March 28, 2005
1. Our authorities wish to express their gratitude to management and the staff for their continuous support and valuable advice in the design and implementation of the current SBA, which has contributed significantly to improving the administration of the Paraguayan economy.
2. Even though democratic rule was restored in early 1989, Paraguay’s significant institutional weaknesses seriously undermined economic management. For many years the economy was characterized by slow growth —only 0.8 percent per year on average in 1995-2002— mainly due to structural impediments to growth, banking sector weaknesses, governance problems, and inefficient public enterprises. Furthermore, attempts to implement and sustain a comprehensive stabilization and reform plan failed mainly because of considerable difficulties in mustering the necessary political and social consensus.
3. Against this background, the government that took office in August 2003 set out to develop a plan to stabilize macroeconomic conditions, particularly oriented to strengthen fiscal sustainability and eliminate important arrears in public debt, enhance transparency and governance, and address long-standing structural weaknesses, in order to bring the economy towards a long-term path of stability, sustained growth, and poverty reduction. Our authorities have made significant efforts to ensure broad support for the envisaged reforms.
4. It is noteworthy, as pointed out by staff, that the Paraguayan authorities have made remarkable progress in implementing their comprehensive and ambitious program, supported by a Fund arrangement, and that macroeconomic results have been impressive during the past year —in fact, the best in decades. Despite last year’s drought that severely affected soy production, the main export crop, GDP grew almost 3 percent in 2004 —4 percent using the new methodology for calculating the GDP, which sets 1994 as the base year. In addition, the inflation rate declined to 2.8 percent, the lowest in 30 years (and significantly below the program target of 8 percent); a fiscal surplus was achieved for the first time in a decade; central government arrears were nearly eliminated from around USD 130 million at the beginning of the present administration; the level of international reserves increased well above the original program target; the net domestic credit of the central bank was maintained within the range agreed with the Fund; the foreign exchange market is stable; and confidence in the banking system has been restored.
5. The observance of almost all end-December quantitative performance criteria and all structural conditions for the current review reflects the authorities’ unrelenting commitment to the program. They request waivers for the non-observance of certain performance criteria, in view of the corrective actions introduced. In this respect, we would like to make the following remarks:
The authorities regret that the limit on the stock of arrears for end-December 2004 was not observed. This was due to the accumulation of inventories by the state-owned petroleum company (PETROPAR) at a time when historically high fuel prices accelerated the accumulation of arrears with suppliers. However, the authorities increased diesel prices last January, which will contribute significantly to a gradual clearing of the arrears. At the same time, they are considering some options to ensure a long-term solution to PETROPAR’s financial difficulties. A cooperation agreement with Venezuela to purchase fuel under preferential conditions will moderate the impact of high oil prices. Notably, a draft hydrocarbons law —to be submitted to Congress in April— will propose the liberalization of diesel prices.
The financial obligation which was considered not paid on time to the Inter-American Development Bank (IDB) in November 2004 was actually a debt the water company (ESSAP) had and which was guaranteed by the government. Time-consuming legal and operative procedures needed to be completed before the payment could be ordered by the Ministry of Finance. Even though it was within the grace period that the Ministry of Finance ordered the payment transaction through the Central Bank of Paraguay, the observance of the Thanksgiving holiday in the U.S. and some operative problems caused a four-day delay until the credit to the IDB was made effective. Given that last year’s arrears were originated in public enterprises, the Ministry of Finance is closely monitoring them to ensure timely payments, and to avoid future slippages it has instructed that all obligations are to be paid on their due date rather than using grace periods.
6. At this stage, we would like to recall that Paraguay’s short experience in managing a Fund-supported program (the current arrangement is the first in 40 years), the challenge of meeting a heavy structural agenda in a short period, and complex congressional negotiations for the approval of reforms have been the main causes of the delays and slippages in the observance of some performance criteria since the program was launched. However, we would like to stress that, in spite of these limitations, much has been done, and economic results have been remarkable. Over the last 15 months, the authorities have successfully pressed for passage of important legislation regarding the fiscal, banking, cooperative, pensions and customs sectors; taken determined steps to reduce the country’s debt and arrears, made significant efforts to normalize relations with all creditors; introduced procedures to improve transparency and governance (such as enforcement of the public procurement law in all public agencies, as well as independent and external audits in public enterprises and the central bank); and adjusted fuel and utilities prices regularly to restore the financial health of public enterprises. These reflect the authorities’ strong ownership, as well as their ability to gather consensus on the need for several key policies. Moreover, they would like to reiterate their firm commitment to complete the envisaged structural reform agenda in a timely manner, and to implement the necessary measures to lock in the gains achieved so far. At the same time, they intend to implement mechanisms to avoid slippages in the future. In this regard, a joint Ministry of Finance/Central Bank monitoring group has been formed recently to coordinate program implementation with Fund staff through weekly telephone conferences.
7. Even though Congress approved an expansionary 2005 budget —which increased the level of spending, and could eventually endanger the fiscal target envisaged under the program— our authorities remain determined to maintaining fiscal prudence and discipline. In this respect, they are considering a number of budget control mechanisms. Among these, the Fiscal Financial Plan is a strong legal and administrative instrument geared to limit spending units’ operations to available resources. The Ministry of Finance has already used this tool successfully last year. Additionally, the authorities will enhance the monitoring role of the Public Investment Coordination Unit (UCIP) at the Ministry of Finance to ensure an efficient use of resources, and to ensure that capital expenditures remain consistent with the fiscal program and with available financing. It is important to keep in mind that, once macroeconomic stability is achieved, the main challenge will be to attain high and sustained growth. In this regard, the role of the UCIP is crucial to increase public investment to support higher GDP growth, while at the same time maintaining a prudent stance.
8. The authorities’ continuous efforts to strengthen tax and customs administration through wide-ranging measures, and actions geared to reduce tax evasion and combat corruption, have been key in increasing fiscal revenues beyond program projections, by around 35 percent in 2004. Moreover, administrative improvements; a gradual implementation of the streamlined Fiscal Adjustment Law, which broadens the tax base and intends to further formalize the economy; and the introduction of a new Customs Code early this year, have further increased tax collections during the first two months of 2005. The authorities are confident that the introduction of these important reforms, as well as the launching of the public pension system reform early last year, will contribute to placing the country on a path of long-term fiscal sustainability, while creating space for increasing investment and social outlays. Actions in that direction are also consistent with the authorities’ intention to put the debt-to-GDP ratio on a declining trend. The debt burden decreased to 39.8 percent at end-December 2004, from almost 50 percent in 2002, and is expected to fall below 30 percent in 2010.
9. The authorities’ prudent monetary policy is reflected in the stabilization of the guarani, a sharper than anticipated reduction in inflation pressures, a limited growth of the Central Bank’s net domestic credit, and a higher than expected accumulation of international reserves in 2004. The slight pickup in inflation over the last months, as well as moderated pressures in the foreign exchange market, were associated with oil market developments, payment of end-year bonuses, a seasonal spike in food prices, the sharp real appreciation of the Brazilian real against the domestic currency, and a temporary increase in foreign exchange demand. However, the Central Bank was proactive in implementing monetary and exchange rate adjustments. The monetary authorities raised the interest rate on monetary policy instruments in February to control liquidity, and had limited intervention in the foreign exchange market to moderate the seasonal depreciation of the guarani due to the excess foreign currency demand that characterized the first two months of the year. Consistent with the staff’s advice, the Central Bank is monitoring interest rate developments in neighboring countries and the U.S.. Additionally, priority is given to using exchange and interest rates flexibly to meet this year’s inflation objective. Likewise, the authorities give due priority to the prompt implementation of MFD’s recommendations for the modernization of monetary and foreign exchange policies.
10. The authorities continue to strengthen the financial system, including financial cooperatives, by introducing enhanced supervision and regulation. After the 2002 financial crisis, banks are currently in a much better stance, as evidenced by their improved financial indicators, in particular their capital ratios, the share of non-performing loans, and the overall profitability. Thus, credit is finally recovering, especially in domestic currency, which was sharply interrupted in 2002. In this regard, the forthcoming FSAP mission in April will significantly contribute to identifying existing vulnerabilities. Our authorities look forward to the exercise, and intend to follow the staff’s recommendations to enhance banking legislation.
11. Regarding public banks, in early March 2005 the second-tier public bank reform was approved by the Senate, and is expected to be fully approved by Congress around May. Implementation of this law will be instrumental in improving management of credit lines and development financing through intermediation of external resources. In addition, the authorities are confident that Congress will soon approve the first-tier public bank reform draft-law —including the reform of the deteriorated Public National Development Bank (BNF). Meanwhile, much progress has been attained regarding the management and financial conditions of the BNF since new managers were appointed in mid-2003. In addition, the commission created by the authorities in January 2005 aims at developing a medium-term business and restructuring plan for the BNF to enhance its efficiency and reduce its costly impact on fiscal finances. The recent MFD mission provided a helpful diagnose of the BNF’s financial situation and recommendations on how to restructure it, which are currently under consideration by the commission.
12. The authorities’ main objective is to advance steadily with the structural reform agenda, using the opportunity provided by the extension of the Fund-supported program. Plans to improve the efficiency and governance of the public sector are also a centerpiece of the program. Independent regular audits, improvements in transparency, and anti-corruption measures are progressing, while the comprehensive plan for the reform of the civil service — a structural benchmark for the next review— is almost complete. Plans to engage private investors in some public enterprises as a way to increase investment and improve efficiency are also being evaluated by the authorities.
13. The government recognizes that, along with the structural reforms needed to strengthen the institutional framework, a major challenge is to enhance productivity and diversify the economy, considering that Paraguayan exports remain highly concentrated in primary agricultural goods. In this vein, a significant improvement in the investment climate is essential to attract domestic and foreign resources and to lay the foundation for higher and sustainable growth. A broad consensus on an ambitious economic strategy was achieved with the business community and the civil society in the context of a broad-based seminar at the end of last year. On that occasion, actions to address the main hindrances to growth, enhance competitiveness, diversify the economy, reduce inequalities, and improve the business environment were discussed and included in a six-year plan.
14. Our authorities are confident that their policy framework will succeed in attaining the economic objectives envisaged under the program. They are aware of the importance of reforms to change the structure of the economy and ensure long-term growth, while reducing the high unemployment and poverty rates. They acknowledge that the flexibility shown by the Fund since the beginning of the program has given the government enough time to build the consensus needed to ensure approval of key legislation and reforms. Finally, our authorities believe that continuing Fund support is crucial to leverage their efforts to move ahead with the reform process and reinforce policy credibility.