Document of

The World Bank

FOR OFFICIAL USE ONLY

Report No. 16822

IMPLEMENTATION COMPLETION REPORT

PANAMA

DEBT AND DEBT SERVICE REDUCTION LOAN(Loan No 3991-PA)

June 30, 1997

Central America DepartmentLatin America and the Caribbean Region

This document has a restricted distribution and may be used by recipients only in theperformance of their official duties. Its contents may not otherwise be disclosed withoutWorld Bank authorization.

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CURRENCY EOUIVALENTSUS$1 = 1 Balboa

FISCAL YEARJanuary I - December 31

ABBREVIATIONS AND ACRONYMS

BAC Bank Advisory CommitteeBEP Break-Even PriceBNP National Bank of PanamaCAS Country Assistance StrategyCPF 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 CenterICR Implementation Completion ReportIDB 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 PriceRRP Report and Recommendation of the PresidentSBA Stand-by ArrangementSEF Social Emergency FundWTO World Trade Organization

Vice President Shahid Javed BurkiDirector Donna Dowsett-CoiroloLead Economist Ian BannonTask Manager Richard L. Ground

FOR OFFICIAL USE ONLY

IMPLEMENTATION COMPLETION REPORT

PANAMA

DEBT AND DEBT SERVICE REDUCTION LOAN(Loan No 3991-PA)

TABLE OF CONTENTS

PREFACEEVALUATION SUMMARY .. ..

PART I PROCIRAM IMPILIMENTA.N ION ASSIESSMN I

A. Background ,Distortions and Crisis .... .... .. 1Initiation of Adjustment and the Economic Recovery . ... . ... .............. 1External Debt ... 2........ .... ...... ... ............ ..... . . 2

B. Program Objectives and Design ..... . .. . 2.....2Economic Reform Program.......... .. ........ 2External Debt Strategy.. . ... ... .....3The DDSR Agreement ... , 3The DDSR Loan and its Objectives . 4 , . . , , .4Implementation of the DDSR Agreement 5Total and Up Front Costs. .... ...... ... .Financing and Sources of Official Support .. 5

C. Achievement of Program Objectives ...... . .... . 6 ..... ..6Extent of Debt Reduction...7Comprehensiveness and Savings of the DDSR Operation.. .. . .....9Direct Benefits................ .... I...... .I....................Efficiency of Debt Enhancement Funds . . . . . 11Indirect Benefits ... . . . . 13Net Material Benefits ..... .. 14Macroeconomic Outlook .. .14

D. Project Sustainability. 16E. Bank Performance. ... . 18F. Borrower Performance ... ....... .. .. 19G Future Operations .............. .....,.... , 19H. Assessment of Outcome and Key Lessons Learned .............................. 19

This document has a restricted distribution and may be used by recipients only in theperformance of their official duties. Its contents may not otherwise be disclosed withoutWorld Bank authorization.

LIST OF TEXT TABLESTable 1: Panama - Pre-DDSR Arrears Clearance and Rescheduling .......... 2. .......2Table 2: Panama DDSR - Terms of Agreement .............................. .. ... 4Table 3: Panama DDSR - Allocation of Eligible Debt .... . ............................ 5Table 4: Panama DDSR - Total and Up-Front Costs . . .6Table 5: Panama DDSR - Debt Reduction Equivalent .8Table 6. Panama DDSR - Savings and Distribution of Gains.. . 9Table 7: Panama DDSR - Debt Service Relief .. 11Table 8. Panama DDSR - Illustrative Macroeconomic Impact .16Table 9 PanamA DDSR - Creditworthiness and Exposure Indicators ...... ... 17

TEXT FIGURFSFigure 1: Panama DDSR - Market Indicators .. 12

PART 2 STArISTICAL TAB3LEBS

Table I Summary of AssessmentsTable 2. Related Bank LoansTable 3. Project TimetableTable 4 Cumulative Loan DisbursementsTable 5: Project CostsTable 6: Project FinancingTable 7: Status of Legal CovenantsTable 8. Bank ResourcesTable 9: Bank Missions

ANNEXESAnnex 1: Project Implementation Review from Borrower's PerspectiveAnnex II: Bibliography

MAP

This document hais a rcstricted distribution and maV be used h) recipients only ill the p)crformance of theirofficial dutics. Its contents may not othierwvise be disclosed withlout Worlld Bank authorization.

IMPLEMENTATION COMPLETION REPORT

PANAMA

DEBT AND DEBT SERVICE REDUCTION LOAN

(Loan No. 39910-PAN)

This is the Implementation Completion Report (ICR) for the Debt and DebtService Reduction Loan to Panama, for which Loan No. 39910-PAN in the amount ofUS$30 million was approved on March 28, 1996, and made effective on July 3, 1996.

The loan closing date was July 31, 1996. The single tranche was fully disbursedon July 11, 1996.

The ICR was prepared by Richard L. Ground (LADCN), with the collaboration ofJose Gonzalez and Ricardo Tejada (LACDN). The ICR was reviewed by DonnaDowsett-Coirolo (Director, LADCN) and Ian Bannon (Lead Economist, LADCN).

The ICR is based on material in the Project File and on a report by Gary Kleiman(Consultant), who visited Panama in January 1997 with Messrs. Ground and Gonzalez.The Borrower contributed to the preparation of the ICR by furnishing data and reports toBank staff and consultants. The Borrower also contributed its own evaluation of theproject, which is included as Annex I of this document.

DEBT AND DEBT SERVICE REDUCTION LOANPANAMA

(Loan No. 39910-PAN)

Evaluation Summary

The Debt and Debt Service Reduction (DDSR) Loan to the Republic of Panama wasapproved on March 28, 1996, and fully disbursed on July 11, 1996. The US$30 million loanhelped Panama finance the purchase of collateral required for the implementation of the DDSRoperation ("The 1995 Financing Plan") previously agreed with its commercial bank creditors, andclosed on July 17, 1996. The DDSR loan, together with funding from the IMF (US$29.7 million)and IDB (US$30 million) financed about two-fifths of the closing costs of the DDSR operation.The World Bank, the IMF and IDB also provided indirect financing support for the DDSR: theWorld Bank and IDB, through the release of adjustment loan tranches, and the IMEF, through theapproval of SDR drawings under a Stand-by Arrangement.

Program Objectives and Design

Under the DDSR operation, almost all eligible commercial debt (US$4 billion), amountingto 70% of Panama's total public and publicly guaranteed external debt, was restructured. Panamaexchanged about US$2 billion in principal debt for three new instruments, in accordance with theterms of the 1995 Financing Plan. The discount bonds selected by creditors in exchange for theirexisting claims reduced the debt stock, while the front-loaded interest reduction bonds (FLIRBs)and the par bonds they selected reduced debt service. About 82% of the existing principal claimswere exchanged for FLIRBs; close to 14% for par bonds, and the remainder, for discount bonds.The discount and par bonds are fully collateralized in respect of principal; interest on theseinstruments is partially collateralized. Interest on the FLIRBs is partially collateralized; principalis not collateralized. In addition, Panama regularized past due interest (PDI) of almost US$2billion by making a down payment of about US$132 million, and issuing uncollateralized PDIbonds to holders of eligible debt for about US$1,351 million at a market interest rate. Theremaining PDI was forgiven. One creditor, holding eligible debt of about US$29 million, and theeligible interest thereon, did not participate in the 1995 Financing Plan.

The DDSR operation was expected to accelerate growth and reduce poverty, by: (i)eliminating the debt overhang and the associated "tax" on future output, which acted as adisincentive to reform efforts and private investment; (ii) sharply reducing market uncertainty overPanama's ability and willingness to fully service its external debt, and the sizable distortions andcosts such uncertainty entails; and (iii) offsetting the adverse effect on the investment climate andflows deriving from the disengagement of the U.S. from the Canal and former Canal Zone.Substantially reduced market uncertainty was expected to translate into appreciable growthbenefits to Panama by lowering the sovereign risk premium and the spread between real domesticand international interest rates, by restoring Panama's access to international capital markets oncompetitive terms and maturities for both public and private sector borrowers, and byencouraging direct foreign investment.

i.

Achievement of Objectives

Implementation of the DDSR operation achieved a debt reduction equivalent (DRE) of30% of eligible commercial debt, compared to the average of 35% secured in previous DDSRs.The total DRE (net of additional official financing) amounted to 18% of Panama's total public andpublicly guaranteed external debt, which is slightly higher than the average of previous DDSRs(16%). Moreover, the total DRE amounted to 14% of Panama's GDP, or a proportion severaltimes the average in previous operations (5%), reflecting the heavy weight of commercial debt inPanama's total debt, and the large debt overhang affecting the economy. This is why the operationis so crucial to Panama's fiture growth prospects. In addition, the DDSR operation achieveddebt reduction at a substantially lower financial cost to Panama than an open market debtoperation with a like amount of debt reduction would have entailed. These savings were anestimated US$778 million, or an amount equivalent to 9.1% of GDP. These savings were severaltimes greater than those garnered by other countries through DDSR operations (3% on average).

The Republic of Panama provided upfront enhancements of about US$220 million toimplement the DDSR operation. The operation generates financial savings of US$820 million innet present value terms, or 9.5% of GDP, compared to a counterfactual involving a debt rolloverand full interest service. The internal rate of return over the stream of financial savings is 25%.This is well above both the cost at which Panama could borrow the enhancement funds and thecritical level employed in the Bank's project lending. The costs to Panama of the operation mayturn out to be somewhat higher, depending on the outcome of the legal actions lodged against theRepublic of Panama in the United States by the creditor who did not participate in the 1995Financing Plan.

In addition to these direct benefits, the operation is generating the expected large indirectbenefits. Indeed, in January 1997, the major international risk classification agencies assignedPanama a sovereign credit rating of BB+, only slightly below investment grade (and onlysurpassed by two other countries in Latin America), while Panamanian private corporate issuersreceived an investment grade rating (putting them in the same category as their Chilean andColombian counterparts). One month later and merely seven months after closing the DDSR, theRepublic of Panama returned to the international capital market for the first time in a decade withspectacular results: its 5-year bond issue was heavily oversubscribed (totaling US$500 million or5.8% of GDP). Furthermore, the spread was merely 175 basis points over five-year U.S.Treasury Bonds. By way of comparison, Colombia floated a ten-year US$750 million bond issueone day after Panama's issue at 140 basis over the U.S. Treasury benchmark. The Governmentutilized 80% of the proceeds from the bond issue to repurchase PDI bonds and FLIRBs, andintends to use the rest for the same purpose. This operation secured an additional financialsavings to Panama on its debt service obligations of US$77 million in net present value terms(equivalent to 0.9% of GDP).

As a result of the DDSR and the progress achieved by the Government in implementing itseconomic reform program, the risk premium faced by Panama on long-term borrowings abroadplunged some 950 basis points in the short space of fifteen months, from about 1200 basis pointswhen the 1995 Financing Plan was issued, to about 250 basis points in February 1997. Panama's

iii

risk premium is now only slightly higher than Colombia's, and the private sector recently hasborrowed funds on the international capital market at competitive rates. Such a turnaround insuch a short period of time is unprecedented. At the same time, both domestic bond and equitymarkets enjoyed a watershed year in 1996 on bullish sentiment accompanying the debt agreement.Volume on Panama's stock exchange almost doubled from end-1995 to end-1996, while the stockprice index climbed 25%, and the net asset value for the bellwether Panama Balanced Fundsubscribed by international investors was up 30%. On top of this, in a market that had beenentirely dominated by fixed income instruments, 1996 saw three initial public offerings that raisedthe share of equity activity to over 5%. Moreover, during the first five months of 1997, the stockprice index climbed a further 21%.

Economic growth accelerated during the first quarter of 1997, reaching 3.6% with respectto the first quarter of 1996, when growth was slightly negative. This upswing was spearheadedby a rise of 38% in the value added in ports, the reactivation of construction, and renewed stronggrowth in electricity generation following last year's drought. Growth for 1997 as a whole isexpected to surpass 4%, and accelerate further in subsequent years, in large part because privateinvestors are responding to the Government's reform program and enhanced credit standing withlarge-scale investments in the restructuring of the Panamanian economy.

Risk and Sustainability

While the DDSR greatly improved Panama's capacity to service its debt, it couldpotentially constrain Panama's latitude to adjust debt service to adverse external shocks in theevent such shocks were larger than the debt relief achieved, or to domestic policy shocks. Moreparticularly, it would raise the transactions costs of an eventual debt restructuring relative to onein which loans were simply rescheduled, as in a Multi-year Resheduling Agreement (MYRA). Ineffect, the DDSR agreement raised the relative share of debt held in bonds from about 8 to 62%.The conversion of bank loans to bonds and additional lending by IFIs for DDSR raised the shareof relatively inflexible debt from about 19 to 85%. Nonetheless, the share of preferred creditorsin public debt service actually declined in 1996, to about 35% from 45% in 1995 (because Panamawas still accumulating arrears on commercial debt in 1995). On an accrual basis, the share ofpreferred creditors is projected to remain below the Bank's guideline of 35% during the nextdecade. Debt service to the Bank as a proportion of public debt service was about 11% in 1996,and is projected to average about 10% during 1998-2000, and somewhat less thereafter. Debtservice to the Bank as a fraction of exports also is projected to be far below the Bank's guidelineover the course of the next decade (1.3% in 1996, and lower thereafter).

Reduced flexibility per se translates into greater risk in the event of adverse externalshocks or domestic policy shocks; however, DDSR also mitigated the vulnerability of theeconomy to external shocks. First, it diminished the debt service burden and radically enhancedcreditworthiness. Second, it reduced the exposure of the economy to both interest rate risk--bychanging 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, the DDSR operation provides Panama with options to adjust debt service to externalshocks. For instance, Panama could capitalize interest payments on PDI bonds exceeding an

iv

annual interest rate of 4% during the first six years after closing; or use interest collateral to payup to 12 months interest on the par and discount bonds, and up to 6 months interest on theFLlRBs. In addition, current fiscal policies, coupled with the measures the Government is takingto consolidate fiscal balance over the longer-term, are projected to generate nonfinancial publicsector surpluses greater than 1% of GDP by the year 2000. Such additional resources wouldsignificantly increase the Government's capacity to absorb external shocks and to implement anefficient debt management strategy.

The economy is more vulnerable to domestic policy shocks in a post-DDSR world, but therisk of such shocks is considered slight. Panama's unique, nine decades-old dollar-basedmonetary regime provides a stable anchor for the macroeconomic framework. Maintenance ofsound economic policies also would be encouraged by the up-front cost that Panama paid toregain creditworthiness, and debt management strengthened as creditworthiness improves and thecost of mismanagement increases. Indeed, DDSR serves as a powerful deterrent to policyslippage. Moreover, the current Administration enjoys a solid majority in the LegislativeAssembly; has achieved major progress in implementing the lengthy reform agenda during its firstthree years; and has launched a second round of policy reforms for implementation during its finaltwo years in office. Nonetheless, support for the reform program could erode in this dualisticeconomy if investment in infrastructure and well-targeted social safety net programs were to lag,and if the high unemployment rate does not begin to subside.

The Bank is working with the Government to minimize this risk though an investmentlending program focused on poverty reduction; by enhancing implementation of the recentlylaunched portfolio in the social sectors; and through ESW and policy dialogue. In addition, theBank has substantially advanced discussions with the Government on the preparation of a newstructural adjustment operation to back the implementation of a second generation of policyreforms. The Bank would provide this support in concert with the IMF (which is preparing anExtended Fund Facility) and the IDB (which recently approved a utilities' sector adjustment loanand is preparing a financial sector adjustment operation).

Bank Performance

Panama's exceptionally successful DDSR operation could not have been concludedwithout the support of the Bank, the IMF and IDB. The Bank's performance in coordinatingsupport, evaluating the project, and processing the DDSR Loan was highly satisfactory. The Banktook six months, from the preparation of the Briefing Note for the Board, to Board approval ofthe DDSR loan. The loan was disbursed three and one-half months after Board approval, andclosed one week later. The Bank spent a very modest amount (US$71,000 in direct costs) on thepreparation and supervision of a US$30 million loan which was indispensable for the restructuringof almost US$4 billion of external debt, at a savings to Panama of 9% of its GDP and withpotential benefits of a similar magnitude.

v

Borrower Performance

The Government fielded a highly competent team to negotiate and carry out the DDSRagreement. The Government team expertly handled all the complexities of the operation withcompetence and diligence, and the 1995 Financing Plan achieved all its objectives. Withimplementation of the accord and follow-up actions with the international credit-rating agencies(also supported by the Bank) the Government successfully completed a well-designed strategy forrestoring the country's creditworthiness. This accomplishment, together with the substantialprogress simultaneously achieved in carrying out the other elements of its economic reformprogram, is creating the conditions required to lift the growth of Panama's economy to itspotential.

Lessons Learned

The analysis of Panama's DDSR operation confirms lessons from previous DDSRoperations: (i) the success of the operation depends principally on the credibility of the country'seconomic reform program; (ii) the concerted, menu-based approach to debt reduction providessignificant cost savings to the debtor country compared to market-based debt reduction; (iii)creditor banks also improve their financial position; (iv) the inclusion of a new money option isnot essential for securing both full participation of creditors and substantial cost savings; and (v)net benefits are higher when DDSR is backed financially by the International FinancialInstitutions.

PART I: PROGRAM IMPLEMENTATION ASSESSMENT

A. Background

1. Distortions and Crisis. Over the past twenty-five years, the sharp segmentation ofPanama's economy by distortionary Government policies has kept output growth far belowpotential. As state expenditure mounted relative to GDP and policy interventions proliferated,domestic prices of importables and non-traded goods rose faster than international prices despitethe dollar-based monetary regime, most resources were channeled into rubrics in which theeconomy possesses a comparative disadvantage; productive private investment was crowded out,foreign investment flows dried up; and the competitiveness of international services was eroded.Social services were expanded greatly, especially social security for public sector employees andtertiary education, but unemployment soared and two-fifths of the population was pushed intopoverty despite Panama's relatively high per capita income, leaving the country with one of themost unequal distributions of income in the hemisphere.

2. The expansion of the state and inflated domestic absorption were financed by foreignborrowing' in 1980, Panama had one of the largest per capita commercial bank debts in the world.During the early 1980s, these distortions, together with the international debt crisis, plunged theeconomy into recession. The economic downturn was exacerbated by the political crisis in the late1980s and the imposition of external economic sanctions. The Government ceased to service itscommercial bank, bilateral and bonded debt in 1987, and fell into arrears with the IFIs in 1988. In1988-89, the money supply plunged an estimated 30%, and economic activity contracted 16%.'

3. Initiation of Adjustment and the Economic Recovery. During 1990-94, 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 level 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.

4. Beginning in 1993, however, economic growth decelerated, falling to less than 3% by end-1994; and unemployment was still very high (almost 14%). While the economic recoverysubstantially strengthened public finances, the previous Administration did not implement thepolicies required to consolidate fiscal balance over the longer term. Progress in carrying out otherkey structural adjustment measures needed to achieve economic growth in line with Panama'sdevelopment potential and to adjust to sharply declining bilateral aid and gradual disengagementof the U.S. from the former Canal Zone also was slight. In the absence of major structural

'For a detailed analysis, see World Bank. Panama A Dual Economy in Transition. Report No. 13977-PAN (Grey Cover).Washington, D.C.: Country Department II, Latin America and the Caribbean Region, July 20, 1995.

2

reforms, debt relief and restoration of creditworthiness, economic growth was expected to revertto the 2.5% trend registered during the previous twenty years.

5. External Debt. Significant progress in normalizing relations with the internationalfinancial community was achieved during this period (Table 1). In February 1992, theGovernment cleared its arrears with the IFIs and the Paris Club. In May 1994, an agreement wasreached 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

Creditor Amount Date ConditionsUS$ Million

IFI's 640 February, 1992 Affears 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 upfiont, and US$415 millionequivalent were rescheduled over 10 years, with 5 years grace.

Commercial Bonds 472 April, 1994 Up-front paymnent on PDI of US$44 million, with USS428 millionInterest Arrears 188 exchanged for eight-year bonds, of which USS418 million werePrincipal Arrears 253 denominated in US dollars, with an interest rate of LIBOR+I%, andScheduled Principal 30 US$10 million in yen with an annual interest rate of 3.75%.

Source. Panama. Ministry of Planning and Economic Policy (MIPPE).

B. Program Objectives and Design

6. Economic Reform Program. The Administration inaugurated in September 1994launched a comprehensive economic reform program to accelerate economic growth and reducethe high incidence of unemployment and poverty, with the support of Bank ESW, technicalassistance and adjustment lending.2 The program encompasses measures to: (i) consolidate long-run fiscal sustainability; (ii) redress institutional imperfections and price distortions; and (iii)normalize relations with external creditors.

7. Over the past two years and nine months the Government has made considerable progressin implementing its reform program. Long-term fiscal sustainablity and the scope for domesticresource mobilization has been substantially enhanced, through elimination of the ComplementaryPension Fund (CPF) and its replacement with a private contractual savings scheme for publicsector employees. Efficiency in resource use and private investment have been promoted throughprivatization and regulatory reform, especially in ports (with privatization in telecoms, electricity

2 The Country Assistance Strategy was agreed with the new Government in December 1994, and discussed by the Board inFebruary 1995. The CAS proposed a high case lending program that could include a DDSR loan provided Panamacomplied with the second tranche conditions of the ERL. (Country Assistance Strategy of the World Bank Group for theRepublic of Panama. Report No. 13846-PAN, December 28, 1994). Studies and technical assistance for the newGovermnent's economic reforn program included Panama: A Dual Economy in Transition. op.cit.; La Universalizacionde los Incentivos Impositivos, Panama, March 1995 (Mimeo.); Proteccion Efectiva de los Productos Agropecuarios v suefecto en los Precios Intemos. (Mimeo.) August 1995; La Poltica Azucarero v la Privatizacion de La Victoria.(Mimeo.) October, 1995; Analysis del Impacto Fiscal de Largo Plazo de las Leves Laborales Especiales. (Mimeo.)December 1995; Proyecto de Ley General de Sueldos, (Mimeo.), January, 1996; Separacion de Costos en el SistemaIntegral de Salud. (Mimeo.) April 1996; Provecto de Lev de Defensa de la Competencia. (Mimeo.) December, 1995.The Government's reform program also was supported through the ERL, the Closing Date of which was extended fromMarch 31 1995 to June 30, 1996 (and subsequently to March 31, 1997) as well as the DDSR Loan.

3

and water underway). Efficiency also has been fostered by trade, tax and labor market reforms,and by price deregulation. These reforms have, in turn, mitigated the bias against employmentcreation, reduced the high cost of the consumption basket, and stimulated agricultural production,where most of the poor are employed. The elimination of the highly inequitable CPF, togetherwith the expansion of targeted interventions for low income groups, especially for those mostsusceptible to malnutrition and vector-transmitted diseases, has significantly improved thetargeting of public expenditure to the poor.3

8. External Debt Strategy. Integral to the Government's economic program is a strategy torestore Panama's creditworthiness and foster foreign investment. To that end, the Administrationinitiated informal conversations with the commercial banks upon taking office in September 1994,and launched formal negotiations with the BAC in December 1994. The Government sought acomprehensive debt and debt service reduction (DDSR) agreement that would significantlyreduce the debt stock; bring future debt service payments into line with the economy's projecteddebt service capacity; and shield future commercial debt service payments from interest rate andexchange rate risk.4 The Government also sought an agreement that would be cost effective aswell as financially viable. The need for official support for DDSR also played an important role inthe speed with which the Government moved on outstanding structural adjustment issues.5

9. The DDSR Agreement. On May 5, 1995, Panama and the BAC achieved a DDSRagreement in principle. 6 On October 4, 1995, the term sheet was issued, with closing expectedon April 30, 1996.7 The operation was designed to reduce debt and debt service through theexchange of eligible debt for new instruments, and substantial past due interest (PDI) forgiveness.Eligible debt encompassed all medium- and long-term commercial bank debt contracted by theGovernment and state entities. It was estimated at US$3.936 billion (half of which was PDI), ornearly 70% of Panama's public and publicly guaranteed extemal debt. It included all principalarrears and PDI as of closing, as well as remaining scheduled principal (due during 1996-97)."

10. The DDSR offered creditors four options for exchanging their principal claims (Table 2below). Each was freely available to holders of debt titles on a voluntary basis; the optionsselected were not subject to reallocation. No creditor, however, was permitted to participate inthe Agreement unless it did so with all of its eligible debt. The agreement also restructured PDI,by means of: (i) PDI forgiveness; (ii) partial PDI payments prior to closing; (iii) a downpayment

3 For details on the implementation of the economic reform program, see PANAMA - Economic Recovery Loan (Loan 3438-PA) Release of the Third Tranche (Partial Waiver of One Condition. (R97-46), March 19, 1997.

4 World Bank staff, and IF and IDB representatives made presentations 'at the December 1994 meeting on their respectiveprograms for Panama, including the conditions under which they could support a debt reduction accord.

5 The Government also began negotiating with non-Paris Club bilaterals (Mexico and Venezuela) to restructure about US$307million in medium-term debt, including arrears of US$248 million. In addition, the Government obtained earlyLegislative approval of Panama's accession to MIGA, and ratified the Convention on the Settlement of InvestmentDisputes, strengthening guarantees to foreign investors.

6 A briefing note on the agreement in principle was distributed to the Board in September 1995. ("Panama - Commercial BankDebt and Debt Service Reduction Operation: Briefing Note," SecM95-1029, September 19, 1995)

7 Republic of Panama, 1995 Financing Plan. October 4, 1995. In October 1995, the Government and BAC undertook aninternational "road show" to promote the Financing Plan. World Bank, IM and IDB staff participated in this effort.

8 Eligible debt also included US$19 million 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.

4

on PDI at closing; and (iv) a PDI bond. A major component of debt reduction would be obtainedthrough a recalculation of interest on principal at market rates and of interest on such interest atthe one-month LIBOR, and by waiving all contractual penalties. The PDI bond also was designedas a back-loaded amortization instrument. The BAC and the Government estimated that thisfavorable treatment would result in PDI forgiveness of US$590 million.

Table 2: PANAMA DDSR - Terms of Agreement

insruments Matunity interest Collateral Form

Menu of Ontions1. Par Bonds (with 30 yr. bullet Yr. 1:3.00% Principal secured by thirtyyear 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 tirty-year Registered(45%onfacevalue) 13/16% zero coupon U.S. Treasury securities.

Rolling inrest guarantees startingwith 9 months coverage at an interest rateof 7.0% per annun, increasing in 2 years tocover 12 months at a rate of 7.50/o, securedby cash or permitted investments

3. Front-Loaded 18 yr. with 5 yr. of grace Yr. 1:3.50% Rolling interest guarantees up to 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 six months at an interest rateYr. 6:4.75% of 5%, secured by cash or permitedYr. 7: 5.00% investmens No principal collateal.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 installmts Yr. 5-7: 5.75%Yr. 7-20: six monrithLIBOR + 13/16%

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

Past Due Interest1. US$132 nillion cash

2.PDIBonds(US$1351 20yr. with 10 yr. grace 6monlhLIBOR+ None Registered

million par exchange) and 21 semi-annual 13/16 %

installments as follows:

installments 1-8: 2% of

principal;9-11,33%; 12-21,

7.5%

3. Forgiveness (US$492 million)

Source: Republic of Panama, 1995 Financing Plan (October 4,1995); Panama. MIPPE; and Bank Advisory Committee (BAC).

11. The DDSR Loan and its Objectives. On March 28, 1996, the Board approved a free-standing DDSR loan of US$30 million to the Republic of Panama, and the Republic's request for

5

a Limited Waiver of the Negative Pledge Clause, to support DDSR.9 The objectives of the loanwere to accelerate growth and reduce poverty by assisting the Government in: (i) implementingdebt and debt service reduction; (ii) consolidating fiscal balance and structural reforms; and (iii)normalizing relations with commercial creditors and reestablishing creditworthiness. The DDSRprogram was expected to substantially enhance the effectiveness of the Government's economicreform program by: (i) sharply reducing market uncertainty over Panama's ability and willingnessto fully service its external debt, and the sizable distortions and costs such uncertainty entails; (ii)offsetting the impact on the investment climate and flows deriving from the disengagement of theU.S. from the Canal; and (iii) reducing the debt overhang and the associated "tax" on futureoutput, which was acting as a disincentive to reform efforts and private investment. Reducedmarket uncertainty would translate into appreciable growth benefits by lowering the sovereignrisk premium and real domestic interest rates, and by restoring Panama's access to internationalcapital markets on competitive terms and maturities for public and private sector borrowers.

12. Implementation of the DDSR Agreement. 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; 13.7% to the par bonds,and the remainder to the discount bonds (Table 3 below).'0 While this allocation resulted in lessdebt and debt service reduction than a balanced one, it also resulted in considerably lower up-front costs, ensuring the efficiency and viability of the operation.

Table 3: PANAMA DDSR - Allocation of Eligible Debt SI

US$ Millions Percent

Principal (1,968.0) 1,913.8 (100.0) 100.0Discount Bonds (48.0) 45.5 (2.4) 2.4Par Bond (268.0) 262.7 (13.6) 13.7FLIRBs (1,612.2) 1,568.6 (81.9) 81.9Principal Forgiveness (39.0) 37.0 (2.0) 1.9

Past Due Interest (1,968.0) 1,975.9 (100.0) 100.0Payments prior to closing (30.0) 24.0 (1.5) 1.2PDI Downpayment at closing (100.0) 108.0 (5.0) 5.5PDI Forgiveness (590.4) 492.0 (30.0) 24.9PDI Bonds (1,247.6) 1,350.9 (63.4) 68.4

a/ Values in parentheses are the estimates contained in the RRP. Teother figures are actuals. Totals may not add due to roundling.

Source: Panama. MIPPE.

13. Total and Upfront Costs. Eligible debt was US$3,889 million, or only slightly less thaninitially calculated. Total closing costs amounted to US$223.6 million, of which US$199.6 millionwas paid on the July 17, 1996 Closing Date (Table 4 below).

14. Financing and Sources of Official Support. The Bank worked in concert with the IMFand IDB on the financing plan for the Government's reform program and DDSR operation. OnNovember 29, 1995, the IMF approved a 15-month Stand-by Arrangement (SBA) for SDR 69.8

9 Report and Recommendation of the President of the International Bank for Reconstruction and Development to the ExecutiveDirectors on a Proposed Debt and Debt Service Reduction Loan of US$30 Million to the Republic of Panama and onRelated Measures to Support the Debt Reduction Program of the Republic of Panama. (Report No. P-6810-PAN) March5, 1996.

10 These figures on eligible debt exclude that portion for which commitments for new instruments were not received. Onecreditor, holding eligible debt of about US$29 million, and the eligible interest thereon, did not participate inthe 1995 Financing Plan and has brought legal action against the Republic of Panama in the United States.

6

million to support the program and DDSR, and on March 29, 1996, approved the Government'srequest for SBA Augmentation and release of DDSR set asides. Direct IMF support totaledUS$29.7 million. On December 13, 1995, the IDB approved a DDSR Loan of US$30 million.Disbursement was made contingent on disbursement by the Bank of its US$30 million DDSRloan, which occurred on July 11, several days ahead of the Closing Date. The Governmentfinanced the remaining upfront costs of US$134 million from its own resources. The Governmenthad substantially augmented its resources by meeting the second tranche release conditions of theIDB Public Enterprise Reform Loan (US$35 million), and achieving compliance with the secondtranche release conditions of the World Bank ERL (US$25 million), which also triggered therelease of the second tranche (US$27 million) of a Japan OECF loan which cofinanced the ERL.

Table 4: PANAMA DDSR - Total and Up-Front Costs a(US$ Millions)

Elisible Debt for Menu Options Prindpal Actual PDI Actual Total Estimate Total ActualEligible Debt (1,968.0) 1,913.8 (1,968.0) 1,974.9 (3,936.0) 3,888.0PDI payments prior to closing . (30.0) 24.0 (30.0) 24.0PDI Downpayment (100.0) 108.0 (100.0) 108.0PDI Forgiveness (590.4) 492.0 (590.4) 492.0Principal Forgiveness (39.0) 37.0 (39.0) 37.0Eligible Debt for Menu Options (1,929.0) 1,876.8 (1,247.6) 1,350.9 (3,176.6) 3,227.7

Menu Options Debt AllocationPrincipal

Discount Bonds (48.0) 45.5Par Bonds (268.0) 262.7FLIRBs (1,612.2) 1,568.6

Past Due InterestPDI Bonds (1,247.6) 1,350.9

Financing Costs WPDI payments prior to closing (30.0) 24.0PDI downpayment at closing (100.0) 108.0Cost of Collateral (96.3) 91.6

Principal (55.3) 55.3Interest (40 9) 36.3

Total (226.3) 223.6(o/w Up-front Costs) (222.6) 218.0

Financing: (226.3) 223.6IBRD (30.0) 30.0IMF (30.0) 29.7IDB (30.0) 30.0Panama (136.3) 133.9

a/ Values in parentheses are the estimates contained in the RRP. The other figures are actuals. Totals may not add due to rounding.b/ Includes collateral "top-ups" of about US$4 million in 1997-99.

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

C. Achievement of Program Objectives

15. The objectives of the DDSR operation and the supporting Bank DDSR loan are being metor surpassed. The DDSR operation:'1

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

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). Program Completion Report. Argentina: Debt and DebtService Reduction Loan (Loan 3555-AR!. Report No. 13885.

7

(ii) resulted in a debt reduction equivalent (DRE) of US$1,157 million, or 30% ofeligible debt and 18% of total public and publicly-guaranteed debt;

(iii) achieved this debt reduction at a savings amounting to 9.1% of Panama's GDPcompared to the cost of a market-based debt reduction;

(iv) yielded cash flow savings of US$820 million in 1996-2026 in net present value terms,or 9.5% of GDP, compared to counter-factual debt service, resulting in an IRR of 25%;

(v) generated net benefits, potentially reaching 9.1% of GDP, and

(vi) reduced interest rate risk by changing 53% of eligible debt into fixed-rate instruments,and reduced exchange rate risk by converting 17% of the debt denominated in non-UScurrencies into US dollars.

16. Achievement of these objectives did, however:

(i) curtail Panama's flexibility to adjust future debt service to shocks, inasmuch as 70% ofthe external debt heretofore subject to rescheduling was transformed into bonds; and

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

17. Extent of Debt Reduction. The DDSR resulted in a DRE of 30%, against the estimateof 31% provided in the RRP, because the Government and the BAC overestimated PDIforgiveness. The DRE is relatively low compared to that (35%) secured in previous DDSRs dueto several factors (Table 5 below). First, the relatively high market price of the debt prior to theagreement placed a relatively low ceiling on Panama's potential DRE: the pre-deal price ofPanamanian debt (55 cents) was far above the average (34 cents) for other DDSR countries(Table 6 below). The strength of the pre-deal price stemmed partly from the lengthy time periodthat had elapsed since announcement of the Brady plan in 1989 (subsequent to that datesecondary market debt prices recovered) and partly from Panama's stronger fiscal/balance ofpayments position relative to other Brady countries. Second, the drop in international interestrates lowered the DRE. at the interest rates obtaining when the Agreement in Principle wasissued, the DRE would have been 1.7 percentage points higher. Third, the low share (32%) ofeligible debt still owned by the BAC limited its ability to negotiate debt reduction: in particular, itprecluded inclusion of a mandatory rebalancing clause in the accord. Fourth, the unexpectedlyhigh share of commitments to the FLIRBs reduced the DRE relative to a balanced allocation.12

18. This result also reflects the relative confidence of investors in Panama's long-termeconomic prospects and creditworthiness--82% of eligible debt was exchange for theuncollateralized FLIRBs, as well as the growing preference of traders for high-yieldinginstruments in emerging markets. Finally, Panama's poor track record in meeting commitments tocommercial creditors likely curtailed its negotiating capacity--Panama had not made any servicepayment on this debt since 1987; was one of the two countries to have defaulted on aninternational bond issue during the debt crisis; and almost all eligible countries had alreadyconcluded DDSR agreements.

12 With a balanced commitment allocation, the DRE would have been 40%; however, upfront costs would have been US$366million rather than US$224 mnillion. In this case, the buy-back equivalent pnce of the operation would have been higherthan the secondary market price prevailing prior to the DDSR Agreement in Pnnciple, potentially jeopardizing officialsupport for the operation

Table 5: 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 Conmnercial Additional Total Total Total DRE DREValue Value Money Value of of Value of Equivalent Adjust- Debt DRE as a % Official DRE Debt as % of as percentageEligible Debt Commercial New Interest Collateral ments Reduction of Eligible Lending Reduction d/. Total of GDPDebta/ Reduction Debt Commercial Service Equivalent Debt Equivalent Debt

Reducton 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)] [(9)/(1)] [(10)-(11)1 [(12)/(13)]

Panama 3865 637 0 637 3228 433 92 525 1162 30 90 1072 5806 18 14

Principal 1914 37 0 37 1876 433 92 525 562 29DiscountBond 83 37 0 37 46 0 11 11 48 58ParBond 262 0 0 0 262 106 53 159 159 61FLIRBs 1569 0 0 0 1569 327 28 355 355 23New Money Option 0 0 0 0 0 0 0 0 0

Past Due Interest 1951 600 0 600 1351 0 0 0 600 31PDI Bond 1351 0 0 0 1351 0 0 0 0 0 OOPDI Down Payment 108 108 0 108 0 0 0 0 108 100PDI Retroactive 492 492 0 492 0 0 0 0 492 100Reduction

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 8Philippines 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 4Jordan 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 10Dominican Republic 1186 687 0 687 499 0 58 58 745 63 0 745 4284 17 8

eighted Averag 35 16 5

at Does not include the US$24 million of PDI paid by Panamna before the closing dates by/ For Panama calculated at the interest rates prevailing on August 1, 1996, for other countries, calculated at the market rates prevailing at the time oftheir 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 arrears on this debt and net use of IMF resources

Source: World Bank staff estunates.

9

19. Nonetheless, the DDSR resulted in a total DRE (net of additional official financing) ofPanama's total public and publicly guaranteed debt of 18%, a reduction greater than that achievedin previous agreements (16%). Moreover, total DRE amounted to 14% of Panama's GDP, or aproportion several times the average in previous operations (5%), reflecting the heavy weight ofcommercial debt in Panama's total debt, and the large debt overhang affecting the economy. Thisis why the operation was so crucial to Panama's future growth prospects.

Table 6: PANAMA DDSR - Savings and Distribution of Gains a/

DDSR Market Value Market Value Break-Even Post Deal Savings relative to Pre-Deal Distnbution 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 c/ of dollars d/ dollar e/ dollar f percent dollar g/ percent

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

Panama (167) 165 (2249) 2156 (0.60) 0.57 (0.80) 0.77 (25%) 26% (0.55) 0.55 (81%) 91%

Mexico 5252 20206 0.41 0.52 21% 0.36 69%

Philippines 670 3749 0.46 0.52 12% 0.40 50%

Csta 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 b/ 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/ Values in parentheses are the estimates contained in the RRP. The other figures are actuals.b/ Second Phase.c/ Prepayment of collateral (interest collateral valued at 1-secondary market price), plus PDI downpayment and cash for buy-back.d/ For Panama based, on average quotations of when and if issued instruments through January 11, 1996.e/ BEP = (Market value of new portfolio)/(Eligible Debt). The BEP measures the average price at which the DDSR occurredf/ PDN = (Market value of new mnstrumnents net of enhancements)/ (Eligible Debt-DRE)g/ PDP is the price in the month before DDSR was announced, except for Philippines Phase 2, Bulgaria, Poland and Panama, Bulgana, Polandand Panama, where it is the price before negotiations started.

Source: World Bank staff estimates.

20. Comprehensiveness and Savings of the DDSR Operation. The DDSR operationachieved debt relief at a substantially lower financial cost to Panama than a market-based debtreduction would have entailed, because the comprehensiveness of the menu approach virtuallyeliminated the free rider problem associated with a market-based debt reduction. In effect, theDDSR occurred at an average market price of 57 cents on the dollar, or a price about 26% lowerthan the post-deal price at which an open market operation with a like amount of debt reductioncould occur, which is somewhat higher than the average in previous DDSR operations (Table 6above).13 The resulting savings compared to a market-based debt reduction reached US$778million, or 9.1% of GDP. These savings are several times greater than those garnered by othercountries through DDSR (3% of GDP on average). At the same time, Panama obtained 91% of

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

10

the overall benefits generated by the operation, compared to an average of 59% for previousDDSR operations. The DDSR also was cost effective, as measured by the IMF.

21. Evaluating the material benefits--the direct cash flow implications and the indirectdevelopment impact--of the DDSR operation requires explicit assumptions about the course ofaction 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 relations with creditors commencing in 1991, and partly on the basis of marketexpectations that Panama would fully restore these relations in the medium-term. Had this notbeen the case, the economic recovery would have been a slow and painful process--without therestoration of confidence, it is unclear how the money supply, which plunged an estimated 30%during 1987-89, would have been replenished. Similarly, a decision to continue to accumulatecommercial arrears rather than regain creditworthiness through DDSR would have prevented theeconomy from reaping significant benefits from fiscal and structural reforms because it wouldhave rapidly destroyed the confidence of domestic and foreign investors in the economy, possiblyresulting in demonetization and stagnation (and undermining support for reform).

22. As a result of such considerations, re-establishment of creditworthiness was an integralpart of the Government's economic program from the outset. Consequently, a counterfactualrooted in the extrapolation of commercial arrears accumulation lacks plausibility. Comparing thedirect effects of DDSR to scheduled debt service also is an implausible counterfactual becausethat debt was scheduled to be amortized by end-1997. In light of these considerations, andfollowing the approach adopted in the Board documents for all DDSR operations supported bythe Bank since 1992, when this type of analysis was introduced, two counterfactuals could beconsidered: a MYRA or a debt rollover with full interest service.14 The DDSR provides greaterdebt service relief when compared to a MYRA, because the debt would be amortized muchquicker in a MYRA. Taking this as an upper bound, the counterfactual selected to assess the debtservice relief 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%).15

S see "Analytical Aspects of Debt and Debt Service Reduction Operations," op. cit.

5 Clearly, m 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 vanants of full debt service counterfactuals has been cntiqued on the grounds thatthey are mconsistent with market expectations of partial default, as reflected m the discount in the secondary marketprice of commercial debt prior to DDSR. (See Eduardo Fernandez-Arias, "Costs and Benefits of Debt and Debt ServiceReduction." The World Bank. International Economics Department. Working Paper No. 1169, August, 1993). Thisargument has considerable merit, but in all cases post-DDSR market prices for exchanged debt have remained below par,which suggests that the market continues to expect some degree of default. (In other words, market-consistentcounterfactuals would compare discounted DDSR debt service streams against discounted MYRA or rollover debtservice streams to measure debt service relief).

I1

23. Direct Benefits. In the initial year, when the upfront costs were incurred, the liquidityimpact of DDSR as compared to the debt rollover counterfactual was highly negative (US$64million). During 1997-2000, however, DDSR will provide annual average debt service relief ofabout US$102 million compared to the counterfactual, due to lower interest payments. During2001-2016, debt service relief will be negative (US$90 million per year), because the FLIRBs andPDI bonds will be amortized. Subsequently, debt service relief will turn sharply positive (US$636million annually) because only US$316 million of the par and discount bonds remain to beamortized (Table 7). During the entire 1996-2026 period, DDSR will provide debt service reliefof US$820 million in net present value terms, or about 9.5% of GDP.

Table 7: PANAMA DDSR - Debt Service Relief al

(US$ Millions)1996 1997 1998 1999 2000 2001-2016 a/ 2017-2026 a/

DDSR Agreenent

(1) Downpayment on PDI (100) 108

(2) Collateral Purchases (93) 92 (1) 1 (1) 1 (0) 1 (0) 0 (0) 0 (0) 0

(3) Amortization (0) 0 (0) 0 (0) 0 (0) 0 (0) 0 (206) 220 (42) 43

(4)InterestPayments (70) 74 (144) 160 (153) 178 (163) 192 (172) 201 (165) 192 (19) 19

(5) Earnungs on Collateral (0) 0 (0) 0 (0) 0 (0) 0 (0) 0 (1) 1 (1) 1

Additional Official Lendin2 b/

(6) Loan Amount (90) 90

(7) Amortization (0) 0 (0) 0 (0) 0 (8) 8 (15) 15 (7) 7 (0) 0

(8) Interest Payments (1) 1 (5) 6 (5) 7 (5) 7 (5) 6 (5) 5 (0) 0

Courterfactual c/

(9) Amortization (0) 0 (0) 0 (0) 0 (0) 0 (0) 0 (0) 0 (375) 370

(10)InterestPayments (115) 120 (233) 261 (242) 290 (251) 307 (258) 306 (310) 329 (306) 326

UJpfront Liquidity Impact of DDSR

(I1) = [-(1)-(2)+(6)] (-103) -110 (-1) -1 (-1) -1 (-1) -1 (0) 0 (0) 0 (0) 0

DDSR Debt Service Relief

(12) InterestReliefofDDSR (44) 46 (83) 100 (83) 112 (83) 115 (81) 105 (141) 137 (287) 308

[(10)-(4)+(5)-(8)I

(13) Amortization Relief (0) 0 (0) 0 (0) 0 (-8) -8 (-15) -15 (-213) -227 (333) 328

[(9)-(7)-(3)]

(14) Total Debt Service Relief (-59) -64 (82) 99 (81) 111 (74) 109 (66) 90 (-72) -90 (621) 636

[(12)+(11)+(13)]

a/ Annual averages, with roundmg errors. Figures in parenthesis are the estimates contained in the RRP. The other figures are actualsb/ Includes US$30 million from IDB, US$30 million from IBRD and US$29.7 million from IMF.c/ Counterfactual consists of an exchange of existing debt for 30-year bullet matunty mstrument with interest rate of LIBOR +13/16%.

Source: World Bank staff estimates

24. Efficiency of Debt Enhancement Funds. The IRR of the operation is about 25% 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. 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$92 millioncollateral cost and US$108 million PDI payment; and (ii) debt service on the new instruments.

12

Figure 1: PANAMA DDSR - Market Indicators

Evolution of Spreads of Panama's FLIRB and PDI Bonds over U.S. Treasuries

1200 I

1000- ,FLIBPD!

800 - -

6 600-

400 -

VM ~ ~ ' '0 %0 'D Q 0 '0 '0 t- F o% ON 0% % 0 % 0 % 00 %

F § i X X a ~~~S -i i

Evolution of the Stock Exchange Index

300

250-

200

150 b/

100

50~~~~~~~~~~~~~~0%

a, 0% 0 % % 0% 0.0% 0% Cs 0%

CZ > S S S X X~~- z t m

Real Annual Interest Rates Evolution of Net Transfers

14 - i ((. of GDP)

6 / -8 / a/ b/nam 6

12 42

10 0-t----

9 ~~~~~~~~~-2 89 90 91 92 93 94 95 96 7

6 - -6 I. = _-B a

4-

2 III I II -- 4t$---14

00 0% 0 - e a -16 -

Notes: The interior lines in the graphs correspond to the following events: a/ Announcement 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-Intemational Edition (Several Issues),Panana. Bolsa de Valores; Panama Comptroller General; IMF. Intemational Financial Statistics, and World Bank staff estimates.

13

25. Indirect Benefits. The magnitude of the indirect benefits of DDSR depends heavily onthe extent to which economic reforms redress the institutional and structural causes of the debtoverhang. The Government's reform program is eliminating these causes. At the same time,DDSR is substantially enhancing the effectiveness of the reform program in creating theconditions for accelerating growth to potential and reducing poverty. In particular, in a very shortperiod of time the DDSR operation has drastically reduced market uncertainty over Panama'scapacity and willingness to service its debt by: (i) eliminating Panama's arrears and normalizing itsrelations with commercial creditors; (ii) reducing the present value of debt service payments by19%; (iii) shielding 53% of commercial interest obligations from interest rate risk and allcommercial obligations from exchange rate risk; and (iv) transforming commercial loans intobonds, thereby allaying concerns about future reschedulings and rendering actual payments morepredictable. Official support for DDSR further curtailed market uncertainty, by ensuring acredible financing plan, and by signaling that the Government is undertaking the reforms neededto revive sustainable growth, and restore and maintain creditworthiness. Finally, marketuncertainty also has subsided because the large cost of debt service default in a post-DDSR worldprovides a strong incentive for Panama to meet the debt service obligations assumed under theDDSR agreement.

26. Reduced market uncertainly already has translated into appreciable benefits to Panama bydrastically lowering the sovereign risk premium and restoring Panama's access to internationalcapital markets on competitive terms and maturities for both public and private sector borrowers,and by encouraging domestic and foreign investment. Indeed, in January 1997, the majorinternational risk classification agencies assigned Panama a sovereign credit rating of BB+, justbelow investment grade (and only surpassed by two other countries in Latin America), whilePanamanian private corporate issuers received an investment grade rating (putting them in thesame category as their Chilean and Colombian counterparts). One month later and merely sevenmonths after closing the DDSR, the Republic of Panama returned to the international capitalmarket for the first time in a decade with spectacular results: its 5-year bond issue was heavilyoversubscribed (totaling US$500 million or 5.8% of GDP) only seven months after the closure ofthe DDSR. Furthermore, the spread was merely 175 basis points over five-year U.S. TreasuryBonds. By way of comparison, Colombia floated a ten-year US$750 million bond issue one dayafter Panama's issue at 140 basis over the U.S. Treasury benchmark. The Government hasutilized 80% of the proceeds from the bond issue to repurchase PDI bonds and FLIRBs, andintends to use to rest for the same purpose This operation secured an additional financial savingsto Panama on its debt service obligations of US$77 million in net present value terms (equivalentto 0.9% of GDP).

27. As a result of the DDSR and the progress achieved by the Government in implementing itseconomic reform program, the risk premium faced by Panama on long-term bonds plunged morethan 850 basis points in the short space of fifteen months, from about 1200 basis points when the1995 Financing Plan was issued, to 250 basis points in February 1997 (Figure 1).16 Panama's riskpremium is now only slightly higher than Colombia's, and the private sector recently hasborrowed funds on the international capital market at competitive rates. Such a turnaround insuch a short period of time is unprecedented. The reduction in the spread between interest rates in

16 The FLIRB and PDI principal are not collateralized, providing the best measures of market perception of Panama's long-term

sovereign risk.

14

Panama and the U.S. was less dramatic but still significant: from 4.5 to 3.5 percentage pointsbetween the achievement of the DDSR agreement and end-1996.

28. At the same time, both domestic bond and equity markets enjoyed a watershed year in1996 on bullish sentiment accompanying the debt agreement. Volume on Panama's stockexchange almost doubled from end-1995 to end-1996, while the stock price index climbed 25%(and only slightly less in real dollar terms), and the net asset value for the bellwether PanamaBalanced Fund subscribed by international investors was up 30%. On top of this, in a market thathad been entirely dominated by fixed income instruments, 1996 saw three initial public offeringsthat raised the share of equity activity to over 5%. Moreover, during the first five months of1997, the stock price index climbed a further 21% (Figure 1 above).

29. In capital-constrained countries like Panama, renewed access to foreign savings oncompetitive terms results in efficiency gains because additional financing can be used for highreturn investments. This impact should be especially significant for Panama because the monetaryregime makes it more difficult to shift resources from nontradeables to tradeables. Therepurchase of Brady bonds is one striking example of this; another is the investment by a foreignfirm in May of 1997 of US$652 million (equivalent to 7.6% of GDP) for the purchase of 49% ofthe shares of the state telecoms firm and management control--by far the largest direct foreigninvestment made in Panama since the construction of the canal. The strategic foreign investor isexpected to invest an additional US$500 million over the next several years in the expansion andupgrading of telecoms services in Panama. Additional large scale foreign investment projects areunderway (paras. 34-3 5 below).

30. Renewed access of the Government to domestic capital markets and reduction in interestrate spreads also should facilitate efficient management of government finances. This is especiallytrue in Panama, where, due to the monetary regime, transitory deficits cannot be sustained unlessthe Government is able to borrow from the market at competitive ra.es. Thanks to the DDSR andimproved economic policies, in December 1996, the Government realized its first domestic bondissue (for US$75 million) since the early 1980s. As such issues become a routine part of publicfinance management, they also will accelerate the development of the capital market.

31. 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.'7 The difference between the pre- and post-deal market pricesof the eligible debt provides an approximation of the overall benefits of the DDSR operation. Thedifference 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 obtained91% of these benefits, amounting to about US$778 million, or 9.1% of GDP. 8

'7 J Bulow and K. Rogoff, "Sovereign Debt Repurchases: No Cure for Overhang," Quarterly Journal of Economics. Vol.CVI, pp. 1219 September, 1991.

18 The costs to Panama of the operation may turn out to be somewhat higher, depending on the outcome of the legal actionslodged against the Republic of Panama m the United States by the creditor who did not participate in the 1995 FinancingPlan.

15

32. Macroeconomic Outlook. Both the short and longer-term economic outlook is positive.In 1996, the overall balance of the nonfinancial public sector registered a surplus of 0.8% ofGDP. Inflation was 2.3%, marking the eighth consecutive year in which domestic inflation wasless than external inflation. The current account balance of payments deficit is estimated to havedeclined to about 2.3% of GDP in 1996 from about 4.4% in 1995, due primarily to the debt reliefobtained through the DDSR, and despite a decline in service income generated by the activities ofthe U.S. Defense Department. The overall balance of payments registered a surplus equivalent toabout 1% of GDP. At end-1996, the public and publicly-guaranteed external debt amounted to anestimated US$6.3 billion, or an estimated 74% of GDP (against 87% in 1995). Despite thefavorable evolution of these indicators, real GDP growth remained sluggish, at 2.5%.Nonetheless, following the 1988-89 crisis, 1996 was the first year since 1992, when the rate ofeconomic recovery peaked, in which output growth was higher than in the previous year.

33. Moreover, growth accelerated considerably during the first quarter of 1997, reaching3.6% with respect to the first quarter of 1996, when growth was slightly negative. This upswingwas spearheaded by a rise of 38% in the value added in ports, the reactivation of construction,and renewed strong growth in electricity generation following last year's drought. Growth for1997 as a whole is expected to surpass 4%, and accelerate further in subsequent years, in largepart because private investors are responding to the Government's reform program and enhancedcredit standing with large-scale investments in the restructuring of the Panamanian economy.

34. In addition to the investments in telecoms (para. 28 above), a new US$100 million privatetrans-shipment port will commence operations in 1997, and the strategic private investor whoacquired the National Port Authority's major ports in early 1997 will spend US$150 million tomodernize them over the next three years. This transformation of Panama' port sector constitutesa remarkable success story, and will play a pivotal role in the future development of the country.The Northern Expressway, which will provide a sorely-needed high-speed thoroughfare betweenTocumen International Airport and downtown Panama City, will be concluded in late 1997.Construction of the Panama City-Colon Expressway, which also will remove a majortransportation bottleneck, will commence in 1997, as will that of the Southern Expressway.These highways are being built and financed by strategic private foreign investors who arelicensed to levy tolls and maintain the expressways for 30 years. Their total cost is US$560million.

35. Also, a new export processing zone is under construction on the site of a former U.S.military base, at a cost of US$115 million; in 1997, a privately-owned and operated electricitygenerating plant of 50mw will be constructed at a cost of US$50 million (with a 100mw plantexpected to follow in 1999); during 1997-98, a privately-owned drinking water plant will be builtat a cost of US$40 million; during 1997-99, US$25 million is to be invested annually in thedevelopment and expansion of cellular telephone service; in 1997-99, a tourism development atCosta Blanca on the Pacific Coast will be constructed, with total investment amounting toUS$150 million; during 1997-2000, two copper mines will be developed with total investments ofUS$800 million (or about 9% of 1996 GDP); and during 1997-2001, the Fort Amador TourismProject will be developed at an estimated cost of US$495 million.

36. The long-term benefits of the DDSR operation can be illustrated by modelingmacroeconomic performance and comparing it to the projected result under the counterfactual(Table 8 below). Economic growth under the DDSR is projected to rise 1 percentage point of

16

GDP during 1996-2000 to 4.5% per annum, and to 5.3% during 2001-04. This would occur onthe strength of projected increases in the rates of national savings and domestic investment, aswell as through greater efficiency of investment, in response to the elimination of policydistortions and improved creditworthiness. Such growth would represent a substantialimprovement over the 1981-95 trend (less than 3%) as well as projected growth under thecounterfactual. Higher growth would be financed mainly by a stepped-up domestic savings effort(public as well as private) under this scenario, as reflected in the projected decline of the currentaccount deficit to an average of 3.8% of GDP during 1996-2000 and 2.6% during 2001-04. Atthe same time, the quality of net external resource transfers would improve dramatically, asarrears accumulation is replaced by growing foreign direct investment and, eventually, privatecommercial capital inflows. Official net disbursements are projected to continue to play animportant role during 1997-98, before declining to an amount equivalent to less than 15%, onaverage, of total net external financing during 1999-2004.

TABLE 8: PANAMA DDSR - Illustrative Macroeconomic Impact(Percent)

Actual. DDSR Counterfactual1990-94 1995 Ave. 1996-2000 Ave. 2001-2004 Ave 1996-2000 Ave 2001-2004

Annual Real Growth RatesGDP (market prices) 7.0 23 45 5.3 36 40

Per Capita GNP 7.7 1.0 42 53 32 4.1

Per Capita Consumption 20 0.2 1 9 37 1.3 2.8

hnflation (annual averages) 1.1 0.5 1.3 1.3 1.3 1.3

National Accounts (% of current GDP)

Total Investment 194 23.3 24.6 25.5 22 4 23.0

Public 32 3.3 43 44 3.3 3.4

Private 16.1 20 0 20 3 21.1 19.1 19.6

National Savings 17.5 18.9 20 8 22.9 180 19.7

Foreign Savings 19 44 38 26 44 3.3

Public Sector (% of current GDP)

Total Current Revenues 31.2 31.1 29 8 29.1 288 281

Total Capital Revenues 0.3 0.2 0 2 0.2 02 0.2

Total Expenditures 33.1 28.2 29.1 276 30.7 29.6

Overall Balance -1.6 -0.4 0.9 1 6 -1 7 -1 4

External Sector (% of current GDP)

Current Account -4 1 -4.3 -3 8 -2 6 4.4 -3.3

Resource Balance 1 2 -0 5 -1.5 -0.5 -1.3 -0.7

Inports GNFS 38.5 35 0 41.5 43 1 40.8 42 0

Exports GNFS 39.7 34 4 39.9 42.6 39 5 413

Adjusted Resource Transfer 1.6 3.1 27 1.1 22 10

Fmnancing gap 0 0 0.1 0.4 -0.4 -0.1

Source: World Bank staff estimates.

D. Project Sustainability

37. While the DDSR greatly improved Panama's capacity to service its debt, it couldpotentially constrain Panama's latitude to adjust debt service to adverse extemal shocks in theevent such shocks were larger than the debt relief achieved, or to adjust to domestic policyshocks. More particularly, it would raise the transactions costs of an eventual debt restructuring

17

relative to one in which loans were simply rescheduled, as in a Multi-year ReschedulingAgreement (MYRA). In effect, the DDSR agreement raised the relative share of debt held inbonds from about 8 to 62% (Table 9 below). The conversion of bank loans to bonds andadditional lending by IFIs for DDSR raised the share of relatively inflexible debt from 19 to 85%.Nonetheless, the share of preferred creditors in public debt service actually declined in 1996, toabout 31% from 45% (because Panama was still accumulating arrears on commercial debt in1995). On an accrual basis, the share of preferred creditors is projected to remain below theBank's guideline of 35% during the next decade. Debt service to the Bank as a proportion ofpublic debt service was about 11% in 1996, and is projected to decline to about 10% during1998-2000, and to somewhat less thereafter. Similarly, debt service to the Bank as a fraction ofexports is projected to be far below the Bank's guideline over the course of the next decade(1.3% in 1996, and lower thereafter).

Table 9: PANAMA DDSR - Creditworthiness and Exposure Indicators a!(Percent)

Actual Estimated Proiected

1994 1995 1996 1997 1998 1999 2000 2001-2004

With DDSRDOD/GDP 88.8 873 73 6 72.4 70 4 67 8 64.8 53.8Debtservice/XGS 19.9 19 1 12.1 14.4 11 9 11 8 11.2 11.5Debtservice/currentpublicrevenues 27.2 31 5 192 23 4 19 5 191 18.3 19.0Preferred and Secured DS/PPG DS b/ 24.1 23.4 36 1 343 34.4 348 35 8 36 1Preferred DS/PPG DS b/ 24 1 23 4 34 8 319 32 2 33.6 345 32.3BankDS/PPGDS 15.1 132 11.3 114 112 9.5 86 9.5Bank DSIXGS 2 1 1.5 1.3 1 3 1.1 1 0 09 1.0hiflexible DOD/DOD c/ 196 19.1 85 2 87 4 86.4 862 85 4 81.2Inflexible DS/DS c/ 37 1 39.2 81.4 79 8 83.6 84 8 86 0 92 4With CounterfactualDOD/GDP 88.8 87.3 76 0 74.2 719 68 8 64.2 55 3Debtservice/XGS 19.9 19 1 19.2 21.3 19.4 18.5 17.3 14.9Debtservice/currentpublicrevenues 27.2 31 5 24.9 28.5 265 26.0 248 21.8Preferred and Secured DS/ PPG DS b/ 24.1 23 4 287 23 7 26 1 26.8 277 33 3Preferred DS/PPG DS b/ 24 1 23 4 28 7 23 7 26 1 26 8 27 7 33.3BankDS/PPGDS 151 13.2 7.4 67 67 58 6.0 80Bank DS/XGS 2 1 1 5 1.6 1 5 1.4 1.1 1.1 1.2iflexible DOD/DOD c/ 196 191 25.3 26 4 26 5 26 8 27.7 29 6Inflexible DS/DS c/ 37 1 39.2 62.0 52 6 43 2 43 0 44.0 42.4

a/ Accrual basis.b/ Includes collateralized bonds (discount and par bonds).c/ That part of Panama's debt that cannot be readily rescheduled or deferred multilateral debt, bonds and Parns Club. It does not include short-terrn debtSource World Bank staff estimates

38. Reduced flexibility per se translates into greater risk in the event of adverse externalshocks or domestic policy shocks; however, DDSR also mitigates the vulnerability of theeconomy to external shocks. First, it diminished the debt service burden and radically enhancedcreditworthiness. Second, it reduced the exposure of the economy to both interest rate risk--bychanging 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, the DDSR operation provides Panama with options to adjust debt service to external

18

shocks. For instance, Panama could capitalize interest payments on PDI bonds exceeding anannual interest rate of 4% during the first six years after closing; or use interest collateral to payup 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 nonfinancial publicsector surpluses greater than 1% of GDP by the year 2000. Such additional resources wouldsignificantly increase the Government's capacity to absorb external shocks and to implement anefficient debt management strategy.

39. While the economy is more vulnerable to domestic policy shocks in a post-DDSR world,the risk of such shocks, especially fiscal shocks, is considered to be slight. Panama's unique, ninedecades-old monetary regime provides a stable anchor for the macroeconomic framework.Maintenance of sound economic policies also would be encouraged by the up-front cost thatPanama 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 three years; and has launched a second round of policy reforms forimplementation during its final two years in office. Nonetheless, support for the reform programcould erode in this relatively wealthy but dualistic society--in which 40% of the population lives inpoverty and narrow-interest groups traditionally have thwarted reform--if investment ininfrastructure and social safety net programs continues to lag, and if growth does not begin toaccelerate and the high unemployment rate to subside in the medium-term.

40. The Bank is working with the Government to minimize this risk though our investmentlending program focused on poverty reduction; by enhancing implementation of our recentlylaunched portfolio in the social sectors; and through our ESW and policy dialogue. In addition,the Bank has initiated discussions with the Government on the preparation of a new structuraladjustment operation to back the implementation of its second generation of policy reforms. TheBank would provide this support in concert with the IMF and the IDB (para. 44 below).

E. Bank Performance

41. Panama's exceptionally successful DDSR operation could not have been concludedwithout the support of the Bank, the IMF and IDB. The Bank's performance in coordinatingsupport, evaluating the project, and processing the DDSR Loan was highly satisfactory. On atechnical level, Bank staff provided the Authorities with regular evaluations of the DDSR as itevolved through it various stages, and supported the Government in its conversations with theBAC, and in promoting the 1995 Financing Plan to international financial community. Inaddition, the IDB Board documentation for its loan was based largely on the draft RRP; and theAuthorities made ample use of the RRP analysis of the DDSR to publicize the Financing Plan inits public pronouncements and official documents.

42. Bank staff took 6 months, from the preparation of the Briefing Note for the Board, toBoard approval of the DDSR loan. The loan was disbursed 3.5 months after Board approval, andclosed one week later. The Bank spent US$71,000 in direct costs on the preparation andsupervision of a US$30 million loan which was indispensable for the restructuring of almost US$4billion of external debt, at a savings to Panama of 9% of its GDP and with potential benefits of a

19

sirnilar magnitude. The average time period for the preparation of previous Bank DDSR loanswas 13.5 months, with 21 months elapsing between the Briefing Note and disbursement. Theaverage direct cost for preparation and supervision of previous DDSR loans was US$113,000.

F. Borrower Performance

43. The Government fielded a highly competent and experienced teamn to negotiate and carryout the DDSR agreement. The Government team expertly handled all the complexities of theoperation with competence and diligence, and the 1995 Financing Plan achieved all of itsobjectives. With implementation of the accord and follow-up actions with the international credit-rating agencies (also supported by the Bank) the Government successfully completed a well-designed strategy for restoring the country's creditworthiness. This accomplishment, togetherwith the tremendous progress the Government simultaneously achieved in carrying out the otherelements of its economic reform program, is creating the conditions required to lift the growth ofPanama's economy to its potential. In addition, as a result of this experience, the Ministry ofPlanning and Economic Policy greatly improved its capacity to manage its external debt.

G. Future Operations

44. The Central America Department has held discussions with the Authorities on a possiblefollow-on structural adjustment operation to support the Government in the consolidation ofongoing reforms and the implementation of a second generation of institutional and structuralreforms. Such an operation would be designed and implemented in concert with the IMF andIDB. The IMF and the Government currently are preparing a program that would be backed bythe Fund's Extended Fund Facility, over the course of the 1997-2000 period. IDB recentlyapproved a Public Enterprise Reform Loan, and is preparing a Financial Sector Adjustment Loan.

H. Assessment of Outcome and Key Lessons Learned

45. The outcome of the DDSR operation was highly satisfactory. It was a model for a well-executed concerted effort to achieve results on the ground. In just over six months a virtuouscycle was completed of smooth DDSR exchange, receipt of near investment grade ratings, andhighly successful return to sovereign borrowing. The surge in Panama's Brady prices, practicallydoubling from January 1996 to January 1997, to lead that asset class, is a clear-cut indicator ofthe success of this DDSR operation. Bank participation was critical to DDSR credibility andviability, particularly as the Republic could not provide sufficient collateral on its own, nor show,in 1994-95, a solid reform track record.

46. Analysis of Panama's DDSR operation--perhaps the next-to-last such operation--confirmslessons from previous DDSR operations. (i) success of the operation hinges principally on thecredibility of the country's economic reform program; (ii) the concerted, menu-based approach todebt reduction provides significant cost savings to the debtor country compared to market-baseddebt reduction; (iii) creditor banks also improve their financial position; (iv) the inclusion of a newmoney option is not essential for securing both full participation of creditors and substantial costsavings; and (v) net benefits are higher when DDSR is backed financially by the International

20

Financial Institutions.'9 These lessons have been well described in previous ICRs and other Bankdocuments.20

9 Fifteen of the 17 highly indebted countries orgmally envisaged as candidates for debt restructuring at the inception of theIBRD Program to Support Debt and Debt Restructuring have restructured their commercial bank debt. Of these, 10 havereceived Bank financial support for DDSR. Peru (November 1996) was the most recent beneficiary of the BR)Dprogram. In addition, 4 other countries, including Panama, have borrowed from the Barnk for DDSR.

20 See, in particular, Program Completion Report. Argentina: Debt and Debt Service Reduction Loan, op. cit., and "The IBRDProgram To Support Debt and Debt Service Reduction," April 4, 1995.

PART II: STATISTICAL TABLES

Table 1: Summary of Assessments

Table 2: Related Bank Loans

Table 3: Project Timetable

Table 4: Cumulative Loan Disbursements.

Table 5: Project Costs

Table 6: Project Financing

Table 7: Status of Legal Covenants.

Table 8: Bank Resources

Table 9: Bank Missions

Table 1: PANAMA DDSR - Summairy of Assessmenits

A. Achievement of Objectives Substantial Partial Negligible Not Applicable

Macroeconomics Policies VSector PoliciesFinancial Objectives

Institutional Development LV

Physical Objectives

Poverty Reduction

Gender ConcernsOther Social Objectives V

Environmenital Objectives VPublic Sector Managemlent tPrivate Sector Dcvelopmente VDebt and Debt Servicc Rcduction i

JB. Proj'ect Sustainability Likely Unlikely Uncertain

C. Bank Petformance Highly Satisfactory Satisfactory Deficilent

Identification V

Preparation Assistance V

Appraisal VSupervision

D. Borrower Peiformance Highly Satisfactory Satisfactory Deficient

Preparation $Implementation V

Covenant Compliance V

E. Assessment of Outcome Highly Satisfactory Satisfactory Deficient............... ...... . .. . . .<...........

Table 2: PANAMA DDSR - Related Bank Loans

Loan Title Purpose 7 Year of approval Status

gPeceding OperatiOon -- -_-

Economic Recovery Loan Structural Adjustment 1992 Completed

(Loan 34380-PAN) and InstitutionalDevelopment

FoUliwiizg Operadons

Public Policy Reform Structural Adjustment Under

and Institutional Preparationm ~~~Development.

Table 3: PANAMA DDSR - Project Timetable

Steps in project cycle Date Plaiined Datte Revised Date Actual

Identification May-95 May-95 May-95

Preparation Sep-19-95 Sep- 19-95 Sep- 19-95

Appraisal Jan-30-96 Jan-30-96 Jan-30-96

Negotiations Feb-26-96 Feb-26-96 Feb-26-96

Letter of Development Policy* Mar-05-96 Mar-05-96 Mar-05-96

Board Presentation Mar-28-96 Mar-28-96 Mar-28-96

Signing April-96 May-03-96 May-03-96

Effectiveness June-96 Jul-03-96 Jul-03-96

Tranche Release June-96 Jul- 11-96 Jul- 11-96

Project Completion Jun- 15-96 Jul- 17-96 Jul- 17-96

Loan Closing Jun-30-96 Jul-3 1-96 Jul-3 1-96

*1995 Financing Plan Waiver of Negative Pledge Clauscs Annex V. Report No P-68 10-PAN

Table 4: PANAMA DDSR - Cumulative Loan IDisbursements

FY 96 FY 97

Appraisal Estimate (US$m) 30 0 30 0

Actual (US$m) 0 0 30.0

Actual as % of Estimate 0% 100%

Date of Disbursement July 1 1, 1996

Table 5: PANAMA DDSR - Project Cost*

Appraisal Estimate (US$M) Actual .S.. .

Item Local Foreign Local Forein..___....__________.,___.._ Costs Costs t Costs Cests

PDI payment prior to closing - 30 0 30.0 - 24.0 24.0

PDI downpayment at closing - 100.0 100.0 - 108.0 108.0

Cost of Collateral (principal) - 55.3 55.3 - 55.3 55.3

Cost of Collateral (interest) - 40.9 40 9 - 36.3 36.3

TOTAL - 226.3 226.3 - 223.6 223.6

*Includes collateral "top-ups" of about US$4 million in 1997-99.

Table 6: PANAMA DDSR - Project Financing

BR1 -R30.0 30.0 - 30.0 30.0

IMF 30.0 30.0 - 29.7 29.7

EDB 30.0 30.0 - 30.0 30.0

Panama - 136.3 136.3 - 133.9 133.9

TOTAL - 226.3 226.3 - 223.6 223.6

Table 7: PANAMA DDSR - Status of Legal Covenants

Wt ... . . . se ....... ..

Loan No. 2.03 10 CD Jun-30-96 Jul-31-96 The Loan Closing Date shall be June 30, 1996 or a later Fulfilled3391-PAN date as the Bank shall establish.

3.01 (a) I C The Borrower shall maintain separate accounting records Fulfilledof the payments financed out of the proceeds of the Loan.

The Borrower shall have the accounts and records foreach fiscal year audited by independent auditors Being3.01 (b) 1 CD Jun-30-97 Aug-3 1-97 acceptable to the Bank and furnish the audit to the Bank Contracted

no later than six months after the end of each such year.

For all withdrawals made from the Loan Account, the3.01 (c) 1 C Borrower shall maintain records and enable the Bank to Fulfilled

examine such records and retain them until at least 1 yearafter the Bank has received the audit report for thefiscal year in which the last withdrawal from the LoanAccount was made.

The Borrower and the Bank shall, from time to time,4.01 (a) 9 C exchange views on the Program and the 1995 Financing Fulfilled

Plan.

The Borrower shall provide the Bank a report on the4.01 (b) 9 C Program in such detail as the Bank shall reasonably Fulfilled

request.

The Borrower shall keep the Bank informed of all notices,4.02 (a) 9 C certificates and confirmations issued to or received by the Fulfilled

Borrower in respect of the Collateral.

Table 7: PANAMA DDSR - Status of Legal Covenants

Ori i .al Atv1 ed.-Coeatyp ftisentdflnnt - fl~r~ih~

hgr"t 8¢ion | t§teu stata$ ~~~~~date :Date,~ .b s ^ * ftt * i

Loan No. The Borrower shall provide the Bank monthly reports3391-PAN 4.02 (b) 9 C - with respect to the Collateral within 15 days of the receipt Fulfilled

thereof.

6.01 (a) 11 C-- The Borrower has confirmed the availability of adequate Fulfilledresources to implement the 1995 Financing Plan.

6.01 (b) 12 C - The Borrower's macroeconomic policy framework is Fulfilledconsistent with the objectives of the Program.

The Borrower has entered into agreements with

6.01 (c) 3 C - Participating Lenders for the exchanged of Eligible Debt, Fulfilled

under the 1995 Financing Plan.

Present Status: Covenant Types

C = covenant complied with 1 = Accounts/audits 8 = Indigenous people

CD = complied with after delay 2 = Financial performance I revenue 9 = Monitoring, review, and reporting

CP = complied with partially 3 = Flow and utilization of project funds 10= Project implementation not covered by

NC = not complied with 4 - Counterpart funding categories 1-9

NYD = not yet due 5 = Management aspects of the project 11= Sectoral or cross-sectoral budgetary or

or execution agency other resources allocation6 = Environmental covenants 12 = Sectoral or ross-sectol policy/

7 = lnvoluntary resettlement regulatory / insditutional action13 = Other

Table 8: PANAMA DDSR - Bank Resources*

. Stage I Planned Revised Actual

* Pwct COie Weeks US$ Weeks US$ Weeks US$

Through Appraisal 20.0 50,200.00 20.8 49,200.00 20.8 58,700.00

Appraisal Through 0.0 0.00 2.2 5,900.00 2.2 5,800.00Board Approval

Supervision 1.0 2,900.00 1.0 2,900.00 2.0 6,500.00

Completion 8.0 21,700 00 6.0 19,600.00 4.0 14,300.00

Totadl 29.0 74,800.00 30.00 77,600.00 29.0 85,300.00

*Includes recorded direct cost only.

Table 9: PANAMA DDSR - Bank Missions

........ . . . . . .......................... ........ __

Stage of Month/ Year Number DaYs -Speaized staff .......... R..LV...Project Cycle of Persons A Field skills reprvend aM .plemet Development

~~~~~~~~~~~~Snu b~ie __ _ .___

Through Appraisal Oct-Nov /95 1 6 TM N / A N / A None

Appraisal throughBoard Approval - -

Supervision May / 96 1 4 TMHighly Highly NoneSatisfactory Satisfactory

Completion Jan / 97 2 5 TM, FC Hghy Highly NoneSatisfactory Satisfactory

a/ Task Manager (TM); Financial Consultant (FC).

7

ANNEX I

PROJJECT IMPLEMENTATION REVIEW FROMBORROWER'S PER$PECTIVE

Loan No. 3991-PA

Annex IPage 1 of 5

Republic of PanamaMinistry of Planning and Economic Policy

Directorate of Public Credit

Project Implementation Review from Borrower's Perspectivere: Loan No. 3991-PA for US$ 30 million

Introduction

On March 28th, 1996 Loan No. 3991-PA for US$ 30 million (the "Loan") wasapproved by the International Bank for Reconstruction and Development (the "Bank") tothe Republic of Panama ("Panama"). The loan has been successfully disbursed andimplemented and this is the first implementation report submitted by Panama pursuant toits terms and conditions.

I. Overall Assessment of the Project

1. Project Objectives. The objectives of the Loan were:

a). Implementing debt and debt service reduction ("DDSR").b). Consolidating fiscal balance and structural reformn.c). Normalizing relations with commercial creditors, reestablishing

creditworthiness and accelerating growth and development.

Comments: From Panama's perspective, all three of the above objectives have beenachieved to varying degrees. Panama's DDSR realized a relief of US$1.2 billion or 31%of the US$3.8 billion eligible debt.

SAVINGS OBTAINDED IN THE RESTRUCTURINGOF THE COMMERCIAL BANK DEBT

17th OF JULY, 1996(In millons of Balboas)

Elegible Debt on 6/30/96 3,830.00

M inus debt reduction:PDI (1,911.1 -1,350.0/PDI) 561.10DiscountSond capitalreduction 41.20TOTAL 602.30

debtas restructured on 7/1 7/96 3,227.70

Total savings inAbsolute reductions 602.30Debt Service 600.00T O T A L 1 ,2 0 2.3 0

Annex IPage 2 of 5

Project Implementation Review from Borrower's Perspectivere: Loan No. 3991-PA for US$ 30 millionPage 2

This was realized through retroactive contractual interest rate recalculation,reduction in debt interest rates for the new debt vis a vis existing market rates and actualprincipal forgiveness. When compared with other Panamanian debt restructuring, thePlan was a cost-effective transaction.

Comparative costs of normalizing Panama's debt

(in millons of dollars)

1 992 1 996S o u r c e

IF I Loans 233.1 90.0P a n a m a n ia n fu n d s 3 3 4 . 8 13 4 .7D o n a tio n s 1 3 3.0 0 .0T O T A L 7 0 0.9 2 2 4.7

iU se sB IR F 220.3B ID 1 67.6F M I 252.8F ID A 4.9P a ris C lub 3 9 .9Partial Paym ents 1 32.0P u rc h a s e o f c o lla te ra l 9 2 .7T 0 T A L 6 8 5.5 2 2 4 .7

s a v in g s re a liz e d 0.0 6 0 2 .3

Although Panama has one lone rouge creditor who did not participate in the 1995Financing Plan, overall the objectives of the Loan were met to Panama's greatsatisfaction.

The DDSR has had a beneficial impact on fiscal and structural reforms bylowering and fixing the contractual debt service. This should assist Panama in adjusting tothe changes anticipated with the exit of U.S. Armed Forces from the Panama Canal areaand with the reversion of the Canal to Panama. Sovereign risk spreads have beenlowered so that capital is lower now to both private and public borrowers than it wasbefore the DDSR. In addition, Panama has normalized its relations with the majorcommercial creditors and gained access to capital markets for both the government andprivate borrowers. Panama's credit rating as a sovereign risk has improved as reportedby Moody's and Standard & Poor. Moody's rated Panama as Bal and Standard & Poorgave it a BB+, reflecting a "just" below investment grade rating. Panama's Brady Bondshave moved up in value in the secondary market, reflecting a growing confidence inPanama as a credit risk.

Annex IPage 3 of 5

Project Implementation Review from Borrower's Perspectivere: Loan No. 3991-PA for US$ 30 millionPage 3

Comparative Graph by year of thetotal Public Debt (in millons of Balboas)

8000 -

7000-

6000 -

5000-

4000 -

3000-

2000 -

1000

089 90 91 92 93 94 95 96

December

In February of 1997 Panama placed US$ 500 million in its oversubscribedinaugural bond issue. Entry into capital markets and fiscal stability is a centerpiece ofPanama's economic policy as it enters the global economy and moves to modernize itsproductive sectors. Accession to the World Trade Organization has been approved byPanama's National Assembly and should be effective shortly.

2. Panama's performance during the evolution of the Loan. The Loan was just onepart of a complex financial operation that comprised the 1995 Financing Plan forPanama. A team from the Ministry of Planning and Economic Policy successfullynegotiated with the Bank the terms and conditions of the Loan while structuring the loansneeded to fully finance, through loans from other IFIs, the 1995 Financing Plan (the"Plan"). Panama was able to dovetail all the various financial and legal requirements tocomplete the Plan both with debt holders and the cofinancing IFIs. Panama assembledand worked with a diverse group of professionals to complete this transaction. Theintegration of this diverse multidisciplinary group was a valuable experience which isimportant for future financial transactions.

Recent exchanges with the Bank have identified the need to complete anindependent audit of the Loan. Panama has also revised the figures used by the Bank inMarch of 1996 during the approval process to evaluate the amount of debt forgiveness ofthe transaction.

Annex IPage 4 of 5

Project Implementation Review from Borrower's Perspectivere: Loan No. 3991-PA for US$ 30 millionPage 4

3. Bank's performance during the evolution of the Loan. The Loan was the result ofa long and thoughtful process to structure the DDSR for Panama. During negotiations,Bank staff were very helpful in explaining the Bank's guidelines, policies and procedureswhile being sensitive to Panama's concerns, needs and limitations. The Bank waivedvarious conditions imposed on other existing loan agreements to permit the pledge of zerocoupon bonds and other collateral as part of the Plan.

II. Operational Phase of Project.

The Loan was one component of the Plan. The IADB and the IMF also supportedthis DDSR operation. The successful closure of this transaction is an ample indicator thatthe Loan met its operational goals. Panama requested disbursal shortly before the July17th, 1996, closing and this was accommodated under the Loan. Operationally, thetransaction and the objective have been met. Panama has now moved to debtmanagement in order to reduce the stock of debt using various strategies available in thefinancial market. Over the coming year Panama hopes to go to market again on differentterms and tenors to establish an "all Panama yield curve" to serve as a benchmark.

MI. Assistance in ICR preparation.

Panama has provided the Bank with the necessary information on the economic,financial, social, institutional and other conditions related to the DDSR operation. Forexample, Panama has achieved significant per capital debt reduction.

REAL DEBT PER CAPITA(In 1982 Balboas)

2,7002,600-

2,500 -2,400 *

2,300- F

2,200 -

2,100 -2,000

1,900 -89 90 91 92 93 94 95 96

YEAR

Annex IPage 5 of 5

Project Implementation Review from Borrower's Perspectivere: Loan No. 3991-PA for US$ 30 millionPage 5

A Bank mission visited Panama in January to meet with government officials andupdate the evaluation of the DDSR and prepare the ICR. There is regular and systematicexchange of information between Panama and the Bank in order to assure the efficientimplementation and follow-up of this project.

Conclusion

The Loan together with the aid of other IFIs permitted Panama to normalize andresolve commercial debt defaults that had existed since 1987. The Directorate of PublicCredit has gained important experience in negotiating and implementing various loans,including the Loan, and is in the process of complying with the audit required by theLoan. A close working relationship has developed between Bank staff and governmentofficials which permitted the successful completion of the DDSR. Panama has beenpleased with the response of the international financial markets to both the DDSR and thestructural reform packages implemented to globalize and modernize Panama's economy.Panama now has access to cheaper capital to finance its various needs, be these by publicor private sector borrowers. This strategy should have important social benefits inreducing poverty and creating a stable fiscal base as the economy expands.

Ar/Licda. Ai MendezDirector, Directorate of Public CreditMinistry of Planning ad Economic Policy

ANNEX II

BIBLIOGRAPHY

.............................. ............ ..................................... ................................................................

Annex IIPage 1 of 2

Bibliography

Bulow, J. and K. Rogoff. Sovereign Debt Repurchases: No Cure for Overhand. QuarterlyJournal of Economics. Vol. CVI. September, 1991.

Fernandez Arias, Eduardo. Cost and Benefits of Debt and Debt Service Reduction. WorldBank Staff Working Paper, No. 1169. International Economics Department.Washington, D.C.: August, 1993.

World Bank. La Universalizacion de los Incentivos Impositivos (Mimeo). Panama: March,1995

World Bank. Proteccion Efectiva de los Productos Agropecuarios y su efecto en losPrecios Internos (Mimeo). Panama: August 1995.

World Bank. La Poltica Azucarera y la Privatizacion de La Victoria (Mimeo). Panama:October, 1995.

World Bank. Analysis del Impacto Fiscal de Largo Plazo de las Leyes LaboralesEspeciales (Mimeo). Panama: December 1995;

World Bank. Proyecto de Ley General de Sueldos (Mimeo). Panama: January, 1996.

World Bank. Separacion de Costos en el Sistema Integral de Salud (Mimeo). Panama:April 1996.

World Bank. Proyecto de Ley de Defensa de la Competencia (Mimeo). Panama:December, 1995.

World Bank. Panama: A Dual Economy in Transition. Report No. 13977-PAN (GreyCover). Washington, D.C.: 1995.

World Bank. Country Assistance Strategy of the World Bank Group for the Republic ofPanama. Report No. 13846-PAN. Washington, D.C.: December 28, 1994.

World Bank. PANAMA - Economic Recovery Loan (Loan 3438-PA) Release of the ThirdTranche (Partial Waiver of One Condition). R97-46. Washington, D.C.: March 19,1997.

Annex IIPage 2 of 2

World Bank. Analytical Aspects of Debt and Debt Service Reduction Operations.SecM92-296. Washington, D.C.: March 9, 1992.

World Bank. Report and Recommendation Of The President of the International Bank forReconstruction And Development To The Executive Directors On a ProposedDebt and Debt Service Reduction Loan Of US$30 Million To The Republic ofPanama And On Related Measures To Support The Debt Reduction Program OfThe Republic Of Panama. Report No. P-6810-PAN. Washington, D.C.: March 5,1996.

World Bank. Program Completion Report. Argentina: Debt and Debt Service ReductionLoan (Loan 3555-AR!. Report No. 13885. Washington, D.C.: 1995.

World Bank. PANAMA - Economic Recovery Loan (Loan 3438-PA) Release of the ThirdTranche (Partial Waiver of One Condition). R97-46. Washington, D.C.: March 19,1997.

World Bank. Analytical Aspects of Debt and Debt Service Reduction Operations.SecM92-296. Washington, D.C.: March 9, 1992.

World Bank. Program Completion Report. Argentina: Debt and Debt Service ReductionLoan (Loan 3555-AR). Report No. 13885. Washington, D.C.: 1995.

World Bank. Panama - Commercial Bank Debt and Debt Service Reduction Operation:Briefing Note. SecM95-1029. Washington, D.C.: September 19, 1995.

World Bank. Review of IBRD Debt Reduction Program. Washington, D.C.: April 4,1995.

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Report No.: 16822Type: ICR