDUSTRY

Exports ofcertain types of goods could benefit from the countrgs geographical location and from access to airand maritime transportation systems.:e Such is the case of the food industry, however, the ilated costs of rawmaterials anid public services preclude the development of the industry along competitive lin:es.§. Products such asbiscuits, chocolates, sweets ;and drinks all haveas main components of their direct production costs, packaging, Pour,sugars, edible oils, dairy products, energy, water, communications, labor and transportation services, each of which has

: artificially high costs caused by curTent economic policies.: Sugar, dairy products and edible oils are directly affectedby quantitative cofntrols or prior permits,: flour and cocoa are subject to high tariffs, as are packaging and wrapping.Electricity, water and telecommulucations are much more expensive than in neighboring countries as, the result oof

: ineficient state enterprises. Labor costs are high due to a rigid employment regime, h4ile transportation andshipment expenses reflect the costs of an obsolete infrastructure and .a regime characterized by regulations andprivileges. Consequently, although the food industry possesses technological and managerial. capacities allowing. it....access to markets, policy distortions make it impossible to achieve any sort of competitive edge. This phenomenonequally affects industries oriented toward the domestic market. Thiscase illustrates the care that must be takenhin thedesign of programs to liberalize the economny. If, for example, the plan to liberalize the processed foods market iscarried out,vwithout reforming agricultural protection, public services charges, and the labor laws, damage will beinflicted on the industry, impairing its development possibilities as a potenti alexport sector.

4 For example, rice imports face a nominal tariff of 90%, and fall under a quota system; however, IMA recently authorizedthe import of a large shipment of rice at a zero tariff.

27 Panama: A Dual Economy In Transition

87. The previous Administration launched a trade reform, with the support of the WorldBank, through the ERL. Most specific import tariffs have been converted to ad valorem ones;tariffs on most industrial and agroindustrial products reduced; and a number of import quotasaffecting basic grains liberalized. But the process frequently has been counteracted andinterrupted. The current Administration is committed to deepening and accelerating trade reform.

88. A meaningful process of trade reform would, on the production side, depress theprofitability of importable agroindustrial and agricultural goods, which currently employ about10% of the labor force. The great majority of these goods are not labor-intensive; displaced laborcould be absorbed by the development of new agricultural exports, which are typically morelabor-intensive. The most significant output response in the medium term likely will occur innontraditional agricultural exports, such as fruit, frozen and fresh vegetables, and the foodindustry. Traditional exports like shrimps, meat, fish, coffee and leather also should show asignificant production response as the anti-export bias of the trade regime is curtailed and pricesignals rendered more transparent and less subject to arbitrary manipulation. Even the productionof importables which currently receive high protection could show a positive supply response overthe long haul, inasmuch as the current regime, with its drastic and unpredictable price variations,depresses investment in and the modernization of these rubrics. The supply response fortraditional exports like sugar will be limited by the quotas granted by the US. Any significantdevelopment of export processing zones will hinge fundamentally on labor market reform.Although exports of goods do not seem able to lead an accelerated growth process, in a smalleconomy like the Panamanian one, expansion in just a few activities can provide significantmomentum to overall economic growth.

89. Meaningful trade liberalization, together with price deregulation and anti-trust legislation,also should reduce the cost of living, especially for lower income groups, as the goods with thesteepest protection (foods and manufactures such as footwear and garments) represent about50% of the average family consumption bundle.

CHAPTER IV THE REFORMAGENDA AND GOVERNMENT ECONOMIC PROGRA

90. Growth prospects...positive but lower than recent performance. Although the economicrecovery has been strong and investment stands at about 25% of GDP, investment is ofexceptionally low quality--during the past two decades, total factor productivity growth has beennil or slightly negative. The negative productivity of investment is explained largely by the severedistortions prevalent throughout the economy. The high investment rate is largely the result of ahearty "appetite" for capital, induced by the large distortions prevailing in goods and labormarkets. Consequently, under current policies, and now that the economic recovery has run itscourse, growth likely will revert to the feeble trend registered during 1981-93, or rather less than3% per annum. But comprehensive economic reform, along the lines recommended in this reportcould boost annual GDP growth to 5% or more over the medium-term, while enhancing theeconomy's employment-generating potential.5

91. Leading export services..new challenges and moderate growth. With the exception ofthe ZLC, future growth prospects of most export services are moderate or low. Furthermore,formidable new challenges arising from an evolving external environment will have to be faced.Responding to these challenges will require comprehensive reforms to build up institutionalcapacity, expand the role of the private sector, and deregulate economic activity.

5 Macroeconomic projections under different policy scenarios have been prepared for this report and are available on request.

Panamd: A Dual Economy In Transition 28

92. Reverted areas... less than expected The estimates of the economic value associated withthe Reverted Areas prepared for this report are much lower than those commonly cited in publicdebate (about US$4.2 billion versus US$25 billion). Moreover, the benefits arising from thereverted areas are partially neutralized by a diminished aggregate demand associated with thedismantling of U.S. defense activities in the country.

93. Duality... to a large extent, policy-induced Panama is a "dual" economy, withpronounced differences in growth and productivity across economic sectors, with a few leadingsectors accounting for a large part of total foreign income generation but a low share ofemployment. Arguably, part of the income distribution problems of the country arise fromstructurally-induced duality. To a large extent, however, duality and income distributionproblems have been brought about by policy-induced distortions. Over the years, the country hasconverged to a system whereby the surpluses of key leading sectors are extracted through highlydistortionary state interventions, which, in turn, greatly exacerbate duality and its adverseconsequences.

94. Government...needs to become much more efficient. The state is large, inefficient and amajor source of economic instability. This unwieldy apparatus largely reflects the array of specialwage and working conditions obtained by over one-half of the state labor force, the lavish pensionsystem, and an inadequate tax structure and base. Reforms in these areas are urgently needed, butthey must also be accompanied by a redefinition of the roles and functions of the public sector.

95. Labor market policies.. urgent reform needed Under prevailing institutions and policies,Panama would need to grow 12% per year to achieve a 5% unemployment rate by the year 2000.Under such conditions, however, growth most likely would not exceed 3% per annum. In sectorssuch as industry and construction, the Labor Code generates excess labor costs equivalent tomore than 60% of the base wage bill.

96. Basic services and infrastructure.. expensive and inefficient. Basic services, particularlytelecommunications, ports, and electricity are expensive, as these public utilities charge tariffsabove marginal costs both to obtain public revenues and to finance extensive privileges for publicemployees working in these agencies. By way of contrast, the public water company recoversonly 57% of the cost of producing and delivering deficient water and sanitation services to thepopulation. Excessive tariffs and deficient basic services are eroding the ability of the traditionalleading sectors to continue to expand, and severely linmit the scope for the development of newactivities. The highway and road network also is inadequate.

97. Trade and price interventions...pervasive and highly distortionary. The trade regime isthe most protectionist in the region, and represents a formidable barrier to the revitalization of thePanamanian economy and poverty reduction. In the absence of meaningful trade reform, whichwould entail a drastic reduction in tariff levels and quantitative restrictions affecting agriculture,the food processing industry and construction, agriculture cannot be transformed, nor rural orurban poverty significantly reduced.

98. Poverty and inequality...high and largely the result of policy distortions. Althoughaggregate social indicators are relatively favorable, poverty and income inequality are unusuallyhigh relative to Panama's per capita income. Moreover, poverty and income distributionworsened during the 1980s, as pervasive policy distortions constrained growth, inhibited jobcreation, and redistributed income from the poor to the relatively more affluent.

A. The Reform Agenda

99. The Challenge of Policy Reform. In the absence of comprehensive policy andinstitutional reforms, Panama will not be able to surmount the new external challenges nor solve

29 Panama: A Dual Economy In Transition

its long-standing problems of "duality," insufficient employment generation, and bad incomedistribution. The complex array of policy interventions and distortions in Panama also points tothe need for careful sequencing of policy reforms. Indeed, the prevailing distortions imposecompetitive disadvantages in the various sectors of the economy that must be removed in a well-coordinated sequence, to avert unnecessary welfare losses. Moreover, the political feasibility ofimplementing such a reform program will hinge on sequencing the various policy reforms in asuch a way that no one sector bears undue transitional costs. Finally, the active pursuit of anumber of reforms will have to be phased-in over a lengthy period simply due to the sheer volumeand weightiness of the issues.

100. Phase I: Fiscal Adjustment, Poverty Alleviation, Regulatory Reform andPrivatization. The reform program should be launched with public sector reform because successof the program likely will depend crucially on private sector perceptions that the state iscommitted to putting its own house in order before it cuts programs to the private sector's likingor raises taxes; because the state is the most inefficient sector in the economy and the high costs itimposes on the private sector will need to be redressed to enable the economy to better competein its traditional growth sectors and to develop new internationally competitive activities; becausethe state will need to retarget its spending to the poor and to provide transitional support to thoseaffected by the reform process; and because the timely conclusion of a debt restructuring dealrequires a prompt adjustment of public finances to release the resources needed to service it.

101. In this context, the following sequence of public sector reforms suggests itself. First,measures to effectively check the growth of the public sector wage bill should be adopted; clearly,such an initiative should precede any effort to augment taxes on the private sector. This meansthat at some point, the issue of the Special Laws will have to be addressed, albeit in the meantimevarious expedients can be used to continue to curb the growth of the wage bill. At the same time,social spending needs to be reallocated to programs that directly alleviate poverty, such as theSocial Emergency Fund. More far-reaching social sector reform probably should be carried out ina later phase. Second, a simpler, more equitable and less distortionary tax system should beintroduced; in particular, the value added tax (ITBM) should be extended to all services, whilelow uniform income and import tax rates should be instituted, and tax exemptions and subsidiesphased-out;6 however, such a reform, to the extent that it raises the effective tax burden onbusinesses and individuals (e.g., by eliminating tax subsidies), should only be implemented intandem with price reforms in the electricity, telecommunications and port services.Contrariwise, such price reforms cannot be implemented to their full extent without offsettingrevenue measures along the lines suggested. Third, an external debt restructuring accord shouldbe implemented. Fourth, once regulatory reform is underway, privatization of basic servicesshould be vigorously pursued.

102. Panama cannot afford substandard and costly infrastructure. The guiding principle ofpublic policy should be to promote and facilitate competition in the provision of services. Where itis unlikely that competition will emerge, because of technical considerations (e.g., economies ofscale), price regulation could be based on a CPI-x system in order to assure consumers fallingrates over time. In order to facilitate the emergence of competition wherever it can exist, it isvital to modify the legal and regulatory frameworks for each of the basic services. This stepshould be taken prior to partial or full privatization. The general recommendation is to transfer all

6A flat, all inclusive ad valorem tariff of 6% wvould generate at least as much revenue as the plethora of tariff levels andexemptions currently in force; however, while trade reform, especially targets and timetable for tariff reductions should bepublicly announced at the beginning of the reforn program, it should not be undertaken in isolation from goods and labormarket deregulation, as described in Phase I] below.

Panamd: A Dual Economy In Transition 30

the regulatory, enforcement and planning functions currently performed by state enterprises, toautonomous regulatory bodies with an independent, technical orientation. Reforms in the portssector can be implemented without new legislation. In addition, further progress in incorporatingthe public services companies is warranted, in order to ensure autonomy from the CentralGovernment. As corporations, even if not fully private, they also would be free from theprovisions of the Fiscal Code and the ex-ante scrutiny by the Comptroller. Finally, tariff reforn isessential. Users should face the correct price (marginal cost) of service provision. If subsidies forlow-income groups are deemed necessary, they should be direct income subsidies and not builtinto the fees.

103. Finally, the measures needed to eliminate the mushrooming social security deficit shouldbe left for the last phase of public sector reform because of the fierce opposition it will spawn. Asin the case of streamlining the bloated state wage bill, eliminating this deficit can be achievedsolely by reforming the Special Laws. In the end, fiscal sustainability cannot be attained withoutthese major reforms. Pension fund reform, if it entails private provider schemes, also could stepup domestic resource mobilization and spur a revival of the financial system. Financial systemreform, while needed, is much less urgent, and could be delayed.

104. While the public sector reform is unfolding, the Governrment also needs to conclude theimplementation of the measures required for a smooth turnover of the Panama Canal and thedevelopment of the reverted areas. First, and foremost, the legal framework should grant theCanal Authority autonomy, financial solvency, immunity to political pressures, and freedom toapply out-sourcing policies. The 1994 amendment to the constitution that creates the CanalAuthority includes provisions of autonomy and immunity to political pressures, but alsointroduces ill-advised restrictions on Canal management in respect of the labor regime. Thisamendment has to be ratified by the current Legislative Assembly, which provides the opportunityto redress the anomalous wage scales prevailing in the Canal Commission. Second, although thepotential for cost reduction in canal operations exists, and an innovative approach to managementand toll policy could result in greater revenues for Panama, a precautionary strategy of sticking tothe status-quo that guarantees a smooth transition of ownership of the Canal to Panamanianhands, with no negative effects on service reliability, will be by itself be a success. Third, in orderfor the country to maximize the potential benefits of the reverted areas, the reversion processmust be incorporated in the broader context of economic liberalization. This would requireresisting the temptation to create new enclaves and the past practice of handing-out revertedassets to state entities, in the spirit of policy-induced duality.

105. Phase II: Trade Liberalization, Price Deregulation and Labor Code Reform. Theelimination of the major policy-induced distortions affecting the private sector will need toproceed on a broad front. The Labor Code needs to be overhauled. At the same time, a uniform,low ad valorem import tax (no higher than 10%) should be introduced, and all nontariff barriers,export taxes, prohibitions and quotas eliminated. With such a tariff regime, customs reform willno longer be a burning issue. The use of sanitary laws to restrict trade also needs to bediscontinued, and these laws brought into line with WTO norms. Anti-dumping norms consistentwith WTO standards should replace high tariffs and quantitative restrictions. At the same time,explicit regulations in the area of animal and agricultural hygiene and quality control are needed toenhance export performance. In addition, the TCC system for nontraditional exports should bereplaced with an efficient system of general export refunds, based on rebating taxes actually paid.As trade barriers are dismantled, price controls should be rescinded, and all discretionary authorityto control prices repealed. Simultaneously, anti-trust laws need to be instituted, and other barriersto market entry (e.g., the Panamanian nationality requirement for engaging in retail trade anddiscrimination against foreign truckers) abolished.

31 Panama: A Dual Economy In Transition

106. Labor legislation reform, especially the reduction of excess wage costs in protectedsectors, is essential for sustainable trade reform, as removal of wage-inflating restrictions isequivalent to a real exchange rate depreciation. But employees who benefit from the Labor Codeclearly would be unwilling to countenance fundamental reforms to the Code unless the prices offood, housing and other necessities are brought down, something which trade reform wouldaccomplish, by raising real incomes of the poor and reducing upward pressures on wages.Similarly, employers in protected activities clearly would be unwilling to accept meaningful tradereform unless the Labor Code is greatly modified prior to or in conjunction with trade reform, andthe prices of basic services simultaneously rationalized. At the same time, price deregulationwould not be welcome by the public without trade reform. One reform that could and should beinstituted right way is elimination of rent controls, because it will generate broad-based benefits.

107. Labor market reform should entail: (i) a drastic reduction in the number of labor regimes;(ii) unification of the various minimum wages; and (iii) a liberalization of the Labor Code,including (a) allowing dismissal for economic reasons, without the prior approval of the Ministryof Labor; (b) allowing employees and employers to negotiate such labor costs as vacations, thethirteenth month salary and educational insurance; (c) limiting severance compensation to onemonth per year of service, with a ceiling of 10 years; (d) leaving collective bargaining toemployees and employers, without the intervention of the Government; (e) eliminating closelydefined job demarcation and other restrictions on inter- and intra-firm worker mobility; (f)eliminating restrictions on piece-rate pay and temporary contracts; (g) rescinding the prohibitionagainst wage reductions; (h) promoting greater union democracy, explicitly making membershipvoluntary in law, and allowing the existence of more than one union per firm; and (i) removingthe prohibition against the operation of private employment agencies.

108. Phase m: Social Sector and Governance Reforms. Other key public sector reforms,which could be initiated at any time, include education reform, health care reform, andjudicial reform. Nonetheless, the reform agenda is so formidable, and the need to reinvigoratethe economy so pressing, that it probably would prove advisable to postpone major social sectorreforms until the major economic reforms are well underway. In addition, economic policyreforms should raise real incomes of the poor in the short-run. Another reason for doing so is thateducation reform, like social security reform, is going to provoke considerable opposition. In thecase of education, much greater emphasis needs to be attached to improving its quality, especiallyat the pre-primary, primary and intermediate levels; and on expanding coverage of pre-primaryand intermediate education, targeting rural areas and the urban poor. The Government needs to (i)acquire more authority vis-a-vis teachers' unions in mapping-out sector strategies and policies; (ii)introduce management information systems on resource utilization, costs and results; (iii) instituteadequate policies for training, promotion and human resource transfer; (iii) develop a textbookpolicy; (iv) institute an evaluation and monitoring system; and (iv) raise tuition at state universitiessharply. More generally, social spending needs to be much more effectively targeted.

109. Phase IV: Land Tenure Reform. Trade reform is a necessary but insufficient conditionfor modernizing Panama's backward agricultural sector. Land tenure reform, as it pertains to theprovision of land titles to the large numbers of farmers lacking them, is also needed to providethe population economically active in agriculture with sufficient incentive to modernize, and toenable the rural sector to gain access to credit at more competitive prices. This reform is alsoneeded for soil conservation.

B. The Government's Medium-Term Economic Reform Program

110. The Government is well aware of the challenges facing the economy, and has takenimportant steps to implement its comprehensive Medium-Term Economic Reform Program

Panamd: A Dual Economy In Transition 32

(MTEP). The MTEP encompasses trade and pricing reforms; reforms to restore a viable medium-term fiscal framework and creditworthiness; privatization and rehabilitation of economicinfrastructure; reform of the labor code; and expansion of social safety net mechanisms, healthcare reform; and educational reform. In addition, a top priority of the Government is thesuccessful transition of the Canal and the development of the reverted areas.

111. Fiscal Policies. A law that introduces a career stream in the public sector, which willfacilitate the modification of the special laws and help identify labor redundancies, was approvedby the Legislative Assembly in June 1994. While the deficit of the CSS should diminish as theprovisions of a 1991 reform law are phased-in, a key priority of the Government is to undertake amore far-reaching reform of social security, opening it up to the private sector and reducing itsadverse employment effect. In addition, in June 1995, the Legislative Assembly approved theFiscal Incentives Harmonization Law, which gradually eliminates a large number of tax breaks andsubsidies, both direct and indirect, for import-substituting activities and nontradeables, whileenhancing fiscal sustainability and laying the groundwork for trade reform. In May 1995, thePresident submitted to the Legislative Assembly legislation to liberalize the Labor Code, and ispreparing a new public sector employment regime, with the support of the ERL technicalassistance component, that would replace the plethora of special labor laws effecting about 50%of state employment. Also, the previous Administration privatized several goods-producing stateenterprises and several more enterprises are slated for divestment during 1995-96. A law whichwould earmark all receipts from privatizations for investment in infrastructure and povertyreduction programs recently was approved by the Legislative Assembly. The Government has notyet announced plans to generalize the value added tax.

112. Basic Services and Infrastructure. The Government, with the support of the ERL andthe IDB's PERL, is pursuing a two track approach to redress deficiencies in basic services andinfrastructure. One centers on upgrading enterprise efficiency, rationalizing pricing policies andrehabilitation; the other, on strengthening enterprise autonomy, regulatory reform andprivatization. Under the first track, enterprises have cut physical and nontechnical losses;improved metering and billing; reduced accounts receivable and payable; and increased outlays formaintenance and investment. In addition, procurement procedures have been streamlined andtariffs for some basic services partially rationalized (international phone calls and some portservices). Under the second track, the Government is focusing on regulatory reform andcontestability by: (i) separating policy formulation, regulatory and service delivery functionswithin each subsector and restructuring operating entities along commercial lines in accordancewith private corporate law; and (ii) unbundling the operations of utilities and public works entitiesto enable competition in those aspects of service delivery which do not possess natural monopolycharacteristics.

113. To this end, the Legislative Assembly recently approved a Law which provides for theincorporation and partial privatization of the telecommunications firm. A similar bill was rejectedunder the previous Administration. The Legislative Assembly also approved an amendment to thestate electricity company charter law that opens the generation of electricity to the private sector.In addition, concessions have been granted to the private sector to develop the cellular telephonemarket, and build and operate new port facilities. APN fees for container handling recently wereslashed by two-thirds, bringing them into line with those charged by the new private port atManzanillo. In the transportation subsector, the Government is focusing on rehabilitation,deregulation and out-sourcing. A concession has been awarded to a foreign firm to construct andoperate a Panama City-Col6n tollroad. During the second semester of 1995, the Administrationplans to submit to the Legislative Assembly a bill that would establish the regulatory frameworkand entity for the electricity sector, and another bill that would do the same for thetelecommunications sector.

33 Panamd: A Dual Economy In Transition

114. Trade Policies. The Government has launched another round of trade reforms, in thecontext of its incorporation in the WTO, focusing on elimination of all nontariff barriers, gradualreduction of tariffs to a range of 0 to 30% (but with many exceptions for basic grains andprocessed foods) and the phasing-out of fiscal subsidies (which has been initiated with the recentpassage of the Incentive Harmonization Law). While this clearly represents a considerableimprovement over present policies, such a tariff band, especially with the much higher tariffs foragricultural and agroindustrial goods, will remain too wide to induce the major reallocativeresponse needed to energize the large nonenclave sector of the economy or to significantly reduceinflated domestic prices. Thus, it would continue to thwart the transformation of Panama's feebleagriculture and poverty-stricken rural sector, regardless of other policy initiatives. With this inmind, the Government is exploring further trade reform initiatives.

115. Pricing Policies. Remaining price controls are to be removed in tandem with further tradereform measures, and the Price Regulation Office transformed into a consumer protection agency.A bill that would curb barriers to competition (by eliminating the Price Regulation Office,introducing antitrust statutes, and instituting antidumping norms) will be submitted to theLegislative Assembly during the second semester of 1995. In addition, legislation that wouldliberalize the housing market--but retain rent controls, is under consideration by the LegislativeAssembly. These controls should be completely eliminated.

116. Labor Market Policies. The Administration recently submitted a far-reaching reform ofthe Labor Code to the Legislative Assembly. The proposed bill would: (i) soften the provisionthat prohibits employers from reducing wage rates, and allow new employees to be hired at anywage rate (equal to or higher than the minimum wage); (ii) curtail dismissal costs; (iii) eliminatethe disincentives to both piece rate pay and temporary contracts; (iv) substantially reduce thedirect role of Government in labor-management relations, including removal of the provision thatrequires employers to obtain prior Government approval of layoffs and dismissals; and (v) rescindthe ban on private employment agencies.

117. Poverty Reduction. The Government's strategy for mitigating poverty and inequalityconsists of four chief elements. The first is the introduction of conditions that will revivesustainable growth. In this context, the economic program emphasizes reform policies that willmitigate the bias against employment creation and reduce the high cost of the consumptionbasket. In addition, the incentive framework will be altered so as to encourage increasedagricultural production and employment opportunities in the countryside, where most of the poorlive. Second is the introduction of new mechanisms to protect those most susceptible tomalnutrition and vector-transmitted diseases. The third facet is improving efficiency and equity insocial expenditures through sector reforms, especially in education and health; curbing growth inthe wage bill; instituting cost recovery, and targeting subsidies to the most vulnerable groups.The fourth is institutional modernization and capacity-building.

118. External Debt Strategy. Normalization of relations with external creditors forms a keyelement of the Government's medium term economic program. In May 1994, Panama reachedagreement with external bond holders on a refinancing arrangement, and in May 1995, achievedan agreement in principle on a debt and debt service reduction accord with its commercial bankcreditors. The Government also intends to resolve its arrears situation with Mexico andVenezuela. These efforts should cheapen the cost of foreign financing, reestablish Governmentaccess to the international capital market, and encourage foreign direct and portfolio investment.

BIBLIOGRAPHY

Barletta, N. A. (1993): "El Proyecto Nacional 1991-2000. Contribuci6n al dialogo entre panamefios",mineo.

Fernandez, M. (1993): "La politica econ6mica y la distribuci6n de rentas en Panama", in Fundaci6nAnde and ICEG, eds., La experiencia de la apertura comercial y ajuste de las empresasen Costa Rica, Chile. Mexico y Panama, Panama.

Gregory, P. and A. Davila (1993): "Evaluaci6n del C6digo del Trabajo de la Republica de Panama",Final Report, Development Technologies, Inc.

Leamer, E. et.al., (1994): Central America and The North American Free Trade Agreement.LA2CO, The World Bank, September.

Manfredo, F. (1994): Several conferences and letters.

Moreno, J.L. (1994): "La necesidad de una politica econ6mica de mercado y liberalizaci6n econ6mica:El caso de Panama", in FIIES, La politica econ6mica panamefia y sus consecuencias,Panama.

Riveros, L. (1988): "International comparisons of wage and non-wage costs of labor", mimeo,CECMG, The World Bank October.

Spinanger, D. (1983): "El mercado laboral en Panama: Un analisis del impacto en el empleo delC6digo del Trabajo", mimeo, Kiel Institute for the World Economy, USAID/Panama,October.

World Bank (1994): Panama: Country Assistance StrategY. Report No. 13846-PAN (Grey Cover).Washington, D.C.: Country Department II. Latin America and the Carribbean Region.

World Bank (1995): Panama. Issues in Basic Education. Report No. 13701-PAN (Grey Cover).Washington, D.C.: Country Department II, Latin America and the Caribbean Region.

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