Paraguay: Staff Report for the 2004 Article IV Consultation and Second Review Under the Stand-By Arrangement and Requests for Waiver and Modifications of Performance Criteria

1. After years of economic stagnation and periodic economic crises, the government of President Nicanor Duarte Frutos took office in August 2003 and embarked on an ambitious program of economic reforms. The staff agreed on a set of policies to be supported by a Fund arrangement in October 2003, and the Board approved a 15-month Stand-By Arrangement on December 15, 2003. Performance under the program thus far has been satisfactory in most areas. The first program review was concluded on April 12, 2004. For the second review, 9 of 11 end-March quantitative performance criteria were observed, including all monetary and fiscal deficit targets (Table 1). Missed PCs included the wage bill ceiling and one missed target on arrears. The Fiscal Adjustment Law (PC for end-May) was approved in a weakened version on June 25; the authorities have committed to a set of compensatory measures to compensate for the reduced revenue yield of the law.

Abstract

1. After years of economic stagnation and periodic economic crises, the government of President Nicanor Duarte Frutos took office in August 2003 and embarked on an ambitious program of economic reforms. The staff agreed on a set of policies to be supported by a Fund arrangement in October 2003, and the Board approved a 15-month Stand-By Arrangement on December 15, 2003. Performance under the program thus far has been satisfactory in most areas. The first program review was concluded on April 12, 2004. For the second review, 9 of 11 end-March quantitative performance criteria were observed, including all monetary and fiscal deficit targets (Table 1). Missed PCs included the wage bill ceiling and one missed target on arrears. The Fiscal Adjustment Law (PC for end-May) was approved in a weakened version on June 25; the authorities have committed to a set of compensatory measures to compensate for the reduced revenue yield of the law.

I. Introduction

1. After years of economic stagnation and periodic economic crises, the government of President Nicanor Duarte Frutos took office in August 2003 and embarked on an ambitious program of economic reforms. The staff agreed on a set of policies to be supported by a Fund arrangement in October 2003, and the Board approved a 15-month Stand-By Arrangement on December 15, 2003. Performance under the program thus far has been satisfactory in most areas. The first program review was concluded on April 12, 2004. For the second review, 9 of 11 end-March quantitative performance criteria were observed, including all monetary and fiscal deficit targets (Table 1). Missed PCs included the wage bill ceiling and one missed target on arrears. The Fiscal Adjustment Law (PC for end-May) was approved in a weakened version on June 25; the authorities have committed to a set of compensatory measures to compensate for the reduced revenue yield of the law.

Table 1.

Paraguay: Quantitative Performance Criteria

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Sources: IMF Country Report No. 04/66; TMU; and staff estimates.

NIR is adjusted upward (downward) for any increase (decrease) in reserve requirement deposits. Similarly, the NDA target will be adjusted upward (downward) following the adjustment in the NIR.

As measured below the line (it differs from balance in Table 5 where it is measured above the line).

Indicative target.

Targets for end-August 2004 and thereafter have been set to zero, reflecting the authorities’ clearance of arrears in advance of the original program schedule.

The ceiling is adjusted downward by any excess in program lending above US$15 million (expressed in guaraníes). The stock of floating debt in September has been revised, due to a mistake in reporting, from G277 billion to G384 billion.

2. At the time of the last Article IV consultation on March 10, 2003, Directors recommended the adoption of a comprehensive program of fiscal and structural reforms in order to set Paraguay on a path of sustainable growth. They suggested that the strategy should center on restoring fiscal sustainability, improving the efficiency of the public sector, strengthening the banking sector, and improving governance and fighting corruption. Specifically, they urged the authorities to adopt a comprehensive and balanced fiscal package, including measures to increase tax revenues as well as appropriate spending restraint, and efforts to correct financial problems in certain public enterprisers. Directors also emphasized the need to reform the public employees’ pension plan. Directors noted that monetary policy had responded pragmatically to the difficulties faced in 2002, but they urged the authorities to strengthen the operational framework of monetary policy, to establish a clear nominal anchor and increase the central bank’s operational independence. Directors encouraged the authorities to monitor the situation of banks closely and to take a proactive stance in response to any difficulties. In particular, Directors expressed concern about the precarious financial situation of the National Development Bank (BNF). They urged the authorities to implement without further delay a comprehensive restructuring and reform of the bank, along the lines of the program designed last year with the support of the IDB.

II.Background and Recent Developments

3.The Paraguayan economy is only beginning to emerge from a long period of slow growth. Over the two decades to 2002, per capita income fell by an average of 0.6 percent per year (Table 2 and 3). This stagnation reflected weak macroeconomic management and a series of structural problems, which impeded growth and left the country more vulnerable to the effects of economic shocks. The main structural problems include:

Table 2.

Paraguay: Selected Economic Indicators, 2000-04

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Sources: Paraguayan authorities; and Fund staff estimates.

Consolidated public sector, including the quasi-fiscal operations of the BCP.

Foreign currency items are valued at a constant exchange rate.

Contribution to M5 growth.

Table 3.

Paraguay: GDP and Prices

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Sources: Central Bank of Paraguay; and Fund staff estimates.
  • Political instability. During the 1990s, the political system was rocked by a coup attempt, the assassination of a vice-president, the resignation of a president, and a subsequent period of government by an interim President, González Macchi, who was not popularly elected.

  • Serious governance problems. Corruption, inefficiency, poor guarantees of property rights, and lack of transparency have afflicted both the public and private sectors. Paraguay has consistently ranked among the worst in the world in surveys of perception of corruption (See Box 1).

  • A weak banking system plagued by a series of crises. Bank closures affected the financial sector in several rounds from 1995 to 2003, reducing the total number of banks from 35 to 14.

  • Inefficient public enterprises in key sectors. Government firms are a strong presence in the water, electricity, transport, telecommunications, petroleum, cement, and banking sectors. Many are poorly run and their performance has depressed growth in the rest of the economy.

  • Low and falling productivity. Poor human capital formation, inefficient public services, and governance problems have contributed to the deterioration.

  • High poverty and unemployment with limited social protection. Income inequality is high, and nearly half the population lives on less than US$2 per day. Social spending per capita is one-fourth of the Latin American average.

4. A sharp recession in 2002 was followed by a tentative recovery in 2003. The regional crisis, problems with drought and foot-and-mouth disease in agriculture, and a banking crisis, all contributed to a drop of 2.3 percent in GDP in 2002 (Table 2 and3). There was a sharp depreciation of the exchange rate in 2002 and inflation accelerated, reaching 20 percent in early 2003. A bumper harvest produced positive GDP growth of an estimated 2.6 percent in 2003. The easing of the regional crisis and the clear victory of Nicanor Duarte Frutos in the April 2003 presidential elections provided an increased perception of economic and political stability later in the year. Banking system deposits recovered, the exchange rate appreciated against the dollar, and inflation eased to 9 percent at year-end. The nonagricultural economy remained stagnant, however.

5. In 2004, the economy has stabilized but growth remains modest (Figure 1 and2) A late season drought depressed output of soy, the largest export crop, reducing expected agricultural output growth to near zero. Nonagricultural output is recovering, producing a forecast GDP growth for 2004 slightly above 2 percent. The guaraní has strengthened by 4 percent against the dollar so far in 2004, despite strong Central Bank purchases of foreign exchange. The strong guaraní contributed to a sharp fall in inflation. Year-on-year inflation through June was 5.5 percent, with inflation for the year as a whole expected at 4-5 percent.

Figure 1.
Figure 1.

Paraguay: Selected Economic Indicators

Citation: IMF Staff Country Reports 2005, 059; 10.5089/9781451832433.002.A001

Source: Central Bank of Paraguay.
Figure 2.
Figure 2.

Paraguay: Exchange Rates

Citation: IMF Staff Country Reports 2005, 059; 10.5089/9781451832433.002.A001

Source: Central Bank of Paraguay.

6. The political environment for reform has improved, but important challenges remain. President Duarte Frutos has demonstrated an ability to advance important political and economic reforms, despite not having a majority in the Senate.1 He has appointed reform-minded people to key positions in the government and retains a high degree of support in public opinion polls. However, the government’s support in Congress is fragile, with opposition parties often inclined to oppose government initiatives for political reasons, and increasing resistance from special interests whose privileges are affected by reform measures. There is also pressure from within the president’s own Colorado party from factions, which have traditionally benefited from patronage and rent-seeking behaviors. Reform efforts must also confront long-standing and pervasive governance problems that seriously affect the efficiency of the public sector and generally act to undermine change (see Box 1).

7. The fiscal situation has improved markedly since the new government took office in August 2003. The consolidated balance of the nonfinancial public sector (NFPS) moved from a deficit of 3.1 percent of GDP in 2002 to balance in 2003 (Table 4). The primary balance improved from a deficit of 1.3 percent of GDP in 2002 to a surplus of 2.4 percent in 2003. The main features of the improvement in 2003 were:

Table 4.

Paraguay: Operations of the Consolidated Public Sector 1/

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Sources: Ministry of Finance; and Fund staff estimates.

Public sector comprises only the nonfinancial public sector and the central bank.

Measurement error to reconcile above-the-line estimate with measure of the fiscal balance from the financing side.

Assumes quasi fiscal deficit of central bank entirely financed. Excludes quasifiscal loss from payments of Multibanco depositors for G123.1 billion.

Table 5.

Paraguay: Central Government Operations

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Sources: Ministry of Finance; and Fund staff estimates.

Includes receipts from the binational hydroelectric plants Itaipu and grants. No new revebnue from Yacyreta expected beyond April 2004 in projections.

Measurement error to reconcile above-the-line estimate with measure of the fiscal balance from the financing side.

Includes payments of ESSAP external debt amortizations for US$6.3 million in 2003 and US$11.6 million in 2004, as well as arrears.

Includes pension payments to central government employees and Chaco War veterans..

  • Expendituresweretightlycontrolledthroughouttheyearinthecentralgovernment. Current spending in the central government fell from 15 percent of GDP to 13 ½ percent of GDP (Table 5). A wage freeze for public sector employees and pensioners was the biggest factor, but control of goods and services spending and lower interest rates on public debt also contributed. Capital spending fell slightly in nominal terms in 2003, in part as the result of financing constraints on investment projects.

  • TaxcollectionsincreasedsharplybeginninginAugust2003duetochangesintaxandcustomsadministrations. In the period August-December, tax collection increased by over 40 percent on 2002, compared to an increase of only 14 ½ percent during the first seven months of the year. For the year as a whole, tax revenues rose from 9 percent of GDP to 10 percent.

  • Theoutturnofpublicenterprisesimproved. The operating surplus of the enterprises rose from 1.4 percent of GDP in 2002 to 2.1 percent of GDP in 2003, due mainly to the effect of an appreciating exchange rate on dollar costs in key enterprises. Results are expected to improve further as the guaraní remains strong and management changes have been made in some of the more problematic firms (Table 6).

Table 6.

Paraguay: Operations of the Rest of the Public Sector 1/

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Sources: Ministry of Finance and Fund staff estimates.

Defined as the nonfinancial public sector and the BCP, excluding the central government.

Assumes quasi fiscal deficit of central bank entirely financed. Excludes quasifiscal loss from payments of Multibanco depositors for G123.1 billion

8. For 2004, the public finances are expected to improve further. The central government will run a slight surplus. The early approval of the Public Pension Reform Law (the caja fiscal) is expected to generate savings on the order of ½ percent of GDP in transfer payments. Continued low international interest rates and the normalization for external payments arrears will cause interest payments to fall slightly compared to 2003. Most importantly, the continued strong performance of revenue collections in the first half of the year suggests that tax revenues as a share of GDP will reach a historical high of near 12 percent of GDP. For the consolidated public sector, the surplus is expected to be around 1.5 percent of GDP, due to further improvements in the outturn of the public enterprises, as well as an improvement in the social security institute (IPS).

9. The authorities have made significant progress in clearing substantial public sector payments arrears (Table 7 and8). From a stock of over US$250 million (4½ percent of GDP) at end-2002, arrears were reduced to US$185 million in 2003 (3 percent of GDP) and have fallen further to US$128 million by April 2004. Arrears to the World Bank and IDB were cleared in late 2003. The government obtained a short-term loan from the Central Bank in early 2004 to clear arrears to Paris Club countries ahead 2 of the schedule contemplated in the program. Of remaining external arrears, the largest components are those of the state-owned oil firm Petropar with its fuel suppliers.

Table 7.

Paraguay: Public Sector Arrears

(In millions of USS)

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Sources: Ministry of Finance; and Fund staff estimates.

Public sector pending obligations more than 1 day overdue, except for last 4 columns (see footnote 2)

The program considers as arrears: (i) all payments past due over 30 days; (ii) nondisputed arrears; (iii) domestic

Based on preliminary data. The $15 million central government external arrears refer to disputed arrears with Belgium and South Africa, so would be excluded from program targets.

For the purposes of the target on domestic floating debt in March, interest on new bonds not yet processed and verified are not part of domestic debt as of March 31, 2004.

Includes about US$14 million in disputed arrears, except for the last four column (see footnote 2)

Paid by the BCP, the guarantor, under the program.

Table 8.

Paraguay: Public Sector Financing

(In milllions of US$, unless otherwise stated)

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Sources: Ministry of Finance; and Fund staff estimates.

Includes measures under the program, as well as an assumption of a US$33 million BCP loan to the central government.

Includes rollover of $138 million in maturing domestic bonds on November 15.

Includes amortizations of the financial public sector guaranteed by the Republic of Paraguay.

10. Domestic arrears have been lowered to a level comfortably below the end-March program target, and stricter conditions for ministries to stay within budget allocations should help maintain this margin. In November 2003, an agreement was reached with holders of domestic bonds in default since December 2002 to exchange those bonds for new ones with extended maturities and a slight NPV reduction. A Law passed in December determined that the government would honor interest payments after December 26 according to the new terms and dates. There have been delays in completing the technical exchange itself, leading to the accumulation of interest arrears on the new bonds.3 However, all old bonds that have been submitted by June 15 will be exchanged into new bonds (about 80 percent of the eligible amount), and all overdue interest on these new bonds will be paid (prior action for the review).

11. After climbing to near 50 percent of GDP in 2002 and 2003, the public sector debt-to-GDP ratio is expected to drop sharply to 43 percent in 2004. The drop is due to the expected fiscal surplus, plus a rise in U.S. dollar GDP (due to economic growth and currency appreciation against the dollar). About 90 percent of the debt is external, half of which is owed to international financial institutions and one-quarter to Taiwan, Province of China. Debt service remains relatively low (external debt service was 4.5 percent of GDP in 2003), because Paraguayan debt is mostly long term and at concessional interest rates.

12. Monetary policy has been geared toward a flexible exchange rate regime since the defacto currency peg was abandoned in 2001 (Figure 3). Nevertheless, the Central Bank of Paraguay (BCP) has maintained a strong presence in the foreign exchange market, accumulating and selling reserves to resist sharp movements in the guaraní. The BCP has limited the growth of the domestic money supply mainly through sales of the bank’s Letras de Regulación Monetaria (LRMs), the stock of which has grown sharply over the past 3 years, from G/. 300 billion at end-2001 to around G/. 1.6 trillion in mid-2004 (Table 9 and 10). Interest rates on LRMs have declined from their peak of 33 percent in August 2002, reaching 9½ percent by April 2004. However, the real interest rate has actually risen on LRMs since mid-2003, as inflation has fallen more rapidly than the interest rate. Base money growth accelerated sharply in 2003, as the economy began to remonetize after the banking crises. Base money rose by 58 percent in 2003, but the growth rate has since fallen to below 25 percent, but base money as a share of GDP remains reasonable by historical standards. The appreciation of the guaraní in 2003 also contributed to a greater willingness of agents to hold local currency, and as a result, some de-dollarization occurred (from 69 percent of deposits at end-2002 to 64 percent in mid-2004).

Figure 3.
Figure 3.

Paraguay: Selected Financial Indicators

Citation: IMF Staff Country Reports 2005, 059; 10.5089/9781451832433.002.A001

Source: Central Bank of Paraguay.
Table 9.

Paraguay: Monetary Program

(In billions of guaraníes; end-of-period; valued at constant exchange rate)

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Sources: Central Bank of Paraguay; and Fund staff estimates.