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Guatemala: Staff Concluding Statement of the 2018 Article IV Mission

Underpinned by solid, hard-earned macroeconomic stability, Guatemala’s near-term growth has been good but falls short of the rates needed to achieve Guatemala’s aspirations to meaningfully lift the living standards of its citizens. The mission recommends greater policy support for the economy over the near-term as well as supply side reforms—including an integral fiscal reform—that would sustain higher per capita growth rates and lift more Guatemalans out of poverty into the medium-term. The legacy of the Peace Accords and the Fiscal Pact are good basis to articulate the national dialogue in the pursuit of the Sustainable Development Goals.

1. Raising living standards continues to be the main challenge facing Guatemala . Income per capita over the past decade has grown at an average rate of 1 percent, a rate that is insufficient to meaningfully reduce Guatemala’s high levels of poverty (currently at 60 percent of the population). Over the last two years, even though strong remittance inflows have helped sustain private consumption, growth has decelerated as a result of weak confidence, insufficient contribution of budget spending to growth, court-mandated suspensions of mining activities, and unfavorable external conditions. This slowdown has been broad-based, evident in employment, private consumption, and credit growth.

2. The mission forecasts a subdued recovery in the near term . Better U.S. growth, accommodative monetary conditions, and some support from pent-up government spending should allow growth to rise gradually to 3.6 percent by 2019. Achieving better growth outturns will require efforts to boost both public and private investment (which, at 14 percent of GDP overall, is low relative to Guatemala’s peers). However, inadequate budgetary revenue constrains the government’s ability to spend on physical and human capital and political fragmentation have diminished the prospects for those future reforms that would help attract private investment.

3. Inflation is expected to remain within the central bank’s target range, with risks skewed toward the lower part of the band . Despite political uncertainties over the last couple of years, a sound monetary policy management helped keep inflation expectations firmly anchored. Also, slowing activity, low oil prices, and a strong currency kept headline inflation comfortably within the 4±1 percent target range last year, leaving aside a couple of short-lived bouts of food inflation. Core inflation has been mostly below the 3 percent lower bound of the target range in 2017 and, as of February 2018, is falling. Even as oil prices return to higher levels, staff’s projected economic slack into 2019 is expected to result in a headline inflation rate that is below the mid-point of the target range over the near term.

4. The external position is stronger than implied by Guatemala’s medium-term fundamentals and desirable policies . The combination of low oil prices and an upsurge in remittance inflows have resulted in a sizable improvement in the current account coupled with a modest appreciation of the exchange rate. By the same token, a partial normalization of these forces is expected to bring the current account to a modest deficit by 2021. Staff analysis suggests that the current account in 2017 was around 2¼ percent of GDP above what would be expected given Guatemala’s young population and low per capita income. Spending more on public infrastructure, expanding social protection, and removing structural impediments to investment would facilitate an adjustment to a small current account deficit over the medium-term. Such an adjustment should be expected to be accompanied by a further, modest appreciation in the exchange rate.

5. The mission assesses the risks to the outlook to be tilted downwards . Domestic risks that are worth highlighting include both binding budget limits and insufficient progress in addressing spending under-execution, both of which limit the ability of the public sector to support growth. The delayed resolution of judiciary decisions that will allow for the normalization of the operations of a large mining company is also a risk. While global financial conditions are currently very accommodative, they could tighten abruptly, raising the future cost of external financing and weighing on growth. Guatemala also faces serious, albeit low probability, tail risks from future restrictions on financial transfers from the U.S. that disrupts remittances, an increase in the deportations of Guatemalan nationals from the U.S, or from a broader global retreat from trade openness and cross-border integration.

Recalibrating the Policy Mix

The macroeconomic policy mix should be geared towards supporting demand. Ideally, such support should come from a loosening of spending limits and an improvement in the government’s ability to execute growth-enhancing social and infrastructure programs. However, the contribution of fiscal policy to economic growth may fall short of expectations. If true, and growth and inflation outturns are weaker than the central bank’s forecasts, further monetary policy support should be considered.

6. A supplementary budget is necessary to support near-term growth and address longstanding infrastructure gaps and social needs. After Congress rejected the government’s 2018 budget (which proposed a debt-financed increase in spending of around 10 percent in real terms), the government’s ability to meaningfully expand spending is constrained. The government’s supplementary budget—that would aim to raise spending by up to ½ percent of GDP in 2018—merits support. During this budget year, a particular focus should be placed on raising capital spending. Spending should be increased by around 1 percent of GDP starting in 2019, centered on a few large-scale, high-impact programs designed to address essential social and infrastructure needs (below). Over the medium-term, this higher spending should be financed through a comprehensive tax reform.

7. In parallel, best efforts should be deployed to improve the execution of spending . Reforms of the Procurement Law, adopted over the past two years, have facilitated greater oversight over public spending and contributed to tackling corruption. However, as a side-effect, these new controls have led to slower execution of spending, given continued reluctance by public officials to execute projects because they could be personally liable and, at times, the lack of unified criteria in the assessment of bidding process by auditors. The mission welcomes efforts towards the identification of outstanding obligations for projects carried over from the previous year, and improved clarification in the application by Comptroller auditors of administrative versus criminal procedures. Additional measures to speed up execution, without diluting the appropriate focus on governance, could include a reform of the General Comptroller towards the development of preventive capacities and concurrent auditing, consensual interpretation of the norms applied to procurement, and the application of unified criteria to protect public employees from potential arbitrary decisions by auditors. The creation of the Vice Ministry for Transparency, aimed at coordinating and supervising the myriad decentralized entities involved in procurement, also shows promise coupled, in the medium term, with a new procurement law. The revised framework would favor the design of a national investment strategy to be input into a multi-year investment budget.

8. Monetary policy is rightly accommodative and further reductions in the policy rate should be considered if growth and inflation disappoint relative to the central bank’s forecasts . Reflecting monetary policy accommodation, policy rates, adjusted for expected inflation are negative and are below estimates of the neutral policy rate. Nonetheless, there are important uncertainties to the outlook, including inadequate budget execution preventing fiscal policy from sufficiently supporting domestic demand. If activity indicators have not strengthened by mid-year and inflation risks appear to remain to the downside, the central bank should remain open to further lowering policy rates to support the economy. The recently-adopted microcredit, collateral, and factoring laws should facilitate monetary policy transmission. Putting in place a comprehensive securities market and public debt law, continued efforts towards discouraging financial dollarization, and encouraging competition in the banking sector would help deepen financial intermediation, support growth, and improve monetary policy transmission over the medium term.

9. The central bank’s inflation targeting framework would benefit from allowing for greater exchange rate flexibility . Over the past 2−3 years, amidst strong remittance inflows and soft nominal imports from terms of trade gains, the central bank’s foreign currency intervention rule has led to a sustained accumulation of foreign currency reserves. Going forward, the authorities should continue to allow greater currency flexibility to facilitate a smoother external adjustment to changing global and domestic conditions. Further widening of the margin under which FX intervention is triggered and reducing the amount of intervention undertaken once the rule has been triggered warrant consideration. If remittance flows were to abruptly decline, the authorities should respond with both sales of foreign exchange and a depreciation on the exchange rate.

Higher Potential Growth, Better Living Standards and A More Resilient Financial System

Reversing the downward trend in investment is key to raising living standards and capitalizing on the demographic dividend expected to occur over the next two decades. This will require actions on multiple fronts. First, improving business environment conditions. Second, an integral fiscal reform encompassing continued tax administration efforts, tax policy changes, and spending flexibility, all geared at high- impact projects in pursuit of the Sustainable Development Goals. Third, expanding social protection by creating more formal jobs in the economy. Last, but not least, sustained efforts to improve governance.

10. A better business climate is vital to spur private investment . The government is introducing an online system for businesses tax reporting and registration as well as a system of arbitration to resolve business disputes. Further efforts could be made to coordinate all entities involved in the awarding of construction licenses and reduce judicial backlogs in contract disputes. Simplifying customs procedures will be important to maximize the gains from the recently adopted customs unions with Honduras, with no detriment to ongoing revenue mobilization efforts or the warranted control of illicit flows. The authorities should strive for a swift incorporation of ILO Convention 169 into Guatemala’s domestic legal system in a way that balances the need to attract investment and jobs in extractive industries with the rights and protections for indigenous people. Strengthening competition policies, including through the adoption of the pending competition law will be important to spur domestic investment and improve Guatemala’s attractiveness to foreign investors.

11. Revenue mobilization efforts need to continue, within the context of an integral fiscal reform . A comprehensive tax reform is needed to raise revenues to at least 15 percent of GDP. A variety of tax policy changes will be needed including an increase in the PIT rates (which could be frontloaded), a simplification of the corporate income tax, higher indirect taxes, and redirecting some existing tax deductions to improve health and pension coverage. The resulting taxation system should be progressive, and any regressive effects compensated via well-targeted social spending (below). Tax reform efforts should be reinforced with continued tax and custom administration efforts to fight tax evasion, with a focus on reinforcing controls of the VAT with an emphasis on risk-based auditing, strengthening the large-taxpayer office management, improving the use of tax information to detect and correct non-compliance, enhancing SAT's tax collection executive faculties, including through better operationalization of bank secrecy provisions, and tightening controls of ports and the customs clearance process.

12. The additional revenues mobilized should be geared towards high-impact projects in pursuit of the Sustainable Development Goals . Such emblematic programs include increased coverage and quality of pre-primary and secondary education; enhanced preventive and primary health care; higher coverage of pensions, particularly for the self-employed, to alleviate poverty of the elderly; and improved coverage and targeting of the main cash transfer program. Such social investments are expected to more-than-offset any potential regressive effects arising from the proposed tax reform. Clearly, given the amounts involved, any such disbursements should hinge upon an improved coordination amongst the line Ministries involved and be subject to systematic evaluation as part of the annual budgetary exercise. The size of the existing infrastructure gap could require some private sector participation, for which it would be desirable to provide legal certainty to private investors by consolidating the numerous regulations currently existing in the sector.

13. As a complement to revenue mobilization, s pending needs to be made more productive . Achieving this goal would ideally be helped by scaling back the current earmarking of revenues and mandatory spending floors. Couching spending objectives within a medium-term budget framework, and greater accountability for outturns though an ex-post evaluation of performance would be important objectives in this respect. Labor-intensive health and education spending needs to be made more effective, including by shifting the input mix away from personnel costs and toward greater capital outlays. Better aligning pay with performance in the provision of such services and reforming current regulations of the Laws on the Civil Service and Salaries in Public Administration will be important milestones. Completing the public-sector personnel census is a wise decision to make the hiring public officials more transparent and to assess the cost of their salaries.

14. Tackling labor market informality will promote a fairer tax and social protection system . High informality in Guatemala results in low coverage for basic social protections, high poverty, and low productivity. Addressing informality would be facilitated by making the determination of the minimum wage more predictable, and as with part-time pay, less binding; raising the productivity of informal workers (by e.g., investment in rural roads and irrigation in the poorest areas); fostering apprenticeship schemes such as Mi Primer Empleo and other vocational training programs, and making the self-employed eligible for health and pension systems.

15. The financial system is well regulated and the time is ripe for it further modernization . Banks are well capitalized, appear to have sufficient liquidity, and nonperforming loans are low. Sharp increases in interest rates or severe liquidity shocks in U.S. dollar funding markets could challenge banks’ resilience, although such shocks would be absorbed within available capital and liquidity buffers. Moreover, efforts are ongoing to buttress banks’ ability to withstand such shocks, including through a requirement of supplemental capital for market risk and a liquidity coverage requirement for foreign currency holdings. The mission recommends further tightening of prudential requirements on FX loans to unhedged borrowers if existing measures fall short. More generally, circumstances seem appropriate for a gradual move towards Basel III standards. Finally, the new banking law currently with Congress, if passed, would strengthen the bank resolution framework and reinforce depositor protection. The initiative would introduce greater clarity regarding the triggers of an effective resolution, as well as safeguards for the use of public funds in the open-bank intervention scheme.

16. Improved governance is critical to durably raising investment . A reference for the region, collaboration between the General Prosecutor’s office and the International Commission Against Impunity in Guatemala has been effective in enhancing independent investigation of acts of corruption. There is scope to strengthen the integrity of the judiciary by enhancing the appointment procedures for judges and magistrates (via reform of the Law and Regulation for the Nominations Committee), effectively implementing the merit-based system for the advancement of judges’ careers, and fully applying the sanctions system—as per the new law on the judicial career. Online publication of judicial decisions is another important step towards reinforcing legal certainty. There is also room to strengthen the regime of asset disclosures for public officials through a more coordinated application, and stricter supervision, by the Comptroller's Office within the framework of the Public Probity Law. An additional step, to avoid conflict of interest and tackle illicit flows, is to ensure transparency on the ultimate beneficial ownership of corporate vehicles.

17. A stronger AML/CFT framework is paramount to support efforts against corruption and organized crime. Adoption of a revised AML/CFT bill, already endorsed in 2014 by the bank supervisor, the private sector, and international organizations, would make it more difficult to conceal proceeds of corruption and would deter illicit flows. The bill and implementing regulations, when established, would (i) expand the list of reporting entities to include notaries and other non-financial businesses and professionals, (ii) enhance preventive measures for reporting entities, (iii) establish an obligation for financial institutions to adopt a risk-based approach to managing and supervising risks and a sound sanctioning regime for noncompliance, (iv) improved protection for supervisors, and (v) enhance interaction between the supervisor and law enforcement authorities. In addition, risk-based AML/CFT supervision should be strengthened, both for offsite and onsite activities. Lastly, additional consideration should be given to reinforcing the supervisory framework of cooperatives.

The IMF mission would like to thank the authorities for their outstanding cooperation and open dialogue.

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