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Document of The World Bank FOR OFFICIAL USE ONLY Report No. 32497-GT INTERNATIONAL BANK FOR RECONSTRUCTIONAND DEVELOPMENT PROGRAM DOCUMENT FOR A FIRST BROAD-BASED GROWTH DEVELOPMENT POLICY LOAN IN THE AMOUNT OF US$ 100 MILLION TO THE REPUBLIC OF GUATEMALA JUNE 9,2005 Central America Country Management Unit Latin America and Caribbean Region International Bank for Reconstructionand Development I I This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its content may not otherwise be disclosed without World Bank authorization. Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized
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Page 1: World Bank Documentdocuments.worldbank.org/curated/en/225071468252663053/...Impuestos a Empresas Mercantiles y Agricolas (Commercial and Agricultural Enterprise Tax) Ley del Impuesto

Document of The World Bank

FOR OFFICIAL USE ONLY

Report No. 32497-GT

INTERNATIONAL BANK FOR RECONSTRUCTION AND

DEVELOPMENT

PROGRAM DOCUMENT

FOR A

FIRST BROAD-BASED GROWTH

DEVELOPMENT POLICY LOAN

IN THE AMOUNT OF US$ 100 MILLION

TO

THE REPUBLIC OF GUATEMALA

JUNE 9,2005

Central America Country Management Unit Latin America and Caribbean Region International Bank for Reconstruction and Development

I I This document has a restricted distribution and may be used by recipients only in the performance o f their official duties. I t s content may not otherwise be disclosed without World Bank authorization.

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AAA AML BANGUAT BIS CAS CEA CECMA C E M CEPAL

CFAA - CPAR CGC CPAR CPI DNCAE DPL DR-CAFTA FATF FDI FONDETEL FONTIERRAS FSAL FSAP FTA GAFI GANA GDP GUAPA IBRD I C A ICAO ICR I C T IDA IEMA IETAP

IFC IIG IMF INCAE

INE INTFCAP

L A C M D G MFP

CURRENCY EQUIVALENTS US$l.OO = 7.60 QZ (Quetzales) (June 2005)

Fiscal Year January 1 - December 31

SELECTED ACRONYMS AND ABBREVIATION Analytical and Advisory Activities Anti-Money Laundering Guatemalan Central Bank Bank o f International Settlements Country Assistance Strategy Country Environmental Assessment Centro de Estudios de la Cultura Maya (Center for Mayan Cultural Studies) Country Economic Memorandum Comisidn Econdmica Para AmCrica Latina y el Caribe (Economic Commission for Latin America and the Caribbean) Country Financial Accountability Assessment I Country Procurement Assessment Review Controlaria General de Cuentas (General Comptroller’s Office) Country Procurement Assessment Report Consumer Price Index Normative Directorate for Procurement and Contracting Development Policy Loan Dominican Republic - Central America Free Trade Agreement Financial Action Task Force Foreign Direct Investment Fondo para el Desarrollo de la Telefonia (Rural Telephone Fund) Rural Land Municipalities Financial Sector Adjustment Loan Financial Sector Assessment Program Free Trade Agreement Grupo de Accidn Financiera Internacional Gran Alianza Nacional (Grand National Alliance) Gross Domestic Product Guatemala Poverty Assessment International Bank for Reconstruction and Development Investment Climate Assessment International Civ i l Aviation Organization Implementation Completion Report Information and Communication Technologies International Development Association Impuestos a Empresas Mercantiles y Agricolas (Commercial and Agricultural Enterprise Tax) Ley del Impuesto Extraordinario y Temporal de Apoyo a 10s Acuerdos de Paz (Temporary and Extraordinary Tax to Support the Peace Agreements) International Finance Corporation Invest in Guatemala International Monetary Fund Instituto Centroamericano de Administracidn de Empresas (Central American Institute for Business Administration) Instituto Nacional de Estadistica (National Statistics Institute) Instituto TCcnico de Capacitacidn y Productividad (Technical Institute for Training and Productivity) Latin America and the Caribbean Millennium Development Goals Ministerio de Finanzas Publicas (Ministry o f Public Finance)

.. 11

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MIGA MSME NGO OBA OIRSA PER PFM PIB PPP PRONACOM PSIA SAG SAIA SAT SIECA

~

ACKNOWLEDGEMENTS

The World Bank Group greatly appreciates the close collaboration with the Government o f Guatemala in the preparation o f this Development Policy Loan (DPL).

The DPL team, including Anai Herrera, Yira Mascaro, Sabine Perrissin, Ricardo Tejada and Manuel Vargas, would l ike to thank the entire country team for their contributions. Special thanks go to several colleagues in the Bank for critical inputs especially, Solange Alliali, Todd Crawford, Michael Goldberg, Laura Rawlings, Mario Sangines and Morag Van Praag.

SIAF SIAFMUNI SIT SME SWAP TA UN UNDP USAID USDA USFAA UTJ

a

VAT WBI

This document has a restricted distr ibution and may b e used by recipients only in the performance of their official duties. I t s contents may no t be otherwise disclosed without Wor ld Bank authorization.

FOR OFFICIAL USE ONLY Multilateral Investment Guarantee Agency Micro Small and Medium Enterprise Non-Governmental Organization Output-Based Aid Plant and Animal Control Office Public Expenditure Review Public Finance Management Product0 Interno Bruto (Gross Domestic Product) Public private partnerships Promotion of National Competitiveness Poverty and Social Impact Assessment Government Auditing System Antinarcotics office Superintendencia de Administracih Tributaria (Tax Administration Superintency) Secretaria de Integracion Economica Centroamericana (Central American Economic Integration Secretariat) Integrated Financial Management Systems Municipal Integrated Financial Management Systems Superintendencia de Telecomunicaciones (Telecommunications Superintendency) Small and Medium Enterprise Sector-wide Approach Technical Assistance United Nations United Nations Development Program United States Agency for International Development United States Department of Agriculture United States Federal Aviation Authority Unidad Tecnica Juridica de Administracion de Tierras (Technical Juridical Unit for Land Administration) Value Added Tax World Bank Institute

Vice-president Pamela Cox Country Director Jane Armitage

Sector Director Ernest0 May Task Managers: Neeta Sirur and C. Felipe Jaramillo

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Page 5: World Bank Documentdocuments.worldbank.org/curated/en/225071468252663053/...Impuestos a Empresas Mercantiles y Agricolas (Commercial and Agricultural Enterprise Tax) Ley del Impuesto

LOAN AND PROGRAM SUMMARY

GUATEMALA First Programmatic Broad-Based Growth Development Policy Loan

Republic of Guatemala MINISTRY OF PUBLIC FINANCE US$lOO million Fixed Spread Loan (FSL) i n U.S. Dollars with level repayments of principal commitment-linked. Automatic Rate Fixing, based on cumulative disbursements of US$lOO million. The Borrower requested to maintain all the embedded conversion options that FSL currently offers and also chose a total repayment period of 20 years, including 2 years of grace. Debt service payments wi l l be made on May 15 and November 15 of each year, with the following Amortization Schedule, during the life of the Loan:

Payment Date Installment Share November 15,2007 2.78%

May 15,2008 2.78% November 15,2008 2.78%

May 15,2009 2.78% November 15,2009 2.78%

May 15,2010 2.78% November 15,2010 2.78%

May 15,2011 2.78% November 15,2011 2.78%

May 15,2012 2.78% November 15,2012 2.78%

May 15,2013 2.78% November 15,2013 2.78%

May 15,2014 2.78% November 15,2014 2.78%

May 15,2015 2.78% November 15,2015 2.78%

May 15,2016 2.78% November 15,2016 2.78%

May 15,2017 2.78% November 15,2017 2.78%

May 15,2018 2.78% November 15,2018 2.78%

May 15,2019 2.78% November 15,2019 2.78%

May 15,2020 2.78% November 15,2020 2.78%

May 15,2021 2.78% November 15,2021 2.78%

May 15,2022 2.78% November 15,2022 2.78%

May 15,2023 2.78% November 15,2023 2.78%

May 15,2024 2.78% November 15,2024 2.78%

May 15,2025 2.70%

i v

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Commitment Fee

Front-End Fee Tranching Objectives

Description

Benefits

Risks

ODeration ID Number

0.85% on undisbursed loan amounts for the f i rs t four years, beginning 60 days after the loan agreement i s signed, and 0.75% on undisbursed loan balances thereafter. 1% o f the loan amount. Single tranche for the full amount o f the loan, minus the front-end fee. The proposed Programmatic Development Loan i s part o f a programmatic series o f three to four DPLs intended to support the fundamentals and three main pillars o f the government’s development plan “Vamos Guatemala”. Within this framework, i t focuses on actions aimed at improving the business and investment climate, creating fiscal space for greater social investment and achieving key milestones in improving the fiduciary environment. Other key areas for growth identified in education, health and nutrition and rural infrastructure are supported within the CAS program through investment operations, which build on the ongoing portfolio o f interventions in these areas. Future DPL operations are expected to focus more intensively on the growth agenda (trade, investment climate, public private partnerships, access to credit by SME) while maintaining attention to transparency and efficiency in public spending. The first loan o f the program wi l l focus on policy and institutional aspects related to broad-based growth and supports actions in three areas: (i) promoting growth and improving the investment climate, especially by focusing on trade, (ii) enhancing fiscal space for priority investment, and (iii) achieving greater transparency and public sector modernization. The key benefits expected from the program are:

Meetingfiscal needs: Board approval o f this loan and i t s related disbursement would not only help the government to meet i t s objective o f diversifying financing sources but to secure financing on more favorable terms. This would support the government’s goal o f fiscal stabilization and efficient spending. Endorsement of sound policy and vehicle for dialogue: The DPL would secure overall continuity o f the Bank’s policy dialogue with Guatemala, strengthening the Bank’s reputation as a reliable development partner.

The operation i s subject to four main risks during the implementation o f the D P L series:

Political gridlock, given a divided Congress which creates obvious r isks for the timely passage and subsequent implementation of the Government’s legislative agenda, Societal tensions related to the country’s post-conflict status, especially around controversial areas like continued trade liberalization, promotion o f increased private participation in infrastructure, and issues surrounding property rights and land, Exogenous shocks related to natural disasters, which could necessitate unanticipated spending for emergency assistance and reconstruction, and Shocks related to a deteriorating external environment, (e.g., low commodity prices, persistently high o i l prices, global recession, political difficulties in the U.S. for DR-CAFTA ratification, unfavorable conditions in financial markets) that could affect the economy negatively.

*

*

D

PO94365

V

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GUATEMALA: FIRST BROAD-BASED DEVELOPMENT POLICY LOAN

I . I1 . 111 . Iv .

V .

TABLE OF CONTENTS

Country Context ........................................................................... 1 Economic Context and Recent Macroeconomic Performance ........................ 2 Government Priorities and Development Plan .......................................... 6 Key Issues in Restoring Broad-Based Growth .......................................... 8 A . Trade and Regional Integration ..................................................... 8 B . Investment Promotion and Business Climate ...................................... 9 C . Property Rights ......................................................................... 11 D . Infrastructure ......................................................................... 11 E . Financial Sector Strengthening ....................................................... 13 F . Enhancing Capacity for Priority Spending .......................................... 14 G . Transparency and Public Sector Management .................................... 16 The Proposed Loan ......................................................................... 17 A . B . C . D . E . F . G . H . I .

Link to CAS ............................................................................. 17 Lessons Learned ........................................................................ 17 Design o f DPL .......................................................................... 18 Programmatic Framework ............................................................. 20 Fiduciary Aspects ...................................................................... 20 Loan Administration ................................................................... 21 Monitoring and Evaluation Arrangements ......................................... 21 Poverty and Social Impact Analysis and Environment ........................... 22 Risks .................................................................................. 23

ANNEXES

Annex 1 . Guatemala at a Glance ...................................................... 25 Annex 2 . Debt Sustainability in Guatemala ........................................... 27 Annex 3 . Letter of Development Policy .............................................. 29 Annex 4 . Actions Supported by DPL 1 .............................................. 41 Annex 5 . Government of Guatemala Plan to be supported by the DPL Series

. Results Framework ....................................................... 42 Annex 6 . Public Financial Management Milestones . Guatemala

Development Policy Loan .................................................... 46

BOXES. CHARTS AND TABLES

Box A: Links between DPL and prior analytical and fiduciary work ........... Chart 1: Diagram of “Vamos Guatemala!” .......................................... Table 1: Trade flows as share of GDP ................................................ Table 2: Guatemala - Key macroeconomic Indicators ..............................

19 7 3 4

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G U A T E M A L A

First Broad-Based Growth Development Policy Loan

I. Country Context

1. With a multi-ethnic population of about 12.6 million and a per-capita GDP of about $2,200, Guatemala i s the largest economy in Central America. While a source of cultural strength and rich historical heritage, Guatemala’s ethnic diversity has also unfortunately been accompanied by a pattern o f conflict and exclusion since colonial times. In the latter half of the 20th century, long-standing socio-political and economic tensions sparked a debilitating 36-year civil war, which ended in 1996 with the signing of a set of Peace Accords between government and guerrilla leaders, following protracted negotiations. The Peace Accords marked an important turning point in Guatemala’s development. In addition to ending the armed conflict, they aimed to reverse the country’s historically exclusionary pattern of social and economic development, setting national targets in four main areas: (i) resettlement, reincorporation and reconciliation, (ii) human development, (iii) productive and sustainable development, and, (iv) modernization of the state and improved governance. In the nine years since the signing of the Accords, progress towards achievement o f the specific targets contained therein has been uneven, with major gains in some areas (e.g., reductions in the military, decentralization, coverage o f social and basic services) but slower-than-hoped-for progress in others (accelerating economic growth, raising tax revenues to 12% of GDP, land registrationhedistribution and reducing crimehiolence).

2. Largely as a result of the country’s historical legacy, about 56 percent of all Guatemalans lived in poverty in 2000 and about 16 percent in extreme poverty. Although poverty fell during the 1990s, when real GDP growth rates reached 4 percent or about 1.4 percent per capita on average, this positive trend almost certainly deteriorated in the first years o f the new millennium, given an economic slowdown (2001-2003) associated with a series o f economic shocks (see below). Besides high levels o f income poverty, Guatemala’s social indicators in education, health and nutrition are also very poor, often falling below the indicators observed in countries with substantially lower per-capita incomes. For example, the World Bank 2003 Poverty Assessment indicates that despite significant improvements in primary enrollments over the last decade, the average schooling o f the adult (14+) population in 2001 was 4.3 years, compared to 4.4 years averaged by low income countries. Guatemala’s health outcomes are also unsatisfactory: l i fe expectancy at birth i s 65 years, compared with 69 years on average for lower middle income countries, and infant and maternal mortality rates are high at 40-45 per thousand and 270 per 100,000 respectively. Perhaps most alarmingly, malnutrition rates among Guatemalan children are very poor-based on the height-for-age measure, some 44 percent o f children aged under five years were stunted at the start of the decade, with four-fifths o f the malnourished children coming from poor, indigenous households.

Poverty and Millennium Development Goals.

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3. In order to reduce extreme poverty by half between 2000 and 2015 and thus accomplish the first of the Millennium Development Goals, Guatemala needs to significantly accelerate economic growth as well as ensure that the benefits of growth reach the poor. Calculations presented in the Bank’s recent Country Economic Memorandum (CEM) indicate that to meet the extreme poverty MDG by 2015, the economy needs to grow at a per capita rate of at least 2.4 percent or approximately 5 percent per annum in real terms. In addition to growth, i t i s critical to increase public spending on human development and infrastructure investments that facilitate the participation o f the poor in the growth process.

11. Economic Context and Recent Macroeconomic Performance

4. Despite i t s political troubles over the past several decades, Guatemala has been relatively stable from a macroeconomic standpoint over most o f that period - experiencing far less volatility and lower inflation compared with regional averages. With respect to growth, however, the Guatemalan economy has performed more poorly than the rest of the region, with an especially poor record in the 1980s, when per capita income declined drastically due to regional macroeconomic instability and the intensification of Guatemala’s civil war. In the 1990s, the Guatemalan economy posted an annual average growth rate of slightly over 4 percent per annum (1.4 percent per capita). While this pace was a dramatic improvement over the previous decade, i t was nonetheless a somewhat disappointing outcome given high growth expectations following the cessation o f the civil war in 1996 and major structural reform efforts-in trade and financial sector liberalization, private participation in telecommunications and power and increased spending and policy improvements in education and health- ongoing since the mid-1980s. and remained low, falling below the population growth rate during 2001-03, with probable negative repercussions on the country’s already-high poverty rates, as noted above (CEM, 2004).

Since 1999, growth rates once again declined

5 . Slow growth in Guatemala in the period 2001-03, in contrast with developments elsewhere in LAC, was due both to external and internal factors. Internally, the investment climate was negatively affected b y a widespread lack of confidence in the former government associated with unpredictable changes in public policy, deterioration in governance and a weakening of the rule o f law-which, in turn, gave rise to an intense conflict between the Government and significant segments o f the private sector. Moreover, the perception of widespread corruption in the last 2 years o f the previous administration and the relaxation o f fiscal discipline in 2003 (an election year) also adversely affected Guatemala’s image at home and abroad. On the external front, the terms of trade were negatively affected, mainly through a drastic and long-lived collapse in the world price o f coffee. Export revenues from this crop fell from close to $580 million in 1999 to $268 million in 2002, with a severe impact on the nearly 600,000 Guatemalans directly and indirectly involved in the coffee business prior to the price decline. Rising oi l prices following 9/11 have also tended to depress growth. In addition, recession in the U.S. and other trading partners in the 2000-02 period resulted in falling

2

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demand for Guatemalan exports (e.g., muquilu products) and affected manufacturing activity through investor sentiment and other channels.

6. External balance. Slow growth in exports i s a key factor in explaining the sizeable trade imbalance of recent years, financed mainly by rapidly-growing workers remittances. The latter stood at 8.5 percent o f GDP in 2003 and are expected to continue to rise in the medium term. The improvement in the trade/GDP ratio since 1991 has been largely the result of the rapid growth of imports, which i s at the root of Guatemala’s large trade imbalances. As shown in Table 1, exports as a share o f GDP continued to account for less than 20 percent of GDP in 2001, with l i t t le improvement since the early 1990s. However, the aggregate numbers hide important changes in the structure of exports, with a booming muquilu sector and a dynamic non-traditional agriculture export sector (e.g., flowers, seasonal vegetables, f ru i ts and organic crops) yielding a more diversified trade basket. The current account deficit has been declining since 2001, but i t remains high at about 4.3 percent of GDP at end 2004 and the latest estimates show an average current account deficit of 3.9 percent of GDP for the rest of the CAS period. Overall, however, Guatemala’s external position remains stable. Due to the lack of good quality balance of payments data in Guatemala, i t i s hard to infer from historical figures how much of the current account has actually been financed by debt creating flows, as an important share of private sector financing i s believed to be unreported remittances and FDI. In addition, there are no obvious signs of balance of payments instability in Guatemala, as the international reserves position i s currently very strong (equal to 5 months of imports in 2004) and the total external debt (including private sector) remains at manageable levels.

Table 1: Trade flows as share of GDP 1991 2001 change

Guatemala 0.39 0.50 0.11 Export s/GDP 0.18 0.19 0.01 Imports/GDP 0.21 0.31 0.10

Export s/GDP 0.20 0.31 0.10 Central America average 0.48 0.75 0.27

Imports/GDP 0.28 0.45 0.17 Source: World Bank with data from Central Banks and private sector sources.

7. Fiscal trends. Since the 1980s, Guatemala has established a solid record o f responsible fiscal management. The country’s ratio o f public debt to GDP has consistently remained one of the lowest in LAC and i s currently below 20 percent (see Annex 2 for more information on debt, including external private debt). Total public spending exhibited a marked increase after the Peace Accords, rising from around 9 percent of GDP in 1994-96 to 13 percent in 1999 but the ratio slipped again in 2003-04. The share to the social sectors has also risen considerably over the past 8 years, but much more i s needed for key investments to reduce poverty and support economic growth. This, in turn, requires a considerably higher level o f revenues in order to be sustainable. Thus far, successive governments have faced an uphill battle in their efforts to raise revenues up to the 12 percent Peace Accords target. Powerful vested interests have

3

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consistently opposed tax initiatives in Congress or, in some instances, launched successful court challenges to achieve the strike down o f taxes approved by the legislature. Af ter some progress in 2000-02 in raising the tax/GDP ratio, the ratio slipped again in 2003 as the courts overturned some key corporate taxes and a tax on petroleum products and derivatives.

8. Future challenges. Guatemala’s medium-term challenge i s to boost growth, push ahead with poverty reduction and address dismal social indicators. As discussed in a recent Country Economic Memorandum, C E M (June 2004) prepared by the Bank, this w i l l require the creation o f fiscal space to strengthen key public investment programs (mainly in the social sectors and infrastructure), deepen some o f the reforms o f recent years (including in strengthening the investment climate and public institutions), while maintaining sound macroeconomic management. Inter alia, this agenda w i l l l ikely require stronger revenue measures to facilitate an increase in funding for critical investments, while improving the effectiveness and targeting o f spending.

Table 2: Guatemala - Key Macroeconomic Indicators* (as % o f GDP, unless othemise indicated)

Actual Projected 2000 2001 2002 2003 2004 2005 2006 2007

National Accounts and Prices Real GDP (% change) 3.6 CPI (% change, av.) 6.0

Real exch. rate (% change, $/Qz) 1.6 Gross Domestic Investment 17.8 Gross National Savings 12.4 Central Government finance Total revenues 10.4

o f which, Tax Revenues 9.5 Total expenditures 12.2

o f which, Social exp. 5.0 Deficit (-) Surplus (+) -1.8

Balance of Payments Current account balance -5.4

Trade Balance -8.6 Merchandise Exports (fob) 16.0 Merchandise Imports (cif) 24.6

Reserves (in months o f imports o f GNFS ) 3.9 Public and Publicly Guaranteed Debt Total Public Debt 18.0

Domestic Debt 5.8 External Debt 12.2

5.6 External Debt Service / Exports of GNFS Memorandum items

GDP (US$ mill.) 19,291

2.3 7.6 5.6

17.7 11.9

11.1 9.7

12.9 5.5

-1.9

-6.0 -10.9 13.6 24.5

4.6

18.5 5.6

12.9

6.5

20,978

2.2 8.0 3.0

18.7 13.6

11.4 10.6 12.4 5.1

-1.0

-5.3 -12.8 12.1 24.9

4.0

17.0 4.5

12.5

7.8

23,268

2.1 5.5

-3.5 18.7 15.8

11.1 10.3 13.4 5.3

-2.3

-4.3 -12.6 12.3 25.0

4.5

18.8 5.6

13.2

7.8

24,730

2.7 7.5 5.7

17.6 13.3

11.0 10.3 12.0 5.0

-1.0

-4.3 -13.6 12.5 26.2

4.7

19.3 5.9

13.4

8.2

27,45 1

3.2 5.7 2.6

17.7 13.6

11.1 10.5 12.8 5.6

-1.8

-4.1 -13.4 12.7 26.1

4.3

19.5 5.6

13.9

9.1

29,841

3.5 5.7 1.7

18.1 14.1

11.3 10.7 12.8 6.1

-1.6

-4.0 -13.2 13.4 26.6

4.3

19.3 5.1

14.2

9.5

32,128

4.0 5.8 1.6

17.9 14.0

11.6 11.0 13.1 6.4

-1.6

-3.9 -13.1 14.3 27.4

4.3

19.2 5.0

14.1

13.1

34,758

* Preliminary 2004 estimates from the IMF reveal a lower deficit (0.4% ), as a result o f the accounting treatment o f (1) capitalization o f the Fund for the Protection o f Depositors; (2) reduction o f arrears on M I C I V I floating debt; and (3) deposits intended for ex-PACs payments Source: Bank of Guatemala, Ministry o f Finance and Bank Staff estimates. GNFS = goods and non-factor services

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9. Recent Developments. The current (Berger) administration came into office in early 2004 wi th a strong commitment to pursue compliance with the Peace Accords, while at the same time taking strong steps to attack corruption and improve the investment climate for growth. During i ts f i rs t year, much of i t s energies in the economic sphere had to focus on addressing serious fiscal troubles, as a Constitutional Court decision in early 2004 struck down the presumptive income tax, the Zmpuesto a Empresas Mercantiles y Agricolas (IEMA) which, in 2003, had generated about half of all revenues from enterprises (subsequently, in late 2004, the Court also struck down a tax on petroleum and derivatives). These decisions, coupled with large spending commitments by the outgoing administration, led to tax collection and fiscal deficit projections for 2004 of under 9 percent o f GDP and 4.5 percent o f GDP. To address this impending crisis, the government worked to obtain consensus on drastic actions on both the expenditure and revenue fronts. On the former, i t enacted substantial expenditure cuts (3 percent in nominal terms) in all areas of the budget, with the exception of spending on education, health, and housing, which grew by about 4 percent. The cuts included an unprecedented reduction in the military by one-third (about 12,000 personnel) and a significant downsizing o f the civil service (by about 20 percent). On the revenue side, the Government developed a package of tax policy reforms for Congressional approval in mid-2004 and simultaneously began to address weaknesses in tax administration and enforcement. The tax package met with only partial success in Congress, where i t was watered down in a number of areas. These reductions were, however, offset by a better- than-expected outcome under the tax administration and, especially, enforcement, effort. B y end 2004, net revenue stood at 10.3 percent o f GDP, unchanged from 2003. The fiscal deficit was sharply reduced to 1 percent of GDP, allowing for a small financial surplus for the combined public sector. Public expenditures were partially financed through a 30-year, US$330 million Eurobond issue in September 2004, which was heavily oversubscribed at 8.125 percent. In May 2005, the Government worked with Congress to pass a revised version o f the petroleum and petroleum derivatives tax law, which w i l l reinstate revenues lost as a result o f the 2004 Constitutional Court decision.

10. At the core o f Government’s fiscal policy for the remainder o f i t s term i s a two- pronged strategy predicated on: (i) raising revenues towards the 12-percent target o f the Peace Accords; and (ii) maintaining low budget deficits while raising the efficiency o f public spending. Given the compression in public spending in 2004, the Government expects to boost i t s investment program in 2005 and 2006, in turn, implying somewhat larger deficits o f 1.8 and 1.6 percent o f GDP, respectively. With regard to revenue collections, the Government’s strategy going forward i s to continue to strengthen tax administration and enforcement under its 106-point plan (with technical assistance from the Fund and from the Bank, through an ongoing tax administration project). Over the next several months, the plan i s to engage a wide range of interest groups in round table discussions on social priorities-including the challenges and spending requirements of achieving the MDGs-and the sources o f funding available to meet them. In addition, the Government i s continuing i ts efforts to vigorously attack corruption and improve the impact and transparency of public expenditures (with support from the Bank’s Integrated Financial Management Project and an ongoing PER). This, inter alia, should help build

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confidence in the fiduciary role of the Government in the use of public funds and, consequently, reduce opposition to a new tax effort. Finally, as part of i t s regional integration objectives, the Government expects to work with i t s Central American neighbors to harmonize taxes and duties.

11. Growth Outlook. The overall outlook for economic growth improved with the incoming Berger Administration due both to the government’s anti-corruption, pro- business stance and a favorable international context. In 2004 real GDP growth reached 2.7 percent (just above population growth rates for the first time in 3 years). This improved but still- modest growth rate, despite the turnaround in the investment climate in 2004, was due to rising o i l prices, continued low coffee prices (until the last quarter of 2004 when they began to recover) and delays in the execution o f the government’s investment plan during the first months of 2004. Looking ahead, the potential ratification o f the free trade agreement with the U.S. (DR-CAFTA), and the deepening of regional integration efforts that the Berger administration has been leading within Central America, offer significant opportunities for attracting new investment and fostering trade- led growth, particularly if they are accompanied by complementary reforms. Clearly, higher growth levels of the magnitude needed to meet Peace Accords targets require a resumption o f reforms as outlined in the Bank’s recent CEM, particularly those related to strengthening governance (including contract enforcement and protection of property rights), the regulatory framework (for PPP and labor), and the competitiveness agenda (including educationhuman development, infrastructure, finance and regional integration). Many of these are addressed in the Government’s plan for economic and social reactivation -Vamos Guatemala! discussed briefly below.

111. Government Priorities and Development Plan

12. The current Government, in office since 2004, has demonstrated considerable commitment to the achievement o f national goals established in the 1996 Peace Accords in the political and human rights, as well as socio-economic, spheres. I t s main emphases include fighting corruption, enhancing security and reactivating broad-based economic growth (stagnant in the 2001-2003 period) as a means o f reducing poverty and inequality. I t s policy document, Vamos Guatemala! (Let’s go, Guatemala!), was launched in August 2004 and lays out an ambitious program for building social solidarity, competitiveness and trust (chart 1).

13. As shown below, Vamos Guatemala comprises four main areas for action during the remainder of the Berger Administration’s term. At the base are a set o f fundamentals aimed at addressing the foundations o f the national development program which comprise: a stable macroeconomic framework, security (including both citizen security with respect to crime and violence and legal security-access to speedy justice); and improved governance and public sector institutions. Resting on this foundation are three strategic pillars as follows:

0 Guate Solidaria - aimed at promoting social solidarity, reduced inequality and greater economic integration through strengthening social protectiodnutrition programs for vulnerable groups, accelerating investments in education and health

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and development o f social-economic infrastructure in indigenous and rural areas as a means o f reducing inequality and creating opportunities; Guate CreceKompite - aimed at accelerating growth to above the 4 percent observed in the 1990s, this component o f the strategy emphasizes trade expansion, financial sector strengthening, improved investment climate, export promotion, public-private partnerships for investments in housing and infrastructure (principal roads, ports and airports, renewable energy), development o f high potential sectors (e.g., tourism and forestry), support for MSMEs and greater attention to quality standards and technological innovation;

Guate Verde - aimed at promoting sustainable development including building central and sub-national capacity for environmental analysis, assessment and monitoring, strengthening protected areas management, conserving bio-diversity and preservation o f social and cultural heritage.

In addition to the above components, and recognizing the constraints imposed by the small size of the state, the Vumos Guatemala strategy formally incorporates a cross- cutting emphasis on the development o f public-private (both business and community groups) partnerships across key areas o f public action.

0

Chart 1: Diagram of “Vamos Guatemala ! ” r

*SOCIAL PROTECTION .EDUCATION AND OPORTUNITY CREATION *INCREASE IN RURAL PRODUCTION CAPACITY *SOCIAL PARTICIPATION aGUATEMAL4NS ABROAD

*PUBLIC INVESTMENTS .PUBLIC AND PRIVATE ALLIANCES *PRIVATE INVESTMENTS .PROMOTION OF EXPORTS *SUPPORT AND DEVELOPMENT OF MSMEs *PRODUCTIVITY INNOVATION AND INVESTMENT CLIMATE CONSUMER PROTECTION

*ENVIROMENTAL CAPACITY STRENGHTENING *DECENTRALIZED ENV MANAGEMENT *PROTECTED AREAS MANAGEMENT .PRESERVATION OF SOCIAL & CULTURAL HERITAGE

I I I M

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14. The Bank’s CAS for Guatemala, covering the period FY05-08, was developed within the Vamos Guatemala program, which represents a satisfactory framework for moving forward the Bank’s core objectives o f (i) reducing poverty and inequality; and (ii) fostering sustained, equitable growth. The strategy adopted by the Bank i s to move forward with a balanced program o f roughly equal amounts of investment lending and quick-disbursing support in the base case, the former focused on directly reducing poverty and strengthening governance and the latter focused on reigniting equitable growth. This document lays out the program for broad-based growth to be supported by the DPL series, with special reference to the f i rst loan (for US$100 million), which i s scheduled for Board presentation in July 2005. The design of the DPL series draws on an extensive body of recent analytical work undertaken by the Bank. Chief among these are the 2003 Guatemala Poverty Assessment (GUAPA), the CEM (2004) the Investment Climate Assessment (2004), and three ongoing studies -- the regional DR-CAFTA Study, the Public Expenditure Review and joint CFAA-CPAR -- which are all now nearly complete.

IV. Key Issues in Restoring Broad-Based Growth

15. Guatemala’s key challenges in restoring broad-based growth are: (i) taking advantage o f expanding trade opportunities and ensuring that SMEs can share in those opportunities, (ii) strengthening the climate for both domestic and foreign investment and business, (iii) modernizing property rights, (iv) addressing infrastructure bottlenecks to growth, (v) continuing to strengthen and deepen the financial sector, (vi) enhancing the capacity for efficient and effective poverty-oriented public spending, and (vii) strengthening public sector management and transparency. The principal issues and government plans with respect to each o f these areas are discussed further below in some depth as they form the background to the specific actions supported by this DPL series. Controlling the high levels of crime and violence i s another key element o f the effort to promote growth in Guatemala. Issues in this area are not described here as they l ie beyond the scope o f this DPL operation. I t should be noted, however, that Government i s currently working with a number o f bilateral donors (including Japan, Spain and USA) to implement an integrated strategy to address this problem, within a regional context.

A. Trade and Regional Integration

16. As noted above, the new Administration views trade expansion as a principal driver of growth in Guatemala in the short- to medium-term and i s expending considerable political and institutional capital on expanding trade and investment opportunities. The Guatemalan Congress ratified the US-Central America-Dominican Republic Free Trade Agreement (DR-CAFTA) in March 2005, with implementation due to follow immediately after the treaty i s ratified by the U.S. Congress. A s im i la r agreement i s already in effect with Mexico and discussions are underway with Canada, the European Union, Chile and Colombia. At the same time, Guatemala i s spearheading regional integration efforts within Central America, with steps already being taken towards a Central America customs union, through the harmonizing and simplification o f

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customs procedures with neighboring countries, most notably El Salvador and Honduras. To ensure that opportunities opened up by the new agreements are widely disseminated and to help Guatemalan businesses understand requirements to access the U S and Mexican markets, the Government i s committed to establishing an FTA Management and Trade Compliance Office within the next few months. I t has also taken steps to facilitate and promote foreign investment and support quality improvements in Guatemalan products, as discussed further below.

17. The strategy for trade expansion also assigns a central role to ensuring that the benefits of new trade opportunities are accessible to SMEs, both directly through access to export markets and indirectly by developing strategic linkages with FDI and local exporting companies. As part o f this initiative, steps are already being taken by the Presidential Commission for Competitiveness (PRONACOM) to develop associations of SME entrepreneurs (the “grupos gestores”) throughout the country and to improve the availability o f market intelligence, including data on export contacts, via a joint program of the PRONACOM and the National Institute of Statistics (INE). In addition special efforts are being made to reach out to indigenous entrepreneurs through the Association o f Mayan Entrepreneurs and support to CECMA to create an Indigenous Competitiveness Research Center. Finally, a network of “infocenters” with internet connectivity i s being established to disseminate information throughout the country, and are expected to act as important focal points for support to SMEs. Building on these steps, a comprehensive strategy and operational plan for information dissemination and training to SMEs i s currently being developed and wi l l be put into effect over the next several months.

18. Aware that, over time, some low income farmers and laborers are likely to be displaced from traditional livelihoods, the government, led by the Ministry of Agriculture, has also launched an ambitious initiative to promote alternative employment in non-traditional agriculture, sustainable forestry and off-farm activities in sectors such as tourism and agribusiness. In partnership with the private banking sector and groups such as the non-traditional exporters association, Agexpront, the initiative combines technical assistance and marketing help for micro, small and medium rural producers with improved access to finance via the commercial banking system, through the provision of a Government guarantee. The initiative i s being supported by USAID and other donors and w i l l be carefully monitored to evaluate impact and implement course corrections as necessary.

B. Investment Promotion and Business Climate

19. A primary focus o f the Government’s agenda for competitiveness i s improving the country’s investment and business climate. Within this theme, an important emphasis i s placed on reducing the costs of doing business through: (i) simplification of regulations and clarification of rules for dealing with customs and speeding up cargo clearance procedures at key airports and ports; (ii) reducing red tape and standardizingklarifying pre-investment requirements for labor, environment and other issues with the eventual aim of creating a one-stop shop for business registrations; (iii) strengthening of national systems for manufacturing standards and quality (with

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accredited laboratories, linked to relevant international bodies), including certification systems established in partnership with business associations; and (iv) promoting e- commerce. Advances have already been made in each o f these areas, in part with assistance from the Bank’s Competitiveness Enhancement Project. Steps are also being taken to build consensus for, and pass, a domestic competition law, including a system for consumer protection.

20. Another critical area concerns the promotion of foreign direct investment (FDZ). A newly-established agency, Invest in Guatemala (IIG), leads this effort with assistance from MIGA. The agency has recently finalized i t s promotion strategy which highlights investments in light manufacturing, tourism, call centersbusiness process outsourcing and agribusiness. The strategy outlines targets for new investments, job creation, indirect employment, and the expected impact of these FDI flows on exports. In the next two years, IIG i s seeking to effectively measure the amount of local value added. This w i l l set a benchmark to implement programs that increase linkages between the local private sector and international investors operating in Guatemala to provide goods and services that further increase local value added. IIG can already point to a number of successes in attracting foreign investments. Over the next several months, Government intends to increase the operating autonomy of IIG, through a partnership with reputable private sector foundation(s) operating in Guatemala.

21. To ensure institutional coordination in the competitiveness area, the Government has created an Office of the Presidential Commissioner for the Promotion of National Competitiveness (Pronacom) and established a system of monthly meetings between Pronacom, the Ministry of Economy, and representatives o f the private sector, universities and civil society, to review and monitor work plans and progress achieved. Pronacom i s part of a Central American network of government competitiveness agencies, allowing the region to coordinate closely as i t faces the challenges presented by the DR-CAFTA agreement. In carrying out its mandate, Pronacom has developed a strategy o f alliances with key local partners such as Agexpront and the tourism sector as well as close connections with regional and international institutions such as INCAE, the USDA, the World Bank Group and the UN system. Thus far, Pronacom i s holding itself to a high standard of performance, with concrete indicators in priority areas for the private sector and DR-CAFTA. The coming into office o f the Berger Government already improved Guatemala’s World Economic Forum competitiveness ranking-80 out o f 104 countries in 2004 versus 89 out of 102 in 2003-largely reflecting increased confidence in macroeconomic management and in public sector institutions. However, the Government recognizes that there i s clearly a long way to go to make Guatemala a very attractive country for investors, with a supportive business environment.

22. As part of the effort to increase the productivity o f Guatemalan businesses, the Guatemalan Government i s also emphasizing means o f encouraging the adoption of new technologies and promoting innovation-an area in which Guatemala i s lagging badly. In addition to the appointment o f a Presidential Commissioner for Science and Technology, the Government i s in the process o f developing a program to link universities and research centers with the private sector in order to stimulate the research

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and development process in Guatemala. Another key priority i s the reform of the national training system, led by INTECAP as a means of raising the sk i l l s level of the labor force. The main goal i s to reduce INTECAP’s role from a provider o f in-service training for employees of businesses into a regulator and certifier of training programs organized and implemented by the private sector within the f i rms themselves. A third goal i s to reorient the focus of the Council of Science and Technology towards improved technological diffusion among small- and medium-sized enterprises and expand the role of the private sector in i t s advisory board. In addition, consideration i s being given to the design of a system of incentives to promote the acquisition of new technology via capital goods purchases, technology licensing arrangements and other appropriate mechanisms.

C. Property Rights

23. Fundamental to Guatemala’s growth agenda-as well as to the achievement of increased social solidarity and a better business climate-is the question o f secure rights to land. Over the past several years, considerable progress has been made on cadastral surveying and regularization of land-largely in urban, but also in rural, areas. This progress i s threatened however by limited titling and the transitory nature of the institutional framework. For example, in the Department of Peten only about a quarter o f land parcels surveyed have been titled and registered reflecting both the institutional weaknesses of the titling entities (municipalities for urban, and FONTIERRAS for rural, land) and the transitory nature of the current cadastral process. While some municipalities have started addressing the f irst problem by implementing creative mechanisms to increase the number and speed of titling-e.g., reducing fees for land adjudication or introducing gradual payment schemes-the legal framework for cadastral registry remains inadequate. What i s needed i s the full integration o f the cadastre and the registry (Regisfro de la Propiedud), as well as measures to increase the transparency and accountability of the registry itself. Government i s now working towards passage by Congress of a modern law o f cadastre and land registry to enable expansion o f the pilot to the rest of the country. This i s being given high priority b y Government given that the reform of land administration i s central to Guatemala’s development agenda. Indeed, Government has set an ambitious goal o f completing cadastral surveying o f 75 to 80 percent of the populated land area b y the end of i t s term.

D. Infrastructure

24. On the supply side o f the economy, the Government’s growth strategy places strong emphasis on increased investments in infrastructure (roads, ports and airports, telecommunication and ICTs and renewable energy), through developing public-private partnerships for both financing and implementation. As a f i r s t priority, the Government has proposed a series o f large infrastructure projects in the transport sector to be implemented via public private partnerships. These include: link roads in the northern and Pacific corridors, a link road connecting the Atlantic and Pacific ports, a partial metropolitan beltway for Guatemala City and the construction o f a freeway from Guatemala City to El Rancho. To establish an adequate legal basis for this effort, the Government intends to present a framework law (and associated sectoral laws) for public-

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private partnerships and/or concessions to the Congress in 2005 as well as a law facilitating private participation in the construction o f a major northern link-road connecting some o f the poorest areas of the country.

25. Efforts are also underway to establish partnerships with the private sector to improve management of key infrastructure such as airports and ports. One step already taken with respect to the main international airport in Guatemala City (La Aurora) has been to establish a management committee comprised o f users (including airlines, cargo companies, the tourism agency etc.) and representatives o f the civil aviation authority for better management of the airport. The committee, in collaboration with the civil aviation authority, w i l l oversee the upgrading of airport facilities and operation in accordance with a master plan which nearing completion. Action i s also being undertaken to upgrade Guatemala’s USFAA ranking to Category I through a program o f strengthening the civil aviation authority. This would enable direct flights (both cargo and passenger) to U.S. destinations by Guatemalan carriers. Government’s efforts with respect to seaports during 2004 and early 2005 focused on upgrading their security certification to international standards. With this achieved, the focus i s now on improving the efficiency of operations at Puerto Santo Tomas, the country’s publicly-run main Atlantic sea port, through establishment of a privately-operated cargo handling and warehouse facility.

26. Over the past decade, Guatemala made huge strides in access to telephones due to the telecommunications privatization and liberalization reforms program implemented by the end of the 1990s. The number of fixed lines has risen from 400,000 to one million; and cellular phones, from 30,000 to 1.2 million. These improvements were due largely to changes in the legal and regulatory framework and institutions (Le., the Superintendencia de Telecomunicaciones or SIT) that stimulated private sector competition and investment as well as the establishment of a universal access program (Le., FONDETEL) to stimulate private sector investment in public payphones in rural areas. Nevertheless telecom access in Guatemala-especially in rural areas-remains among the lowest in the region, and this wi l l continue to be the case without additional incentives despite growth of cell phone networks. The Berger administration i s committed to stimulating increased private sector investment in telecommunications and information technologies (ICTs) by updating the legal and regulatory framework to make i t consistent with DR-CAFTA, to take into account market and technological innovations and to encourage the use of ICTs to improve governance, delivery o f services and increase the competitiveness of Guatemala’s economy. In order to address the growing urban-rural “digital divide”, FONDETEL adopted a rural access strategy that uses output-based aid (OBA) mechanisms aimed at fostering private sector provision to each municipality of at least one internet access point that enables local governments, NGOs, private sector and operators broad band access to the internet and to ensure that all rural localities have at least one public payphone. Implementation of the rural access strategy i s already underway and the strategy i s being incorporated into a broader Information Society Strategy which aims at determining priorities for the national broad-band internet network. This effort i s being supported by IBRD and WBI.

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E. Financial Sector Strengthening

27. Guatemala has made significant progress in i t s financial sector reform program following a banking crisis in 2001. At the core of the reform program i s a package of five financial sector laws approved by Congress between October 2001 and April 2002: Monetary Law, Banking and Financial Groups Law, Bank Supervision Law, Central Bank Law, and Money Laundering Law. These laws addressed a number of deficiencies in the financial sector legal framework identified by the 2000 FSAP. In particular, they aimed at the following: (i) reform of the monetary policy legal framework for the conduct o f monetary and financial policy, including the capitalization of the Central Bank, (ii) reform o f the financial sector legal framework aimed at strengthening the regulation of financial groups and creating an orderly market exit mechanism, enhancing credit risk management, and increasing access to financing, (iii) reform of bank supervision legal framework aimed at strengthening the autonomy of the Superintendent of Banks and i ts legal and institutional capacity to supervise financial groups, and raise banking sector regulation towards international standards, and (iv) enactment of legislation to prevent money laundering to reduce illegal activities and comply with international norms. In addition, the reform program contemplates the consolidation of the banking system through restructuring or closure of insolvent banks, and through mergers and acquisitions, using the restructuring mechanism of the new banking law.

28. These reforms have contributed to making the banking system better able to withstand external shocks and facilitate growth. In fact, Guatemala’sfinancial sector has strengthened substantially since 2000, due to improvements in the prudential regulatory framework and stepped-up onsite inspections, although the situation of the banks i s s t i l l fragile due to the low level of provisions and excessive amount of related lending. The authorities have made progress in the licensing, supervision and registration of financial conglomerates, including offshore banks which are now required to be part of licensed conglomerates in order to operate. With assistance from a Bank TA loan, Guatemala i s also implementing a significantly strengthened anti-money laundering (AML) regime.

29. To complete the modernization of the financial sector legal framework, the Government has recently submitted to Congress a package of five bills of law and i s working in the preparation of another nine bills that should be ready for submission to Congress later this year. The five bills recently submitted are: (i) The Law Against Funding of Terrorism, which would make i t a crime to fund terrorist activities. Enactment of this law was a commitment taken by Guatemala when the Financial Action Task Force (FATF) excluded Guatemala from the l i s t o f non-cooperating countries and territories in July 2004; (ii) The Complementary Law for the Strengthening o f the Banking System, which, among other things, would remove tax impediments to the sale of assets among banks and income generated by trusts; (iii) The Microfinance Law, which would allow non-bank financial intermediaries to operate as lenders under regulation and supervision by the Superintendent o f Banks; and (iv) The Law o f Reciprocal Guarantees, which would provide the basis for the establishment of associations that would provide collateral for i t s member companies to facilitate access to credit; and (v) The Law of Movable Guarantees, which would facilitate the use and

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repossession of non-traditional collateral, to facilitate access to credit. This new package o f financial sector laws aims to increase prudent lending to groups and enterprises today largely excluded from bank financing, such as micro, rural and small and medium enterprises (SMEs). These proposed legal reforms need to be complemented with further reforms of the legal, judicial and bankruptcy environment that affect creditor rights and their judicial enforcement. Several of these laws are supported under the third tranche of the ongoing FSAL, with the remainder included in the proposed DPL series. In addition, i t i s necessary to continue to strengthen the capacity of the Superintendent towards implementation of Basle II-like supervision-analysis of bank risks and implementation of risk-based consolidated supervision-though not necessarily involving an explicit change towards that framework in the immediate future.

30. In addition to further strengthening o f the legal framework, there are also a number of other important outstanding issues in the banking sector that Government i s addressing as a matter of priority. These include: (i) low provisions in offshore banks, (ii) the presence of illegal offshore banks operating in Guatemala (actions to deal with several of these are underway), (iii) weaknesses in selected banks, (iv) the high levels of related party lending throughout the banking system and (v) modernization of the payments system (a new electronic system i s already being piloted by Banguat and w i l l be implemented shortly).

F. Enhancing Capacity for Priority Spending

31. A key element of the Government’s growth agenda - particularly the effort to increase the “inclusiveness” o f growth - i s the objective of increasing public spending in key areas such as human development (education, health and nutrition) and on rural economic infrastructure. Government has adopted a two-fold strategy for the achievement of progress towards this objective: (i) concerted effort to raise tax collections which are s t i l l considerably short o f the target of 12% of GDP established in the Peace Accords; and (ii) improving the efficiency o f public expenditures by shifting allocations to priority sectors and strengthening budgeting processes in ways intended to improve the use of resources by these key sectors. The Government faces tough hurdles with respect to achievement o f the f i r s t of these elements. As noted earlier, to achieve the Peace Accords tax target, the Government w i l l need to overcome opposition to tax increases from interests on both the right and the left, with the former arguing against direct taxes on the grounds of losing competitiveness and the latter opposed to increases in the V A T on the grounds o f regressivity. While reallocation o f resources within the available envelope i s more amenable to Government’s political will, here, too, significant obstacles are imposed by constitutional and other legal mandates which earmark approximately 30% of revenues, leaving very little room for maneuver. The following paragraphs provide some detail with respect to Government efforts to date and i ts plans in each o f these areas.

32. As discussed in some detail in the section on Economic Context (paras 9-10), a key goal for the Berger administration when it came into office in early 2004 was to restore tax revenues to their 2003 levels (10.3% o f GDP), following setbacks in the

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Constitutional Court with respect to the IlEMA (tax on gross corporate revenues). This was achieved via: (i) passage in mid-2004 by Congress of a package of tax policy reforms; and (ii) substantially strengthened tax performance. In May 2005, a revised law on petroleum and petroleum derivatives taxes was also passed to replace a previous law in this area, which was struck down by the Constitutional Court in 2004.

33. Further progress on raising tax revenues remains a significant challenge in Guatemala, but one to which the Government remains firmly committed. Aware of still- substantial resistance to a stronger tax effort, the Government has launched a campaign to promote public awareness and spearhead a national dialogue on the country’s social objectives and needs, define their costs, and build consensus on the appropriate role for the public sector in achieving them. Another key element o f i t s strategy i s to continue to strengthen and modernize tax enforcement as a means o f raising revenues, within existing tax policy. To accomplish this, Government i s focusing on rapid implementation of i t s 106 point tax administration plan, developed with assistance from the IMF and the Bank’s Tax Administration Project, which, inter alia, emphasizes improvement of VAT collections through requiring electronic filing of VAT tax reports by the largest taxpayers and instituting a system of computerized cross-checks to control payments. In parallel, Government expects to work with local governments and the Congress to promote revisions to the municipal tax code to enable increases in property tax revenues, in part through provision o f greater autonomy to the municipalities to set appropriate property tax rates.

34. With respect to increasing spending efficiency, the Government has committed to continue to increase the share o f the social sectors in the total budget, increasing spending by at least a full 1 percent of GDP from i t s 2004 level. This level would imply expenditures on the social sectors of around half o f total public spending and well over half of 2004 revenues. In addition, Government i s committed to strengthening budgetary processes in order to increase the efficiency and effectiveness of core ministries. The Government took a significant leap towards enhanced planning and accountability in key sectors with the introduction in 2005 of agreements among MFP, SEGEPLAN and four major Ministries (Education, Health, Agriculture and Infrastructure, Communications and Housing) to adopt a results-based and multi-annual approach to budgeting. The process has been undertaken under a well-designed plan that has resulted in the early communication of institutional budget ceilings to improve the formulation process, and that i s likely to result soon in a formal medium-term expenditure framework. To validate and sustain what i s by nature a long-term endeavour, a gradual approach i s being adopted. I t i s expected that the 2006 budget w i l l include results-based allocations for key programs in at least two o f the four pilot Ministries, with extension o f the approach to al l four pilot Ministries for the 2007 budget cycle.

35. In addition to the above efforts to strengthen the efficiency and quality of public spending, the Government i s continuing i ts efforts to vigorously attack corruption and improve the impact and transparency of public expenditures (with support from the Bank’s Integrated Financial Management Project, and the ongoing PER and Country Fiduciary Assessment). This, inter alia, should help build confidence in the fiduciary role o f the Government in the use o f public funds and, consequently, reduce opposition to

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a new tax effort. This i s discussed further below, in the section on transparency and public sector management.

G. Transparency and Public Sector Management

36. The Vamos Guatemala plan highlights the need for improved governance, enhanced law and order and public sector management as means of forging higher levels of trust between government and the public and in enhancing investment climate. In addition to the Government’s well-publicized anti-corruption efforts and indictments and the development of a comprehensive strategy for reducing crime and violence, a major thrust in th is regard i s on improving the quality and transparency of public expenditure management through the continuing modernization of budgeting, financial management and procurement practices.

37. At the center of the financial management reform initiated in 1996 i s the integratedfinancial management system (SZAF), whose module for standardized budget formulation and execution i s operating in 43 central government entities -including the Congress- and 20 decentralized agencies. A version tailored to municipal needs (SIAFMUNI) i s under implementation in 46 municipalities. Operation of SIAF has increased the efficiency of budgeting, accounting and treasury operations, as well as their transparency. Worth noting i s the recent roll-out of an internet-accessible fiscal transparency portal that has enhanced public access to budget execution data. The Ministry of Finance i s planning to increase operational coverage of SIAF to seven additional agencies and at least 40 additional municipalities in the short term.

38. Another major step towards public expenditure transparency i s the recent successful launch of an internet-based procurement system (Guatecompras), which i s already in use by 76 public sector agencies and around 185 municipalities. I t i s expected that further development of the system wi l l take place in the context o f a comprehensive strategic plan for e-procurement, focusing in particular on a better interface with SIAF, product classification and information standards, and use o f data for procurement planning. In parallel, steps are being taken to strengthen capacity for procurement in key line ministries and municipalities.

39. The Government i s also well poised to deepen the public financial management reform process in other areas identified in the Country Fiduciary Assessment, such as (i) enhancing transparency o f budgetary documentation by further adoption o f international best practice, (ii) increasing the number o f municipalities that report on a timely basis their budget execution, debt and procurement information, (iii) strengthening the regulatory framework for state procurement, including modernization o f the normative body and tools, (iv) developing more effective internal controls, and (v) improving external oversight through better implementation o f the government auditing system (SAG).

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V. The Proposed Loan

A. Link toCAS

40. The Bank Group’s assistance over FY05-08 i s elaborated in a Country Assistance Strategy discussed by the Board in May, 2005 that proposes a strategic program of lending and non-lending services to support the fundamentals and three main pillars of the government’s development plan “Vamos Guatemala”: (i) promote social solidarity, reduce poverty and inequality and promote economic integration; (ii) accelerate growth to above the 4% observed in the 1990s; and (iii) to ensure the environmental and social sustainability of economic development. In terms of new lending during the FY05-08 period, the strategy adopted i s to move forward with a balanced program which allows for about half of lending to be channeled through a series o f programmatic Development Policy Loans focused on growth, with the other half devoted to an investment program of interventions aimed at directly reducing inequality and poverty and continuing to strengthen governance - all of which are also important elements of the growth agenda (Para 11). The third pillar, related to environmental sustainability would also be supported under the CAS, in part through a proposed local and rural development project, associated GEF grants and AAA activities.

41. The loan proposed in this document, for a total amount o f US$100 million, i s the first in the series of three annual DPLs (US$lOO mill ion each) in the base case of the CAS, and i s integral to the achievement of CAS objectives. The CAS also provides for a fourth DPL of US$120 mill ion in FY08, provided high case triggers are met. The DPL series draws largely on Government’s own priorities as laid out in Vamos GuatemaZa, i t s detailed sectoral plans and the Bank’s analyses o f key issues and desirable policy directions through the GUAPA, CEM, ICA, PER and CFAA and CPAR. Within this framework, i t focuses on policy and institutional aspects related to broad-based growth that are most amenable to support via a program o f single-tranche loans. These include actions aimed at improving the business and investment climate, creating fiscal space for greater social investment and achieving key milestones in improving the fiduciary environment. Other key areas for growth identified in Para 11 -- especially further investments in education, health and nutrition and rural infrastructure -- are supported within the CAS program through investment operations, which build on the ongoing portfolio of interventions in these areas.

B. Lessons Learned

42. The Bank has no prior experience with DPL lending in Guatemala. The most recent experience with adjustment lending has been in the Financial Sector, where results have been extremely positive to date. While a final ICR has not been conducted, the recent CAS Completion Report found that the three-tranche FSAL has been a key part of the effort to stabilize, strengthen and modernize Guatemala’s financial sector following the banking crisis of 2001. Importantly, commitment has remained strong despite a change of government during the implementation o f the FSAL and the inevitable changes of senior officials and personnel as a result o f the election. A key element of the FSAL’s success was i ts basis in rigorous and comprehensive analytical work, a lesson which has

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been adopted in the design o f the DPL series. As noted at the outset, the design o f this DPL i s firmly grounded in the findings o f the Bank's key diagnostic studies-the Poverty Assessment, CEM, ICA, PER and CFANCPAR (see Box A) -as wel l as specific sectoral studies such as the regional DR-CAFTA study, the infrastructure policy note and the findings of PPIAF funded studies on PPP in infrastructure and telecomms/ICTs.

C. Design of DPL

43. The design o f this new lending approach takes into account the lessons learned from past operations in Guatemala and the latest thinking on Development Policy Lending.' The underlying principles o f the operation are the following:

(i) Upfront action instead of ex-post conditionality: This loan has been triggered by the new government's demonstrated commitment to move forward on the Peace Accords agenda, albeit in a dif f icult socio-political context; and by specific and significant policy actions toward those ends.

(ii) Support of reform program instead of specific conditionality. The DPL and the programmatic approach w i l l support a broad government reform program. Lack of reform progress in a specific area can be compensated with actions in others if the overall reform program remains on track.

(iii) Aligning program loans with budgetary cycle. The proposed programmatic approach i s designed to become a predictable l o w cost source o f financing for the government.

Each DPL in this programmatic series o f three to four loans wil l be scheduled for presentation in June or July of each calendar year, to enable the Guatemalan Government to ful ly incorporate them in the budget before it i s presented to the Congress during the third quarter.

' World Bank 2004. Programmatic Adjustment lending retrospective, and World Bank 2004: Good Practice Note: Designing Development Policy Operations, http://intresources.worldbank.orgJ INTCOUNTECONOMICS/ Resources/Designingdevelopment90204 .pdf

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Box A: Links between DPL and prior analytical and fiduciary work

financial intermediaries and secured transactions, including Cadastre law). 6. Promote progressive public spending, esp. human capital and rural in f rastn i r t i i re

proj. 11.2 + Educ. Proj

Public Expenditure Review (Draft report, 2005)

1. Improve and increase level of public spending through fiscal savings generated by greater efficiency gains, but mostly by increased taxation. 2. Foster effectiveness o f public spending in priority sectors l ike health, education and housing 3. Enhance municipal capacity to provide basic services, especially through higher local tax collection and increased accountability.

B. Fiduciary Reports - Recommendations

Country Fiduciary Assessment decentralized agencies and municipalities. (CFANCPAR)

1. Continue expanding the integrated financial management system (SIAF) to

2. Continue expanding use o f the procurement information system

11.

11.2 + Ed. and HealtWnut. Proj.

II.1 + 111 Links to DPL

actions

111 Annex 6

budget execution accounting. 4. Continue enhancing transparency o f municipal fiscal information. 5. Strengthen the government procurement policy and oversight functions, and modemize implementation tools. 6. Prepare and execute action plans to address results o f institutional assessments o f intemal controls. 7. Strengthen the external audit function with, inter alia, effective use o f the govemment auditing system (SAG) in planning and execution o f financial audits.

(Draft report, 2005)

* Other reports regarding Challenges and Opportunities of DR-CAFTA for Central America and specific sector policy notes (eg. infrastructure, rural growth) also underpin the strategies and actions included in the DPL. Poverty and Social Impact Analysis i s being conducted as well and will help address certain issues for DPL 2 and 3.

(Guatecompras), under a comprehensive strategic plan for e-procurement. 3. Enhance quality o f budget and fiscal reporting, and compliance with rules for

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D. Programmatic Framework

44. As noted above the proposed DPL i s part o f a programmatic approach that supports actions in three areas: (i) promoting growth and improving the investment climate, (ii) enhancing fiscal space for priority investment, and (iii) transparency and public sector modernization. A Letter o f Development Policy i s attached (Annex 3) and the policy framework i s included in Annex 5. Box A shows the links between analytic work conducted by the Bank and the actions supported by the DPL. The key measures highlighted as prior actions for this DPL are the following (see referenced paragraphs for further details):

Promoting Growth and Strengthening the Investment Climate 0

0

0

Maintenance o f a stable macro-economic framework DR-CAFTA treaty signed and approved by Congress (Para. 16) Investment promotion office, Invest in Guatemala, established and fully operational (Para.20) Achievement o f international security certification o f al l Guatemalan seaports (Para. 25) Guatemala taken o f f l i s t o f Non-Cooperative Countries o f the Financial Action Task Force (July 2004) (Para. 28)

Recovered revenues lost as a result o f Constitutional Court rulings through: (i) passage in 2004 o f a fiscal package by Congress, (ii) passage o f 2005 law on petroleum and petroleum derivatives taxes, and (iii) improve tax enforcement (Para. 32-33) Budgetary allocations for social expenditures (Peace Accords definition) increased from 5% o f GDP executed in 2004 to at least 5.5% in 2005 (Para. 34)

Integrated Financial Management System (SIAF) operational in 43 central government entities -including Congress-, 20 decentralized agencies, and 46 municipalities; and fiscal transparency portal launched to enhance public access to budget data (Para. 37). Transparent web-based procurement system (Guatecompras) in use in 76 public sector agencies and 185 municipalities (Para. 38).

0

0

Enhancinn Capacity for Public Spending in Prioritv Sectors 0

0

Transparency and Public Sector Management 0

0

E. Fiduciary Aspects

45. To document the current state o f public financial management in the country, the Bank i s finalizing a Country Fiduciary Assessment (CFANCPAR) which indicates that the fiduciary environment is generally adequate, as evidenced by the improvements in the public expenditure management systems made over the past decade and actions taken by the current administration to increase transparency. Whi le challenges remain, the

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government is moving ahead to further strengthen i ts public fiduciary control framework, as described previously in Section II (part G). In connection to this process, the Bank i s actively engaged in policy dialogue with the government to follow up on priorities identified in the Country Fiduciary Assessment. Drawing from this ongoing work, certain key actions (Annex 5) and selective milestones (Annex 6) in the context of the DPL program have been identified to help track the public financial management reform progress. The latter, in turn, i s significantly supported by the Bank-financed Third Integrated Financial Management Project under implementation.

F. Loan Administration

46. The Bank would disburse the loan proceeds into an account of the central bank (BANGUAT) denominated in U S dollar^.^ BANGUAT wi l l immediately credit the disbursed amounts to the Ministry of Finance Treasury Single Account (“common fund”), thus becoming available to finance budgeted expenditures. Within a week of this operation, the Ministry wi l l accordingly provide the Bank with a written confirmation. If, after deposit in BANGUAT, the proceeds of the Loan are not used as determined above (including use for ineligible purposes as defined in the Loan Agreement), the Bank w i l l require the Government to promptly refund the disallowed amount

G. Monitoring and Evaluation Arrangements

47. sources to assess progress for the DPLs, including:

The government and the Bank w i l l take advantage of several important data

Central and nonfinancial public sector budget monitoring from the Ministry of Finance

National Institute for Statistics reports, including a l iving standards survey planned for 2005, and annual tracking surveys

Investment climate surveys

Central Bank of Guatemala reports and analysis

Reviews and analyses of laws and implementing regulations from the Bank and other stakeholders

Data from key Government agencies such as Pronacom and UTJ

Financial audits and follow up of CPAR and CFAA recommendations

Bank and IMF supervision missions and reports

CEPAL and SIECA surveys.

In the context o f the latest IMF central bank safeguards assessment, an action plan has been agreed with BANGUAT. Moreover, BANGUAT i s a participant in the Bank’s Reserves Advisory and Management Program (RAMP).

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48. The government of Guatemala and the Bank have agreed to monitor progress in the DPL program regularly, including at the annual reviews of CAS progress, when revisions to the scale and timing of the Bank's lending program can be undertaken. Discussions wi l l be held with the Ministry of Finance, the main counterpart agency for the loan, who wi l l be in charge of M&E for the loan and for collecting from the appropriate sources the data necessary to assess implementation progress. Other agencies that w i l l play an important role in th is process are the Central Bank (for financial sector issues), the Ministry o f Economy and the Commission for Competitiveness (for trade and investment climate issues) and the Office of the Commissioner for the Government's Plan.

49. Semi-annual reviews wi l l take place between the Ministry o f Finance and the Bank team aimed at identifying areas of strengths and weaknesses and possible assistance needed to maintain momentum toward the government's planned medium-term outcomes and address possible downside risks. A mid-term review w i l l be made in the first quarter o f 2006, when the government and the team wi l l jointly evaluate progress in achieving the outcomes laid out for the program.

H. Poverty and Social Impact Analysis and Environment

50. The actions supported by this first DPL are not expected to have any adverse distributional impact. To the extent that these measures have played a role in Government's ability to maintain social spending levels, their impact on income distribution i s expected to have been positive. This i s confirmed by public expenditure incidence analysis undertaken in the context o f the GUAPA which indicates that public social expenditures (Peace Accords definition) are generally pro-poor. With respect to future fiscal reforms, a PSIA i s being undertaken to help determine the distributional implications of the various tax measures being considered. Results of the PSIA (which i s nearing completion) wi l l feed into the national dialogue on fiscal reform and into the design o f actions to be supported by future loans in the DPL series. With respect to the social impact of CAFTA, the Banks regional report "DR-CAFTA: Challenges and Opportunities for Central America" found that about 84% of the Guatemalan population are net consumers who would benefit from price reductions as a result of increased competition. Once DR-CAFTA i s in effect (expected in the second half o f 2005), the agreement grants long grace periods and slow tariff phase outs (7 to 20 years) for sensitive agricultural activities. However, the Bank's report concluded that some groups o f poor rural households engaged in these agricultural activities may require assistance during a transition to increased competition. To better understand the circumstances o f the specific groups who may be affected, PSIA work (planned for FY06) w i l l concentrate on further narrowing down the potentially affected population by analyzing potential price reductions by commodity and by region, enabling the design o f targeted programs to assist these groups. Such programs would be part o f the policy dialogue for future DPLs and other Bank interventions in Guatemala.

51. The specific policies supported by this DPL operation are not expected to entail significant impacts on the environment, forests or other natural resources. However, to

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the extent that measures supported by the DPL program are successful, over time, in attracting new investment (including in infrastructure) and trade expansion, there w i l l be a need to strengthen Guatemala’s national institutional capacity to identify and address environmental policy and regulatory issues. With this in mind, a strategic Country Environmental Analysis (CEA) i s planned for FY06 which w i l l identify cost-effective approaches to closing gaps in institutional capacity and the regulatory framework for environmental protection. The results of the CEA can thus provide timely inputs for the preparation o f subsequent loans in this programmatic DPL series.

I. Risks

52. Continued strong performance by the Government i s subject to three main r isks during the implementation of the DPL series: (i) political gridlock, given a divided Congress, (ii) societal tensions related to the country’s post-conflict status, and (iii) exogenous shocks, related either to natural disasters or a deteriorating external environment. These are described below.

53. Politicul risk i s inherent in a post-conflict situation such as Guatemala’s, where there continue to be deep fissures within society and where the electorate i s very polarized and where the Government lacks a simple majority in Congress. This, in turn, creates obvious risks for the timely passage and subsequent implementation o f the Government’s legislative agenda. Currently, consensus needs to be reached with opposition parties for all legislative priorities, with important implications not only for the pace of reforms, but also the ability to retain the technical and policy coherence of the agenda within a political context of continuous trade-offs and compromises. Likely to be especially controversial i s the fiscal reform agenda which (as discussed in para 33) i s strongly opposed for different reasons by powerful interests on both the right and the left, but remains central to the country’s medium- and long-term growth efforts, including the drive to reduce poverty and inequality, forge greater social and economic solidarity and achieve higher growth rates in a sustainable manner. Political as well as social tensions also arise in other politically controversial areas including continued trade liberalization and promotion of increased private participation in infrastructure, and issues surrounding property rights and land, all of which are crucial to accelerating growth and are central to the Government’s agenda.

54. Efforts now underway to consolidate support for the executive’s development agenda in Congress, through the creation o f a single GANA party or a unified bloc with a common policy platform could help progress on key legislative initiatives. Efforts by the international community (including IDB, UNDP, bilateral and WBI capacity-building initiatives) to modernize and professionalize Congress should also help create better understanding of the technical issues surrounding the legislative agenda. In addition, the Government’s public communicatiodconsultation initiative around social needs and sources o f funding, as well as i t s continued anti-corruption and public expenditure transparency campaign, could help build consensus around goals and the development challenges in the social sphere but also build support for a broader tax effort. I t should

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also be noted that DPL-supported goals o f achieving increases in social spending are largely predicated on actions to improve the quality and targeting of social spending and increase the share of social spending in the budget so that possible delays in raising overall tax revenues would not by themselves derail DPL goals.

55. Besides political and social risks, Guatemala i s also susceptible to external risks deriving f rom natural phenomena and shocks related to international economic trends. As with the other Central American countries, Guatemala i s vulnerable to natural disasters (hurricanes, and seismic or volcanic activity) which could necessitate unanticipated spending for emergency assistance and reconstruction, thereby affecting achievement o f established development goals in the short term. In addition, there remains the threat of shocks from the external economic environment (e.g., low commodity prices, persistently high oi l prices, global recession, political difficulties in the U.S. for DR-CAFTA ratification, unfavorable conditions in financial markets) that affect the economy negatively-keeping growth rates low and negatively affecting efforts to raise tax revenues.

56. The Bank’s DPL program i s particularly well suited for managing the r isks inherent in Gatemala’s difficult political and social context. The choice o f a programmatic series of single-tranche operations for the provision of quick-disbursing support means that there wi l l be several points at which the Bank’s program could be reassessed if political gridlock or social tensions appear to be derailing the development agenda, despite the Government efforts to address them. In addition, the overall flexibility of the single tranche design means that - provided overall progress i s on track - - specific elements of the planned program could be adjusted in terms of the scope and form of specific reforms as well as necessary sequencing changes to take into account changing political and social realities.

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Annex 1 Guatemala at a Glance

22.7 22.5 19.2 19.1 12.6 12.6 58.1 58.4

POVERTY and SOCIAL Guatemala

40

20 3o

10 0

-10

2004 Population, mid-year

Average annual growth, 1998-04

Population (%) Labor force PA)

Most recent estimate (latest year available, 1998-04) Poverty (% of population below national poverty line) Urban population (“A of total population) Life expectancy at birth (years) Infant mortality (per 1,000 live births) Child malnutrition PA of children under51 Access to an improved water source (% ofpopulatfon) lllrteracy (% of population age 15+) Gross pnmary enrollment (% of school-age population)

Male Female

KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1984

GDP (US$ billions) 9.5 Gross domestic investmenWGDP 11.6 Exports of goods and ServicedGDP 13.0 Gross domestic savingdGDP 9.4 Gross national savingdGDP 7.5

Current account balancdGDP -4.0 Interest paymentdGDP 1 .o Total debWGDP 25.1 Total debt service/exports 21.5 Present value of deWGDP Present value of debvexports

1984-94 1994-04 (average annual growth) GDP 3 3 3 4 GDP per capita 0 8 0 7 Exports of goods and services 4.2 3.2

85.6 92.3 7.2 4.2

12.6 2,050 25.9

2.6 3.5

56 41 65 36 44 92 30

102 108 96

1994

13.0 15.7 17.5 8.4

10.2

-5.4 0.8

26.4 11.6

2003

2.1 -0.5 4.6

-20 1 -GDI *GDP

Latin America & Carib.

534 3,260 1,741

1.5 2.1

77 71 28

86 11

129 131 126

2003

24.7 18.7 16.2 7.2

15.8

-4.3 0.6

18.6 5.9

2004

2.7 0.1

12.4

3.1 1.7

Lower- middle income

2,655 1,480 3,934

0.9 1.2

50 69 32 11 81 10

112 113 111

3oL I

Development diamond’

Lifa axwctancv

T GNI Gross per primary capita PnrnllmPnt

Access tn imnrovad water sniirce

-Guatemala Lower-middle-income group

2004

27.5 17.6

2004

27.5 Economic ratios.

17.7 17.6

~ 17.7 3.5

13.3 13.3 35 i

-4.3 0.7

19.5 5.4

Trade

Economic ratios.

Trade

Investment Domestic savings I Investment

-4.3 Domestic 0.7 savings

19.5 5.4

Indebtedness

STRUCTURE of the ECONOMY

PA of GDP) Agriculture Industry

Services

Private consumption General government consumption Imports of goods and services

Manufacturing

(average annual growth) Agriculture Industry

Services

Private consumption General govemment consumption Gross domestic investment Imports of goods and services

Manufacturing

1984 1994

25.6 24.5 19.8 19.7 15.9 14.3 54.6 55.8

82.9 86.1 7.7 5.6

15.2 24.9

1984-94 1994-04

2.9 2.5 3.3 3.1 2.2 2.0 3.5 3.9

3.3 3.9 4.1 3.9 7.1 6.5 8.8 7.9

2003 2004 1 Growth of investment and GDP (%) c

1.4 2.2 20 0.6 2.2 2.0 3.3

5.8 3.8 -0.8 -10.3 -10

O

-8.6 -1.2 -Ex~orls . IOl lmports 0.6 15.8

Note: 2004 data are preliminary estimates,

* The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond will be incomplete.

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Guatemala

PRICES and GOVERNMENT FINANCE

Domestic prices

Consumer prices Implicit GDP deflator

Government finance (% of GDP, includes current grants) Current revenue Current budget balance Overall surplusldeficit

change)

TRADE

(US$ millions) Total exports (fob)

Coffee Sugar Manufactures

Total imports (cif) Food Fuel and energy Capital goods

Export price index (1995=100) Import price index (1995=100) Terms of trade (1995=100)

BALANCE of PAYMENTS

(US$ mii/ions) Exports of goods and services Imports of goods and services Resource balance

Net income Net current transfers

Current account balance

Financing items (net) Changes in net reserves

Memo: Reserves including gold (US$ miilions) Conversion rate (DEC, /oca//US$)

EXTERNAL DEBT and RESOURCE FLOWS

(US$ millions) Total debt outstanding and disbursed

IBRD IDA

Total debt service lBRD IDA

Composition of net resource flows Official grants Official creditors Private creditors Foreign direct investment Pottfolio equity

World Bank program Commitments Disbursements Principal repayments Net flows Interest payments Net transfers

1984

3.4 4.1

1984

1,132 366 71

1,279 86

300 203

12 14 86

1984

1,228 1,428 -199

-207 28

-378

395 -1 7

296 1 .o

1984

2,377 151

0

273 26 0

22 87

5 38 0

50 8

14 . -6

12 -18

1994

10.9 11.7

1994

1,687 318 172 984

2,781 557 201 706

90 92 97

1994

2,279 3,222 -943

-1 43 386

-700

760 -60

659 5.8

1994

3,430 177

0

307 60 0

89 113 42 65 0

0 29 44

-15 16

-31

2003

5.5 5.7

11.1 2.1

-2.3

2003

3,048 299 212

2,080 6,721 1,652

908 1,485

159 148 107

2003

4,271 7,466

-3,195

-329 2,462

-1,062

1,583 -521

2.808 7.9

2003

4,608 428

0

385 37 0

134 -5

280 116

0

30 45 18 27 19 8

2004

7.5 8.2

11.0 2.8

-1.0

2004

3,438

2,291 7,181

1,579

161 150 108

2004

4,851 8,718

-3,867

-31 9 3,006

-1,179

1,761 -581

3,389 8.0

2004

5,342 478

0

41 6 46 0

137 88

387 125

0

0 79 29 50 17 33

Inflation (%) h 8 6 4

10

2 1 99 w 01 02 a3

-GDP deflator *CPI

1 Export and import levels (US$ mill.)

Current account balance to GDP ( O h ) 1 0

1

2

-3

4

5

-6

-7 1

Composition of 2004 debt (US$ mill.)

A 478

D 1,600

E 501 F. 1,297

A - IBRD E. Bilateral B . IDA D - Other multilateral F - Private C . IMF G - Short-term

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Annex 2 Debt Sustainability in Guatemala

Guatemala has one of the lowest debt levels as a share of GDP in Latin America and among developing countries worldwide, which reflects a tradition of very conservative macroeconomic management. However, a question still remains of how sustainable are current public debt levels given the also low levels of tax collections. To explore this issue a medium term sustainability analysis was done under the macroeconomic scenario shown in Table 2 of this program document, which assumes full delivery of the $610 mill ion IBRD CAS envelope. Under the baseline scenario public external debt would stabilize at approximately 14 percent of GDP by 2008 (see table A2.1 below). Total public debt service would increase slightly to 10.8% o f exports by 200S4, as a result of higher interest payments on recent bond issues. Even though the baseline scenario assumes that sovereign bond financing w i l l continue in the future, the use of less costly DPL lending during the 2005-2007 period would prevent sharper increases in interest payments. These conclusions are consistent with the preliminary analysis for the Public Expenditure Review-PER (see Public Domestic Debt section below) as well as with the IMF ’s debt sustainability analysis from i ts recent Article IV report, although the latter actually estimates a declining debt path (see Box A2.1 for details).

Table A2.1 Guatemala - External Debt Exposure Indicators

Actual EStilMte Proiection 2000 2001 2002 ’ 2003 2004 2005 2006 2007 2008

Total debt outstanding (TDO, US$m)a 3.435.7 3,772.2 3,941.5 4,607.7 5,342.0 5,974.0 6,542.6 7.018.3 7,534.9 of which, Public Sector 2,352.2 2,702.2 2,907.2 3.265.7 3,683.6 4,152.0 4,570.4 4,909.1 5.303.0

IBRD TDO (US$“ 295.7 329.5 399.8 427.6 477.6 650.8 781.9 917.5 965.1

Total debt service (TDS, US$” 306.2 329.4 368.8 385.1 474.0 584.8 674.0 959.7 886.7 of which, Public Sector 217.3 252.7 311.1 334.7 400.0 481.6 542.1 801.5 701.7

Total Debt and debt service indicators (%) TDO I GDP 17.8% 18.0% 16.9% 18.6% 19.5% 20.0% 20.4% 20.2% 20.0% TDS I Exports of GNFS 7.9% 8.5% 9.3% 9.0% 9.8% 11.0% 11.8% 15.7% 13.6%

Public Debt and debt service indicators (%) Public TDO I GDP 12.2% 12.9% 12.5% 13.2% 13.4% 13.9% 14.2% 14.1% 14.1% Public TDS / Exports of GNFS 5.6% 6.5% 7.8% 7.8% 8.2% 9.1% 9.5% 13.1% 10.8% Preferred creditor debt I TDO 46.1% 44.3% 48.1% 42.5% 38.9% 38.0% 36.7% 35.0% 32.1% Preferred creditor DSI TDS (%) 44.4% 50.4% 51.0% 52.9% 50.0% 49.2% 48.5% 38.2% 42.5%

IBRD exposure indicators IBRD Debt I TDO 8.6% 8.7% 10.1% 9.3% 8.9% 10.9% 12.0% 13.1% 12.8% IBRD DSI TDS 11.1% 10.3% 9.6% 9.5% 9.7% 9.4% 10.0% 7.6% 8.9% IBRD DS I Exports of GNFS 0.88% 0.87% 0.89% 0.85% 0.95% 1.04% 1.17% 1.20% 1.20% Share of JBRD portfolio (%) 0.24% 0.27% 0.33% 0.37% 0.43% 0.60% 0.73% 0.85% 0.87%

a. Includes public and publicly guaranteed debt (including use o f IMF credits i f any), private nonguaranteed and short term debt. b. “GNFS” denotes exports of goods and non factor services services. c. Preferred creditors are defined as IBRD, IDA, IFC, multilateral development banks and the IMF and the BIS.

A one time increase in amortization payments i s observed in 2007, as the outstanding US$150 million due in that year i s repaid.

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This baseline scenario also indicates that all external vulnerability indicators would remain sound. A moderate GDP growth o f 3.8 percent on average is expected during the period, while the external current account balance would improve somewhat, reaching 3.8 percent of GDP by 2008 as a result o f steady growth in remittances and stronger nontraditional exports. The scenario also contemplates that debt-creating inflows would be reduced due to new DR-CAFTA-related foreign direct investment and as a result, Guatemala’s private external debt would also stabilize around 5.9 percent o f GDP by 2008, slightly lower than 2004 levels. International reserves would also remain strong at 4.3 months of imports throughout the period.

Public Domestic Debt

In its fiscal sustainability section, the ongoing PER complements the results discussed above by including public domestic debt in i t s analysis. I t s preliminary findings suggest that Guatemala’s total public debt o f almost 19 percent o f GDP (including domestic debt) i s sustainable, even in a scenario that contemplates the same GDP growth rates experienced in recent years (averaging 2.3 percent during 2002-04) and a balanced primary fiscal deficit. However, in this pessimistic scenario there i s little room for additional borrowing to finance significantly higher levels o f public spending in social sectors. The PER concludes that until Guatemala has proven its capacity to grow faster, there appears to be little scope for financing a significant expansion o f public spending through greater deficits and, therefore, attention must focus instead on raising tax revenues.

Box A2.1 The IMF and Debt Sustainability in Guatemala

In i ts recent Article IV consultation report o f May 2005, the IMF finds that Guatemala’s external and public debt outlook i s sustainable, even under alternative negative shocks scenarios for the underlying macroeconomic variables. The baseline scenario estimates that total public debt would decline to 15 percent o f GDP by 2010, from 18 percent in 2004. Similarly, public external debt wi l l decline from 14 to 12 percent o f GDP during the same period.

A “weaker policy” scenario was prepared to illustrate the main vulnerabilities that remain under the baseline scenario. Under this scenario tax revenues are not raised, inflation remains at current levels and the financial reform i s postponed. The results show that public debt would remain at 18 percent by 2010, instead o f declining. Nevertheless, the ratio o f public debt to tax revenue would s t i l l be the lowest in Central America and Guatemala’s protection against vulnerabilities would remain relatively strong. Temporary negative shocks to key variables (interest rate, exchange rate and GDP growth), would lead to some increase in the level o f public and external debt, but the ratios return to a declining path once the shocks disappear. Under such negative circumstances, the IMF warns that the investment climate could be affected, raising the cost of borrowing for Guatemala and further lowering GDP growth.

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Annex 3 Letter of Development Policy (English translation follows)

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Letter of Development Policy English Translation

May 30,2005

Mrs. Pamela Cox Vice-president for Latin America World Bank Washington, D.C.

Dear Ms. Cox:

As you know, the Bank’s Country Assistance Strategy (CAS) for Guatemala covering the period 2005-2008 includes a program o f three Development Policy Loans (DPLs), whose main objective i s to support the different areas of the Government’s program aimed at achieving i ts goals of promoting greater economic growth and reducing poverty.

Within this context, and given that the first loan i s being prepared this year, the Government of Guatemala i s requesting that the World Bank to move forward with the First Broad-Based Growth Development Policy Loan, for an amount of US$lOO.O million. These resources wi l l support the economic and social components of the Government’s Program, as well as improve the country’s external indebtedness profile.

With respect to the economic program, we’d l ike to note the results achieved in 2004 in the areas o f economic growth, fiscal and monetary policy and in strengthening the external position. In particular, macroeconomic stability was consolidated, economic performance improved, relations between the public and private sectors were strengthened and the investment climate improved. As a result, the rate of growth accelerated to 2.7 percent, well-above the rate achieved in the previous year (2.1%). On the external side, exports rose and a substantial increase was observed in remittances. Foreign exchange reserves continued to rise, to a level equal to approximately 5.2 months of imports of goods and services. While the exchange rate has had a tendency to appreciate, it has remained stable overall. Inflation reached 9.296, higher than the target set by the monetary authorities, due in part to pressure from higher international o i l prices. Currently, inflation i s showing a declining trend which indicates that 2005 inflation levels wi l l be lower than in the preceding year. With respect to the fiscal position, the deficit was contained to 1% o f GDP, and i t i s expected to remain below 2.0% in 2005.

The Government’s social development program i s being carried forward within the framework of Vamos Guatemala!, our national initiative to promote economic reactivation and social harmony through programs o f rapid and broad-based impact. Vamos Guatemala! i s a central component o f Government’s program for 2004-2008, which seeks to achieve Peace Accords targets. I t includes specific, measurable projects that promote a favorable investment climate and concrete benefits for Guatemalan households.

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Vamos Guatemala! i s comprised of four main components: Guate Solidaria, Guate Compite, Guate Crece, and Guate Verde. Below, find the most important measures to be undertaken within these areas, especially those that pertain to the DPL program.

I. Economic growth and improvement in the investment climate of Investment (Guate Crece and Guate Compite)

In this area we are working on improving infrastructure, both with regard to road maintenance and the construction of new projects. With respect to promotion o f private investment, we are promoting a Concessions Law which seeks to encourage private investment in major projects (metropolitan beltway, the northern highway and the Pacific Corridor). We have also created the “Invest in Guatemala” office, under the oversight of the Ministry of Economy, with the objective of stimulating private investment.

In addition, we are improving tourism infrastructure through improved security, hotel capacity, improved flight schedules etc. In terms of improving exports we are accelerating the process of achieving a Central American customs union and harmonizing and simplifying customs procedures with neighboring countries. We have made progress in reducing the times and costs for customs processes as well as improved services in ports and airports to achieve the international certification necessary to ensure efficient operation of these facilities.

In addition, we have negotiated important trade treaties, notably the Dominican Republic, Central America and United States of America Free Trade Treaty (DR-CAFTA)), which was approved by Congress in March 2005, by means o f decree 31-2005 published on March 16, 2005. In parallel, we have initiated negotiations for treaties with other trading partners, including the European Union, Canada, Chile, Colombia and Taiwan. We have also improved the implementation of VAT reimbursements for exporters.

A t the same time, we are promoting public investment in technological innovation and quality promotion as primary elements in improving access for small and medium enterprises to developed country markets.

11. Stability and macroeconomic consolidation

Public Finances

Immediately upon taking office in early 2004, the current Administration has moved rapidly to restore the credibility of public institutions, apply fiscal discipline and regain the confidence of the markets. As part o f this effort, the Government reaffirmed commitment to the Peace Accords and adopted a plan for improving tax collections and strengthening tax administration. These measures allowed for regaining the income which had been lost as a result of adverse judgments by the Constitutional Court which had eroded the tax base o f the country.

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Specifically, in May 2004, the Executive presented to the Congress a series o f initiatives aimed at increasing taxes with the purpose of complying with commitments included in the Peace Accords. B y means of Decree no. 18-04, the Congress approved the Law of Income Tax (Zmpuesto Sobre la Renta); and, through decree 19-04, i t approved the Law for an Extraordinary and Temporary Tax in Support of the Peace Accords (IETAAP in i t s Spanish acronym). Although the Executive’s proposal was only partially approved, the passage o f these laws made it possible to avoid a decline in tax revenues, which amounted to 10.3% of GDP for the year 2004, equal to revenues in 2003. Additionally, the Executive adopted a strategy for the strengthening o f tax administration, with technical assistance from the International Monetary Fund.

In May o f this year, the Congress approved Decree 38-2005 - Reforms to the Law on Taxes on the Distribution of Crude Petroleum and Combustible Fuels Derived from Petroleum -- through which revenues lost as a result o f a Constitutional Court ruling at the end o f 2004, were restored.

The actions in support of public finances wi l l continue in the coming months through continued implementation of the strategic plan of the Superintendency for Tax Administration and through other actions to be identified via a dialogue with key sectors in society.

In addition to the above, the Government has set in motion a strategy for internal and external debt aimed at securing longer terms and more favorable interest rates, which, in turn, has allowed for an improvement in the public debt profile and maintained access to international credit at reasonable cost. All this has contributed to the strengthening of public finances, a central element of the Government’s program.

Strengthening of the Financial sector

Guatemala has made significant progress in i t s financial sector reform program, which includes the approval by Congress o f the Central Bank Law, the Bank Supervision Law, Banking and Financial Groups Law, the Monetary Law and the Fund for Savings Protection Law. The Government has also issued the regulations needed to make these laws fully operational. Currently, the country continues with the deepening and strengthening o f the financial system, through moving forward new initiatives and through controlling contingent risks, including clean-up o f the Credit0 Hipotecurio Nacional. In addition, banking supervision continues to be strengthened, in particular through moving towards Basle-II-like, risk-based supervision.

In addition, i t i s worth noting that as a result o f the (Government’s) policy of transparency in public sector management and support for the fight against money- laundering and drug-trafficking, Guatemala was removed from the l i s t o f non- cooperating countries by the Financial Action Task Force in July, 2004.

Other priorities include the implementation o f a regulatory framework to facilitate the expansion of credit to groups that have traditionally been excluded from the formal financial system and at the same time to take steps to assure the stability o f non-bank

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financial intermediaries. Towards these ends, the following draft laws have been developed: (a) Law on Micro-Finance Institutions; (b) Law on Reciprocal Guarantees; (c) Law on Movable Property. We hope that these laws w i l l be reviewed and approved by the Congress during the current year.

111. Social investment (Guate Solidaria)

In parallel to the economic program, the Government i s implementing a social program which seeks an increase in (social) expenditure accompanied by improved efficiency and targeting o f these expenditures. In effect, the current Government i s promoting a strategy for human development (Guate Solidaria), whose actions, taken together, wi l l contribute to the reduction of the poverty which affects a large proportion of society, especially in rural areas. I t i s also committed to improving the nutritional status o f the most vulnerable population groups. To achieve this, the Government i s giving high priority to social investment, which, in turn, wi l l be accompanied by concentrated attention to the most vulnerable groups and through the promotion of better coordination between the priority social sectors such as health, education, nutrition and food availability, thereby increasing the efficiency and impact in this area.

This integrated strategy wi l l be implemented in the municipalities and localities determined to be the most vulnerable from the standpoints of social risk and poverty, identified by having the most number of unmet basic needs. I t i s anticipated that households most affected by extreme poverty would be able to improve the quality of l i fe in the medium-term and be able to move out of poverty in the long-term.

IV. Transparency and Public Sector Management

Government Procurement

Regarding procurement issues, significant progress has been made through the launching of an internet-based system (Guatecomprus) for public use, which provides real time information on governmental contracting and procurement transactions. This system allows for more transparency and for a competitive process using best practices on Government’s acquisitions. I t permits all privately owned businesses to access information on, and participate in, al l Government procurement. I t i s already in use by more than 76 public sector agencies and 185 municipalities.

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Integrated Financial Manapement Svstem (SIAF)

In order to promote greater transparency in budgetary execution by al l three Branches of Government, we have moved from a client - server electronic format to a real time internet-based system, SICOIN-WEB. This promotes a more transparent environment and the efficient use of public funds. Currently, the system has been implemented in al l central government entities and in 22 decentralized agencies, which by the end of 2005 i s expected to expand to 6 more.

Regarding local governments, S I A F has been incorporated in 46 municipalities, and plans are to expand to 100 by the end of this year.

Conclusion

As the above indicates, the Guatemalan Government i s strongly committed to taking the necessary steps to promote economic growth, increase employment and improve health and education as well as improving citizen security and fighting poverty. In this context, the support and partnership that the World Bank can bring to the country through approval of the program of Development Policy Loans i s a very important element.

I would like to take this opportunity to thank the World Bank for the support given to our country and to reiterate our appreciation of the same to the Vice-president.

Maria Antonieta Del Cid de Bonilla Minister of Public Finance and

Governor o f the Republic of Guatemala Before the International Bank for Reconstruction and Development

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Annex 4 Actions Supported by DPL 1

I. Promoting Growth and Strengthening the Investment Climate

Maintenance o f a stable macro-economic framework

DR-CAFTA treaty signed and approved b y Congress

Investment promotion office, Invest in Guatemala, established and fully

operational

Achievement o f international security certification o f al l Guatemalan

seaports

Guatemala taken of f l i s t o f Non-Cooperative Countries o f the Financial

Action Task Force (July 2004)

II. Enhancing Capacity for Public Spending in Prioritv Sectors

Recovered revenues lost as a result o f Constitutional Court rulings

through: (i) passage in 2004 o f a fiscal package by Congress, (ii) passage

o f 2005 law on petroleum and petroleum derivatives taxes, and (iii)

improve tax enforcement

Budgetary allocations for social expenditures (Peace Accords definition)

increased from 5% o f GDP executed in 2004 to at least 5.5% in 2005

III. Transparency and Public Sector Manaeement

1. Integrated Financial Management System (SIAF) operational in 43 central

government entities -including Congress-, 20 decentralized agencies, and

46 municipalities; and fiscal transparency portal launched to enhance

public access to budget data

2. Transparent web-based procurement system (Guatecompras) in use in 76

public sector agencies and 185 municipalities

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