OREANDA-NEWS. This note summarizes preliminary findings and recommendations of the mission that visited Guatemala during May 18-31 to conduct the 2016 Article IV consultation. The mission thanks the Guatemalan authorities for their outstanding cooperation and open dialogue.

Context and Focus of the consultation

1. The 2016 Article IV consultation took place against the background of an ongoing unprecedented fight against corruption and impunity in Guatemala. The efforts of the new administration and the legislature are focused on increasing governance, transparency, and accountability in the aftermath of the 2015 political crisis. The authorities have recently adopted important legislative changes, including the procurement law, organic laws of Congress and of the public prosecutor, and the electoral and political parties law. The legislative reforms currently under way, including the Tax and Customs Administration (SAT) law, the constitutional changes to strengthen the judiciary, and the civil service laws will further propel this effort, as will stricter application of the rule of law. In the area of economic governance, IMF technical assistance on tax administration and fiscal transparency is helping shape the next steps in the reform. In this context, the consultation focused on the discussion of policies needed to preserve macroeconomic stability while pursuing institutional reforms and supporting higher long-term inclusive growth.

Recent developments, Outlook, and Risks

2. Economic developments since the 2014 Article IV consultation have been positive.

• The Guatemalan economy withstood the 2015 political crisis well. Growth remained robust; the external position improved; the exchange rate and financial indicators remained stable and confidence recovered quickly. Fiscal revenues, however, fell prompting a cut in government spending. Guatemala’s solid track record of fiscal and monetary policy contributed to this remarkable macro-economic stability.

• Growth has remained robust. The Guatemalan economy has been growing slightly above potential and the output gap is closed. Growth remained at 4.1 percent in 2015 despite the slowdown in public consumption and investment during the political crisis. Private consumption was lifted by lower oil prices and strong remittances, while the unemployment rate remained at a low 3 percent.

• Inflation is close to the center of the target range. Inflation was below the 4±1 percent target range during most of 2015, driven by lower oil prices, but moved above the center of the range in early 2016 due to an increase in food price inflation, in particular in rural areas. Food prices were driven by both demand pressures, including from strong remittances inflows, and by weather-related supply shocks. Core inflation declined further below the target range, likely reflecting second-round effects from lower oil prices as well as the impact of the exchange rate appreciation.

• The balance of payments improved substantially in 2015, resulting in an external position moderately stronger than implied by fundamentals and desirable policies. The current account deficit shrank from 2 to ? percent of GDP on the back of low international oil prices and robust remittances. The deficit was over-financed by FDI and public sector borrowing, leading to foreign reserve accumulation with net international reserves standing at 4.2 months of imports at end-2015. The external position is moderately stronger than the level consistent with fundamentals and desirable policies—in part due to the relatively low fiscal deficit—suggesting that Guatemala does not face serious price competitiveness problems. However, signs of structural competitiveness weaknesses, such as low human and physical capital as well as high crime and corruption, highlight the need for addressing structural rigidities to help accelerate the economy’s response to shocks and restore external equilibrium.

• The fiscal deficit fell below the budget target of 2 percent of GDP in 2015 and public debt remains low. The shortfall in revenues of 1? percent of GDP was offset by even larger cuts in spending, driven in part by delays in multilateral loan disbursements. As a result, the 2015 fiscal deficit turned out ? percent of GDP lower than the budget target. At 24 percent of GDP, public debt is among the lowest in the region though it is moderately high in relation to fiscal revenues.

• The monetary policy rate has been reduced and the exchange rate has remained stable. The central bank has reduced the policy rate in 2014-15 by a cumulative 200 basis points amid declining inflation. The exchange rate has remained broadly stable vis-?-vis the U.S. dollar, with some central bank participation to stem volatility. The exchange rate fluctuation margin under the participation rule was widened slightly in 2015 as part of the gradual process to allow for more exchange rate flexibility.

• The financial system appears sound, though vulnerabilities remain. Credit expanded rapidly in 2015, slanted towards foreign-currency loans. The growth of the latter, however, has now slowed as large electricity projects financed by loans in foreign currency have been completed. Banks meet regulatory capital norms although capital is low by regional standards. They also have sufficient liquidity cushions but reliance on foreign funding has continued to rise, with bank foreign liabilities standing at a decade high and among the highest in the region. Relatively large government bond holdings are another source of vulnerability. Private sector balance sheets appear healthy, with foreign currency loans concentrated in the corporate sector.

• Progress towards social objectives has been limited. Only one fourth of the Millennium Development Goals quantitative targets for 2015 were met, with none of the goals met for the rural and indigenous population. Moreover, there have been reversals of trends in extreme poverty and school enrollment. Low fiscal revenues and the need for a comprehensive strategy to address social challenges remain key hurdles to progressing towards the new Sustainable Development Goals.

3. The macroeconomic outlook remains benign. Growth is set to return to its trend rate of 3? percent in 2016 and gradually rise to 4 percent in the medium term as a result of the measures to increase transparency and efficiency of public spending. Inflation is expected to remain within the central bank’s target range. The external current account deficit is projected to widen to 1? percent of GDP by 2021, driven by gradual reversal of the oil price decline and strong domestic demand, while remaining more than fully financed by FDI. Reserves are projected to remain adequate. The fiscal deficit is expected to remain stable at 1? percent of GDP in 2016 and hover around this level in the medium term.

4. However, risks are tilted to the downside. Growth could be negatively affected by an unexpected slowdown in global growth or by U.S. monetary policy normalization if accompanied by extreme bouts of financial volatility. The latter could also raise bank rollover risks and credit risk from unhedged borrowers if accompanied by a substantial currency depreciation vis-?-vis the U.S. dollar. Conversely, continued multilateral appreciation in line with the dollar could negatively affect competitiveness. There are also downside risks from potential reductions in provision of financial services by global banks as part of their de-risking strategies. On the domestic side, failure to credibly address the crisis in the SAT and other institutional weaknesses, to increase investment in physical and human capital or to raise spending on security and social programs, could continue to impede inclusive growth.

Near-term Policy Mix

Preserving macroeconomic stability and room to deal with shocks while starting to address pressing structural needs, including low security, lack of physical and human capital, as well as high malnutrition, poverty and inequality, will be key in the short term.

5. A broadly neutral fiscal stance is appropriate from a cyclical perspective but structural needs could justify a temporarily higher deficit, if revenue shortfalls were to persist. The primary balance is expected to remain near zero in 2016 with the output gap closed. While the first-best option is to arrest the revenue decline and mobilize resources to cover planned budget spending, a slightly higher-than-budgeted fiscal deficit could be justified to prevent cuts in priority spending in the event of revenue shortfalls. This would not jeopardize fiscal sustainability but would allow the government to maintain its announced social and anti-corruption reform agenda.

6. SAT reform is a priority, both to raise revenue and to contribute to the fight against corruption. In this regard, measures to address governance, management and operational difficulties in line with IMF recommendations are crucial. These include: (i) adopting the new SAT law; (ii) strengthening management and broadening the implementation of pro-integrity measures internally; (iii) strengthening customs by ensuring more effective control of goods, more accurate valuation of imports, and stricter control of special trade regimes; (iv) more effective control of large and medium-size taxpayers’ compliance; (v) taking measures to improve VAT administration, including the enforcement of issuance of VAT invoices; and (vi) improving taxpayer services, including by broadening e-services. However, the impact of these measures is likely to take some time.

7. Monetary policy is broadly appropriate but the authorities should remain vigilant if price pressures intensify. Lower real lending rates, stronger credit growth, and higher housing prices contributed to a small loosening of financial conditions in 2015 despite an appreciation of the real effective exchange rate. The estimates of the neutral policy rate point to an accommodative monetary stance. However, core inflation is below the target range and inflation expectations have been firmly within the range since 2012. Hence, the mission does not recommend an immediate monetary tightening, but the central bank should stand ready to increase the policy rate if inflationary pressures intensify.

8. Sound financial sector policies have contributed to the stability of the financial system but continued vigilance is warranted. In light of the ongoing global regulatory changes and increased risks for banking systems which have limitations in their AML/CFT frameworks, the authorities are taking steps to fortify the financial system. In particular, they are developing a comprehensive macro-prudential program, strengthening control of customer identification, performing national risk assessments, increasing the frequency of on-site inspections, taking steps to increase protection of supervisors and exploring the experience of other countries with bank resolution and deposit insurance frameworks. So far Guatemala has not been materially affected by de-risking. The mission encourages the authorities to continue effectively implementing risk-based AML/CFT supervision, continue bringing the framework in line with the 2012 FATF standards and 2014 FSAP update recommendations to help enhance financial integrity and improve financial system’s preparedness to possible shocks.

Medium and Long Term Policy Challenges

Strengthening fiscal, monetary and financial sector policy frameworks as well as fostering institutional changes will support economic policy-making and improve resilience to shocks in the longer term.

Reorienting fiscal policy while maintaining debt sustainability

9. Staff recommends focusing fiscal policy on structural objectives in the longer term while guarding sustainability. The mission believes that raising fiscal revenues to at least 15 percent of GDP would be essential in the longer term, to accommodate higher social and infrastructure spending and to support efforts to durably reduce crime and corruption. For example, staff analysis suggests that eradicating extreme poverty would require at least 1 percent of GDP in fiscal spending. Continued strengthening of the SAT will be needed to reverse the trend of falling tax compliance levels and to garner additional revenue, including taking strategic measures such as: (i) strengthening the SAT’s legal framework; (ii) encouraging staff responsibility by strengthening the performance evaluation system and actively and consistently addressing integrity issues; and (iii) broadening and improving the quality of the SAT’s digital services. To complement these efforts, the authorities should consider a comprehensive review of the tax policy framework with the goal of broadening the tax base and possibly raising tax rates—while taking distributional and macro-economic considerations into account (personal income tax rates are particularly low by international comparison). In this regard, the IMF stands ready to provide technical assistance. Lowering the currently high degree of revenue earmarking could also help make resources more fungible.

10. Improving fiscal transparency and efficiency could help increase government credibility. In this regard, the mission encourages the authorities to implement the IMF’s recent technical assistance recommendations on fiscal transparency, including: (i) improving fiscal accounting, consolidation, and reporting; (ii) protecting tax administration from political interference; (iii) improving control and audit of fiscal spending, including strengthening of units in charge of planning government purchases and internal auditing; and (iv) regulating and making government’s direct purchases more transparent. The mission welcomes the measures already taken by the authorities in this direction, including those aimed at improving transparency in the procurement of goods and services. Transparency efforts should be supplemented with measures to raise spending efficiency.

Strengthening monetary and financial frameworks

11. The mission advises completing transition to full-fledged inflation targeting. To this end, recent improvements in monetary transmission to credit and repo interest rates are encouraging. However, additional efforts are needed to further strengthen the monetary transmission mechanism. In this regard, the mission recommends: (i) continuing to gradually increase exchange rate flexibility to credibly convey to the public the primacy of the inflation objective; (ii) consider taking additional measures to discourage credit dollarization; (iii) developing the private debt and securities market; (iv) further refining the framework for monetary operations, including liquidity management; and (v) authorizing and honoring government obligation to cover past and current operational losses of the Central Bank that are eroding its capital base and impeding the conduct of monetary policy.

12. The mission encourages the authorities to use the current period of stability to further fortify the financial system. While the financial system can withstand a range of sizable shocks and interbank links are limited, large dollarization of loans, fast growing bank foreign liabilities and exposure to the government represent vulnerabilities. The mission recommends implementing 2014 FSAP update recommendations, as well as recommendations of the IMF Cluster Surveillance Report on Financial Integration in CAPDR. In particular, staff sees merit in further strengthening of capital buffers, including through a gradual move towards Basel III standards and an introduction of a capital surcharge for D-SIFIs. In this regard, we welcome ongoing efforts to introduce corporate governance and market risk regulations. While supporting the authorities’ recent efforts to reduce credit dollarization through differential risk weights and gradual elimination of exemptions on mortgage loans and loans to the electricity sector, the mission encourages the adoption of additional macro-prudential measures in case the degree of dollarization persists and credit quality deteriorates. The mission supports the ongoing effort to introduce a liquidity coverage ratio in aggregate and by currency. Staff emphasizes the importance of strengthening the supervision of conglomerates, including through adjustment of the legal framework in line with international standards, appointment of national lead supervisors and creation of a regional council for financial stability.

Achieving Higher Long-Term Inclusive Growth

13. The mission encourages the authorities to better articulate their long-term strategy for raising growth and making it more inclusive. Actions will be required on several fronts. Higher spending on security, the judicial system, infrastructure, education, health, and social assistance will be needed to spur growth and alleviate currently high poverty, malnutrition, and inequality. This, in turn, will require higher government revenues. Improving efficiency and targeting of social assistance programs will also be important. The mission welcomes the recent initiative to reform a food support program, to improve control of beneficiaries of social support, and to strengthen coordination among various ministries providing social assistance. Continued progress on regional and international integration, stronger competition policies, including through the adoption of the pending competition law, as well as measures to stimulate rural development will also help boost growth.

14. Further financial deepening will help support growth in the longer term. Guatemala’s financial development exceeds the level implied by its macroeconomic fundamentals. At the same time, financial development, in particular market development, is still low by regional standards and there are no indications of a significant risk buildup. The mission recommends fostering legal and institutional frameworks to facilitate growth of the financial system as the country reaches higher income and education levels while maintaining adequate regulatory oversight. Specifically, the adoption of the securities market law, continued progress on dematerialization of government securities market, including by strengthening the payment system oversight function of the central bank and creating a working group to coordinate market development, would be beneficial. Standardization of government securities and stronger protection of minority shareholders could also facilitate the development of the securities market. Finally, the development of strong property and ownership rights and improvements in the legal system would be needed to facilitate financial deepening in the longer term.

15. The mission is encouraged by the recent progress in financial inclusion and recommends following through on the government initiatives in this regard. While Guatemala lags other emerging markets on financial inclusion, its relatively low income and education levels, high levels of informality and weak rule of law impose constraints on further inclusion. The time is ripe, however, for laying the legal and regulatory foundation for raising financial inclusion as the country continues to grow. In this regard, the mission strongly supports government efforts to develop a national financial inclusion strategy and reduce entry costs by introducing simplified bank accounts for low-income customers. The mission recommends strengthening the regulatory framework for financial inclusion further, in particular, by facilitating the development of the credit reporting systems, strengthening market conduct rules, improving regulation of electronic payments, lowering entry costs, and improving financial education. The recently adopted regulation of mobile financial services and the microfinance law are important steps in this direction. As entry barriers are lowered, it would be also beneficial to examine financial institutions’ lending practices and credit concentration limits.