This record is a partial extract of the original cable. The full text of the original cable is not available.

UNCLAS SECTION 01 OF 07 TEGUCIGALPA 001625 
 
SIPDIS 
 
SENSITIVE 
 
STATE FOR WHA/CEN, WHA/EPSC, DRL/IL, EB/IFD/OMA 
STATE PASS AID FOR LAC/CEN 
TREASURY FOR E. ILVETSKI 
 
E.O. 12958: N/A 
 
TAGS: EFIN EAGR ETRD HO
SUBJECT: Honduran Government Paper on Agricultural Finance 
Reform 
 
REF: Teguz 1581 
 
¶1. As indicated in reftel, on June 30 the Finance Minister 
provided to Econcouns a 32-page analysis entitled "Honduran 
Agriculture Laws," intended to answer IMF and USG questions 
on the rationale behind the April 2003 passage of Law 68- 
¶2003.  The document was prepared by the Finance Ministry 
together with Honduran Banking Commission President Ana 
Cristina de Pereira.   This cable provides a detailed 
English language summary of the paper.   The full Spanish 
language version has been faxed to WHA/CEN (Brett Makens). 
The paper makes the case that the government did the best it 
could, within legal strictures, to limit and manage the 
fiscal cost of a series of imprudent agricultural finance 
laws.  The paper also clarifies that the previous 
agricultural support programs, replaced by Law 68-2003, were 
already being implemented and having a significant effect on 
GOH finances.  Finally, the paper clarifies that the GOH 
understands that resumption of credit to the agriculture 
sector will be a slow process (given the moral hazard 
problems created by these various loan forgiveness 
programs). 
 
Begin Detailed English Language Summary. 
 
HONDURAN AGRICULTURAL LAWS 
 
INTRODUCTION 
 
Several laws that provided financial support to the 
agriculture sector were adopted by the GOH between 2000 and 
¶2003.  The objectives of these laws was to reactivate 
agricultural production, severely affected by the impact of 
Hurricane Mitch in late 1998 on the value of agricultural 
assets, the capacity of the sector to generate employment 
and income, and on the supply of exportable products. 
Damages from Hurricane Mitch in Honduras have been estimated 
by ECLAC at $2.6 billion (principally agricultural 
production and road and bridge infrastructure). 
 
Government assistance to farmers in these years rested on 
the assumption that the reactivation of agricultural 
production could be achieved by partially resolving the 
financial problems faced by farmers.  The measures taken by 
the government in this period included interest rate 
subsidies and forgiveness of some agricultural debt.   The 
implementation of these measures, however, had two important 
negative effects that doomed the laws to failure: 
 
1) An increase in debt levels resulting from the 
accumulation of interest payments that were capitalized into 
each loan.  This lowered the profitability of new investment 
projects. 
 
2) Each of these laws failed to achieve its expected goals 
and consequently increased the social and political pressure 
for new measures containing additional benefits, raising the 
fiscal cost, increasing the moral hazard, and perpetuating 
the problem instead of resolving it. 
 
At the same time, the debt reduction, interest rate subsidy 
and new credit programs provided to farmers involved high 
costs for the GOH.  Previously, the schemes were expanded in 
order to augment partial payments made by the GOH to the 
financial institutions on behalf of farmers, thus reducing 
the levels of debt (partial forgiveness of the principal). 
This last benefit was financed through the issuance of 
government bonds, sold on market terms. 
 
Given that the conditions of debt restructuring implied 
repayment schedules with long grace periods, the farmers 
could manage the interest payments during the grace period, 
helped by the interest rate subsidy financed by the 
government.  Nonetheless, the lack of viability of the 
mechanisms was made evident when the repayment schedule 
required the amortization of the principal. 
 
The lack of a definitive solution caused increasing fiscal 
commitments without achieving the desired result.  It also 
hurt the functioning of credit markets; in particular, bank 
credit for the agricultural sector declined in real terms. 
The agricultural sector's rate of growth and contribution to 
GDP has been declining steadily, with a consequent negative 
effect on the social situation.  Poverty in Honduras is 
concentrated in rural areas. 
Additionally, the Honduran financial system has suffered a 
worsening of the arrears in the credit portfolio and a 
reduction in the profitability of financial institutions, 
because of the increase of the nonproductive assets (bad 
debts and repossessed rural properties) as well as the lack 
of dynamism of new investment projects in the sector. 
 
Recognizing the need to resolve the problem in all its 
dimensions, the GOH has designed a new policy proposal that 
not only seeks to resolve in a definitive form the problem 
of the accumulated debt levels of farmers, but also to 
establish new rules of the game for participants in 
agricultural credit markets, trying to return discipline to 
the market and limiting the fiscal cost associated with the 
implementation of the new mechanism. 
 
THE CONTENT OF THE PREVIOUS AGRICULTURAL FINANCE LAWS 
 
Law 28-2000 
 
Law 28-2000 entered into effect on April 28, 2000.  It 
created a framework for the alleviation of the financial 
burden on farmers who were affected by natural phenomena and 
had loans in arrears.  The benefits were made available to 
borrowers with loans approved between June 1997 and January 
2000, either with resources from FONAPROVI or private banks. 
 
It established a fixed interest rate of 24 percent for 
direct bank loans and 19 percent for loans from FONAPROVI 
provided for the production of basic grains, vegetables, 
plantains, watermelon, and tubers and 24 percent for the 
remaining types of production.  Interest rate subsidies 
varied from 8-16 percentage points for loans in these 
categories and cattle projects, and 2 percentage points for 
other types of agricultural production. 
 
In addition, Law 28-2000 directed the government to provide 
loan guarantees from resources of the National Complementary 
Guarantee Fund (FONGAC) - a fund administered by FONAPROVI 
with resources transferred by the Ministry of Finance - for 
up to 70 percent of the amount of new loans provided by 
financial institutions for the rehabilitation of farms. 
 
Decree 28-2000 did not establish specific terms for the 
restructuring of farm debts.  But the PRODUCOM program, 
which functioned like a trust fund of the Ministry of 
Finance in FONAPROVI, authorized up to seven years with 18 
months' grace period for the payment of rescheduled loans. 
 
The law also approved transfers to the state-owned National 
Bank of Agricultural Development (BANADESA) for 115 million 
lempiras, of which 15 million were to be used for the 
program of supervised credit, which channels small loans to 
the reformed campesino (organized small farmer) sector. 
 
Law 32-2001 
 
Law 32-2001 established the legal framework to authorize 
interest rate subsidies and reductions in the debt balance 
owed by farmers affected by natural phenomena, who had taken 
out loans for agriculture, forestry, cattle, beekeeping, 
poultry, aquaculture, fishing, agriculture mechanization 
services, irrigation, grain drying, or salt extraction. 
 
Loans approved after June 31, 2000 and beneficiaries of Law 
28-2000 were designated as eligible for the benefits of this 
law.  It provided interest rate subsidies ranged from 7 to 
16 percentage points for basic grains, vegetables, 
plantains, watermelon, tubers, cattle, and coffee and two 
percent for other types of crops. 
 
The law established a maximum amount for loan rescheduling 
of 4 million lempiras per borrower.  It also established a 
reduction in the capital balance for beneficiaries in one of 
the three following situations: 
 
1) Direct credits by banks, FONAPROVI loans, or other 
rediscounting sources, and savings and loan cooperatives, 
affected by natural phenomena and in arrears or due on 
December 31, 2000 and classified as loan risk category III 
or IV; 
 
2) Beneficiaries of Law 28-2000, and 
3) Borrowers from savings and loan cooperatives, under the 
same circumstances. 
 
Debt reduction of 50 percent was provided, up to a maximum 
level of debt forgiveness per borrower of five million 
lempiras. 
 
The law required the banks to provide new loans for the 
rehabilitation of farms, unless the farmers decided to forgo 
this financing in writing.  The farmer had to pay the 
interest owed, from January 1, 2001 through the date of 
presentation of the application. 
 
Of the 50 percent of debt relief, ten percent was financed 
by the banks and 40 percent by the GOH, through the issuance 
of 10-year bonds, with interest rates equivalent to the 
average deposit rate.  The law authorized up to 600 million 
lempiras in government bond issuance. 
 
Two additional mechanisms were established: 
 
1) For original loan balances of 300,000 lempiras and more 
that had financed production of basic grains in areas of 50 
manzanas or less, the law provided debt forgiveness of 40 
percent immediately.  An interest rate subsidy of five 
percentage points was authorized for the remaining loan 
balance. 
 
2) For loans by small producers of basic grains with loan 
balances of 50,000 lempira or less classified in loan risk 
categories III and IV, full debt forgiveness (90 percent 
paid by GOH and 10 percent by the banks) was provided. 
Loans classified as risk category V were to be bought by the 
Ministry of Finance with a discount of 80 percent. 
 
The GOH transferred the 115 million lempiras to BANADESA, as 
directed in Law 28-2000, and forgave the debt that BANADESA 
owed to the GOH. 
 
The law established an interest rate subsidy of 8 percent 
for growers of basic grains, to be paid with Central 
Government funds, independently of whether a guarantee was 
received from FONGAC. 
 
Law 128-2001 
 
Law 128-2001 modified various articles of law 32-2001.  It 
allowed benefits to accrue from the moment that the farmer 
signed the contract with a financial institution.  It also 
expanded the coverage to farmers who had received a loan 
before July 31, 2001, in order to pay a previous loan that 
had qualified for benefits under law 32-2001, and the 
borrowers from banks declared in forced liquidation. 
 
Law 128-2001 created the option of raising the ceiling for 
debt forgiveness from 5 million to 10 million lempiras in 
those cases in which there had been destruction of the 
productive asset. 
 
Law 81-2001 
 
Law 81-2001 approved the issuance of bonds by FONAPROVI of 
up to 1.2 billion lempiras at terms of 18 months, 10 years 
and 15 years in order to create lines of credit for working 
capital, capital goods and rediscounting of up to 70 percent 
the restructured credits in the previous three laws.  To 
qualify, the loans needed to be used for reactivation and 
rehabilitation of the agriculture sector.  The law provided 
interest rate subsidies of between four and eleven 
percentage points. 
 
Law 11-2002-E 
 
Law 11-2002-E added to the beneficiaries of the interest 
rate subsidies in 81-2002 the following products: 
machinery, equipment and parts; harvesting of pasture; 
construction;  planting; acquisition of livestock and 
poultry; and production of rhyzomes.  It extended the 
deadline for application of benefits to December 31, 2003. 
 
ESTIMATES OF THE COSTS OF THE PREVIOUS DECREES 
 
Interest Rate Subsidies 
The loans that have been covered by interest rate subsidy 
under the different decrees: 
 
Decree 28-2000                  L 1,417.1 million 
Decree 32-2001                  L 2,097.9 million 
Decree 81-2002                  L   848.7 million 
Total                           L 4,363.7 million 
 
During 2000-2002, 195.8 million lempiras in interest rate 
subsidies were provided.  These amounts were provided to 
farmers as reimbursements for interest payments already 
made; these reimbursements were deducted from the value of 
the trust fund.  In Decree 128-2001, the system was changed. 
After that, the farmer only paid the interest net of the 
subsidy, and FONAPROVI credited the account of the financial 
institution directly.  This broke the link between farmer 
compliance with payment obligations and the authorization of 
the GOH to continue authorizing subsidies. 
 
The total amount of interest subsidies authorized by the 
five previous laws was: L 1,494.4 million, of which L 195.8 
million was paid out during 2000-2003. 
 
Debt Forgiveness 
 
Estimates of costs incurred through the authorization of 
debt forgiveness (as of May 31, 2003) are: 
 
Total bond issue authorized           L 600   million 
Total bonds issued                    L 274.1 million 
 
One large bank, Banco Atlantida, received L 101.2 million in 
bonds (slightly above the 99.4 million authorized as a 
result of errors in program management).  All other banks 
are far under their limits. 
 
Guarantees 
 
The National Fund of Complementary Guarantees (FONGAC) has 
issued certificates to guarantee the payment of balances 
owed by farmers benefiting from the different laws.  After 
taking into account the deductions from the value of the 
trust fund for subsidy payments, there was a legal limit of 
issuance of L465 million in guarantees.  Of this amount, 306 
million were issued as of December 31, 2002 and another L 
175.7 million were authorized.  FONGAC's financial capacity 
to guarantee new loans thus has been totally exhausted.  To 
comply with the obligations for loan guarantees in the laws, 
the Central Government would need to make additional 
transfers to FONAPROVI.  The GOH estimates that this 
contingent liability is L2.5 billion lempiras. 
 
The total committed fiscal resources (estimated at the end 
of May 2003) over the period 2000-2019 is 2.9 billion 
lempira, with another 2.5 billion lempira in contingent 
liabilities for the loan guarantees. 
 
THE PROPOSED NEW POLICY 
 
The policy framework designed to resolve these earlier 
problems is based in the following assumptions: 
 
¶1. Lending to the agricultural sector is affected negatively 
by structural problems.   Credit risk does not depend on the 
capacity to pay of an individual but on generalized market 
risks such as climatic conditions, or the international 
price of an export crop like coffee. 
 
¶2. Social and political pressures have resulted in misguided 
policies focused on the reduction of debt levels instead of 
the search for income-generating alternatives.  The attempt 
at debt reduction was not successful because it did not 
materialize immediately and the system permitted the 
capitalization of interest, with the result that debt levels 
actually increased. 
 
¶3. The benefits have worsened the country's payment culture 
and degraded the quality of risk posed by the banks' 
agricultural clients. 
 
¶4. The debt burden represents a tax on the profitability of 
future investments in the agricultural sector that provides 
disincentives to the renewal of agricultural activity. 
¶5. The lack of investment is reducing the supply of 
agricultural production, which in turn negatively affects 
employment, income and the social situation in rural areas. 
 
The new framework is contained in Law 68-2003.  It creates a 
financial mechanism to distribute losses and generate 
conditions that will spur growth in the agricultural sector. 
It supercedes all the previous laws and establishes a 
mechanism that treats all beneficiaries of the program 
uniformly. 
 
Law 68-2003 establishes a government trust fund, financed 
through annual transfers from the Central Government budget, 
of decreasing amounts, starting in 2003 and ending in 2012. 
The trust fund will have the ability to issue securities 
for: 
 
-- Acquisition of the portfolios restructured under decrees 
28-2000, 32-2001, 128-2001, 81-2002, and 11-2002-E.   The 
trust fund will provide debt reduction of 50 percent of the 
balance on the loan at the moment of its acquisition and 
will enter into contracts with the financial institutions 
for the recovery of the remaining 50 percent.  This will be 
done with a payment plan over 10 years and an interest rate 
of 8.725 percent. 
 
-- Payment of the net present value of the interest rate 
subsidies for rehabilitation and reactivation, authorized 
under the mentioned laws.  The GOH will use a discount rate 
of 8.725 percent to calculate the net present value.  The 
borrowers will need to pay the remaining balance of their 
loans, using the original terms. 
 
The law authorizes issuance of government bonds up to a 
maximum of 4 billion lempiras (with the bulk of the funds to 
be used for the purchase of the portfolio accounts 
rescheduled by financial institutions).  The interest rate 
to be paid on the bonds is 5 percent. The bonds will be 
issued for a ten-year period, with annual amortization that 
will be guaranteed (for 50 percent) by the financial 
institutions.  The remaining 50 percent will be guaranteed 
with the amounts paid by the GOH through annual transfers: 
 
Year                      Millions of Lempira 
 
2003                            347.3 
2004                            322.0 
2005                            241.5 
2006                            198.6 
2007                            173.6 
2008                            123.5 
2009                             93.6 
2010                             77.7 
2011                             63.8 
2012                             51.8 
------                        ------- 
Total                         1,693.4 
 
Through the investment of the resources received annually, 
FONAPROVI (the National Fund for Production and Housing) 
will generate the necessary resources to cover the interest 
and principal payments.  Thus, the sum of the GOH 
contributions will be lower than the guaranteed amount. 
 
The law repeals the guarantees authorized by the GOH in the 
previous laws for the financial institutions, for 
rescheduled loans and for reactivation and rehabilitation 
loans, including the certificates that had been issued by 
FONGAC. 
 
The decree establishes, in addition, conditions for new 
credits by financial institutions that will be rediscounted 
with FONAPROVI funds: 
 
a) detailed technical and financial evaluation of the loan 
b) crop insurance (covering risks like natural disasters) 
c) contracted marketing mechanism 
d) sufficient guarantees 
 
The law also allows financial institutions to arrange 
insurance or guarantees against price declines, for those 
loans that finance agricultural exports outside of Central 
America.  Embassy Note: These risk reduction mechanisms were 
strongly encouraged by the authors of the IMF-World Bank 
Financial Sector Appraisal (FSAP) for Honduras, completed 
earlier this year.  End Note 
 
The law ratified the creation of the Fund for the Small 
Producer, through GOH transfers to BANADESA (L140 million in 
2003, 130 million in 2004, and 130 million in 2005). 
 
The tables below provide the government's estimates of the 
costs implicit in the earlier regime and the new one: 
 
Financial Costs of Previous Scheme 
      (millions of lempira) 
                        Nominal       Present Value 
 
Int. Rate Subsidies       1,494           1,121 
Interest costs of bonds     363             230 
Transfers to BANADESA       575             340 
Recap.of FONGAC             482             482 
Bond for debt relief         --             298 
                         ------         ------- 
                          2,914           2,470 
 
Financial Costs of Current Scheme 
      (millions of lempira) 
 
                        Nominal        Present Value 
 
Transfers to trust        1,693            1,386 
Interest costs of bonds     166              129 
Transfers to BANADESA       575              340 
Int.subsidies paid          196 
                          -----            ----- 
                          2,630            1,856 
 
RESTRICTIONS ON THE DESIGN OF THE POLICY FRAMEWORK 
 
The GOH confronted limitations in trying to design the 
optimal solution to the problem. 
 
First, the repeal of the laws does not eliminate the rights 
authorized to the borrowers which were beneficiaries of each 
law at the time they took effect.  The majority of the 
beneficiaries already had received payments. 
 
All the legal consultations undertaken by the government 
concluded that it was impossible to apply a new legal 
framework retroactively.  This meant that even when the laws 
were repealed, the only gain was that new farmers could not 
benefit from these laws after the date of the repeal 
entering into force. 
 
For this reason, the government had to look for a financial 
mechanism that simultaneously applied the same level of 
fiscal resources already committed and still permitted the 
reduction of future contingencies, effecting an efficient 
distribution of the economic losses already incurred and 
help the farmers reactivate their operations. 
 
The second important restriction is the existence of deposit 
insurance in Honduras, which guarantees 100 percent of the 
deposits by the public in financial institutions that are 
members of the deposit insurance, until September 2003. 
After this point, the insurance will be limited to 50 
percent and later to USD 10,000 per depositor after 
September 2004. 
 
Thus, if the government were to have shifted totally the 
losses of the agricultural sector to the financial system, 
it would have led to an immediate recognition of the losses 
by these financial institutions.  This would have occurred 
in the context of a fragile financial sector with a limited 
capacity to generate profits and an ongoing process of 
financial sector consolidation.  The Government of Honduras 
did not consider it in its interest nor its financial 
capacity to undertake these risks. 
 
RECENT EVOLUTION OF THE AGRICULTURAL SECTOR 
 
The amount of agricultural loans covered by the various 
previous laws represented 7.7 percent of the total loan 
portfolio of Honduran commercial banks and 44.6 percent of 
the agricultural loan portfolio (as of Febrary 28, 2003). 
The continual issuance of decrees during the grace periods 
of the loans kept these loans in low category 
classification, with low provisioning requirements, given 
that they still had not arrived at a period of amortization 
of the principal.  Only 4.3 percent of these refinanced 
credits were provisioned as of January 31, meaning that the 
losses came directly out of bank profits or capital during 
those periods, without eliminating the acquired rights by 
the borrowers. 
 
The mechanism created by Law 68-2003 permits financial 
institutions to gradually absorb the impact of their 
respective losses. 
 
New credit provided to the agricultural sector annually has 
fallen precipitously.  These declines were 5.9 percent in 
1999 and then 15.8 percent, 22.1 pecent, and 51.4  percent 
in 2000, 2001, and 2002.  New agricultural loans represented 
only 4.1 percent of the total credit issued by the banking 
system in 2002, down from 8.3 percent in 1998.  The decline 
in agricultural finance is one of the factors contributing 
the stagnation of agricultural production. 
 
Given the recent experience of the commercial banks with 
agricultural loans, no important reactivation of credit for 
this sector is expected in the next few years.  The 
introduction of new rules for the approval of agricultural 
credit will instead be the source of a process of natural 
selection of debtors and a channeling of credit through 
suppliers like agrochemical firms, agricultural service 
providers, concentrate factories, and agricultural 
processing firms. 
 
In the experience of other countries that have had similar 
problems, the change in the sources of credit for the 
agricultural sector have served to restore a payment culture 
and improve the administration of credit risk in the formal 
financial sector. 
 
In addition, this new situation implies the search for 
alternatives on the part of the GOH for the channeling of 
credit to the small producer, through the contracting of 
specialized technical assistance and within the framework of 
bank consolidation. 
 
End Detailed English Language Summary. 
 
Palmer