On behalf of the Paraguayan authorities, we thank the staff for a thoughtful report and for the open and useful policy discussions held with the Paraguayan authorities on the occasion of the sixth and final review of the Stand–By Arrangement (SBA).
1. The Paraguayan economy has been steadily improved during the last five years, concurrent with the two SBAs signed with the IMF and a positive external environment. All performance criteria were met, some by large margins, and most of the structural conditionalities are expected to be fully completed by the end of July 2008. The staff rightly points out that the macroeconomic outcomes were significantly better than anticipated, while there is a wide consensus among the staff and the authorities that the two successive SBAs were successful in buttressing economic stability, boosting growth, deepening structural reforms and reducing poverty.
2. The Paraguayan authorities are committed to meeting the program’s targets that are still in progress, and the newly elected authorities have already signaled their support to consolidate macroeconomic stability and to pursue further structural reforms. Although they do not wish to request a successor SBA at the completion of the current one, they have expressed their intention to maintain a fluid dialogue and strong relationship with the Fund.
Recent Developments – Outlook
3. In 2007, Paraguay’s real GDP grew 6.8 percent as the result of strong recovery of the agricultural sector, mainly driven by improved productivity and expansion of soybean crops. This outcome was extraordinary not only because it has duplicated the historical average growth of the country, but it was also higher than most neighboring countries. The outlook for the present year remains positive mainly due to a continued expansion of agriculture and an expected recovery of the livestock sector.
4. According to the Central Bank of Paraguay (BCP)1, annualized GDP growth reached 7.6 percent at the end of the first quarter of 2008. The best performer was the construction sector which registered a 24.6 percent growth compared with the first quarter of last year, mostly thanks to the works in the Yacyreta Hydroelectrical Dam—the completion of which is projected by end–2008. In the same period, exports registered an annual growth of 13.6 percent, while imports grew 16.5 percent on an annual basis. Under the present developments, the authorities expect real GDP will grow more than the projected 5 percent in 2008.
5. The main concern of the Paraguayan authorities is the recent surge in inflation, which has exceeded the target range of the SBA (core inflation between 2½–7½ percent). Although erratic and volatile, last year’s inflation fell to 6 percent from 12.5 percent at the end of 2006. During the first six months of this year, headline inflation had reached 5.4 percent and it rose to 13.4 percent year–on–year at end–June. As is the global trend, external shocks stemming from high food and fuel prices have had a negative impact on the consumer price index (CPI). The food component weights about 35 percent in the CPI basket and food prices had increased by 26 percent year–on–year at the end of June, thus speeding up inflation.
6. Moreover, considering the percentage changes in the different components of domestic demand, the authorities do not believe the economy is overheating. Domestic and public consumption growth are lower than GDP growth and the increase in domestic demand is explained by the high growth in export–oriented investments, mainly in the agricultural and livestock sectors. However, the authorities are committed to maintain price stability and to switch to a tougher stance in order to bring inflation to a more comfortable level by the end of the year.
7. The guarani has gone through a long period of appreciation, which started in 2003. In the first six months of 2008, the guarani has appreciated by almost 20 percent against the U.S. dollar, and when compared with the end–2002 exchange rate, the dollar value has decreased almost by half in guarani terms. This trend reflects the worldwide weakness of the dollar, as well as strong capital inflows. Although non–traditional exports are negatively affected by the appreciation of the Paraguayan currency, exports from the agricultural and livestock sectors would not necessarily be hampered thanks to large investments made to enhance productivity. In this regard, the BCP is willing to intervene in the foreign exchange market to alleviate the destabilizing effects of sharp appreciation. The authorities will not seek to change the long–term trend of the currency but, in the short term, they believe that is possible to affect the speed of the adjustment. The authorities are pleased with the staff’s appraisal that the exchange rate is in line with fundamentals.
8. Continuing the trend of recent years, strong foreign currency inflows have led to continued reserves purchases by the BCP to avoid a sudden appreciation of the exchange rate. Since the beginning of the year, international reserves have increased by almost 30 percent to record levels equivalent to 4 months of imports or 1.6 times the volume of foreign currency deposits in the banking system. The strong reserve position will shield the economy from external shocks and a further deterioration of the global economy.
9. Regarding the international claims in dispute, the authorities are closely monitoring the developments and they are engaged in resolving the pending issues with the involved parties.
10. Sound fiscal policies were constantly employed throughout the program. This year, improved tax collections and government expenditures constrained by the financial plan approved by the Ministry of Finance (MH), resulted in an overall fiscal surplus of 1½ percent of GDP at the end of May 2008. This outcome was possible despite the 2008 budget position (deficit) approved by Congress. The authorities have agreed with the staff to maintain and even tighten the fiscal stance to contain inflationary pressures. The aim is to improve the program goal’s overall balance by saving the proceeds of the first semester to achieve an overall surplus of ½ percent of GDP by end–2008. The authorities concur with the staff on the importance of applying tight expenditure controls without holding back capital infrastructure, although they recognize this would be a difficult task given the rigidities of the budget and the social pressures that the new government is already sensing.
11. In general, tax revenues have improved during the execution of the SBAs, especially thanks to the reforms introduced in tax administration and customs enforcement. Regarding expenses, the implementation of the expenditure commitment control system and the establishment of a Single Treasury Account to consolidate all accounts not established by law were positive steps commended by the staff. The public debt (excluding BCP notes) has decreased to around 22 percent of GDP and it is projected to decline further to 17 percent of GDP by end–2008. Although these achievements were difficult to attain, the authorities recognize the need for further reforms—especially in the budgetary process—and they are willing to address this issue with the incoming authorities.
12. Considering the acceleration of inflation since the beginning of 2008, the BCP has started to tighten its monetary policy by increasing the interest rate of its notes by 150 basis points in March 2008 and later by increasing banking reserve requirements. To optimize monetary interventions, the BCP has changed the modality to conduct open market operations by switching to weekly competitive auctions of its notes from fixed interest rate notes. The outcome was positive since the amount sterilized has increased and the interest rate has slightly decreased. With these measures, the authorities remain confident that the annual monetary growth—currently at 34 percent—will be slowly and gradually reduced to a reasonable level compatible to a single digit inflation in the short term.
13. However, the monetary authorities have agreed that in the event of a worsening scenario, they are ready to switch to a tougher stance, although they have concerns that additional interest rate increases combined with the strong appreciation of the guarani could lead to large inflows of carry trade monies, complicating the monetary management. Therefore, future tightening is going to be carefully evaluated before taking action.
14. The financial system continues to perform well, despite the global financial turmoil. The staff points out that foreign banks’ funding from parent banks and other international banks account for less than 2 percent of liabilities, which indicates a low exposure to liquidity risks coming from a deterioration of the banking credit abroad. In addition, banks are well capitalized, profitable, and adequately provisioned. The rapid credit expansion has not affected the quality of the portfolio, since nonperforming loans are steadily declining. Although credit growth is high compared to other sectors’ growth, the percentage of private credit to GDP (18 percent) it is still low when contrasted to the level of past years, as well as in relation to other economies in the region. Moreover, the credit growth reflects the better positioning of the country’s economy after years of stagnation. Figure 4 of the staff report clearly exposes the banking credit crunch after successive banking failures and the gradual recovery after the crisis.
15. One of the most successful stories was the recovery of the National Development Bank (BNF), a public financial entity. The reforms implemented by the authorities have been rewarding and by end–2007 the bank presented a capital adequacy ratio that doubles the minimum required and a reduced NPL rate of only 7.8 percent. These indicators are impressive, after the bank had been assessed as an insolvent institution with a record ratio of 48 percent of NPL to total outstanding loans. However, the reforms must continue to improve and align the BNF’s indicators in relation to those of private banks.
16. The Paraguayan authorities are grateful for the continued support from Fund missions and technical assistance, which enabled a successful restructuring of the financial system. In this regard, they expect to continue the fruitful dialogue to continue improving the prudential environment and address the shortcoming in the regulatory and supervisory framework through future technical assistance missions.
Structural Reforms Developments
17. Most of the structural conditionalities were met and those which are in progress are expected to be completed in the coming days. One of the most important reforms refers to the implementation of a renewed payment system along with the approval of the draft of the payment system law. This draft was originally projected to be approved by the Economic Cabinet by end–September 2007, but it was delayed until recently. The BCP’s authorities stated that the draft was remitted to the Economic Cabinet a week ago after a thorough review by involved parties and receiving technical advice from the World Bank. The Vice Minister of Economy has already issued a press release informing that the final draft was approved and it will be sent to Congress in the coming days.
18. Regarding the capitalization of the BCP, it’s been agreed by the monetary and fiscal authorities to strengthen the financial position of the bank. By end–2007, two Presidential decrees had approved the reconciliation of claims between the MH and the BCP and the issuance of bonds to clear this debt. Two months ago, a new decree was enacted to authorize the payment using the 2008 budget. The MH is now in the process of transferring the bonds to the BCP. Moreover, the MH is also in the process of sending the remaining claims that are still in dispute to the Attorney General for his compliance, prior to forwarding a draft legislation to Congress for its approval.
19. The benchmark regarding the signing of result–oriented contracts and the adherence to performance standard by five State Owned Enterprises (SOEs), were not fully met. All entities presented their business plans but these were weak and incomplete. We concur with the staff’s assessment that the underperformance in this area was a consequence of the uncertainties associated with the post–election political transition period, taking into account that the managers of these SOEs will not remain in office (the inauguration ceremony of the recently elected authorities will be held on August 15). However, under prior contracts some important structural and operatives changes had taken place in some of these SOEs.
Moreover, the publication of the SOEs’ audits and their quarterly assessments by the Supervisory Council of Public Enterprises is a welcome development, which has already brought transparency and is expected to convey accountability to these public entities.
20. Finally, the implementation of the conditional–cash transfer program known as Tekoporã continues to be a successful experience. By end–May 2008, more than 19,000 lowincome families had received transfers from the program. Although the program was not designed to deal with the current food crisis, it has helped the poor sectors of the population alleviate the distress caused by the food price increases. The authorities are planning to expand the coverage of the social safety net program to 100,000 households by the end of the year. Although this target may imply logistical problems, the authorities are willing to take the risk in order to cope with the food crisis. The staff’s presentation included in Box 3 of their report, reflects a fair assessment of the program.
21. The structural reforms that have been implemented are strong signals of the Paraguayan authorities’ commitment to achieve the necessary changes to improve the business climate, attain a high level of investment, and continued growth. The recent positive economic outcomes have place the country in good position to weather possible external shocks and to continue its path of macroeconomic stability and growth, which will reduce poverty and inequalities.
22. The authorities believe that the implementation of the program has been successful in the completion of its targets, for which they want to thank the staff and Management for their support. In this regard, we would like to mention that the authorities consent to the publication of the staff report. Going forward, the newly–elected authorities have mentioned their willingness to continue the fruitful dialogue with the Fund and they are looking ahead to strengthening the engagement, especially through technical assistance support.
Updated Report on GDP – Quarterly and Annual Information, First Quarter 2008.