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Document of

The World Bank

FOR OFFICIAL USE ONLY

Report No. P-6810-PAN

REPORT AND RECOMMENDATION

OF THE

PRESIDENT OF THE

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

TO THE

EXECUTIVE DIRECTORS

ON A

PROPOSED DEBT AND DEBT SERVICE REDUCTION LOAN

OF US $30 MILLION

TO THE

REPUBLIC OF PANAMA

AND ON RELATED MEASURES

TO

SUPPORT THE DEBT REDUCTION PROGRAM

OF THE REPUBLIC OF PANAMA

MARCH 5, 1996

This document has a restricted distribution and may be used by recipients only in the performance oftheir official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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CURRENCY EQUIVALENTS

US$1 = 1 Balboa

FISCAL YEAR

January 1 - December 31

ABBREVIATIONS AND ACRONYMS

BAC Bank Advisory CommitteeBEP Break-Even PriceBNP National Bank of PanamaCAS Country Assistance StrategyCFZ Colon Free ZoneCPF Complementary Pension FundDDSR Debt and Debt Service ReductionDRE Debt Reduction EquivalentERL Economic Recovery LoanESW Economic and Sector WorkFLIRB Front-loaded Interest Reduction BondIBC International Banking CenterIDB Inter-American Development BankIFC International Finance CorporationIFI International Financial InstitutionsIMF International Monetary FundIRR Internal Rate of ReturnLIBOR London Inter-Bank Offer RateMIGA Multilateral Investment Guarantee AgencyMIPPE Ministry of Planning and Economic PolicyMYRA Multi-Year Rescheduling AgreementNFPS Non-financial Public SectorOECF Overseas Economic Cooperation FundPDI Past Due InterestPDN Post-Deal PricePDP Pre-Deal PriceSBA Stand-by ArrangementSEF Social Emergency FundWTO World Trade Organization

FOR OFFICIAL USE ONLYTABLE OF CONTENTS

Loan and Program Summary ....................................................... i

I. EVOLUTION OF THE ECONOMY AND EXTERNAL DEBT ......................2Background: Distortions and Crisis 2......................................................2Initiation of Adjustment and the Economic Recovery ........................................... 2E xternal D ebt ....................................................... 2

II. PANAMA'S ECONOMIC PROGRAM AND EXTERNAL DEBTSTRATEGY ....................................................... 3Macroeconomic Framework and Performance ..................................................... 3Fiscal Policies and Public Sector Finances ......... .................. __ 4Tax Reform ....................................................... 4Basic Services and Infrastructure ..................................................... 5Labor Market Reform ...................................................... 5Trade Reform ....................................................... 5Price Deregulation ....................................................... 6Poverty Reduction ....................................................... 6External Debt Strategy ....................................................... 6

HI. THE DDSR AGREEMENT ....................................................... 7Eligible Debt ...................................................... 7Menu of Options ...................................................... 7Creditor Response and Allocation of Debt ....................................................... 9Total and Upfront Costs ....................................................... 9Financing and Sources of Official Support ...................................................... 10Debt Service Implications ...................................................... 10

IV. EVALUATION OF THE DDSR OPERATION . . .11................... 1A. Financial Analysis ...................................................... 12Extent of Debt Reduction ....................................................... 12Comprehensiveness of the DDSR Operation . . .................................................... 14B. Material Benefits ...................................................... 15Direct Benefits ....................................................... 16Efficiency of Debt Enhancement Funds . . .................................................... 16Indirect Benefits .......... ............................................ 16Net Material Benefits ........... ...................... . 18C. Macroeconomic Outlook ...................................................... 20Short-Term Prospects ................................................ . .... 20Medium- and Long-term Outlook ...................................................... 21D. Creditworthiness and Debt Management ..................................................... 21Reduced Debt Burden .................................. 21Burdensharing ........................................................ 22Reduced Flexibility ........................................................ 23Exposure Risk ...................................................... . 23

This document has a restricted distribution and may be used by recipients only in the performance of theirofficial duties. Its contents may not otherwise be disclosed wiLhout World Bank authorization.

V. BANK ASSISTANCE STRATEGY AND PROPOSED DDSR LOAN .. 24A. Country Assistance Strategy ........................................................... 24B. The Proposed Debt and Debt Service Reduction Loan ................................. 25Eligibility for DDSR Support ........................................... 25The Proposed DDSR Loan ........................................... , , . ......... 25Conditions of Effectivenesss ............ ................. 26Disbursement Arrangements ,.. . ,,,,,.......... 26Prepayment Provisions ............................. 27Waiver of Negative Pledge Clauses , ............. 27Burdensharing ................................... ,,.......... 27C. Risks and Benefits ............................. 27

VI. RECOMENDATION ............................. 28

LIST OF TEXT TABLESTable 1: Panama - Pre-DDSR Arrears Clearance and Rescheduling ............ ............3Table 2: Panama DDSR - Eligible Debt ...................................................... 7Table 3: Panama DDSR - Terms of Agreement ...................................................... 8Table 4: Panama DDSR - Allocation of Eligible Debt .............................................. 9Table 5: PanamA DDSR - Total and Up-Front Costs ............................................. 10Table 6: PanamA DDSR - Debt Service Implications ............................................. 11Table 7: Panama DDSR - Debt Reduction Equivalent .......................................... 13Table 8: Panama DDSR - Savings and Distribution of Gains ................................. 14Table 9: Panama DDSR - Debt Service Relief ................................... ,,,,,,,,,,.15Table 10: Panama DDSR - Illustrative Macroeconomic Impact . . 20Table 11: Panama DDSR - Creditworthiness and Exposure Indicators . . 22

TEXT FIGURESFigure 1: Panama DDSR - Market Indicators ..................................................... 19Figure 2: Panama DDSR - Impact on Burdensharing and Flexibility ....................... 22

ANNEXESAnnex I: Statistical AnnexAnnex II: Debt and Debt Service Reduction Loan: Supplementary Data SheetAnnex III: Statement of Bank LoansAnnex IV: Statement of IFC InvestmentsAnnex V: Request of Limited Waiver of the Negative Pledge Clause

MAP

This repor Was p ed by Ricbhard LGrtondw LAC) wt theth clla'ort-o of .- a.r..0 Arbe1ez WA2WCO). TheDpartment tDirector is EhtihlerL. ..Seg..a;.teC...yertios..Divsin gChief is (Donna Wse-Coirolo; "and the Lead Economist is Wan Ba -n The Ta- Force for this:oprati included Thom Duva EG DJungr (RSCR}; ijdarshn Goop a ECl_; and Ray lVaMraes COCFVW:).

PANAMA

DEBT AND DEBT SERVICE REDUCTION LOAN

Loan and Program Summary

Borrower: Republic of Panama

Amount: US$30 million

Terms: Standard amortization term, grace period, and interest rate for fixed-rateUS dollar single currency loans with an expected disbursement period of 0-1 years.

Objectives: The objectives of the operation are to assist the Government in: (i)implementing debt and debt service reduction; (ii) consolidating fiscalbalance and structural reforms; and (iii) normalizing relations withcommercial creditors, reestablishing creditworthiness, and acceleratinggrowth and development.

Benefits and Risks: The proposed loan would: (i) restructure almost 70% of Panama's publicand publicly guaranteed debt; (ii) result in a debt reduction equivalent(DRE) of 31% of the eligible commercial debt and 19% of total publicand publicly-guaranteed debt at a savings amounting to about 10.7% ofPanama's GDP compared to the cost of a market-based debt reduction; (iii)yield cash flow savings of US$917 million in 1996-2026 in net presentvalue terms, or 12.4% of GDP, compared to counter-factual debt service;(iv) generate net benefits potentially reaching 10.7% of GDP; and(v) reduce interest rate risk, by changing 53% of eligible debt into fixed-rate instruments and reduce exchange rate risk by converting 17% of thedebt denominated in non-US currencies into US dollars. DDSR is expectedto substantially enhance the effectiveness of the reform program inaccelerating growth to potential by: (i) substantially reducing marketuncertainty over Panama's ability and willingness to fully service itsexternal debt, and the sizable distortions and costs this uncertainty entails;(ii) offsetting the adverse effect on the investment climate and flowsderiving from the disengagement of the U.S. from the Canal and formerCanal Zone; and (iii) reducing the debt overhang and the associated "tax"on future output.

While DDSR would greatly improve Panama's capacity to service debt,it would raise the share of relatively inflexible debt from 21.9 to 90.2%.Nonetheless, the share of preferred creditors in public debt service wouldactually decline in 1996, to about 31% from 45% in 1995. On an accrualbasis, the share of preferred creditors is projected to remain below theBank's guideline of 35% during the next decade. Both debt service to theBank as proportion of public debt service and as a fraction of exports areprojected to remain considerably below Bank guidelines during the nextdecade. Moreover, Panama has several options in the context of the DDSR

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operation to adjust debt service to external shocks, such as capitalizinginterest payments on PDI bonds exceeding an annual interest rate of 4%during the first six years after closing, and/or using the interest collateral topay up to 12 months interest on the par and discount bonds, and up to 6months interest on the FLIRBs. In addition, current fiscal policies, coupledwith the measures the Government is taking to consolidate fiscal balanceover the longer-term, would significantly increase the Government'scapacity to absorb external shocks and implement an efficient debtmanagement strategy. The risk of domestic policy shocks in a post-DDSRworld is considered to be slight.

Disbursements: The proposed loan would be disbursed in one tranche upon loaneffectiveness to help finance the costs of acquiring principal and/or interestcollateral of the par and/or discount bonds, and/or interest collateral of theFLIRBs, and/or to reimburse Panama for such costs if these were alreadyincurred after November 14, 1995.

Poverty Category: Not applicable.

Rate of Return: The internal rate of return (IRR) on the financial resources allocated toDDSR, based on the savings in payments to commercial banks, would be18%. This IR.R is above both the cost at which Panama could borrow theenhancement funds and the critical level employed in the Bank's projectlending.

Appraisal Report: Not applicable.

REPORT AND RECOMMENDATIONOF THE PRESIDENT OF THE

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENTTO THE EXECUTIVE DIRECTORS

ON A PROPOSED DEBT AND DEBT SERVICEREDUCTION LOAN

OF US$30 MILLION TO THE REPUBLIC OF PANAMAAND ON RELATED MEASURES

TO SUPPORT THE DEBT REDUCTION PROGRAMOF THE REPUBLIC OF PANAMA

1. I submit the following report and recommendation for proposed measures to support theRepublic of Panama in the implementation of its Debt and Debt Service Reduction (DDSR)Agreement with its commercial creditors.' The DDSR agreement is comprehensive: it covers allmedium- and long-term commercial bank debt contracted by the Republic of Panama. Eligibledebt approaches US$4 billion, or nearly 70% of Panama's public and publicly guaranteed externaldebt. Eligible debt encompasses all principal and principal arrears (about US$2 billion), all pastdue interest (also close to US$2 billion), and some short-term debt (US$19 million). Remainingshort-term commercial debt in arrears (US$44 million) was restructured under a separateagreement.

2. The DDSR operation involves: (i) an exchange of original principal for par bonds,discount bonds, front-loaded interest reduction bonds (FLIRB) or debt conversion bonds; and (ii)normalization of past due interest (PDI) through partial forgiveness, PDI payments prior toclosing, a down payment on PDI at closing, and a PDI bond. The expected closing date of theDDSR operation is April 30, 1996.

3. Proposed World Bank measures to support the DDSR operation would encompass:

* A DDSR Loan to the Republic of Panama for US$30 million, consisting of US$20 millionin set asides from the three-year lending program and US$10 million in additional funds,to help finance principal and interest collateral of the instruments exchanged for eligibleprincipal; and

* A limited waiver of the negative pledge clauses in loan and guarantee agreementsbetween the Republic of Panama and the Bank to permit a pledge of collateral of up toUS$115 million for the DDSR instruments.

' A note on the DDSR agreement entitled "Panama - Commercial Bank Debt and Debt Service Reduction Operation: BriefingNote," (SecM95-1029), was distributed to the Executive Directors on September 19, 1995. The World Bank alsoprovided a letter to the international banking community outlining possible support for the DDSR agreement. This letterwas included in the Republic of Panama's 1995 Financing Plan (October 4, 1995) which describes the detailed terms ofthe DDSR agreement.

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4. This report analyzes the effects of the proposed DDSR operation on Panama's medium-term growth prospects and creditworthiness, and provides a justification for the deployment ofWorld Bank resources to support DDSR. Section I outlines the domestic origins of Panama'sdebt crisis and initiation of adjustment efforts. Section II discusses the Government's economicprogram. Section III presents the costs, financing plan and debt service implications of the DDSRagreement. Section IV evaluates the DDSR operation in terms of its debt and debt servicereduction, material benefits, and projected effects on Panama's growth prospects andcreditworthiness. Section V discusses the Bank's assistance strategy and the proposed DDSRloan. Section VI presents the recommendations.

I. EVOLUTION OF THE ECONOMY AND EXTERNAL DEBT

5. Background: Distortions and Crisis. Over the past twenty-five years, the sharpsegmentation of the economy by distortionary Government policies has kept output growth farbelow potential. As state expenditure mounted relative to GDP and policy interventionsproliferated, domestic prices of importables and non-traded goods rose faster than internationalprices despite the dollar-based monetary regime, most resources were channeled into rubrics inwhich the economy possesses a comparative disadvantage, productive private investment wascrowded out, foreign investment flows dried up, and the competitiveness of international serviceswas eroded. Social services were expanded greatly, especially social security for public sectoremployees and tertiary education, but unemployment soared and two-fifths of the population waspushed into poverty despite Panama's relatively high per capita income, leaving the country withone of the most unequal distributions of income in the hemisphere. The expansion of the state andinflated levels of domestic absorption were financed by foreign borrowing; in 1980, Panama hadone of the largest per capita commercial bank debts in the world. During the early 1980s, thesedistortions, together with the international debt crisis, plunged the economy into recession. Theeconomic downturn was exacerbated by the political crisis in the late 1980s and the imposition ofexternal economic sanctions. The Government ceased to service its commercial bank, bilateral andbonded debt in 1987, and fell into arrears with the IFIs in 1988. In 1988-89, the money supplyplunged an estimated 30%, and economic activity contracted 16%.2

6. Initiation of Adjustment and the Economic Recovery. During 1990-95, considerablestrides were made in reducing the large imbalances accumulated during 1987-89. Followingresolution of the political crisis, the removal of economic sanctions and implementation of anadjustment program with the support of the IFIs (in the case of the Bank, through the 1992Economic Recovery Loan, or ERL) rekindled confidence and resulted in repatriation of privateassets and large bilateral aid flows that remonetized the economy, and fueled private investmentand pent-up consumption demand. By 1994, per capita GDP surpassed the pre-1987 peak and theunemployment rate had been reduced by 6 percentage points from the 1990 peak; domesticinflation was below international inflation; public finances were in balance; import coverage ofreserves had increased to almost 2 months; and the public and publicly-guaranteed external debthad declined from 133% to 81% of GDP.

7. Growth, however, is decelerating, to an estimated 3.5% in 1995, and unemployment is stillvery high (almost 14%). While the economic recovery substantially strengthened public finances,

2 See World Bank. 1995. Panama: A Dual Economy in Transition. Report No. 13977-PAN (Grey Cover). Washington, D.C.:Country Department II, Latin America and the Caribbean Region.

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the previous Administration was unable to implement the reforms required to consolidate long-term fiscal balance. Progress in carrying out key structural adjustment measures needed to achieveeconomic growth in line with Panama's development potential also was modest. Although theoverall balance of payments position improved considerably, a current account deficit of themagnitude recorded in recent years (about 6.5% of GDP) cannot be sustained in light of the stilllarge debt overhang, sharply declining bilateral aid, and gradual disengagement of the U.S. fromthe former Canal Zone. In the absence of major structural reforms, debt relief and restoration ofcreditworthiness, growth will revert to the less than 3% trend registered during the past fifteenyears now that the economic recovery has run its course.

8. External Debt. Significant progress in normalizing relations with the internationalfinancial community also was achieved during this period (Table 1). In the first quarter of 1992,the Government cleared its arrears with the IFIs and the Paris Club. In April 1994, an agreementwas reached with external bondholders on arrears of about US$472 million. In April 1993, theGovernment initiated negotiations with commercial banks on debt restructuring; however, theparties were unable to reach a financially viable agreement prior to the May 1994 elections.

Table 1: PANAMA - PRE-DDSR Arrears Clearance and Rescheduling

, S . S~~W I*. S S

IFI's 640 February, 1992 Arrears accumulated up to 1990 were fully paid in 1992.In 1991, debt service was resumed.

Paris Club 453 March, 1992 Arrears of US$38 million were paid upfront, and US$415 millionequivalent were rescheduled over 10 years, with 5 years grace.

Commercial Bonds 472 April, 1994 Up-front payment on PDI of US$44 million, with US$428 millionInterest Arrears 188 exchanged for eight-year bonds, of which US$418 million werePrincipal Arrears 253 denominated in US dollars, with an interest rate of LIBOR+ 1 %, andScheduled Principal 30 US$10 million in yen with an annual interest rate of 3.75%.

II. PANAMA'S ECONOMIC PROGRAM AND EXTERNAL DEBT STRATEGY

9. The Administration inaugurated in September 1994 has made great headway inimplementing the reforms needed to consolidate fiscal and external balance, and to redress thepervasive price distortions that are preventing the economy from realizing its developmentpotential, and causing high unemployment and widespread poverty. Moreover, the scope anddepth of the public enterprise, tax, labor market, and trade reforms which the Government iscarrying out go beyond the actions agreed in these areas in the ERL. Full normalization ofrelations with external creditors forms an integral part of the Government's economic program.

10. Macroeconomic Framework and Performance. In 1995, the nonfinancial public sector(NFPS) registered a deficit (accrual basis) of an estimated 0.6% of GDP. Inflation was less than1%, which marked the seventh consecutive year in which domestic was less than externalinflation. This, coupled with the further depreciation of the US dollar against reserve currencies,led to a depreciation of Panama's real effective exchange rate of about 4%, following acumulative depreciation of 18% during 1989-94. The current account deficit (commitment basis)is estimated to have declined to about 6.5% of GDP in 1995 from about 7% in 1994, dueprimarily to a recovery of exports from the downturn registered in 1994, and despite a decline inservice income from U.S. Defense Department activities. The overall balance of payments(excluding arrears accumulation) recorded a deficit of an estimated 2% of GDP; but net external

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financing, including accumulation of arrears, reached about 5% of GDP, enabling the NFPS toaugment its net deposits at the National Bank of Panama (BNP) by 3 percentage points of GDP.At end-1995, the public and publicly-guaranteed extemal debt was an estimated US$5.8 billion, or78% of GDP (against 81% in 1994); about US$3.8 billion was owed to commercial banks,US$0.7 billion to IFIs, US$0.7 billion to bilaterals, and the remainder to bondholders (US$0.4billion) and suppliers (US$0.2 billion).3

11. Despite the favorable evolution of these indicators, real GDP growth decelerated to anestimated 3.5% in 1995 from 4.7% in 1994, while the unemployment rate edged-up to 14%.Growth continued to decelerate sharply across all the sectors which led the economic recovery,especially construction (in which growth declined to an estimated 3% in 1995 from 32% in 1993),the Colon Free Zone (to 5% from 14.5%), manufacturing (to 3% from 7%) and the InternationalBanking Center (to 5% from 11%). In some sectors the slowdown appears to have beenaccentuated by uncertainty over the outcome of major changes to tax, labor, trade and stateenterprise legislation initiated in 1994. The underlying causes of this slow growth, however, arepronounced price distortions and deficient basic services which have kept trend growth well under3% for the past two decades, and which the Government's reform program is now redressing.

12. Fiscal Policies and Public Sector Finances. The 1996 budget approved by theLegislative Assembly targets a shift in NFPS operations to a surplus of 0.4% of GDP (exclusiveof expected privatization proceeds of 3.2% of GDP), with NFPS savings targeted to rise to 5.1%from 3.4% of GDP in 1995. This result would be achieved through a reduction in externalinterest obligations by an estimated 2.3% of GDP as a result of the DDSR operation, andcontainment of the wage bill through a continuation of the hiring freeze (excluding the health,education and security sectors, which are subject to constitutional provisions) and the wage freeze(other than the automatic wage adjustments mandated by the special labor laws). This program isbeing supported by the IMF SBA as well as by the ERL. Consolidation of long-term fiscalbalance hinges on bringing public sector wage bill growth and social security spending undereffective Government control. To this end, the Government is preparing, with the support of theERL technical assistance component, a General Public Sector Wage bill that would replace thespecial public sector labor laws and introduce a merit-based civil service. The Authorities plan tosubmit the bill to the Assembly in June 1996, and implement the new employment and wagepolicies in the 1997 budget. A bill to liquidate the insolvent Complementary Pension Fund (CPF)for state employees, also being prepared with the support of the ERL, would be submitted to theAssembly in June, 1996, together with the General Public Sector Wage bill and associated reformsto the special labor laws. The new pension policies also are expected to be implemented in the1997 budget. This solution would gradually eliminate CPF-related Government transfers (about0.4% of GDP in 1995) and significantly improve equity of social expenditures. In addition, bySeptember 1996, the Government intends to prepare a proposal for the reform of the SocialSecurity System.

13. Tax Reform. In July 1995, the Legislative Assembly approved the Fiscal IncentivesHarmonization Law, which significantly reduces distortions and allocative inefficiencies caused bythe tax system, while enhancing fiscal sustainability. This Law, also prepared with support of theERL technical assistance component, unified the corporate tax rate at 30%; gradually phases-outmost of the tax breaks and subsidies to import-substituting activities; extends to all importers the

3 At end-1995, the total net debt of the NFPS, i.e, including domestic debt less NFPS deposits at the BNP, amounted to US$4.9billion, or, 66% of GDP. See Annex I for these and other text figures which are not specifically referred to text tables.

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preferential import tariff of 3%; increases the tax rate on traders in the Colon Free Zone from arange of 2.5-8.5% to 15%; phases-out the generous tax credit for nontraditional exports, andreduces home mortgage subsidies through more narrow targeting.

14. Basic Services and Infrastructure. The Government reform program in basic services,which is being supported by the IDB and the Bank, is focusing on regulatory reform,contestability and privatization by: (i) separating policy formulation, regulatory and servicedelivery functions within each subsector and restructuring operating entities along commerciallines in accordance with private corporate law; and (ii) unbundling the operations of utilities andpublic works entities to enable competition in those aspects of service delivery which do notpossess natural monopoly characteristics, and opening each subsector to private participation.

15. To this end, in telecommunications, in February 1995, the Legislative Assembly approveda law which provides for the incorporation and partial privatization of the telecommunicationsfirm, and in July 1995, approved a law which effectively opens the cellular telephone market tothe private sector. In January 1996, the Assembly approved the General Telecommunications Lawand in February 1996, the Basic Services Regulatory Entity Law (telecoms, electricity, water andsanitation). In electricity, in February 1995, the Assembly approved an amendment to theelectricity company charter law that opens the generation, transmission and distribution ofelectricity to the private sector, and the Government has initiated a BOO structure for privatedevelopers for a 100MW thermal power plant. The General Electricity bill, being prepared withWorld Bank support, is expected to be submitted to the Assembly in the second quarter of 1996.In water and sanitation, with the support of the IDB, the Government is preparing a GeneralWater and Sanitation bill that would permit private participation in the sector, for submission tothe Assembly in the second quarter of 1996. In the port sector, all of the state port authority's(APN) service delivery functions will be transferred to private operators, and APN will betransformed into a regulatory entity through. legislation to be submitted to the LegislativeAssembly in the second quarter of 1996. The transfer to private operators of all the installations inthe main state ports still managed and operated by APN is also to be completed by during thatperiod. In addition, contracts for ownership, construction and operation of four new ports havebeen signed with private operators. Manzanillo, a US$100 million state-of-the-art privatecontainer port and trans-shipment facility, developed with the support of IFC, commencedoperations in 1995, is Panama's main port facility, and is enabling the country to begin to realizeits potential as an international maritime transport center. The Government also is focusing onrehabilitation, deregulation and private participation in transport infrastructure. Concessions havebeen awarded to foreign firms to construct and operate tollroads between Panama City andColon, and between the international airport and Panama City. Finally, in December 1995, theLegislative Assembly approved a new Public Procurement Law, which brings public sectorprocurement procedures more in line with international standards.

16. Labor Market Reform. In August 1995, the Legislative Assembly overhauled the highlyrestrictive Labor Code, curbing the intervention of Government in employer-employee relationsand giving employers more flexibility to determine wages, to tailor employment to marketconditions, and to reassign employees within the firm.

17. Trade Reform. In addition to the improvements introduced by the Fiscal IncentivesHarmonization Law, the Government has completed almost all the bilateral negotiations requiredfor the accession of Panama to the World Trade Organization (WTO); upon entry into the WTO,which is expected in mid-1996, nominal tariffs will be reduced from the current range of 0-90% to

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0-40% (with the exception of tariffs on certain agricultural commodities), and to a range of 0-30% within five years, while nontariff barriers will be consolidated in the new tariff structure. InDecember 1995, the Cabinet issued a decree which significantly reduces tariffs on the mainagricultural commodities and eliminates nontariff barriers to the import of these products.

18. Price Deregulation. In December 1994, the Government issued a decree which relaxesrent controls, and in December 1995, issued a series of resolutions which remove remainingprice controls on the main agricultural commodities. In January 1996, the Legislative Assemblyapproved a law that would further curb barriers to competition by abolishing the Price ControlOffice, institute anti-trust norms, and introduce anti-dumping provisions in line with WTOstandards. At the sector level, the monopoly affecting the transport of goods to and from the CFZhas been declared illegal by the Supreme Court; entry into the trucking industry is beingliberalized, and the Government plans to reform the highly regulated domestic petroleum market.

19. Poverty Reduction. The Government's strategy for mitigating poverty and inequalityrests on the introduction of conditions that will revive sustainable growth and retargeting socialspending to the poor. In this context, the economic program emphasizes reform policies that willmitigate the bias against employment creation and reduce the high cost of the consumptionbasket. In addition, the incentive framework will be altered so as to encourage increasedagricultural production and employment opportunities in the countryside, where most of the poorare located. The Government also is instituting new mechanisms to protect those most susceptibleto malnutrition and vector-transmitted diseases, through the Social Emergency Fund (SEF), andimproving efficiency and equity in social expenditures through sector reforms, especially ineducation and health; instituting cost recovery, and targeting subsidies to the most vulnerablegroups. The Bank is supporting these efforts through the ERL; the Rural Health Project; theproposed Basic Education Project; the proposed SEF Project; the proposed Land Managementand Rural Poverty project; and a Poverty Assessment.

20. External Debt Strategy. Integral to the Government's economic program is a strategy tofully normalize relations with creditors, restore Panama's creditworthiness and create a climateconducive to foreign investment. To this end, the Administration initiated informal conversationswith the commercial banks upon taking office in September 1994, resumed formal negotiationswith the BAC in December 1994, and moved rapidly to achieve a comprehensive agreement thatwould significantly reduce the debt stock; bring future debt service payments into line with theeconomy's projected debt service capacity; and shield future commercial debt service paymentsfrom interest rate and exchange rate risk. From the outset the Government was also cognizant ofthe need to achieve an agreement that would be cost effective as well as financially viable givenprevailing resource constraints. Indeed, the need for official support for DDSR played animportant role in the speed with which the Government has moved on outstanding structuraladjustment issues. In line with its strategy, the Government also is negotiating with non-ParisClub bilaterals (Mexico and Venezuela) to restructure about US$280 million in medium-termdebt, including arrears of about US$248 million. Additionally, on December 27, 1995, theLegislative Assembly approved Panama's accession to MIGA, and ratified the Convention on theSettlement of Investment Disputes, further strengthening guarantees to foreign investors.

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m. THE DDSR AGREEMENT

21. On May 5, 1995, the Republic of Panama and the BAC achieved an agreement inprinciple on a DDSR operation. On October 4, 1995, the term sheet was issued; the expectedclosing date is April 30, 1996. The DDSR operation is comprehensive, and reduces debt and debtservice through a menu of options for exchanging eligible debt for new instruments, andsubstantial PDI forgiveness. This section details the main provisions of and creditor response tothe DDSR agreement; closing costs and financing sources; and its debt service implications.

22. Eligible Debt. The DDSR operation encompasses all medium- and long-term commercialbank debt contracted by the Government and state entities. Eligible debt is about US$3.9 billion(including about US$2 billion of PDI), or nearly 70% of Panarna's public and publicly guaranteedexternal debt (Table 2 below). Eligible debt includes all principal arrears and PDI as of the closingdate, as well as remaining scheduled principal on medium- and long-term commercial bank loans,which falls due during the rest of 1996 and in 1997.4 The eligible debt almost doubled between1987, when Panama ceased to service this debt, and the expected closing date.

Table 2: PANAMA DDSR - Eligible Debt(US$ Million)

1987 1988 1989 1990 1991 1992 1993 1994 1995 a/ 1996 a/

DOD end-of-period 1970 2182 2422 2664 2886 3076 3255 3451 3809 3936 b/Disbursements 0 0 0 0 0 0 0 0 0 0Amortizationnotpaid 209 632 307 124 126 106 105 99 133 127c/Interestnotpaid 2 212 240 242 222 190 179 196 358 127d/

Memo:Amortization arrears 209 841 1148 1272 1398 1504 1609 1708 1841 1968Interest arrears 2 214 454 696 918 1108 1287 1483 1841 1968

a/ Estimated. Final figures will be determined when reconciliation is completed.b/ Includes all principal falling due in 1996 and 1997.c/ Includes US$127 million of scheduled principal due in 1996 and 1997 under termns of DDSR Agreement.d/ Includes interest due and not paid through the expected April 30, 1996 Closing Date ofthe Agreement.

Source: Panama. MIPPE, and World Bank staff estimates.

23. Menu of Options. The DDSR menu offers creditors four options for exchanging theirprincipal claims (Table 3 below). The operation treats PDI separately. Each of the options isfreely available to holders of debt titles on a voluntary basis, and the options selected are notsubject to reallocation. No creditor, however, will be permitted to participate in the Agreementunless it does so with all of its eligible debt. These options are:

(i) Par Bonds (registered) at below-market interest rates, commencing at 3% in year oneand rising to 5.5% in years eleven through thirty, with a bullet payment upon maturity (30 years);

(ii) Discount Bonds (registered) with a discount of 45%, at an interest rate of LIBOR plus13/16%, with a bullet payment upon maturity (30 years);

(iii) Front-Loaded Interest Reduction Bonds (registered) at below-market interest ratesduring years one through seven, commencing at 3.5% in year one and gradually rising to 5% inyear seven, and at the six-month LIBOR plus 13/16% thereafter, with a maturity of 18 years and agrace period of 5 years; and

4 Eligible debt also includes US$19 mnillion in contingent liabilities. In December 1995, Panama also reached an agreement torestructure remaining commercial arrears (US$44 million in short-term credits): US$10 million in PDI was paid upfront,another US$10 million PDI payment will be made in April 1996, and the principal was rescheduled over four years.

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(iv) New Money Option: Creditors who select the new money option will purchase DebtConversion Bonds equal to the full face amount of principal tendered in the exchange and alsowill commit to purchase an amount of New Money Bonds equal to 10% of the eligible debtexchanged for Debt Conversion Bonds by such creditor, on the terms indicated in Table 3.

Table 3: PANAMA DDSR - Terms of Agreement

Instruments Maturity interest Collateral Form

Menu of Ontions1. Par Bonds (with 30 yr. bullet Yr. 1: 3.00% Principal secured by thirty-year Registeredbelow market Yr. 2: 3.25% zero coupon US. Treasury securities.interest rates) Yr. 3: 3.50% Rolling interest guarantees starting

Yr. 4: 3.75% with 9 months coverage at an assumedYr. 5-6: 4.25% interest rate of 3.07% per annum andYr. 7-8: 4.75% increasing in 3 years to cover 12 monthsYr. 9-10: 5.25% at an assumed interest rate of 4.25%,Yr. 11-30: 5.50% secured by cash or permitted investments.

2. Discount Bonds 30 yr. bullet 6 month LIBOR + Principal secured by thirty-year Registered(45% on face value) 13/16% zero coupon U.S. Treasury securities.

Rolling interest guarantees startingwith 9 months coverage at an interest rateof 7.0% per annum, increasing in 2 years tocover 12 months at a rate of 7.5%, securedby cash or permitted investments

3. Front-Loaded 18 yr. with 5 yr. of grace Yr. 1: 3.50% Rolling interest guarantees upto RegisteredInterest Reduction and 27 semi-annual Yr. 2: 3.75% year 7 covering 6 months at an assumedBonds (par exchange) equal installments Yr. 3:4.00% rate of 3.55% per annum and increasing

Yr. 4: 4.25% by reinvestment of interest on collateralYr. 5: 4.50% to cover up to six months at an interest rateYr. 6: 4.75% of 5%, secured by cash or pernittedYr. 7: 5.00% investments. No principal collateral.Yr. 8-18: 6 monthLIBOR + 13/16%

4. New Money Optiona. Debt Conversion Bonds 20 yr. with 9.5 yr. of Yr. 1: 4.50% None Registered(par exchange) grace and 22 semi-annual Yr. 2-4: 4.75%

equal installments Yr. 5-7: 5.75%Yr. 7-20: six monthLIBOR + 13/16%

b. New Money Bonds 15 yr. with 7.5 yr. of 6 month None Registered(10% of new money exchanged grace and 16 semi-annual LIBOR + 13/16%for Debt Conversion Bonds) equal installments

Past Due Interest1. US$130 million cash

2. PDI Bonds (US$1248 20 yr. with 10 yr. grace 6 month LIBOR + None Registeredmillion par exchange) and 21 semi-annual 13/16 %

installments as follows:installments 1-8: 2% ofprincipal; 9-11,3%; 12-21,7.5%

3. Forgiveness (US$590 million)

Source: Republic of Panama, 1995 Financing Plan (October 4,1995), and Panama. MIPPE.

24. The principal of the discount and par bonds will be collateralized in full by the pledge of30 year U.S. Treasury zero-coupon bonds delivered on the closing date. Payment of nine monthsof interest would be secured on a rolling basis by the pledge of cash or permitted investmentsdelivered on the closing date. Panama will pledge additional cash or permitted investments sothat, on the third anniversary of the issuance of these bonds, the payment of twelve months ofinterest would be so secured. The principal of the FLIRBs is not collateralized. Until the seventh

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anniversary after closing, payment of 6 months of interest on the FLIRBs would be collateralizedon a rolling basis by the pledge of cash or permitted investments delivered on the closing date.Earnings on the collateral accounts would accrue to Panama once the collateral requirements aresatisfied. Applications will be made to list all bonds on the Luxembourg stock exchange.

25. The agreement restructures PDI by means of: (i) PDI forgiveness; (ii) partial PDIpayments prior to closing; (iii) a downpayment on PDI at closing; and (iv) a PDI bond forremaining PDI. A major component of debt reduction would be obtained through a recalculationof interest on principal at market rates (six-month LIBOR plus 13/16%) and of interest on suchinterest at the one-month LIBOR instead of contractual rates, and by waiving all contractualpenalties. This favorable treatment results in PDI forgiveness of US$590 million. During June-December 1995, Panama made partial payments on PDI totaling US$24 million, and will make afurther payment of US$6 million at the end of March, 1996. At closing, Panama will make aUS$100 million downpayment on PDI. Remaining PDI (US$1248 million) would be exchangedfor PDI Bonds. These bonds would carry a maturity of twenty years, a grace period of ten years,and an interest rate of the six month LIBOR plus 13/16% per annum. During the first six yearsfollowing the closing date, Panama will have the option to capitalize a portion of accrued interestin an amount up to the difference (if positive) between LIBOR plus 13/16% per annum and 4%per annum. The PDI bond is a back-loaded amortization instrument: For installments 1 to 8, eachsemi-annual principal payment will be equal to 2% of the outstanding principal; for installments 9to 11, to 3%; and for installments 12-21, 7.5%. The PDI bond is not collateralized.

26. Creditor Response and Allocation of Debt. Creditors responded to the 1995 FinancingPlan with commitments for 98.5% of the debt eligible by the November 14, 1995 date requestedby Panama: 81.9% of these commitments was allocated to the FLIRBs; 13.6% to the par bonds,and 4.5% to the discount bonds (Table 4 below). While this allocation results in less debt anddebt service reduction than a balanced one, it also results in considerably lower up-front costs.

Table 4: PANAMA DDSR - Allocation of Eligible Debt

US$ Millions PercentPrincipal 1,968.0 100.00Discount Bonds 87.8 4.46Par Bond 268.0 13.62FLIRBs 1,612.2 81.92

Past Due Interest 1,968.0 100.00Payments prior to closing 30.0 1.52PDI Downpayment at closing 100.0 5.08PDI Forgiveness 590.4 30.00PDI Bonds 1,247.6 63.40

27. Total and Upfront Costs. The total costs of closing the DDSR agreement would amountto an estimated US$226 million, of which US$193 million would be paid to creditors on theclosing date (Table 5 below). Of the total cost, US$130 million corresponds to payments on PDI,consisting of a US$100 million PDI downpayment that Panama would effect on the closing date,and US$30 million in partial PDI payments made during June, 1995-March, 1996. The remainderis composed of the cost of the collateral for the discount bonds (US$12 million), the par bonds(US$56 million), and the FLIRBs (US$29 million). The principal collateral (US$55.3 million) hasalready been purchased. The cost of the interest collateral is predetermined at 5.25% of thediscount exchange, 2.3% of the par exchange, and 1.77% of the FLIRB exchange.

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Table 5: PANAMA DDSR - Total and Up-Front Costs(US$ Millions)

Eligible Debt for Menu Options Principal PDI TotalEligible Debt 1,968.0 1,968.0 3,936.0PDI payments prior to closing 30.0 30.0PDI Downpayment 100.0 100.0PDI Forgiveness 590.4 590.4Eligible Debt for Menu Options 1,968.0 1,247.6 3,215,6

Menu Options Debt Allocation (% of total)Principal

Discount Bonds 4.46 87.8Par Bonds 13.62 268.0FLIRBs 81.92 1,612.2

Past Due InterestPDI Bonds 100.0 1,247,6

Financing Costs a]PDI payments prior to closing 30.0PDI downpayment at closing 100.0Cost of Collateral 96.3

Principal 55.3Interest 40.9

Total 226.3(o/w Up-front Costs) (222.6)

Financing: 226.3IBRD 30.0IMF 30.0IDB 30.0Panama 136.3

a/ Includes collateral "top-ups" of about US$4 nillion in 1997-99.

Source: Panma. MIPPE, and World Bank staff estimates.

28. Financing and Sources of Official Support. The Government has requested support

from the World Bank, the IMF and the IDB to help finance the costs of DDSR. On November

29, 1995, the IMF approved a 15-month Stand-by Arrangement (SBA), for SDR 69.8 million to

support the Government's economic program and DDSR. The SBA includes set asides (25% of

each purchase), and would accommodate an augmentation of the SBA, to support the DDSR. Itis expected that the request for Augmentation of the SBA (by SDR 14 million) and release of the

accumulated set asides (SDR 5.8 million) would be presented to the IMF Board on March 20,1996. On December 13, 1995, the IDB approved a DDSR Loan of US$30 million to Panama.

Disbursement is contingent, inter alia, on the approval by the IMF of the DDSR Augmentationand release of the accumulated set-asides, and the approval by the World Bank of a DDSR loan.

The proposed World Bank loan of US$30 million to support the DDSR operation would be

structured as a free-standing instrument. The Government would finance the remaining upfront

costs of the DDSR agreement, estimated at US$103 million, as well as the additional costs of

about US$30 million, from its own resources (Table 5 above). The Government recently has

strengthened its net deposits at the BNP by meeting the second tranche release conditions of the

IDB Public Enterprise Reform Loan (US$35 million), and achieving compliance with the second

tranche release conditions of the World Bank ERL (US$25 million), which also would trigger the

release of the second tranche (US$27 million) of a Japan OECF loan which cofinances the ERL.

29. Debt Service Implications. The DDSR operation results in three phases of debt service:

(i) the first five years, when only interest payments are due on the DDSR instruments; (ii) years 6

to 20, when amortization payments on both the PDI bonds and the FLIRBs are made; and (iii)

years 21 to 30, when, following the retirement of the PDI bonds, the FLIRBs and amortization of

official loans, interest payments are due only on the discount and par bonds (Table 6 below).

TABLE 6: PANAMA DDSR - Debt Service Implications(US$ Millions)

Discount Par FLIRBs PDI Total Official TotalBonds Bonds Bonds New Bonds Lending

1996 1 4 28 36 70 1 71

1997 3 8 58 74 144 5 149

1998 3 9 62 79 153 5 159

1999 3 10 67 84 163 13 176

2000 3 11 71 88 172 20 193

2001-2016 a/ 4 14 157 196 371 11 382

2017-2026 a/ 9 28 0 25 61 0 61

Annual averages. Totals may not add due to rounding effors.

Source: World Bank staff estimates.

IV. EVALUATION OF THE DDSR OPERATION

30. This section analyzes the DDSR operation in respect of its: (i) debt reduction equivalent;(ii) financial savings as compared to a market buyback; (iii) material benefits; and (iv) impact ondebt management and creditworthiness.5 Implementation of the DDSR operation would:

(i) restructure almost 70% of Panama's public and publicly guaranteed debt;

(ii) result in a debt reduction equivalent (DRE) of US$1209 million, or 31% of theeligible commercial debt and 19% of total public and publicly-guaranteed debt;

(iii) achieve this debt reduction at a savings amounting to about 10.7% of Panama's GDPcompared to the cost of a market-based debt reduction;

(iv) yield cash flow savings of US$917 million in 1996-2026 in net present value terms,or 12.4% of GDP, compared to counter-factual debt service, resulting in an IRR of 18%;

(v) generate net benefits, potentially reaching 10.7% of GDP;

(vi) reduce interest rate risk, by changing 53% of eligible debt into fixed-rate instrumentsand reduce exchange rate risk by converting 17% of the debt denominated in non-UScurrencies into US dollars;

(vii) within a reduced overall debt burden, curtail Panama's flexibility to adjust future debtservice obligations to shocks, inasmuch as 70% of Panama's external debt heretoforesubject to rescheduling would be transformed into bonds; and

(vii) augment the relative exposure of the IFIs, from 12 to 18% of Panama's public debt.

5 This analysis follows the approach proposed in "Analytical Aspects of Debt and Debt Service Reduction Operations,"SecM92-296, March 9, 1992. See also World Bank (1995). Prograrn Completion Report. Argentina: Debt and DebtService Reduction Loan (Loan 3555-AR). Report No. 13885.

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A. Financial Analysis

31. Extent of Debt Reduction. The DDSR results in a DRE of US$1209 million or 31% ofeligible debt (see Table 7 below).6 This DRE is composed of: (i) a decrease in the face value ofcommercial debt of about US$730 million, as a result of: (a) the downpayment at closing of PDI(US$100 million), (b) partial PDI forgiveness (US$590 million), and (c) an exchange of 4.5% ofprincipal at a discount of 45% (US$40 million); (ii) the principal prepayment equivalent ofcollateral placed beyond Panama's reach (US$96 million); and (iii) the net present value ofinterest service reduction through the par bond and FLIRB exchanges (US$383 million).

32. This DRE of eligible commercial bank debt is relatively low compared to the average(35%) secured in previous DDSRs. First, the relatively high market price of the debt prior to theagreement placed a relatively low ceiling on potential DRE. In fact, the pre-deal price ofPanamanian debt (55 cents) was far above the average for other DDSR countries (34 cents). (SeeTable 8 below.) The strength of the pre-deal price stemmed in part from the lengthy period oftime that has elapsed since announcement of the Brady plan (subsequent to that date secondarymarket debt prices generally have recovered) and in part from the stronger fiscal/balance ofpayments position of Panama relative to other Brady countries. Second, the recent drop ininternational interest rates vis-a-vis the DDSR interest rate caps lowered the DRE. At the interestrates obtaining when the Agreement in Principle was issued (May 5, 1995), the DRE would havebeen 32.7% (with actual commitment allocations). Third, the low share (32%) of eligible debt stillowned by the BAC limited its ability to negotiate debt reduction: in particular, it precluded theinclusion of a mandatory rebalancing clause in the DDSR agreement. Fourth, the unexpectedlyhigh share of commitments to the FLIRBs reduced the DRE relative to a balanced allocation.7

This result also reflects the relative confidence of investors in Panama's long-term economicprospects and creditworthiness (FLIRB principal is not collateralized), as well as the growingpreference of traders for high-yielding instruments in emerging markets. Finally, Panama's poortrack record in meeting commitments to commercial creditors likely curtailed its negotiatingcapacity--Panama had not made any service payment on this debt since 1987; was one of the twocountries to have defaulted on an international bond issue during the debt crisis; and almost alleligible countries had already concluded DDSR agreements.

33. Nonetheless, the DDSR results in a total DRE (net of additional official financing) ofPanama's total public and publicly guaranteed debt of 19%, a reduction greater than that achievedin previous agreements (16%). Moreover, total DRE amounts to 15% of Panama's GDP, or aproportion several times the average in previous operations (5%). Although Panama obtained aDRE of eligible debt below the average for previous countries, the DDSR operation is crucial toPanama's future growth prospects due to the heavy weight of commercial debt in Panama's totaldebt, and to the large debt overhang affecting the economy.

6 This DRE reflects the actual allocation of eligible debt (see Table 4 above) and interest rates prevailing on February 1, 1996.By convention, the DRE excludes the DDSR agreement PDI payments (US$30 million) made prior to closing.

7 With a balanced commitment allocation, and using February 1, 1996 interest rates, the DRE would have been 40.2%;however, upfront costs would have been US$366 million rather than the actual figure of US$226 million. Furthermore,in this case the buy-back equivalent price of the operation would have been higher than the secondary market priceprevailing prior to the DDSR Agreement in Principle.

Table 7: PANAMA DDSR - Debt Reduction Equivalent

(US$ Millions)

Face Value of Changes Adjustments Debt Reduction Equivalent (DRE)

Face Face New Net Face Face Value Present Prepayment Net Commercial Commercial Aditional Total Total Total DRE DREValue Value Money Value of of Value of Equivalent Adjus- Debt DRE as a % Official Debt Debt as % of as percentageEligible Debt Commercial New Interest Collateral ments Reduction of Eligible Lending Reduction d/ Total of GDPDebt a/ Reduction Debt Commercial Service Equivalent Debt Equivalent Debt

Reduction Debt Reduction b/ (DRE)(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15)

[(2)_(3)] [(1)_(4)] [(6)+_(7)] [(4>_(8)] __Y_1__ _I_0__1__ [(12__(13)]

Pansam 3906 730 0 730 3176 383 96 479 1209 31 90 1119 5806 19 15

Pricispal 1968 39 0 39 1929 383 96 479 519 26DiacountBonds 88 39 0 39 48 0 12 1 2 51 58ParBonds 268 0 0 0 268 95 56 151 151 56FLIRBs 1612 0 0 0 1612 288 29 317 317 20New Money Option 0 0 0 0 0 0 0 0 0

Pat Due Interest 1938 690 0 690 1248 0 0 0 690 36PDI Bonds 1248 0 0 0 1248 0 0 0 0 0

PDI Down Payment 100 100 0 100 0 0 0 0 100 100PDI Retroactive Reduction 590 590 0 590 0 ° 0 | 590 100

Ecuador 7429 1315 0 1315 6114 1031 528 1559 2874 39 305 2569 12522 21 18Mexico 47170 7061 1027 6034 41136 7090 7166 14256 20290 43 3732 16558 81205 20 8Philippmes c/ 6600 2603 828 1775 4825 1107 472 1579 3354 51 465 2889 26004 11 7CostaRica 1608 1029 0 1029 579 115 37 152 1181 73 177 1004 3979 25 19Venezuela 19011 1921 1166 755 18256 2491 1729 4220 4975 26 687 4288 26170 16 10Uruguay 1610 628 89 539 1071 158 111 269 808 50 140 668 4625 14 8Nigeria 5339 3310 0 3310 2029 612 357 969 4279 80 0 4279 34625 12 13Argentina 29335 3265 0 3265 26070 5159 3032 8191 11456 39 2117 9339 58426 16 4lordan 895 142 0 142 753 114 120 234 376 42 0 376 7184 5 8Brazil 57600 3994 350 3644 53956 3196 3783 6979 10623 18 0 10623 93573 11 2Bulgaria 8174 3146 0 3146 5028 302 389 691 3837 47 231 3606 12211 30 35Poland 14333 6780 135 6645 7688 1425 599 2024 8669 60 380 8289 43623 19 10DominicanRepublic 1186 687 0 687 499 0 58 58 745 63 0 745 4284 17 8

Weighted Average 35 16 5a/ Does not include US$30 million of PDI paid by Panama before the closing date.

b/ For Panama calculated at the interest rates prevailing on December 1, 1995, for other countries, calculated at the market rates prevailing at the time of their respective agreements.Figures include the expected present value of interest service under recapture clauses, where applicable.

c/ The Philippines operation was concluded in two phases.

d/ At the beginning of the year in which the DDSR operation was concluded. Includes Long Term and Medium Term Public Debt,

interest arrest on this debt and net use of IMF resources.

Source World Bank staff estimates.

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Table 8: PANAMA DDSR - Savings and Distribution of Gains

DDSR Market Value Market Value Break-Even Post Deal Savings relative to Pre-Deal Distribution of Gains

Operations of Enhancements of New Instru- Price (BEP) Price (PDN) market buy-back Price (PDP) PDN-BEP/

Millions of ments. Millions cents per cents per PDN-BEP/PDN cents per PDN-PDP/

dollars b/ of dollars c/ dollar d/ dollar e/ percent dollar f/ percent

(1) (2) (3) (4) (5)=(4-3)/(4) (6) (7)=(4-3)/(4-5)

Panama 167 2249 0.60 0.80 25% 0.55 81%

Mexico 5252 20206 0.41 0.52 21% 0.36 69%

Philippines 670 3749 0.46 0.52 12% 0.40 50%

Costa Rica 210 383 0.24 0.39 38% 0.12 56%

Venezuela 1819 10678 0.50 0.61 18% 0.37 46%

Uruguay 423 1048 0.60 0.74 19% 0.56 78%

Nigeria 1623 2131 0.40 0.45 11% 0.21 21%

Philippines a! 986 2504 0.52 0.76 32% 0.52 100%

Argentina 3086 13425 0.46 0.56 18% 0.18 26%

Bulgaria 628 1978 0.24 0.30 20% 0.20 60%

Poland 1951 5381 0.51 0.84 39% 0.30 61%

Average 1529 5794 0.45 0.59 23% 0.34 59%

a/ Second Phase.

b/ Prepayment of collateral (interest collateral valued at 1-secondary market price), plus PDI downpayment and cash for buy-back.

c/ For Panama based, on average quotations of when and if issued instruments through January 11, 1996.

d/ BEP = (Market value of new portfolio)/(Eligible Debt). The BEP measures the average price at which the DDSR occurred.

e/ PDN = (Market value of new instruments net of enhancements)/ (Eligible Debt-DRE).

f/ PDP is the price in the month before DDSR was announced, except for Philippines Phase 2, Bulgaria, Poland and Panama, Bulgaria, Poland

and Panama, where it is the price before negotiations started.


34. Comprehensiveness of the DDSR Operation. The DDSR operation achieved debt reliefat a substantially lower financial cost to Panama than a market-based debt reduction would haveentailed, as the comprehensiveness of the menu approach virtually eliminated the free riderproblem associated with a market-based debt reduction. In effect, the DDSR occurred at anaverage market price of 60 cents on the dollar, or a price about 25% lower than the post-dealprice at which an open market operation with a like amount of debt reduction could occur, whichis similar to the average in previous DDSR operations (Table 8 above).8 The resulting savingscompared to a market-based debt reduction are about US$792 million, or 10.7% of GDP. Thesesavings are several times greater than those garnered by other countries through DDSR (3% ofGDP on average). At the same time, Panama obtained 81% of the overall benefits generated bythe operation, compared to an average of 59% for previous DDSR operations. The DDSR also iscost effective, as measured by the IMF.

8 The post-deal price is approximated by the price of the non-collateralized portion of the creditors' new portfolio. Thisstripped price is calculated as the market value of the new instniments minus the principal prepayment equivalent of thecollateral, divided by the face value of the new instruments minus the DRE. World Debt Tables 1993-94, Vol. 1, Box 2.3.

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Table 9: PANAMA DDSR - Debt Service Relief a/(US$ Millions)

1996 1997 1998 1999 2000 2001-2016a/ 2017-2026a/

DDSR Agreement

(1) Downpayment on PDI 100

(2) Collateral Purchases 93 1 1 1 0 0 0

(3) Amortization 0 0 0 0 0 206 42

(4) Interest Payments 70 144 153 163 172 165 19

(5) Earnings on Collateral 0 0 0 0 0 1 1

Additional Official Lendine b/

(6) Loan Amount 90

(7) Amortization 0 0 0 8 15 7 0

(8) Interest Payments 1 5 5 5 5 5 0

Counterfactual c/

(9) Amortization 0 0 0 0 0 0 375

(10)InterestPayments 115 233 242 251 258 310 306

Up-front Liquidity Impact of DDSR

(11)= [-(1)-(2)+(6)] -103 -1 -1 -1 0 0 0

DDSR Debt Service Relief

(12) Interest Relief of DDSR 44 83 83 83 81 141 287

[(l0)-(4)+(5)-(8)]

(13) Amortization Relief 0 0 0 -8 -15 -213 333

[(9)-(7)-(3)](14) Total Debt Service Relief -59 82 81 74 66 -72 621

[(12)+(1l)+(13)J

a! Annual averages. Totals may not add due to rounding errors.

b/Includes US$30 million from IDB, US$30 million from IBRD and US$30 million from IMF.

c! Counterfactual consists of an exchange of existing debt for 30-year bullet maturity instrument with interest rate of LIBOR +13/16%


B. Material Benefits

35. Evaluating the material benefits--the direct cash flow implications and the indirectdevelopment impact--of the DDSR operation requires explicit assumptions about the course ofaction that the Government and its creditors would have otherwise pursued. Clearly, if it wereassumed that Panama would continue to accumulate arrears indefinitely in the absence of a DDSRoperation, the effect of DDSR on Panama's cash flow position would be negative. The indirectbenefits of DDSR as compared to such a scenario, however, would be strongly positive, resultingin overall positive net benefits. In effect, the strong economic recovery achieved by Panamaduring the past five years was in large part the result of the progressive restoration of domesticand international investor confidence in the country--as evinced by the dramatic turnaround incapital flows (including the return of flight capital). This was secured partly on the basis of thenormalization of relationships with creditors commencing in 1991, and partly on the basis ofmarket expectations that Panama would fully restore these relationships in the medium-term. Hadthis not been the case, the economic recovery would have been a slow and painful process--without the restoration of confidence, it is unclear how the money supply, which plunged anestimated 30% during 1987-89, would have been replenished. Similarly, a decision to continue toaccumulate commercial arrears rather than regain creditworthiness through DDSR would prevent

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the economy from reaping significant benefits from fiscal and structural reforms because it wouldrapidly destroy the confidence of domestic and foreign investors in the economy, possiblyresulting in demonetization and stagnation (and undermining support for reform).

36. As a result of such considerations, re-establishment of creditworthiness has been anintegral part of the economic program from the outset, and the current Administration has movedrapidly to achieve this goal. Consequently, a counterfactual rooted in the extrapolation of the pasthistory of commercial arrears accumulation lacks plausibility and must be rejected. Comparing thedirect effects of DDSR to scheduled debt service also is an implausible counterfactual becausethis debt is scheduled to be amortized by 1997. In light of these considerations, and following theapproach adopted in the Board documents for all DDSR operations supported by the Bank since1992, when this type of analysis was introduced, two counterfactuals could be considered: aMYRA or a debt rollover with full interest service. The DDSR provides greater debt servicerelief when compared to a MYRA, because the debt would be amortized much quicker in aMYRA. Taking this as an upper bound, the counterfactual selected to assess the debt servicerelief from DDSR is full interest service, with a debt rollover (i.e., exchange of existingcommercial debt for a 30-year bullet maturity instrument at LIBOR plus 13/16%).9

37. Direct Benefits. In the initial year, when the upfront costs of DDSR are incurred, theliquidity impact of DDSR as compared to the debt rollover counterfactual is highly negative(US$103 million). (See Table 9 above.) During 1997-2000, however, DDSR would provideannual debt service relief of about US$76 million compared to the counterfactual, due to lowerinterest payments. During 2001-2016, debt service relief would be negative (US$72 million peryear), because the FLlRBs and PDI bonds would be amortized. Subsequently, debt service reliefwould turn sharply positive (US$621 million annually) because only US$316 million of the parand discount bonds remain to be amortized. During the entire 1996-2026 period, DDSR wouldprovide debt service relief of US$917 million in net present value ternis, or about 12.4% of GDP.

38. Efficiency of Debt Enhancement Funds. The IRR of the operation is about 18% asagainst the counterfactual, which is above the cost at which Panama could borrow theenhancement funds and the critical level employed in the Bank's project lending. 10 Gross benefitsconsist of the: (i) flow of debt service relief under the counterfactual; (ii) interest earnings oninterest collateral accounts; and (iii) funds to be released from the FLIRB collateral account in2003, and the par and discount bond accounts in 2026. Gross costs include the: (i) US$96 millioncollateral cost and US$100 million PDI payment; and (ii) debt service on the new instruments.

39. Indirect Benefits. The magnitude of the indirect benefits of DDSR depends on the extentto which economic reforms redress domestic causes of the debt overhang. The Government'sreform program is eliminating these causes. At the same time, DDSR is expected to substantially

9 Clearly, in a post-Brady world, it would make little sense for Panama (or any other Brady-eligible country) to agree toanything less than a DDSR operation. Nonetheless, a debt rollover would be an alternative far superior to continuedarrears accumulation, owing to the strongly adverse development impact of the latter course of action. Finally, it alsoshould be noted that the selection of variants of full debt service counterfactuals has been critiqued on the grounds thatthey are inconsistent with market expectations of partial default, as reflected in the discount in the secondary market priceof commercial debt prior to DDSR. This argument has considerable merit, but in all cases post-DDSR market prices forexchanged debt have remained below par, which suggests that the market continues to expect some degree of default. (Inother words, market-consistent counterfactuals would compare discounted DDSR debt service streams against discountedMYRA or rollover debt service streams to measure debt service relief).

Against a MYRA counterfactual, the IRR of the DDSR operation would be 32%. With the balanced allocation discussed infoonote 6 above, and against a rollover counterfactual, the IRR would have been 20%.

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enhance the effectiveness of the reform program in accelerating growth to potential and reducingpoverty. Indeed, without DDSR the reform program would not significantly improve Panama'slong-run development prospects. The DDSR operation would achieve this result by: (i)substantially reducing market uncertainty over Panama's ability and willingness to fully service itsexternal debt, and the sizable distortions and costs this uncertainty entails; (ii) offsetting theadverse effect on the investment climate and flows deriving from the disengagement of the U.S.from the Canal and former Canal Zone; and (iii) reducing the debt overhang and the associated"tax" on future output, which also acts as a disincentive to reform efforts and private investment.

40. The DDSR operation would alleviate market uncertainty over Panama's capacity andwillingness to service its debt by: (i) eliminating Panama's arrears and normalizing its relationswith commercial creditors; (ii) reducing the present value of debt service payments by 19%; (iii)shielding 53% of commercial interest obligations from interest rate risk and all commercialobligations from exchange rate risk; and (iv) transforming commercial loans into bonds, therebyallaying concerns about future reschedulings and rendering actual payments more predictable.Official support for DDSR should further curtail market uncertainty, by ensuring a crediblefinancing plan, both for the upfront costs of the operation and future financing requirements, andby signaling that the Government is undertaking the reforms needed to revive sustainable growth,and restore and maintain creditworthiness. Finally, market uncertainty should subside because thecost of debt service default in a post-DDSR world would rise dramatically, providing a strongincentive for Panama to meet the debt service obligations assumed under the DDSR operation.

41. Substantially reduced market uncertainty would translate into appreciable benefits toPanama by reducing the sovereign risk premium and real domestic interest rates, and by restoringPanama's access to international capital markets on competitive terms and maturities for bothpublic and private sector borrowers, providing an environment conducive to the recovery ofPanama's International Banking Center, increasing net resource transfers from abroad, investmentand growth. Following the pattern of other Brady countries, Panama plans to seek a rating fromthe major international credit rating agencies to establish relative creditworthiness after theconclusion of the DDSR operation. Assignment of the rating and improved grading which shouldresult, would expand external funding access for corporate issuers for whom the sovereign ratingacts as a benchmark. While direct commercial bank lending to Panama may not resume for sometime, renewed commercial lending for project finance and growing direct foreign investment couldbe expected to play a key role in upgrading Panama's dilapidated infrastructure and developingthe reverted areas thanks to DDSR. In capital-constrained countries like Panama, improvedaccess to foreign savings also results in efficiency gains because additional financing can be usedfor high return investments. This impact would be especially significant for Panama because themonetary regime makes it more difficult to shift resources from nontradeables to tradeables.

42. Another key consideration in evaluating the potential indirect effects of the DDSRoperation on Panama is the positive impact it would exercise on the investment climate in light ofthe disengagement of the U.S. from the administration of the Canal and of the U.S. DefenseDepartment from the former Canal Zone.

43. Increasing output of a highly indebted country like Panama enables creditors to extractproportionally higher actual debt repayments. This debt overhang "tax" directly reduces incomerelative to output, and acts as a disincentive to private investment and growth-enhancing policies.The DDSR operation would increase welfare by reducing the debt overhang tax, provided itreduces the net present value of expected service on risky debt. Valued at the pre-deal price of 55

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cents, eligible debt under the Panama DDSR amounted to about US$2.1 billion, or 29.1% ofGDP. In December 1995, the market value of risky commercial debt--the noncollateralizedportion of the creditors' new portfolio--was about US$2 billion, or 27% of GDP. This implies areduction in the average debt overhang tax of about 2.1% of GDP and a declining marginal tax asoutput rises, and a higher return to growth-enhancing policies. This benefit, in turn, reinforces theincentives for the adoption of such policies. This positive incentive is larger than the abovefigures suggest because the DDSR bonds establish a much lower debt service profile as comparedto the situation in which ongoing amortization payments would immediately capture an upsideshock favoring the country.

44. A number of countries (e.g., especially Mexico) which have concluded DDSR operationshave realized significant indirect fiscal savings through the effect of DDSR in lowering realdomestic interest rates and fiscal outlays on domestic debt service. This specific indirect fiscaleffect is not relevant in the case of Panama due to the absence of exchange rate risk and debtdominated in domestic currency; however, real lending rates are high in Panama (about 10%), andDDSR should reduce these toward real international rates by reducing sovereign risk premium,and fostering increasing flows of debt and equity financing to Panama, as argued above. At thesame time, the discipline imposed on public debt management authorities from market-determinedprices of debt instruments should facilitate transition to market-based internal debt managementpractices. Moreover, the previous and the present Administration have been undertakingsubstantial fiscal adjustments, in anticipation of the material benefits of DDSR.

45. The recent evolution of forward looking market-based indicators is suggestive of theindirect benefits of DDSR, inasmuch as these financial variables tend to adjust quickly to newinformation regarding the future (Figure 1 below). Especially relevant are secondary market debtprices, stock market prices, and country credit ratings because they tend to adjust immediately tonew information. Remarkably, the price of Panamanian debt on the secondary market has climbed49% since the announcement of the DDSR Agreement in Principle in May 1995, from 49 cents to73 cents, in December 1995. This is a clear-cut indication that the market expects DDSR togenerate substantial indirect benefits for Panama (even discounting external factors that resulted ina general, albeit considerably lower, increase in Brady bond prices during this period). Also, sinceNovember 1, 1995, when the when-and-if issued Panama Brady instruments began to trade, thespread of the FLIRB over the equivalent maturity U.S. Treasury stripped bond has systematicallydeclined, from more than 1100 to less than 700 basis points (in early February 1996). This furtherindicates that the market's perception of Panama's sovereign risk has improved as a result ofDDSR. 1 In addition, the country's creditworthiness, as measured by the semi-annual rating of theInstitutional Investor, has been trending upward relative to the global average. Domestically, thestock exchange also has registered gains (about 6% in dollar terms since May 1995), but thismarket is very thin. In line with improved creditworthiness, net external transfers to Panama rosefrom 3% to an estimated 4.7% of GDP during 1994-95.

46. Net Material Benefits. The net material benefits of DDSR that would accrue to Panamamay be estimated on the basis of changes in market valuations of eligible debt between the pre-and post-deal periods, as compared to the average price at which the DDSR operation wasconsummated. In an open market buy-back creditors could be expected to capture all benefitsresulting from the debt overhang. The difference between the pre- and post-deal market prices ofthe eligible debt provides an approximation of the overall benefits of the DDSR operation. The

I 1 The FLIRB principal is not collateralized, providing the best measure of market perception of Panama's sovereign risk.

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difference between the break-even and the post-deal prices provides an indicator of the benefitswhich accrued to the country, while the difference between the break-even and the pre-deal pricesprovides an indicator of the benefits which accrued to commercial creditors. Panama obtained80% of these benefits, amounting to about US$792 million, or 10.7% of GDP.

Figure 1: PANAMA DDSR - Market Indicators

Evolution of Secondary Market Prices Evolution of Spreads of FLIRB over U.S,of Debt Treasury Bonds (b. p.) 1995-96

1200

70 1100

60 1000

50 90040

30- a/ rv~ 800

20 700

10 b21 0 600-

X0 C .fi , 11/1 11/22 12/13 1/4 1/25

Evolution of Credit Ratings Evolution of the Stock Exchange Index

35° 0 250

35 a Global Average 200

25

20 150

15 100

co Pana-mra^

505

X0 a, C> oDec-92 Dec-93 De-94 Dec-95

Annual Real Interest Rates Evolution of Net Transfers (% of GDP)

14

12

10 M 8 O 9 2 9 4 9

8 -5

4

2 ~~~~~~~~~~~~~~~~~~-15

00 00 O O C % 0

Notes: The interior lines in the graphs correspond to the following events: a/ Announcemnent of Brady Plan (March 10, 1989); b/ Agreement inPrinciple of DDSR operation (May 5, 1995).Source: LDC Debt Report and Emerging Market Debt Report; Bloomberg; Institutional Investor-hnternational Edition (Several Issues);Panama. Bolsa de Valores; Panama Comptroller General; IMF. International Financial Statistics, and World Bank staff estimates.

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TABLE 10: PANAMA DDSR - Illustrative Macroeconomic Impact

(Percent)

Actual Est.DDSR Counterfactual

1990-94 1995 Ave. 1996-2000 Ave. 2001-2004 Ave. 1996-2000 Ave. 2001-2004

Annual Real Growth Rates

GDP (market prices) 7.0 3.5 4.5 5.3 3.6 4.0

Per Capita GNP 7.7 4.9 4.2 5.3 3.2 4.1

Per Capita Consumption 2.0 2.9 1.9 3.7 1.3 2.8

Inflation (annual averages) 1.1 1.3 1.3 1.3 1.3 1.3

National Accounts (% of current GDP)

Total Investment 19.4 23.5 24.6 25.5 22.4 23.0

Public 3.2 4.0 4.3 4.4 3.3 3.4

Private 16.1 19.5 20.3 21.1 19.1 19.6

National Savings 17.5 17.1 20.8 22.9 18.0 19.7

Foreign Savings 1.9 6.4 3.8 2.6 4.4 3.3

Public Sector (% of current GDP)

Total Current Revenues 31.2 31.1 29.8 29.1 28.8 28.1

Total Capital Revenues 0.3 0.3 0.2 0.2 0.2 0.2

Total Expenditures 33.1 32.0 29.1 27.6 30.7 29.6

Overall Balance -1.6 -0.6 0.9 1.6 -1.7 -1.4

External Sector (% of current GD?

Current Account -4.1 -6.4 -3.8 -2.6 -4.4 -3.3

Resource Balance 1.2 -1.8 -1.5 -0.5 -1.3 -0.7

Imports GNFS 38.5 40.3 41.5 43.1 40.8 42.0

Exports GNFS 39.7 38.6 39.9 42.6 39.5 41.3

Adjusted Resource Transfer 1.6 4.7 2.7 1.1 2.2 1.0

Financing gap 0 0 0.1 0.4 -0.4 -0.1


C. Macroeconomic Outlook

47. Short-term Prospects. The policy measures which the Government is carrying out withthe support of the IFIs should further strengthen the macroeconomic framework in 1996, andbegin to boost economic growth toward the potential rate of expansion. The 1996 Budget targetsa shift in NFPS balance to a surplus of 0.4% of GDP (excluding expected proceeds of 3% ofGDP from the privatization of the telecoms entity), with an increase in both savings andinvestment, especially in infrastructure and the social sectors. Central Government currentexpenditure is projected to decline by 2.3 percentage points of GDP in 1996, through a reductionin external interest obligations and containment of the wage bill. Inflation is projected to remainabout 1%, while the current account balance of payments deficit is projected to decline to about4% of GDP thanks to the relief obtained through the DDSR operation. Net external financing ofthe NFPS is projected to be positive for the first time in a decade, as a result of the expectedprogress in implementing policy-based loans, including those to finance the upfront costs of theDDSR, and an acceleration in the implementation of WFI-financed investment projects whichrecently have come on stream. Net private capital inflows are projected to grow sharply in 1996,thanks to privatization receipts, the reduction in the sovereign risk premium, and as thedevelopment of the areas reverting to Panama under the Canal treaties gets underway. As aresult, the overall balance of payments is projected to register a surplus equivalent to 3% of GDP.

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48. The appreciable decline in interest rates that has taken place during the last part of 1995should increase the demand for money. This should accelerate the expansion of domestic creditto the private sector, and foster higher growth in imports and interest rate-sensitive sectors in1996. The budgeted increase in externally-supported public investment in infrastructure, and theinitiation of a number of important private projects (in ports, mining, telecommunications andtourism) also should impart more dynamism to the economy. Finally, as economic agents begin toadjust to the new incentive framework, both investment in and output of tradeables should rise.

49. Medium- and Long-Term Outlook. The long-term benefits of the DDSR operation canbe illustrated by modeling macroeconomic performance under this scenario and comparing themto the projected results under the counterfactual (Table 10 above). Economic growth under theDDSR is projected to rise 1 percentage point of GDP during 1996-2000 to 4.5% per annum, andto 5.3% during 2001-04. This would occur on the strength of projected increases in the rates ofnational savings and domestic investment, as well as through greater efficiency of investment, inresponse to the elimination of policy distortions and improved creditworthiness. Such growthwould represent a substantial improvement over the 1981-95 trend (less than 3%) as well asprojected growth under the counterfactual. While higher growth would be financed mainly by astepped-up domestic savings effort (public as well as private) under this scenario, as reflected inthe projected decline of the current account deficit to an average of 3.8% of GDP during 1996-2000 and 2.6% during 2001-04, the quality of net external resource transfers would improvedramatically, as arrears accumulation is replaced by growing foreign direct investment and,eventually, private commercial capital inflows. Official net disbursements are projected tocontinue to play an important role during 1997-98, before declining to an amount equivalent toless than 15%, on average, of total net external financing during 1999-2004. (See Annex I.)

D. Creditworthiness and Debt Management

50. Reduced Debt Burden. DDSR would facilitate debt management and substantiallyenhance Panama's creditworthiness by increasing its capacity and willingness to service its debt,both directly (through debt reduction) and indirectly (through enhanced economic performance).In 1996, the DDSR operation would lower total public and publicly-guaranteed debt by 11.4percentage points of GDP, to about 67%; and diminish debt service payments by 10.6 percentagepoints of exports of goods and nonfactor services, to 17.6%, and by almost 13 percentage pointsof nonfinancial sector public revenues, to 22.2% (Table 11 below). Over the longer run, totalpublic and publicly-guaranteed debt is projected to decline to about 53% of GDP by the year2000, and to an average of about 43% during 2001-04. Similarly, the debt service ratio woulddecrease to 14.4% by the year 2000; and debt service as a share of NFPS revenues would declineto 20.2%. Furthermore, the maintenance of sound economic policies would be encouraged by theup-front cost that Panama has paid in order to regain creditworthiness, and debt managementstrengthened as creditworthiness improves and the cost of mismanagement increases. A debtrollover counterfactual would also improve creditworthiness indicators, but by considerably lessthan DDSR. Also, under that counterfactual, Panama would have less incentive to honor debtservice obligations because the cost of default would be lower.

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Table 11: PANAMA DDSR - Creditworthiness and Exposure Indicators a/(Percent)

Actual Estimated Proiected

1994 1995 1996 1997 1998 1999 2000 2001-2004

With DDSR

DOD/GDP 81.1 78.3 66.8 64.1 60.8 57.3 53.2 42.8

LTdebtservice/XGS 25.5 28.2 17.6 18.2 16.3 15.5 14.4 14.3

MLTdebtservice/currentpublicrevenues 30.7 35.0 22.2 23.9 21.9 21.3 20.2 20.9

Preferred and Secured DS/PPG DS b/ 20.9 19.9 32.6 29.8 33.3 34.7 35.7 35.7

Preferred DS/PPG DS b/ 20.9 19.9 31.3 28.0 31.2 32.5 33.4 33.2

BankDS/PPGDS 10.4 6.4 8.1 8.0 8.1 7.0 7.2 8.3

Bank DS/XGS 2.7 1.9 1.6 1.5 1.4 1.2 1.1 1.2

exible DOD/DOD c/ 23.5 21.9 90.2 91.1 91.6 91.4 90.6 91.7

Iflexible DS/DS c/ 30.8 27.0 78.9 88.3 87.4 87.1 88.2 93.9

With Counterfactual

DOD/GDP 81.1 78.6 76.0 74.2 71.9 68.8 64.2 55.3

MLTdebtservice/XGS 25.5 28.2 19.2 21.3 19.4 18.5 17.3 14.9

MLT debt service/current public revenues 30.7 35.0 24.9 28.5 26.5 26.0 24.8 21.8

Preferred and Secured DS/ PPG DS b/ 20.9 19.9 28.7 23.7 26.1 26.8 27.7 33.3

PreferredDS/PPGDSb/ 20.9 19.9 28.7 23.7 26.1 26.8 27.7 33.3

Bank DS/PPG DS 10.4 6.4 7.4 6.7 6.7 5.8 6.0 8.0

BankDS/XGS 2.7 1.9 1.6 1.5 1.4 1.1 1.1 1.2

nflexible DOD/DOD c/ 23.5 21.8 25.3 26.4 26.5 26.8 27.7 29.6

nflexible DS/DS c/ 30.8 27.0 62.0 52.6 43.2 43.0 44.0 42.4

Accrual basis.

/ Includes collateralized bonds (discount and par bonds).

/ That part of Panama's debt that cannot be readily rescheduled or deferred: multilateral debt, bonds and Paris Club. It does not include short-rm debt

ource: World Bank staff estimates.

51. Burdensharing. The reduction of commercial bank debt, coupled with additional lendingby IFIs to help finance DDSR (and disbursements under ongoing operations), would augment theshare of official creditors in the present value of Panama's remaining obligations, from 23 to 32%;in particular, it would raise the relative burden of the IFIs, from 12 to 18%. By the same token,the burden of private creditors would decline, from 77% to 68% (Figure 2).

Figure 2: PANAMA DDSR - Impact on Burdensharing and Flexibility

by Creditor Class ------ ------- by Instrument----

70-

60 AdditionalX~ 50- -Lending

50SW40 - Pre"-deal|

3- 30 0E Post-deal

2010

0

muOu

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52. Reduced Flexibility. While DDSR would greatly improve Panama's capacity to serviceits debt, it would potentially constrain Panama's latitude to adjust debt service to adverse externalshocks in the event such shocks were larger than the debt relief achieved, or to domestic policyshocks. More particularly, it would raise the transactions costs of an eventual debt restructuringrelative to one in which loans were simply rescheduled, as in a MYRA. In effect, DDSR raises therelative share of debt held in bonds from about 8 to 68%. The conversion of bank loans to bondsand additional lending by IFIs for DDSR would raise the share of relatively inflexible debt from21.9 to 90.2%. While this result is an inevitable outcome of the mechanics of the Brady solution,the extent of this increase is high relative to that resulting from previous DDSR operationsbecause of the heavy weight of commercial bank debt in Panama's total debt. Nonetheless, theshare of preferred creditors in public debt service would actually decline in 1996, to about 31%from 45% in 1995 (because Panama was still accumulating arrears on commercial debt in 1995).On an accrual basis, the share of preferred creditors is projected to remain below the Bank'sguideline of 35% during the next decade. Debt service to the Bank as proportion of public debtservice is projected to be about 8% in 1996 and to remain on the order of 7 to 8% throughout theprojection period. Similarly, debt service to the Bank as a fraction of exports is projected to befar below the Bank's guideline over the course of the next decade (1.6% in 1996, and lowerthereafter). (See Table 11 above.)

53. Exposure Risk. Reduced flexibility per se translates into greater risk to the Bank in theevent of adverse external shocks or domestic policy shocks; however, DDSR also mitigates thevulnerability of the economy to external shocks. First, it diminishes the debt service burden andenhances creditworthiness. Second, it reduces the exposure of the economy to both interest raterisk--by changing 53% of eligible debt into fixed-rate instruments, and to exchange rate risk--byconverting the 17% of eligible debt formerly denominated in non-U. S. currencies into US dollars.Moreover, Panama has several options in the context of the DDSR operation to adjust debtservice to external shocks: it could (i) capitalize interest payments on PDI bonds exceeding anannual interest rate of 4% during the first six years after closing; and (ii) use the interest collateralto pay up to 12 months interest on the par and discount bonds, and up to 6 months interest on theFLIRBs. In addition, current fiscal policies, coupled with the measures the Government is takingto consolidate fiscal balance over the longer-term, are projected to generate NFPS surplusesapproaching 1% of GDP by 1997, and rising to 1.4% by the year 2000 (Annex I, Table 5). Suchadditional resources would enable the Government to implement an efficient debt managementstrategy and significantly increase its capacity to absorb external shocks.

54. A sensitivity analysis reveals that a permanent increase of 100 basis points above projectedLIBOR would augment the current account deficit by only 0.3 percentage points of GDP onaverage during 1996-2000 relative to the baseline projections--an increase which could beabsorbed by a somewhat slower rate of accumulation of NFPS net deposits at the BNP thanprojected.12 Similarly, a secular merchandise terms of trade shock of 5% would augment thecurrent account deficit by only 0.3 percentage points of GDP on average during 1996-2000relative to the baseline, due to the small weight of merchandise exports in total current accountreceipts. Finally, a sizable capital account shock (e.g. a reduction of annual capital inflows by10% during 1996-2000, or about 1% of annual GDP, relative to projected flows) also could beabsorbed without significantly affecting projected growth or Panama's ability to service its

12 The illustrative macroeconomic projections presented in Table 10 above incorporate the impact of two external shocks: thesharp reduction in bilateral aid (which comrnmenced in 1994) and the depressive impact of the U.S. disengagement from theformer Canal Zone on service receipts.

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external debt (by lowering the accumulation of NFPS net deposits from 3.7 to 2.2 months ofimports), provided Panama continues to pursue sound macroeconomic policies, and implementneeded structural and institutional reforms.

55. While the economy would become more vulnerable to domestic policy shocks in a post-DDSR world, the risk of such shocks, especially fiscal ones, is considered to be slight. Panama'sunique, nine decades-old monetary regime provides a stable anchor for the macroeconomicframework. Maintenance of sound economic policies also would be encouraged by the up-frontcost that Panama has paid to regain creditworthiness, and debt management strengthened ascreditworthiness improves and the cost of mismanagement increases. Indeed, DDSR would serveas a powerful deterrent to policy slippage. Moreover, the current Administration enjoys a solidmajority in the Legislative Assembly; has achieved major progress in implementing the lengthyreform agenda during its first fifteen months; and has an additional three and one-half years inoffice. Nonetheless, support for the reform program could erode in this relatively wealthy butdualistic society--in which 40% of the population lives in poverty and narrow-interest groupstraditionally have thwarted reform--if investment in infrastructure and social safety net programscontinues to lag, and if growth does not begin to accelerate and the high unemployment rate toease in the medium-term. The Bank is working to minimize this risk through the ongoingadjustment operation; a renewal of investment lending, focusing on poverty reduction; byenhancing project implementation; and through our ESW and policy dialogue. As the Bank'slending portfolio moves from adjustment to investment lending, non-formal and non-lendinginstruments will play a growing role in risk management and ensuring continuity in the reformprocess, as will closer coordination with our sister organizations. (See also para. 61 below.)

V. BANK ASSISTANCE STRATEGY AND PROPOSED DDSR LOAN

56. The Government of Panama has requested support for the DDSR agreement from theWorld Bank, the IMF and the IDB. The Government also has indicated that it intends to requesta limited waiver of the negative pledge clauses in its loan and guarantee agreements with theBank. This section discusses the Bank's Country Assistance Strategy; Panama's eligibility forBank support of DDSR; the proposed Bank measures to support the DDSR operation; therequest for the waiver of the negative pledge clause; and burdensharing among donors.

A. Country Assistance Strategy

57. The Country Assistance Strategy (CAS) for Panama was discussed by the Board onFebruary 7, 1995. The CAS adopted a selective, two-pronged approach focusing on revivingsustainable growth and poverty alleviation. The ongoing ERL adjustment operation is promotingconsolidation of a sustainable fiscal/macroeconomic framework, the restructuring andprivatization of state enterprises, and elimination of policy-induced price distortions required toaccelerate economic growth to potential and mount an efficacious poverty alleviation strategy,both through the quick-disbursing policy-based component and the technical assistancecomponent, which is supporting the Government unit in charge of implementing the Authorities'economic program and has financed the preparation of key reform legislation. The base lendingprogram is devoted entirely to direct interventions in support of poverty alleviation, and includesoperations designed to mitigate the more immediate causes of poverty and operations to enhancehuman resource development, especially in rural areas where the majority of the poor live. Thisprogram is composed of the Rural Health Project, which recently became effective, and the

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following proposed projects: Basic Education, Social Emergency Fund, and Land Managementand Rural Poverty Project. The ESW is designed to support this two-pronged approach,providing a parallel track for enriching the policy dialogue.13 The CAS presented a high caselending program that would include support for DDSR. The CAS indicated that the triggers formoving to a high case lending program would be solid progress in implementing theGovemment's economic program; compliance with ERL second tranche conditions; andconclusion of a DDSR agreement consistent with the revival of sustainable growth.

B. The Proposed Debt and Debt Service Reduction Loan

58. Eligibility for DDSR Support. Panama meets the eligibility criteria for Bank DDSRsupport. First, the Government has met the conditions delineated in the CAS for moving to thehigh case lending program: it has made great progress in implementing a comprehensiveadjustment program; has successfully complied with the second tranche conditions of theEconomic Recovery Loan,14 and has achieved a DDSR agreement which satisfies Bank criteria forDDSR support. Second, the Government has demonstrated a need for DDSR to achieve itsmedium-term development objectives. In effect, the Government has been unable to accommodatecontractual interest and amortization on its external commercial debt. An attempt to do so wouldhave thwarted the remonetization of the economy and led to a depression of economic activity.Third, the Government lacks sufficient resources to close the DDSR operation without officialsupport, of which the proposed Bank DDSR loan is an integral part. Fourth, the DDSR operationachieves an appropriate balance between debt and debt service reduction. In effect, it: (i) induceda high degree of participation by commercial creditors and is likely to result in continuedcommercial bank involvement with Panama; (ii) would bring debt service payments in line withthe Government's debt service capacity and the financing requirements of accelerated economicgrowth; and (iii) is cost effective, as the Government's investment in DDSR achieves asatisfactory rate of return with respect to alternative means of regularizing arrears. Finally, theresources devoted to DDSR would make a material contribution to the country's development.

59. The Proposed DDSR Loan. Bank DDSR guidelines stipulate that the Bank can providesupport to eligible Borrowers for DDSR in accordance with the following criteria: (i) throughset-asides, in an amount of up to 25% of the three-year adjustment lending program, or of up to10% of the overall three-year lending program; and (ii) through additional funds, in an amount ofup to 15% of the three-year lending program. The guidelines also stipulate that priority is to begiven to set asides, and that additional funds would be provided only if there is a clear need forfurther support for DDSR, and the country is implementing a strong adjustment program and hasa solid track record of adjustment. Finally, the guidelines also allow for the use of a high caselending program to determine the DDSR loan amount.

60. The base case three-year lending program proposed in the CAS is US$180 million, andconsists exclusively of investment operations; the high case is US$225 million. As explainedabove, Panama has met the triggers for moving to the high case program. The proposed DDSRloan of US$30 million would be composed of US$20 million in set asides and US$10 million inadditional funds. The additional resources are fully justified: (i) Panama's fiscal constraint would

13 See, in particular, Panama: A Dual Economy in Transition, op.cit.14 A detailed discussion of Panama's performance under the adjustment loan is presented in the President's Memorandum

entitled "Panama - Economic Recovery Loan (Loan 3438-PA) - Release of the Second Tranche (Waiver of One Conditionand Partial Waiver of One Condition)", R-96-21, February 14, 1996.

- 26 -

prevent it from completing the DDSR operation without the additional funds; and (ii) during thepast fifteen months, the country has compiled a solid track in implementing a strong adjustmentprogram. The set asides would be offset by a reduction in the high case amount for the proposedFY98 Rural Poverty and Natural Resources Management Project, from US$75 million to US$55million. The proposed loan would be a free-standing operation, inasmuch as the future lendingprogram does not contain any adjustment operations. The proposed DDSR loan of US$30 millionwould help finance principal and/or interest collateral of the DDSR instruments exchanged foreligible principal.

61. When the Bank provides DDSR support on a free-standing basis, the operation shouldcarry appropriate policy conditionality if the Bank does not have a substantial adjustment lendingprogram in the country. The Bank will continue to support and monitor the Government'simplementation of the economic program, of which the DDSR operation is an integral part,through the third tranche of the ERL, and would continue to be heavily involved in the design andimplementation of the economic program through the technical assistance component of the ERL;hence, no further policy conditionality is required for the proposed DDSR loan. At the same time,the Bank will increasingly rely on non-lending instruments to foster policy reform. The recenteconomic report constituted the first step in this direction, and the Bank currently is preparing aPoverty Assessment which the Government expects to use to substantially improve social sectorpolicies. The Government's fiscal policy performance also will be monitored by the IMF throughthe SBA which extends to March, 1997. In addition, the IDB is preparing two sector adjustmentloans for 1996, one in the area of public enterprise reform, and another to strengthen prudentialnorms and financial system supervision.

62. Conditions of Effectiveness. Conditions of effectiveness would include: (i) consistency ofthe macroeconomic policy framework with the objectives of the proposed loan; (ii) a requirementthat the DDSR operation offer documents be satisfactory to the Bank, and (iii) a legal opinionfrom the Borrower satisfactory to the Bank that the Loan Agreement is valid and legally bindingon the Republic of Panama. In view of the fact that the Republic of Panama already has receivedcommitments from creditors for the exchange of 98.5% of the debt eligible under the DDSRagreement, or a participation above the threshold (95%) required for effectiveness in previousDDSR loans, no such condition is needed.

63. Disbursement Arrangements. It is proposed that, upon effectiveness, the full amount ofthe DDSR Loan be made available to the Borrower to help finance the costs of the principaland/or interest collateral of the par bonds and discount bonds, and/or interest collateral of theFLIRBs; however, no withdrawals would be made from the approved DDSR loan unless theBank shall have approved the procedures for withdrawal, and is satisfied with the arrangement forthe maintenance of collateral. The Bank would disburse (on account of the Borrower) eitherdirectly to the collateral agent to provide funds for the acquisition of collateral or to the Borrowerto reimburse it for the cost of collateral already acquired. The Bank would provide under theproposed DDSR loan up to 100% retroactive financing if needed, on the basis of eligibleexpenditures incurred after November 14, 1995 (i.e., the cut-off date for the receipt ofcommitment allocations from creditors under the DDSR agreement).

64. The Government would be required to have the records and accounts of the paymentsfinanced out of the proceeds of the loan audited by independent private auditors acceptable to theBank, and to furnish to the Bank the audit reports and other information regarding those recordsand accounts and the audit thereof The Closing Date of the Loan would be June 30, 1996.

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65. Prepayment Provisions. Under the Loan Agreement, the Government would be entitledto repurchase any of the DDSR instruments at any time and price, provided it is not on default onany of the new instruments. The DDSR Loan Agreement would include provisions entitling theBank to request prepayment of funds to the extent that the collateral they finance is released toPanama, unless the funds in question are used for eligible imports (in the case of set asides) orfurther debt and debt service reduction (in the case of additional funds or set asides). 15 The Bankwould attempt to reach a consensus with Panama, the IMvF and the IDB regarding the use of loanproceeds from all three institutions to achieve a proportional allocation of funds to collateral inorder to trigger proportional prepayment obligations in the event of release of collateral.

66. Waiver of Negative Pledge Clauses. The Government has requested, pursuant to theterms of the negative pledge clauses in the loan and guarantee agreements between the WorldBank and the Republic of Panama, that the World Bank consent to the pledge of collateral in theamounts required for the par bonds, discount bonds and FLIRBs to be issued by Panama. It isestimated that a waiver of up to US$115 million would be required for this purpose. The pledgeof collateral will be for up to the 30-year life of the par and discount bonds. The Bank hasreceived a letter from the Government formally requesting the waiver of the negative pledgeclause (Annex V). In this letter, the Government has reaffirmed its obligation to continue to maketimely payments on its loans from the Bank and has affirmed that such loans would not be subjectto rescheduling. The Government has also stated its understanding that the consent by the WorldBank to a waiver of the negative pledge clause would be limited to the transactions included in theDDSR operation as described in this report and would be without prejudice to the Bank's positionon the negative pledge clause under its loan and guarantee agreements in general.

67. Burdensharing. The IDB, the IMF and the Bank would each provide about US$30million equivalent to help finance the costs of DDSR, amounting to 40% of the total costs of theoperation. The Government of Panama would finance the remainder from its own resources.

C. Risks and Benefits

68. The expected benefits of the DDSR operation are detailed in section V above. Potentialrisks to the materialization of these benefits and to the ability and willingness of Panama to fullyservice its external debt in a timely fashion could arise from both domestic and external sources.Domestically, political opposition could erode the Government's majority in the LegislativeAssembly and/or result in intolerable disruptions of civic affairs, to the detriment of the futureimplementation of the Government's economic program. To date, however, there is littleevidence that opponents of reform have the strength to mount a serious challenge to theGovernment. Indeed, the Government has achieved a significant majority in the Assembly in allthe votes to date on reform legislation, including highly contentious legislation such asprivatization and labor code reform, thanks to the consistently solid backing of the governingparty and its allies. Moreover, elections are not scheduled until 1999. Efforts of domestic interestgroups to block reform through strikes and protests likewise have consistently failed. TheGovernment also has substantially enhanced the public sector's institutional capacity to implementthe reform program, with the support of the Bank, through the ERL. Nonetheless, the sharpincome disparities and high incidence of poverty, in conjunction with the plethora of special

15 If the Executive Directors approve the proposed simplification of disbursements under structural and sectoral adjustmentloans and credits, these provisions would be revisited to reflect the liberalization in the documentation required forstructural adjustment operations.

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interest groups who benefit from the status quo, will continue to pose a risk to economic reformuntil growth begins to accelerate and unemployment subsides. In the Government's view the bestway to minimize this risk is by continuing to rapidly implement needed reforms, while stepping-upinvestments in basic services and social safety net programs.

69. Externally, the Government's reform program will be supported by the recently approvedIMF SBA, as well as by the Bank's ERL (through June 30, 1996 in the case of the quick-disbursing component, with a possible extension to end-1996 for the technical assistancecomponent) and ESW. In addition, the IDB is preparing two adjustment operations, a secondpublic enterprise reform loan and an investment sector loan, both of which are scheduled forboard presentation in CY96. More generally, the external environment is projected to befavorable over the medium-term, with no significant external price shocks foreseen. In thiscontext, however, Panama needs to adjust to: (i) the impact of the progressive disengagement ofthe U.S. Defense Department from the former canal zone during the remainder of the century andof the withdrawal of the U.S. from administration of the Canal itself, and (ii) a sharp decline inbilateral aid flows.

70. The transfer of the Canal Zone looms large in the future development of the country.Panama must cope with the withdrawal during 1995-99 of some US$300 million annually (orabout 4% of GDP) that U.S. entities a'ld personnel pump into the economy, and the attendant lossof 6,000 high-paying jobs. At the same time, bilateral aid from the U.S, which amounted toUS$500 million during 1990-93 and played an important role in the rapid recovery of theeconomy, declined sharply beginning in 1994. Transferal of the Canal per se to Panama wouldoffset only a fraction (about US$50 million annually) of the income loss from the disengagementof the U.S. Defense Department. Development of the surrounding territory that also is revertingto Panama should offset the impact of the U.S. departure, but may do so fully only over thelonger term. Enhancing investor confidence will be crucial to this process. While the ability ofPanama to maintain and operate the Canal is not an issue, securing investor confidence andsufficient external financing on competitive terms will be critical, especially in light of the U.S.withdrawal. It is precisely in this respect that the successful conclusion of the DDSR operationprobably would make its biggest contribution to the future development of the country.

VI. RECOMMENDATION

71. I am satisfied that the proposed loan would comply with the Articles of Agreement of theBank and would be consistent with the approved guidelines for Bank support of DDSR Programs.I therefore recommend that the Executive Directors approve the Debt and Debt ServiceReduction Loan on the terms and conditions proposed. I also recommend that the ExecutiveDirectors consent to the request of the Panamanian Government for a waiver of the negativepledge restrictions in the Bank's loan and guarantee agreements with the Republic of Panama, tothe extent and based on the conditions proposed, such consent to become effective upon receiptby the Government of all similar consents required from other creditors.

James D. WolfensohnPresident

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Table 1: PANAMA DDSR - Key Economic indicators Annex I

Page I of 7

Indicator Actul E_tmated Projected1994 1995 1996 1997 1998 1999 2000 2001-2004 a/

National Accounts (in % of GDP)

Gross Domestic Product (at mkt prices) 6,975 7,413 7,810 8,228 8,710 9,220 9,S07 11515

Agriculture b/ 10.5 10.3 10.1 9.9 9.7 9.4 9.2 8.6

industry b/ 14.8 14.6 14.4 14.3 14.2 14.0 13.9 13.5

Services b/ 74.8 75.1 75.5 75.8 76.2 76.5 76.9 77.9

Total Consumption 76.8 78.3 77.8 77.7 77.2 76.4 75.4 75.0

Gross Domestic Fixed Investrnent 25.0 23.5 24.0 24.0 24.5 25.0 25.5 25.5

Total Government 3.8 4.0 4.7 3.9 4.2 4.2 4.6 4.4

Private (incl. change in stocks) 21.2 19.5 19.3 20.1 20.3 20.8 20.9 21.1

Exports (GNFS) c/ 38.0 38.6 39.1 39.4 39.7 40.4 41.2 42.6

Imports (GNFS) c/ 39.8 40.3 40.8 41.1 41.5 41.8 42.1 43.1

Gross Domestic Savings 23.2 21.7 22.2 22.3 22.8 23.6 24.6 25.0

Gross National Savings 18.1 17.1 19.8 19.8 20.5 21.3 22.4 22.9

Memorandum Items

GDP (in MillionUS$) 6,975 7,413 7,810 8,228 8,710 9,220 9,807 11,515

GNP per capita (US$, Atlas method) 2,729 2,863 3,042 3,146 3,288 3,422 3,581 4,069

Real Annual Growth Rates

GDP at mkt. prices 4.7 3.5 4.0 4.0 4.5 4.5 5.0 5.2

GDY 4.9 3.3 4.1 4.1 4.5 4.5 5.0 5.2

Real Annual per capita Growth Rates

GDP at mkt. prices 2.8 1.5 2.4 2.1 3.0 2.6 3.2 3.8

Total Consumption 4.4 2.9 1.9 2.1 2.3 1.6 1.8 3.7

Private consumption 6.5 5.2 1.3 2.1 2.2 1.3 1.4 3.6

Incremental capital-output ratio 5.5 7.4 6.1 6.3 5.6 5.7 5.2 5.1

Balance of Payments (% of GDP)

Resource Balance (1.8) (1.8) (1.8) (1.7) (1.7) (1.4) (0.9) (0.5)

Current Acc. Bal (excl. grants) (6.9) (6.4) (4.2) (4.2) (4.0) (3.7) (3.1) (2.6)

Current Acc. Bal (incl. grants) (3.6) (3.7) (2.3) (2.3) (2.4) (2.2) (1.9) (1.7)

Real Growth Rates (%)

Merchandise Exports (f.o.b.) (2.3) 7.9 9.3 6.5 6.4 7.4 9.6 7.8

Primary 1.0 4.4 4.0 4.0 4.0 3.7 3.6 3.5

Other (5.0) 10.9 13.6 8.4 8.1 9.9 13.6 10.1

Merchandise Imports (c.i.f) 4.1 3.5 4.4 4.1 4.3 4.2 4.6 5.3

Public Finances (% of GDP) d/

Current Revenues 31.7 31.1 31.0 30.0 29.6 29.3 29.3 29.1

Current Expenditures cl 27.3 28.0 26.1 25.4 24.8 24.2 23.5 23.2

Cur. Acc. Surplus(+) or Deficit(^) 4.3 3.1 4.9 4.6 4.8 5.1 5.8 5.9

Capital Expenditure (net) 3.5 3.7 4.5 3.7 4.0 4.0 4.4 4.3

Overall Deficit 0.8 (0.6) 0.4 0.9 0.8 1.1 1.4 1.6

Memorandum Items

Foreign Int. Due & not Paid 3.2 3.9 0.0 0.0 0.0 0.0 0.0 0.0

Table 1: PANAMA DDSR - Key Economic Indicators Annex I

(Continued) Page 2 of7

Indicator Actual Estinated

1994 1995 1996 1997 1998 1999 2000 20 0 1-2004a/

Monetary Indicators

M2/GDP 69.4 69.4 71.4 73.4 73.4 73.4 73.4 73.4

Growth ofM2 (%) 15.5 6.3 8.4 8.3 5.9 5.9 6.4 6.6

Private Sector Credit Growth/

TotalCreditGrowth(%) 150.8 217.8 162.1 148.2 105.4 97.6 105.7 103.8

Price Indices (1992=100)

Merchandise Exports 105.2 106.4 107.6 109.7 112.6 115.5 118.7 125.7

MerchandiseImports 109.8 114.2 116.7 118.9 121.8 124.7 127.6 135.2

RealExchangeRate e/ 101.5 104.7 106.8 107.9 109.2 110.4 111.7 114.6

ConsumerPricelndex(%growthrate) 1.3 1.3 1.3 1.3 1.3 1.3 1.3 1.3

GDP deflator (% growth rate) 1.5 2.7 1.3 1.3 1.3 1.3 1.3 1.3

a/ Annual averages

b/ Sector components are estimated at market prices.

c/ "GNFS" denotes goods and non factor services.

d/ Data refer to the Non-Financial Public Sector. Accnial Basis.

|e/ An increase denotes depreciation.

|Sources: Contraloria, MIPPE, IMF and Bank staff estimates.

Table 2: PANAMA DDSR - Balance of Payments Amex I

(USS Millions) Page 3 of 7

Actual EsFimated Proiected

1994 1995 1996 1997 1998 1999 2000 2001-2004 a/

Total Exports of GNFS 2652.9 2857.9 3050.3 3242.0 3462.1 3721.2 4037.2 4905.3

Merchandise (FOB) 684.2 746.8 825.0 896.4 978.6 1078.4 1214.4 1561.7

Non-FactorServices 1968.7 2111.1 2225.3 2345.6 2483.5 2642.8 2822.8 3343.6

TotallmportsofGNFS 2779.2 2990.4 3190.3 3382.7 3613.2 3852.6 4124.1 4962.4

Merchandise (FOB) 2223.0 2391.7 2548.3 2702.1 2887.0 3079.1 3296.3 3972.2

Non-Factor Services 556.2 598.7 642.0 680.6 726.2 773.5 827.8 990.3

Resource Balance -126.3 -132.5 -140.1 -140.7 -151.0 -131.4 -86.9 -57.1

Net Factor Income -347.9 -330.6 -178.3 -193.2 -193.5 -203.6 -210.6 -237.0

Factorreceipts 842.9 871.0 901.5 931.2 954.1 982.6 1013.9 1095.9

FactorPayments 1190.8 1201.6 1079.9 1124.4 1147.7 1186.1 1224.5 1332.9

Total Interest Due (scheduled) b/ 370.7 422.1 278.1 298.5 311.2 321.2 328.4 347.4

InterestPaid 147.1 133.1 205.9 298.5 311.2 321.2 328.4 347.4

Due but not paid 223.6 289.0 72.1 0.0 0.0 0.0 0.0 0.0

Other Factor Payments 820.1 779.4 801.8 825.9 836.4 864.9 896.1 985.4

Net private Current Transfers -7.7 -8.0 -8.0 -8.0 -8.0 -8.0 -8.0 -8.0

Current Account Balance -481.9 -471.1 -326.4 -341.9 -352.5 -343.0 -305.5 -302.1

Official capital grants 228.2 200.0 150.0 150.0 140.0 140.0 120.0 105.0

Privateinvestment(net) 201.2 210.9 453.3 249.8 267.9 287.5 310.4 375.4

Net LT Borrowing -274.0 -296.7 3278.2 321.8 22.5 -30.5 -6.4 -61.1

DisbursementsperDRS 468.4 95.8 3544.4 620.8 282.7 231.2 252.5 285.0

LT Repayments (scheduled) 313.6 392.5 266.2 298.9 260.3 261.7 258.9 346.1

Principal repaid 163.5 217.7 266.2 298.9 260.3 261.7 258.9 346.1

Duebutnotpaid 150.1 174.8 0.0 0.0 0.0 0.0 0.0 0.0

Other long-term inflows (net) -428.8 -0.0 -0.0 0.0 0.0 0.0 0.0 0.0

Adjustments to Scheduled debt service -23.2 439.8 -3839.9 -333.0 0.0 0.0 0.0 0.0

Debt Service not paid 373.7 463.8 72.1 0.0 0.0 0.0 0.0 0.0

Reduction in arrears/prepayments (-) -396.9 -24.0 -3912.0 -333.0 0.0 0.0 0.0 0.0

Other Capital Flows (net) 436.0 132.1 534.8 -11.3 -4.9 15.4 -59.3 -44.2

Net Short-Term(ST Capital 0.1 -0.1 -55.3 -2.0 12.9 47.1 -24.8 -26.7

Capital Flows n.e.i. -396.8 132.2 590.1 -9.3 -17.8 -31.7 -34.4 -17.5

Errors and omissions 832.7 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Change m net inteml reserves -86.4 -215.0 -250.0 -35.5 -73.0 -69.5 -59.2 -73.0

(- indicates increase)

Memorandum Items:

Total Gross Reserves 570.7 785.7 1035.7 1071.2 1144.2 1213.7 1272.9 1397.4

Total Gross Reserves inmonths imports 2.5 3.2 3.9 3.8 3.8 3.8 3.7 3.4

Exchange rates

Annual Average (Balboas/US$) 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0

Current Account Balance as % GDP -6.9 -6.4 -4.2 -4.2 -4.0 -3.7 -3.1 -2.6

al Annual averages.


Table 3: PANAMA DDSR - External Financing Requirements and Sources Annex I

(US$ Millions) Page 4 of 7

Actual Estimnated ProLected

1994 1995 1996 1997 1998 1999 2000 2 001-2004 a/

Financing Requirements 881.9 1078.6 842.6 676.3 685.8 674.2 623.6 721.2

Current account deficit 481.9 471.1 326.4 341.9 352.5 343.0 305.5 302.1

Amortization due 313.6 392.5 266.2 298.9 260.3 261.7 258.9 346.1

Official 107.8 112.3 103.4 139.6 145.6 145.6 139.3 142.8

DDSR Agreementb/ 205.0 279.7 162.5 159.0 77.1 78.6 82.1 57.6

Private 0.8 0.5 0.4 0.4 37.5 37.5 37.6 145.7

Increase in reserves 86.4 215.0 250.0 35.5 73.0 69.5 59.2 73.0

Financing Sources 881.9 1078.6 842.6 676.3 685.8 674.2 623.6 721.2

Foreigndirectinvestment 201.2 210.9 453.3 249.8 267.9 287.5 310.4 375.4

Disbursements 14.8 95.8 367.8 286.8 282.7 231.2 252.5 285.0

Official 14.8 95.8 367.8 286.8 271.7 202.9 203.7 190.8

Private 0.0 0.0 0.0 0.0 11.0 28.3 48.8 94.2

IMF net purchases 12.8 -23.8 53.9 -9.3 -17.8 -31.7 -34.4 -17.5

Arrears 373.7 463.8 72.1 0.0 0.0 0.0 0.0 0.0

Othercapital c/ 279.4 331.9 -104.4 149.0 152.9 187.1 95.2 78.3

a! Annual averages.

b/ Considers payments due to commercial banks on eligible debt in 1994 and 1995.

c/ Includes official capital grants and capital n.e.i.


Table 4: PANAMA DDSR - External Debt Stocks and Flows a/ Auex I


Actual Estimated Proiecb

1994 1995 1996 1997 1998 1999 2000 2001-2004 b/

A Gross Disbursements

Public8&PubliclyGuaranteed c/ 468.4 95.8 3544.4 620.8 282.7 231.2 252.5 285.0

a. Multilateral 14.8 84.5 282.3 266.6 251.7 182.9 183.7 170.8

of which IDA 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

ofwhichlBRD 1.5 11.2 106.5 28.0 44.5 51.2 59.1 63.9

b. Bilateral 0.0 11.3 85.5 20.2 20.0 20.0 20.0 20.0

c. Private creditors 453.7 0.0 3176.6 334.0 11.0 28.3 48.8 94.2

ofwhichbonds 428.8 0.0 3176.6 334.0 0.0 0.0 0.0 0.0

Private Non-Guaranteed

Total Long-Tern Disbursements 468.4 95.8 3544.4 620.8 282.7 231.2 252.5 285.0

Net Short-Term Capital 0.1 -0.1 -55.3 -2.0 12.9 47.1 -24.8 -26.7

IMF Purchases 14.1 13.6 106.1 18.1 0.0 0.0 0.0 0.0

Total Disburs. (LT+IMF+ST) 482.7 109.3 3595.2 636.9 295.7 278.4 227.6 258.3

B. Amortizations

Public & Publicly Guaranteed 313.6 392.5 266.2 298.9 260.3 261.7 258.9 346.1

a. Multilateral 91.8 84.4 75.3 75.4 79.5 73.8 73.0 109.1

of which IDA 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

of which IBRD 53.6 39.7 30.9 31.7 29.5 23.1 22.7 30.1

b. Bilateral 16.0 27.9 28.1 64.1 66.1 71.8 66.3 33.6


of which bonds 0.8 0.5 0.4 0.4 37.5 37.5 37.6 145.7


Total Long-Term Amortizations 313.6 392.5 266.2 298.9 260.3 261.7 258.9 346.1

IMF Repurchases 1.3 37.4 52.2 27.4 17.8 31.7 34.4 17.5

Total Amortizations (LT+IMF) 314.9 429.8 318.4 326.4 278.0 293.4 293.4 363.6

C. Net Disbursements c/

Public&PubliclyGuaranteed 154.8 -296.7 3278.2 321.8 22.5 -30.5 -6.4 -61.1

a. Multilateral -77.1 0.1 207.0 191.2 172.2 109.2 110.7 61.7

ofwhich IDA 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

of which IBRD -52.2 -28.5 75.6 -3.7 15.0 28.1 36.4 33.8

b. Bilateral -16.0 -16.6 57.4 -44.0 -46.1 -51.8 -46.3 -13.6

c. Private creditors -150.1 -280.2 3013.7 174.6 -103.6 -87.8 -70.8 -109.1

of which bonds 428.0 -0.5 3176.2 333.6 -37.5 -37.5 -37.6 -145.7


Total Long-Term Net Disb. 154.8 -296.7 3278.2 321.8 22.5 -30.5 -6.4 -61.1

NetShort-TermCapital 0.1 -0.1 -55.3 -2.0 12.9 47.1 -24.8 -26.7

Net use of IMF Credit 12.8 -23.8 53.9 -9.3 -17.8 -31.7 -34.4 -17.5

Total net Disburs. (LT+IMF+ST) 167.8 -320.6 3276.7 310.5 17.6 -15.1 -65.7 -105.3

Table 4: PANAMA DDSR - External Debt Stocks and Flows a/ Annex I(US$ Millions) Page 6 of 7

(Contlnued)

Actual Estimated Proiected

1994 1995 1996 1997 1998 1999 2000 2001-2004 b/

D. Interest


a. Multilateral 44.1 40.3 49.7 60.7 75.8 85.8 93.7 108.1

of which IDA 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

of which IBRD 18.0 14.7 17.3 18.4 18.4 19.8 22.1 28.6

b. Bilateral 18.9 24.9 25.2 22.7 22.4 19.8 17.3 13.7


of which bonds 37.6 0.1 70.2 170.6 176.8 183.5 190.1 210.4


Total Interest on Long-Tenn Loans 363.3 414.3 198.6 291.4 304.3 314.0 322.8 354.1

Interest on Short-Term Debt 1.0 0.0 -1.9 -4.0 -3.7 -1.5 -0.7 -8.0

IMF Charges 6.4 7.8 9.2 11.2 10.6 8.7 6.3 1.4

Total Interest (LT+IMF+ST) 370.7 422.1 205.9 298.5 311.2 321.2 328.4 347.4

E. External Debt


a. Multilateral 582.9 583.0 790.0 981.2 1153.4 1262.6 1373.2 1547.8

of which IDA 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

of which IBRD 205.6 177.1 252.7 249.0 264.0 292.1 328.5 417.7

b. Bilateral 673.6 657.0 714.4 670.5 624.4 572.6 526.3 479.6


ofwhichbonds 3.0 2.6 3178.8 3178.4 3140.9 3103.3 3065.7 2729.6


Total Long-Tern DOD 3922.5 3800.6 5110.8 5180.5 5202.7 5172.2 5165.7 5006.4

Short-Term Debt 1600.3 1896.1 -54.4 -56.4 -43.5 3.7 -21.2 -124.0

Use of IMF Credit 133.2 109.4 163.3 153.9 136.2 104.4 70.0 10.0

Total DOD (LT+IMF+ST), of which: 5656.0 5806.2 5219.7 5278.1 5295.3 5280.3 5214.6 4892.4

Principal Arrears 1927.1 2101.9 2101.9 2.3 2.3 2.3 2.3 2.3

Interest Arrears 1600.0 1895.9 0.7 0.7 0.7 0.7 0.7 0.7

F. Debt and debt Burden Indicators:

Total debt service (nil US$) 685.6 852.0 524.4 624.9 589.3 614.6 621.8 711.0

Interest (LT + ST + IMF) 370.7 422.1 205.9 298.5 311.2 321.2 328.4 347.4

Principal (LT + IMF) 314.9 429.8 318.4 326.4 278.0 293.4 293.4 363.6

a/ Accrual Basis

b/ Annual Averages

c/ Includes the Bond rescheduling in 1994, the DDSR operation in 1996 and the rescheduling of Bilateral Debt with Mexico and Venezuela


Table S: PANAMA DDSR - Public Sector Finances a/ Annex I


Actua Estimated Po1994 1995 1996 1997 1998 1999 2000 2001-2004 b/

A. Consolidated Non-Finanial Public Sector

TotalCurrentRevenues 2208.0 2307.0 2421.1 2468.4 2578.2 2701.6 2873.6 3350.0Directtaxes 789.0 854.0 991.9 1045.0 1106.2 1171.0 1245.5 1462.3Indirecttaxes 365.0 377.0 476.4 419.6 409.4 424.1 549.2 621.0

Ondomestic goods and services 187.0 205.0 296.8 230.4 209.0 212.1 323.6 356.2Oninternationaltrade 178.0 172.0 179.6 189.2 200.3 212.1 225.6 264.8

Non-Tax Receipts 1054.0 1076.0 952.8 1003.8 1062.6 1106.5 1078.8 1266.6

TotalCurrentExpenditures 1907.6 2076.0 2110.6 2090.0 2160.1 2231.4 2304.7 2671.4Interestonexternaldebt 321.6 428.0 350.2 298.5 311.2 321.2 328.4 347.4Interest on domestic debt 57.0 34.0 93.7 98.7 104.5 110.6 117.7 138.2Transferstoprivate sector 257.3 332.3 271.0 234.5 210.4 185.1 149.3 186.4TransferstootherNFPS 275.4 292.2 333.4 341.8 353.3 364.9 376.9 436.9Subsidies c/. 12.1 12.5 15.7 13.9 13.5 14.0 18.1 19.5Consumption 984.2 977.0 1046.6 1102.6 1167.2 1235.5 1314.2 1542.9

Wages and salaries 729.2 723.9 775.4 816.9 864.8 915.4 973.7 1143.2Other consumption 255.0 253.1 271.2 285.7 302.4 320.1 340.5 399.8

Budgetary Savings 300.4 231.0 310.6 378.5 418.1 470.2 568.8 678.6Capital Revenues 24.0 23.0 15.6 16.5 17.4 18.4 19.6 16.9Total Capital Expenditures 268.0 296.0 367.1 320.9 365.8 387.3 451.1 505.1

Capitaltransfers 96.0 131.0 140.6 115.2 139.4 138.3 176.5 171.2Budgetazyfixedirnvestinent 172.0 165.0 226.5 205.7 226.5 249.0 274.6 333.9

Overallbalance(-=deficit) 56.4 -42.0 -40.9 74.1 69.7 101.4 137.3 190.4

Sources offinancing (+) -56.4 42.0 40.9 -74.1 -69.7 -101.4 -137.3 -190.4Official Capital Grants 0.5 0.0 75.0 75.0 70.0 70.0 60.0 52.5Extemal Borrowing(net) 94.2 -434.7 -1387.1 312.5 4.7 -62.2 40.9 -78.6Monetary System Credit (net) -224.8 -219.8 -271.1 -331.6 -66.9 -35.3 -86.8 -102.9Other Domestic Borrowing (net) -373.4 118.5 1479.8 -129.9 -77.4 -73.9 -69.7 -61.4

B. Shares of GDP at current prices (%)Current revenues 31.7 31.1 31.0 30.0 29.6 29.3 29.3 29.1Current expenditures 27.3 28.0 26.1 25.4 24.8 24.2 23.5 23.2Budgetary savings 4.3 3.1 4.9 4.6 4.8 5.1 5.8 5.9

Capital revenues 0.3 0.3 0.2 0.2 0.2 0.2 0.2 0.2Capita expenditures 3.8 4.0 4.7 3.9 4.2 4.2 4.6 4.4OverallBalance(-deficit) 0.8 -0.6 0.4 0.9 0.8 1.1 1.4 1.6Official capital grants 0.0 0.0 1.0 0.9 0.8 0.8 0.6 0.5External Borrowing(net) 7.8 1.9 -0.6 3.8 0.1 -0.7 -0.4 -0.7Monetary System Credit (net) -3.2 -3.0 -3.5 -4.0 -0.8 -0.4 -0.9 -0.9Other (net)d/ -5.4 1.6 3.5 -1.6 -0.9 -0.8 -0.7 -0.5

C. NFPS DOD end of yearExterna Debt 5656.0 5806.2 5219.7 5278.1 5295.3 5280.3 5214.6 4892.4Net Debt To Monetary System -843.8 -1025.2 -1380.6 -1447.5 -1482.8 -1569.6 -1629.3 -1922.6OtherDomesticDebt 153.8 '18.1 139.2 9.2 -68.2 -142.2 -211.8 -366.4Total debt 4966.0 4899.1 3978.2 3839.8 3744.3 3568.5 3373.4 2603.4TotalGovernmentdebtas%GDP 71.2 66.1 50.9 46.7 43.0 38.7 34.4 21.5

D. Tax burden indicators (%/6)

Directtaxes/GDP 11.3 11.5 12.7 12.7 12.7 12.7 12.7 12.7Indirtaxesondomestic G&S/GDP 2.7 2.8 3.8 2.8 2.4 2.3 3.3 3.1Indirtaxesondom G&S/privConsum 4.4 4.4 6.1 4.5 3.9 3.7 5.5 5.2Taxes int trade /merchm im 26.0 23.0 21.8 21.1 20.5 19.7 18.6 17.0

a/ On accrual basis.b/ Annual averages.c/ Data from National Accounts.d/ Includes USt250 million frm privatization in 1996.Source: World Bank staffeibmate

Annex HPage 1 of 1

Debt and Debt Service Reduction Loan

Supplementary Data Sheet

Section I: Timetable of Key Events

(a) Time taken by the Country to prepare the program: 10 months

(b) Prepared by: Ministry of Planning and Economic Policy

(c) First Presentation to the Bank: December 1995

(d) Departure of Appraisal Mission: Not Applicable

(e) Completion of Negotiations: February 1996

(f) Planned Date of Effectiveness: April, 1996

Section II: Special Bank Implementation Action

None

Section III: Special Conditions

The following have been established as conditions of effectiveness:

(a) consistency of the Borrower's macroeconomic framework with theobjectives of the adjustment program supported by the ERL; and

(b) confirmation by the Borrower, in form and substance satisfactory to theBank, that sufficient resources are available to close the DDSR operation.

It has been established that no withdrawals from the loan account shall be made unless:

(a) The Bank shall have approved the procedures for such withdrawals; and

(b) The Bank shall be satisfied with the arrangements for the maintenance of thecollateral

SI%IVOTMMNV 90IO NMWLV~LS

StJO.IIVWIJO Jf1oH-9 )NVff AO L1VI s

LU X~~~~~~.... .. .

Annex 3

Page lof I

PANAMA

STATUS OF BANK GROUP OPERATIONSSTATEMENT OF BANK LOANS

(As of December 31,1995)(USSmiulion)

Amount in USS million

Creditl Fiscal (leOm ncellation)

Loan No. Year Borrower Purpose Bank IDA Undisu=

1. 32 loans Ily disbursed 505.63

w/o SECALs, SAls, and Program loans

Ln 2357-PAN 1984 Panama Strucural Adjusnmed 1 60.20

Ln. 2768-PAN 1994 Structral Adjustment 1 49.83

Sub-total 110.03

2. Undisbursed loans

Ln. 3438-PAN a/ 1992 Panama Economic Recovery 120.00 59.01

Ln. 3686-PAN 1994 Panama Road Rehabilitation 60.00 56.46

Ln. 3841-PAN 1995 Panama Rural Health 25.00 25.00

Sub-total 205.00 140.47

Total 710.63

O/w has been repaid 441.32

Total now held by Bank 269.31

Amount sold: 9.21

Of which has boeen repaid: 9.21

Total Undbbuned 140.47 140.47

a/ SAL, SECAL, or Program Loan.

Source: World Bank

AN f. ::

STATUS OF BANK. GROUP OPERTIONS- STATEMT OF IFC :INVESTMZNTS:

Annex 4Page I of 1

PANAMA

STATUS OF BANK GROUP OPERATIONS

STATEMENT OF IFC INVESTMENTS(As of December 31, 1995)

(USS million)

Fiscal Original gross comintments Held Held by UndisbursedYears by Partici- (including)Committed Obligor Type of Business IFC IFC Partici- IFC pants Participants

Loan Equity pants Total

1971 Corp de Hotelero a! Tourism 1.21 0.27 -1.48 ---

1978 Vidriospanamenos a/ Glass Factory 2.40 1.40 - 3.80

1979/85/86 Bco. Latino Americano Money & 47.33 2.50 - 49.83 2.09 - -

de Exportaciones, S. A. Capital Markets

1993 Banco Continental Credit Line 5.00 - - 5.00 5.00 - 3. 27

1995 Manzanillo Transport & storage 25.00 - 35.00 60.00 25.00 35.00 -

Total Gross Conunitnents b/ 80.94 4.17 35.00 120.11

Less Cancellations, terminations,repayments and sales 50.94 2.08 - 53.01

Total Conmiitnents Now Held c/ 30.00 2.09 35.00 67.09 32.09 35.00 3.27

Pending Commitments

Total commitnents Held and Pending 30.00 2.09 35.00 67.09Conunitments

Total Undisbursed Conmitments 3.27 0.00 0.00 3.27

a/ Investments which have been fully canceled, terminated, written-off, sold, redeemed or repaid.b/ Gross Commitments consist of approved and signed projects.c/ Held Commitments consist of disbursed and Undisbursed investments.

Source: IFC

: :: : : : :: : :: : : : : :::: :::~~~~~~~~~~~~~..... ... ................... .... . ....... . . . . . . ... . .. ... .... .. :: .. . . .. . .:~~~~~~~~~~~~. .::: ...

. ... : : : ... :.:...... ... .... .. ... ........~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

'~~~~~~~~~~~~~~~~~~. . '' ............ I

Annex VPage 1 of8

March 5, 1996

International Bank forReconstruction and Development1818 H Street, N.W.Washington, D.C. 20433United States of America

Attention: Mr. Edilberto L. SeguraDirectorCountry Department IILatin America and Caribbean Regional Office

Re: Republic of Panama 1995 Financing PlanWaiver of Negative Pledae Clauses

Dear Mr. Segura:

We make reference to the 1995 Financing Plan forthe Republic of Panama (the "Republic") dated October4th, 1995, which has been distributed to commercial bankcreditors of the public sector of Panama (the "FinancingPlan"). Copies of the Financing Plan have previouslybeen furnished to the staff of'the International Bankfor Reconstruction and Development (the "Bank").

The Financing Plan represents the culmination ofdiscussions with the Republic's Bank Advisory Committeeon the readjustment and reduction of the external publicsector debt of Panama owed to commercial banks. TheFinancing Plan contains a number of voluntary,market-oriented options to be offered to commercial bankcreditors of the Republic and certain other publicsector obligors, options which are innovative andflexible and which will provide significant cash flowrelief to the Republic during the short and medium termwhile the Republic pursues a structural adjustmentprogram aimed at correcting existing external andinternal imbalances in the Panamanian economy andintroducing market reforms in order to achieve sustainedeconomic growth.

Annex VPage 2 of 8

International Bank forReconstruction and DevelopmentMarch 5, 1996Page 2

The Financing Plan contemplates that holders ofeligible commercial bank debt will exchange outstandingprincipal amounts due under certain medium- andlong-term loan agreements ("Eligible Principal") and aportion of interest claims ("Eligible Interest" andtogether with Eligible Principal, "Eligible Debt") forbonds issued by the Republic. Panama's commercial bankcreditors may choose among (1) Discount Bonds ("DiscountBonds"), (2) Par Bonds ("Par Bonds") or (3) InterestReduction Bonds ("IRBs" and together with the DiscountBonds and the Par Bonds, "Principal Bonds"). Each ofthese options will involve an exchange of existing debtinstruments for newly issued bonds. Eligible InterestClaims will be exchanged for newly issued Past DueInterest Bonds ("PDI Bonds" and together with thePrincipal Bonds, "Bonds").

To date, Panama's commercial bank creditors haveresponded favorably to the Financing Plan -- creditorsholding in excess of 98% of the Eligible Principal haveelected to exchange their Eligible Principal for one ormore of the options listed above. They are expected toexecute the requisite bond exchange agreements beginningin April, 1996, copies of which will be furnished to thestaff of the Bank. It is currently contemplated thatthe Financing Plan will be consummated in late May, 1996(the "Closing Date").

The purpose of this letter is to request formallythat the Bank, pursuant to the terms of the negativepledge clauses contained in the Bank's loan andguarantee agreements with the Republic and its agenciesand other public sector entities, consent to the pledgeby the Republic of collateral to secure the PrincipalBonds in order to permit the consummation of theexchange of Eligible Principal for such Bonds.

Each of the Principal Bonds will be issued by theRepublic. Bank creditors wishing to exchange theirEligible Debt for Par Bonds or IRBs will do so at par,and bank creditors wishing to exchange their EligibleDebt for Discount Bonds will do so at a discount of 45%from par. Eligible Interest claims will be exchangedfor PDI Bonds issued by the Republic in an aggregateprincipal amount equal to the aggregate amount ofinterest claims, as recalculated under the FinancingPlan. All the Bonds will be issued in registered form

Annex VPage 3 of8


only. The Bonds will be listed on the Luxembourg StockExchange.

The Discount Bonds will have a tenor of 30 yearswith a bullet repayment at final maturity and will bearinterest, payable semiannually in arrears, at a floatingrate equal to 13/16% per annum over the six-month Londoninterbank offered rate for Eurodollar deposits("LIBOR"). The entire face amount of the Discount Bondsat maturity will be secured by a pledge of U.S. Treasuryobligations and twelve months of interest thereon willbe collateralized by cash or certain other permittedinvestments. The Republic will pledge cash or permittedinvestments, in U.S. dollars, in an initial amount, tobe delivered on the Closing Date, equal to nine monthsof interest payments on the Discount Bonds at theassumed rate of 7.00% per annum. The Republic willpledge additional cash or permitted investments in twoequal annual installments of .85% of the principalamount of the Discount Bonds then outstanding commencingon the first anniversary of the Closing Date, whichamounts, together with all interest collateral amountpreviously delivered, and earnings thereon, as a resultof retention and reinvestment of interest paid on suchinterest collateral, will increase to an amount equal to12 months of interest payments on the Discount Bonds atthe assumed rate of 7.5%. Bank creditors holdingU.S. $86.5 million of Eligible Debt have so farcommitted to exchange their Eligible Debt for DiscountBonds. Accordingly, an aggregate of approximatelyU.S. $47.5 million face amount of Discount Bonds will beissued on the Closing Date. This amount representsapproximately 4.5% of the total Eligible Debt.

The Par Bonds will have a tenor of 30 years witha single bullet repayment at final maturity and willbear interest, payable semiannually in arrears, at fixedinterest rates -- 3.00% per annum from the Closing Dateto the first anniversary of the Closing Date; 3.25% perannum from the first anniversary of the Closing Date tothe second anniversary of the Closing Date; 3.50% perannum from the second anniversary of the Closing Date tothe third anniversary of the Closing Date; 3.75% perannum from the third anniversary of the Closing Date tothe fourth anniversary of the Closing Date; 4.25% perannum from the fourth anniversary of the Closing Date tothe sixth anniversary of the Closing Date; 4.75% perannum from the sixth anniversary of the Closing Date to

Annex VPage 4 of 8


the eighth anniversary of the Closing Date; 5.25% perannum from the eighth anniversary of the Closing Date tothe tenth anniversary of the Closing Date; and 5.50% perannum thereafter. The entire face amount of the ParBonds at maturity will be secured by a pledge of U.S.Treasury obligations and twelve months of interestthereon will be collateralized by cash or certain otherpermitted investments. The Republic will pledge cash orpermitted investments, in U.S. dollars, in an initialamount, to be delivered on the Closing Date, equal tonine months of interest payments on the Par Bonds at theassumed rate of 3.07% per annum. The Republic willpledge additional cash or permitted investments in threeequal installments of .40% of the principal amount ofthe Par Bonds then outstanding commencing on the firstanniversary of the Closing Date, which amounts, togetherwith all interest collateral amounts previouslydelivered, and earnings thereon, as a result ofretention and reinvestment of interest paid on suchinterest collateral, will increase to an amount equal to12 months of interest payments on the Par Bonds at theinterest rate payable on the Par Bonds for thesubsequent year. Bank creditors holdingU.S. $264.0 million of Eligible Debt have so farcommitted to exchange their Eligible Debt for Par Bonds.Accordingly, an aggregate of approximatelyU.S. $264.0 million face amount of Par Bonds will beissued on the Closing Date. This amount representsapproximately 13.6% of the total Eligible Debt.

The principal of the IRBs will be payable in27 equal semiannual installments commencing on the fifthanniversary of the Closing Date through the eighteenthanniversary of the Closing Date. The IRBs will bearinterest, payable semiannually in arrears, at a fixedrate equal to 3.50% per annum from the Closing Date tothe first anniversary of the Closing Date; 3.75% perannum from the first anniversary of the Closing Date tothe second anniversary of the Closing Date; 4.00% perannum from the second anniversary of the Closing Date tothe third anniversary of the Closing Date; 4.25% perannum from the third anniversary of the Closing Date tothe fourth anniversary of the Closing Date; 4.50 perannum from the fourth anniversary of the Closing Date tothe fifth anniversary of the Closing Date; 4.75% perannum from the fifth anniversary of the Closing Date tothe sixth anniversary of the Closing Date; 5.00% perannum from the sixth anniversary of the Closing Date to

Annex VPage 5 of8


the seventh anniversary of the Closing Date; andthereafter at a floating rate equal to 13/16% per annumover LIBOR. During the first seven years of theirtenor, the IRBs will have the benefit of a rollingguaranty of six months of interest in the form of apledge of cash and certain other permitted investments.The Republic will pledge cash or permitted investments,in U.S. dollars, in an amount, to be delivered on theClosing Date, equal to six months of interest paymentson the IRBs at the assumed rate of 3.55% per annum.Such interest collateral, as a result of retention andreinvestment of interest paid on such interestcollateral, will increase to an amount equal to sixmonths of interest payments on the IRBs at the annualinterest rate of 5.0% per annum. Bank creditors holdingU.S. $1,588.0 million of Eligible Debt have so farcommitted to exchange their Eligible Debt for IRBs.Accordingly, approximately U.S. $1,588.0 million faceamount of IRBs will be issued on the Closing Date. Thisamount represents approximately 81.9% of the totalEligible Debt.

The PDI Bonds will be payable in 21 semiannualinstallments commencing on the tenth anniversary of theClosing Date through the 20th anniversary of the ClosingDate -- Installments 1 through 8, each for an amountequal to 2.00% of the face amount of outstandingprincipal; installments 9 through 11, each for an amountequal to 3.00% of the face amount of outstandingprincipal; and installments 12 through 21, each for anamount equal to 7.50% of the face amount of outstandingprincipal. The Past Due Interest Bonds will bearinterest, payable semiannually, at a floating rate equalto 13/16% per annum over six-month LIBOR. PDI Bondswill not be collateralized.

In order to permit the consummation of theissuances and exchanges of the Bonds, appropriatewaivers of the negative pledge and pari passu clauses inloan and credit agreements obligating the Republic orcertain other public sector obligors will be required.In connection with the execution of the requisite bondexchange agreements noted above, the Republic hasreceived all consents and waivers necessary under theloan agreements pertaining to the Eligible Debt for theimplementation of the Financing Plan.

Annex VPage 6 of 8


In addition, the Republic is requesting, andanticipates receiving shortly, a waiver of the negativepledge and pari passu clauses in its loan and guarantyagreements with the Inter-American Development Bank andwith other official creditors listed in Annex A. Noother consents or waivers from any other creditors arerequired for the implementation of the Financing Plan.

The Republic hereby requests that the Bankconsent to the provision by the Republic of collateralacquired by it at a net cost of no more thanU.S. $113.4 million to the extent necessary to securethe Bonds to be issued in connection with the FinancingPlan as described above. of this amount, the Republicestimates that it will be required to deliver collateralof U.S. $92.3 million on the Closing Date and that thetotal cost of funding the various categories ofcollateral will be as follows: U.S. $8.5 million forcollateral for the principal of the Discount Bonds;U.S. $2.5 million for interest on the Discount Bonds;U.S. $47.1 million for collateral for the principal ofthe Par Bonds; U.S. $6.1 million for collateral forinterest on the Par Bonds; and U.S. $28.1 million forcollateral for interest on the IRBs. The Republicrequests that the Bank's consent extend not only toexisting loan and guarantee agreements with the Bank,but also to loan and guarantee agreements which aresigned during the three-year period for the delivery ofthe collateral.

The Republic hereby affirms its obligations tocontinue to make timely payments on its loans from theBank and affirms that such loans will not be subject torescheduling requests. The Republic states its expressunderstanding that the consent by the Bank to thisrequest would be limited to the transactions describedabove and would be without prejudice to the Bank'sposition on the negative pledge clause under its loanand guarantee agreements in general.

Should you have any questions concerning thewaiver request, please contact Mr. Raul Gasteazoro atthe Ministry.

Annex VPage 7 of 8


Our Government greatly appreciates your activesupport in the important task of implementing theFinancing Plan and thereby reducing the stock andservice of Panama's public external debt to commercialbanks. Thank you for your attention to this matter.

Very truly yours,

Guillermo 0. Chapman Jr.Minister of Planning andEconomic PolicyRepublic of Panama

Annex VPage 8 of 8

ANNEX A

As to the negative pledge and pari passu clauses:

The Export Import Bank of the United States

As to pari passu clause:

Department of DefenseUS Agency for International DevelopmentCommodity Credit CorporationHousing Guaranty Program

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