February 19, 2020

An International Monetary Fund team led by Alejandro Santos visited Panama from February 4 through 17 to conduct the discussions for the 2020 Article IV consultation. The team met with the Minister of Economy and Finance Héctor Alexander, Banks Superintendent Amauri Castillo, as well as other senior public officials and private sector representatives.

Following a temporary slowdown in 2018-19, the economy is poised for a rebound in 2020 and will remain among the most dynamic in Latin America. The outlook is positive, but the authorities should remain mindful of risks to growth stemming from both domestic and external factors. The new government’s strategy should aim at preserving Panama’s competitive advantage as an attractive business destination while focusing on social priorities to ensure sustainable and inclusive growth. With this goal in mind, Panama needs to enhance its productivity and competitiveness while improving social outcomes. Exiting the FATF grey list by strengthening the AML/CFT policies while enhancing tax transparency will be key to maintaining Panama’s position as a regional financial center. It is also increasingly important to reinforce fiscal discipline amid growing debt and underperforming revenues, in order to ensure both public debt sustainability and fiscal policy credibility. Given the importance of the financial system in the Panamanian economy, the authorities should continue to bolster systemic risk assessment, risk-based supervision and put in place robust frameworks for macroprudential policy and crisis management. Finally, against the backdrop of rising water demand and climate volatility, Panama needs to prioritize efficient resource management.

The economy is rebounding from a temporary slowdown

• Weaker activity in 2019. Real GDP grew by about 3 percent in the first three quarters of 2019 (y/y) amid easing in the construction and service sectors, following a slowdown in 2018 driven by a construction strike. However, there are indications that the economy began to recover in the last quarter as a new copper mine launched full-scale commercial production, and 2019 growth is estimated at 3½ percent y/y. The unemployment rate increased to 7.1 percent in August 2019 from 6 percent a year ago, reflecting less economic dynamism.

• Subzero inflation. CPI inflation remained persistently weak in 2019, staying below zero most of the year, closing at -0.1 percent (y/y) and averaging -0.4 percent.

• Stable fiscal deficit. The overall deficit of the NFPS reached 3.1 percent of GDP in 2019 (compared to 3.2 percent of GDP in 2018) as an underperformance in tax revenue and accelerated execution of spending by the outgoing administration required an expenditure tightening in the second half of 2019. The fiscal deficit for 2019 was below the 3½ percent limit established in the revised social and fiscal responsibility law (SFRL). The relatively high deficit, pre-financing operations, along with the payment of accumulated arrears in the amount of over 2 percent of GDP, led to an increase in Panama’s Central Administration debt burden to about 46 percent of GDP at end-2019, although it is close to 40 percent on a net basis.

• Improved external position. The current account deficit narrowed to an estimated 6.6 percent of GDP in 2019 (from 8.2 percent of GDP in 2018) aided by rising copper exports and remained financed mainly by foreign direct investment.

The outlook is positive, but the balance of risks is skewed to the downside

• Growth will recover, and Panama will remain among the most dynamic economies in Latin America. Output growth is projected to rebound to 4.8 percent in 2020, supported by full-scale copper production and robust private investment. Over the medium term, growth is expected to stabilize at its potential annual rate of 5 percent. Inflation is expected to pick up to 1 percent y/y in 2020 amid accelerating economic activity and stabilize at 2 percent y/y in the medium term. Meanwhile, the external position is projected to continually improve, reducing the current account deficit to 5 percent of GDP by 2023. The fiscal balance is also expected to gradually improve—in line with the amended fiscal rule—with the NFPS deficit converging to 2 percent of GDP by 2022.

• The balance of risks is tilted to the downside. Main domestic risks to growth are related to setbacks in exiting the FATF watchlist and complying with SFRL deficit ceilings, both of which could expose Panama to reputational damage and thus reduce its competitiveness and erode policy credibility of the new administration. Continued oversupply in the domestic property market could adversely impact financial stability and the real economy through a price correction and rising NPLs. Social tensions could disrupt economic activity and cause policy missteps. On the upside, copper exports could be more important than anticipated. Among external risks, the most notable ones are a slowdown in Canal activity, weaker-than-expected global growth, escalating trade tensions, the spread of the coronavirus as well as an erosion in competitiveness due to U.S. dollar appreciation. Other risks include a sharp tightening of global financial conditions leading to rising domestic interest rates which drive up debt service and refinancing costs. Cyberattacks can bring significant disruptions to digital infrastructure, while climate-change related weather events can adversely affect Canal activity, agriculture and tourism.

Enhancing the fiscal framework is needed to sustain budgetary discipline amid rising debt

• The envisaged fiscal consolidation is needed. To this end, the government modified the deficit ceiling under the fiscal responsibility law once again, to 3½ percent of GDP in 2019 followed by a gradual adjustment to 2 percent of GDP by 2022, which appears appropriate, and the limit has already been observed for 2019. Continued consolidation efforts are imperative to ensure debt sustainability, especially given the recent rise in public debt levels driven by a relatively high deficit, pre-financing operations and the borrowing needed to pay accumulated arrears which were unrecorded previously.

• A thorough assessment of the revenue potential and expenditure efficiency is required. Reform of tax and customs administrations, attending social needs, and improving the efficiency of public spending are imperative to sustain growth amid revenue shortfalls. In addition to improving the capacity of tax and customs administrations, action is required to review Panama’s complex tax exemptions that significantly erode the tax base. On the expenditure side, realigning current spending with social needs—including by investing more in education—and improving the effectiveness of social spending will be crucial to achieve sustainable and inclusive growth. Capital projects, including those executed through newly-established PPPs, need to be carefully assessed and prioritized going forward. Meanwhile, the pension system needs to undergo a gradual reform by better aligning incoming contributions with expected payouts amid shifting demographics.

• Measures to further reinforce the fiscal framework should be adopted. The authorities should recover their track record of fiscal discipline enabled by the fiscal responsibility law, by enhancing the fiscal framework and solidifying their commitment to sound fiscal policymaking. This would involve appointing the members of the fiscal council to further promote accountability and facilitate informed public debate on fiscal policy. In addition, over the medium term the new administration should consider adopting a structural rule to build fiscal buffers for economic downturns with the aim of making fiscal policy less pro-cyclical and therefore a more effective macroeconomic stabilization tool. Finally, the authorities should strengthen budgetary execution rules to avoid the recurrence of arrears while at the same time strengthen the recording of fiscal accounts by limiting the use of turnkey projects and deferred payment contracts in public investment projects.

Financial integrity and tax transparency frameworks should be enhanced

• Exiting the FATF grey list must remain a priority. Building on the momentum of recent legislative action, the authorities should continue addressing the deficiencies in Panama’s AML/CFT regulatory framework identified by the FATF. Specifically, the authorities should update the national risk assessment and the AML/CFT strategy, update the newly-created registry of beneficial ownership information for firms, and enforce legal action in cases of money laundering and unlicensed remittances. Upgrading the legal framework and its effectiveness is key to strengthening Panama’s position as a regional financial center. The ongoing efforts to increase public awareness of money laundering and other suspicious financial activity are welcome. Close cooperation and fluid communication with regional and international authorities on financial integrity will be needed to ensure a prompt exit from the grey list. 

• Efforts to further enhance tax transparency and information exchange should continue. On the back of recent progress in addressing the OECD Global Forum’s legal recommendations (which resulted in upgrading Panama to “partially compliant” with its global tax-transparency standard), the authorities should continue addressing the shortcomings identified in the agency’s 2019 review. Specifically, Panama should dissolve dormant entities and respond to exchange-of-information requests in a timely manner.

Financial sector reforms are needed to build resilience and monitor risks

• Upgrades to the financial surveillance toolkit are needed. With significant progress in the regulatory framework towards adoption of Basel III, the authorities should focus on macroprudential policy and further upgrading the regulatory toolkit. It would also be important to put in place an adequate liquidity support facility for banks and robust frameworks for crisis management, including by enhancing the range of resolution tools. To better monitor macrofinancial risks, data gaps with respect to granular information on household and corporate balance sheets and property prices should be addressed.

• The country has potential to develop the fintech sector. Adopting cybersecurity and fintech regulatory frameworks in line with international standards while capitalizing on Panama’s digital and mobile connectivity could place the country as a regional fintech hub.

Addressing structural needs and social priorities is urgent

• Implementation of structural reforms will be key to secure high potential growth. Sustaining high rates of growth will require continued improvements in productivity and competitiveness, a strengthening of policies related to labor mobility, governance and institutional capacity, and enhancing the innovation and technological sophistication in key industries. To remain an attractive destination for doing business, Panama needs to upgrade the skill level of its workforce, streamline the insolvency framework and improve the functioning of the judicial system. In addition, enhancing water management is vital both for the expanded Canal operations and a growing population, especially given the climate change risks.

• Social issues should be prioritized. It will be important to continue reforming social policies to maintain broad-based and inclusive growth, this requires strategic policy action in the areas of education (both access and quality), gender equality, social protection programs, and poverty reduction in the comarcas.

********************************************************************

The mission would like to thank the Panamanian authorities for their excellent cooperation, kind hospitality, and candid and open discussions.