Throughout 2023, the Panama Canal Authority has introduced various restrictions on the size and frequency of vessels transiting the canal amid an extended period of low water levels. Just last week, authorities reduced the daily number of available bookings for passage from 31 to 25. These conditions highlight the fundamental need for Panama to diversify its economy beyond the canal and related services. The transition already appears to be underway.

The Panama Canal serves as the main transit point between the Atlantic and Pacific oceans, facilitating trade between the U.S. and Asia and connecting markets in Latin America, Europe and Canada. Approximately 5-6 percent of all seaborne trade passes through the canal. However, the global economy is undergoing a reorganization, part of which is reflected in changing trade patterns, which will have deep implications for Panama’s economy. Since the easing of the COVID-19 pandemic, global trade has rebounded slowly, with the volume of total trade growing annually by just 2.4 percent last year and an expected 1.7 percent this year. Meanwhile, due to a number of crises around the world, some of the trade that was previously conducted through the Panama Canal has been diverted to other routes. For example, U.S. fuel and gas supplies that were previously destined for Asian markets are now being sold to European customers, meaning these suppliers no longer need passage through the canal to get their goods to market.

For Panama, this is an existential issue given the canal’s critical role in the country’s economy. According to the U.S. International Trade Administration, 80 percent of Panama’s gross domestic product is accumulated through the services sector – the largest contributor to which is the canal. Even other contributors like banking, logistics, activities in the Colon Free Trade Zone, insurance, container ports and flagship registry revolve around canal operations.

However, this arrangement is problematic not just because of the lack of economic diversification but also because it leaves Panama’s economy at the mercy of two factors out of the country’s control: global trade and water levels at the canal. Regarding trade, the shipping industry has been affected by a number of recent challenges, including container ship overcapacity, military conflicts (especially in the Middle East) and new environmental regulations. Maersk, the world’s second largest ocean carrier, announced on Nov. 3 that it will cut 3,500 jobs over the next few months on top of the 6,500 positions it eliminated earlier this year. The company said the move is pre-emptive and part of a strategy to weather challenging prospects the industry is anticipating for 2024.

In addition, declining water levels have forced canal authorities to repeatedly adjust operations. A severe drought in Panama, exacerbated by the El Nino effect, has resulted in an 80 percent decline in rainfall in the basins that feed into the canal. That authorities have already said they will limit passage to 18 vessels a day starting in February 2024 indicates that they don’t see the situation improving any time soon. The restrictions in crossings will result in rising toll prices and longer wait times, which will in turn increase transport costs for exporters and the price of goods for consumers. It was recently reported that two liquefied petroleum gas carriers turned around within 10 miles of the canal and sailed away, presumably due to high fees and delays. It’s not unreasonable to believe that more companies will eventually seek alternate routes to protect their bottom lines.

The Panamanian government has over the years adopted measures it believed would guarantee that the canal could adapt to changes in global shipping. The country had gradually structured its banking sector in such a way to attract international business, which helped it generate profits through its canal operations. And in 2016, Panama completed a major expansion project that allowed the canal to accommodate larger shipping vessels and remain a major transit route for international companies. But the recent changes in shipping patterns and environmental conditions have added urgency to the government’s efforts. In recent months, talks have accelerated on building a dry canal, something the country has considered for years. In October, the Panama Maritime Chamber called on the government to expedite the project, especially as Mexico and Colombia are considering construction of alternate transport routes. The government is also developing other areas of the economy unrelated to the canal through its Sexta Frontera initiative.

The most recent and potentially impactful move, however, has been its bid to get Panama off the Financial Action Task Force’s gray list of countries that require increased monitoring for failing to impose measures to combat money laundering and terrorism financing. Panama was on the gray list from 2014 to 2016 due to its banking sector’s lack of compliance with FATF standards and over concerns that the country was acting as a tax haven. It was relisted in 2019 but removed just last month.

The FATF is essentially a tool for likeminded countries to publicly shame governments that don’t comply with its expectations but has no authority to directly enforce its standards. Instead, countries are encouraged to adopt certain practices in order to avoid ending up on the watchdog’s gray and black lists. The organization has the sole power to add or remove countries from its lists and monitors progress on adoption and implementation of international rules for fighting money laundering. Many economists and financial institutions have tried to quantify the effects of FAFT listings on a country’s economy. A working paper by the International Monetary Fund concluded that countries on the gray list saw capital inflow declines of 7.6 percent of GDP on average, while foreign direct investment inflows decreased by an estimated 3 percent of GDP.

Appearing on an FATF list is a barrier to international business in a number of ways. Companies doing business with listed countries may need to perform extra due diligence to ensure all transactions are aboveboard, which could involve additional costs. It could also reduce a government’s access to capital and lead to lost business opportunities and reduced investor confidence. Thus, Panama’s removal from the list will aid its efforts to attract more investors and diversify its economy.

Even despite the FATF designation, the country’s economy performed remarkably well over the past decade. From 2014 to 2019, Panama’s GDP grew at an average rate of 4.7 percent, well above the regional average of 1.1 percent. Over this same period, Panama’s net FDI inflows were between $4 billion and $5.25 billion annually, according to the World Bank, the highest levels since 1977, when the bank began releasing the figures. Obviously, the country’s GDP and FDI took a hit in 2020 because of the pandemic, but both have since rebounded strongly.

Diversifying a national economy is easier said than done. There are several factors working in Panama’s favor, most notably the country’s financial system. Panama has fully institutionalized dollarization, and there are no exchange controls or restrictions on the movement of capital. Credit from established lenders is readily accessible, and the country boasts an active and modern capital market. But Panama also has a number of economic challenges to overcome, including social obstacles to diversification. Some segments of the population may be resistant to new types of economic activity – signs of which were on full display during recent protests over foreign-run mining operations. In addition, investments are unevenly distributed throughout the country, with large disparities between indigenous communities and urban dwellers. While solutions to these problems remain elusive, one thing is clear: Panama’s ability to maximize its global position will depend as much on its ability to manage the canal as on its efforts to diversify and integrate the national economy.