Journal Issue

Paraguay: Addressing the Stagnation and Instability Trap

Alejandro Santos
Published Date:
December 2009
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1 Overview

Alejandro Santos

One could be excused for believing that there is a deep understanding of the Paraguayan economy. After all, a quick Google search of Paraguay’s economy reveals 7½ million entries (which is about 10 times higher than the entries for the economies of Argentina or Brazil). Unfortunately, that is not the case. With the exception of a few publications from domestic think thanks and reports by international organizations, there is a real scarcity of economic analysis or knowledge about the Paraguayan economy.1

While many economies in Latin America have frequently been in the spotlight, relatively little is known or reported about Paraguay. The economic takeoff of Chile, the opening up of Mexico, the successful stabilization of Brazil, and the ups and downs of Argentina have occupied the headlines of newspapers, inspired seminars, and become the subject of research papers, but outside the country not much attention has been given to the problems of the Paraguayan economy. This book, which originates from discussions between IMF staff and the authorities on how to correct economic imbalances and institutional shortcomings, aims to fill that gap.

Stagnation and Instability Syndrome

By many standards, Paraguay lagged behind the region in the past quarter century and became an outlier in the Latin American context. It seemed as if Paraguay had its own timing, patterns, and ways of doing things under the south side of the sky. While most of the region had multiple debt restructurings and some spectacular defaults, Paraguay continued servicing its external obligations on time. This distinctiveness is epitomized by the famous description of the country as “an island surrounded by land” by the renowned Paraguayan writer Augusto Roa Bastos (1917—2005). This perception of uniqueness is perhaps rooted in its history; Paraguay is the country with the most armed conflicts in Latin America and one associated with some of the longest political regimes in South America.2

However, this sense of backwardness has not always been part of Paraguay’s economic history. Paraguay was at the cutting edge of economic growth and prosperity throughout the 1960s and 1970s, and real per capita income multiplied two and a half times. This episode coincided with the construction of the Itaipú dam (the largest in the world at that time) together with Brazil, a project several times larger than Paraguay’s economy. The strong economic impulse of this large (and long-term) project, together with a stable economic and social environment, transformed Paraguay into the fastest growing economy in Latin America during the 1970s.

Unfortunately, the rapid growth faded and turned into chronic stagnation once the Itaipú project was completed. It is estimated that real per capita income fell by some 20 percent between the early 1980s and the early 2000s. The record growth of the 1970s became the record stagnation of the following quarter century. Few countries in Latin America did as poorly as Paraguay during this period.

The authorities tried to sustain the pace of economic expansion after the completion of the Itaipú project by deepening the development of the “eastern frontier” (with the modernization of agriculture and the emergence of Ciudad del Este as an economic center) and increasing public borrowing to create and expand state-owned enterprises (i.e., steel and cement), but all sources of rapid economic growth were exhausted by 1980. By then, the economy overheated and experienced a form of Dutch disease as Paraguay’s currency, the guaraní, became too strong during the rapid economic expansion and lost competitiveness. Furthermore, the “equilibrium” real exchange rate depreciated as the terms of trade deteriorated, and the economy began to stagnate while the population continued growing.

Following a period of capital account liberalization, rapid public borrowing, and banking deregulation in the late 1980s and early 1990s, economic performance continued to be poor and began to spill over to the financial sector, leading Paraguay to a series of episodes of recurring and costly financial distress since the mid-1990s. Contagion from the regional crisis in 2002 exacerbated inherent weaknesses in the financial system, undermined confidence, and precipitated large deposit runs and an acute financial crisis that depressed the economy further and complicated macroeconomic management. This represented the worst economic and financial crisis in decades and confronted the authorities with some sobering challenges. In response to this crisis, the incoming Duarte-Frutos administration adopted an ambitious stabilization program in 2003, which was supported by the International Monetary Fund (IMF) through 2008.

In Search of Cures and a Policy Agenda

The challenge for the authorities was to develop policies that would strengthen the fundamentals of the economy and allow sustained growth to avoid the pattern of expansion and abrupt economic collapse of the past. The authorities decided to address their economic problems, although not entirely clear at the time, in two stages. The first stage was to address the most pressing macroeconomic imbalances with a stabilization program while beginning a process of economic reform (2003—05). The second stage was to tackle medium-term growth and institutional issues with a structural reform program (2006—08). The role of the IMF during this period was to assist the authorities in the design of their programs by providing analysis and examples of best practices in other countries. The authorities displayed a high level of ownership to their reform efforts. All major initiatives that took place during this period—the fiscal adjustment law, the public pension reform, the customs code, the second-tier development banking law, the reform of the national development bank, improved tax administration, expenditure control systems, strengthened banking regulations, the conditional cash transfer program, and others—were designed by the Paraguayan authorities.

By mid-2005, when it was clear that the economy had been successfully stabilized and had started to grow, the authorities shifted their focus from the short-term stabilization concerns to the medium-term growth issues. There was a general consensus that maintaining a stable economy was not sufficient to unlock the sources of growth necessary to eliminate poverty and enhance the well-being of the population. This would require the development of a policy agenda that would include a set of ambitious structural reforms in strategic areas, embedded in an overall framework consistent with maintaining macroeconomic stability. In the context of this policy dialogue, IMF staff assisted the authorities with some analysis and began writing several papers to better understand the trade-offs confronted and the available policy options. This book presents those papers.

While studying the main weaknesses of the Paraguayan economy in the past, the authorities identified five key areas where specific policy agendas and initiatives would be needed. Thus, the discussions on a strategic blueprint evolved around several policy pillars broadly defined as (1) strengthening macroeconomic performance, (2) eliminating turbulence and deepening financial reform, (3) fine-tuning monetary and exchange rate policy, (4) managing fiscal institutional weaknesses, and (5) enhancing growth prospects and reducing poverty. It became clear that designing such a set of reforms would require the expertise of other institutions, in particular the World Bank and the Inter-American Development Bank, which got actively engaged in the discussions. After several rounds of productive discussions, the result was a compilation of policy proposals characterized by a high degree of ownership by all parties involved in the discussion and served in the design of the economic program. The structure of this book broadly follows the policy pillars identified at the time of the 2006—08 program.

Strengthening Macroeconomic Performance

Chapter 2 presents an overarching introduction to the Paraguayan economy. It provides an overview of recent macroeconomic performances and assesses them by using standard models from the economist’s toolbox. Alejandro Santos and Brieuc Monfort review different statistical and accounting methodologies to construct potential GDP and output gaps and use them to assess the cyclical position of the economy. All indicators suggested that GDP was above its historical potential by the mid-2000s, which may point to demand-side pressures, but could also reflect an increase of productivity related to structural reforms (a theme later analyzed in greater detail in Chapter 11). The output gap in turn is used to assess the appropriateness of the fiscal-monetary policy mix. The analysis of the fiscal position with respect to the economic cycle shows that fiscal policy has been at best mildly countercyclical on average, although not consistently so every year. The analysis of monetary policy shows that it has been guided less by the evolution of inflation and output, as postulated in a traditional Taylor rule, than by the exchange rate and the external position. The authors conclude with policy recommendations to address identified shortcomings. In particular, they point to the importance of developing—and regularly updating—tools to assess the cyclical position of the economy. From a macroeconomic standpoint, fiscal policy should aim at avoiding a procyclical stance that increases the volatility of economic activity and reduces social welfare. Monetary policy would benefit from being geared more toward inflation than the exchange rate, as a policy dominated by “fear of floating” tends to be self-perpetuating and to build up vulnerabilities.

Eliminating Turbulence and Deepening Financial Reform

For nearly a decade through 2003, recurrent financial crises were a feature of the Paraguayan economy. No less than five crises, of varying magnitudes, occurred from 1995 to 2003. In Chapter 3, Montfort Mlachila offers a panorama of the causes, costs, and consequences of these crises. Drawing on the vast literature on financial crises, he establishes that, unlike most financial crises internationally, those in Paraguay were not primarily caused by severe macroeconomic imbalances. While inflation was relatively high, the macroeconomy was basically sound with some growth and strong fiscal fundamentals at the onset of the first crisis in mid-1995. The main cause was elsewhere. The first wave of crises was largely the result of a very rapid pace of financial liberalization without adequate prudential regulations and safeguards, while the second wave was due to contagion from Argentina. Following general economic liberalization after 1989, by 1995 the number of banks and financial companies (financieras) had practically doubled. This led to widespread weak banking practices, including (1) poor risk evaluation; (2) connected lending; and (3) very rapid growth of (often illicit) off-balance-sheet transactions, with subsequent development of a parallel financial system. The direct fiscal and quasi-fiscal cost of the crises amounted to more than 15 percent of GDP. The consequential fallout from the crises was considerable and long-lasting. The most enduring legacy of the crises has been the creation of a dysfunctional banking system characterized by continuing financial fragility, reduced levels of financial intermediation, high spreads, increased dollarization, capital flight, and a weak balance sheet of the central bank. Furthermore, there has been a sharp reduction in financial intermediation away from private credit in favor of deposits at the central bank of Paraguay (BCP) and investments in BCP bills (letras de regulación monetaria, LRMs). On the positive side, a salutary effect of the crises was the creation of a sounder financial system. Nonetheless, the chapter concludes that, given the relatively low level of Paraguay’s compliance with Basel Core Principles, there is need to further deepen ongoing prudential reforms, an issue that is taken up in the next chapter.

In Chapter 4, José Giancarlo Gasha reviews the developments in the financial system from the early 2000s, presents the main features of the authorities’ efforts to reform the financial system, and outlines the remaining challenges. The author suggests that the reestablishment of macroeconomic stability offers a window of opportunity for strengthening the financial system and developing capital markets in Paraguay. Over the past few years, the authorities have started to implement a comprehensive reform program in the financial sector aimed at enhancing the resiliency of the banking system by upgrading the regulatory and supervisory framework, restructuring the public National Development Bank (Banco Nacional de Fomento, BNF) and eliminating the systemic risk it once posed, and further engendering confidence in the guaraní by initiating financial strengthening of the BCP. The remaining reform agenda should include measures aimed at further buttressing the regulatory and supervisory framework, enhancing governance, upgrading supervisory capacity and accountability, improving the availability and quality of credit information, and enhancing creditors’ rights and insolvency procedures. The agenda should also address the regulatory and supervisory shortcomings of the buoyant cooperative sector, upgrading the payment system, and implementing a number of reforms aimed at developing incipient domestic capital markets.

Tobias Roy discusses in Chapter 5 structural financial weaknesses at the BCP that have impaired efficient monetary policy implementation in Paraguay. These weaknesses pertain to liquidity services that constrain the central bank’s ability to operate as lender of last resort and the development of interbank and capital markets. Even more important, the BCP’s fragile financial position undermines its credibility and independence, as interest rate decisions are made with a view to minimize their impact on the bank’s balance sheet, which can lead to excessive money creation and higher inflation. In addition, the lack of central bank capital, if unaddressed, can lead in the long run to explosive paths for the BCP’s outstanding debt. The chapter analyzes this issue within a dynamic debt sustainability framework and makes long-run projections for the BCP’s capital and debt. It finds that under realistic parameter settings, capital and debt could indeed become unstable over time, if the BCP abstains from resorting to inflation tax. The last part of the chapter discusses policy options for a financial strengthening of the BCP.

The BNF has experienced a successful reform process, passing from being a systemic risk institution within the Paraguayan financial sector to one of financial soundness. In Chapter 6, Luís Duran-Downing and Santiago Peña offer an overview of the conditions that led to the BNF’s troubles, notably ineffective financial incentives and lack of sound lending practices, leading to the deterioration of its financial position. It subsequently discusses the reforms implemented during 2003—07, including the administrative and financial measures to restore the financial soundness of the bank and the challenges ahead to continue in a sustainable position. The chapter also presents the international experience in reforming development banks and gives an overview of the previous attempt to reform the bank. The experience of the BNF suggests that reforming development banks is feasible and that the cost of this reform could be limited.

Fine-Tuning Monetary and Exchange Rate Policies

In Chapter 7, Brieuc Monfort and Santiago Peña use different methodologies to explore the dynamics of inflation since the liberalization of the economy in the early 1990s. An introductory section is devoted to analyzing the structure of the consumer price index published by the central bank. It also examines the properties of a broad range of core inflation indicators, for example, in terms of discerning medium-term trend inflation or predicting future inflation. Two different analytical frameworks are then used to assess econometrically the long-term determinants of inflation and its short-term dynamics. In the markup theory of inflation, prices are modeled as a function of domestic costs and imported prices. In the monetary theory of inflation, prices result from a deviation of real money demand from its long-term equilibrium. The chapter concludes that money, in particular currency in circulation, is an important determinant of inflation dynamics, but it also validates the role of cost push factors for the short-term evolution of inflation, such as imported inflation from Brazil or food prices. In addition, it suggests that inflation inertia remains high, most likely due to the wage indexation mechanism or entrenched inflation expectations.

The equilibrium exchange rate in Paraguay is the topic of Chapter 8 where Bergljot Barkbu and Brieuc Monfort use a set of different methodologies to assess the level of the real exchange rate using a few econometric techniques. The real exchange rate in Paraguay has appreciated over the past few years, exceeding its pre-banking crisis level from 2002, and the question of a potential overvaluation has been an important issue with significant implications for monetary policy. The econometric analysis uses four methodologies to assess the level of the exchange rate: two based on statistical indicators, and the other two on econometric models. A general conclusion from the analysis is that the undervaluation experienced during the early 2000s was subsequently corrected, but there is no conclusive evidence that this correction has brought the exchange rate above its equilibrium. Comparing statistical indicators to the level determined by purchasing power parity does not suggest that the real exchange rate is overvalued when structural breaks are accounted for. In addition, statistical indicators do not reveal any significant impact of the real exchange rate on competitiveness through export market shares. Finally, while both econometric models point to some overvaluation, accounting for the structural break occurring with the 2002 banking crisis, as well as the impact of the binational hydroelectric power plant, reduces the estimated overvaluation significantly.

Managing Fiscal Institutional Weaknesses

In Chapter 9, Florencia Frantischek notes that despite considerable strides in stabilizing the fiscal situation and considerable structural reforms undertaken over the past several years, Paraguay still requires a more comprehensive fiscal reform. Considerable gains have been made in increasing tax collections and reining in expenditures, leading to a sharp decline in the overall public debt level. Nonetheless, in view of the pressing need to reduce poverty and better support growth—including through investment in needed infrastructure—while maintaining fiscal sustainability, an ambitious fiscal reform agenda should be put in place. Paraguay still has a comparatively low tax mobilization ratio while being saddled with a very high wage bill compared with other Latin American countries. The chapter systematically describes the main issues and proposes policy options for each of the four areas: tax policy, revenue administration, public expenditure, and public financial management. On the revenue side, the main recommendations are to complete and deepen the 2004 tax reforms to better tax personal and agricultural incomes, as well as to institute an effective property tax. The principal recommendations on the expenditure side are to implement a modern framework for public sector employment and pay, reform the budgetary process to reduce the discretionary powers of Congress to modify the budget at will, and restructure the unwieldy pension system.

Enhancing Growth Prospects and Reducing Poverty

Benedikt Braumann uses the growth accounting methodology to analyze Paraguay’s long-run growth potential in Chapter 10. While the subject was briefly touched upon in Chapter 2 with a focus on the recent business cycle, the author takes a long-term view in this chapter going back to 1940. He highlights the lessons that can be learned from the episode of high growth in the 1960—70s and the subsequent period of stagnation in the following two decades. Past experience shows that anchoring higher growth requires productivity growth to translate into sustained capital accumulation. The stagnation period was marked by deteriorating relative prices and a volatile financial sector. These factors, along with a neglect of human capital, infrastructure, and property rights, made much of the previous investment obsolete. Improved education, governance, and financial regulation are needed to ensure that future capital investment receives the appropriate return for the risk it takes. This will help translate the increase in productivity over the past few years into sustained capital accumulation, and meaningfully reduce poverty.

In Chapter 11, Pedro L. Rodríguez throws some light on the growth record, focusing on microeconomic and structural policies. Using growth regressions, he finds that the recent uptick of growth can be explained not just by favorable terms of trade and external demand, but also by increased macroeconomic and financial stability and structural reforms. The author also identifies a number of binding constraints for growth and explores four recommendations to raise growth. Improving the business environment, one of the weakest in the region, could help foster much needed investment. Revamping the role of state-owned enterprises would remove potential bottlenecks for growth. Modernizing the agriculture sector would allow Paraguay to capitalize on one of its comparative advantages and to achieve productivity levels similar to those in the region. Finally, reducing institutional instability would provide a more predictable economic environment. Progress has recently been made on most of these issues, but more is needed to buttress the progress so as to set the stage for a sustainable, higher growth path.

Pablo Molina and a team from the Inter-American Development Bank focus on measures that contribute to a more efficient and effective use of public expenditure allocated to the poor in the short to medium term in Chapter 12. The chapter proposes the use of poverty maps as a targeting tool that can help to increase the efficiency of public resources allocated to poverty reduction. In addition, it provides a sectoral assessment of education, health, social protection, and small-scale farming and proposes specific sectoral policies to help reduce poverty. It emphasizes measures aimed at giving the poor better access to education and health services, including through conditional income transfers, and improving the quality of government services in these areas. Finally, it proposes a reorientation of public expenditure aimed at small-scale farming.

I Strengthening Macroeconomic Performance

2 Assessing Macroeconomic Policies

Alejandro Santos and Brieuc Monfort1

The main macroeconomic problem in Paraguay is the persistence of high unemployment and low growth for an extended period of time. Over the past 50 years, Paraguay has turned from being one of the most dynamic economies of Latin America in the 1960s and 1970s to one of the most stagnant economies in the world in the 1990s and early 2000s. Unlike most Latin American countries, Paraguay has avoided macroeconomic imbalances of dramatic proportions, such as hyperinflation, runaway fiscal deficits, or excessive foreign debt. The growth accounting exercise of Chapter 11 shows that the substandard growth performance of the past decade is due mainly to structural problems and low productivity, but poor macroeconomic policies have also contributed to low growth by creating instability and uncertainty, leading to reduced levels of investment and capital accumulation.

This chapter assesses macroeconomic performance over the 1990s and 2000s, providing policy recommendations to address identified shortcomings. The chapter tries to identify the appropriateness of fiscal and monetary policies against specific objectives. The second section analyzes changes in long-term growth and within business cycles and constructs an indicator of output gap used in the other sections of the chapter. The next section assesses fiscal policy within two dimensions: (1) the consistency of fiscal policy and debt sustainability and (2) whether fiscal policy was used as a stabilizing instrument against the business cycle. The fourth section analyzes whether monetary policy has been implemented with the ultimate objective of achieving price stability. The final section concludes and proposes some policy recommendations.

Growth, Cycles, and Output Gaps

Long-Term Trends

While the average growth rate of the economy has been 4½ percent over the past 40 years, there have been clear changes in trends on at least three occasions. Breaks in trend occurred after 1981, 1995, and 2002. This has created four distinct periods in the economic history of the country (Figure 2.1).

Figure 2.1.
Real GDP

(Logarithmic scale)

Source: IMF staff estimates.

  • Golden Era. The first period goes from 1965 to 1981, when the economy grew at an average annual rate of over 7½ percent. High growth during this period came mainly from the construction of the Itaipú hydroelectric dam in the 1970s on the border with Brazil (the largest dam in the world until recently) as well as from the development of agriculture in the western part of the country.

  • Sharp Deceleration. The second period goes from 1982 to 1995, when the growth rate was reduced by more than one half, to less than 3 percent. It coincided with the development of Ciudad del Este as a center for triangular regional trade, the transition to democracy, and the presence of higher unemployment and underemployment rates in the economy.

  • Stagnation. The third period covers 1996 to 2002, when the economy virtually came to a halt and unemployment rates increase further. This period is associated with a series of domestic financial crises and global instability (including the Asian 1997 and Russian 1998 crises) and its impact on the regional economy, with Brazil exiting its exchange rate regime in 1999 and culminating with the debt default in Argentina in 2001.

  • Recovery. The fourth period covers only the period 2003–05, when the economy began to grow at rates not observed in a decade, and the unemployment rate fell. It coincides with a regional recovery and the adoption of an economic program supported by the International Monetary Fund (IMF).

Over the long run, episodes of high growth have been associated with stability whereas periods of low growth have tended to be more volatile (Table 2.1). Over the past 40 years, there was a clear inverse relationship between growth and stability (as measured by the coefficient of variation of real GDP growth). Following a period of instability and stagnation, the economy grew in the “recovery” period with notable stability. While the higher growth with stability would have been part of the pattern of the past, there seems to be a new tendency for even higher stability. In fact, the coefficient of variation of the latest growth episode (2003–05) is even lower than during the “Golden Era” of the 1960s and 1970s. This remarkable development points toward significant improvements in macroeconomic management in the country.

Table 2.1.Economic Growth Trends(In percent)
1. Golden Era (1965–81)7.70.4
2. Sharp Deceleration (1982–95)2.90.9
3. Stagnation (1996–2002)0.212.8
4. Recovery (2003–05)3.70.2
Sources: Central Bank of Paraguay; and IMF staff estimates.Notes: Average real GDP growth and the coefficient of variation.
Sources: Central Bank of Paraguay; and IMF staff estimates.Notes: Average real GDP growth and the coefficient of variation.

The only relevant role of macroeconomic policies in influencing long-term growth is through the establishment of a stable economic environment. Although expansive short-term macroeconomic policies tend to expand the level of income, those expansions are usually shortlived, and if not properly timed, they could lead to inflation and stagflation. As Chapter 11 shows, a stable macroeconomic environment is more relevant for growth than previously thought. Long-term growth is given by resource endowment, factor accumulation, and productivity. Only through structural reforms can the rate of resource accumulation be changed (i.e., more capital and better labor), and the level of factor productivity be improved by changes in frameworks and institutions (i.e., development of capital markets, strengthening the labor market institutional framework, and land reform).

Business Cycles

One of the striking features of the Paraguayan economy is that output declines have been quite rare. Over the past 40 years, real GDP fell in only four years (1982, 1983, 1999, and 2000); the growth rate was zero in only one year (2002); and there was low growth (i.e., lower than 1 percent) in three years (1986, 1996, and 1998). If these years were the standard for bad economic performance, about two-thirds of them occurred—not surprisingly—during the “Stagnation” period. By contrast, there were 17 years in which real GDP growth was higher than 5 percent; the great majority of them occurred during the “Golden Era.” It is important to note that population growth during the whole 40-year period was about 2½ percent a year and that in about one-fourth of the observations economic growth was lower than the population growth; the bulk of these cases were observed during the “Stagnation” period.

An “ideal” pass filter was used to estimate the business cycle. Measuring the business cycle is a difficult and often controversial task. There is no unique method for analyzing cycles, especially when there are changes in trends. Lately, Corbae and Ouliaris (2006) have proposed a new approach to estimating the business cycle econometrically by combining frequency domain techniques with spectral regression methods. Their “ideal” band pass filter for estimating deviations from the trend has been shown to have superior statistical properties to the Hodrick-Prescott (1980) filter and the Baxter-King (1999) filter. The results are shown in Figure 2.2. It is worth noting that for each of the growth periods identified before, there is either a full business cycle associated with it or else a whole phase of a given cycle.2

Figure 2.2.
Business Cycle

Source: IMF staff estimates.

Over shorter time horizons, there has been a tendency for the business cycle to reduce its amplitude and phase. There have been three cycles over the past 40 years (Table 2.2). The longest and more pronounced cycle was during the “Golden Era”; it lasted 15 years and created large deviations from the trend (in the range of -6½ to +12¼ percent). The second longest and more pronounced cycle was during the “Sharp Deceleration” period; it lasted 14 years and had lower variations from the trend, especially on the upswing (in the range of –6¼ to 5 percent). The third cycle has been the shorter and less volatile one and covers the “Stagnation” period on the downswing and the “Recovery” period on the upswing. It has lasted 10 years and presents a much lower variability from the trend (in the range of –4¾ to 3¾ percent). The reduction in the amplitude of the business cycle also points toward improvements in the conduct of macroeconomic policy.

Table 2.2.Business Cycles(In percentage deviation from trend)
1. Golden Era1967–76 (10)-6.61977–81 (5)12.3
2. Sharp Deceleration1982–86 (5)-6.21987–95 (9)4.9
3. Stagnation1996–2002 (7)-4.8
4. Recovery2003–05 (3)3.7
Sources: Central Bank of Paraguay; and IMF staff estimates.
Sources: Central Bank of Paraguay; and IMF staff estimates.

Macroeconomic policies should be designed with a view to minimize the amplitude of the business cycle. Although it is tempting to take action only on the downswing through expansionary policies to avoid a recession, policy frameworks should be in place to undertake contractionary policies on the upswing to prevent overheating and inflation. For this reason it is important to strengthen the budgetary framework (including through the development of fiscal responsibility laws) and the monetary framework (including by strengthening the financial viability and independence of the central bank).

Output Gap

It is difficult to make assessments about the output gap in an economy that is in the process of increasing its growth potential, but most variables indicate that the economy was operating beyond its capacity by 2005. The sustained growth in the economy since 2003, the significant reduction in the unemployment rate over the same period, and increases in real wages in the previous years indicate that there was a positive output gap (defined as the ratio of actual to potential output).

Three methods were used to estimate the output gap, and all of them point toward a positive output gap. On average these methods suggest that there is a positive output gap of about 2 percent in 2005 (Table 2.3).3

Table 2.3.Output Gap(In percent)
1. Production Function0.7
2. “Ideal” Pass Filter3.7
3. Okun’s Law1.2
Source: IMF staff estimates.
Source: IMF staff estimates.
  • Production Function. This method consists of estimating an aggregate Cobb-Douglas production function and then projecting potential output based on resource availability and an estimate of total factor productivity (similar to the growth accounting exercise of Chapter 11). Braumann (2000b) used a similar method for Paraguay and found at the time a large negative output gap for 2000. Updating his methodology using data through 2005 reveals that there is currently a small positive output gap (0.7 percent). Chapter 12 presents similar results.

  • Statistical Filter. This method simply uses any of the well-known filters to separate trend from cycle, and then uses the cycle to see how much it departs from the trend. The “ideal” pass filter mentioned before indicates a positive output gap in 2005, although the estimate (3.7 percent) might be affected by end-point bias.

  • Okun’s Law. This method, proposed by Okun (1962), estimates how much output can be generated by a reduction of the unemployment rate by 1 percent (the Okun coefficient). Although there are not enough observations to estimate a reliable coefficient, the least square estimate was only 0.8 (a relatively low value). On the assumption that the natural rate of unemployment in Paraguay is 7.3 percent (see below), the difference between the natural rate and the 2005 unemployment rate implies a small positive output gap (1.2 percent).

The Okun relationship highlights the presence of low growth in the economy and structural problems in the labor market. Figure 2.3 shows the relationship between output growth (g) and changes in the unemployment rate (∆u), that is, Okun’s law. The relationship underscores two features of the Paraguayan economy.

Figure 2.3.
Okun’s Law

Source: IMF staff estimates.

  • A low natural growth rate of the economy. The intercept of the fitted line is 1.8 percent, which would be an estimate of the natural growth rate of the economy (i.e., real GDP growth in the steady state when there are no changes in the unemployment rate). This estimate is very close to the average growth rate of the economy over the past 25 years, which is 2.2 percent.

  • A high natural rate of unemployment. The slope of the fitted line is 0.8 (the Okun coefficient). For each 1 percent reduction in the unemployment rate, output increases by 0.8 percent, which is low by international standards and suggests low labor productivity.4 Notice that the observation for 2005 actually lies along the fitted line in the northwest quadrant, which implies a growth above the natural rate and an unemployment rate below the natural rate of unemployment. A movement along the fitted line to the intersection of the vertical axis (the steady state with no change in unemployment) would imply an increase in the unemployment rate of 1.5 percentage points to a natural rate of unemployment of 7.3 percent and a fall in output of 1.2 percent, which gives the estimate of the output gap. The relatively high estimate of the natural rate of unemployment indicates serious problems in the functioning of the labor market.

The authorities should strengthen their capabilities to forecast potential output and the output gap. This should not be difficult to achieve because both the central bank and the Ministry of Finance have research departments able to make projections on output and the phase of the business cycle. These forecasts would need to be transmitted to policymakers to help them shape their views on how to conduct policies. As Paraguay develops capital markets and more market analyses become available, the authorities should incorporate those forecasts and views into their own projections. Assessments about the output gap need to be reviewed periodically given the ambitious structural reform agenda in the authorities’ program. Once structural reforms take hold, the productive capacity of the economy expands and early signs of a positive output gap may disappear.

Fiscal Policy Appraisal

This section evaluates fiscal policy against two main objectives: maintaining debt sustainability and conducting a countercyclical policy. The analysis is based, for the first part, on a debt accumulation equation and, for the second part, on the fiscal impulse methodology.

Debt Sustainability

The debt dynamics depend on the primary fiscal deficit, the difference between interest rate and growth, and the real depreciation. For simplicity, all public debt is assumed to be denominated in U.S. dollars.5 Denote Et the exchange rate of the guaraní in U.S. dollar terms, Dt the debt outstanding at time t denominated in dollars, Ft the fiscal balance in local currency, Bt the primary balance in local currency, and rt the nominal interest rate on foreign debt in dollars. The debt accumulation equation can be written as follows:6

Dividing by nominal GDP in dollar terms (i.e., Pt Yt /Et) and subtracting [Dt-1Et-1/Pt-1Yt-1] on both sides gives

Finally, denoting dt and bt as the debt and primary fiscal balance ratios in terms of GDP, and π the inflation rate, g the real growth rate, and δ the depreciation rate, and after rearranging, equation (2) can be approximated by7

A primary surplus and a high real growth rate tend to reduce the debt ratio, while a high real interest rate and an exchange rate depreciation tend to increase the debt ratio.

The debt dynamics of the past 15 years show three distinct periods (Figure 2.4).

Figure 2.4.
Public Debt

(In percent of GDP)

Source: IMF staff estimates.

  • Stable Path (1992–95). The nonfinancial public sector (NFPS) debt ratio remained relatively stable in the early 1990s, hovering around 20 percent. The depreciation of the exchange rate put upward pressure on the debt ratio, but that was compensated by a higher primary surplus and lower real interest rate (Table 2.4).

  • Unsustainable Path (1996–2002). The NFPS debt ratio rose from 20 to 70 percent between 1996 and 2002 owing, by and large, to the sharp depreciation of the guaraní, although fiscal policy was loose and was also a cause of the debt buildup. During this period, the guaraní depreciated against the U.S. dollar by more than 230 percent (of which 100 percent took place in 2001–02 as a spillover from the crisis in Argentina). This contributed to an debt increase of close to 50 percentage points. In addition, the economic recession fueled an increase of the primary deficit, which contributed to a further increase of the debt ratio by almost 10 percent.

  • Back to Sustainability (2003–06). The NFPS debt-to-GDP ratio subsequently declined to about 30 percent by 2006, reflecting the combination of a lower interest rate, higher growth, and a higher primary surplus. Since 2002, all factors have contributed to the decline of the debt rate, namely, the exchange rate has strengthened cumulatively by more than 25 percent, the primary balances have returned to surplus, the nominal and real interest rates have fallen, and the cumulative real growth exceeds 15 percent.

Table 2.4.Public Debt Decomposition(In percent of GDP)
Public debt119.571.727.5
Cumulative change-3.152.2-44.2
Primary deficit-3.69.0-12.1
Real interest rate-4.8-7.1-15.9
Real GDP growth-2.30.1-6.4
Exchange rate5.948.6-8.1
Source: Fund staff estimates.

End of period.

Source: Fund staff estimates.

End of period.

The authorities should improve their debt management capabilities. Although considerable progress has been observed in handling debt issues since 2003, consideration should be given to the creation of an office at the Ministry of Finance to handle all public debt and public credit issues. The office should have an updated debt reporting system to ensure that the fiscal authorities are always aware of the debt profile and obligations falling due. The office should also be in charge of designing a medium-term debt strategy and developing guidelines on the terms of the borrowings for the public sector.8 The office should participate in the preparation of the budget and in other macroeconomic discussions to constantly assess the sustainability of the public debt.

Countercyclical Policy

This section assesses whether fiscal policy in Paraguay has followed or resisted the business cycle. A casual glance at the data suggests that fiscal surpluses in the early 1990s and since 2002 were associated with relatively higher growth, whereas fiscal deficits in the late 1990s and early 2000s were related to the period of economic crisis. However, this correlation is likely to reflect the impact of automatic stabilizers in periods of upswing or downswing rather than the overall direction of discretional fiscal policy. The use of the fiscal impulse methodology allows filtering out cyclical effects.

The methodology rests on the construction of a cyclically neutral balance, from which the fiscal impulse is calculated. The cyclically neutral balance would result from allowing only the automatic stabilizers to play. To proxy this situation, discretionary expenditures are maintained as an unchanged proportion of long-run GDP (potential output), while tax revenues are computed using a fixed tax rate and actual GDP. The cyclically neutral balance (N) is thus calculated as

where Y is actual nominal output, Y* is potential output measured at current prices, τ is the ratio of revenues to GDP, and γ is the ratio of expenditures to GDP. Both ratios were frozen at their average level for the period considered, 1990–2006. The fiscal stance (S) is the difference between the cyclically neutral balance (B) and the actual balance (F).

A positive fiscal stance signals an expansionary policy. The fiscal stance is not an ideal gauge of fiscal policy because the structure of the budget may evolve over time or the sustainable level of deficit may change depending on interest rates or growth. The fiscal impulse (I)—defined as, the change in the fiscal stance (S)—is the preferred gauge of fiscal policy:

A positive fiscal impulse thus means that the fiscal policy is expansionary.

Exogenous factors to the fiscal position were excluded from the calculations. On the revenue side, royalties from the hydroelectric plants at Itaipú and Yacyretá were removed, because their variations reflect the impact of electric production or the modification of the contracts in the late 1990s. On the expenditure side, interest payments were also removed because they follow a pattern that is determined by past public debt obligations. Interest payments are sometimes included in the fiscal impulse exercise, if government interest expenditures increase household incomes and purchasing power, but this effect should be limited in Paraguay because only a tenth of interest payments are paid on domestic debt. Thus, the fiscal policy indicator is the primary fiscal balance excluding royalties. The calculations are conducted for the central government and then extended to the consolidated public sector.

Fiscal policy has been mildly countercyclical on average over the 1990–2006 period. The sample period is divided in three subperiods that correspond to different phases of the business cycle (Table 2.5):9

Table 2.5.Fiscal Policy Indicators(In percent of GDP)



1. Primary balance1.6-1.41.6
2. Adjusted primary balance1-0.5-4.6-2.2
3. Neutral primary balance1-2.4-2.7-2.3
4. Fiscal stance (3-2)-1.91.9-0.1
5. Fiscal impulse (∆4)-0.10.6-0.4
6. Output gap (in percent)1.3-0.71.8
7. Real GDP growth (in percent)
Source: IMF staff estimates.

Excluding royalties.

Source: IMF staff estimates.

Excluding royalties.

  • Upswing 1990–95. During this period, the economy grew by 3.7 percent annually. The fiscal stance was contractionary, about 2 percentage points of GDP below the neutral balance. The fiscal impulse was broadly neutral.

  • Downswing 1996–02. The impact of successive banking crises and contagion effects from the crises in Brazil or Argentina led to an average economic growth rate of close to zero. The fiscal impulse was supportive of growth, representing 0.6 percentage points of GDP. The ability to sustain countercyclical policies was hampered by the sharp increase in debt.

  • Upswing 2003–06. The economy recovered and returned to a growth rate close to those of the first subperiod. The fiscal stance was broadly neutral on average while the fiscal impulse was negative, representing about -0.4 percentage points of GDP.

However, efforts to maintain a countercyclical policy have not been maintained, leading to period of procyclical policies. The lack of endurance in maintaining the right fiscal stance has led to periods in which fiscal policy has been procyclical; this has been particularly true in the early 2000s. Although the fiscal impulse was positive on average during the crises of the late 1990s–early 2000s, it was negative in 2000 and 2001, thus reinforcing the business cycle. It is possible that the large fiscal expansion in 1999 required a correction the following years, despite the persistence of the crisis or that the market imposed limits on the level of borrowing that forced a change in the fiscal stance (Figure 2.5). More recently, although the fiscal impulse is negative on average, it has been on an upward trend and procyclical in 2005 and 2006. Overall, fiscal policy has not been consistently procyclical over the period: the correlation between the output gap and the fiscal stance is negative, as expected, but is not significantly different from zero, whereas the one between the output gap and the fiscal impulse is also insignificant but shows signs of procyclical policies (Table 2.6 and Figure 2.6).

Figure 2.5.
Fiscal Balance, Fiscal Impulse and Output Gap

(In percent of GDP)

Source: IMF staff estimates.

Table 2.6.Fiscal Correlations with Output Gap
Central AdministrationNonfinancial Public Sector
CoefficientStd. ErrorCoefficientStd. Error
Fiscal stance-0.200.17-0.120.18
Fiscal impulse0.
Source: IMF staff estimates.
Source: IMF staff estimates.

Figure 2.6.
Correlation Between Output Gap, Fiscal Stance, and Fiscal Impulse

(In percent of GDP)

Source: IMF staff estimates.

The procyclical fiscal policies of 2005–06 are driven by an expansion in public investment. An analysis of the fiscal impulse by economic classification revealed that a significant part of the positive impulse in the mid-2000s was due to higher capital expenditures (Figure 2.7). This is likely to reflect a catching up after a contraction in 2003–04. Although current expenditures also contributed to the fiscal impulse, their contribution is much lower. Extending the analysis to the consolidated nonfinancial public sector, the fiscal impulse over 2005–06 is only 0.2 percentage points of GDP on average (against 0.8 for the central government). This difference can be explained in part by improvements in the financial position of the public enterprises that mitigated the fiscal impulse coming from the central government.

Figure 2.7.
Decomposition of the Fiscal Impulse

(In percent of GDP)

Source: IMF staff estimates.

There is significant room for improving the conduct of fiscal policy over the business cycle. Although fiscal policy has been strengthened significantly since the early 2000s, it remains subject to political pressures and uncertainties related to the approval of budgets that deviate significantly from the executive branch’s budget submission. It must be recognized that if fiscal policy was procyclical in 2005–06, there were fiscal surpluses in both years and it was politically impossible to run a countercyclical policy. In both years the executive branch had to use a “financial plan” to cut expenditures by about 2 percent of GDP with respect to budgetary appropriations. However, this situation highlights the weaknesses of the fiscal institutions in Paraguay (see Chapter 9). The authorities are encouraged to work in two areas to address this problem: (1) strengthen the budgetary design phase to ensure that the budget proposal envisages a countercyclical policy to reduce the magnitude of the business cycle, and (2) strengthen the legal framework to prevent the congress from turning around the fiscal stance. These reforms are difficult and will require time. The authorities are encouraged to develop an information campaign to make the public aware of the situation and gain political support for these reforms.

Monetary Policy Evaluation

The conduct of monetary policy is complicated by the wide range of potentially conflicting objectives pursued by the monetary authority. The central bank law states that the fundamental objective of the central bank is “to preserve and to monitor the stability of money,” a somewhat ambiguous objective because it can refer to either internal or external stability. In addition, the central bank charter states that monetary, credit, and exchange rate policies are to be decided in coordination with other unspecified institutions, although the central bank is responsible for their implementation. Beyond inflation, monetary policy objectives seem to have included at different times real activity, the level and rate of change of the exchange rate, and the level of official international reserves.

This section investigates the determinants and constraints of monetary policy. It analyzes the impact of real activity, inflation, and the external environment on policies. In addition, monetary policy has been constrained by the fragility of the banking system and afflicted by recurrent crises between 1995 and 2003, by the level of dollarization, and by the weak balance sheet of the central bank. To summarize the factors influencing monetary policy, we estimate a Taylor rule reaction function, augmented by external variables, and compare the results for Paraguay with those of other countries in the region.

Monetary Policy Environment

The monetary environment in Paraguay is characterized by an intermediate level of dollarization, high volatility, and a weak banking system. In 2004, dollarization in Paraguay was about one half of deposits and loans. This places Paraguay in an intermediate position between a group of highly dollarized countries in the region (Peru, Bolivia, Uruguay, and Ecuador, with dollarization above 70 percent) and countries with a low level of dollarization (Chile, Colombia, Brazil, and Argentina since the end of the currency board, with dollarization below 20 percent). Dollarization is not the legacy of a period of hyperinflation as in many countries in the region, but rather the impact of the contagion of financial uncertainty from other countries. Moreover, volatility of the economy is among the highest in the region, in part the result of Paraguay’s financial and trade linkages with its two large neighbors that have turbulent economic history, Argentina and Brazil. Weak supervision of the banking system and external shocks have contributed to a fragile financial system. Despite recent improvements, traditional prudential indicators tend to underestimate the vulnerability of the financial system because of deficiencies in supervision.

Models of a monetary policy rule give preeminence to interest rates in the analysis of monetary conditions over monetary aggregates. This may not be relevant to countries where interest rates are not good policy signals, either because of an underdeveloped interbank market or because of limited transmission to other interest rates. To analyze the monetary policy rule in Paraguay, we use the interest rate on central bank bills called letras de regulación monetaria (LRMs) as the policy interest rate. Although the stock of LRMs was relatively marginal in the mid-1990s, the stock of LRMs has grown since 2000 to sterilize large capital inflows. In addition, throughout the sample period, the interest rate on LRMs is closely correlated with other relevant interest rates, such as the deposit rate on local currency and, to a lesser extent, to the lending rate in local currency (Figure 2.8). Furthermore, the analysis of monetary aggregates over the same period is complicated by the significant demonetization following recurrent banking crises, especially in 2002, and the ensuing remonetization.

Figure 2.8.
Importance of the LRM Rates

Interest Rate and Stock of LRM

Source: IMF staff estimates.

Interest rates and international reserves have been used to smooth the path of the exchange rate. Although the volatility of the nominal effective exchange rate (NEER) is the largest in a selection of Latin American countries in Table 2.7, the flexibility of the exchange rate is low as measured by the Calvo-Reinhart (2002) index and similar to that of highly dollarized economy such as Peru or Bolivia. Highly dollarized economies tend to limit nominal exchange rate changes at the cost of large changes of net international reserves (NIR) or interest rate because of “fear of floating.” This can be explained by balance sheet effects and by the high pass-through of depreciation to domestic prices. As in many dollarized economies, the exchange rate pass-through in Paraguay is significant, and the impact of an exchange rate shock is long-lasting (Figure 2.9).10 By contrast, in countries with low dollarization, the interest rate is used to control inflation, while the exchange rate floats more freely and NIR adjusts. Given the inherent high volatility of the exchange rate in Paraguay, efforts to smooth the path of the exchange rate would require large changes of NIR and interest rates, which are indeed the most volatile of the sample above (Table 2.7).

Figure 2.9.
Motivations for “Fear of Floating”

Source: IMF staff estimates.

Table 2.7.Comparison of Dollarized Economies
Level of Dollarization
Deposit dollarization2.011.947.064.185.3
Loan dollarization6.110.351.773.997.7
Volatility of: 1
Interest rate7.62.310.66.82.4
Exchange rate flexibility Calvo-Reinhart index
Sources: Rennhack and Nozaki (2006); and IMF staff estimates.

Standard deviation of annual growth rates normalized by their average, 1994–2006.

Calvo-Reinhart index (1990–2004), variance of nominal exchange rate changes over the variance of NIR changes and short-term interest rate changes. An index closer to zero indicates less flexibility.

Sources: Rennhack and Nozaki (2006); and IMF staff estimates.

Standard deviation of annual growth rates normalized by their average, 1994–2006.

Calvo-Reinhart index (1990–2004), variance of nominal exchange rate changes over the variance of NIR changes and short-term interest rate changes. An index closer to zero indicates less flexibility.

Until the mid 2000s, interest rates seem to have responded more to changes in the exchange rate than to inflation. Interest rates were hiked substantially in 1998–99 and in 2001–03 following the end of the currency board in Argentina. Only in 2005–06 was the gradual rise in interest rates disconnected from exchange rate movements. It has responded to inflationary pressures coming from the need to issue more LRMs to sterilize capital inflows and from the inflationary pressures following the appreciation of the Brazilian real and the subsequent rise of imported prices. Interest rates have been maintained at a moderate level owing to the continued needs to sterilize and to contain inflationary pressures (Figure 2.10).

Figure 2.10.
Do Interest Rates Target the Exchange Rate or Inflation?

Source: IMF staff estimates.

Net international reserves have been used as an alternative instrument to smooth the exchange rate. High international reserves allow the central bank to lower interest rates, while rates are adjusted once reserves are depleted. Particularly telling is the example of 2000, when a US$400 million loan from Taiwan allowed the central bank to drastically reduce the interest rate, the high level of which may have contributed to slow economic activity. One year later, as reserves were gradually exhausted in an attempt to stabilize the exchange rate and returned to the previous level, the central bank raised interest rates again. To a certain extent, the initial decline of the interest rate after 2003 may also be related to the high level of capital inflows feeding into reserves, until the impact of capital inflows added to inflationary pressures (Figure 2.11).

Figure 2.11.
Reserves, Growth and the Real Exchange Rate

Source: IMF staff estimates.

Estimation of a Monetary Policy Rule

A traditional Taylor rule, augmented by additional variables, was estimated to capture the specific objectives and constraints of monetary policy in Paraguay. The specification of the monetary policy rule and the idea to compare high and low dollarized economies borrow from the work of Leiderman, Maino, and Parrado (2006). The traditional Taylor rule has the central bank adjusting the interest rate (it) to the inflation gap (πt) and output gap (OGt) (see Taylor, 1993). Following Leiderman, Maino, and Parrado we also estimate alternative reaction functions, by accounting for the impact of international interest rate conditions with the inclusion of the interest rate on U.S. federal funds (FFt), or for external conditions by adding the change in net international reserves (∆NIRt) and the change of the real effective exchange rate (∆REERt). Finally, to complete the model, the lag interest rate (it-1) is added to accommodate the behavior of smooth and slow adjustment of the interest rate toward its desired level. The final equation is the following:

Because some of the variables considered in the right-hand side are endogenous, the model is estimated using a method that yields consistent estimates in the presence of simultaneous equation problems. For this purpose, the generalized method of moments (GMM) is used. Estimations were carried out using quarterly data for the period 1995Q1 to 2006Q2. In the baseline cases, inflation and changes in the real effective exchange rate (REER) and NIR are measured as year-on-year changes. The first lag of independent variables is used as instruments.

The traditional determinants of the Taylor rule are not significant for Paraguay. Regressions are presented in Table 2.8 for the period mentioned before. The estimation of a reaction function with only inflation and the output gap presents serious serial correlation of the residuals (regression 1); when the lag interest rate is added to correct for this issue, the coefficients on both inflation and output are not significant (regression 2). In the augmented model with external variables, the change of NIR is significant but not the change of REER (regression 3). The results are similar when inflation is replaced by an ad hoc inflation gap, computed as the deviation of the inflation rate from its trend calculated by the Hodrick-Prescott filter (regression 4). If changes in variables are measured on a quarterly basis instead of a yearly basis, only the lag dependent variable remains significant. Finally, if a variable for the change of NEER is added (while the changes in REER are removed to avoid multicolinearity), this last variable is significant while the changes of NIR remain significant (regression 5).

Table 2.8.Estimation of Augmented Taylor Rules for Paraguay
SpecificationTaylor RuleLagged Dependent VariableFull Set of VariablesInflation GapNominal Effective Exchange Rate
Inflation (π)0.56 *1.86-0.16-0.860.090.48-0.14-0.44-0.12-0.52
Output gap (OG)-0.48-0.75-0.23-0.82-0.06-0.22-0.17-0.60-0.02-0.09
REER change (∆REER)0.040.29-0.01-0.11
NEER change (∆NEER)0.12 *1.91
NIR change (∆NIR)-0.06 **-2.04-0.05 *-1.64-0.08 **-2.34
U.S. federal funds (FF)-0.04-
Lagged dependent variable (i-1)0.86 ***14.640.81 ***8.610.84 ***8.550.89 ***8.10
Constant (α)9.64 ***2.863.52 *1.862.671.322.471.324.60 *1.77
Durbin Watson (DW)0.371.661.841.851.96
Source: IMF staff estimates.Notes: One (*), two (**), and three (***) asterisks denote significance at 10, 5, and 1 percent level, respectively.
Source: IMF staff estimates.Notes: One (*), two (**), and three (***) asterisks denote significance at 10, 5, and 1 percent level, respectively.

The monetary rule in Paraguay presents some similarities with that of other dollarized economies. Table 2.9 presents the results of the same monetary rule estimated for two countries with low dollarization, Chile and Colombia, and two with high dollarization, Peru and Bolivia, over the same sample period. All countries present a strong inertia of interest rate. In both Chile and Colombia, the output gap is significant, while it is not in both Peru and Bolivia, as in Paraguay. It is possible that in dollarized economies, the impact of output gap as an indicator of future inflation is counterbalanced by an opposite relation between interest rate and output gap, as confidence shocks simultaneously raise the risk premium and depress output. The change of international reserves is significant in Paraguay and Peru, suggesting, as stated by Leiderman, Maino, and Parrado (2006), that both countries “use their reserves as front line buffers against shocks and adjust their monetary policy to replenish their reserves once they have been used. When the REER is replaced by the NEER for the two dollarized economies, the exchange rate coefficients remain insignificant, unlike in Paraguay.

Table 2.9.Estimation of Augmented Taylor Rules for Selected Latin American Economies
Low DollarizationMedium DollarizationHigh Dollarization
Inflation (π) *** ***
Output gap (OG)0.63 ***3.50.29 ***5.8-0.06-0.2-0.46-1.0-0.01-0.5
REER change (∆REER)0.030.4-0.02-
NIR change (∆NIR)-0.09-1.30-0.01-1.0-0.06 *-2.0-0.10 *-
U.S. Fed Funds (FF)-0.45 *-1.730.030.5-0.04-0.11.02 **
Lagged dependent variable (i-1)0.90 ***10.00.75 ***12.50.81 ***9.00.33 **2.50.92 ***7.1
Constant (α)1.401.00.57 ***3.42.671.2-0.61-
Durbin Watson (DW)2.001.751.842.191.80
Implicit interest elasticity2.000.560.471.150.38
Sample period1994–20061994–20061995–20061996–20061994–2006
Source: IMF staff estimates.Notes: One (*), two (**), and three (***) asterisks denote significance at 10, 5, and 1 percent level, respectively.
Source: IMF staff estimates.Notes: One (*), two (**), and three (***) asterisks denote significance at 10, 5, and 1 percent level, respectively.

Until recently, monetary policy in Paraguay seems to have been geared toward stabilizing the exchange rate. Over the sample period, interest rates have responded more to changes in the exchange rate than to inflation, as evidenced by econometric results. An augmented Taylor rule model only captures the impact of changes of the nominal exchange rate and of the changes in net international reserves. The increase of interest rates to respond to inflationary pressures in 2005–06 is too recent to be captured in regression. Besides, the appreciation of the real exchange rate has made less pressing the temptation to stabilize the exchange rate, but it remains unclear if the central bank would resist the temptation once depreciation pressures emerge.

Although the focus on the exchange rate is understandable given the high pass-through and balance sheet effects, the “fear of floating” tends to be self-perpetuating. The central bank policy to limit exchange rate movements may encourage dollarization of liabilities. The high pass-through of exchange rates to inflation is another reason the central bank has little tolerance for large exchange rate changes. However, it is also regime dependent and tends to decline as central banks let the exchange rate float more freely. Leiderman, Maino, and Parrado (2006) present some evidence of a decline of the pass-through in Peru, despite the high level of dollarization, as the central bank moves toward a full-fledged inflation targeting framework with the focus on inflation rather than on the exchange rate. In the medium run, Paraguay could thus gain by adopting a monetary policy more focused on inflation than on the exchange rate.

The authorities should continue addressing their “fear of floating” and embracing a more flexible exchange rate regime. The past tendency of the monetary authority to control the exchange rate may be understandable by the high pass-through and the high dollarization, but the authorities should continue in their efforts to break a self-perpetuating regime. A solid monetary policy and a strengthening of prudential regulation on the banking system are the best way for the central bank to enhance its credibility and eventually lead to a lower dollarization. In the meantime, the authorities should continue working toward the adoption of an inflation targeting framework once credibility is established and dollarization reduced.11

Concluding Remarks

This chapter has used standard macroeconomic tools to analyze recent macroeconomic policies in Paraguay. The construction of potential GDP and output gap, by using either a production function, statistical filters, or Okun’s law, facilitates the assessment of the cyclical position of the economy. All indicators suggest that by the mid-2000s, GDP was above its historical potential, although this may reflect an increase of productivity due to the impact of structural reforms. The output gap in turn can be used to assess the fiscal stance and measure possible demand-side inflationary pressures.

Although fiscal policy has been strengthened to regain debt sustainability, the fiscal stance is only mildly countercyclical and cannot be sustained, leading at times to a procyclical fiscal stimulus. The analysis of the fiscal position with respect to the economic cycle shows that fiscal policy has been at best mildly contracyclical on average, although not consistently so every year. In particular, the fiscal impulse was positive in 2005 and 2006, despite the high position in the economic cycle. However, it is recognized that restrictions were imposed on the fiscal authority by an overly expansive budget approved by congress.

The analysis of monetary policy shows that it has been guided less by the evolution of inflation and output than by the exchange rate and the external position. This seems to be explained by the high dollarization and the “fear of floating.” Recently, however, the central bank, aided by favorable exchange rate conditions, seems to have taken a more reactive position toward inflation.

Looking ahead, macroeconomic policies in Paraguay should aim at avoiding or reducing any procyclical elements and should be geared toward reducing the inflation level and its volatility rather than smoothing exchange rate movements. Specifically, this would require the following:

  • Identify business cycles. Develop tools to assess the cyclical position of the economy, and discern any possible shift of potential output related to economic reform.

  • Strengthen the fiscal framework. Avoid procyclical fiscal policy that increases the volatility of economic activity and reduces social welfare.

  • Focus on inflation control. Gear monetary policy more toward inflation than the exchange rate, as a policy dominated by “fear of floating” tends to be self-perpetuating and to build up vulnerabilities.

II Eliminating Turbulence and Deepening Financial Reform

3 Recurrent Financial Crises: Causes, Costs, and Consequences

Montfort Mlachila1

Paraguay had a series of recurrent financial crises in the eight years from 1995 to 2003. During that period, more than half of the banks and two-thirds of nonbank financial institutions were closed or liquidated. In contrast to most financial crises, the crises in Paraguay were not mainly caused by severe macroeconomic imbalances—although economic growth was anemic—but rather by inherent weaknesses of the financial system in the first wave (1995–98) and by contagion from Argentina in the second wave (2002–03).

The repeated crises seriously disrupted the payment system and sharply curtailed private credit, undoubtedly contributing to the decline in real GDP growth. Furthermore, the direct fiscal and quasi-fiscal costs of the crises to the government and central bank were quite high at more than 16 percent of GDP, cumulatively. Not surprisingly, in the aftermath of the crises, dollarization increased, disintermediation rose, confidence in the financial system faltered, capital flows became more volatile, and the sovereign’s creditworthiness diminished. As a direct consequence of the crises, financial fragility in the economy increased, creating an environment where economic policymaking, including the control of inflation, has become more challenging.

Since the last financial crisis in 2003, the economy has rebounded with growth, reaching almost twice its long-term average, and poverty has been reduced by nearly a third. This performance was anchored by broad-based economic reforms launched by the new government elected in 2003. The reforms focused on reestablishing fiscal and monetary discipline, leading to a significant reduction in the public debt level, the containment of inflation, the strengthening of the guaraní, and a record level of international reserves. The financial system has strengthened significantly over the past few years. The level of nonperforming loans has been reduced dramatically, profitability has increased, and capital adequacy ratios are above the regulatory minimum. Even the National Development Bank (Banco Nacional de Fomento, BNF), the weakest bank following the last crisis, has regained solvency. Nonetheless, large swathes of the financial system are inefficient, characterized by very high liquidity and intermediation spreads and relatively limited lending to the private sector. For instance, at end-2006, less than half of banks’ domestic assets were claims on the private sector. Going forward, there is need to significantly enhance the still weak prudential regulations and supervision of the financial sector.

The main objective of this chapter is to review the fundamental causes, estimate the direct and indirect costs, and analyze the consequences of the crises. After establishing the general causes of crises in the literature, the chapter describes how the crises unfolded, starting with the historical context. The chapter then endeavors to estimate the costs of the crises and its consequences. The next sections review the optimality of the authorities’ response, draw some policy lessons, and provide some concluding remarks.

Causes of Financial Crises—An Overview of the Literature

Financial crises can arise from multiple sources that can interact and reinforce each other to aggravate and accelerate the crisis. For this reason, a strict typology of crises is artificial and of limited analytical use (Hoelscher and Quintyn, 2003). Nonetheless, some simplification is necessary for exposition. Broadly speaking, there are two types of crises: those that are predominantly microeconomic in origin, and those that are essentially macroeconomic. The first category covers those crises that emanate from poor lending practices that can entail price bubbles and excessive credit concentration, leading to serious balance sheet weaknesses, such as high levels of nonperforming loans, large and undetected currency and maturity mismatches, and undercapitalization. Financial crises that are predominantly macroeconomic in nature arise from a deterioration in the macroeconomic environment, for example, in monetary, exchange rate, and fiscal policies or in exogenous shocks (including through contagion).

A number of factors determine if a crisis becomes systemic.2 These are (1) weaknesses of financial institutions, (2) strength of the economy, and (3) the policy response. The latter can be conditioned by the political circumstances of the country, including how much confidence the public has in policymakers. The worst financial crises, whatever the initial trigger, are those in which macroeconomic shocks affect a weak financial system, and the authorities are unwilling or unable to decisively address the problems. This often leads to “twin crises,” that is, currency and financial crises (Kaminsky and Reinhart, 1999).

Financial crises that are fundamentally microeconomic in nature are usually caused by poor prudential regulation and enforcement. According to Kane (1999), there are six stages in regulation-induced crises:

  • The first stage involves the rapid creation of what he calls “zombie” banks through lax entry requirements and weak prudential regulation and supervision.

  • In the second stage, as the phenomenon increases, well-connected depositors begin moving their deposits to stronger financial institutions (flight to quality) in an escalating “silent run.”

  • The third stage occurs when there is a general loss of confidence by deposit holders in the ability of the government to guarantee their deposits, and they start to withdraw massively from weak financial institutions.

  • The fourth stage is usually characterized by interventions by the authorities typically accompanied by the injection of public funds.

  • The fifth stage occurs when efforts to recapitalize are less than successful, thus requiring a cleanup of zombie institutions through closure, liquidation, and mergers.

  • The final stage involves the “blame game,” and changes in financial policies.

Poor macroeconomic policies can seriously affect otherwise sound financial institutions. Weak economic growth reduces incomes and, therefore, reduces deposit growth and the ability of borrowers to adequately service their loans on a timely basis. A deterioration in the fiscal situation can lead to a rapid accumulation of public debt to which financial institutions become exposed. If the situation becomes untenable, inflation can increase rapidly, leading to a currency crisis. This in turn can promote dollarization, which inherently increases vulnerability to unsound exchange rate policies—for example, when borrowing is done in foreign currency, but incomes are in local currency.

There is a vast literature on the leading causes of financial crises. It is useful to highlight three of the main approaches used: the “signals approach,” a limited dependent variable regression approach, and the binary classification tree (BCT) approach.3 In the “signals approach,” as in the Kaminsky and Reinhart (1999) twin crises paper, there is an analysis of key economic variables before and after a crisis in order to identify the threshold at which individual variables can signal an impending crisis. This approach finds that banking crises are often associated with large exchange rate movements, that is, a currency crisis. Banking crises are frequently preceded by rapid financial liberalization (and high growth in credit)—a phenomenon experienced in Paraguay (see below)—a decline in output, a rise in lending rates, a decline in export growth rates, and an appreciating real effective exchange rate (REER).

In an application of the signals approach on Paraguay, Fuertes and Espinola (2006) investigate the main determinants of bank weaknesses. They use the level of bank nonperforming loans as the main indicator (signal) of bank weakness (“inefficiency” in their terminology). Using a panel regression model for the period between 1995 and 2003, they find that the main causes of bank fragility are slow economic growth and the deterioration of the external current account. They use the current account as a proxy for external influences on bank weakness as banks lend heavily to the import and export sectors. On the other hand, they find that micro-prudential indicators, such as liquidity, capital adequacy, and the rate of return, have a limited, and only a short-term, impact on nonperforming loans (NPLs).

In the limited dependent variable regression approach, as in Demirgüç-Kunt and Detragiache (1998) and Demirgüç-Kunt, Detragiache, and Tressel (2005), the key idea is to compute the probability of a banking crisis. These authors find that the probability of a crisis increases with low GDP growth, high inflation, low reserve cover of broad money, high real interest rates, and positive credit growth.

In an innovation in the banking crisis literature, Duttagupta and Cashin (2008) use the binary classification tree approach. The BCT approach aims at identifying the thresholds at which specific variables are able to split a database of indicators into nodes at which the probability of a crisis increases and those at which it declines. The main advantage of the method is that it recognizes that a combination of many factors could be more instrumental in causing crises rather than the deterioration of a unique set of factors. Moreover, the approach takes into consideration the fact that there may be nonlinear interactions among variables that cause a crisis. In their study, Duttagupta and Cashin analyze 50 emerging markets and developing countries over the period from 1990 to 2003. They find that foreign exchange risk, poor financial soundness indicators, and general macroeconomic instability are also key sources of vulnerability (Figure 3.1). In particular, there are three conditions that make a country crisis-prone: (1) very high inflation (above 19 percent), (2) highly dollarized bank deposits combined with nominal depreciation or low liquidity, and (3) low bank profitability. Interestingly, according to their model, Paraguay is not found to be crisis-prone because, although it had high inflation at the start of the crisis in 1995, it also had significant terms of trade improvements, both relative to the threshold. In an extension of their approach, Duttagupta and Cashin also estimate the factors underlying a banking crisis using a logit model, which supports the main findings of the BCT model. The estimated probability of crisis for Paraguay using the logit model increases continuously to reach a peak in 1993 (3.3 percent), declines temporarily in 1994 (1 percent), and increases again in 1995 (2.5 percent), after which it declines gradually for the rest of the sample period.4

Figure 3.1.
Binary Classification Tree, Baseline Model, 1990–2005

Source: Duttagupta and Cashin (2007).

Note: TOT= Terms of trade.

FX= Foreign exchange.

A major critique of most of the banking crisis literature is that it does not typically take into account bank-level issues related to compliance with internationally accepted prudential requirements. This is an important consideration in the case of Paraguay, and probably also explains why Paraguay is not deemed crisis-prone according to Duttagupta and Cashin (2008). The main reason most studies—especially those involving the use of panel data—do not take into account prudential requirements as a variable is that typically there are no time series observations for it. A recent paper by Demirgüç-Kunt, Detragiache, and Tressel (2006) goes some way in establishing the linkages between compliance with Basel Core Principles and bank soundness. In a cross-section study of 39 countries, they find that countries that require banks to regularly and accurately report their financial data to regulators and market participants have sounder banks (as measured by Moody’s financial strength ratings), after controlling for macroeconomic variables, sovereign ratings, and reverse causality.

How the Crises Unfolded5

Historical Background

Following the introduction of democracy in Paraguay in 1989, the country underwent a significant number of market-based structural economic reforms. The exchange rate was unified and the guaraní was floated in 1989. This was followed by the freeing of interest rates, the elimination of selective credit controls, and the authorization of foreign currency loans by banks to exporters. The Central Bank of Paraguay (Banco Central de Paraguay, BCP) also introduced open market operations through the use of monetary control instruments (létras de regulación monetaria, LRMs). At the same time, the BCP significantly reduced access to its rediscount window, which had been a major source of financing for banks.6 In 1992, foreign currency loans for import substitution activities were authorized, and legal reserve requirements for domestic deposits were reduced (from 42 to 30 percent) and unified with those on foreign currency.

During the 1989–94 period, despite relatively high inflation, the economy was stable, at least compared to other Latin American countries when they faced similar crises. Real GDP growth averaged more than 3½ percent, and fiscal surpluses were recorded during most of the period (Table 3.1). The external sector also remained fairly robust, in part spurred by a sharp real depreciation, and current account surpluses were observed during most of the period.7 Significant financial deepening also occurred, as the M2-GDP ratio increased from 22 to 37 percent during the period (Figure 3.2). Private sector credit also grew very rapidly. In part as a result of the sharp depreciation of the guaraní, inflation increased sharply during the period, averaging about 24 percent (Figure 3.3).

Figure 3.2.
Paraguay: Financial Deepening and Intermediation

(In percent of GDP)

Source: IMF staff estimates.

Figure 3.3
Number of Financial Institutions

Source: IMF staff estimates.

Table 3.1.Paraguay: Selected Macroeconomic Indicators
Real sector (in percent)
Real GDP growth5.
Inflation (period average)26.438.224.315.917.520.613.
Real effective exchange rate (average depreciation)
External sector (in percent of GDP)
Current account balance6.
Official reserves12.312.917.210.110.815.013.712.310.211.414.310.912.615.416.617.617.217.0
Official reserves (in millions of US$)4336619625626311,0311,0931,0498368659787637146299691,1681,2971,702
Official reserves (in months of imports)
Terms of trade changes8.235.4-10.12.4-4.29.8-2.33.2-2.6-1.85.6-
Central government (in percent of GDP)
Overall Balance2.03.0-0.2-
Money and credit
Broad money growth74.739.441.139.828.828.6126.
Private sector credit15.615.820.323.726.630.526.928.836.828.730.329.731.929.517.617.017.617.0
Sources: Paraguayan authorities, and IMF staff estimates.
Sources: Paraguayan authorities, and IMF staff estimates.

As a result of the rapid pace of financial liberalization, a large number of banks and finance companies (financieras) started operating during the 1990–94 period (Table 3.2). In the words of Insfrán Pelozo (2000), “practically each large company had its own bank and each bank its own financiera.” This was facilitated by loose regulations on minimum capital and other entry requirements. Although this contributed to the financial deepening to some extent, it led to a wide dispersion in the size of financial institutions, thereby limiting the scope of economies of scale. As a result, in order to remain competitive, most financieras offered high deposit rates and charged even higher lending rates, thus contributing to the maintenance of high intermediation spreads.

Table 3.2.Number of Entities in the Financial System
Sources: Insfran Pelozo (2000), and author’s estimates.
Sources: Insfran Pelozo (2000), and author’s estimates.

The situation was exacerbated by very weak prudential regulations and enforcement by the Superintendency of Banks (SIB). The weakness stemmed from a lack of qualified and experienced personnel and lack of political backing for strong enforcement. As early as 1990, it was well known that as many as 40 percent of the existing commercial banks had serious capital shortfalls or very weak profitability. Although the SIB developed a new regulatory framework to toughen entry requirements and impose stricter capital requirements in 1990, heavy lobbying by bank owners led to a five-year grace period for the entry into effect of most of the binding measures.

In this climate, poor banking practices, particularly (but not exclusively) among locally owned banks, were allowed to flourish. These included (1) poor risk evaluation, (2) connected lending, and (3) rapid growth of off-balance-sheet transactions. The latter led to the creation of a parallel financial system as financial institutions attempted to circumvent both prudential and macroeconomic regulations. A common practice was to book only part of the deposits in official accounts. The rest of the deposits with limited documentation were known as “gray” deposits, while those with only “IOUs” were known as “black” deposits. Furthermore, existing legislation did not require registered (as opposed to bearer) shares in bank ownership, effectively precluding the identification of related parties and making it difficult to impose effective sanctions. Consequently, losses were not readily acknowledged and were often deferred or deliberately hidden from supervisors.

Waves of Bank Interventions and Closures

First Blood (1995)

Difficulties in the financial sector started to emerge in late 1994. Citing liquidity needs, several local banks sought support from the BCP. However, the problems turned out to be far more severe than initially thought. When the second and third largest (locally owned) private banks—Bancopar and Banco General—failed to meet their clearing obligations in May 1995, the authorities refused to provide further financial assistance because their owners repeatedly failed to live up to their recapitalization commitments, and these banks were intervened. In the course of the next few weeks, two other banks—Bancosur and Banco Mercantil—and five financieras also were intervened. The four failed banks held about 15 percent of the system’s total assets.

In order to preempt a systemic bank run and prevent the collapse of the payments system, the authorities decided to honor deposits in the intervened banks. As there was no deposit guarantee scheme in place, the BCP extended credit to the intervened institutions. During 1995 alone, the BCP spent about G 700 billion (4 percent of GDP) in its efforts to avoid the propagation of the crisis, an amount about equal to currency in circulation at the outset of the first wave. Furthermore, the BCP created special credit facilities (Red de Seguridad and Préstamos de Rehabilitación) to provide longer-term resources to banks in what were called “rehabilitation programs,” with a view to providing time to ailing institutions to restructure and recapitalize. In fact, none of the banks under rehabilitation were successful in finding financial health. The authorities’ decision to guarantee all deposits in full encouraged the largest depositors to take their money and put it in safer banks, maybe because of the lack of credibility.8 Moreover, the existing owners of banks had no incentives to improve their performance given the availability of easy money from public sources.

Despite the high costs incurred during the first wave of bank closures, and notwithstanding improvements in supervision, the financial system remained weak, while extremely fragile institutions were permitted to continue operating. Throughout 1995 and 1996, the system’s capital base deteriorated further, the proportion of impaired loans increased sharply to over 10 percent, and although provisions grew at a stepped-up pace, their coverage of doubtful loans did not keep up, particularly during 1996. To some extent this reflected more transparent accounting, including the normalization of off-the-books accounts, but, as events would later prove, many problems remained unresolved. During 1996, several small finance houses were either intervened or voluntarily liquidated, but no major institution would be closed again until 1997.

Rearranging the Deck Chairs while the Ship Is Slowly Sinking (1997)

The lack of decisive action following the first crisis sowed the seeds for the next one. Although the congress did take some legislative action in May 1996 by approving a new banking law, this was “too little too late.” The law granted increased powers to the SIB to intervene and close financial institutions, to require annual external audits, and to restrict operations of institutions in noncompliance with limits on lending to related parties or with minimum capital requirements. It also fixed limits on lending to any single borrower and required disclosure of share ownership so that bank owners could be fully identified, and it provided for the creation of a centralized credit bureau. Finally, the law limited deposit insurance to the equivalent of 10 minimum wages (about US$2,200 per account). Although the new legislation enhanced the instruments at its disposal, the SIB’s capacity to carry out its duties remained impaired by its lack of adequate human resources. As a result, another crisis became inevitable.9

In 1996 and the first half of 1997, as a result of the government’s reluctance to intervene in any more banks, in the misplaced hope that the restructurings would work, there were no major bank closings. Nonetheless, the crisis lingered on and the BCP continued to provide ample financial assistance to troubled institutions. At the same time, the authorities encouraged the Social Security Institute (IPS) to provide indirect financial support by increasing its deposit holdings in some of the troubled banks, de facto becoming by far the largest depositor (especially in Banco de Desarrollo and BIPSA). In January 1997, IPS was persuaded to capitalize Banco de Desarrollo by transforming G 26 billion of its deposits into equity, supposedly to avoid the bank’s failure.

In 1997, bank closures were reignited with the intervention of Banco Union, the country’s largest private local bank. The bank had received loans from the central bank since 1995 to cover deposit withdrawals associated with the contagion effect of the closures of other institutions. When the bank’s savings and loan affiliate was intervened by the government, Banco Union had to enter into a “rehabilitation program” with the central bank, and received G 85 billion in fresh resources. Even with this assistance, the bank failed to meet its obligations or find a buyer and was intervened in June. Attempts by the authorities to induce recapitalization by existing or new shareholders failed during the second half of the year, and in early 1998 it was finally decided to liquidate the bank. Another bank, BIPSA, which had also been in search of a buyer, failed to obtain fresh capital, and depositors withdrew their deposits. It was intervened by the SIB soon after Banco Union, and was subsequently closed. Another bank, CORFAN, ceased as a separate entity when it was absorbed by Banco de los Trabajadores (BNT).

To its credit, during the second wave of bank closures the BCP became increasingly less eager to provide unlimited financial assistance to intervened banks than it had been in 1995. Unfortunately, the actions of congress exacerbated the already precarious situation and promoted moral hazard on the part of both depositors and banks. The 1996 banking law had limited the guarantee on financial sector deposits to US$2,400, but pressure soon mounted to increase the coverage of deposit insurance. The new wave of bank closures, which had not been met with full guarantee of deposits, drew enormous protests and led congress to pass a new law (Ley 1186/1997) increasing the limit to 100 monthly minimum wages (approximately US$24,000).

The new wave of bank closings triggered a systemic run on deposits. In contrast to what was observed during the first wave, on this occasion depositors’ behavior was governed by “flight to quality” considerations. The limit imposed on implicit deposit insurance, as well as the extended debate over its level, contributed to this outcome. During this process, foreign-owned banks, which were perceived as less risky than locally owned banks, increased their share of deposits by almost 12 percentage points. In contrast, those local banks that were eventually closed suffered the brunt of the run on deposits, with their share declining by more than 12 percentage points. Increased transparency of banking statistics, as evidenced, for example, by the publication of CAMEL10 rating exercises—which had been introduced in the 1996 banking law—most likely contributed to depositors’ more discriminating behavior.

Shaken and Stirred (1998)11

Despite the effects of the financial crises, the power of vested interests prevailed. In part because the parties directly involved in the crisis (i.e., depositors and bank owners) did not suffer much from the crisis as public funds assisted banks, political resistance to deal forcefully with the still insolvent institutions remained strong. Rather than decisively taking action to force the restructuring of viable institutions, or to close insolvent ones, the authorities chose further regulatory forbearance and accounting flexibility, coupled with central bank support, rehabilitation programs, and the transfer of public sector deposits to weak banks. Under these conditions, the fragility of several banks—some with negative net worth—lingered on. As a result, the delay in taking action increased the total cost of the financial sector cleanup and burdened the public sector with a large stock of nonperforming assets. The entire financial system came close to a total meltdown with the most difficult case so far in the saga, the BNT.

In June 1998, the SIB intervened in BNT. The bank had entered into a rehabilitation program with the BCP in August 1997. By May 1998, total financial assistance provided by the BCP to BNT reached G 92 billion (½ percent of GDP), while IPS deposits in the bank surpassed G 230 billion (more than 1 percent of GDP). This was the country’s fourth largest bank at the time, with 6½ percent of the system’s assets. Although more than 90 percent of the bank’s loan portfolio was overdue, BNT claimed cumulative losses of only G 16 billion and a capital base of G 91 billion. However, examination of the bank by SIB auditors revealed an alarming lack of liquidity, an almost complete dependency on public sector deposits, and actual losses almost 15 times higher than reported on, some G 220 billion. Under the circumstances, the SIB decided it had no option but to close the bank, and criminal charges were brought against the bank’s administrators. In the end, 13 banks and 35 financial companies were closed or liquidated between 1995 and 1998.

Catching a Head Cold from the Neighbors (2002)

Although the banking system progressively recovered, mainly by becoming predominantly foreign-owned (80 percent), the underlying financial strength was precarious. The SIB had become progressively more assertive and forced most of the fragile institutions to be merged or recapitalized. By end-2000, the SIB indeed deemed that all private banks were broadly sound.12 Only the BNF, the only remaining public bank, had serious weaknesses, mainly a large portfolio of NPLs. The BNF was only able to survive through very large liquidity injections from the government, public enterprises, and the IPS. By the end of-2000, more than 50 percent of its deposits were from the public sector (of which 60 percent were from the IPS).

The recovery of the financial system was all the more fragile because the economy had become very weak with a serious recession setting in from 1999. The fiscal situation deteriorated rapidly and a full-blown currency crisis occurred in 2001, characterized by a massive loss of official reserves and a precipitous fall in the guaraní. The inherent weaknesses in the economy were exacerbated by the sharp deterioration in the Argentine and Brazilian economies, Paraguay’s main economic partners.

It was contagion effects from the Argentine neighbor that brought about the next financial crisis to Paraguay. In 2002, it became common knowledge that the Argentine-Uruguayan conglomerate, Grupo Velox, which owned Banco Alemán, the third largest bank in Paraguay with about 11 percent of banking system assets, was facing serious financial difficulties. Grupo Velox owned a large number of financial institutions in Argentina, Paraguay, and Uruguay. A significant proportion of the deposits collected by these financial institutions were channeled to an offshore bank, Trade and Commercial Bank (TCB), which in turn lent the money to the group’s nonfinancial enterprises. As a result of the deposit freeze in Argentina (corralito) and subsequent bank runs in Uruguay, TCB faced serious liquidity problems. This prompted a deposit run on Banco Alemán. The authorities acted decisively and closed the bank. Four financieras were also closed in 2002.

The Last Straw (2003)

In May 2003, the authorities were forced to intervene in a medium-sized locally owned commercial bank, Multibanco, after uncovering fraud in the bank. Given the seriousness of the fraud, including possible kickbacks to lure public deposits, the authorities acted swiftly and closed the bank. Multibanco controlled about 5 percent of total banking system assets. During 2003, three banks and four financieras voluntarily closed owing to low profitability. Since then there has not been a financial crisis in Paraguay.

In the end, from a total of about 34 banks in 1995, only 16 remained at the end of 2003, of which 13 were either foreign-owned or majority foreign-owned. The number of financieras declined even more rapidly, by over two-thirds, from about 65 in 1995 to only 18 in 2003.

Costs of the Crises

Estimating the costs of a financial crisis is rather difficult. Direct fiscal costs are relatively easy to estimate, but indirect ones—in terms of overall cost to the economy—are virtually impossible to assess. According to Hoelscher and Quintyn (2003), the main types of costs are:

  • Gross costs to the public sector: outlays by the government and the central bank in terms of liquidity support, deposit payments, recapitalization, and purchase of impaired assets.

  • Net costs to the public sector: gross costs net of any recoveries from the sale of assets, and repayments of loans by recapitalized entities.

  • Economic costs: forgone economic growth owing to the disruption of the payments system and intermediation.

Ideally, the costs should be computed in net present value terms. This is because both support to institutions and recoveries can take place over a prolonged period. In practice this is rather difficult to do because the event horizon is difficult to estimate ex ante. In the case of Paraguay, estimates of costs are made broadly following the above methodology, with some case-specific considerations.

Direct Costs

In this chapter the direct costs of the crisis are estimated in two steps (Table 3.3). The first step draws on Jaramillo (2000) who estimated the costs for the three crises between 1995 and 1999. The total cost was estimated at between G 1,700 billion (9 percent of GDP) and G 2,600 billion (13 percent of GDP), depending on the assumption of the proportion of the value of assets recovered.13 Based on ex post information on actual NPL recoveries, the upper bound of Jaramillo’s estimate (more than 13 percent of GDP) is likely to be closer to the truth.

Table 3.3.Estimates of Direct Costs of Financial Crises, 1995–2003(In percent of GDP)
Annual CostCumulative
Source: For 1995–1998, includes upper bound calculation of Jaramillo(2000), and for 1999–2003, author’s own calculations.

Including Instituto de Previsión Social (IPS) losses.

Source: For 1995–1998, includes upper bound calculation of Jaramillo(2000), and for 1999–2003, author’s own calculations.

Including Instituto de Previsión Social (IPS) losses.

For the 1999–2003 period, the estimated costs of the crises are G 377 billion (1.4 percent of GDP). This is a rough estimate of the cost based on the gross lending to troubled institutions by the BCP, as additional detailed information—such as recapitalization bonds by the government and direct payout to depositors—is lacking. This estimate is likely to be the lower bound.

Furthermore, the direct cost to the IPS needs to be incorporated in the estimates. In order to beef up weak banks, the IPS was ordered to transfer some of its deposits to some of them, such as Banco de Desarrollo and BNT. In the end, all the intervened banks ended up being closed, and IPS lost in excess of G 620 billion (3 percent of GDP) to banks that were liquidated between 1997 and 1998. The IPS’s financial health was only saved (somewhat) when the government agreed to absorb G 525 billion of these losses through a long-term bond yielding a 1 percent annual real interest rate.14

The total cost of all the financial crises in Paraguay is of the order of 16 percent of GDP.15 Compared with the experiences of other developing countries, especially those in Latin America, the cost of Paraguay’s financial crises is relatively moderate (Table 3.4). This is in part because the relative shallowness of the financial system and relative strength of the economy at the beginning of the crises somewhat mitigated the associated costs. In the contagion-induced crises of the 2000s the direct costs were somewhat mitigated by decisive action by the authorities. Unlike during the 1990s, the authorities did not attempt to restructure clearly insolvent entities, but proceeded to promptly close them.

Table 3.4.International Comparisons of Fiscal Costs of Banking Crises(In percent of GDP)
Latin America

Indirect Costs

As indicated above, indirect losses due to financial crises are very difficult to establish. Loss of output can have multiple sources, including the external environment. In the case of Paraguay, during the 1990s the economy was already growing relatively weakly, as it had indeed done during most of the 1980s, so it is difficult to ascribe the output loss directly to the crises. Nonetheless, the average real GDP growth rate of the economy did decline from 3.3 percent during 1990–94 to about 1.6 percent during 1995–99. At the same time, the crises contributed to increasing macroeconomic instability and vulnerability as a result of the disruption in the payment and intermediation system. By the time the crises of the 2000s hit, the economy was already in a full-fledged recession and took nearly four years to recover. Furthermore, depositors and borrowers lost considerable confidence in the financial system, especially in guaraní-denominated assets. The switch to foreign exchange–denominated assets reduced seigniorage revenues for the government and increased vulnerabilities for the economy.

Consequences of the Crises

The fallout from the financial crises was considerable and long-lasting. The most enduring legacy of the crises has been the creation of a inefficient banking system characterized by continuing financial fragility, reduced levels of financial intermediation, increased dollarization, capital flight, and a weak balance sheet of the central bank. The main positive outcome of the crises is that they forced the formalization of the financial system—notably by eliminating parallel accounting schemes—and forced the authorities to embark on serious reforms of the regulatory framework, although there is still a long way to go.16 The key reforms initiated included the following:

  • The adoption of the Bank Resolution Law in November 2003. The key reforms under the law included (1) creation of a deposit insurance fund with a defined limit per individual depositor, (2) development of legal tools to allow for the quick transfer of deposits to other financial institutions during bank resolutions, and (3) delegation of authority to the BCP to issue necessary regulations while giving adequate legal protection to public officials during the resolution process.

  • The adoption of the Public Banking Law in July 2005. This permitted the creation of a second-tier public bank. At the same time, the BNF (a first-tier bank) was recapitalized and modernized with the aid of new management.17 A new second-tier bank, Agencia Financiera de Desarrollo (AFD), was formed in 2006 with the aim of providing medium- and long-term financing to small and medium-sized enterprises, mainly by using on-lent resources from multilateral financing institutions.

  • The adoption of regulations by the BCP Board of Directors on asset classification, provisioning requirements, and imputation of accrued interest in November 2003 (Resolución 8/03). Originally planned to be phased in progressively with full implementation in January 2007, the effective date was postponed to October 2008, following enhancement of the resolution during 2007.

Remaining Weaknesses

The financial system in Paraguay has improved considerably since the last crisis (Table 3.5), but a number of weaknesses remain. The level of capital adequacy ratios (CARs) has risen since the crisis, and efforts have been made to bring it in line with international standards, especially since the adoption of Resolución 1/08 (which replaced Resolución 8/03). Nonetheless, although profitability has increased in the past few years, this has been done mainly through increased exposure to the public sector, notably to LRMs—whose stocks have dramatically increased over the past few years. If banks were to revert to more normal activities or if interest rates on LRMs were to decline significantly (as happened during 2007), this would reduce their profitability significantly.

Table 3.5.Paraguay: Banking System Indicators
I. Total banking system (II+III+IV+V)
Share in assets100.0100.0100.0100.0100.0100.0100.0100.0100.0
Capital adequacy ratio (percent) 120.717.417.616.917.920.920.520.420.1
NPLs/total loans11.814.816.616.519.720.610.86.63.3
Rate of return on assets (ROA)
Rate of return on equity (ROE)
Liquid assets/total assets 225.325.121.723.025.132.630.826.623.3
Foreign exchange deposits/total deposits57.359.759.765.368.661.755.052.749.1
II. Total foreign-owned banks
Share in assets46.648.347.045.148.447.435.831.329.1
Capital adequacy ratio (percent)
NPLs/total loans5.29.314.115.320.120.811.06.43.6
Rate of return on assets (ROA)
Rate of return on equity (ROE)60.333.520.230.415.
Liquid assets/total assets228.724.621.622.227.129.825.429.024.5
Foreign exchange deposits/total deposits63.964.663.267.871.165.665.265.161.2
III. Total majority-owned foreign banks
Share in assets32.229.934.938.333.
Capital adequacy ratio (percent)121.017.717.716.819.921.017.717.817.4
NPLs/total loans5.09.810.610.610.412.
Rate of return on assets (ROA)
Rate of return on equity (ROE)36.812.48.618.313.415.525.835.345.8
Liquid assets/total assets224.828.
Foreign exchange deposits/total deposits62.764.964.369.370.762.353.851.748.8
IV. Total domestic-owned private banks
Share in assets8.
Capital adequacy ratio (percent)118.116.615.214.813.614.113.313.415.6
NPLs/total loans5.
Rate of return on assets (ROA)
Rate of return on equity (ROE)
Liquid assets/total assets220.718.717.320.118.338.838.134.034.6
Foreign exchange deposits/total deposits54.656.449.461.862.660.757.654.751.5
V. National Development Bank (BNF)
Share in assets13.012.711.
Capital adequacy ratio (percent)130.018.421.222.918.830.025.026.532.2
NPLs/total loans44.549.144.646.556.256.248.940.319.4
Rate of return on assets (ROA)-6.90.2-0.50.3-4.7-
Rate of return on equity (ROE)-30.41.4-4.22.0-27.3-
Liquid assets/total assets216.124.416.720.417.330.752.031.233.8
Foreign exchange deposits/total deposits13.421.619.327.042.532.723.620.613.1
Source: Superintendency of Banks.

Definition of capital adecuacy ratio does not fully comply with international standards.

Liquid assets are calculated as the sum of cash, reserves, accounts in banks and lending in interbank market.

Note: NPL= nonperforming loan.
Source: Superintendency of Banks.

Definition of capital adecuacy ratio does not fully comply with international standards.

Liquid assets are calculated as the sum of cash, reserves, accounts in banks and lending in interbank market.

Note: NPL= nonperforming loan.

Financial Disintermediation

Virtually all indicators point to the fact that financial disintermediation occurred in the aftermath of the financial crises. First, the financial deepening ratio (M2/GDP) declined considerably after the first crisis, from more than 35 to less than 30 percent in one year, and has steadily declined over time, to less than 25 percent at the end of 2006. Second, a similar pattern is observed in credit to the private sector. However, for this variable, unlike for the first one, there was a sharp contraction in private sector credit as a percentage of GDP from 2003 onward, although there has been some recovery in 2006–07. From this period onward, banks engineered a major portfolio shift away from lending to the private sector in favor of deposits at BCP and investing in LRMs (Tables 3.6 and 3.7).

Table 3.6.Summary Balance Sheet of Commercial Banks(In billions of guaranís)
Claims on public sector69101196324460367302528653569449653
Central government4798187283450353292519643554427624
Public entities2217377942261217
Central bank bills (LRMs)17223027020058381632986021,1712,0142,644
Deposits in central bank1,0321,1721,1871,4181,6311,7342,1002,2473,0833,5063,2833,218
Claims on financial institutions553557465784933029463070
Deposit-taking institutions16923201738292629453070
Non-deposit taking institutions3926332640466330100
Claims on private sector3,7134,5125,0714,9655,5195,7976,6066,5924,9525,7366,4807,069
Other assets6011,0751,1837421,0421,0591,0391,2209208908311,309
Public sector3861,0469098518601,0091,0271,1151,1041,3931,6031,784
Central government3238847567197267698899158991,0791,2491,282
Public entities63162153132134240137200204314355502
Private sector3,5364,1114,5864,9985,9176,2787,3007,3857,7228,6979,3189,765
Financial institutions7985884810683331242335437333422
Other liabilities1,7402,3372,5502,3202,8173,0983,2673,7043,1573,4653,6094,421
Memorandum itemsIn percent of GDP
Total assets41.945.145.841.144.343.846.744.435.334.532.932.3
Central bank bills (LRMs)
Sources: Banco Central de Paraguay, and IMF staff estimates.
Sources: Banco Central de Paraguay, and IMF staff estimates.
Table 3.7.Structure of Domestic Assets of Commercial Banks(In percent)
Claims on public sector1.
Central government0.
Public entities0.
Central bank bills (LRMs)
Deposits in central bank18.316.414.918.418.619.120.420.630.129.425.121.5
Claims on financial institutions1.
Deposit-taking institutions0.
Non-deposit taking institutions0.
Claims on private sector65.863.363.764.562.963.864.160.448.448.149.547.2
Other assets10.715.114.99.611.911.710.
Source: IMF staff calculations.
Source: IMF staff calculations.

The portfolio shift was in part motivated by the change in the maturity structure of deposits. From 2000, there was a sharp increase in demand deposits, away from savings deposits, in part as a result of the sharp depreciation in the guaraní and attendant inflation (Figure 3.4). From about 25–30 percent of total deposits, demand deposits now account for close to 70 percent, a trend that has remained steady despite improved economic outcomes over the past several years.

Figure 3.4
Banking Sector Deposit and Credit Developments

Sources: Paraguayan authorities, and IMF staff calculations.

To a large extent, both phenomena above (lower real money balances and shorter maturities) can be explained by the evolution of interest rates. Following the first financial crisis, lending spreads in guaranís rose dramatically from an already high level of more than 20 percentage points to about double this level (Figure 3.5). This happened as banks increased lending rates far more than deposit rates. Although spreads since 2003 have declined somewhat, they remain above pre-crisis levels. Moreover, this was achieved mainly by drastically reducing the remuneration of deposits to nearly zero, while maintaining effective lending rates at very high levels.

Figure 3.5
Interest Rates

(In percent)

Sources: Paraguayan authorities, and IMF staff calculations.

Increased Dollarization

The negative consequences of dollarization are well-documented in the literature.18 First, it is relatively more difficult to conduct independent monetary policy in a dollarized economy as the monetary authorities cannot control dollar-linked interest rates. Second, in the same vein, as local and foreign currency become closer substitutes, efforts to control monetary aggregates become increasingly ineffective. Third, dollarization can severely limit the ability of the central bank in acting as a lender of last resort when the banking system is in distress.

Financial crises undoubtedly contributed to the increased dollarization in Paraguay. Both liability and asset dollarization increased with the advent of the crises, although there has been a reversal since 2003 (Figure 3.4). Liability dollarization was on a declining trend until the first crisis in 1995, which reversed the trend. The dollarization trend accelerated from 1997 until early 2003, peaking at about 70 percent of total deposits. Since then, there has been a downward shift, to about 45 percent by the end of 2007. Asset dollarization (measured by foreign currency lending to the private sector) followed a similar pattern, albeit with lower intensity, peaking at about 60 percent in 2003. By the end of 2007, it had gone down to about 44 percent, mainly owing to improved economic outcomes, which led to the appreciation of the guaraní, inter alia.

Weak Balance Sheet of the Central Bank

Repeated financial crises have directly led to significant weakening of the BCP balance sheet. As a result of intervening in many financial institutions, the BCP has ended up with a large stock (G 1,300 billion or 2.5 percent of GDP at the end of 2006) of what are essentially nonperforming assets, seriously impairing its balance sheet (Table 3.8). The consequences of a weak central bank balance sheet are well documented in Chapter 5 and include impairing the central bank’s ability to conduct effective monetary policy as its losses are covered mainly by issuing currency and/or short-term debt (LRMs). The literature has shown that financially weak central banks typically are not as effective in controlling inflation as strong ones.

Table 3.8.Summary Balance Sheet of the Central Bank of Paraguay(In billions of guaranís)
Claims on public sector1,2701,2791,3579431,1881,3941,3531,5812,3732,2692,5872,5392,320
General government1,0481,0401,0896598821,0631,0041,4042,1432,0342,1442,1171,909
Public enterprises222239268284306331349177230236444422411
Claims on financial institutions1148061,0521,4111,1781,2431,2561,2821,4551,5011,4121,3801,354
Commercial banks965818415154557742222
Deposit-taking institutions12110420342736445827006
Non-deposit taking institutions15232181817978787878787771
Banks in liquidation2181857951,0181,1331,1341,1541,3151,3951,3331,3021,275
Claims on private sector771215182226283234333327
Other assets3883844051,7641,0451,3991,5061,9002,4781,5311,6871,7321,782
Monetary base1,7572,0532,2072,4272,7373,1373,1743,5783,7565,0165,7685,9836,334
Central bank bills (LRMs)3520225131938276462845781,0711,5522,2933,224
Public sector4886696914865751,3338197107031,1461,2321,1761,576
General government4305805724665461,3198047077011,1191,1851,0991,467
Public enterprises59891192029151533284777108
Private sector27265255587280871241321116458
Other liabilities1,3361,5781,7102,6672,0102,5732,6533,2115,2103,5674,0283,7212,768
Memorandum itemsIn percent of GDP
Total assets28.729.728.231.627.532.428.031.037.331.931.529.627.5
Claims on financial institutions in liquidation0.
Central bank bills (LRMs)
Sources: Banco Central de Paraguay, and IMF staff estimates.
Sources: Banco Central de Paraguay, and IMF staff estimates.

Lessons from the Crises19

There are several important lessons that can be drawn from Paraguay’s experience with recurrent financial crises (Box 3.1). These include the timing, sequencing, and content of reforms and the optimal response to a crisis. The most fundamental lesson from the Paraguayan experience is that the timing and sequencing of reforms have a material impact on the outcome. Premature and uncontrolled deregulation was a major cause of the first crisis. While there was little doubt that a number of financial sector reforms were urgently needed to move away from a heavily repressed financial system, this could have been done without loosening the entry requirements for new firms or prudential regulations for existing financial institutions. This was all the more important given that essential banking skills, such as risk assessment and credit monitoring, were sorely lacking. Although the authorities did have fairly well-thought prudential regulations as early as 1990, they allowed the power of vested interests to water them down and effectively postpone them for up to five years.

The content of the measures during the financial liberalization also was inadequate. Leaving reserve requirements at very high levels promoted the appearance of an informal financial sector, complete with parallel accounting schemes (and in some cases outright fraud), as financial institutions sought to evade implicit taxes. Although interest rate liberalization was the appropriate measure to encourage competition for deposits and loans, it needed to be accompanied by a substantial enhancement of prudential regulation and supervision, and robust exit policies to punish or push out non-compliant firms.

As underlined by García-Herrero (1997a, b), recent history—in terms of authorities’ response to a crisis—heavily conditions how stakeholders react. The behavior of depositors and banks was affected by the government’s and congress’ initial handling of the crisis. There was a general perception that there was an implicit guarantee for all banks and for all deposits. To the extent that this perception was validated ex post, moral hazard was increased. Financial institutions therefore competed for liquidity with little consideration of costs, and depositors went to the highest bidder without adequately assessing risk. As Jaramillo (2000) emphasized, during the first crisis some weak local banks surprisingly increased their deposit market share relative to sounder banks (mostly foreign owned) by raising interest rates. As a result, this was a case of “bad money chasing good money,” and there was initially no flight to quality.

Paraguay: Lessons from Banking Crises, 1995–2003

Paraguay has a history of financial crises, having experienced five crises during an eight-year period from the mid-1990s. These episodes illustrate what to do and what not to do when confronted with a banking crisis. The response was generally inadequate in the first three crises, but the authorities, notably the Superintendency of Banks (SIB), responded appropriately and in a timely manner to the 2002 and 2003 crises. The authorities’ learning experience is evidenced by the cost of the crises, which amounted to only 1 percent of GDP in the last two episodes against 15 percent for the earlier crises.

Table : Banking Crises in Paraguay—Causes, Magnitude, and Policy Response
DateCause of the CrisisBank(s) AffectedPolicy Response
1995It was the by-product of a rapid financial liberalization without adequate safeguards in terms of sound prudential regulations and enforcement. The crisis was triggered when two large banks failed to meet their clearing obligations.Second and third largest banks with 16 cumulative percent of deposits.Inadequate. The authorities decided to honor deposits in the intervened banks, without imposing sanctions on the banks that did not improve their performance.
1997The crisis occurred principally owing to the authorities’ inadequate response to the first crisis, as regulatory forbearance and generous de facto deposit guarantees allowed financial institutions and depositors to continue with the status quo without paying adequate attention to risk. The first private bank was eventually intervened.First largest bank with 7 percent of deposits. Some financieras were also affected.Inadequate. The authorities closed two banks. Despite the SIB’s increased reluctance to provide support, the coverage of deposit insurance was increased while regulatory forbearance, accounting flexibility, and transfer of public sector deposits to weak banks allowed them to survive.
1998The financial situation of the fourth largest bank deteriorated and its liquidity dried up while depending increasingly on public sector deposits.Fourth largest bank with 6 percent of deposits. Some financieras affected.Mixed. The bank was closed and the SIB encouraged the merger and recapitalization of the banking system.
2002The deposit freeze in Argentina led to a bank run on its local subsidiary.Third largest bank with 11 percent of deposits.Adequate. The bank was closed.
2003It was mainly a result of fraud in a medium-sized locally owned bank.Eighth largest bank with 5 percent of deposits.Adequate. The bank was closed.

Lessons that can be drawn from the crises include the following:

  • An effective banking resolution strategy needs to identify which banks are solvent or insolvent. Supporting fundamentally insolvent institutions is unlikely to succeed, and even more so if inefficient bank owners continue running their banks.

  • Generous de facto deposit guarantees distort incentives and encourage excessive risk-taking over time. Guarantees should be limited and accompanied by an effective restructuring plan and otherwise remove the pressure from the authorities to rapidly resolve the underlying banking problems.

  • Responsibility must be defined. Who bears the ultimate cost, such as the treasury, needs to be clarified up front in order to avoid burdening the central bank balance sheet with nonperforming assets.

Supporting fundamentally insolvent institutions—no matter how well intentioned the stakeholders may be—is usually unlikely to succeed. Thus the restructuring plans, which did not have adequate safeguards, provided strong incentives for insiders to withdraw their funds and shift them to more solid institutions. It was also rather presumptive to expect that bank owners who were inept at running their banks prior to the crisis would suddenly turn virtuous, especially if there were no incentives to do so.

Finally, an important lesson from Paraguay’s experience is that it is extremely difficult to transfer quasi-fiscal losses incurred during the crisis to the government. As shown above, and in Chapter 6, many years after the first crisis, the BCP is still hobbled with a large stock of nonperforming assets that have contributed to operating losses and reduced its ability to more effectively control inflation.

Concluding Remarks

Paraguay had five serious financial crises during an eight-year period from 1995. The first crisis occurred mainly as a result of rapid financial liberalization without adequate safeguards in terms of sound prudential regulations and enforcement. This led to a very rapid growth in the number of financial institutions, both banks and financieras, a large number of which were operating without proper banking standards, especially in terms of risk management. The weak banking supervision and high reserve requirements also promoted the appearance of a parallel financial system as institutions tried to avoid high implicit taxes.

The next crisis (1997) occurred principally because the authorities’ response was inadequate in the first crisis. Many insolvent institutions were allowed to continue operating due to regulatory forbearance. Generous de facto deposit guarantees allowed financial institutions and depositors to continue with the status quo without paying adequate attention to risk. By the third crisis (1998), the authorities had become less willing to entertain weak institutions and were promptly closing them. Nonetheless, in part as a result of the debilitating effects of the crises, the economy had fallen into recession by 1999, setting the stage for another bout of crises.

The next wave of crises (from 2002) was mainly caused by contagion from Argentina and Uruguay. The financial crises in the neighboring countries affected a major Argentine-owned bank in Paraguay in 2002 and had serious systemic implications. The final crisis of 2003 was mainly a result of fraud in a small bank. In both cases the authorities acted decisively and promptly closed the institutions.

The costs of the crises were considerable, albeit lower than in some Latin American countries, such as Argentina, Ecuador, Chile, Venezuela, and Uruguay. The direct fiscal and quasi-fiscal costs have been estimated at 16 percent of GDP. The recurrent crises also undoubtedly weakened economic growth.

The most lasting effect of the crises has been continuing fragility of the financial system. This is characterized by weak compliance with internationally accepted prudential requirements, although this has been improving over the past few years. In part related to the financial fragility, banks have become overly cautious, maintaining high liquidity levels and high intermediation spreads. This in turn has led to disintermediation.

At the same time, the crises promoted an increase in asset and liability dollarization, thus complicating monetary policy implementation. Finally, as a direct consequence of bailing out ailing financial institutions, the central bank balance sheet has been saddled with a large volume of what are essentially nonperforming loans. This has reduced its ability to more effectively fight against inflation.

Going forward, if Paraguay is to avoid another wave of financial crises, there is a need to deepen ongoing financial reforms. The current level of compliance with Basel Core Principles is very low by Latin American standards, and operational and legislative reforms are urgently needed in this area. Finally, there is a need to address the financial weakness of the central bank balance sheet if it is to more effectively play its role of inflation fighter and, ultimately, lender of last resort.

4 Reforming the Financial System

José Giancarlo Gasha1

The macroeconomic stability of recent years in Paraguay provides a window of opportunity to address key vulnerabilities in the financial sector that would otherwise be an obstacle to growth. After a decade of financial instability that dramatically reduced the size of the banking system in Paraguay (Chapter 3), the recovery of economic activity, the significant reduction in inflation, and the strengthening of the guaraní have provided a favorable environment for the recovery of financial intermediation. Over the past few years, the authorities have started to implement a comprehensive reform program in the financial sector aimed at enhancing the resiliency of the banking system by upgrading the regulatory and supervisory framework, restructuring the public development bank (Banco Nacional de Fomento, BNF) and eliminating the systemic risk it once posed (Chapter 6), and further entrenching the confidence in the guaraní by initiating the financial strengthening of the Central Bank of Paraguay (BCP) (Chapter 5). Further implementing reforms in the financial sector will contribute to financial deepening and development, and thus to economic growth.

The relationship between financial development and economic growth has been documented extensively. It is usually accepted that financial deepening positively influences economic growth, although reverse causality cannot be excluded. The services to the economy provided by the financial system may affect growth by increasing the rates of capital accumulation and by improving the allocation of resources. Additional services include risk management, mobilization and allocation of financial resources, facilitation of transactions, and monitoring of investment projects. It is argued that more developed financial systems provide better services and that the development of the financial system affects the efficiency with which an economy allocates its resources and its rate of savings. Evidence suggests that countries with larger financial sectors (relative to GDP) have higher levels of real per capita income and higher rates of growth (see Roubini and Sala-i-Martín, 1992; and Levine, 2004).

Financial deepening in Latin America is relatively shallow. The average level of bank credit to the private sector in Latin America is estimated at about 30 percent of GDP, a rate that is only one-third that of developed countries, less than one-half that of East Asia and the Pacific, and about two-thirds that of the Middle East and Asia.

Disintermediation has been particularly severe in Paraguay over the past several years. Private sector credit declined from 26 percent of GDP in 1998 to 15 percent in 2005. In addition, the number of banks declined by two-thirds because of the financial turmoil of the late 1990s described in Chapter 3. The size of bank credit to the private sector in Paraguay is low, even compared with other countries in the region (Figure 4.1). The relatively low level of bank deposits and broad monetary aggregates also indicates that the financial system is not very efficient at mobilizing resources for credit and growth.

Figure 4.1.
Financial Deepening in Selected Latin American Countries

(Broad money as a percentage of GDP, average 2001–05)

Source: IMF staff estimates.

Financial shallowness is a symptom of institutional and regulatory fragility. The low growth in bank credit reflects weak corporate governance, inadequate regulatory and supervisory frameworks, insufficient contract enforcement, and the lack of creditworthy lending opportunities. Despite a successful turnaround in macroeconomic performance, the general distrust in the banking system and the guaraní still persists. The BCP is hampered in its provision of services by weaknesses in its balance sheet and the lack of appropriate instruments, which undermines the effectiveness of its monetary policy operations (Chapter 5).

Comprehensive financial reform is needed to foster financial intermediation. The reform agenda should include measures aimed at further strengthening the regulatory and supervisory framework, enhancing governance, upgrading supervisory capacity and accountability, improving the availability and quality of credit information, and enhancing creditors’ rights and insolvency procedures. The reform agenda also involves addressing the regulatory and supervisory issues related to the buoyant financial cooperative sector and upgrading the payment system, as well as implementing a number of reforms aimed at developing the incipient domestic capital markets.

This chapter analyzes the situation of the financial system and provides policy recommendations to address identified vulnerabilities. The remainder of this chapter is organized as follows: the first section focuses on the regulatory framework for effective banking supervision, and the next section deals with institutional factors and creditor rights. The next sections review the systems of information and credit registries, measures to modernize and rationalize Paraguay’s payment system, and the regulatory and supervisory framework for financial cooperatives. The last section focuses on the Paraguayan capital markets and a strategy to develop them.

Regulatory and Supervisory Framework

Evidence suggests that countries with better financial policies and stronger regulatory and supervisory frameworks for banking are more likely to achieve sustainable financial deepening. Although macroeconomic factors are important determinants of bank’s soundness, adequate credit risk management, as well as solid regulatory and supervisory frameworks are critical in mitigating the impact of macroeconomic pressures (see Das and others, 2005). The legal framework for banking supervision and financial intermediation in Paraguay needs to be brought in line with international standards and good practices. The legal framework should improve governance rules, facilitate risk management, and enhance the sanctioning capacity of the Superintendency of Banks (SIB). Fit-and-proper rules applicable to shareholders, managers, and directors of banks need to be strengthened. In addition, provisions regulating capital adequacy and the classification of loans should be streamlined. Further provisions should enhance the SIB’s enforcement capacity, including by broadening the schedule of penalties and fines for breach of regulations and by preventing appeals (and judicial review procedures) from suspending the effect of supervisory decisions.

The SIB lacks autonomy and resources to adequately perform its duties, and it does not have sufficient sanctioning capacities. Lack of independence is a major shortcoming, as is the limited availability of human and financial resources. There is no clarity about the material resources that are available to the SIB within the BCP (which is worrisome, given basic infrastructure needs). Sanctions are approved by the central bank board, following an internal procedure that in practice is unduly long and that is frequently followed by a judicial review. Once an appeal is presented, the implementation of all supervisory decisions is suspended for periods that frequently exceed one year.

Capital requirements are more lax than international standards. There are no provisions in the current legislation for the supervisory oversight of bank policies, procedures, and credit risk management. Although capital requirements at 10 percent of risk-weighted assets are higher than the Basel minimum of 8 percent, they do not distinguish between Tier 1 and Tier 2 capital, and there are no capital requirements for market risk. Risk weights for loans backed by mortgages, warrants, and other collateral are no higher than 50 percent, even for commercial loans, and there are no limits on the amount of the asset revaluation reserve that is treated as capital. Regulation of credit risk is based on the review of individual loan exposure rather than on credit policies. The SIB has required banks to submit credit manuals and adopt credit policies since 2003. However, SIB staff requires additional training to carrying out effective supervision of banks’ risk management practices.

A resolution passed by the BCP in 2003 (Resolución 8/03) would have upgraded prudential regulations related to loan classification and provisioning, but its implementation was delayed.2 Resolución 8/03 tightens rules on the arrears period to be applied for each risk category, the required provisioning, information requirements for borrowers, and limits on the use of collateral to reduce provisioning requirements. However, further improvements are necessary, including strengthening classification requirements based on expected losses rather than arrears, improving rules on connected lending, tightening the valuation of collateral, and reducing the period for constituting provisions in line with international standards.

A stronger legal and regulatory framework is needed to eliminate vulnerabilities and reduce the likelihood of financial instability. With a well-documented record of financial crises in the period of 1995–2003 and one of the weakest regulatory frameworks in Latin America, Paraguay should embrace an ambitious and multipronged reform effort to address the identified problems. Some of the reforms can be made by issuing new prudential regulations, whereas others would require changes to existing banking legislation. As part of these efforts, the SIB would also need to strengthen its structure, governance, and human resources. In this process, it will be essential to improve banks’ capital requirements and to adopt best international practices.

In June 2007, the central bank designed an ambitious strategy to increase compliance with the Basel Core Principles for Effective Banking Supervision to bring Paraguay’s regulatory and supervisory framework in line with international standards. The strategy included the following steps:

  • Fully implement a modified Resolución 8/03 (which was approved by the BCP in September 2007) on credit requirements, loan classification, and provisioning requirements; becoming effective in October 2008 (renamed as Resolución 1/08).

  • Enforce prudential regulations, including for opening financial institutions and banks’ credit risk management practices, and strengthening the Superintendency of Banks’ risks unit.

  • Implement additional regulatory changes, including strengthening protection for supervisors, strengthening financial and operational risk management practices, increasing coordination between supervisory bodies, using fit—and-proper criteria, and enhancing on-site, off-site, cross-border, and consolidated supervision.

  • Amend the current legislation, in particular the Banking Law and the Central Bank Law, to improve governance rules, enhance the independence and sanctioning capacity of the Superintendency of Banks, further strengthen fit-and-proper criteria, and strengthen capital requirements, by the end of 2009.

Paraguay’s level of compliance with the Basel Core Principles for Effective Banking Supervision is low. Following the authorities’ strategy, Paraguay should significantly increase its compliance with the Basel Core Principles by the end of 2009, which will require significant changes in the regulatory setting as well as modifications to the legal framework.

Institutional Factors

There is strong evidence that improving creditor rights enhances access to credit (see La Porta and others, 1997 and 1998). Lenders must be assured that if the borrower refuses to pay, they will be able to turn to the legal system to execute or liquidate any existing guarantee promptly at a low cost. Creditor rights are relatively less protected in Latin America than in other parts of the world, both in terms of what is enshrined in the law and the degree of law enforcement. Paraguay (and most Latin American countries) compares unfavorably to other countries on credit access issues, including creditor rights, duration of bankruptcy procedures, efficiency of the judicial system, and protection of property rights (Box 4.1).

Shortcomings in Paraguay’s legal and institutional frameworks for insolvency and creditor rights hinder credit access. Ineffective enforcement mechanisms and cumbersome insolvency proceedings are a barrier to credit access. Moreover, there is no framework for out-of-court corporate restructuring. As Paraguay seeks to foster higher access to credit and bank services, a number of institutional factors are critically important. These factors include the enforcement of contracts, the role of credit registries and bureaus in information sharing, and the importance of creditor rights.

Creditor Protection: Paraguay and Latin America

In Paraguay, as in most Latin American countries, the legal framework is generally hostile to credit operations. Good debtors have no way to distinguish themselves from bad debtors, so they face high interest rate spreads and collateral requirements. At the same time, creditors are unable to enforce contracts or to foreclose on collateral. Moreover, in some Latin American countries, laws, regulations, and the judicial system tend to favor debtors in disputes with creditors, making it more costly for creditors to exercise rights stipulated in contracts. In terms of current legislation, an index of creditor rights suggests that Paraguayan and Latin American creditors are three times less protected than creditors in other emerging economies. An index constructed by the Inter-American Development Bank (2004, see table below) measures whether creditor rights’ regulations: (1) impose an automatic stay on assets in case of reorganization, (2) give secured creditors the right to be paid first in case of bankruptcy, (3) require firms to consult with creditors before filing for reorganization, and (4) mandate removal of a firm’s management during reorganization. A higher index suggests better protection of creditor rights.

Creditor Protection in Latin America and Other Regions
CountryCreditor Rights1Rule of Law 2
Costa Rica0.500.65
Dominican Republic0.250.45
El Salvador0.250.42
Trinidad and Tobago0.250.58
Latin America average0.250.46
OECD average0.470.85
Other emerging economies average0.730.50
Sources: IADB (2004).

Normalized index from 0 to 1. Proxy for “What the law says.”

Normalized index from 0 to 1. Proxy for “Degree of law enforcement.”

Sources: IADB (2004).

Normalized index from 0 to 1. Proxy for “What the law says.”

Normalized index from 0 to 1. Proxy for “Degree of law enforcement.”

Paraguay and Latin America in general fare less favorably not only in terms of what the law says, but also in terms of the degree of law enforcement. Paraguay fares less favorably even with respect to other Latin American countries. On a 0-to-1 scale, Paraguay scores 0.34, Latin America and other emerging economies score 0.50, and Organization for Economic Cooperation and Development (OECD) countries score 0.85. Latin American countries need to modernize the legal, regulatory, and judicial frameworks that underpin creditors’ rights, to bring them more in line with best international practices.

Paraguay and the rest of Latin America also fare poorly on several other indicators commonly used as proxies for the institutional environment. Duration of bankruptcy procedures, efficiency of the judiciary system, and registration systems for property rights and securities are less developed than in other emerging economies. For example, registries for transactions over real estate are not always standardized and computerized in a way that makes the information accessible to the financial system.

Measures to improve creditor rights and the insolvency system should cover both legal and institutional aspects. Key measures should include (1) reforming legislation for efficient enforcement proceedings; (2) improving the legal framework for guarantees and security over assets; (3) implementing a comprehensive plan for the modernization of registries, including computerized technology for recording; (4) introducing a modern insolvency law providing for effective reorganization and liquidation proceedings; (5) implementing a comprehensive judicial reform; (6) setting up an independent and effective body responsible for regulating and supervising insolvency administrators (empowered to set standards of conduct aimed at underscoring fairness, impartiality, transparency, and accountability); and (7) creating an environment conducive to out-of-court processes for dealing with cases of corporate financial difficulties or insolvency.

Information and Credit Registries

Credit registries play an important role in the development of credit markets. Evidence suggests that the availability and quality of information is crucial for sound lending decisions. Greater availability of information stimulates financial development, reduces default rates, and increases access to credit. The existence of credit registries helps mitigate information asymmetry problems (e.g., moral hazard and adverse selection).

There is only one public registry and one private credit bureau operating in Paraguay. The public credit registry was established in 1995 and is operated by the SIB. It shares information only with those banks and finance companies it supervises. Financial institutions are required to submit data for all loans greater than G 99,999 (about US$20) each month. The SIB checks the data for errors and missing information and then requests corrections. The consolidated data for the financial system are made available for consultations only once all data have been validated and rectified. The credit reports include data on the total debt each borrower has outstanding and payment overdue by more than 30 days for small borrowers (60 days for large ones). There is no charge for the service, which appears to be underutilized, as institutions do not regularly request data past the last 30 days.

A private credit registry also operates in Paraguay. It maintains a large set of data on more than 3 million people and provides automated consultation services to more than 300 clients, including all banks, finance companies, and cooperatives. The clients of the private credit registry (INFORCONF) also include retails shops that extend consumer loans, cellular telephone service providers, and schools and health clubs, among many other types of businesses that check the reports before hiring or making rental agreements. INFORCONF’s database includes loan payments overdue by more than 60 days, legal judgments, bad checks, tax debt, bankruptcy, and other negative data, all of which are kept on record for different amounts of time, depending on the applicable law.

Credit information in Paraguay compares relatively well with respect to other countries in the region, but financial institutions are grossly underutilizing the data available, in particular from the public registry. According to the SIB, institutions do not regularly request data past the last 30 days, overlooking past payment history. The lack of interest in their borrowers’ longer credit histories might suggest that financial institutions still lack the capacity or incentives to improve their customers’ creditworthiness assessment (Box 4.2).

Information and Credit Registry

Accurate credit information has substantially greater predictive power for the performance of firms than the data contained in financial statements alone. Public and private credit registries in Paraguay fare relatively well compared with other countries within and outside the region in terms of the number of institutions reporting data and the amount of data reported on individuals and on businesses. The table below shows an index that measures the quality of both public and private registries and bureaus. Private credit bureaus in Paraguay and Latin America score higher than in other emerging economies and even in some Organization for Economic Cooperation and Development (OECD) countries. However, Paraguay and other countries in the region could benefit from further improvements in the quality of credit registries, including the broadening of the amount of data reported on individuals and businesses, the number of procedures to verify the data, and the number of institutions allowed to access the data.

Credit Registries in Latin America and Other Regions
Private Credit Bureau1Public Credit Registry2
Colombia0.70No Registry
Costa Rica0.290.44
Dominican Republic0.680.27
EcuadorNo Bureau0.66
El Salvador0.550.51
HondurasNo Bureau0.50
NicaraguaNo Bureau0.39
Panama0.62No Registry
VenezuelaNo Bureau0.60
Latin America average0.650.47
United States0.90No Registry
OECD average0.480.53
Other emerging economies average0.470.52
Sources: IADB (2004), and various World Bank surveys.

Normalized index from 0 to 1. Proxy for quality of private credit bureaus.

Normalized index from 0 to 1. Proxy for public credit registry.

Sources: IADB (2004), and various World Bank surveys.

Normalized index from 0 to 1. Proxy for quality of private credit bureaus.

Normalized index from 0 to 1. Proxy for public credit registry.

Payment Systems

Deepening and strengthening the financial system and developing local capital markets require modern and efficient payment systems. These systems enhance liquidity management, facilitate transactions, and mobilize financial resources as well as improve the conduct of monetary policy. The infrastructure for payments and for clearing and settlements of securities in Paraguay is still basic, risky, and inefficient. Checks are the main instruments for interbank payment. The clearing of checks is not protected against a default of a participant. Securities are issued mainly in paper form and clearing and settlements are usually cumbersome and time-consuming.3 The current public payments system in Paraguay significantly hampers the developments of financial markets. In this regard, the development of a legal and regulatory framework for revamping the payment system is part of the authorities’ reform agenda.

Outstanding legal issues should be addressed as a priority by the BCP. Major areas to be improved in the legal framework include settlement protection against bankruptcy procedures, dematerialization or immobilization of securities, custody arrangements, netting arrangements, repo operations, the pledge underlying lending operations, and electronic documents and signatures.

The introduction of a real-time gross settlement (RTGS) system would allow the BCP to comply with the Core Principles for Systemically Important Payment Systems and reduce systemic risk. The RTGS system would become the backbone of financial markets and support the central bank’s monetary policy operations as well as the efficient settlement of securities transactions. To ensure early adoption of the RTGS system, the BCP should finalize the preparation of rules and procedures relating to the use of the system, including tools for managing legal, financial, and operational risks.

Other key elements of a strengthening strategy include the implementation of an automated clearinghouse (ACH), the development of a security depository, and the strengthening of the payment system oversight function. Migration from paper-based retail payment instruments (cheques) to electronic payment instruments is key to increase the efficiency of the payments system. In this regard, the BCP should consider the implementation of an ACH that would allow the processing of these electronic payment instruments also at the interbank level. A securities depository should be developed. It would be linked to the RTGS system in order to allow for delivery versus payment, helping the development of the interbank money market and the securities markets. To facilitate transactions, a formal National Payment System Council should be established.

Financial Cooperatives

Financial intermediation by cooperatives in Paraguay is among the highest in Latin America. Some estimates suggest that the share of cooperatives’ credit in the financial system is about 28 percent, which is high compared with approximately 6 percent in Honduras, second highest in the region.4 The number of members of credit and savings cooperatives (CACs) as a percentage of the population ages 15 to 64 is similarly very high (approximately 23 percent) compared with other countries in the region (Table 4.1).

Table 4.1.Cross-Regional Comparison: Share of CAC Loans as Percent of Credit to the Private Sector, and CAC Membership as a Percent of the Population Ages 15–64
CountryCredit to the

Private Sector (%)

Ages 15–64
Costa Rica5.0Costa Rica10
Dominican Republic0.9Dominican Republic2
El Salvador0.9El Salvador2
Source: World Bank staff estimates.1Includes public and private domestic debt.2Data comprises both equity and bond markets.
Source: World Bank staff estimates.1Includes public and private domestic debt.2Data comprises both equity and bond markets.

Financial cooperatives are steadily increasing their participation in the financial system, accounting for approximately 20 percent of deposits by the end of 2007. Available information suggests that cooperatives’ credits and deposits are growing much faster than those of the banking system. Whereas at the end of 2006 cooperatives’ deposits grew by 40 percent, bank deposits grew by only 8 percent. The growth of the system is mainly driven by the expansion of a relatively few large cooperatives. The largest 40 CACs (out of more than 200 institutions) account for approximately 80 percent of the credit portfolio. Participants in the financial system argue that the relative large size of Paraguay’s cooperatives sector can be partly explained by the lack of confidence in the banking system and from their institutional status vis-à-vis banks and finance companies. Historically, cooperatives have operated without many of the costs imposed by capital adequacy requirements, provisioning norms, or regulatory costs associated with inspections, audits, and data compilation for supervisory purposes. Regulatory arbitrage will diminish as the standards of the entity in charge of regulation and supervision of cooperatives (INCOOP) improves.5

Until recently cooperatives were largely unregulated, but some advances have been made in the past few years. In 2004, Law 2157 put in place a basic legal and regulatory framework for cooperatives: the new role of INCOOP as the regulatory agency of the system was formalized, and basic solvency, assets classification and provisioning criteria were established (Resolución 499, General Regulatory Framework, GRF). However, an effective supervisory framework is still being developed. Norms governing the operations of cooperatives are less stringent than those for banks and finance companies: (1) minimum capital requirements do not exist for cooperatives, versus a requirement of US$3 million for banks and US$1.5 million for finance companies; (2) risk-weighted capital adequacy requirements are 10 percent for banks and finance companies, whereas cooperatives have a reserve requirement of 8, 6, and 4 percent according to their size; (3) second-tier capital can include specific provisions for cooperatives, contrary to standard practices for banks and finance companies; and (4) periods of delinquency requiring 100 percent provisioning in some cases can be as high as 541 days for cooperatives, versus 361 days for banks.

The “General Regulatory Framework for Cooperatives” entered into effect in 2007. This framework aims at establishing capital requirements, classifying loans and provisioning requirements, and establishing liquidity requirements, as well as introducing a basic framework for carrying out effective supervision by enhancing information requirements and in situ and extra-situ supervision. The framework currently covers the largest institutions of the system, which account for approximately 80 percent of the system’s assets; and it is expected to cover medium-sized cooperatives by the end of 2009.

INCOOP is currently developing a system of financial surveillance for the largest cooperatives. A system of financial soundness indicators and basic risk analysis is being implemented. INCOOP is already consolidating financial information of the largest cooperatives and designing a deposit insurance type of fund. Improving the quality and the quantity of information provided by the cooperative sector remains a priority not only for supervisory purposes but also for the adequate measurement and control of monetary aggregates.

The design of the general regulatory framework for the sector is being improved. INCOOP is strengthening its operations in a number of areas, including by (1) designing complementary regulations, (2) strengthening supervision and auditing, (3) strengthening the system of statistics and data analysis, (4) restructuring the administrative and operational structure, and (5) designing a “stabilization” fund for mergers and acquisitions within the sector. INCOOP has also started working in the design of a credit risks registry for the sector and is drafting the regulation for a deposit insurance fund for the sector. It intends to implement the fund by early 2010.

Development of Local Capital Markets

Well-functioning domestic capital markets make a vital contribution to the efficiency and stability of financial intermediation. Local capital markets improve the competitiveness of financial intermediation by providing savers an alternative to bank deposits; providing longer term (or more competitive) funding of public debt, corporate, housing, and infrastructure than may be available from the banking system alone; and allowing banks, insurers, pension funds, and other intermediaries to manage their maturity and interest rate risks. Robust local capital markets can also act as a “spare tire” for the financial system, thereby enhancing financial stability, encouraging improved transparency and corporate governance by corporations, and helping reduce the risks associated with foreign currency borrowings.

However, capital markets in Paraguay are still very thin and underdeveloped. Their size is far smaller than in other Latin American and emerging market countries (Table 4.2). Activity is very limited in all types of instruments, in both local and foreign currency and in both primary and secondary markets. Investors strongly prefer fixed income instruments and tend to hold the securities until maturity, significantly limiting secondary market activity. The main securities are corporate bonds and the central bank’s monetary control bills (letras de regulación monetaria, LRMs). Disclosure requirements are reasonable, but the degree of informality of firms is so high that only a few large companies would find it attractive to list on the stock exchange. Market capitalization, at around US$500 million, represents only 5 percent of GDP.

Table 4.2.Comparative Size of Capital Markets, End–2006(In percent of GDP)
Equity MarketBond Markets1
Costa Rica8.670.1
Dominican Republicna41.4
El Salvador42.140.8
Latin America56.649.6
Emerging countries64.642.4
Sources: BIS, World Federation of Stock Exchanges, Bloomberg, national aurthorities, and IMF staff estimates.

Includes public and private domestic debt.

Data comprises both equity and bond markets.

Sources: BIS, World Federation of Stock Exchanges, Bloomberg, national aurthorities, and IMF staff estimates.

Includes public and private domestic debt.

Data comprises both equity and bond markets.

Few firms are listed on the stock exchange (BVPASA), and most of them are concentrated in the service and commercial sectors. In 1995, the government extended some fiscal incentives (reduction of the income tax rate through 2008) to firms registered on the BVPASA, and as a result the number of listed firms increased from 13 to 61. However, the number has remained rather stable since then, currently at 55, with few new listings, mostly in the trading sector. Equity trading is very limited and usually between existing shareholders.

The investor base is very narrow, comprising a relatively small number of institutional investors, some high net worth individuals, and smaller investors—foreign investors are by and large absent. The main institutional investors include banks (which mainly invest in BCP’s LRMs), the public Instituto de Previsión Social (IPS), some private pension funds (Cajas), and insurance companies, all of which primarily invest in banks and finance companies’ certificates of deposits.6 Except for some banks, institutional investors have limited capacity to conduct financial analysis and risk management. Moreover, many institutional investors lack investment guidelines and limit disclosure of information on their assets and liabilities.

Following the reestablishment of macroeconomic stability, capital markets in Paraguay are ripe for development. The macroeconomic stability of recent years and favorable external conditions provide a window of opportunity to implement a comprehensive strategy for developing capital markets. The main constraints are related to the high degree of informality of firms, lack of economic and financial information, and legal and infrastructure issues. A comprehensive strategy aimed at tackling weaknesses in these areas should be built around the following matters: business environment, legal framework, regulation, market infrastructure, and supply of and demand for securities.

A good business environment is necessary for the development of securities markets. Excessive requirements to set up a business can discourage entrepreneurs from becoming “formal” corporations that could later access the securities market. The lack of reliable financial information on corporations can in turn affect investors’ willingness to invest in securities rather than depositing their money in the banking sector.7 Priorities in this area include (1) streamlining the process to start a business; (2) enhancing the processes for constitution, registration, and execution of collateral; (3) modernizing insolvency laws to provide for effective reorganization and liquidation proceedings; (4) implementing the Fiscal Adjustment Law (Ley de Adecuación Fiscal), which require firms with sales over G 6 billion to audit their financial statements; and (5) introducing International Financial Reporting Standards (IFRS).

A sound regulatory framework for capital markets is needed to set out the rights and obligations of market participants. Within the rule of law, they provide adequate protection of creditors’ rights, good disclosure standards for issuers of public securities, sound accounting standards, and assurance that markets will be administered fairly and efficiently. Reforms in this area should include (1) strengthening the National Securities Commission (CNV), (2) strengthening the sanctioning capacity of CNV, (3) improving the legal framework for securitizations, (4) amending the legal requirements for rating agencies, (5) developing a code of corporate governance, and (6) clarifying tax treatment of a number of financial instruments and market participants.

An adequate, reliable, and cost-effective market infrastructure will strengthen confidence in holding and transacting in securities and price discovery. Current market infrastructure is limited, adding to the time and costs of transacting in securities while also resulting in risks and delays in settlement and clearing. Infrastructure improvement will reduce transaction costs and times, reduce risks of settlement and clearing delays, encourage higher primary and secondary market activity levels, and support a broadening of the investor base, including foreign participation. Key measures in this area include (1) drafting laws for dematerialization and central security depository, (2) enhancing the legal framework for clearing and settlement, and (3) developing transaction reporting requirements.

Improvements in public debt management and investor’s relations programs would help in the development of local capital markets. The legal framework related to public debt management is needed to develop and implement a medium-term debt strategy. The Ministry of Finance should complete an inventory of its obligations to ascertain precise composition of debt portfolio and associated risks (foreign exchange, rollover, and interest rate). In addition, the modality for BCP’s recapitalization should be incorporated in the strategy (see Chapter 5). Finally, the government should prepare an investors’ relations program to explain and support securities’ issues and disseminate the plans for public debt management.

Concluding Remarks

Macroeconomic stability and favorable external conditions offer a window of opportunity for strengthening the financial system and developing capital markets in Paraguay. A deeper and more resilient financial system and a well-functioning domestic capital market will make a vital contribution to the efficiency and stability of financial intermediation and increase savings and improve resource allocation, thus contributing to a more robust economic growth.

The issues involved and actions needed to strengthen the financial system are broad ranging. Consistent implementation of the needed set of reforms will be critical. Regulation and supervision of the financial system and capital markets should be enhanced to increase their depth and resiliency; legal and regulatory changes to strengthen creditors’ rights need to be advanced; and the infrastructure for payments, clearing, and settlements in the financial system and capital markets should be upgraded. Sound macroeconomic policies and structural reforms will provide the necessary background for implementing this comprehensive agenda.

The needed set of reforms requires continued commitment at a high level and determined implementation of measures that should be as specific as possible, including near-term and medium-term objectives. It should assign responsibility and accountability to the appropriate institution for the specific components and measures and provide for consultation with the financial sector, as broad-based private sector participation is essential for strengthening the financial sector and developing capital markets.

Further strengthening of banking regulation and supervision would contribute to continuing building trust in the financial system. The continuous implementation of the BCP’s strategy to increase compliance with the Basel Core Principles would spur the effectiveness of the legal and regulatory framework. The efforts should be particularly directed toward the “core” of banking business: capital adequacy, asset classification, provisioning, credit and financial risk management practices, and supervision and controls.

The important development of cooperatives in recent years warrants the constant upgrading of the sector’s regulatory framework. The authorities need to ensure that all financial intermediaries are subject to similar regulatory and supervisory standards to avoid regulatory arbitrage, undue competition, and the generation of potential financial risks.

Strengthening creditors’ rights and overhauling the Paraguayan payment systems would help the mobilization of resources and the development of capital markets. Streamlining insolvency procedures represent a critical step to support the supply of credit to the private sector. Focusing on a few measures could improve the trading infrastructure significantly, in particular preparing a comprehensive payment system law, including for securities depository, improving registration and listing systems, and enhancing the financial and economic data of firms.

5 Strengthening the Central Bank

Tobias Roy1

Paraguay’s external vulnerability, in a region that has experienced large macroeconomic shocks, calls for a strong central bank that is capable of delivering prudent and flexible monetary policies for low inflation. However, operational deficiencies and a weak financial position have undermined the central bank’s efficiency at controlling liquidity and conducting monetary policies. Some of these deficiencies emerged as an aftermath of Paraguay’s history of financial crises (Chapter 3); others reflect a lack of instruments as well as legal and operational constraints (see Lönnberg, Åke, and Peter Stella, 2007).

The efficiency of the financial system and its ability to support high economic growth is also suffering from limitations in central bank services. Concerns about the central bank’s ability to provide timely liquidity add to the private sector’s difficulties at transforming maturities and providing longer-term financing instruments (see also Chapter 4). Addressing these issues will require a stronger and more independent central bank.

Achieving and safeguarding central bank independence requires appropriate provisions in the Central Bank Law. Besides granting protection and autonomy to the central bank administration, clear rules for distributing profits, sharing losses, and the topping up of capital shortfalls by the government are essential elements that are currently lacking in the Paraguayan Central Bank Law (Ley 489/95). However, although appropriate legislation may be necessary for de facto central bank independence, it is not sufficient, because any such rules, even if stipulated by law, need to be made consistent with the legal framework for the central government budget. Typically, capital transfers required by topping-up rules in a central bank law still require authorization by congress. Therefore, a regular and complete compensation for capital losses cannot be expected to occur automatically, even if there are well-specified rules for it. This problem can be avoided only if the central bank’s financial position is strong enough to make recurrent losses highly unlikely.2

This chapter focuses on the operational and financial (rather than legal) dimensions of central bank independence and strength. The remainder of the chapter is organized as follows: the next section takes stock of some weaknesses in the central bank’s provision of liquidity services. In particular, this section focuses on instruments for more effective liquidity management. The following section explores the case for restoring the financial integrity of the Central Bank of Paraguay’s (Banco Central de Paraguay, BCP) balance sheet. It presents the analytics and dynamics of central bank debt and capital, making use of a standard recapitalization model (see Appendix 5.1). This model is formulated in real terms, which allows for an intuitive and straightforward treatment of the inflation tax. It will be applied to generate a range of different scenarios to illustrate the impact of key variables and assumptions on debt and capital dynamics. Subsequently, the next section focuses on policy options for financial strengthening of the central bank, comparing a once-and-for-all recapitalization with more gradual approaches, which rebuild capital over time by focusing on the central bank’s cash flow problem.

Weaknesses in the Provision of Central Bank Services

Liquidity Services at the Central Bank

The high degree of free reserves in the banking system (Figure 5.1) indicates a need for strengthening the workings of the money market. Part of the large level of liquidity held by banks has structural causes in that it reflects deficiencies in the payments and clearing system. However, stimulated by the experience of banking crises in the past, banks’ large liquidity buffers also serve as self-insurance against systemic liquidity shocks, as the Central Bank has few effective instruments to inject short-term liquidity into the market. As a result, there are few interbank market transactions, making it difficult for the BCP to transmit monetary policy signals at the shorter end of the interest rate maturity spectrum. Banks have little incentive to rely on interbank markets to cover their liquidity needs given uncertainty about refinancing conditions, which is compounded by the fact that central bank interventions are not guided by systematic procedures of daily liquidity forecasting for the system. The lack of a reliable facility that would give banks short-term access to liquidity also holds back the development of domestic capital markets and limits the tradability and liquidity of domestic bonds and securities. Finally, the fragmentation of the money market is aggravated by the multitude of different maturity terms and due dates for the LRMs (letras de regulación monetaria) issued by the BCP to mop up liquidity.

Figure 5.1.
Excess Liquidity in the Banking System

Source: IMF staff estimates.

The central bank has started to address these shortcomings by designing and implementing a short-term collateralized lending facility (FLIR—Facilidad de Liquidez de Corto Plazo con Reporto de Instrumentos de Regulación Monetaria) based on LRMs that resolves legal obstacles to outright repo operations. By way of the FLIR facility, banks can use LRMs as collateral for accessing short-term liquidity at a maturity of 1 to 10 days. The eligible amount is determined by the present value of the underlying LRM paper, adjusted by a discount factor. The interest rate applied to the facility is meant to provide an upper bound to interbank money market rates and is determined by the Executive Committee of Open Market Operations.

As an appropriate next step, the central bank could take measures to rationalize the issuance of LRMs. The multitude of different maturities of central bank bills and a plethora of due dates of these zero-coupon-type instruments contribute to market fragmentation and discourage banks from engaging more actively in the market. To encourage the emergence of market pricing mechanisms for securities, the BCP could usefully reduce the number of maturities for issues of central bank bills and cluster the due dates of LRMs around a limited number of focal dates. This would also facilitate assigning markets a greater role in determining interest rates and prices during LRM auctions.

In addition, the BCP should let its interventions on the money market be guided by liquidity forecasts on a daily basis with a view to achieving a greater degree of precision at matching demand and supply. These forecasts would need to be undertaken by a specialized unit at the BCP and would require the development of a model that helps project fluctuations in the public demand for money. But even in the absence of such a model, the BCP’s foreign exchange interventions, plus the banks’ legal reserve requirements on deposits and a well-coordinated information flow with the Ministry of Finance’s treasury, would provide sufficient information for an improved daily liquidity forecast. The BCP should set up a unit that collects and processes this information. A joint committee with the Ministry of Finance that would meet at least once per week could produce the necessary information for an improved daily liquidity forecast.

Financial Weaknesses at the Central Bank

There is a fundamental link between the financial solvency of a central bank and the efficiency of its monetary policy operations. This relationship may not be obvious at first glance—after all, it is hardly conceivable that a central bank could default on its own currency (see Stella, 1997). There is also the deceptive appearance that financial capital does not constrain a central bank’s capacity to restrict and expand the amount of currency issued, which is usually regarded as the main instrumental variable between monetary policy objectives and outcome. However, a financially weak central bank generates losses, and it does not have fiscally sound means to cover these losses. As a consequence, central banks with weak financial positions tend to finance their losses with money creation, which in turn tends to lead to higher inflation.3

Experience in developing countries shows that central bank financial weakness and inflation outcomes are clearly correlated. Ize (2006) compared two large samples of central bank accounting data, which were divided into financially weak and financially strong central banks. One of the findings is that inflation in sample countries with weak central banks was nearly three times as high as inflation in sample countries with strong central banks. The study concludes that weak performers tend to make up for their financial difficulties by following looser monetary policies. In a recent study, Klüh and Stella (2008) confirmed these results.

Financial weakness also impairs monetary policy efficiency by undermining central bank credibility. As long as a transparent and reliable profit/loss-sharing mechanism with the government’s treasury is not in place, a central bank can finance its losses either by printing money or by issuing short-term debt to the financial system, usually in the form of sterilization papers. While printing money may directly conflict with monetary policy objectives, issuing debt will increase interest obligations and subsequent losses, which may lead to an unsustainable path for central bank debt.

Continued losses and rising central bank debt could, at some point, destroy the credibility of monetary policies. First, if central bank debt appears to be headed for an explosive path, the ultimate resort to inflationary finance will appear increasingly likely. Second, markets perceive that central bank’s decisions on interest rates may be biased downward, because higher interest rates would hurt an already feeble balance sheet.4 In addition, the loss of credibility may worsen the policymaker’s trade-off between disinflation and undesirable real economy effects (which, in turn, feeds back into a further loss of credibility). It follows that financially weak central banks need to be capitalized in order to reestablish their policy credibility.5 Financial strengthening of the BCP would be a precondition for a successful transition toward an inflation-targeting regime.

Factors Determining Central Bank Capital: A Simple Analytical Framework

The minimum level of capital that allows a central bank to maintain a stable inflation rate depends on a number of factors (Table 5.1). These factors are related to the state of development of the financial system, a history of macroeconomic and financial system instability, general acceptance of the national currency as a means of payment, and the carrying costs for holding a desired stock of net international reserves.

Table 5.1.Baseline Scenario Assumptions for Projections of Central Bank Capital and Debt
(In percent)
Real GDP growth rateg3.0
Domestic real interest rater5.5
Foreign real interest rater*2.0
Country risk premiumρ3.5
Domestic inflationπ3.0
Foreign inflationπ*2.0
(In percent of GDP)
Initial Conditions:
Net international reservesnir18.0
Monetary basemb8.0
Nonremunerated foreign-currency liabilitiesfc3.3
Central bank operating costsoc0.35
Central bank capital (t0 = 2006)k-3.7
Central bank debt (t0 = 2006)-nda10.4
Source: IMF staff estimates.
Source: IMF staff estimates.
  • Net international reserves (NIR). Whenever the (domestic currency) value of the optimum stock of NIR exceeds the demand for currency, the central bank needs to mop up excess liquidity by issuing central bank debt, which is a source of losses. Hence, the higher the desirable ratio of NIR to currency issue, the more interest-earning central bank capital is needed.

  • Carrying costs. In most developing countries, the domestic interest rate paid on sterilization papers is higher than the interest rate received on NIR assets. This differential creates carrying costs of holding reserves that will rise with the spread of domestic over international interest rates. Assuming an open capital account, one might consider such carrying costs as arising from a risk premium on domestic currency debt that drives a wedge between international and domestic real interest rates.

  • External vulnerability. Exposure of the balance of payments to external shocks requires a higher buffer of NIR, giving rise to higher carrying costs.

  • Dollarization. This affects both the demand for currency and the optimum level of international reserves (see Leiderman, Maino and Parrado, 2006). Demand for domestic currency issue will fall with rising dollarization (and hence reduce the base for the inflation tax), whereas the precautionary level of NIR to cover foreign currency deposit liabilities in the economy will be higher. This drives up the desirable ratio of NIR to currency (and hence carrying costs).

  • Financial system fragility. Following a history of banking crises and macroeconomic instability, confidence in the financial system is likely to be shaky for quite some time even after successful stabilization and improvements in financial sector regulation. Again, this may require a relatively higher stock of NIR.

  • Operating costs. A higher share of central bank operating costs relative to the monetary base requires a higher level of (interest-generating) capital. Given the existence of economies of scale and externalities in central banking, operating costs, if measured in terms of GDP ratios, are typically higher in smaller countries.6

  • Desired level of inflation. The more ambitious (i.e., lower) the inflation target is, the more capital may be needed, given everything else (Figure 5.2). This is because a reduction in inflation tax would need to be replaced by genuine sources of income.7

  • Fundamentals of debt dynamics. Since capital is meant to provide a central bank with balance sheet stability in the context of a dynamic debt exercise, similar factors and assumptions determine the outcome as in conventional debt-sustainability analyses. These assumptions relate to (1) the expected growth rate of the economy and (2) domestic and foreign real interest rates, including the country risk premium.8

Figure 5.2.
Inflation Rate Needed to Maintain Constant the Initial Level of Central Bank Capital

(Baseline assumptions)

Source: IMF staff estimates and simulations.

Note: NIR= Net international reserves.

Even with stable policy objectives and behavioral parameters, central bank capital and debt can become highly unstable. Assume that the central bank’s policy objective is broadly related to (or at least consistent with) a certain stable ratio of the monetary base to GDP, international reserves and other foreign currency—denominated items also bear a stable GDP ratio. But central bank capital will be determined by profits and losses and is not bound by any GDP ratio.9 Therefore, central bank debt can explode within certain parameter ranges. If the central bank wishes to maintain a stable ratio of the monetary base to GDP in the face of shrinking capital, it will need to issue additional debt. But growing interest payments on central bank debt will accelerate the decay of its capital. As a result, central bank debt explodes, and capital will become infinitively negative unless the debt is inflated away through surprise inflation.10 A sufficient (though not necessary) condition for this outcome is that the domestic real interest rate exceeds the economy’s growth rate.11

Central Bank Debt and Capital Assuming No Action Is Taken

In this section, the framework introduced so far will be used to generate simulations of future capital paths for the Central Bank of Paraguay (BCP). For defining the initial conditions in this exercise, values were chosen such that they appear broadly in line with BCP data toward the end of 2006 (Table 5.1). Assumptions regarding future interest rates and growth rates in this baseline scenario are conservative (Figure 5.3 includes a number of the different scenarios).

Figure 5.3
Passive Long-Term Simulations for Central Bank Capital, 2006–99

(Percentage of GDP)

Source: IMF staff estimates and simulations.

In the mechanical baseline scenario BCP losses would accumulate, driving capital to minus 69 percent of GDP and central bank debt up to 75 percent of GDP by the end of the century. This would clearly not be a sustainable outcome. Most likely, a public debt crisis would erupt long before, or the BCP would need to resort to inflation tax on the monetary base to reduce its losses.

However, the dynamics could get considerably worse if the BCP continues to purchase net international reserves at a rate faster than GDP growth. Large purchases of foreign exchange are often undertaken to maintain a competitive exchange rate in the face of a strong balance of payments. Central bank debt then needs to be issued to sterilize the monetary impact and prevent inflationary pressures from rising. In the context of the baseline scenario, an increase in the NIR-to-GDP ratio to 25 percent over the next seven years would accelerate the explosion of debt, which would reach 178 percent of GDP by the end of the century.12

External shocks, interest rate hikes, or a rise in dollarization would also accelerate the explosion of central bank debt. The most interesting of these scenarios appears to be the case of rising dollarization, which would both erode the monetary base as a source of inflation tax and requires a higher NIR target to cover against potential foreign currency outflows from the banking system. It is likely that this scenario would be aggravated by negative second-order effects that could result in a vicious cycle: continued capital losses might favor an inflationary response, which leads to a rise in dollarization and a decay in the monetary base. This might, in turn, raise the country risk premium and the real interest rate, which could over time reduce investment and economic growth, accelerating capital losses and leading to more inflation. This scenario illustrates the need to address central bank losses early on.

The Amount of Capital Needed

Achieving a sustainable financial situation at low inflation may require a capitalization of the BCP. The steady-state version of the model produces a trade-off between more ambitious (that is, lower) inflation rates and higher levels of capital, if financial equilibrium of the central bank is to be sustained over time (Figure 5.2). 13

For the parameters chosen for the baseline scenario, this trade-off would imply constant capital at an inflation rate of 6.3 percent. At higher levels of international reserves (25 percent of GDP), the inflation tax needed to compensate for central bank losses would require permanent inflation on the order of 9½ percent. But these mechanic scenarios rest on optimistic assumptions on the external environment and on a stable money demand at comparatively high levels of inflation. It is rather more likely that the current level of negative capital cannot be financed over the long run through inflation tax without provoking deleterious knock-on effects.

To achieve an inflation rate comparable to industrial country levels, central bank capital would need to be raised substantially. According to the assumptions of the baseline scenario, a permanent inflation rate of 2 percent could require central bank capital as high as 10 percent of GDP. However, this scenario would not take into account the positive second-order effects that would arise from the credibility gains of a sustainable monetary policy framework. A sufficiently strong recapitalization would engender a virtuous cycle: risk premiums would fall over time, demand for domestic currency would pick up, dollarization would recede, and the optimal precautionary level of net international reserves would subside. All these factors would contribute to a substantial improvement of the central bank’s profit and loss account. By comparing different methodologies and benchmarks, a recent technical assistance report by the IMF concluded that an initial capital endowment of 2½ percent of GDP could be sufficient to maintain a sustainable capital base for the BCP. With an estimated negative initial BCP capital of 3.7 percent of GDP from the balance sheet, this would require a financial strengthening of the BCP through a capital injection on the order of 6¼ percent of GDP (IMF, 2006).

Policy Options for Financial Strengthening

Experience in various countries suggests that there are many different ways to strengthen financially a central bank.14 While the case for a fast and comprehensive recapitalization is unambiguous in economic terms, in reality the process often takes many years and is arduous and complicated. Given the political ramifications of a central bank recapitalization, this should not be surprising.

The economic case for an immediate recapitalization through a transfer of short-term bonds is clear-cut, as this measure involves zero fiscal costs for the public sector as a whole (including the central bank accounts). An undercapitalized central bank that pays interest on its domestic debt by issuing money or debt taxes the economy exactly in the same way as a Ministry of Finance that orders the printing press or issues debt titles. The shift of this debt to the treasury does not increase public debt by a cent, it just makes it more visible and enhances the transparency of the fiscal accounts. Moreover, a straight and fast recapitalization will lock in the credibility gains for the central bank’s monetary policies at an early stage. This should actually produce a fiscal dividend over the longer term, as equilibrium real interest rates consistent with expectations of low and stable inflation (including on public debt) will be lower. The immediate recapitalization approach provides the guidance and serves as a benchmark against which all other approaches would have to be measured.

But promoting a fast central bank recapitalization is a daunting task for policymakers. First, it opens up a Pandora’s Box of explaining the sources of the central bank’s capital shortfall. In many countries, these are related to bank bailouts in the midst of financial crises of the past that were caused by inadequate supervision and regulation. The obvious first question by the interested citizen tends to be, “Who stole all the money, and why do we now have to come up with it by tax payments on public debt?” Second, the transfer of interest payments on public debt from the central bank to the central government rectifies the reported budget numbers, but it enhances the central government’s “true” deficit. This is hard to explain in countries suffering from widespread poverty, because the interest paid on debt appears to compete with social expenditures. Third, there is often confusion between central bank assets and central bank capital. How can it be that a central bank that holds record amounts of international reserves is poor? (Ironically, it is in many cases precisely the accumulation of international reserves that exacerbates central bank losses.) On the other hand, the costs of not solving the problem appear very abstract and indirect: higher inflation and high real interest rates can always easily be blamed on other factors not under the control of the politician who speaks.

To take on such a thorny debate requires not only vision but also political courage. It is therefore no wonder that the fast solution favored by economic engineering has not always been followed. In some countries (for example, Chile), more gradualist strategies were adopted, and they can also succeed whenever they are bolstered by long-term policy commitment and huge fiscal surpluses. The remainder of this section presents both the benchmark approach of a fast recapitalization and a more gradualist strategy designed by the Paraguayan authorities.

Recapitalization through Transfer of Short-Term Treasury Bills

The most straightforward way to implement a recapitalization is a transfer of short-term central government treasury bills at market value to the central bank. The infusion of assets will lift capital as the residual in the balance sheet, and the immediate receipt of income through interest paid by the treasury will eliminate losses. What is more, the use of short-term treasury bills that are renewable on a rollover basis reestablishes the central bank’s control over the structure of its balance sheet, as treasury bills can be used short term for monetary policy operations and in the medium term to retire sterilization bills from the market.15

The retirement of sterilization bills and their replacement by treasury bills has several advantages. First, the burden of servicing the interest would directly fall on the treasury, which is a transparent way of informing about the “true” size of public debt. Second, it would give a clear signal that the costs of monetary policy operations are ultimately to be borne by the treasury. Given the identical nature of such papers (in particular if the central bank, as banker of the government, guarantees the redemption and rollover of short-term treasury bills), the interest paid on treasury bills should be identical to the interest paid on sterilization bills of the same maturities and characteristics, so there should be no fiscal extra costs.

This assumption is not always borne out by reality. Market imperfections and local idiosyncrasies (as well as differential tax treatment) may induce an interest differential between treasury bills and sterilization bills. Arguably, a gradual and hands-on strategy of “testing the waters” by offering and introducing treasury bills alongside sterilization bills, in a continuously increasing amount, may be the preferable venue for the central bank to pursue.

To preserve financial soundness of the central bank, a recapitalization should be complemented by the introduction of rules for the retention and distribution of central bank profits and losses to the treasury. Unexpected losses, owing to monetary operations or to revaluations of the exchange rate, would ideally be covered by a rather automatic compensation mechanism (which could, for example, be defined in terms of a target central bank capital—to-GDP ratio that is considered a prudent buffer). The reassurance to the treasury (and its potential boon) is that the risk is one-sided: if central bank capital is too low, treasury would have to face the bill anyway. However, if it turns out to be too high, the excess profits of central bank operations will be automatically transferred to the budget.16

The Idiosyncratic Solution: Shoring up Central Bank Income

Transferring assets and liabilities from one public entity to the other may seem trivial in economic terms, but it can entail substantial political and legal difficulties. To overcome such constraints, technicians at the Ministry of Finance and the central bank in 2007 devised a homegrown alternative strategy for financial strengthening of the BCP that would broadly achieve the objectives of the benchmark approach, but would respond better to constraints as seen at the time. It consists of the following elements:

  • Step 1: Shore up central bank income by a permanent guarantee to cover losses up to 0.5 percent of GDP by transfers from the central government budget.

  • Step 2: Quickly regularize claims between the central bank and the Ministry of Finance that are uncontroversial and not subject to legal dispute.

  • Step 3: Get cooperation between the central bank and Ministry of Finance to obtain with the judicial system the quantification and resolution of disputed claims.

  • Step 4: Once legal clarification has been obtained, write off nonperforming assets from the central bank balance sheet and recapitalize the central bank with bonds, in a magnitude that responds to the country’s needs and prospects.

A permanent income support guarantee of up to 0.5 percent of GDP would indeed give the BCP breathing space and shore up its financial situation until the legal status of the claims within the public sector is revised. But it would not obviate the need to make up with a bonds transfer for any shortfall remaining after legal clarification, because the income support would only prevent a further deterioration of central bank capital rather than fix the problem. A further disadvantage of the approach is that central bank debt would continue ballooning in real and nominal terms.17

Concluding Remarks

The advantage of a quick transfer of bonds to the central bank is that it is inherently forward looking. It is informed by what the central bank needs to successfully implement monetary policies for the long-term future. The “idiosyncratic approach” appears attractive in political terms, as it delays the recognition of interest paid on public debt in the budget. But it relies on a legal process that is backward looking, and that may hold up the fourth step that would finally resolve the underlying economic problem of the central bank’s financial weakness. This legal uncertainty translates into ongoing distrust regarding the central bank’s capacity to pursue the monetary policies that are best for the country. To strengthen the idiosyncratic approach, one could reverse steps 4 to 1, and it would actually resemble the quick benchmark approach of bond transfers.

The problem of negative central bank capital is economic in nature. It cannot be defined away by shifting legal definitions as to what does and what does not constitute public debt. Because the central bank cannot properly perform its functions under impaired financial conditions, its situation needs to be rectified quickly, for the benefit of the country. The economic nature of the problem also implies that the approach to fix it must be forward looking rather than backward looking. Certainly, Paraguay’s arduous transition from an authoritarian regime to democracy, which includes the pain of a series of financial crises, has left many accounts from the past that need to be settled. But this institution is too valuable for the country to be damaged by being held hostage to the legal resolution of claims and losses from the past.

Appendix 5.1: Dynamics of Central Bank Capital

Balance Sheet Identity of the Central Bank:

where (nda) = “net domestic assets” = interest-bearing domestic assets minus interest-yielding domestic liabilities; nir = net international reserves; k = central bank capital; mb = monetary base = currency issued plus non-interest-bearing domestic currency liabilities of the central bank; and fc = non-interest-bearing foreign currency liabilities of the central bank; all variables are expressed as share of GDP).

Central Bank Profit Equation in Real Terms:

where θ = real central bank profits as share of GDP; r* = real foreign interest rate; r = real domestic interest rate; π = domestic inflation; and oc = central bank operating costs as share of GDP.

Dynamic Path of Central Bank Capital (Equations (1), (1a) in main text):

where k-1 = central bank capital of the previous period; and g = real GDP growth rate.

where ρ = risk premium on domestic currency assets.

Substituting (A-4) for r* and (A-1) for nda in (A-3) yields

Setting k = k-1 =k(s) and solving for k(s) or for π transforms (A-5) in

Steady State Conditions (Equations (2), (2a) in main text):

6 Restructuring the National Development Bank

Luís Duran-Downing and Santiago Peña1

The National Development Bank (Banco Nacional de Fomento, BNF) has experienced a successful reform process, passing from being a systemic risk institution within the Paraguayan financial sector to an institution of financial soundness. The experience of the BNF suggests that reforming development banks is feasible and that the cost of this reform could be limited. It also highlights that financial performance and efficiency of development banks could be greatly improved if certain preconditions exist to facilitate their rehabilitation. Keys among these are large intermediation spreads, market confidence, effective demand for financial services, and commitment to profitability and sustainability of operations from the bank’s Board of Directors. Although several attempts to reform the BNF were made in the past, it was only by mid-2003 that a new administration embarked on an unorthodox plan to improve the financial situation of the bank.

This chapter examines the conditions that led to the BNF’s troubles, the reforms implemented during 2003–07, the process of recovery of its financial position, and the challenges ahead for the bank to continue in a sustainable position. The first section presents background material about the BNF, and the next section describes the process of deterioration of its financial position, resulting from ineffective financial incentives and lack of sound credit practices in the concession of loans. The following sections present the international experience in reforming development banks, an overview of the previous attempts to reform the bank, and the administrative and financial measures implemented since 2003 to restore the financial soundness of the bank. The last section draws conclusions about the BNF process and outlines the challenges for the future.


The state-owned BNF was established on March 14, 1961, through Law-Decree 281/61, with the objective to promote agriculture, industrial, and commercial activities. Although the BNF, in principle, is subject to the same prudential regulations applied to private banks, it is governed by its own charter (Ley Orgánica) and is excluded from the banking resolution law (Law 2334/03).2

According to its own charter, the bank is divided into three business areas: an agricultural department, a commercial department. and a development banking department. All three areas have their own capital endowment and maintain separate accounting that resembles three different funds. However, they are supported by the same administrative and operational infrastructure. The BNF’s obligations are guaranteed by the Paraguayan state in full, and its charter prescribes that losses from the agricultural department will be absorbed by the government, through the Ministry of Finance.

After more than 45 years of operations, the BNF is the country’s fifth largest bank, with 10 percent of the total assets and deposits in the banking sector at the end of 2007. Moreover, the BNF has by far the largest branch network with 49 branch offices throughout the country in addition to its headquarters in Asunción. The bank employs more than 1,000 persons, which is about one-third of all employees in the domestic banking system. The bank is also the fifth largest lender to the agricultural sector, with a market share of about 10 percent (Figure 6.1 and Table 6.1).

Figure 6.1.
Branch Network of BNF

Source: Banco Nacional de Fomento (BNF).

Table 6.1.BNF Size Compared to the Banking Sector as of December 2007
BanksBranchesStaffTotal AssetsShare in

DepositsShare in

(Number)(Number)(G Million)(Percent)(G Million)(Percent)
Total banking system1573,40621,861,093100.017,661,893100.0
National Development Bank (BNF)491,0061,864,7008.51,573,3338.9
Private Banks1082,40019,996,39291.516,088,56091.1
Foreign-owned banks166326,206,93428.45,026,37428.5
Citibank N.A.1651,300,2535.9908,5385.1
HSBC Bank Paraguay S.A.52001,222,7555.61,087,6626.2
ABN AMRO BANK62352,578,80211.82,050,22511.8
Banco Do Brasil S.A.160762,1473.5687,0993.9
Banco de la Nación Argentina372342,9771.6292,8511.7
Majority-owned foreign banks428928,598,80839.36,720,18838.0
Interbanco S.A.164103,332,29415.22,560,57914.5
Sudameris Bank S.A.E.C.A.81891,233,1415.6908,9195.1
Banco Bilbao Viscaya Argentaria Paraguay S.A.91683,217,14814.72,566,86114.5
Banco Integración S.A.9125816,2243.7683,8303.9
Domestic-owned private banks508765,190,65023.74,341,99724.8
Banco Regional S.A.202901,783,4568.21,469,2988.3
Banco Amambay S.A.5133696,4143.2601,0163.4
Banco Continental S.A.E.C.A.254532,710,78012.42,271,68412.9
Source: Statistical Report of the Superintendency of Banks, December 2007.
Source: Statistical Report of the Superintendency of Banks, December 2007.

Evolution of the Bank During 1995–2002

The BNF experienced a rapid deterioration of its balance sheet during the period from 1995 to 2002, which in part was caused by contagion from the financial crisis experienced in Paraguay during the same period (Chapter 3). The deterioration of the BNF’s balance sheet also reflected institutional problems.

During the 1995–2002 period, nonperforming loans (NPLs) increased from 12 percent of the total loan portfolio to 56 percent. Many of these NPLS had a political motivation (Figure 6.2). The bank also experienced excess liquidity because of significant deposits from social security funds and the central administration (about 93 percent of total deposits at the BNF in December 2002). Liquid assets were 77 percent of total assets, compared with 50 percent for the rest of Paraguayan commercial banks. One of the main problems was the staffing structure of the bank. Although the BNF’s main activity is lending, loan officers accounted for only 6 percent of the total staff by 2002, even though the BNF’s ratio of personnel to loan portfolio was at least twice as large as the banking sector’s average. with the branches employing on average fewer than eight persons per location, the overstaffing problem was concentrated at the bank’s office in Asunción. With just 35 percent of the loan portfolio, the Asunción office employed about 60 percent of the total staff by 2002.3

Figure 6.2.
Evolution of Nonperforming Loans During the Period 1995–2002

(Percent of total loans)

Source: Banco Nacional de Fomento.

A substantial share of the BNF’s institutional problems was also attributable to serious shortcomings in its corporate governance. Since the early 1990s, the BNF was managed by a board (Consejo de Administración) consisting of a president, seven directors, and seven assistant directors, which included representatives of the Ministry of Finance, the Ministry of Agriculture, the Ministry of Industry, and the Central Bank of Paraguay, as well as representatives from the agricultural, industrial, and livestock industries. No technical requirements or prudential limits on financial decisions were set for board members in the BNF’s charter. As a result, the board has traditionally been very accommodative to political pressures, resulting in disregard for sound financial practices or technical considerations. An important share of NPL cases were granted by the BNF’s directors, overriding the previously negative assessments made by appraising loan officers.

With rising NPLs, the capital adequacy ratio became negative at the end of the 1990s, and it reached –7½ percent by 2002 (measured by international standards). In terms of profitability, the three business lines had deteriorated substantially since the mid 1990s, but surprisingly the losses were smaller in the agricultural department. The losses of each business line as of 2002 were estimated at about 30 percent for development finance, 20 percent for commercial, and 10 percent in agriculture. This lack of profitability was primarily due to a high cost structure, low interest rates charged on loans, and the very poor quality of the loan portfolio.

International Experience in Restructuring Public Banks

There have been different approaches taken by countries in solving serious problems with public banks. Successful public bank restructurings have applied prompt corrective actions and a comprehensive approach addressing both balance sheet (stock) and income statement (flow) problems of insolvent public banks. It has also involved addressing weaknesses in accounting, legal, regulatory, and supervisory frameworks. International experience also suggests, strongly, that operational restructuring has been a necessary condition for banks to be successfully restructured and to return to profitability and sustained solvency. Management deficiencies have been identified as one of the main causes of banks’ problems, and progress in banks’ restructuring has been highly correlated with the resolution of the management issue.

Permanent improvements in a bank’s financial position require regaining solvency and profitability. Stock problems have been mainly addressed by financial restructuring operations, whereas profitability problems have been addressed mainly by operational restructuring measures. In general, banks with large holdings of nonperforming assets have high provisioning costs and low earnings that reduce capital. Therefore, a corrective action for stock problems requires reductions in nonperforming loans and, ultimately, increases in capital. Unless improvements in the income position of a bank occur, the need for future restructuring will be latent. Reducing expenses and increasing levels of interest income will enable banks to increase capital and improve their viability. Interestingly, international evidence suggests that countries have been more successful in solving the solvency (stock) problems than in solving the profitability (flow) ones. Whereas the former may be addressed quickly, for instance, by swapping bonds for nonperforming loans, the latter usually require addressing operational and management deficiencies that are more difficult to implement and take more time. Also, the design of restructuring packages has been biased toward addressing financial restructuring at the expense of operational restructuring.

Public bank restructuring has taken different forms in different countries. Successful restructuring processes have involved substantial operational and financial restructuring even in cases that led to privatizations. Usually government intervention (including recapitalization) has been linked to the operational part of the restructuring. When privatization was considered, the sale of shares to strategic investors yielded the best outcomes. In some cases privatization was postponed, and in the interim, steps were taken to strengthen governance and put banks on a more commercial footing.

Particularly successful cases of public banks’ restructuring include those of India, Peru, and Poland.

  • In India, in the early 1990s the system was dominated by public banks. The strategy was to gradually reform public banks, without privatization, while increasing competition in the system. The restructuring of public banks included the injection of public funds; significant tightening of prudential standards; increased competition by liberalizing entry rules; and substantial operational savings by staff reduction and branch closures.

  • In Peru, after the hyperinflation of late 1980s, the public banks were in severe distress. Most public banks were liquidated except for COFIDE (Financial Corporation for Development). COFIDE’s role was completely redefined, and the bank received a mandate to act solely as a second-tier bank. It underwent a profound operational and management restructuring, including a drastic reduction of staff and closure of branches and offices. Currently, COFIDE is one of the largest and more solid financial institutions in Peru.

  • In Poland, the system was transformed from a monobank system to a largely privatized banking sector in less than 10 years. Most public banks underwent operational and management restructuring as well as recapitalization processes prior to privatization. However, the recapitalizations were contingent on asset quality review and development of sound restructuring strategies.

Previous Attempts to Reform the BNF

The government made at least two major attempts to restructure the BNF and other public financial institutions. The strategies included elements from international best practices, but the government failed to complete them because of lack of support from congress. First, the government submitted a draft law to congress in 2003 to provide limited budgetary support as a way to deal transitorily with serious problems in the capital adequacy and liquidity of the BNF, which concluded with the approval by congress of Law 2100/03. Second, the government embarked on a comprehensive reform of the financial public sector in 2004, which aimed at streamlining public banking by submitting legislation to congress, with a view to restructuring public banking into two tiers. The bill to reform the deposit taking or first-tier financial institutions, including the BNF, was of systemic importance, given the implications in terms of moral hazard, the fact that they would take deposits from the public, and the possible fiscal impact.

Law 2100/03

Although Law 2100/03 attempted to reform the governance structure and balance sheet of the BNF by modifying its charter and establishing credit limits, congress in fact approved a substantially revised version of the law on April 20, 2003, leaving practically unchanged the highly politicized structure of the executive board (which has been a major issue), and authorized the BNF to write off practically all bad debts, capitalizing the bank with negotiable government instruments. The legislation also established credit ceilings, narrowing the focus of the BNF to the agricultural sector and authorizing the Ministry of Finance to liquidate nonperforming assets by contracting private assets managers.

More specifically, Law 2100/03 included the following features:

  • Focus. It narrowed the scope of activities of the bank to loans for the agricultural sector and medium-sized and small enterprises and the provision of banking services. It also limited loans to the equivalent of about US$14,500 for maturities of less than one year, US$43,800 for up to three years, and US$102,100 for more than five years.

  • Governance. It approved a corporate structure similar to the existing one of the Board of Directors, but it eliminated the representative from the industrial sector. The new structure included a president and representatives from (1) the Ministries of Finance, Agriculture, and Industry and Commerce; (2) the central bank; (3) the agricultural sector; and (4) the livestock sector.

  • NPL. It authorized the transfer of a nonperforming portfolio (in categories 4 and 5) to the Ministry of Finance, in exchange for negotiable and transferable government bonds of up to about US$50 million (G 340 billion) with 15 years’ maturity, including 3 years of grace, and 12 percent interest. The Ministry of Finance was to liquidate the portfolio received from the bank either through auctions or through the creation of a trust fund for that purpose.

  • Capital. It provided for the capitalization of certain liabilities of the bank with the government, amounting to about US$12 million (G 80 billion).

  • Offset. It authorized compensation for the losses of the Agricultural Department of the bank on loans made on behalf of the government amounting to US$7 million (G 48 billion).

Even though Law 2100/03 called for the transfer of the nonperforming portfolio to the Ministry of Finance, in exchange for negotiable and transferable government bonds, the new administration decided not to carry out this exercise and instead the BNF opted to manage the liquidation of these assets.

In October of 2004, congress approved Law 2502, which broadened the scope of the BNF and greatly increased the credit limits established by Law 2100/03. Pressures to ensure credit availability for the upcoming harvest helped to garner support for this law, undermining the government’s reform efforts. Along with broadening the scope of BNF operations, the new law gave the BNF the monopoly for public sector foreign exchange transactions (something that was later reverted), and increased its credit limits.4 The law also excluded the BNF from the application of Law 2334 on deposit guarantees and liquidation of financial institutions. However, the BNF continued to be subject to the prudential rules and limits applied to financial system institutions in general.

Alternative Public Banking Sector Reform Strategy

The government sent to congress legislation to reform the public banking sector in early 2004. The legislation aimed at (1) consolidating several public lending institutions into a retail bank for micro enterprises and small farmers, and (2) creating a second-tier bank to on-lend resources from bilateral and multilateral development lenders through private banks.

This proposal to address simultaneously the problems of the first-tier (deposit-taking) and second-tier (non-deposit-taking) public banks through an encompassing piece of legislation proved politically difficult. In response to strong congressional opposition, the authorities adopted a two-stage approach to public banking reform.

The first stage involved the creation of a second-tier bank to intermediate external resources. A second-tier public banking law was submitted to congress in November 2004 under fast-track procedures and was approved by July 2005, resulting in the creation of the Financial Agency for Development (AFD).

The second stage involved a phased restructuring of first-tier public banks, in particular the BNF. After months of negotiations between legislators and the executive branch, on May 4, 2006, congress approved Law 2912/2006 that “reforms the first-tier public banks,” introducing substantial modifications to the original draft law prepared by the executive branch, making it extremely expensive to reform the public bank.5 On May 23, 2006, the executive branch issued Decree 7608 vetoing Law 2912/2006, arguing that the approved legislation was not the most appropriate and convenient for the public bank.

Restoring the BNF’s Financial Soundness

A new management team took over the BNF in June 2003 with the objective of restructuring the bank and restoring its financial soundness in line with Law 2100/03. This new management team embarked on a process of reforms, which proved to be successful but departed from the international experience in reforming public banks. This unorthodox process of reforms, which included administrative and financial measures, was based on tailor-made actions specifically designed to address problems and bottlenecks encountered at the BNF. Furthermore, in this process the new team took the decision to avoid any fiscal cost for the government, even though Law 2100/03 provided the legal support for the Ministry of Finance to recapitalize the bank through the transfer of BNF nonperforming loans classified in categories 4 and 5 (doubtful and lost loans) to the government in exchange for negotiable and transferable government bonds.

This unorthodox reform process was based on two pillars: first, administrative measures taken to improve the internal operations of the bank and increase the efficiency and productivity of its operations; and second, the financial strategy implemented to increase profitability and strengthen the financial position of the bank.

Administrative Measures

The new administration adopted comprehensive managerial measures to improve the BNF’s operations and the quality of the service by reducing substantially the cost structure of the bank. These measures included

  • Merging. In July 2003, the BNF’s board decided to merge two branches located in the interior of the country (Iturbe and Villarica) and to convert four branches into operational funds (Itacurubi de la Cordillera, Fulgencio Yegros, San Pedro del Parana, and La Colmena), reducing the number branches from 54 to 49. The merging of branches aimed at increasing productivity, taking into account the lack of demand for financial services in certain rural areas. The conversion of branches into operational funds reduced substantially the cost of the bank as they offered limited financial operations to the public and subsequently required fewer personnel (Table 6.2).6

  • Restructuring. The new administration also approved in September 2003 an organizational restructuring of the bank aiming at reducing the number of departments and improving its managerial and reporting structure (Figures 6.A.1 and 6.A.2 in Appendix 6.1). The new organizational structure was designed to be modern, vigorous, and client-oriented in order to satisfy the needs of the market in an efficient way and at a lower cost. A key measure taken within this initiative was the creation of the Risk Department, which was given the role of collecting bad loans before they were sent to the judiciary. This initiative proved to be cost effective as it increased loan recovery and reduced legal costs. The Board of Administration also approved a new set of administrative manuals for each department. This overhaul made internal operations and reporting more efficient, reducing the bureaucratic structure and improving the quality of the service provided to the public.

  • Downsizing. With the objective of strengthening its human resources policy, the BNF hired a specialized consulting firm to determine the profile, professional level, and motivation of the BNF’s staff. Based on this study, the new administration of the bank implemented a plan to rationalize and reduce the number of employees by implementing a voluntary retirement program. Similarly, the board took the decision to terminate short-term contracts with employees and to dismiss employees following the results of administrative investigations for wrongdoing. During the period 2003–06, the BNF reduced its staff by 120 employees (or about 10 percent of the total), bringing down the wage bill and improving the efficiency and productivity of the employees that continued working for the institution. The bank also implemented an ambitious training program to increase the proficiency of its staff and prepare them to perform in a more competitive working environment. Efforts to further reduce the staff of the bank continue and it is expected that more employees could join the voluntary retirement program in the future.

  • Security. The Board of Directors created a Security Division to oversee the information technology (IT) security and the physical security of the institution. The BNF made a large investment in upgrading its IT facilities. The new IT system also provided security mechanisms in all the operations of the bank’s registering, auditing, and accounting controls, thereby reducing the risk of wrongdoing by the staff.

  • Upgrading. The management of the bank took several measures designed to provide more client-oriented service. Limits were established for operations offered by the branches and the authorization to perform operations that were permitted only in the head office. In particular, the Board of Directors also approved strategic yearly plans, setting goals and objectives to be achieved by each branch and department. This tool made managers and staff in general aware of the need to improve the quality of service as they were under a continued performance control by the authorities of the bank.

Table 6.2.Rationalization of Human Resources
Source: Institutional Report June 2006 - BNF
Source: Institutional Report June 2006 - BNF

Financial Measures

The new administration took a more ambitious approach to improve the financial soundness of the bank than originally contemplated in Law 2100/03, which entitled the BNF to transfer its nonperforming loan portfolio to the Ministry of Finance. The new approach focused on reducing risky assets and strengthening asset recovery. In fact, these efforts proved to be extremely successful as they improved the financial position of the bank at no additional fiscal cost.

  • Reduction of NPLs. The reduction in nonperforming loans during the period from 2003 to 07 was the result of a combination of efforts (including the restructuring of the recovery process at the judiciary level) and the tightening of procedures to approve new loans (Figure 6.3). It is worth noting that the rate of nonperforming loans for credits disbursed by the new administration remained within the 1–3 percent range (compared with more than 50 percent for the BNF’s total portfolio). The Board of Directors also negotiated with debtors the reduction or, in some cases, the elimination of punitive interests charged on the nonperforming loan portfolio in order clear arrears.

  • Consumer credit to public sector employees. The Board of Directors made the decision to migrate from the traditional approach of development banking to the multiple banking formats by broadening its lending coverage to consumer credits, mainly to public servants who receive their salaries through the BNF payment system, in addition to the agricultural and industrial sectors (Table 6.3).7 This initiative resulted in high revenues to the bank and helped the bank to finance other sectors that were less profitable, including the manufacturing and agricultural sectors.

  • Management of the judiciary accounts.8 The BNF also reached an inter-institutional agreement with the Supreme Court of Justice to transfer all the judiciary accounts from the central bank to the BNF. The transfer of these funds to the BNF represented an additional funding of about G 100 billion (or about 10 percent of deposits as of December 2004), injecting liquidity to the bank and contributing to financing key production sectors of the economy.

  • Undistributed profits. The BNF registered profits in 2004 following many years of losses in the context of a deteriorated financial position. Every year since then, the bank has registered profits, which have been reinvested to absorb part of the losses generated by the nonperforming loans portfolio. This strategy was instrumental in preventing a fiscal cost to the government from the transfer of bad loans to the Ministry of Finance as envisaged in Law 2100/03.

  • Removal of interest subsidies. The new administration decided to eliminate subsidies, determining the interest rate charged as the sum of the cost of funding, the administrative cost, and a profit margin. In the past, the BNF adjusted the interest rate charged on loans, which used to be set without considering the cost of funding, generating, in most cases, losses with every loan disbursed.

  • Sale of collateral. In the context of the organizational restructuring of the bank, the Board of Directors also created a Real Estate Division to oversee matters related to assets received as collateral from bad loans. This division is in charge of the verification, control, and subsequent sale of assets through public auctions, assuring the best possible price.

  • Intensified loan recovery. The Board of Directors found that one of the main bottlenecks of loan recovery at the judiciary stage was the lack of commitment from external lawyers to perform their outmost effort, as they were receiving their compensation independently of the results at the judiciary stage. The new administration authorized the recently created Risk Department (together with the Internal Audit Department) to control and supervise the performance of external lawyers hired to represent the BNF at the judicial stage. These departments were also entitled to renegotiate and, in some cases, to terminate the contracts with external lawyers. These measures, among others, accelerated the loan recovery process at the judicial stage together with a reduction in the cost for lawyers.

  • Higher private sector deposits. The new administration worked exhaustively to improve the image of the bank within private depositors. This effort proved effective as private sector deposits increased from 30 percent of total deposits in 2002 to 52 percent of total deposits in 2007, despite the fact that the bank continued receiving substantial deposits from the publicly owned Social Security Institute (IPS).

Figure 6.3.
Evolution of Nonperforming Loans During the Period 2003–07

(Percent of total loans)

Source: Banco Nacional de Fomento.

Table 6.3.Financial Indicators for BNF1(In percent unless otherwise specified)
Capital adequacy
Capital-adequacy ratio (current legislation)12.011.725.027.932.235.5
Capital-adequacy ratio (international standards)-7.5-11.7-8.40.618.537.6
Asset quality
Non performing loans56.056.247.639.519.47.8
Provision/non performing loans41.047.745.547.433.276.9
Return on assets-4.7-
Return on equity-27.3-18.76.727.335.25.3
Liquidity and solvency
Liquid assets/deposits31.546.272.352.854.442.3
Liquid assets/liabilities20.236.659.849.650.034.5
Administrative costs
Personnel cost/administrative costs67.468.562.972.358.558.9
Administrative cost/deposits15.
Share of BNF’s credit
Commerce (wholesale)25.525.325.419.08.210.4
Sources: SIB, BNF, and IMF staff estimates.

End of period.

Sources: SIB, BNF, and IMF staff estimates.

End of period.

As a way to strengthen credibility, the government also requested the inclusion of a structural benchmark under the International Monetary Fund’s Stand-By Arrangement.9 The benchmark called for the increase of the capital adequacy ratio to 5 percent for end-June 2006 and 10 percent for end-December 2006 (under international standards). The government also made the commitment that any shortfall on these capital adequacy targets would be met by the Ministry of Finance and that it will maintain subsequently the capital of the BNF at a level sufficient to meet both the capital adequacy ratio of 10 percent as well as any other prudential requirements issued by the central bank. In fact, the balance sheet audited by external auditors (and monitored by the Superintendency of Banks), showed a capital adequacy ratio of 8½ percent in June 2006 (against a 5 percent target) and 18½ percent in December 2006 (against a 10 percent target), owing to high asset recovery and higher-than-expected undistributed profits.

Concluding Remarks

All in all, the financial situation of the BNF improved significantly during the 2003–07 period due to a continued strengthening in the bank’s management, enhanced credit practices, and greater emphasis on delinquent loan recovery, which led to higher profits, lower nonperforming loans, and an expansion in the deposit base. Although the capital adequacy ratio (CAR) was negative at the end- of 2004, it improved to 37½ percent by end-December 2007, eliminating the systemic risk generated by the BNF in the past (Figure 6.4).10

Figure 6.4.
Capital Adequacy Ratio

Sources: Super Intendencia de Bancos, Banco Nacional de Fomento, and IMF staff estimates.

Much has been accomplished, but further restructuring efforts are still needed. A milestone of the restructuring during the 2003–07 period has been to turn around the BNF’s capital from negative (technically bankrupt) to positive through improvements in its administration, which allowed for large profits and significant bad debt recoveries. The BNF’s capital adequacy ratio is currently above the minimum required by the Superintendency of Banks, but it is necessary to continue strengthening the BNF’s management to ensure that the bank remains viable over the medium term.

Although significant progress has been made, further efforts are needed to continue strengthening the bank’s financial position, reducing the vulnerability of the system, and minimizing its potentially systemic risk. To consolidate further the BNF’s financial position, and limit future political interference with the bank’s lending policies, the authorities developed a medium-term business strategy to continue to refocus its operations, reduce operating costs, increase asset recovery, improve credit and risk management practices, and enhance internal controls. Over the medium term, the bank should focus on further improving financial indicators by increasing the level of deposits and lending to the private sector. It should continue to reduce nonperforming loans and strengthen its lending policies, by implementing its strategic plan to further enhance efficiency.

Appendix 6.1: Modifications to the Organizational Chart of the BNF of 2003

Figure 6.A.1.
Organizational Chart Before the Reform

Source: BNF.

Figure 6.A.2.
Organizational Chart After the Reform

Source: BNF.


7 Inflation Determinants: Cost Push Versus Demand Pull Factors

Brieuc Monfort and Santiago Peña1

Paraguay evaded the bouts of hyperinflation that affected most countries in Latin America over the post-Second World War period, but, as inflation started to decline in neighboring countries, it remained afflicted with moderate inflation. In the region, only Paraguay and Colombia have never experienced three-digit inflation over the past 50 years. However, inflation in Paraguay over the past 10 years has been on average higher than in most other countries in the region, as if the experience of hyperinflation (and the institutional changes that resulted) had cured those countries even from moderate inflation.2

Over the recent past, inflation has also been highly volatile. The volatility reflects in part external factors related to the specific position of Paraguay as an exporter of primary commodities (subject to related supply shocks) located between two large neighbors, and exposed to the spillovers from regional financial crises. Paraguay has also been affected by the world increase of food and energy prices.3 Nonetheless, the domestic component to inflation volatility should not be underestimated. For example, in 2006–07 the sharp gyration of a few agricultural product prices led to yearlong decoupling between headline and core inflation that left the general public puzzled.

This chapter uses different methodologies to understand the dynamics of inflation since the early 1990s.4 An obvious starting point is to look at the structure of the consumer price index (CPI) published by the central bank (Banco Central de Paraguay, BCP) and at its different components. Given the high volatility of headline inflation, the rest of the chapter focuses on the determinants of core inflation indicators. Two different analytical points of view are used to assess the long-term determinants of inflation, before encompassing them to study the short-term dynamics of inflation. One approach is the markup theory of inflation, in which prices are modeled as a function of domestic costs and imported prices. In the other approach, inflation results from the deviation of real money demand from its long-term determinants. In particular, the chapter evaluates the impact of different monetary aggregates, from currency in circulation to broad money, to assess which is the most robust. All econometric models are estimated using quarterly data for 1991–2007.

The results suggest that monetary factors, in particular currency in circulation, have played a major role in determining long-run inflation, whereas foreign prices, in particular from Brazil, and some food products have had a large impact on the short-term dynamics of inflation. There is also an interesting dichotomy between the exchange rate with respect to the United States, which matters for currency demand in the long run, and the exchange rate with respect to Brazil, which matters for cost push inflation in the short run. The evolution of some food prices matters beyond their already large share in the CPI basket, possibly because wage indexation—or expectations of continued moderate inflation going forward—tends to lock up price increases.

The following sections discuss headline and core inflation indices and investigate the long-run determinants of inflation using, respectively, the analytical framework of the markup theory and of the monetary approach. Finally, this chapter presents the short-term inflation dynamics and concluding remarks.

Measuring Inflation

Having an accurate and reliable measure of inflation appropriate for monetary policy is far from straightforward. Headline inflation, measured by the CPI, is well known to present both some noise (owing to the impact of its most volatile components) and some bias (owing to substitution effects).5 This section presents the characteristics of headline inflation and discusses the use of alternative inflation indicators.

Headline Inflation6

During the period under study, headline inflation was volatile and influenced by countless supply shocks (mostly food and, to a lesser extent, energy items) that do not reflect aggregate demand pressures or imbalances in the money market.

Food items experienced significant supply shocks over 2007—08, contributing to overall inflation way beyond what would be expected from their share in the basket. Food items can be classified in three main components, each having its own dynamics independent of the others:

  • Fruits and vegetables. These represent 6¼ percent of the CPI basket (reduced to 5 percent in the new index). This is by far the most volatile component of the basket, with a coefficient of variation about five times larger than that of the index in general. Fresh food is naturally influenced by changing weather conditions, but political interference has played an important role since 2006.7 In particular, the wide variations in the price of tomatoes, which represent only about 1 percent of the CPI, could move year-on-year headline CPI by 2–3 percent.8 The wide fluctuations of tomato prices and their impact on headline CPI illustrate to the extreme the substitution bias of headline CPI.

  • Meat products. They represent 10¾ percent of the CPI basket (relatively unchanged in the new index). The category is largely dominated by beef products, which represent about four-fifths of meat products. The domestic price of meat has been influenced not just by the international price of beef but also by the impact of foot-and-mouth diseases (FMD), either at home or in neighboring competing producers.9 Beef prices contributed on average 2 percent to annual inflation between 2003 and 2006.

  • Other food items. They represent 18.4 percent of the basket (against 16.5 in the new basket). Historically, they have tended to evolve in line with non-food prices. Starting in mid-2007, however, milk and bread products have increased worldwide. These products represent about 8–10 percent of the basket and have increased by about 30 percent between June 2007 and June 2008. In the case of milk, the increase in the price responded more to a supply effect owing to a severe drought in the Chaco region of Argentina and Paraguay, affecting milk production.

Another source of supply shocks come from energy products, which represent about 3½ percent of the basket (increased to 5¾ percent in the new basket). Although the international price of oil was relatively stable in nominal terms for most of the 1990s, it fell in real terms, with a significant fall in 1997–98; since then the international price of oil has been on an upward trend. There is no government interference in the market for gasoline and natural gas, and their domestic prices follow closely international trends with a lag. However, the government tries to stabilize the domestic price of diesel, resulting in occasional subsidies. This adds an additional source of uncertainty because diesel prices tend to move in sharp steps. The impact of energy prices is also captured partly by administrated prices because of the role of oil as an input for public transport. Recently and until mid-2007, both energy and administrated prices contributed to lower headline inflation. Since then, administrated prices have increased in line with overall inflation, whereas fuel products increased by twice as much.

Figure 7.1 presents several indicators of inflation stance. An analytically interesting slicing of the CPI consists of distinguishing between tradable and nontradable goods. For clarity, we present tradable goods excluding fruits and vegetables (all tradable goods):

Figure 7.1.
Indicators of Inflation Stances

Source: Authors’ estimates.

  • Nontradable goods. During the first half of the sample, nontradable inflation tended to be consistently higher than average core inflation; this result stands for all categories of nontradable (administrated prices, education or health, other services). By contrast, since 2002, nontradable goods have been consistently lower, even if one excludes administrated prices.10 This may reflect the impact of lower real wages in the public sector since 2001, as evidenced by the lower inflation rate of education or health, but also more broadly a less inflationary environment, also reflected in the trend decline in unit labor costs.

  • Tradable goods. The spikes in inflation, in 1998, 2003, and 2006, are driven primarily by tradable goods. Paraguay experienced significant depreciation with respect to the U.S. dollar in 1998 and 2003. By contrast, in 2006, the depreciation with respect to the U.S. dollar was relatively mild (and following a period of appreciation), but the guaraní depreciated with respect to the Brazilian real. In addition, higher fuel prices seem to have contributed to this last episode of inflation.

Core Inflation Measures

Indices of core or underlying inflation allow abstracting from transitory factors and can be aimed at identifying the permanent component of inflation. The BCP produces two exclusion-based core inflation indicators: “CPIX,” which is headline inflation excluding fruits and vegetables, and “CPIX1,” which also excludes fuel items and products subject to administrated prices. In addition, we suggest two alternative indices of core inflation, a simple non-food inflation index and a trimmed index. The properties of the different core inflation indices are analyzed in the following subsection.

An alternative core inflation index could exclude all food and fuel products as is done in some advanced economies. Although food items can be considered beyond the control of monetary policy because they are driven mostly by supply shocks, such exclusion would appear radical, given that food represents between 35 percent and 40 percent of the CPI.

Finally, a core inflation indicator could be created with a trimmed index by excluding items according to their volatility in a given month rather than being related to a specific category of goods. A trimmed index excludes a fixed portion of the items with the largest decline and with the largest increase. Trimmed indices thus allow excluding a one-off large adjustment—for example, a spike in one item’s price because of supply disruptions. They tend to give a sense of the general direction of inflation. Trimmed indices with symmetric exclusion of the largest and the smallest changes tend to be systematically biased downward because of the tendency of prices to increase sharply but to moderate gradually (Silver, 2006). By contrast, asymmetric indices may reflect better the underlying inflationary trend. We constructed four different trimmed indicators, two excluding symmetrically 10 and 20 percent of the most volatile components, and two asymmetric indices excluding one-third that are the most volatile and two-thirds that are the least volatile.11

Properties of Inflation Indicators

The choice between different core inflation indices depends on their intended uses, that is, whether the index is used to identify current inflation trends, measure inflation produced by excess aggregate demand, or provide an indication of future inflation. To assess the properties of the core inflation indices discussed above, Table 7.1 presents a set of different indicators measuring the desirable properties of the core inflation indices:

Table 7.1.Properties of Inflation Indicators

(Year-on-year change over 1995–2007)1

StandardRMSE with Average over (months)2Attractor Property with Horizon of (months)3Granger Causality with Lags of (months)4
Symmetric trimmed index
At 10%*0.00*
At 20%*0.00*0.00*
Asymmetric trimmed index
At 10%*0.00*
At 20%*0.00*0.00*
Source: IMF staff estimates.

Detailed data for all items of the CPI are available only from Dececember 1994 onward, although the main categories have been backdated by the BCP up to 1992.

Root mean square error (RMSE) of inflation indicator with moving average inflation over 36 or 18 months.

Opposite of coefficient beta.

Probability of test rejecting the hypothesis that core inflation does not Granger-cause headline inflation.

Source: IMF staff estimates.

Detailed data for all items of the CPI are available only from Dececember 1994 onward, although the main categories have been backdated by the BCP up to 1992.

Root mean square error (RMSE) of inflation indicator with moving average inflation over 36 or 18 months.

Opposite of coefficient beta.

Probability of test rejecting the hypothesis that core inflation does not Granger-cause headline inflation.

  • Benchmark. The standard deviation measures the volatility of the index. Similarly, bias measures the deviation of the index from headline inflation. Although headline inflation may be more volatile than core inflation indices, it remains the most comprehensive index and as such is taken as the benchmark for calculating the bias.

  • Volatility. The root mean square error (RMSE) measures the deviation of the indices with the moving average (over 18 or 36 months) of headline inflation. This gives an idea whether the indices reflect medium-term inflation.

  • Attraction. By contrast, the measure of attraction proposed by Marques and others (2003) is more forward looking. It measures the coefficient of the regression of the difference of inflation h period ahead and current inflation with the difference between current headline and core values.12

  • Causality. Granger causality tests also provide some indications on the forward-looking properties of the core index. These tests indicate whether lagged values of core inflation have a predictive power for headline inflation. We do not report in the table the predictive power of headline inflation for the core index considered.

Over the sample period, all exclusion-based core indices show a slightly higher volatility than headline inflation. These indices are also biased downward, the bias being greater for the CPIX1 because of the significant larger increase of administrated prices and fuel prices compared with other prices.13 By contrast and as expected, trimmed mean indices show a much lower volatility but at the price of a significant bias for symmetric indices. The asymmetric index excluding only 10 percent of the items of the basket has both a lower volatility and a small (positive) bias.

Regarding which index offers a better proxy of average inflation over the medium term, non-food inflation and the asymmetric index at 10 percent have the lower RMSE for inflation measured as a moving average of 36 months. If the medium-term inflation is measured over a moving average of 18 months, only the asymmetric indices have significant lower RMSE.

Concerning the forecasting properties of the core inflation indices, the asymmetric indices also present the absolute value of the coefficient closer to unity. The symmetric indices tend to underestimate future headline inflation, whereas exclusion-based indices tend to overestimate future headline inflation and by more than the asymmetric index. Granger causality tests show that most variables tend to Granger-cause headline inflation at longer horizons (three to six months), with the exception of CPIX1 and non-food inflation.

To summarize, this section shows that an asymmetric trimmed index, preferably with a lower cutoff (of 10 percent of the basket) could usefully complement the core inflation indicators currently used by the BCP. Of the exclusion-based core indices used by the BCP, CPIX presents better statistical properties than the narrower CPIX1. By contrast, non-food inflation tends to be a relatively poorer core inflation index, because it tends to present higher volatility, a larger bias than CPIX, or has less predictive power for future inflation at large horizon.14, 15

Analytical and Empirical Setup

This section presents the analytical and empirical framework used to assess the determinants of inflation. The determinants of inflation are based on two different theoretical frameworks: (1) the markup theory of inflation and (2) the monetary theory of inflation. Given that most variables are nonstationary, the relevant equations are estimated using cointegration techniques.

Inflation as a Markup over Costs

In the markup theory of inflation, domestic consumer prices (P) are assumed to be a markup over total producer’s costs. Domestic costs are measured by the unit labor costs (ULC) and other domestic inputs (Pa), such as fuel or administrative prices, whereas external costs are proxied by the prices of different trade partners (Pm). This relationship can be written as:

where eμ–1 is the markup of consumer prices over producer’s costs. The basic model can be expressed in log-linear form with lowercase letters denoting the logarithm of the variable:

If the restriction α + β + γ = 1 (linear homogeneity) is accepted, prices are a weighted average of unit labor cost, other domestic inputs, and foreign prices. Including fuel and administrated prices as separate cost factors allow us to measure both their direct (via their components in the CPI basket) and indirect effect (via the spillover of, say, a fuel shock to other prices).16

Inflation as the Result of Excess Money Supply

In the monetary theory of inflation, inflation is driven by excess money supply over money demand. The equilibrium in the money market entails that real money supply (M/P)s equals real money demand (M/P)d.

This equilibrium condition can be written in log-linear form:

where ms is the log of money supply, p the log of the price level, and the demand for real money balances, md, is a positive function of the log of real income, y, and a negative function of the opportunity cost of holding money, i. Real income captures the transaction motive for holding money, while the opportunity cost captures some portfolio arbitrage effect (precautionary and speculative motives).

Assuming that money demand is linear in its determinants and normalizing for the coefficient of price, the testable long-run money demand relation derived from equation (2) has the following form:

where vt is a constant (vt = v0) or a constant and a trend (vt = v1t + v0) if the specification incorporates the effect of long-run parameter shifts. A number of restrictions can be tested on the functional form of the money demand relationship:

  • Money illusion. The case where mt and pt are cointegrated with β1 = 1 implies long-run price homogeneity: money and prices are moving together in the long run (i.e., no money illusion).

  • Constant velocity. The case where money, prices, and income are cointegrated with β1=–β2=1 and vt is a constant implies that the money velocity is stationary: this implies common movements of money, prices, and income (i.e., no money illusion and unitary income elasticity in money demand). In this case, the resulting model is comparable to the quantitative theory of money, augmented by a term for opportunity cost.

Econometric Methodology

As the variables of interest are nonstationary,17 we use cointegration techniques for the estimation. The cointegrated Vector Auto Regression VAR approach (or Vector Error Correction Model VECM) of Johansen (1991)18 allows us to determine the existence and number of cointegration relations, distinguishing between stochastic trends and cointegration relationships. It also allows encompassing both the long-run and the short-term dynamics. However, the estimated coefficients may be unstable in small samples. To check the robustness of the coefficients, we also use the Dynamic Ordinary Least Squares (DOLS) methodology of Stock and Watson (1993). The DOLS methodology gives consistent estimates of the coefficient of a cointegration relation but, unlike the Johansen procedure, it does not test the existence of a cointegration relation.

In the short run, prices are influenced by the deviation from the long-run equilibrium and by short-term shocks. The long-run relations are provided by equations (1) and (3) above. The short-run equation is the following:

where xt is the vector of endogenous variables and vt is a vector capturing the short-run or long-run constants or trends. A lag structure of k = 2 implies a single term in the difference for the short-term dynamics. The long-run error-correction relation is given by β’ xt-1, while α represents the loading coefficient to the cointegrating vector, which gives an idea of the speed of adjustment following a deviation from the equilibrium relation. In addition to the endogenous variables, the short-run dynamics may also be influenced by some exogenous variables (not represented in equation (3) above). If weak exogeneity of other variables beyond prices holds, the dynamics of inflation can be estimated in a simple univariate setting mixing variables in differences with the long-term cointegrating relationship.

The loading coefficient is particularly important for stability. Assuming that the coefficient of price is normalized to 1 in the cointegration vector, a negative and significant loading coefficient α in the short-term price dynamics means that the relation can be interpreted as an error-correction relation: a deviation of price from its long-run relation in a given period leads to a contraction of prices in the following period and thus to a return to the long-term value. By contrast, a positive coefficient means that the dynamics of inflation is explosive and that deviations from the long-term relation are self-reinforcing.

The model is estimated on quarterly data over 1991Q1 to 2007Q3 using a two-stage estimation strategy. The two long-run relationships (2) and (5) are estimated independently in a cointegrating setting before being combined to study the short-term dynamics. This two-step approach has been successfully adopted in other countries.19 Although less efficient from the econometric point of view, this approach allows us to find estimates closer to the theoretical assumptions.

Markup Theory of Inflation

A summary of the results for the markup equation is presented in Tables 7.2 and 7.3 (Appendix Table 7.A.6.2 reports the full detail of the regression as well as alternative modeling). The results are reported with a lag structure of three quarters for the VAR, although we tested the robustness of the results with different lag structures.20 Results for different inflation indices are presented in Appendix 7.6. In the preferred setup presented below, inflation is measured by the core inflation index CPIX1.

Table 7.2.Summary Results of the Markup Model
UnrestrictedRestrictedDynamic Ordinary Least Squares
Cointegrating vector1
CPI Brazil-0.24*-0.22*0.14*
Loading coefficient0.050.05
Probability of restriction0.63
Source: IMF staff estimates.

The coefficient of price (CPIX1) is normalized to -1.

Denotes significance at the 5 percent level.

Source: IMF staff estimates.

The coefficient of price (CPIX1) is normalized to -1.

Denotes significance at the 5 percent level.

Table 7.3.Short-term Dynamics1
Loading Coefficient

CPI Brazil0.17-0.100.38
Source: IMF staff estimates.

With cointegrating vector: CPIX1-0.88 ULC -0.22 CPI Brazil.

Source: IMF staff estimates.

With cointegrating vector: CPIX1-0.88 ULC -0.22 CPI Brazil.

Table 7.A.6.2.Markup Model of Inflation1
Alternative choice of exchange rate
Prefered Equation2Additional Cost FactorsU.S.Argentina and Arg.

Administered and

Administered and Fuel5NEERG/US$CPICPICPICoreCore3HeadlineCore


Cointegrating vector
Exchange rate0.54-0.07-0.01
CPI Brazil0.24***0.22***0.14***0.25***0.20***0.14***0.19***0.14***-2.04***0.25***0.20***0.33***0.83***0.44***
CPI Argentina0.19-
Oil prices-0.04-0.05
Administered prices-0.18-0.12*
Loading coefficient0.*0.060.07*0.05-0.01***0.17***0.01-0.07**-0.01**0.08**0.090.07**0.01*0.04
Log likelihood458.1458.0528.3579.6617.8747.6627.2480.7502.5502.9500.2613.0461.6458.5444.2445.0437.4
Akaike Information
Criteria criteria-13.3-13.3-14.7-16.4-17.6-20.7-17.9-14.1-14.7-14.7-14.6-17.4-13.4-13.3-12.9-12.9-12.6
Schwarz criteria-12.0-12.0-12.6-14.2-15.4-17.5-15.7-12.9-13.4-13.4-13.3-15.3-12.1-12.0-11.5-11.6-11.3
Lag structure33333223333333333
Cointegration rank
Prob. of LR test
on restriction0.630.010.00
Source: IMF staff estimates.Note: *, **, and ***denote statistical significance at the 10, 5, and 1 percent level, respectively.

For simplicity, in the long-run relation, the coefficient reported are consistent with a normalization of price to -1. By contrast, for the loading coefficient of the price equation, the coefficient is consistent with a normalization to 1 (hence a negative loading coefficient is expected).

Prefered equation: CPIX1 with or without price homogeneity restriction on ULC and exchange rate.

With constraint of linear homogeneity.

International oil price.

Domestic fuel component.

Source: IMF staff estimates.Note: *, **, and ***denote statistical significance at the 10, 5, and 1 percent level, respectively.

For simplicity, in the long-run relation, the coefficient reported are consistent with a normalization of price to -1. By contrast, for the loading coefficient of the price equation, the coefficient is consistent with a normalization to 1 (hence a negative loading coefficient is expected).

Prefered equation: CPIX1 with or without price homogeneity restriction on ULC and exchange rate.

With constraint of linear homogeneity.

International oil price.

Domestic fuel component.

Unit labor cost (ULC) is strongly significant and it is the main determinant of domestic prices. The value of the coefficient is rather stable in different specifications (between 0.75 and 0.9) and robust to different assumptions regarding the lag structure of the VECM (or to the inclusion of other variables). However, the coefficient of the ULC is on the high side compared with other studies.21

To proxy imported inflation, we use the exchange rates of the main trading partners (United States, Brazil, Argentina), with or without correction for inflation. Consumer prices in Brazil are found to influence inflation in Paraguay more than any other indicator of imported inflation. The U.S. dollar exchange rate is not significant, nor is the nominal effective exchange rate. By contrast, the Brazilian CPI is significant, and its coefficient is stable around ¼-–¼. The nonsignificance of the U.S. dollar exchange rate is somewhat surprising, given the high pass-through coefficient from exchange rate to price found in a VAR in difference. The significance of the Brazilian CPI rather than the Argentine CPI can be explained by the relatively larger share of imports coming from Brazil and the higher level of economic integration with Brazil, especially in the eastern part of the country (Figure 7.2).22

Figure 7.2.
Core Inflation and Import Shares

Source: IMF staff estimates.

By contrast, we fail to find a significant impact for oil and administrated prices. The lack of significance of these variables is surprising but robust to different modeling assumptions.23

The linear homogeneity restriction is accepted for our baseline model. In particular, the equation suggests that about 80 percent of core inflation (CPIX1) can be explained by the growth in labor costs (ULC), whereas the remaining 20 percent can be explained by imported inflation from Brazil (CPI Brazil). However, the model is somehow sensitive to the choice of inflation indicator for the dependent variable. When the model is estimated using core tradable prices (instead of core prices), the coefficient of Brazilian CPI has the same weight as ULC, around 0.8 (in this specification the constraint of price homogeneity is rejected). The model using Brazilian CPI and ULC as the explanatory variable performed worst when the dependent variable was CPIX rather than CPIX1: the homogeneity constraint is accepted with CPIX1 at a high significance level but not with CPIX. Estimating the model with DOLS tends to give an even lower coefficient for Brazilian inflation, at 0.14.

However, the model performs poorly as an error-correction mechanism (ECM) for prices and explains less than half of the short-term dynamics of inflation. The loading coefficient of the cointegrating vector in the short-term dynamics of prices is usually not significant (or significant with the wrong sign), which means that deviations from long-term determinants of consumer prices have little influence on prices in the short term. By contrast, the coefficient is highly significant and with a correct sign for the dynamics of the ULC. The model also explains better the short-term dynamics of ULC. This suggests that the cointegrating vector identified may be more relevant for a wage equation than for a CPI equation and that the relation may indicate a stronger link from prices to wages rather than the opposite. This result may come from the mechanism for minimum wage adjustment, which is automatic when cumulative inflation reaches 10 percent after the last adjustment.24 Although minimum wage has direct influence only in the formal sector, it may also affect other labor costs, as it represents a reference wage for workers in general.

Monetary Theory of Inflation

The Demand for Currency25

In this section, inflation is measured by core inflation CPIX. As earlier, the specification of the VAR is based on judgment and statistical tests. The choice of the lag structure of the VAR is based on judgment rather than solely on information criteria.26

In an unconstrained model, the coefficients of currency are close to unity and that of income significantly above unity (Table 7.4). The constraint of long-run price homogeneity (unit coefficient of money) cannot be rejected at reasonable significance levels by the model (i.e., no money illusion). By contrast, the constant velocity assumption is narrowly rejected, while the vector resulting from the constraints is not interpreted as a cointegrating vector by the trace and Eigenvalue tests. A stronger response of real currency demand to real income may reflect the gradual monetization of the economy developed over the period. The coefficient is higher than warranted in the Baumol-Tobin model (which predicts an income elasticity of 0.5) and it is also higher than predicted by a traditional monetarist model (in the quantity theory of money the income elasticity is equal to 1). Although higher than predicted by theoretical model, income elasticity is in line with other studies.27

Table 7.4.Model with Currency in Circulation
Cointegrating vector
Currency in circulation-1.08*-13-13
Opportunity cost-0.65*-0.75*-0.69*
Loading coefficient-0.11*-0.10*-0.10*
Probability of restriction0.480.21
Source: IMF staff estimates.

Restriction on coefficient of currency.

Also weak exogeneity restriction.

The coefficient of price is normalized to -1.

Source: IMF staff estimates.

Restriction on coefficient of currency.

Also weak exogeneity restriction.

The coefficient of price is normalized to -1.

Several variables were used as a proxy for the opportunity cost of holding guaranís. The variable that best captured this relationship was the backward year-on-year depreciation of the guaraní with respect to the U.S. dollar. A model with either the quarterly backward depreciation of the exchange rate or the forward depreciation of the exchange rate (assuming perfect foresight) is less robust in terms of coefficients or number of cointegrating relations. When two opportunity costs are introduced—for example, the annual backward depreciation with respect to the U.S. dollar and the return on guaraní time deposits—cointegration tests suggest the existence of one or no cointegration relation, while some coefficients are not significant or show an unexpected sign.28

Recursive estimation techniques to assess a break in the regime show that the currency demand model has been broadly stable for the past three years (2005–07), but breaks down beyond (Figure 7.3). We perform a rolling regression for the past three years, by estimating the model over a gradually increasing time period. Excluding 2005–07 has little impact on the coefficients of the model. By contrast, it becomes unstable when 2004 is excluded. An alternative estimation without the opportunity cost of currency (only indicative since tests do not show consistently the existence of one cointegration relation) suggests that this may be due to the high variability of the exchange rate around this period.

Figure 7.3.
Recursive Estimation of the Money Demand Model with Currency in Circulation

Source: IMF staff estimates.

The Demand for Narrow Money and Broad Money

The results of estimating money demand based on M1 and M2 tend to be generally weaker than those for currency in circulation, reflecting the significant and sharp variations of these aggregates over the sample period.29 In addition, test statistics suggest the existence of a second cointegration relation, which is difficult to interpret.30 The difficulty to estimate a stable money demand function for M1 and M2 while finding a stable demand for currency may reflect the recurrence of a banking crisis during the sample period, where deposits could be lost in a financial crisis, whereas cash is a safe asset because it is always accepted and honored (Table 7.5).31 The variables included in the VECM encompass demand and return, but not the need for liquidity, which may explain the massive transfer of time and saving deposits in local currency to demand deposits or foreign currency deposits, thus affecting M1 and M2.

Table 7.5.Monetary Aggregate 1990–2007(Percentage, in share of GDP)
Broad money M320.127.028.324.3
Foreign currency deposits2.
Money M217.317.911.814.7
Time and savings deposits3.
Narrow money M17.27.77.611.3
Demand deposits3.
Currency in circulation4.
Source: IMF staff calculations.
Source: IMF staff calculations.

By contrast, the results for broad money are consistent with the quantitative theory of money. The estimation of M3 gives a coefficient of money close to unity. In addition, the income coefficient is also close to unity (when the opportunity cost is measured as the spread between assets within M3 and the letras de regulación monetaria, LRMs). In this specification, the unit elasticity of the income coefficient is also accepted, which means that the velocity of money is stationary. The significance of the LRM rate suggests the effectiveness of monetary policy, as the policy rate has an impact on the public’s decision to hold broad money. However, this result needs to be taken with caution for a number of reasons: the loading factor is significant but with the wrong sign, which makes it difficult to interpret the relation as an equilibrium one; the Eigenvalue test suggests the existence of another cointegration relation; finally, as noted earlier, LRMs were not widely available during the first half of the sample period.

The impact of the monetary aggregate on short-term fluctuations of inflation tends to diminish for broader aggregates. Comparing the result of the estimation among different monetary aggregates shows that the loading coefficient tends to decrease as the monetary aggregate broadens (Table 7.6). For currency in circulation, the loading coefficient to the long-run relation is significant (and between 0.07 and 0.11), and implies that half of the deviation from the equilibrium relation is absorbed between 1 and 1½ years. By contrast, the half-life benchmark is closer to three to six years for M1 and M2. Given the other weak statistical properties of the results for higher monetary aggregates, this makes currency in circulation the most relevant aggregate for studying short-term fluctuations of inflation.

Table 7.6.Comparison of Results with Different Monetary Aggregates
Monetary AggregateCurrency in CirculationM1M2M3
Loading coefficient10.07*-0.13*0.02*-0.04*0.04*n.a.
Half life of deviation (in quarters)4–713–2525
Price homogeneityYesYesYesYes
Constant velocityNoNoNoYes
Income coefficient21.5*–1.6*1.6*–2.9*0.6*–1.6*0.5 n.s.–1*
Relevant opportunity costDepreciationSterilization
with U.S. dollarpaper (LRM)
Source: IMF staff estimates.

When with correct sign.

In model with price homogeneity.

Note: Indicates statistical significance at 5 percent level, and n.s. indicates non significant.

Source: IMF staff estimates.

When with correct sign.

In model with price homogeneity.

Note: Indicates statistical significance at 5 percent level, and n.s. indicates non significant.

Why Has Inflation Not Picked up with High Monetary Growth?

The excess growth of currency in circulation over nominal GDP since 2005 has raised concerns about the potential for fueling inflationary pressures (Figure 7.4). Some market observers argue that the limited impact of high currency growth on inflation since 2005 is due to remonetization after the contraction and low growth of currency in circulation following the currency and banking turmoil of 2001–02. Although this question will be analyzed in the next section (in the context of the analysis of short-term determinants of inflation), the long-term cointegration relationship on currency already identified can shed light on this issue.

Figure 7.4.
Core Inflation and Cointegration Vector

Source: IMF staff estimates.

The coefficient of real income in the baseline model of currency demand is high and already captures monetization of the economy over the sample period. In addition, the appreciation of the exchange rate with respect to the dollar (coming from favorable external conditions) makes local currency more attractive, thus explaining an additional increase in real currency demand. As seen from Table 7.7, this effect had been almost as important as that of real income in 2007 and contributes significantly to reduce the difference between actual and expected inflation (as measured by the cointegration relationship).32 In 2008, the growth of currency in circulation reached a record level, and the deviation from the long-term equilibrium has increased, despite a sizable appreciation of the currency by about 20 percent. In both years, expected inflation based on the long-run relation remains higher than actual inflation, which points to possible inflation risks. As seen in Figure 7.4, an increase of the deviation of currency in circulation from its long-run relationship is followed by a pickup in inflation.

Table 7.7.Determinants of Inflation in 2007 and 20081
In 2007In 2008
Real income-1.656.4-10.64.4-7.3
Opportunity cost0.69-9.8-6.8-12.7-8.8
Expected inflation6.832.4
Actual inflation5.310.5
Source: IMF staff estimates.

Average Q1–Q3 for 2008.

Source: IMF staff estimates.

Average Q1–Q3 for 2008.

Figure 7.5.
Basic Statistics on Monetary Aggregates

Source: IMF staff estimates.

Over the most recent period, the correlation between high currency growth and the appreciation of the currency is not an accident. The appreciation of the currency reflects in part a reversal after the depreciation of the earlier years linked to regional and domestic shocks (the Argentine crisis in 2001 and its spillover on Paraguay’s banking system with a banking crisis in 2002). In addition, significant capital inflows and improvement in the current account have led the BCP to reconstitute its international reserves. Currency in circulation has picked up as only a fraction of the international reserves accumulation has been sterilized. The model suggests that the appreciation of the currency has contributed to increase the demand for real money balances in local currency, thus limiting the inflationary impact of higher currency growth. However, the model predicts that currency growth is higher than what would be warranted to avoid feeding inflationary pressures.

Short-Term Determinants of Inflation

Short-Term Dynamics

This section encompasses the long-term results obtained in the preceding sections to study the short-term dynamics of core inflation. As seen in the previous section on the VECM with currency in circulation, the test of weak exogeneity allows us to consider separately the inflation equation. It is assumed that the coefficients of the variables in the long-run relation are those in the model with price homogeneity and weak exogeneity. A second long-term relation from the markup model is also added. Because the focus is on a core inflation measure by CPIX, the coefficient with this measure of inflation in the unconstrained model is chosen, and then the coefficients of the short-term dynamics are analyzed separately. All the endogenous variables of the VECMs with two lags (“initial” equation) are included initially, then we reduce them to the significant variables and add a few additional exogenous variables (“final” equation). Table 7.8 reports the results of these two equations; only the statistically significant coefficients are reported in the first column (with the exception of the long-run markup equation). The first two lags of inflation are significant, which illustrates the persistence of price shocks.33

Table 7.8.Dynamics of Core Inflation
Loading coefficients to long-run cointegration relations
Money demand equation-0.05***-0.04***
Mark-up equation0.04
d Price (-1)0.49***0.42***
d Price (-2)-0.30***-0.22**
d ULC0.17**
d CPI Brazil (-1)0.06***0.03*
d Administered prices0.10**
d Fruits and vegetables0.02***
Log likelihood208.8218.4
Akaike criteria-6.25-6.51
Schwartz criteria-5.99-6.17
Source: IMF staff estimates.
Source: IMF staff estimates.

The long-run markup cointegration relation is insignificant and the autoregressive coefficients also lack significance. The contemporaneous change in ULC was introduced to improve the fit, and it turns out to be significant. In this case, the first autoregressive coefficient for price also tends to be lower, which suggests that ULC influences prices also by anchoring inflation inertia. ULC may also have a direct effect by raising input costs of products entering into the consumer price index.34

Concerning imported inflation, the exchange rate with Brazil matters for inflation dynamics more than any other exchange rates. Price changes in Brazil also influence the short-term inflation dynamics (but surprisingly not changes in the guaraní-to-U.S. dollar rate). Quarterly changes in prices in Brazil enter the equation with a lag of one quarter (because the contemporaneous change of prices in Brazil is not significant).35

These results are interesting in that in the same inflation model, two different exchange rates affect the results, one in the money demand equation through opportunity cost (the guaraní/U.S. dollar exchange rate) and the other in the short-term dynamics through its impact on imported products (the guaraní/Brazilian real exchange rate). It cannot be excluded, however, that the impact of the guaraní/U.S. dollar exchange rate (captured the long-run cointegrating relationship) reflects more than portfolio arbitrage, but also some traditional imported inflation impact. In this case, the impact of the exchange rate with the U.S. dollar would, however, remain smaller than that of the Brazilian real.36

Finally, to enrich the analysis, specific components of the CPI were introduced in the analysis of the short-term dynamics. Two measures of oil prices were introduced—international prices converted to local currency and the domestic fuel component taken directly from the CPI. Surprisingly, none of these variables are significant, although one would have expected the coefficient to be significant and larger than the share of fuel in core CPI to account for spillover. By contrast, administrated prices are significant and with a coefficient slightly higher than their share in core CPI: the estimated coefficient is of 0.10 against a share in CPIX of 8.3 percent. This probably reflects the fact that the two main items (urban transport and electricity, accounting together for two-thirds of the weights of administrated prices) are important cost components of other products. Finally, although fruits and vegetables are excluded from the core inflation index, they have a specific although modest effect on the dynamics of core inflation, possibly because they tend to reinforce inflation inertia.

The extended model explains accurately the short-term dynamics of inflation. It tends to explain about three-fourths of the variance of inflation over the sample period (Figure 7.6). In the extended model with additional exogenous variables in the short run, the loading coefficient to the cointegrating relation is reduced by half to -0.04 against -0.07 in the restricted VECM and up to -0.13 in some unrestricted specifications presented earlier. The model is also used to make an out-of-sample forecast for 2008, using actual data for the exogenous variables. The model captures the uptick in core inflation in 2008; it also tends to underestimate the actual results by about 1 percentage point.

Figure 7.6.
Core Inflation

Source: IMF staff estimates.

Dynamic Contributions

Dynamic contributions allow us to visualize the role of past and contemporaneous shocks on each explanatory variable estimated in a univariate model. They are produced by inverting the polynomial structure of the model. Using equation (6) and loosed notations in terms of coefficients, we can extract the univariate equation for prices:

where pt is the price index, zt a vector of endogenous or exogenous variables, and the term γ describes either scalars or vectors of coefficients, as appropriate. Using the lag operator L, we can define two polynomials A(L) and B(L) such that:

The dynamic contribution of each variable of zt to inflation is derived from rearranging and differentiating this equation such that:

Given that dynamic contributions rely on infinite polynomials (because of the inversion of A(L)), their precision is poorer for the earlier part of the sample.

Dynamic contributions show that the bulk of inflation dynamics is driven by the evolution of currency in circulation, which is not surprising given the structure of the model we imposed and tested on the data (Figure 7.7). However, currency in circulation has less influence on the short-term dynamics, and none of the periodic spikes in inflation—for example, the rebounds in inflation in 1999, 2003, or 2005—a redirectly related to currency in circulation. Since 2004, currency in circulation has contributed to inflation by 10 to 12 percent, and that would have pushed inflation up had this impact not been compensated by two factors, already discussed above: (1) a buoyant money demand related to the transaction motive (real income) has added a negative impact on inflation increasing from 2 to 5 percent since 2004, and (2) the appreciation of the guaraní (leading to higher demand for local currency) has contributed to reducing inflation by 2.5 percent on average.

Figure 7.7.
Dynamic Contribution to Core Inflation

Source: IMF staff estimates.

1 Represent all other factors only in the short-term dynamics such as ULC, inflation from Brazil, or fruits and vegetables.

The exchange rate has played an important role in explaining the short-run dynamics of inflation. For example, the depreciation of the guaraní against the U.S. dollar (influencing inflation through the opportunity cost) has added about 3.2 percent to inflation in 2002–03, while the depreciation against the Brazilian real added another 0.7 percent of inflation in 2002. The spike in inflation in 2005 can also be explained by exchange rates: the slowdown in the appreciation of the guaraní, despite continued currency growth, contributed to adding about 2 percent to inflation, while the depreciation against the Brazilian currency added another 1 percent to inflation.

Over the sample period, the trend decline of unit labor cost has contributed to a decline of inflation, although occasionally it had the reverse effect of locking in some inflation increases, for example in 2003 or 2006. The moderation of administrated prices since 2003 has also contributed to reduce core inflation by about 1 percentage point over the most recent period, although this is a temporary measure.

In 2008, the uptick in core inflation is explained by the continued increase of monetary supply in excess over money demand. In particular, money supply has continued to increase, while the contribution of the other long-term components of money demand, output, and opportunity cost is now broadly constant. At the same time, the contribution of cost push factors, notably administrated prices, has switched from negative to slightly positive.

Summary and Conclusion

This chapter has attempted to shed light on the determinants of inflation dynamics. Among the key findings of the chapter are the following:

  • Money talks. Although subject to some modeling uncertainty and while the transmission mechanism seems relatively slow, currency in circulation appears as the most relevant monetary aggregate for inflation dynamics. An increase of currency in circulation by 1 percent leads to an increase of inflation by 0.05 points after one quarter, but by 1 percent in the long run. In the money demand function, the coefficient of income larger than unity suggests a trend increased monetization over the sample period. In the long run, the quantitative theory of money holds for broad money, but this result has little relevance for short-term inflation.

  • Pass-through matters. In the short run, a 1 percent increase of imported inflation from Brazil adds 0.03 percent to inflation in Paraguay. In the long run, the exchange rate with respect to the U.S. dollar remains a key factor for portfolio allocation decisions and for money demand. The significance of the depreciation with respect to the U.S. dollar could possibly also capture some pass-through effect from exchange rates to prices.

  • Food feeds inflation. Food accounts for about 35 percent of the CPI basket. However, food prices tend to have a spillover effect on nonfood prices, as evidenced by Granger causality tests and their coefficient in a price equation. The final impact is larger than its weight.

  • Inertia remains strong. A shock of 1 percent to inflation in a given quarter gives rise to an additional increase by 0.4 percent after one quarter and by 0.2 percent after two quarters. The wage indexation mechanism may be partly responsible for locking in any inflation increase, although more generally the high level of inertia could be related to inflation expectations and the credibility of the anti-inflationary efforts.

This study highlights some of the risks for the inflation outlook in 2008–09. Inflation has been subjected to supply shocks, in particular from food, or exchange rate shocks. A reversal of the appreciation of the guaraní against the U.S. dollar, further depreciation against the Brazilian real, or an end of the moderation of administrated prices could lead to higher inflation.

At the same time, this study also presents evidence of monetary policy effectiveness, through volume or through policy rates. Currency in circulation, the monetary aggregate most easily controlled by the central bank (as opposed to broader monetary aggregates), is also the best predictor of inflation. Controlling the rate of currency growth through emission of sterilization bonds allows the inflationary impact of money to moderate. In addition, for broad money, the study suggests that the policy interest rate is also significant in influencing the portfolio allocation of real money balances.

Appendix 7.1:

International Comparisons of Inflation Experiences

Figure 7.A.1.
Inflation in Paraguay and Other Countries in South America

Sources: Country authorities and IMF staff estimates.

Note: In all charts, the plain line represents inflation in Paraguay, and the stacked area represents inflation in a comparator country.

Appendix 7.2:

Features of the Consumer Price Index

Table 7.A.2.Micro-Level Analysis of Prices, 1994–2007(Using the 1992 based CPI basket)
Probability in a given month to:Seasonal Coefficients1
Number of

Weight in

Share of

Average Monthly


Coefficent of


(First AR coefficient)

Fruits and vegetables176.21001.359.
Education and reading164.2200.762.
Miscellaneous expenditures5215.2620.580.741.30.720.490.200.311.
Administrated prices87.700.901.962.
Core inflation (CPIX)27693.8650.700.671.00.760.450.190.361.
Core inflation (CPIX1)26282.5690.650.671.00.750.460.200.341.
Non-food items20261.0520.670.641.00.740.280.100.611.
All items293100.0670.721.01.40.800.450.210.341.
Sources: BCP, and authors’ estimates.

Coefficients are normalized to 1 for Q4; for example, a coefficient of 1.14 for fruits of vegetables in Q1 means prices are on average higher by 14 percent in Q1 compared to Q4. Note: AR= Auto-Correlation.

Sources: BCP, and authors’ estimates.

Coefficients are normalized to 1 for Q4; for example, a coefficient of 1.14 for fruits of vegetables in Q1 means prices are on average higher by 14 percent in Q1 compared to Q4. Note: AR= Auto-Correlation.

Appendix 7.3. The New Consumer Price Index

The BCP started publishing from January 2008 a new CPI based on the 2005 household budget survey. Until then, the weights were based on the 1992 household budget survey. The CPI is not subject to revision, on account of legal constraints, in particular its use for wage indexation. The new CPI series, with a base month in December 2007, will thus be spliced with the older series by applying the same monthly inflation pattern.37

All things being equal, the new index in use since January 2008 should lead to a lower inflation measurement. The new basket gives less weight to food items, which have been one of the main reasons of price increases over the previous two years. Had the weights of the new index been used in 2007, headline inflation could have been 1.5 percent lower on average. In addition, the new CPI basket integrates new products (cell phones, Internet services, personal computers, cable television, etc.) that have experienced low or negative price increases due to lower international prices and network externalities. By contrast, it has a larger weight for oil-related products. Appendix Table 7.A.3.1 provides a comparison of the weights of the CPI in the new and the old index using the new breakdown.38

Table 7.A.3.Weights in the Previous and New Consumer Price Index
Base monthDec. 1992Dec. 2007
Fruits and vegetables6.25.1
Alcohol and tobacco2.11.2
Restaurants and hotels4.85.5
Misc. goods and services10.37.3
Administrated prices7.77.0
Source: IMF staff estimates.
Source: IMF staff estimates.

Food items will continue to have a large influence on the CPI, and their weights remain among the highest in Latin America. In the older CPI, food items accounted for 39 percent of the CPI basket. The new CPI presents a different categorization, with some items accounting for about 5 percentage points of the old index distributed to other categories: these are mostly nontradable items, such as alcohol and tobacco (1.5 points) or restaurants and hotels (3.7 points). Using the same scope for food products as in the new index (i.e., non-alcohol food consumed at home), the share of food items declines by a tenth, from 35 percent to 32 percent. This decline is consistent with Engel’s Law, stating that the relative share of income devoted to food tends to diminish as income grows.

Appendix 7.4. Food Inflation in Latin America

This appendix discusses whether non-food inflation could be considered as a relevant core inflation indicator. We use Granger causality tests to determine whether food inflation Granger-cause or not non-food inflation for a sample of Latin American countries. We test for Granger causality using quarterly growth of prices in VAR with one to four lags.

Table 7.A.4.1.Granger Causality Tests Between Food and Non-Food Inflation
Food Inflation Does not Cause Non-Food Inflation Lags (quarters)Non-Food Inflation Does not Cause FoodInflation Lags (quarters)
Share of Food in CPI12341234
Source: IMF staff estimates.
Source: IMF staff estimates.

Unlike in most Latin American countries, food inflation in Paraguay is a predictor of non-food inflation. In a VAR with long lags, food inflation does not influence non-food inflation, except in Paraguay and Venezuela. In a VAR with two lags, food inflation also Granger-causes non-food inflation in VAR in Brazil and Colombia. By contrast, non-food inflation almost never Granger-causes food inflation (for example, through higher input costs of primary products) except in Colombia and, depending on the number of lags, in Ecuador or Mexico.

The results for Paraguay and Venezuela are interesting in that the situation that food inflation Granger-causes non-food inflation is robust to the number of lags considered. For Paraguay, we can offer two reasons for these results: (1) food is a large part of the CPI basket and thus represents a larger share of workers’ consumption baskets and (2) food price increases potentially have an impact on general prices (and thus non-food prices) through the wage indexation mechanism.

Appendix 7.5. Data Issues, Database Used in Econometric Analysis, and Data Properties

Data for the Markup Model

The most important gap in available statistics to estimate a markup model concerned unit labor cost. Unit labor cost (ULC) is defined here as average wage index minus labor productivity for the economy as a whole. Average wages in the economy are available on a semiannual basis, while minimum wages are available on a monthly basis. Employment data are only available on an annual basis with a lag of about a year. To extrapolate the wage index, we assumed a linear relationship of the variables for the missing quarters. Concerning labor productivity, we used quarterly GDP from the national accounts39 as the denominator and construct a quarterly time series of labor for the numerator. We extrapolate quarterly time series for labor using again quarterly output and the Chow-Lin (1971) methodology. In effect, the pattern of output affecting both the numerator and the denominator is smoothed out as the component entering ULC is labor productivity.

Concerning the price of foreign inputs, we used a set of alternative variables: the nominal effective exchange rate, the exchange rate with the U.S. dollar (with or without adjustment for U.S. inflation), and the prices of imported consumer goods from Argentina and Brazil, using the CPI in both countries converted to guaranís.

In the preferred setup, inflation is measured by CPIX1, but we also estimate the model on headline inflation and core inflation CPIX.

Data for the Monetary Model

Inflation is measured by the core indicator CPIX. Income is proxied by quarterly real GDP. An alternative proxy for income could be gross disposable income, including in addition to GDP the role of foreign transfers and, in particular, of private transfers, which have increased significantly in the recent period. However, this time series is not available in volume and at the desired frequency.

The demand for money is estimated for different monetary aggregates. This will allow the study of which monetary aggregate will offer the most stable money demand function and present the best statistical properties. Our four monetary aggregates are defined as follows.40,41

Currency in circulation: CC

Narrow money M1 = CC + cash in vault and demand deposits

Guaraní Broad Money M2 = M1 + time and saving deposits + certificates of deposit

Broad Money M3 = M2 + dollar deposits

To measure the opportunity cost of a given monetary aggregate with respect to an alternative asset, we explore, when possible, the role of two different asset rates: one alternative asset rate presents the same liquidity as the monetary asset considered but is denominated in another currency, while the other rate has the same currency denomination but corresponds to a less liquid asset. To provide some examples: we compare the zero nominal return of holding domestic currency to the return of holding dollars in cash (the depreciation of the exchange rate) and the return on local currency time and saving deposits; for guaraní broad money, alternative assets could be dollar deposits (for the same liquidity in another currency) or local bonds (less liquid but in the same currency). Using local bonds presents an additional problem, as treasury bills are not widely traded, especially since the government default in 2003. Another class of assets is the BCP sterilization paper (letras de regulacion monetaria or LRMs): these remained marginal during most of the 1990s. As of 1998, they represented less than a tenth of currency in circulation. In recent years, significant foreign exchange inflows have led the BCP to step up its issuance of LRM for sterilization, which stood by the end of 2007 at close to one-quarter of the currency in circulation.

Table 7.A.5.1.Database Used
Time SeriesCodeDescription
Activity and price
GDPlysaQuarterly GDP from National Accounts1
CPIlcpiConsumer price index in Greater Asuncion
Core priceslcpixCPI excluding fruits and vegetables
Core tradableslcpixtTradable prices, excluding fruits and vegetables
Core nontradableslcpixntNon tradable prices
WageslwagAverage wage in greater Asuncion
Minimum wageslwminMinimum wages
Unit labor costlulcAverage wage cost per unit of output, using labor force data from national accounts
Monetary aggregates2
CurrencylccCurrency in circulation
Narrow moneyIm1Currency in circulation + cash in vault and demand deposits
M1AIm1aNarrow money + time and savings deposits
M2Im2Narrow money + time and savings deposits, certificates of deposits
M3Im3M2 and foreign currency deposits
Opportunity cost of money on:3
Demand depositr_ddgDemand deposit in local currency
Time and saving depositr_tsgTime and saving deposits in local currency
Dollar depositr_d$Weighted average of time and saving dollar deposits
Dollar deposit in Gs.r_d$gAbove plus year on year nominal Gs. depreciation
Policy rate on LRMsr_lrmAverage interest rate on sterilization paper (LRM)
M1r_m1Weighted average
M1Ar_m1aWeighted average
M2r_m2Weighted average
M3r_m3Weighted average, converted in Gs.
Dollar cashr_$yYear on year depreciation of the Gs
Dollar cashr_$qQuarter on quarter depreciation of the Gs
Dollar cashr_$fqForward looking q-o-q depreciation of the Gs
Exchange rate and foreign prices
Nominal effective exchange ratelneerINS based NEER with correction from hyperinflation in Brazil before 1994
Nominal exch. ratelerExchange rate with U.S. dollar
U.S. CPIlcpi_usaCPI price in United States, converted in Gs
Brazil CPIlcpi_braCPI price in Brazil, converted in Gs
Argentina CPIlcpi_argCPI price in Argentina converted in Gs
Sources: BCP, International Finance Statistics (IFS, IMF), and authors’ estimates.

Extrapolated using monthly indicator of activity for 1991–94 and 2007.

BCP after January 1995, backdated using IFS.

Expressed in percentage: 100 bp is 0.01. Note: INS= Information Management System Gs= guaraníes

Sources: BCP, International Finance Statistics (IFS, IMF), and authors’ estimates.

Extrapolated using monthly indicator of activity for 1991–94 and 2007.

BCP after January 1995, backdated using IFS.

Expressed in percentage: 100 bp is 0.01. Note: INS= Information Management System Gs= guaraníes

Table 7.A.5.2.Stationarity Tests




Activity and price
Core priceslcpix-2.70-3.69I(1)0.250.08I(1)
Core tradableslcpixt-1.05-4.55I(1)0.130.05I(0)
Core nontradableslcpixnt-5.02-2.16I(0)0.290.13I(1)
Minim. wageslwmin-1.29-5.16I(1)0.210.08I(1)
Unit labor costlulc-4.46-4.68I(0)0.290.05I(1)
Monetary aggregates2
Narrow moneylm10.35-3.05I(1)0.160.18I(2)
Opportunity cost of money on:3
Demand depositr_ddg-1.43-3.14I(1)0.070.04I(0)
Time and saving depositr_tsg-1.90-4.45I(1)0.130.05I(0)
Dollar depositr_d$-1.02-4.85I(1)0.080.07I(0)
Dollar deposit in Gs.r_d$g-2.80-4.21I(1)0.150.04I(1)
Policy rate on LRMsr_lrm-2.39-5.24I(1)0.100.04I(0)
Dollar cashr_$y-3.01-4.15I(0)0.150.04I(1)
Dollar cashr_$q-3.24-6.19I(0)0.140.04I(0)
Dollar cashr_$fq-3.11-6.21I(0)0.150.04I(1)
Exchange rate and foreign prices
Nominal effective exchange ratelneer-1.74-4.22I(1)0.090.08I(0)
Nominal exchange rateler-1.72-2.95I(1)0.130.15I(0)
U.S. CPIlcpiusa-1.69-3.08I(1)0.130.14I(0)
Brazil CPIlcpibra-0.79-5.47I(1)0.120.07I(0)
Argentina CPIlcpiarg-2.79-5.87I(1)0.250.06I(1)
Sources: BCP, IFS, and authors’ estimates.

Extrapolated using monthly indicator of activity for 1991–94 and 2007.

BCP after January 1995, backdated using IFS.

Expressed in percentage: 100 bp is 0.01.

Sources: BCP, IFS, and authors’ estimates.

Extrapolated using monthly indicator of activity for 1991–94 and 2007.

BCP after January 1995, backdated using IFS.

Expressed in percentage: 100 bp is 0.01.

Table 7.A.5.3.Correlation Between Growth Rate of Selected Variables1
Source: Authors’ estimates.

Correlation with quarterly growth rate above the diagonal and correlation with annual growth rate below the diagonal.

Source: Authors’ estimates.

Correlation with quarterly growth rate above the diagonal and correlation with annual growth rate below the diagonal.

Appendix 7.6: Econometric Results for Inflation

Table 7.A.6.1.Some Results of Other Country Studies1
Choice of Push-Cost Equation:Markup EquationTraded Goods Equation
Country:AustraliaJapanUkraine2Russia3Dominican RepublicMadagascar
Sample period1977–19931996–20021996–20041991–20021971–2000
Monetary aggregateBroadBroadEffectiveBroadBroad
moneymoneybroad moneymoneymoney
Long run coefficients
Excess money
Money1 (c)1 (c)1 (c)1 (c)1 (c)
Income-0.5-1.3-1.26-1.65-1 (c)
Opportunity costs2.
Markup model
Foreign prices in local currency0.440.060.170.49
Administered prices/oil prices0.090.330.11
Traded goods
Foreign prices in $1 (c)1 (c)
Exchange rate-1 (c)-1 (c)
Terms of trade0.22
Loading coefficients
Excess money-0.03*3.8*-0.06*-0.05*
Markup model-0.09*-0.04*-0.08ns
Purchasing power parityns0.00ns
Output gap0.08*
Source: IMF staff estimates.

In the long-run relation, the coefficient of price is normalized to 1. In addition:

… indicates that the results were not reported because of the specification chosen,

* ns indicates if the loading coefficient is or is not significant.

Model estimated by dynamic autoregressive lag models, which explains the absence of loading coefficients.

Short-term model estimated in second difference, due to a I(1) inflation process.

Source: IMF staff estimates.

In the long-run relation, the coefficient of price is normalized to 1. In addition:

… indicates that the results were not reported because of the specification chosen,

* ns indicates if the loading coefficient is or is not significant.

Model estimated by dynamic autoregressive lag models, which explains the absence of loading coefficients.

Short-term model estimated in second difference, due to a I(1) inflation process.

Table 7.A.6.3.Results of Money Demand Equation with Currency in Circulation1
Prefered Model2Sensitivity to Opportunity costsSensitivity to Inflation Index




rate on


and external



Core non-


Cointegrating vector
Opportunity cost
Over foreign asset-0.65***-0.75***-0.92***-0.69***0.30***-0.43***-0.31***-1.18***-0.57***-0.63***-0.53***-0.91***
Over domestic asset-2.37***1.52***
Loading coefficient-0.11***-0.10***-0.07***-0.10***-0.11***-0.09***-0.07**-0.09***-0.13***-0.14***-0.10***-0.09***
Log likelihood641.8641.6638.8638.9549.4551.4743.8821.2599.8602.6619.1614.9
AIC criteria-18.6-18.5-18.5-18.5-15.8-15.9-21.9-23.5-17.4-17.2-17.8-17.7
Schwarz criteria-16.9-16.9-16.8-16.8-14.3-14.4-20.4-21.1-15.9-15.2-16.2-16.1
Lag structure2222222222322
Cointegration rank
Prob. of LR test on restriction0.480.050.21
Source: IMF staff estimates.

In both the long-run relation and the short-term dynamics, the coefficients reported are consistent with a normalization of price to 1.

Prefered model: core inflation (CPIX), annual G/$ depreciation for opportunity cost.

Constrained coefficient on currency and weak exogeneity restrictions. Models:

(1a) Baseline: core inflation, annual G/$ depreciation for opportunity cost.

(1b) With unit elasticity restriction on money.

(1c) With unit elasticity restriction on money and income.

(1d) With unit elasticity restriction on money and weak exogeneity restriction.

(2) Alternative opportunity cost: quarterly G/$ depreciation.

(3) Alternative opportunity cost: forward quarterly G/$ depreciation.

(4) Alternative opportunity cost: interest rate on G deposits.

(5) Alternative price index: headline inflation.

(6) Baseline model estimated by DOLS.

Source: IMF staff estimates.

In both the long-run relation and the short-term dynamics, the coefficients reported are consistent with a normalization of price to 1.

Prefered model: core inflation (CPIX), annual G/$ depreciation for opportunity cost.

Constrained coefficient on currency and weak exogeneity restrictions. Models:

(1a) Baseline: core inflation, annual G/$ depreciation for opportunity cost.

(1b) With unit elasticity restriction on money.

(1c) With unit elasticity restriction on money and income.

(1d) With unit elasticity restriction on money and weak exogeneity restriction.

(2) Alternative opportunity cost: quarterly G/$ depreciation.

(3) Alternative opportunity cost: forward quarterly G/$ depreciation.

(4) Alternative opportunity cost: interest rate on G deposits.

(5) Alternative price index: headline inflation.

(6) Baseline model estimated by DOLS.

Table 7.A.6.4.Money Demand Equation with Different Monetary Aggregates1
Narrow Money M1Guarani Broad Money M2Broad Money M3
Alternative asset:2Time and saving depositsDollar currency3Dollar deposits3NoneU.S. federal funds3LRMLRM
Cointegrating vector
Opportunity cost-3.53***0.59-4.84***-3.34***-1.10***-1.56***-1.38***-1.92***-2.06***-1.27***-1.41***-0.40**-1.40***-1.43***
Loading coeff.-0.03**-0.04**-0.02**-0.04***-0.09***-0.06***-0.08***-0.04***-0.04***-0.08***-0.06***0.05**0.08***0.07***0.07***
Log likelihood678.5678.2680.3679.1623.8627.8636.2650.6650.4652.5651.9514.2693.3674.2674.1
AIC criteria-19.8-19.8-19.9-19.8-18.0-18.1-18.1-18.7-18.7-18.7-18.7-15.2-20.0-19.4-19.4
Schwarz criteria-18.3-18.3-18.3-18.3-16.4-16.4-15.9-17.0-16.9-16.9-16.9-14.3-18.3-17.7-17.7
Lag structure222222222222222
Cointegration rank
Prob. of LR test on restriction0.120.270.95
Source: IMF staff estimates

In both the long-run relation and the short-term dynamics, the coefficient reported are consistent with a normalization of price to 1.

Opportunity cost measured as a spread of the return of the alternative asset over the rate of return of a given aggregate.

Return measured with backward depreciation over a year.

Source: IMF staff estimates

In both the long-run relation and the short-term dynamics, the coefficient reported are consistent with a normalization of price to 1.

Opportunity cost measured as a spread of the return of the alternative asset over the rate of return of a given aggregate.

Return measured with backward depreciation over a year.

8 Evaluating Exchange Rate Misalignment1

Bergljot Barkbu and Brieuc Monfort2

The appropriate level of the exchange rate is a hotly debated topic in Paraguay. Business and agricultural associations are vocal about the appropriate level of the exchange rate, and politicians have often echoed their concerns. The exchange rate is also a focus for depositors, who see it as a useful price indicator in a country where inflation is moderate but highly volatile. Somehow surprisingly, most of the debate is centered about the nominal level of the exchange rate with the U.S. dollar, despite the importance of trade within the region, especially with Mercosur countries, and the decreased dollarization in the economy in the most recent period.

The exchange rate is also an important policy question for the authorities. The appreciation of the real exchange rate since 2005 complicated the conduct of monetary policy, as large inflows of official reserves forced the Central Bank of Paraguay (Banco Central de Paraguay, BCP) to issue—at a large quasi-fiscal cost—significant amounts of debt paper to sterilize the impact of reserve accumulation on money growth. By the end of 2007, the real exchange rate has returned to its level prior to the 2002 banking crisis. If the recent appreciation reflects a correction after a nominal overshooting and is explained by the fundamental determinants of the real exchange rate, the recent real appreciation should not be worrying. By contrast, given the historical trend decline of the real exchange rate, one may also consider whether the real exchange rate has corrected too far and is now overvalued. Answering this question requires assessing the magnitude of the misalignment of the real exchange rate from its equilibrium value.

The International Monetary Fund (IMF) monitors all member countries’ exchange rate policies under its surveillance mandate. The IMF’s surveillance aims at promoting global economic stability by overseeing the international monetary system and monitoring the economic and financial policies of its member countries. Assessing whether members’ policies promote external stability is at the core of this mandate and involves an assessment of members’ exchange rate policies. This issue is discussed in the next section. Assessing whether a member country’s exchange rate policy promotes external stability involves evaluating whether the exchange rate is aligned with its equilibrium and, hence, requires a methodology to determine equilibrium exchange rates.

This chapter uses a set of different methodologies to assess the level of the exchange rates. The following sections discuss four methodologies to assess the level of the exchange rate; two of them are based on statistical indicators, and two are based on econometric models. Finally, the last section provides some concluding remarks. The methodologies covered in this chapter are the following:3

  • Real exchange rate indicators. A common first step is to compute an index of the real exchange rate, using different price measures. Under purchasing power parity (PPP), the real exchange rate should be constant over time; thus, its deviation from an historical average could provide an early crude indicator of its appropriate level.

  • Performance of the tradable sector. An indirect approach consists of looking indirectly at the way the exchange rate is supposed to affect the economy, not only through the performance of exports and imports, but more generally through the performance of the tradable sector, directly in competition with foreign goods.

  • Equilibrium exchange rate approach. In contrast to the purchasing power parity assumption, this approach presumes that some determinants, such as productivity differentials or commodity prices, could explain changes of the exchange rate over the long run. A model of the real exchange rate is estimated with respect to these determinants.

  • Macroeconomic balance approach. This approach consists of estimating a “norm” or equilibrium for the current account balance as a function of macroeconomic determinants and, using trade elasticities, to deduce the exchange rate consistet with this current account equilibrium.4

Surveillance and Exchange Rate Policies

Exchange rate assessment is at the core of the IMF’s surveillance activities. Through its surveillance activities, the IMF is constantly monitoring and reporting on the conditions of each of its members’ economies, for which the external conditions and the exchange rate play a key role. Surveillance is aimed at promoting global financial and economic stability. This section provides an overview of how the IMF’s framework for surveillance has been adapted over time to respond to a changing world economy.

Surveillance in its present form was established by Article IV of the IMF’s Articles of Agreement, as amended in the late 1970s after the collapse of the Bretton Woods system of the “par value.” The original Article IV established the par value system under which countries maintained a fixed par value for their currencies in terms of gold and obtained IMF concurrence before making changes in a par value. The system had two basic elements: the United States established the value of the U.S. dollar in terms of gold, and all other member countries established par values of their exchange rates in terms of the dollar. In the early 1970s it became clear that the monetary role of gold had ended and that the U.S. dollar could no longer serve as the sole reserve currency. On this basis, the Second Amendment of the Articles in 1978 took a fundamentally different approach: countries should be free to adopt whatever exchange regime was best suited to their own circumstances, including floating exchange rates. Article IV also established obligations for member countries to collaborate with the IMF and with one another to promote the stability of the global system of exchange rates. In particular, member countries commit to running their domestic and external economic policies in keeping with a mutually agreed code of conduct.

The 1977 Decision on Surveillance over Exchange Rate Policies was designed to implement the IMF’s bilateral surveillance under Article IV. Under this Article, the IMF is charged with overseeing the international monetary system to ensure its effective operation and monitoring each member country’s compliance with its policy obligations. The Article states that, in order to fulfill its functions, the IMF shall exercise firm surveillance over the exchange rate policies of members and shall adopt specific principles for the guidance of all members with respect to those policies. The 1977 Decision established three such principles, which were complemented by a list of six indicators to signal when observance of these principles may require further examination (Box 8.1).

During the 30-year period of implementation of the 1977 Decision, the economic environment changed considerably and significant gaps emerged. Reflecting the period when it was drawn up, the 1977 Decision focused on potential exchange rate manipulation undertaken for balance of payments reasons and on short-term exchange rate volatility. However, it became clear that new issues had emerged with respect to member countries’ exchange rate policies, and they were affecting the functioning of the international monetary system. First, the maintenance of overvalued or undervalued exchange rate pegs for domestic purposes had been a long-standing problem. Second, more recently, capital account vulnerabilities often arising from balance sheet imbalances had become a key issue.

A new Decision on Surveillance of Members’ Policies was approved in June 2007, replacing the 1977 Decision. The 2007 Decision does not alter the obligations by member countries or the IMF’s role in overseeing the international monetary system, but it intends to bring clarity to and update the guidance for its implementation in today’s economic environment. The 2007 Decision focuses on assessing whether countries’ policies promote external stability and, relatedly, intends to increase attention to exchange rate misalignment. External stability is defined as “a balance of payments position that does not, and is not likely to, give rise to disruptive exchange rate movements.” This is seen as equivalent to there not being any fundamental exchange rate misalignment.

One potential problem with making assessments of the exchange rate is that it could be contrary to market sentiment. Under some conditions, exchange rate assessments and market sentiment could reinforce each other. For instance, if the assessment is that the exchange rate is overvalued and market forces push for depreciation, there is a tendency for the exchange rate to return to its long-term equilibrium. However, if the market forced a push for an appreciation of the currency, there will be a tendency to deviate further from the long-run equilibrium. Figure 8.1 shows that observations in the northeast and southwest quadrants are consistent with stability whereas the northwest and southeast quadrants are consistent with instability.

Figure 8.1.
Market Perception and Equilibrium Exchange Rate Model

Source: IMF staff estimates.

Assessing whether a country’s exchange rate policy promotes external stability requires analyzing whether the exchange rate is aligned with its equilibrium. The remainder of the chapter applies different methodologies for determining the equilibrium exchange rate in Paraguay and discusses how to address methodological and country-specific problems and related problems in assessing exchange rate policies.

Principles on Exchange Rate Policies

Assessments of exchange rate policies are subject to four main principles. The IMF uses a combination of principles and indicators in forming assessments about exchange rates of its member countries.

  • Manipulation. A member shall avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members;

  • Intervention. A member should intervene in the exchange market if necessary to counter disorderly conditions, which may be characterized, inter alia, by disruptive short-term movements in the exchange rate of its currency;

  • Cooperation. Members should take into account in their intervention policies the interests of other members, including those of the countries in whose currencies they intervene; and

  • Sustainability. A member should avoid exchange rate policies that result in external instability.

The 1977 Decision established three of these principles (A to C), which were complemented by an additional principle (D) in the 2007 Decision.1

Seven indicators are used to assess whether the above principles are observed. The 1977 Decision established a list of six indicators to provide broad guidance for judgment about when a question of observance of these principles may require further examination, and the 2007 Decision added one indicator referring to large and prolonged current account deficits or surpluses (indicator (vi) below). In addition, the term “fundamental misalignment of the exchange rate” was introduced for indicator (v).

The indicators include the following: 2

  • Protracted large-scale intervention in one direction in the exchange market;

  • Official or quasi-official borrowing that either is unsustainable or brings unduly high liquidity risks, or excessive and prolonged official or quasi-official accumulation of foreign assets, for balance of payments purposes;

  • Current account or capital account restrictions:

    (a) the introduction, substantial intensification, or prolonged maintenance, for balance of payments purposes, of restrictions on, or incentives for, current transactions or payments, or

    (b) the introduction or substantial modification for balance of payments purposes of restrictions on, or incentives for, the inflow or outflow of capital;

  • Pursuit, for balance of payments purposes, of monetary and other financial policies that provide abnormal encouragement or discouragement to capital flows;

  • Fundamental exchange rate misalignment;

  • Large and prolonged current account deficits or surpluses; and

  • Large external sector vulnerabilities, including liquidity risks, arising from private capital flows.

The text of the 1977 Decision was amended slightly in April 1987, April 1988, and April 1995.

Indicators (ii), (iii), (v), and (vi) were modified in the 2007 Decision from the following wording in the 1977 Decision: (ii) an unsustainable level of official or quasi-official borrowing, or excessive and prolonged short-term official or quasi-official lending, for balance of payments purposes; (iii) (a) the introduction, substantial intensification, or prolonged maintenance, for balance of payments purposes, of restrictions on, or incentives for, current transactions or payments, or (b) the introduction or substantial modification for balance of payments purposes of restrictions on, or incentives for, the inflow or outflow of capital; (v) behavior of the exchange rate that appears to be unrelated to underlying economic and financial conditions including factors affecting competitiveness and long-term capital movements; and (vi) unsustainable flows of private capital flows.

Indices of Real Effective Exchange Rate

This section presents statistical methodologies to assess the exchange rate based on the construction of real effective exchange rate indicators. Although some of the theories discussed earlier apply only for the medium to long run, it is also relevant to focus on the situation since the early 1990s, for two reasons: (1) more data are available and (2) a regime change occurred in the early 1990s when Paraguay embarked on a comprehensive liberalization of its economy. During this period, the economy moved to a flexible exchange regime and the financial sector began to be liberalized.5

One commonly used methodology to measure competitiveness is through an index of the real effective exchange rate (REER), which is a weighted average of exchange rates and prices.6 At the IMF, the most commonly used REER index (Information Notice System INS) is constructed as a weighted average of bilateral exchange rate and relative prices: headline inflation as price indicators. The weights reflect the importance not only of the country’s main trade partners but also of its main competitors, and a different treatment is done for primary products, assumed to be offered on a perfectly competitive global market, and manufacturing products, where imperfect competition through product differentiation allowed countries to benefit from a country-specific markup. Alternative assumptions to construct a REER index could produce different results (Figure 8.2):

Figure 8.2.
Alternative Measures of the Real Effective Exchange Rates

Source: IMF staff estimates.

Note: INS= Information Notice System, BCP = Central Bank of Paraguay, CPI = Consumer Price Index, and CPIX = Consumer Price Index Excluding Mortgage Costs.

  • Weights. Assuming an identical starting point in 1997, the REER index used by the IMF is 15 percent higher at end-2007 than the REER index produced by the BCP using different weights.

  • Headline or core inflation. Headline inflation in Paraguay is very volatile. A more stable inflation indicator is the core inflation index (which excludes fruits and vegetables). Using the core inflation index instead of the headline inflation index (and the same weights from the IMF) would produce a REER index 6 percent lower at end-2007 than the baseline consumer price index (CPI)–based REER.

  • Alternative price indicators. To some extent, headline inflation, measuring consumer prices in the capital city, could also be of limited significance to measure external and internal competitiveness for the economy. Alternative price indicators that could be used are the GDP deflator or unit labor costs (nominal wages adjusted for labor productivity).

Despite the differences in measurement, all indices point to a sustained appreciation of the real exchange rate since early 2005.

Bilateral real exchange rates could usefully complement the analysis of competitiveness. Although the REER shows a deterioration of competitiveness between 2005 and 2007, bilateral real exchange rates for some of the main trade partners show a different pattern. For example, the bilateral real exchange rate with Brazil and the European Union has been more stable than the one with the United States over the period. Brazil accounts for one-fourth of the REER index and countries of the European Union for one-fifth. By contrast, the real appreciation with respect to the U.S. dollar and with countries whose exchange rate follows closely the U.S. dollar, such as Argentina, has been stronger. The weight of the United States is similar to that of the European Union, whereas Argentina accounts for only 10 percent of the index.

As a first step, comparing the REER to a medium-term average could provide some indication about the competitiveness of the economy. Under the PPP approach, real exchange rates should be relatively constant over time, as movements of merchandise would allow in principle to arbitrage opportunities between tradable goods in different countries. A large body of literature has been devoted to testing the hypothesis of purchasing power parity and why it does not apply in the short to medium run but does apply in the long run. In the case of Paraguay, the hypothesis that the real exchange rate could be constant over the past 40 years seems to be heroic at best. One reason the purchasing power parity may not have held for the earlier part of the period could be related to extensive controls in the economy, notably with the relative peg of the guaraní to the U.S. dollar until 1989; these controls may have prevented domestic prices to adjust to changes in international prices. Comparing the REER to its average since the early 1990s shows that as of end-2007, the real exchange rate is close to its medium-term average (Figure 8.3).

Figure 8.3.
Nominal Exchange Rate and REER

Source: IMF staff estimates.

One problem with the PPP methodology is that it is quite sensitive to the benchmark comparison period. In addition, the real exchange rate has experienced long-lasting deviations from its average level over the sample period, being 11 percent below this average in 1989 and 1990, then 7 percent above from 1990 to 2001, and finally 12 percent below between 2001 and 2006. One may also dispute that the change from the peg to the U.S. dollar to the free-floating regime is very important.7 Finally, purchasing power parity may not hold over the medium run, as the real exchange rate is affected not just by nominal price changes, but also by some real factors, such as productivity growth (which is looked into the section on the equilibrium exchange rate approach).

Performance of the Tradable Sector

An indirect approach for assessing the exchange rate consists of looking at the performance of the tradable sector at the prevailing exchange rate. If the REER were a major determinant of the performance of each sector, one would expect the tradable sector to be negatively affected when the real exchange rate is relatively strong because tradable goods are penalized both in export markets, because of dearer products, and in domestic markets, because of the competition of cheaper imports. The tradable sector includes the primary and manufacturing sectors, and the nontradable sector includes construction, utilities, and the service sector. As a large part of the tradable sector is also overly influenced by exogenous shocks (weather conditions for agriculture; animal epidemics both in Paraguay and in competitor countries for livestock production and meat processing), we also provide a measure of the tradable sector excluding these two subsectors. The impact of the REER could be looked at through some indicators of performance of the tradable sector in comparison to that of the nontradable sector or, more narrowly, through the performance of exports.

The tradable and nontradable sectors seem to be closely interrelated and not directly influenced by external competitiveness (Figure 8.4). Figures do not offer a clear indication about the impact of the REER on the tradable and the nontradable sectors, over either the long term or the short term. By contrast, both the tradable and nontradable sectors seem to a follow similar pattern. This close correlation of both sectors, irrespective of the position of the REER, may reflect complementarily of the sectors: for example, the high growth rate of the late 1970s reflects both the construction of the Itaipú dam and its spillover on the service sector through transport and trade, and the expansion of the “agricultural frontier” in northeast Paraguay. It may also reflect the influence of common factors, such as the succession of banking crises between 1995 and 2003. More recently, there is little indication that the appreciation of the REER has had a significant negative impact on the tradable sector, but the relatively low REER in the early 2000s did not seem to have an impact either. The tradable sector (excluding agriculture and the meat sector) seems to have decoupled from the economy in general in the first half of the 2000s. This suggests that the difficulties of the tradable sector may have limited relation to the movement of the exchange rate.

Figure 8.4.
Performance of the Tradable and Non-tradable Sectors

Source: IMF staff estimates.

Although the exchange rate seems to have influenced export performance in the long run, there is no clear impact of the real appreciation on exports in the short run. To analyze the impact of the REER on exports, we look at both export volume growth and export market share (Figure 8.5). The trend decline of Paraguay’s export market share may reflect the impact of commodity prices (hence the use of an indicator of market share among non-oil-exporting countries) or the dismal growth performance of the region in the 1980s and 1990s (hence an indicator of market share within Latin American countries). Over the past 40 years, periods of relatively appreciated REER seem to be associated with relatively lower exports, for example in the early 1980s or in the late 1990s, while the relatively depreciated REER of the early 1990s seems to be associated with higher exports. Over the most recent period, market shares (among different subgroups) have been broadly stable despite changes in the REER. In addition, exports have performed relatively well despite the recent appreciation of the exchange rate, although this could be partly accounted for by the expansion of the beef sector in 2005–06 and the recovery of agriculture in 2007.

Figure 8.5.
REER and Export Performance

Source: IMF staff estimates.

The Equilibrium Exchange Rate Approach

Empirical Methodology and Data

The equilibrium exchange rate approach consists of calculating the long-term value of the exchange rate as a function of a set of explanatory variables. The equilibrium real exchange rate is defined as the level toward which, absent new shocks, the real exchange rate would return. The literature on equilibrium exchange rate was initiated by Williamson (1994). Two recent papers have applied this methodology to Paraguay: Rojas Páez and Fernández (2002) and Benelli (2004).

The literature on the equilibrium exchange rate generally encompasses a similar set of explanatory variables. The variables used here are broadly similar to those of Benelli (2004), although some changes have been made in the measurement of these variables (e.g., variables’ weights and a broader set of products for the relative commodity price index). The variables used are the following:

  • Terms of trade. In commodity-producing countries, the terms of trade explain a large portion of the variation in the real effective exchange rate (see Chen and Rogoff, 2002; or Cashin, Cespedes, and Sahay, 2002). Improvements in the terms of trade lead to an appreciation of the REER either through their impact on higher foreign exchange or through wealth effects, as higher export incomes lead to larger spending on nontradables. Terms of trade are measured as a weighted average of Paraguay’s main exports (cotton, soy, wheat, and beef), against the price of manufacturing goods in industrialized countries.8

  • Productivity differentials, the Balassa (1962)-Samuelson (1964) effect. An increase in productivity relative to trading partners in tradable goods raises the relative price of nontradable goods and thus appreciates the real exchange rate. The Balassa-Samuelson effect is measured by real per capita GDP relative to the real per capita GDP of Paraguay’s main trading partners, using the same weights as the IMF’s REER index.

  • Trade openness. A more open trade regime increases competition in tradable goods, reducing their price and the overall price level and thus putting pressure on the real exchange rate to depreciate. Panel regressions usually introduce this effect through a dummy on trade liberalization. By contrast, in time series models, trade openness is usually measured as the sum of exports and imports in percent of GDP. This is the approach chosen in this section.

  • Fiscal position. Two indicators are usually used to capture the impact of the government sector on the REER—the fiscal balance and government consumption, both usually scaled by GDP. The impact of the fiscal position on the REER depends on whether fiscal expenditures are directed mostly toward tradable or nontradable goods. If large fiscal expenditures reflect a higher payroll or higher nontradable expenditures, these should lead to an appreciation of the real exchange rate. The impact could be the opposite, however, if fiscal expenditures are directed toward the tradable sectors or imports.

  • Current account balance. By definition, the current account balance determines the change in a country’s stock of net foreign assets. Thus, an increase in capital inflows that is reflected in a worsening current account balance may cause an appreciation of the real exchange rate as demand for nontradables increases. The negative association between the current account balance and the real exchange rate may simply reflect reverse causality, because a more depreciated real exchange rate may stimulate more exports and discourage imports. We measure the current account balance in percent of GDP.

  • Net foreign assets. Higher net foreign assets are related to a more appreciated REER, through wealth effects, to higher foreign income and higher consumption, in particular of nontradables. Net foreign assets are measured as the sum of official reserves and the banking system’s foreign assets, scaled by GDP.

The model is estimated using quarterly data over 1990Q1 to 2007Q2, which required some careful construction of the data set. Although the sample period is short, especially in regard to the number of explanatory variables, it covers a consistent period since Paraguay moved to a floating exchange rate in February 1989.

As usually done in the literature, we use cointegration techniques to identify a long-run cointegration relationship between the real effective exchange rate and its determinants. As seen in Appendix Table 8.A.2, the variables of interest are integrated in levels, but are stationary in differences, which makes cointegration techniques an appropriate tool to estimate the model. If it exists and is unique, the cointegration relationship can be interpreted as the long-run equilibrium relationship between the real exchange rate and its determinants (the “fundamentals”). The cointegration relationship is estimated by the Johansen (1995) methodology. We use standard tests (trace and Eigenvalue tests) to determine the existence and number of cointegrating relations. To test the robustness of the results, we also use the Dynamic Ordinary Least Squares (DOLS) estimation technique of Stock and Watson (1993).

Table 8.A.2.Stationary Tests
Augmented Dickey-Fuller test (ADF)Kwiatkowski, Phillips, Schmidt and Shin test (KPSS)




Quarterly data
Annual data
Source: IMF staff estimates.Notes: All variables in logarithm except net foreign assets, fiscal and current account balance. I(0) denotes that the variable is stationary and I(1) that the variable is integrated of order 1. For the ADF test, the test statistic for rejecting the null hypothesis of nonstationary level).
Source: IMF staff estimates.Notes: All variables in logarithm except net foreign assets, fiscal and current account balance. I(0) denotes that the variable is stationary and I(1) that the variable is integrated of order 1. For the ADF test, the test statistic for rejecting the null hypothesis of nonstationary level).

General Results and Robustness Checks

Coefficient estimates are sensitive to modeling assumptions but point to some consistent results. We explore in particular the impact of different assumptions concerning the lag structure of the Vector Auto Regression (VAR), the variables included in the VAR, and the definition of the explanatory variables.9 Appendix Table 8.A.3 presents baseline results and sensitivity tests, while Table 8.1 below presents the most significant results. Among the results that stand out are the following:

Table 8.A.3.a.Estimation of Equilibrium REER
Robustness to Lag Structure

Baseline1 lag3 lagsRobustness to Exclusion of Specific Variables
Cointegrating vector
Current account(-)-2.13***-2.56***-2.81***-2.75***-2.57***-2.00***-2.57***-2.13***-2.79***
Loading coefficient-0.030.00-0.14-0.13**0.040.04***-0.110.08-0.14-0.05
Log likelihood1,0199931,055923813.5864819820911619
AIC criteria-27.5-27.7-27.5-25.5-22.0-23.6-22.2-22.3-25.1-16.9
Schwarz criteria-22.7-24.7-21.0-21.8-18.4-20.0-18.6-18.6-21.5-14.2
Lag structure2132222222
Cointegration rank
Source: IMF staff estimates.Notes: Baseline, domestic demand excluding inventories; REER, no proxy for openness.
Source: IMF staff estimates.Notes: Baseline, domestic demand excluding inventories; REER, no proxy for openness.
Table 8.1.Estimation of Equilibrium Exchange Rate for Paraguay
Other studiesThis study

Paez, and





BaselineEstimation by



(set 1)


(set 2)
Up to

Up to

Up to

Cointegrating vector
Current account7.29*1.61*-2.13***-2.09***-2.57***-2.79***-0.7***-2.81***-1.75***
Loading coefficient-0.18*0.47-0.030.04-0.05-0.25-0.090.00
Log likelihood1019813.5619730509873
AIC criteria-27.5-22.0-16.9-28.1-20.4-27.2
Schwarz criteria-22.7-18.4-14.2-22.9-17.5-22.6
Lag structure2222222
Cointegration rank
Source: IMF staff estimates.

Openness is defined as the openness ratio multiplied by foreign direct investment; the fiscal variable is public consumption rather than the fiscal balance.

The quarterly model also includes the REER either Brazil or Argentina as a proxy of other determinants.

Panel estimation on a sample of 48 industrial and developing countries (not including Paraguay).

Note: The proxy for the fiscal variable is government consumption to GDP (hence the positive sign); the openness variable is a dummy based on the Sachs–Warner index; NFA are scaled by exports and not by GDP.
Source: IMF staff estimates.

Openness is defined as the openness ratio multiplied by foreign direct investment; the fiscal variable is public consumption rather than the fiscal balance.

The quarterly model also includes the REER either Brazil or Argentina as a proxy of other determinants.

Panel estimation on a sample of 48 industrial and developing countries (not including Paraguay).

Note: The proxy for the fiscal variable is government consumption to GDP (hence the positive sign); the openness variable is a dummy based on the Sachs–Warner index; NFA are scaled by exports and not by GDP.
  • The current account variable is significant in most cases and displays the correct sign. The coefficient is also broadly stable throughout different estimating assumptions. On average an increase of the current account balance by 1 percentage point of GDP is associated with a real appreciation of 2–3 percent. The results are equally significant and of the same magnitude when capital flows as share of GDP are used instead of the current account balance.

  • The commodity terms of trade variable is significant in many cases. It is of the order of magnitude of 0.2-0.3, which is significantly lower than earlier estimates by Benelli (2004) and IMF (2006). The lower coefficient than estimated in the panel regressions by the IMF could come from the fact the current account is not included in these regressions.

  • The productivity differential parameter, measuring the Balassa-Samuelson effect, is usually significant and of the order of 0.2-0.5. This is somewhat higher than the estimates made by the IMF (0.15). In addition, this variable appears to compete with terms of trade for significance.

  • Net foreign assets (NFAs) are not significant. Scaling NFAs by exports and imports instead of GDP does not change significantly the results.

  • The fiscal balance is also not significant. This could suggest that fiscal expenditures are balanced between tradable and nontradable goods, which is somewhat contradicted by the large wage component of fiscal expenditures.

  • Finally, the openness variable is significant and with the correct sign, suggesting that the gradual opening of the Paraguayan economy over the 1990s and 2000s has contributed to a depreciation of the REER.

Unfortunately, the loading coefficient for the long-term relationship is rarely significant. However, when the coefficient is significant, it has the correct sign, which allows us to interpret the cointegrating vector as an error-correcting mechanism. The low significance of the loading coefficient suggests that deviation of the REER from its long-term relation takes time for correction. This result may be related to the short sample used for the estimation.10

The equilibrium exchange rate is determined by using an estimated coefficient over its filtered determinants. This is the approach suggested by MacDonald and Ricci (2003) and used by Benelli (2004) for smoothing the path of real exchange rate determinants and avoiding too much variability. In Figure 8.6, model 1 presents the results of the REER when using a model encompassing all unfiltered variables. This shows an overvaluation of 14.4 percent in 2007Q3. Models 2–4 present the coefficients applied to variables smoothed using the Hodrick-Prescott (HP) filter and important different assumptions: model 2 presents the use of the HP filter over historical data; this is subject to the traditional end-point problem. To alleviate this problem, model 3 applies the filter on historical and forecasted variables. The forecasts used are those derived from the IMF’s World Economic Outlook (WEO). With the filtered variable over historical data, the overvaluation of the REER is 15.4 percent, whereas it is 13.9 percent when using historical and forecasted data. This diminution of the overvaluation when corrected for the end-point problem is expected, given that the forecast, even though conservative, is more optimistic than the recent past (in particular with higher growth, continued NFA accumulation, and greater openness, all contributing to an appreciation of the REER). Finally, we apply to the historical and projected variables an HP filter with a lower adjustment factor lambda (400), the concern being that the traditional lambda of 1600 tends to smooth out too much the recent improvement of fundamentals observed by Paraguay in the 2004–07 period (fiscal surplus, modest but sustained pickup of growth, reserve accumulation).

Figure 8.6.
Model Uncertainty and Diagnostic on Real Exchange Rate

(Equilibrium exchange rate approach)

Source: IMF staff estimates.

Table 8.2.Diagnostic of REER with Different Model Specifications
Filtered of Right

Hand Scale

Correction forDiagnostic in 2007
ModelPeriodLambdaEnd PointAverageat Q3
Model 11991–2007No11.114.4
Model 2Yes1600No15.615.4
Model 31600Yes14.313.9
Model 440013.713.2
Model 51991–2005160015.915.9
Model 61991–200216003.83.6
Source: IMF staff estimates.
Source: IMF staff estimates.

All previous models thus point to a significant overvaluation of the REER by some 15 percent at the end of 2007 after a persistent undervaluation of 5–10 percent in 2003–05. Interestingly, the macroeconomic balance model presented in the next section also points to an overvaluation of the REER of the same magnitude, while similarly suggesting a persistent undervaluation during the early to mid-2000s. These results are consistent with the Benelli (2004) study that shows some undervaluation in the range of 3–10 percent at the end of 2003. In addition, we found little in the fundamentals of the model to explain the sharp appreciation of the REER since 2005: the improvement of real GDP growth, although notable for Paraguay after a decade of low growth, has led only to stabilizing the productivity differential. NFAs have been rebuilt following the turbulence of the early to mid-2000s, but this variable has limited impact on the model. In the same way, the turnaround in the fiscal balance seems to have little effect on the REER.

In the estimated models, deviations of the REER away from its equilibrium tend to be long lasting. Reinterpreting the results raises the question of whether such periods of deviation could bias the estimation. The model shows that deviations from the long-run equilibrium are corrected only slowly, as is evident from the nonsignificance of the loading coefficient. The models also point to one such deviation, the undervaluation between 2002 and 2005. In addition, the models do not suggest that the deviation during this period was driven by fundamentals.

The size of the nominal depreciation and foreign exchange market volatility suggests that the 2002 depreciation was driven by market sentiment. The real depreciation in 2001–02 was driven by the nominal exchange rate depreciation, not by the inflation differential; this is the largest change in nominal exchange rate over the sample period or since the move to a floating or managed regime (Figure 8.7). The spread measured by Energy Market Bond Index Plus (EMBI+) for Latin America experiences a spike around 2001–02, reflecting the consequences of the crisis in Argentina. In Paraguay, an exchange market pressure (EMP) index also shows increased and persistent volatility around 2001–02.11 Although there is strong reason to believe that the exchange rate was driven by market sentiment in 2001–02, we do not imply that the behavior of the exchange rate was completely disconnected from fundamentals. Growth prospects of the economies marked by the spillover from the Argentine crisis were significantly reduced, and forecasts underestimated the economic recovery. We illustrate these in Figure 8.8, which shows the gradual adjustment of growth forecasts for Argentina and Paraguay made by the WEO, but forecasts from the Consensus Forecast exhibit similar patterns.

Figure 8.7.
Exchange Rate and Capital Market Development

Source: IMF staff estimates.

1 The exchange rate is end-of-period Gs/US$. The bar represents the contribution of the changes occurring during the year to reach the end-of-period level of the following year.

2 The grey bar represent the quarter when the EMP index is above one standard deviation.

Figure 8.8.
Revision of the WEO Forecast 2003-071

(Year-on-year real GDP growth)

Source: IMF, World Economic Outlook (WEO), various semesters.

1Spring WEO forecast.

As an illustration of how the undervaluation of the 2002–05 period affects the equilibrium exchange rate, we reestimate the model on a shorter sample ending in 2001. To some extent, this makes the diagnostic of the position of the REER as of end-2007 less relevant, because we discard the most recent period. However, it offers some insight on where the equilibrium might be had the model parameters been the same as during the 1991–2001 period. The coefficients of the model estimated on a reduced sample are broadly as satisfactory as those obtained on the full sample (with one or two variables exhibiting the wrong signs). Not surprisingly, the new model shows significant undervaluation in 2002–05.12 By contrast, the overvaluation in 2007 is modest, at only 5 percent, and within the confidence interval. Interestingly the loading coefficient become clearly negative (-0.10/-0.25) although still not significant.

The Macroeconomic Balance Approach

The macroeconomic balance approach can be used to evaluate whether a balance of payments position is consistent with external stability. The approach aims at finding the real exchange rate that is consistent with the underlying current account being in equilibrium and the financial and capital accounts not being a source of external instability. Comparing the resulting equilibrium real exchange rate to the actual real exchange rate can determine whether the exchange rate is misaligned.

Theoretical Model

The approach is based on the accounting identity that, at any point in time, equates a country’s current account balance (CAt) with the excess of domestic saving (St) over domestic investment (It):

where St - It is a measure of the net saving. A current account deficit thus implies a net inflow of private and official capital, which again requires a surplus on the capital and financial account.

The current account depends on factors affecting trade and income flows, such as the real effective exchange rate (REERt), the terms of trade (tott), the output gap in Paraguay (yt), and the output gap in the United States (y*t), taken as a proxy of the external environment:

The more depreciated the exchange rate and the better the terms of trade, the more competitive the economy is, which tends to improve the current account balance. The output gap in Paraguay is expected to have a negative impact on the CA because a higher output gap is consistent with higher absorption leading to a more deteriorated current account, while a higher output gap in the United States would be associated with an improved CA balance (Figure 8.9).

Figure 8.9.
Current Account Deficit, Output Gap, and Real Exchange Rate

Source: IMF staff estimates.

The domestic savings-investment balance is determined by domestic factors such as the interest rate in Paraguay (it), the interest rate in the United States (i*t), and the fiscal position (ft) (Figure 8.10).

Figure 8.10.
The Twin Deficits: Current Account and Fiscal Balance

(In percent of GDP)

Source: IMF staff estimates.

Assuming that capital and financial flows to Paraguay depend on the interest rate differential, a higher interest rate in Paraguay and a lower interest rate in the United States would encourage inflows and net savings. The government’s net savings are directly affected by the fiscal balance and would be positively related to the aggregate savings-investment position.

Empirical Approach

The empirical approach consists in estimating an equilibrium model for the current account and the real exchange rate, and assessing the deviations of these variables from their estimated equilibrium. The first step of the empirical method is to estimate simultaneously long-run models for the underlying current account position (equation (2)) and the equilibrium savings-investment position (equation (3)), based on their long-run determinants. The terms of trade, the output gaps, and the interest rates are assumed to be exogenous. The second step is to calculate the equilibrium real exchange rate as the real exchange rate that equilibrates the underlying current account position with its long-run equilibrium. Estimated misalignments can then be obtained by calculating the deviations of the current account and the actual real exchange rate from their estimated equilibrium values.

The approach taken here involves simultaneous estimation of the equations for the equilibrium current account balance and exchange rate. The macroeconomic balance approach is traditionally based on estimated current account norms computed from cross-country panel estimations of relations between the current account and a set of fundamentals. A simultaneous equation approach, however, ensures that the equilibrium equations for the current account and the real exchange rate are internally consistent, which is particularly important when assessing exchange rate policies, which impact both external balances and the exchange rate.

The estimates are based on a cointegrated vector-autoregressive model, in line with the unit root properties of the data series (see Johansen, 1995). Standard misspecification tests do not reveal any problems, indicating that the estimated model is well specified (Table 8.3).

Table 8.3.System Misspecification Tests for Estimated Cointegrated VECM
VectorNormalityAuto Correlation (lags 1 to 4)ARCH (lags 1 to 4)Heteroskedasticity
CA/GDPX2 (2) = 2.99 (0.22)F (4,37) = 0.18 (0.95)F (4,33) = 0.68 (0.61)F (34,6) = 0.51 (0.90)
FB/GDPX2 (2) = 1.33 (0.51)F (4,37) = 1.16 (0.34)F (4,33) = 2.53 (0.06)F (34,6) = 0.29 (0.99)
Logarithm (REER)X2 (2) = 1.24 (0.54)F (4,37) = 0.20 (0.94)F (4,33) = 0.04 (0.99)F (34,6) = 0.27 (0.99)
SystemX2 (6) = 4.85 (0.56)F (36,80) = 0.77 (0.81)naF (204,14) = 0.13 (1.00)
Source: IMF staff estimates.Note: VECM = Vector error correction model, ARCH= Auto-regression conditional heteroskelasticity, CA= Current account, FB= Fiscal Balance
Source: IMF staff estimates.Note: VECM = Vector error correction model, ARCH= Auto-regression conditional heteroskelasticity, CA= Current account, FB= Fiscal Balance

In the short run, the country’s current account and savings-investment position and the determinants of these positions are highly volatile variables. In the long run, however, the variables are expected to converge to equilibrium relations. The long-run equilibrium in the external and domestic sector is estimated simultaneously in a vector error-correction model using quarterly data from 1992Q1 to 2007Q2. The estimated model supports the presence of two such long-run relations in the system of variables.

First Step: Estimated Models for the Long-Run External Current Account and the Equilibrium Savings-Investment Position

The long-run equilibrium of the current account is found to be higher when the economy is more competitive—that is, when the real exchange rate is lower and the terms of trade are higher—and to be negatively correlated with the output gap in Paraguay, as expected. Contrary to expectations, the current account is negatively related to the output gap in the United States, suggesting that when growth is beyond potential in the United States, the current account worsens in Paraguay (Table 8.4):

Table 8.4.Estimated Macroeconomic Balance Model in Cointegrated Vector Autoregressive Model(With or without dummy for cash inflows CI from binationals)
Model (1): Without BinationalsModel (2): With Binationals
First CI relationSecond CI relationFirst CI relationSecond CI relation




Long-run cointegrating vectorsβ1β2β1β2
Current account11.
Real effective exchange rate25.621.330.006.031.400.00
Terms of trade2-2.50.850.00-2.030.890.00
Government balance10.00-0.440.170.00-0.580.17
Output gap in Paraguay30.
Output gap in the United States0.
Nominal interest rate in Paraguay0.00-
Nominal interest rate in the United S0.
Loading coefficientα1α2α1α2
Current account /GDP0.00-0.870.190.00-0.870.19
Real effective exchange rate-
Government balance /GDP-0.330.120.380.14-
Test statisticsX2 (5) = 5.63 (0.34)X2 (6) = 3.40 (0.76)
Source: IMF staff estimates.

In share of GDP, in percent.


Real GDP minus trend GDP, index.

Source: IMF staff estimates.

In share of GDP, in percent.


Real GDP minus trend GDP, index.

The long-run equilibrium savings-investment position is found to be higher when the government balance is higher (an increase of 1 percent of GDP in the fiscal deficit leads to an increase of 0.45 percent of GDP in the current account deficit) and to be positively correlated with the interest rate in Paraguay (although the coefficient is not significant) and negatively correlated with the interest rate in the United States.

The estimated long-run model is strongly supported by the data; in fact, the estimated long-run relations cannot be rejected at a 34 percent confidence level, as indicated by the likelihood ratio test of the imposed restrictions (it is customary to use 5 percent as a lower bound for accepting a model).

Second Step: The Estimated Equilibrium Exchange Rate

To find the long-run equilibrium savings-investment position, the long-run stochastic trends of the variables are extracted with an HP filter and combined using equation (3). It is assumed that the equilibrium savings-investment position is domestically determined, in accordance with the theoretical model. Given the accounting identity in equation (1), it can substitute the equilibrium external current account balance. Together with the stochastic long-run trend of the terms of trade, this substitution determines the long-run equilibrium real effective exchange rate.


The results indicate that there are no imbalances arising from the present level of the current account, but that the real exchange rate is somewhat above the level dictated by fundamentals at the end of 2007 (Figure 8.11). The present level of the external current account appears in line with its equilibrium and is hence consistent with maintaining external stability. The present level of the real effective exchange rate, however, appears to be slightly overvalued in relation to its long-term equilibrium. Compared to the exchange rate that would have been consistent with external stability, the exchange rate appears to be about 10 percent overvalued. The exchange therefore appears to be disconnected with the long-term value of the current account.

Figure 8.11.
Equilibrium Current Account Balance and Equilibrium Exchange Rate

Source: IMF staff estimates.

The finding that the guaraní appears to be overvalued since mid-2006 is difficult to reconcile with market behavior. The guaraní is market-determined and has appreciated significantly over the past two years. During this period, the BCP has built large international reserves. These developments suggest that the market considers the exchange rate to be undervalued compared with its equilibrium level. The next section tries to shed some light on the estimated overvaluation, by taking into account the large cash inflows in foreign exchange from Paraguay’s binational entities.

The Real Exchange Rate in Paraguay and Foreign Exchange Inflows from Binationals

The binational entities, Itaipú and Yacyretá, are important sources of foreign exchange inflows. The binationals exchange their foreign exchange earnings for guaranís in order to pay royalties to the government and wages to Paraguayan employees, as well as payments for other goods and services from Paraguay. Cash inflows from the binationals have fluctuated between 3 percent and 7 percent of GDP annually over the period considered for the estimations. As can been seen from Figure 8.12, the real exchange rate is positively correlated with the cash inflows.

Figure 8.12.
Real Effective Exchange Rate and Cash Inflows from Binational Entities

Source: IMF staff estimates.

A reestimation of the model with a dummy for the foreign exchange inflows from the binationals indicates that these inflows are important determinants of the real exchange rate (Table 8.4). The coefficient on the dummy is positive and highly significant, suggesting that the real exchange rate appreciates in response to higher inflows. The inclusion of the dummy furthermore considerably improves the explanatory power of the model; the model can now only be rejected at a 76 percent confidence level (compared with 34 percent earlier), much higher than the 5 percent that is generally taken as a lower bound.

Taking into account the foreign exchange inflows from binationals also substantially reduces the estimated overvaluation. The foreign exchange inflows from the binationals have been high in the past two years, at about 6 percent of GDP annually, and can explain parts of the observed appreciation. When correcting for these inflows, the estimated overvaluation in 2007 is reduced to about 2 percent (Figure 8.13).

Figure 8.13.
Equilibrium Current Account Balance and Equilibrium Exchange Rate (with binationals)

Source: IMF staff estimates.

Concluding Remarks

This chapter has examined different methodologies to assess the exchange rate in Paraguay. As expected, the diagnostics derived from these methodologies differ somewhat. One firm conclusion that stands out of the analysis is that the undervaluation experienced during the early 2000s has now been corrected.

Nonetheless, we are reluctant to conclude that the correction has brought the exchange rate above its equilibrium, although some versions of both econometric models would lead to the conclusion that the exchange rate was somewhat overvalued by the end of 2007. Regarding the equilibrium exchange rate model, the mild improvement of the terms of trade or the recent pickup of growth does not seem sufficient to explain the recent increase of the real exchange rate. Regarding the macroeconomic balance approach, the model predicts only a more modest appreciation. However, the results of baseline econometric models need to be taken with caution:

  • The models are sensitive to the estimation period and the choice of the specification. In particular, estimating the equilibrium model over a shorter period that excludes the period after the banking crisis of 2002 leads to significantly different results. When this period (possibly marked by an overshooting related to the crisis) is excluded, the real exchange rate appears to be in equilibrium. One missing piece of the puzzle in this interpretation of overshooting of the nominal exchange rate is why the sharp nominal depreciation of 2001–02 has been corrected only in 2006–07.

  • Both econometric models rely on contemporaneous variables. This is in contrast with forward-looking monetary models of the exchange rate. However, introducing forward-looking variables could also contribute to explaining the recent appreciation. In particular, prospects of a possible increase of royalties might have generated expectations of an appreciation of the exchange rate.

  • Finally, the diagnostic of overvaluation is not supported by other indicators beyond statistical or econometrical analysis of the real effective exchange rate. The performance of the tradable sector, which is the focus of the popular debate on the appropriate level of the exchange rate, is thriving and does not seem to have been affected by the strengthening of the exchange rate. Arguably, it also did not seem to have benefited from the undervaluation of the exchange rate in the early 2000s, possibly because of the concomitant tightening of bank credit and general economic contraction.

The limits of this analysis illustrate the need to complement the analysis of the long-run equilibrium exchange rate by a careful analysis of the short-term evolution of nominal exchange rates (with respect to key partners). This task is however beyond the scope of the current study.

Appendix 8.1: Database Description and Additional Regression Results

Some of the explanatory variables for the econometric analysis were not available for the full sample at the desired frequency and had to be constructed for part of the sample period. However, even if some variables were not available, some of their components with valuable information content were available and used for the construction of these variables. Thus, no variables were extended based on purely statistical methods (such as a spline).

There is an obvious trade-off between using existing official data on a shorter period and extending the data set to gain precision in the estimation. However, given the availability of underlying data on an intra-annual basis, we are confident of the benefits of extending the data set using techniques similar to those that would be used by the authorities. An alternative extreme position would be to disregard official data owing to the uncertainty of measuring such key variables as exports and imports, given the importance of smuggling and its sensitivity to small tax legislation changes.

Here are some examples of data construction:

  • The current account is only available on an annual basis before 2000. However, using quarterly data on trade in goods from 1990 onward and ad hoc assumptions on trade in services and income receipts allowed us to construct a series of current account spanning the full period.

  • Quarterly GDP is available only from 1994Q1 onward, but the BCP produced an indicator of activity before 1994. Using the Chow-Lin (1971) methodology and annual data from the national accounts, this allows us to construct quarterly data for 1990–93. Note that this is the same methodology used by the BCP to produce, at a more disaggregated level, quarterly accounts from 1994 onward.

  • Finally, the balance of the government is available only on an annual basis. However, monthly data on fiscal execution, complemented by assumptions on tax elasticity, were used to backdate a time series of fiscal balance before 2000.

Table 8.A.1.Database Used
Time SeriesCodeSources1Description
Econometric models
Real exchange rateIreerInformation Notice Systemand staff estimatesCPI–based REER. Quarterly data based on 18 main trade partners or competitors. Annual data based on 15 partners only before 1980, due to data availability.
Fiscal balancefbyBCPFiscal balance of the central government. Quarterly data derived from fiscal execution 2000–07; earlier data extrapolated using an assumption on tax elasticity and quarterly real GDP.
Current account balancecabyBCP, IFS, and DTSAnnual data from IFS and BCP. Quarterly data for 2000–07 from BCP and 1991–99 data extrapolated using trade data from DTS and smoothing of income and service balances.
Net foreign assetsnfayBCP and IFSNet foreign assets of central bank and deposit money banks.
OpennesslopenyBCP and DTSAverage of imports and exports of goods over GDP. Quarterly data from DTS (registered trade only). Annual data from BCP.
Commodity pricelcompIFS and COMTRADEWeighted average of international prices of four main commodities (soya, beef, cotton, and wheat) against price of industrial goods. Weighted average with variable weights using trade share from COMTRADE.
Relative productivityIbalasBCP and IFSRatio of GDP per capita in Paraguay and the U.S. Annual data based on national accounts. Quarterly data for Paraguay derived using Chow-Lin (1971) methodology and a quarterly indicator for 1991–94 and the Indicador Mensual de la Actividad Economica del Paraguay IMAEP 1994–2007.
Other data
ULC–based REERBCP, Haver AnalyticsNominal wages, total employment, and GDP on an annual basis.
Export market shareDTSTotal exports of goods from a given country or region.
Tradable / nontradable sectorsBCP (national accounts)Tradable: primary sector and manufacturing sector; alternative measure of tradable excluding agriculture, livestock, meat-processing; nontradable: construction, utilities, and service sector.

Banco Central de Paraguay (BCP); International Finance Statistics (IFS, IMF), and Direction of Trade Statistics (DTS, IMF); Haver Analytics; COMTRADE, United Nations.

Banco Central de Paraguay (BCP); International Finance Statistics (IFS, IMF), and Direction of Trade Statistics (DTS, IMF); Haver Analytics; COMTRADE, United Nations.

Figure 8.A.1.
Determinants of the Real Exchange Rate, Quarterly Data 1991–2007


Source: IMF staff estimates.

Table 8.A.3.b.Estimation of Equilibrium REER
Robustness to

Alternative Specification
Robustness to

Period Specification
DOLS Estimation




To 02Q2To 02Q2To 05Q22 lags1 lag3 lag
Cointegrating vector