OREANDA-NEWS. This note summarizes preliminary findings and recommendations of the IMF mission that visited Costa Rica during February 23 – March 7 to conduct the 2016 Article IV consultation. The mission is grateful for the high quality and openness of the discussions and for the cooperation and hospitality of the Costa Rican authorities and private sector.

Panama has had the highest average growth in the region over the past decade and has made significant progress in improving its economic and financial institutions and policies. The economic outlook remains favorable. Although the uncertain external environment poses risks, Panama’s defenses are well placed to cope, should negative external shocks materialize. To preserve and extend Panama’s achievements, the financial and fiscal policy frameworks should be further strengthened and additional policy space built. Supply side reforms, including raising education standards and taking steps to further alleviate poverty, will help build human capital and foster sustainable and more inclusive growth.

Panama’s economic performance is expected to remain strong

1. Panama is expected to continue to have one of the strongest growth rates in Latin America, set against a backdrop of low inflation, a stable financial system, and a declining current account deficit.

  • Growth is projected to remain around 6 percent in 2016 and over the medium term. The economy will be supported by the expected opening of the expanded canal and lower fuel prices, which will counterbalance the effects of slowing global growth and U.S. dollar appreciation. Over the medium term, the increase in canal transit, a dynamic service sector, and investments in the energy, mining, and logistics sectors should help maintain vibrant growth.
  • Inflation is expected to remain subdued in 2016 as a result of low oil prices and price controls on certain food items.
  • The current account deficit, which declined significantly in 2015 to 6.5 percent of GDP, is expected to fall to 3 percent of GDP in the medium term, financed by broad-based foreign direct investment inflows.

2. The anticipated fiscal stance is consistent with a declining debt-to-GDP ratio. The overall fiscal deficit fell to 2.8 percent of GDP in 2015 and is expected to decline to 1.2 percent of GDP over the medium-term. Debt of the Non-Financial Public Sector is projected to fall below 35 percent of GDP over the medium term.

The external environment continues to pose risks to Panama

3. Strong integration with the global trade and financial system brings substantial benefits to Panama, but increases the country’s vulnerability to external shocks. A weakening of global growth could dampen canal revenues and precipitate weaker capital inflows. Tighter and/or more volatile global financial conditions would quickly feed into the local financial system. However, the strong fundamentals of the banking sector and the room to implement a countercyclical fiscal response would help mitigate the impact of either shock on the domestic economy.

4. Smaller Panamanian banks have to deal with increasingly restricted access to correspondent banking services provided by foreign banks. Evolving business models for banks, changes in capital regulations, concerns over compliance with tax rules and international standards on financial sector integrity, and increased due diligence by foreign banks, particularly with links to the U.S., have curtailed some smaller Panamanian banks’ access to correspondent banks. So far, these banks have been able to substitute to other correspondents and the macro-financial impact has been negligible. Nevertheless, further loss of correspondent banking services could undermine cross-border payments and trade finance, with negative implications for the economy. The authorities should quickly develop a contingency plan to deal with accelerating withdrawal of correspondent services.

Significant progress has been made to strengthen financial integrity

5. The authorities’ achievements in improving financial sector integrity are commendable. The authorities have adopted a number of legislative reforms to address weaknesses in the framework for Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT), along the lines of the action plan agreed with the Financial Action Task Force (FATF). The FATF recognized these reforms and their implementation by removing Panama from the list of countries with strategic AML/CFT deficiencies in February 2016. Going forward, the authorities will need to continue to energetically enhance the effectiveness of the AML/CFT regime—particularly on issues of tax transparency—and ensure its full alignment with the revised 2012 FATF standard.

The fiscal framework and institutions should be strengthened to safeguard the sustainability of public finances

6. The authorities have made important advances in the fiscal policy framework. The Social and Fiscal Responsibility Law (SFRL) and the Savings Fund Law have established an operating target with the objective of preserving debt sustainability in the medium term. The framework also provides flexibility to respond to large adverse shocks. In implementing fiscal policy, the authorities should also be commended for strong efforts to ensure transparency and accountability in public spending, particularly on capital investments.

7. A more effective accountability framework is needed to make the fiscal responsibility provisions more binding. Since the SFRL came into force in 2009, deficit ceilings have been relaxed repeatedly through waivers and amendments to the law and the SFRL does not provide for any sanctions in such cases. These repeated revisions signal a weakness in the institutional setting, especially with regard to the accountability mechanism. The cost of noncompliance with SFRL targets should be made explicit and mechanisms put in place to detect and correct slippages during the budget year. The authorities may also consider imposing an explicit and legally-binding fiscal anchor in the medium term (possibly linked to net debt as a share of GDP); introducing multiyear budgeting, and establishing an independent fiscal council to review targets and assess implementation of the framework.

8. The institutional capacity of the revenue agency needs to be strengthened. Tax compliance is very low given Panama’s level of development and economic dynamism. The authorities’ efforts to improve revenue administration, including through VAT retention measures, the development of an improved electronic tax platform, and enhancements to human resources are welcome. These measures should be complemented by developing a tax compliance strategy, broadening the tax base, improving the availability and quality of data, and developing the proper incentives for tax compliance. The authorities should refrain from tax amnesties as they erode tax discipline and undermine the credibility of the tax administration when used repeatedly.

9. Reforms to address the unfunded liabilities of the pension system as a whole will be needed to avoid crowding out other components of public spending. In the absence of parametric reforms, reserves of the defined benefit system will be depleted in about a decade and funding pension obligations thereafter would lead to an annual cost to the budget of 1-2 percent of GDP. Reform options to ensure adequate financing of the pension system could include a gradual increase in the retirement age (to reflect increasing life expectancy) and a reduction in the replacement rate. Early progress on reform would minimize the adjustment and transition costs while maintaining space for other much needed spending initiatives. There would also be merit in exploiting economies of scale by taking a consolidated approach to the management of the assets and liabilities of the defined benefit and defined contribution pension sub-systems.

Efforts are needed to enhance financial supervision and monitor risks

10. The authorities need to take further steps to fully implement the 2011 Financial Sector Assessment Program recommendations. Efforts are underway to improve banking regulations to comply with Basel II. The cross-border supervision and the monitoring of systemic risk need to be enhanced by increasing information exchange with home supervisors of foreign institutions. Since risks deriving from non-bank financial institutions can potentially spill over to the banking sector and threaten financial stability, the supervision of the non-bank financial institutions needs to be strengthened by moving expeditiously to risk-based supervision.

11. In the absence of a lender of last resort and deposit insurance, regulatory requirements need to be adapted to generate larger liquidity buffers against systemic shocks. The liquidity of Panama’s banking system appears high according to the official definition. However, supervisory data collection and liquidity regulation are not in line with the Basel III framework, which makes a comprehensive assessment of bank liquidity difficult. By other publicly available measures, liquidity in Panama’s banking system appears low relative to other comparable countries. The authorities should aim to align financial regulation with the Basel III liquidity framework to ensure banks maintain sufficient high quality liquid assets against liquidity shocks. In addition, the authorities should establish a temporary liquidity facility for banks to address systemic shocks and should develop a plan to coordinate the response to a large unexpected adverse shock to the financial system.

Changes to education system are needed to generate more inclusive growth inclusive growth path

12. Economic growth has contributed to significant poverty reduction over the past decade. Nevertheless, poverty in indigenous areas remains substantially higher than in the rest of the country, partly due to low connectivity and the difficulty of accessing public services from remote locations. Such a high level of inequality can pose important constraints on growth and should be addressed through a more effective system of social safety nets and educational programs that particularly target the needs of indigenous households.

13. Greater focus is needed on enhancing human capital. There is significant scope to improve the quality of public education and health in line with the Government’s Strategic Plan. In particular, it is essential to move forward with efforts to renovate schools and classrooms, introduce the extended school day, revamp programs that improve foreign language and technical skills, and improve R&D opportunities. On healthcare, the focus will be on strengthening the preventive health system and ensuring universal access to primary care. Doing so will help improve education quality, reduce skills shortages, lower youth unemployment, raise productivity, and ultimately improve living standards.