Paraguay: Third Review Under the Stand-By Arrangement, Request for Extension of the Arrangement, and Request for Waivers of Performance Criteria

The staff paper for the Third Review Under the Stand-By Arrangement on Paraguay focuses on the macroeconomic framework and medium-term scenario, risks, and capacity to repay the IMF. There have been delays in implementing some structural measures, especially related to the approval of banking legislation, owing to a shift in the political environment and congressional delays. Macroeconomic performance has been better than envisaged under the program. The authorities have adopted a new strategy involving a two-stage approach that they believe is politically feasible to achieve but will require more time to implement.


The staff paper for the Third Review Under the Stand-By Arrangement on Paraguay focuses on the macroeconomic framework and medium-term scenario, risks, and capacity to repay the IMF. There have been delays in implementing some structural measures, especially related to the approval of banking legislation, owing to a shift in the political environment and congressional delays. Macroeconomic performance has been better than envisaged under the program. The authorities have adopted a new strategy involving a two-stage approach that they believe is politically feasible to achieve but will require more time to implement.

I. Recent Developments

1. The program remains broadly on track but parts of the structural agenda need strengthening. Macroeconomic performance continued to be strong with most quantitative performance criteria observed for end-August.1 However, there were serious delays in implementing the structural reform agenda in the second half of the year as several reforms requiring congressional approval were held up, notably on banking reform.

2. Macroeconomic performance has been better than envisaged under the program.

  • The economy is expected to grow despite a drought. Real GDP is expected to grow by 2½ percent in 2004, in line with program projections. It is estimated that, in the absence of the drought, growth would have reached 3–3½ percent.

  • Inflation is significantly lower than targeted. The program aimed at reducing the inflation rate to 8 percent in 2004. The 12-month consumer price inflation in October fell to 3½ percent. However, the staff expects inflation to increase in the last two months of the year, reflecting administered price adjustments, and reach 6 percent by end-2004.

  • Fiscal policy remains tight and program targets have been observed. The targets for the central government and the consolidated public sector surpluses were exceeded by large margins through end-August 2004, reflecting higher than programmed revenues. Capital expenditures were compressed in the 2004 budget as part of the fiscal consolidation effort. A supplementary budget was introduced in July 2004 as it became clear both that higher spending could be accommodated within the program limits, given stronger than anticipated tax receipts, and that earlier cuts were interrupting implementation of priority and high quality projects financed by the World Bank and IDB. In the event, implementation has continued to be slow and staff projections assume that investment spending will end up considerably below budget in 2004.

    Paraguay: Performance Under the Program

    (In trillions of guaranies, unless indicated)

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    Sources: Paraguayan authorities and Fund staff.

    Central administration.

    Nonfinancial public sector and Central Bank.

    In billions of U.S. dollars.

  • Capital inflows facilitated the observance of monetary targets. Targets for net domestic assets and net international reserves were observed with comfortable margins through end-August 2004, supported by favorable external conditions and strong money demand. As the banking situation normalized and confidence improved, private capital returned. The Central Bank took advantage of this to rebuild reserves, with the resulting net inflows being partly sterilized.

  • The financial system continues to be liquid although weaknesses remain. Banking system deposits continue to rise, and private credit is finally recovering after a long contraction. Overall profitability improved during the first half of 2004 but some banks continue to have losses. The share of nonperforming loans (NPL) declined further, although they remain at over 15 percent of assets.

  • Trade growth remains strong. Exports grew by almost 30 percent in the first nine months of 2004 due to strong soy prices and access to new export markets for meat. Imports grew by over 40 percent in the same period reflecting in part the economic recovery and higher oil prices.2

  • The exchange rate has stabilized. The guaraní has remained broadly stable against the dollar during the year, as net central bank purchases of foreign exchange have offset upward pressures from capital inflows. In real effective terms, the guaraní strengthened by 3 percent since end-December 2003. The current real effective exchange rate is broadly in line with the average of the last five years.

    Paraguay: Recent Developments Annual Growth 1/

    (in percent)

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    Source: Paraguayan authorities.

    With respect to same period of previous year unless otherwise specified.

    Data for 2004 through June.

    12-month growth rate e.o.p.

    Data for 2004 through October.

3. Structural performance has been significantly weaker than in the first half of the year. While some progress was made towards meeting the structural conditionality associated with the third review, the two structural performance criteria established for this review were missed, some benchmarks were only partly observed, and those observed were done with a delay.3 Furthermore, unexpectedly strong political opposition to planned banking legislation made it unlikely that end-year structural targets on banking reform would be met.

4. In October, congress approved a law broadening the scope of the National Development Bank (BNF). Pressures to ensure credit availability for the upcoming harvest led to support for legislation that was not coordinated with the government, and in some respects ran counter to the government's reform efforts. The new law broadened the scope of BNF operations, gave BNF the monopoly for public sector foreign exchange transactions, and increased its credit limits.4 The authorities are confident that: (i) the law will only be in place temporarily, while new first-tier public banking legislation is prepared; (ii) the amount of additional BNF credit will be limited by current prudential regulations; and (iii) current prudential rules will ensure credit quality of additional BNF loans.5 The superintendency of banks will continue to monitor BNF and report to the ministry of finance. Nevertheless, the approval of this law before the restructuring of the BNF increases the risks to BNF's balance sheet.

Paraguay: Structural Reform Agenda for Third SBA Review

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Sources: Paraguayan authorities and Fund staff.

5. The social situation has deteriorated over the last six months as high poverty and income inequality have led to protests. After a period of relative calm, there have been several incidents of peasants taking over land since August and some street demonstrations in Asunción and other cities. Rural demands center on land, while urban protests concern wages and employment. Income inequality has been traditionally high, and nearly half of the population lives on less than US$2 per day. Social spending remains quite low. However, the authorities are seeking to address some of the concerns of the rural poor by introducing a land tax earmarked to buy land to distribute among peasants. The 2005 budget includes a moderate wage increase of about 10 percent after three years of wage freeze. A significant increase in capital expenditure on infrastructure to expand growth potential and employment is also planned.

II. Policy Discussions

6. In view of the delays in implementing the structural reform agenda, the authorities have requested a 6-month extension to the SBA. A number of planned reforms require congressional approval and there is a recess scheduled from mid-December to late-February. In order to consolidate the macroeconomic gains and provide a continued framework while the structural agenda is reinvigorated and the planned reforms are completed, the authorities have requested a six-month extension to the SBA until end-September 2005, with no additional access under the arrangement.

A. Macroeconomic Framework

7. Macroeconomic policies for 2005 will aim at securing the stabilization achieved during the first year of the program, while allowing for a recovery in public investment and growth. Policies will be based on a growth rate of about 3¼ percent, supported by a recovery in agricultural output and investment. Inflationary pressures, mostly derived from expected increases in administered prices (diesel and utilities) and regional inflation, should remain modest. The current account balance is expected to deteriorate somewhat to accommodate higher investment (¶5).6

Paraguay: Macroeconomic Framework, 2002–05

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Sources: Paraguayan authorities; and Fund staff estimates.

Original program (Country Report No. 04/66).

Minus indicates a real depreciation.

Central government.

B. Fiscal Policy 7

8. The fiscal program for 2005 aims at broad budget balance, while allowing a significant increase in public investment. The authorities’ fiscal program for the central government incorporates a small deficit of ½ percent of GDP in 2005 as a recovery in public investment from the compressed level of 2004 is largely financed by higher projected revenues. Consistent with this and with projections for the public enterprises, the program fiscal targets for 2005 envisage overall balance for the consolidated public sector. The overall program targets are broadly similar to the targets for 2004, although with higher public investment and higher revenues. Given the fiscal overperformance now projected for 2004, the program would allow a relaxation in the overall balance in 2005, almost entirely accounted for by higher capital spending. Staff believes there is sufficient room to absorb the higher investment (mainly on water supply, electricity distribution, highway development, and construction of schools) without creating inflationary pressures or an undue widening of the external current account deficit (¶6): 8

  • On the revenue side, the draft budget incorporates conservative assumptions for tax collections, with only modest gains from tax administration and from the implementation of the Fiscal Adjustment Law and the new Customs Code. The authorities are introducing a land tax in 2005 earmarked to cover expenditures related to rural issues.

  • On the expenditure side, the draft budget contemplates higher spending mainly due to faster implementation of high quality investment projects (mostly financed by the World Bank, the IDB and JBIC). A modest increase in current spending is also planned, reflecting a wage increase of some 10 percent (following a three-year freeze) and the creation of a rural institute (to buy land for peasants, financed by the new land tax) to confront emerging social tensions in rural areas. These additional current expenditures are partly offset by further tightening in other spending categories (mostly goods and services and transfers).

    Paraguay: 2005 Budget

    (In percent of GDP)

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    Sources: Paraguayan authorities; and Fund staff estimates

    Original program (Country Report No. 04/66).

9. The small central government deficit for 2005 will be financed primarily by external borrowing. Already contracted project loans will fully finance the program without net additional recourse to domestic sources. The treasury expects to use a combination of bank deposits and floating debt to cover domestic financing needs arising from domestic bonds falling due.

10. In the event revenues are higher than anticipated in the program, an automatic adjustor will ensure that a portion is saved. Since there are upside risks on tax collections, the mission reached understandings on an adjustor on tax revenues so that for each guaraní of additional tax revenues above program projections, 30 cents would be saved while 70 cents could be used to finance higher expenditures. The authorities intend to use the additional resources to finance capital expenditures; the staff will monitor this additional spending in close collaboration with the World Bank and the IDB to ensure that the resources are used for high quality projects. This adjustor will not apply in cases where tax revenues fall short from program projections.

11. Fiscal policy, supported by a policy of a consolidated balanced budget, is consistent with the objective of reducing public debt to 30 percent of GDP over the medium term. A continuation of the current policy stance will allow the authorities to generate a primary surplus of 1¼ percent of GDP a year on average, and a central government overall balance near zero over the medium term. This fiscal stance, together with faster economic growth, would put the public debt to GDP ratio on a rapidly declining trend, reaching the 30 percent objective by 2009.

C. Monetary and Exchange Rate Policy

12. Monetary policy will aim at consolidating inflation during 2005 at 6 percent. The central bank will accommodate an expected 10 percent increase in the demand for currency. Higher oil prices and, more generally, somewhat higher inflation in the world and the region, will lead to some upward price pressures. Having improved the international reserve position, the authorities agreed to use exchange and interest rates flexibly in the coming year to meet the inflation objective. Some proposed improvements in the implementation of monetary policy have been identified by MFD technical assistance missions, including to: (i) build consistency between inflation and exchange rate projections; (ii) strengthen management and procedures at the decision levels; (iii) strengthen and reorganize the Economics Studies Department of the Central Bank; (iv) improve statistics; and (v) improve public communications. The staff called for the early adoption of these recommendations (¶9).

Paraguay: Monetary Program

(In percent of currency the previous period)

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Sources: Paraguayan authorities; and Fund staff estimates.

Original program (Country Report No. 04/66).

13. A modest further buildup of international reserves is projected. With international reserves well above program projections in 2004, the central bank’s objective is to accumulate only US$40 million during 2005 in order to maintain import coverage of reserves at about 4 months. Lower international reserve accumulation will ease the conduct of monetary policy by the central bank. The program also allows for a reduction in commercial bank’ free reserves at the central bank in response to improved credit conditions. To accommodate seasonal factors and a heavy schedule of external payments in March 2005, the program envisages that international reserves will fall temporarily in the first quarter before recovering in June 2005 when exports are seasonally strong.

14. The authorities do not have a fixed exchange rate target but adjust policies to promote exchange rate stability. The authorities embrace a flexible exchange rate regime, recognizing Paraguay’s vulnerabilities to exchange rate movements in neighboring countries, but conduct a tight credit policy aim at generating a stable real effective exchange rate. With reserves now at a more comfortable level, the authorities intend to refrain from large-scale foreign exchange purchases in the future. In the event of downward pressures on the guaraní, the authorities would tighten their monetary policy stance to reduce potential reserve loss.

15. Interest rates on central bank bills (LRM) are expected to become positive in real terms after declining significantly over the past year. With high liquidity in the financial system due to capital inflows, nominal interest rates on LRM have fallen to about 5 percent, below the 6 percent inflation rate. The mission proposed a more active interest rate policy, given the increased U.S. interest rates, and the need to establish a positive real interest rate as a benchmark in the financial system.

16. The central bank has begun to implement a restructuring plan to operate more efficiently and effectively. The reform is expected to reduce the overall size of the bank, while increasing staff resources dedicated to economic studies and banking supervision. The staff noted that eventually new legislation to give the central bank greater independence would be warranted. The authorities feel that attempts to pass a new law now would hamper the prospects for the approval of other priority legislation. The central bank has published its audited financial statements for end-2003, which report its results based on accounting principles substantially similar to international financial reporting standards (structural benchmark).

D. External Issues

17. A 5 percent worsening in the terms of trade is expected to push the current account slightly into deficit in 2005. Soy prices are expected to fall and international oil prices are expected to rise in 2005. Exports and imports are expected to continue to grow in volume terms, but at rates closer to historical levels following the recovery in trade this year. The capital account is projected to remain in surplus due to net public sector borrowing, primarily for investment projects. Net private sector foreign currency deposit flows, which had been quite volatile since the 2002 crisis, are projected at zero next year. However, the high level of liquidity in the domestic banking system carries the risk of sudden outflows.

Paraguay: Balance of Payments(In percent of GDP)

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Sources: Paraguayan authorities; and Fund staff estimates.

Original program (Country Report No. 04/66).

Includes errors and omissions.

18. Progress continues to be made in clearing external arrears. The authorities cleared the remaining arrears to official creditors in September. In addition, arrears owed by the state-owned oil firm PETROPAR to its fuel suppliers are also being cleared in line with the program schedule. Progress is also being made towards resolving disputed arrears.

E. Structural Reform Agenda

19. After significant progress with structural reform in key areas in the first half of 2004, implementation slowed in recent months. As a result, two structural performance criteria appear likely to be missed by end-December; (i) the comprehensive banking law is still being debated in cabinet and so has not been submitted to congress, making its approval by congress by year-end virtually impossible; and (ii) there have been some delays in completing the independent audits for a few public enterprises, which will not be completed by end-December.9 Other structural benchmarks also appear unlikely to be met by year-end. Against that background, the authorities requested a modification of the structural conditionality for end-December, to be completed during the proposed extension of the SBA.

Paraguay: Structural Reform Agenda Originally Scheduled for the Fourth SBA Review

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Sources: Paraguayan authorities and Fund staff.

20. The authorities have re-phased their reform agenda for the program. The staff believes that the new timetable for reforms takes into account the congested agenda of congress and the recess period while strengthening ownership on the reform process. It includes reforms originally due to be completed under this review as well as the proposed modification of reforms originally scheduled for the fourth review. The main reform areas include:

  • General banking reform. This is the third phase of a more comprehensive reform that involves (i) bank resolution legislation; (ii) bank deposit guarantee legislation; and (iii) improvements in prudential regulation and bank supervision legislation. The first two elements of the reform were addressed through legislation approved in late 2003. New legislation (either a new law or an amendment) will be submitted to congress by end-March 2005, and is expected to be approved by end-June 2005 (performance criteria).10 The authorities will also continue making their contributions to the deposit guarantee fund (with a view to an early full capitalization) and will also work towards improving banking standards (¶12).

  • Public banking reform. Proposals to address simultaneously the problems of the first-tier (mostly deposit-taking) and second-tier (mostly nondeposit taking) public banks through an encompassing piece of legislation proved politically very difficult. In response to strong congressional opposition, the authorities have adopted a two-stage approach to public banking reform, which appears to have political support.

    • The first stage involves the creation of a second-tier bank to intermediate external resources. A second-tier public banking law was submitted to congress in November under fast-track procedures and is expected to be approved by mid-December (prior action). This law is expected to be approved by end-May 2005 (structural benchmark).


      Paraguay--Structural Conditionality 2005

      Citation: IMF Staff Country Reports 2006, 078; 10.5089/9781451832471.002.A001

    • The second stage involves a phased restructuring of the first-tier public banks, in particular BNF. A commission will be created by end-February 2005 to oversee the restructuring process.11 The commission’s recommendations will be adopted by end-July 2005 and a first-tier public bank law will be submitted to congress (to supersede the temporary BNF law approved by congress in October 2004) (performance criteria) (¶13).

  • Civil service reform. The authorities are well advanced towards developing a comprehensive plan for civil reform, which is expected to be finalized by end-April 2005 (structural benchmark). The reform aims at reducing redundant positions and improve hiring practices. A comprehensive census of the public administration has been completed (finding a large number of ghost employees) (¶15).

  • Public enterprise reform. The authorities intend to complete independent audits for nine public enterprises and entities. Three have already been completed, two more will be completed by end-December 2004 and four by end-April 2005. Furthermore, these enterprises and entities will be subject to management audits to assess their performance by end-June 2005. Three of the enterprises (ESSAP, COPACO, PETROPAR) will be required to present business plans for the participation of private capital in their operations by end-August 2005 (structural benchmark) (¶16).

  • Other reforms. This involves the recapitalization of the central bank,12 a continuation of the domestic bond exchange and measures (still to be designed) to improve the investment climate (¶19).

    Paraguay: Revised Structural Reform Agenda

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    Sources: Paraguayan authorities and Fund staff.

F. Program Monitoring

21. Waivers. The authorities are requesting waivers for four performance criteria (PC) (2 quantitative and 2 structural): (i) the wage bill was missed by a small margin (by about 1 percent) because congress approved a wage increase to the judicial system (after a three year wage freeze); (ii) the continuous non-accumulation of arrears was breached because of a small delay in paying France; (iii) one of the three audits of public enterprises was not completed on time due to legal ambiguities regarding the company’s assets (end-September), this has now been resolved; and (iv) the public banking law was not approved (end-October), the strategy has been modified and a new approach adopted, which would achieve the original reform objective.

22. Conversion. The authorities request that the indicative target on the fiscal balance of the central administration for end-December 2004 be converted to a performance criterion.

23. Extension, reviews and rephasing. The authorities request a six-month extension to end-September 2005 to be able to implement their structural reform agenda. They intend to continue to treat the arrangement as precautionary. This would entail two additional reviews (the fifth and sixth) to be completed by mid-June and mid-September. The two remaining purchases for SDR 6 million are proposed to be rephased to four purchases for SDR 3 million.

24. Modification. The authorities are requesting the modification of four performance criteria for end-December 2004: (i) the ceiling on the wage bill from G 2.98 trillion to G 3.01 trillion reflecting the wage increase to the judicial system; (ii) the ceiling on the floating debt from G 0.25 trillion to G 0.32 trillion due to the normal budgetary process which commits all budgeted appropriations by end-year; (iii) approval of the comprehensive banking law, now expected for end-June 2005; and (iv) audits for four public enterprises and entities, now expected for end-April 2005.13

25. Adjustor. A fiscal adjustor on tax revenue overperformance is being introduced. The fiscal floor will be increased by 30 percent of any tax revenue overperformance.

26. Conditionality. There will be 8 quantitative performance criteria each quarter and nine structural measures during the remainder of the arrangement as follows:

  • Prior actions. There are two: (i) approval of the second-tier public banking law by at least one chamber; and (ii) completion of ESSAP independent audit.

  • Quantitative performance criteria. With significant progress in normalizing relations with creditors, payment of all external arrears and significant reductions in domestic floating debt, three performance criteria will not apply after end-December 2004: (i) the ceiling on external debt arrears (as it is already zero); (ii) the sub-ceiling on external payments arrears to bilateral sources (also zero); and (iii) the ceiling on central government floating debt (as it reached normal levels). Quantitative performance criteria are established for end-March 2005 and end-June 2005.

  • Structural performance criteria. There are three structural PCs: (i) independent audits for ANNP, DINAC, INC, PETROPAR by end-April 2005; (ii) approval of the comprehensive banking legislation by end-June 2005; and (iii) submission of the first-tier public banking law by end-July 2005.

  • Structural benchmarks. There are four benchmarks: (i) introduce prudential regulations to cooperatives (end-March 2005); (ii) finalize the plan for a civil service reform (end-April 2005); (iii) approval of a second-tier public banking law (end-May); and (iv) present plans for private capital participation in ESSAP, COPACO, and PETROPAR (end-August 2005). A former benchmark requiring all banks to obtain international risk rating was dropped as the staff no longer sees a pressing need for this requirement.

III. Medium-Term Scenario, Risks, and Capacity to Rscepay the Fund

27. The medium-term outlook underscores the importance of further structural reforms to secure sustained increases in per capita income growth and reduce poverty. Under a scenario with continued prudent macroeconomic policies, but with no additional structural reforms beyond this program, growth is projected to be only around 2 percent. This growth rate—similar to that of the last two decades—would result in stagnation in per capita income. Higher growth rates will require further structural reforms. The staff believes that under a scenario of prudent macro policies and deepened structural reform, the growth rate of the economy could be doubled to reach some 4 percent a year. The fiscal adjustment planned under the program would assure fiscal sustainability, with the public accounts remaining near balance and the debt-to-GDP ratio declining to around 30 percent by 2009.

28. Paraguay’s capacity to repay the Fund is strong. The staff believes the risk of nonpayment to the Fund, in the event purchases are made under the precautionary arrangement, is negligible given the improvements under the program to Paraguay’s fiscal and external positions, its payment capacity, and in view of the fact that overall public debt service is low and debt service to the Fund would be small.

29. Notwithstanding the success of the program so far, risks remain. Political support for further reform may be waning and could be insufficient to permit passage of key structural reform legislation. There have been some signs of social unrest, which could push policy makers to follow a more expansionary policy and put at risk the macroeconomic stability achieved over the past year. Rising global interest rates, or a slowdown in the U.S. economy, could affect economic activity in Paraguay. Further increases in oil prices would put pressure on the current account. A high level of credit by BNF may undermine the monetary program.

IV. Staff Appraisal

30. Paraguay’s performance under the program has been strong, despite significant delays in implementing the structural reform agenda in the second half of 2004. The authorities have met most quantitative performance criteria, and those not observed were missed by narrow margins. On the structural side, despite being in a minority in congress, the authorities have succeeded in winning passage of several key pieces of economic legislation over the last 12 months, including the fiscal adjustment law, the customs code, the bank resolution law, and public pension reform law. The heavy structural reform agenda under the program—combined with a difficult political environment—led to significant delays recently, especially for measures requiring congressional approval.

31. Macroeconomic performance has been better than anticipated under the program, although domestic concerns continue about slow growth, high unemployment, and continuing high poverty and inequalities. Economic growth is expected to reach 2½ percent in 2004 despite a drought. The staff estimates that growth would have been ½–1 percent higher in the absence of the drought. At the same time, other key program objectives were comfortably achieved. Inflation was reduced significantly and is expected to be well below program projections; international reserves increased rapidly beyond program expectations; interest rates fell to pre-crisis levels; and the guaraní stabilized. However, the unemployment rate is still almost 20 percent and high poverty is widespread with about half of the population living with less than US$2 a day.

32. An extension of the SBA would allow the authorities to consolidate macroeconomic gains achieved so far, while completing key structural measures in the program. The original SBA was effective in stabilizing the economy but proved too short for completion of the authoritie’ ambitious reform agenda. It will be important to use the period of the extension to advance that agenda to promote sustainable growth and poverty reduction, while preserving the gains in terms of macroeconomic stability.

33. In particular, staff urges the authorities to move ahead as planned with public banking reform, a key element of the structural agenda. There are political challenges involved in this reform. Staff supports the authoritie’ revised strategy, which is an appropriately flexible response to these challenges, but political risks remain. In addition, while staff acknowledges the benefits of improving credit availability to support growth, staff is concerned that the recently approved legislation for the BNF could allow for a resumption of unsustainable lending practices. There are some mechanisms in place, such as a more intensive review process for larger loans, which can mitigate this risk. It will also be important that the authorities monitor BNF lending particularly closely in the run-up to its reform, aimed at strengthening the bank by refocusing its operations, recovering assets and reducing costs. It will be important for the public bank reform process to move forward expeditiously, since legislation will be required both to override the temporary BNF law and to change its management structure.

34. Fiscal policy has been placed on a sustainable path. The fiscal outlook improved significantly following the major improvements in tax administration and the approval of the fiscal adjustment law. The overall fiscal balance will move into surplus in 2004 for the first time in many years. At the same time the government has eliminated sizable arrears, and taken decisive steps toward normalizing relations with all creditors. Tax collections are expected to increase by about 2 percentage points of GDP to 11½ percent in 2004. Expenditures have been kept in check, although capital outlays remain low. The stock of public debt—which had increased rapidly over the past 7 years—is now on a declining trend. For 2005, the authorities are pursuing a balanced overall budget, with an increase in capital expenditure, on high quality investment projects, to be financed by continued high revenues.

35. Monetary policy has been effective in containing inflation while allowing for rapid reserve accumulation. The inflation rate is being contained to below the program objective of 8 percent in 2004. Staff estimates that inflation will not be higher than 6 percent this year even after adjustments in administered prices. Monetary management was complicated by large capital inflows, which threatened to generate rapid monetary expansion (and possible inflationary pressures), or a sharp appreciation of the currency, which could jeopardize the fragile recovery. In order to minimize the risks, the central bank has pursued an active sterilization policy, assisted by significant increases in the demand for money, while accumulating international reserves. For 2005, the authorities have established an inflation objective of 6 percent and intend to use interest and exchange rate policy more flexibly. The staff urges the authorities to monitor closely the credit extended by BNF and be ready to take steps as necessary to contain its expansion so as not to threaten the monetary program.

36. The government will need to continue building consensus for structural reform and macro stability to safeguard the program and promote sustainable growth. Lack of political consensus on the direction and speed of structural reform poses the greatest risk to the program. There have also been signs of social unrest in rural and urban areas which could put pressure on the authorities to loosen fiscal policy.

37. The staff supports completion of the third review under the SBA. In light of the authoritie’ strong commitment to the program and relatively good performance so far, the staff supports completion of the review, the request for an SBA extension, the waivers request, and the proposed modifications to the program.

Paraguay: The Restructuring of the BNF

The National Development Bank (BNF) is the largest public financial institution. Its assets are equivalent to 9 percent of financial sector assets. Over the years, the BNF has incurred losses arising mainly from nonperforming loans to politically-connected borrowers and nonviable sectors, equivalent to 55 percent of the loan portfolio. Liquidity problems have been masked by the transfer of public sector deposits (60 percent of deposits at the BNF), especially from social security funds. Compliance with prudential solvency requirements has been made possible by the absorption by the government of foreign loan obligations, the application of provisions in the BNF charter mandating the coverage by the ministry of finance of losses from agricultural loans (Law 281), and outright government transfers.

The rationalization of the BNF would help address moral hazard risks and contain fiscal outlays arising from the cost of the bank’s large bureaucracy, inefficiency, and lack of strategic focus. In this regard, the government envisaged implementing a plan aiming at consolidating the eight existing public institutions into two institutions, in line with the World Bank’s and the IDB’s recommendations: A public second-tier institution that would channel mainly concessional resources from abroad (first stage) and a first-tier public bank (comprising the BNF and the other five public institutions) that would target small borrowers primarily in the agricultural sector without access to credit from private financial institutions, taking advantage of the BNF’s extensive branch network (52 branches) (second stage). Loans would be subject to strict ceilings, aggregate nonperforming loans would be liquidated by private contractors, and both first- and second-tier institutions would be subject to stringent corporate governance, with no state guarantees or favorable tax treatment.

The transition towards public bank reform was supported by Law 2100 of June 2003, which modified some articles of the BNF charter, by establishing credit ceilings. The ceilings ranged between US$15,000 and US$100,000, narrowing the focus of the BNF to agricultural loans and authorizing the ministry of finance to liquidate nonperforming assets by contracting out private asset managers (still not implemented). A new management removed interest rate subsidies, made some effort on loan recovery, and embarked on a drastic reorganization. However, congress approved in October 2004 modifications of key provisions that would expand the scope of BNF operations and raise lending ceilings. These modifications would complicate the banking reform process.

Before the legal framework for public bank reform is finally enacted, the government can start taking immediate steps toward the restructuring of the BNF. These measures include consolidating the BNF as a specialized institution providing small credits in rural areas, appointing a commission to study the best way to deal with portfolio recovery, reducing cost and recapitalizing the bank, transferring non-performing assets to a separate management unit through a bidding process, and gradually reallocating public sector deposits at the BNF. The restructuring of the BNF should focus on the rationalization of genuine BNF liabilities and yield-earning assets.

The Comprehensive Banking Law

The government has prepared a draft banking law that upgrades Paraguay’s prudential regulatory framework. Approval of the law would allow a significant improvement of banking supervision in several fronts, namely: (a) it would grant powers to exercise consolidated supervision over members of a financial group by including a legal definition of financial groups; (b) it would upgrade governance rules to enhance accountability of bank managers, directors, shareholders, auditors, attorneys and personnel; (c) it would increase minimum capital requirements in line with international standards, (d) it would allow establishing a higher minimum capital adequacy ratio if it is determined that a particular institution is exposed to higher risk; and (e) it would allow the imposition of sanctions at the initiative of the superintendency for infractions.

The banking community has expressed a number of concerns with this draft legislation. Paraguayan financial institutions are apprehensive about (a) their capability to increase their minimum capital from about US$1.5 million to US$4.5 million for banks, and to US$2.3 million for other financial institutions, in the period of five years envisaged in the draft law; (b) the enhanced discretion granted to the superintendency over the central bank board; and (c) the extent of accountability by directors and shareholders. Some members of the cabinet reportedly share these reservations and an updated draft banking law is being prepared at the moment.

An earlier provision in the draft banking law allowed the superintendency to regulate the cooperatives; however, this provision was subsequently discarded. The new law ratifies the broad scope for prudential supervision implicit in the current Banking Law (Law 861/96), which allows the superintendency to regulate and supervise all deposit-taking institutions. The authorities attempted to make these provisions explicit for the regulation of large cooperatives, given their systemic importance. However, this measure was strongly opposed by the cooperative sector and was ultimately discarded by the cabinet. Recently, a special law was approved allowing for self-regulation of the cooperative sector under the coordination of the National Cooperative Institute (INCOOP). However, the new banking law would still maintain general provisions to allow the superintendency to undertake prudential action, if necessary, to address problems in any deposit-taking institution.

Bank resolution and deposit insurance had already been dealt with in a separate legislation in December 2003. An important component of the current Banking Law has already been modified by the approval of a new banking resolution law in 2003 (Law 2334/03). The new law establishes deposit guarantee coverage for up to 75 times the minimum monthly wage (about US$12,000) for private financial institutions, defines the triggers for the adoption of a regularization plan and describes the steps within the regularization process prior to final resolution. Provisions in the new banking resolution law were tested during the intervention of a small finance company (Financentro), whose assets and liabilities would be acquired by a domestic bank. Some implementation problems were associated with the transition to the new scheme, lack of coordination between the central bank and the ministry of finance on the funding of the deposit guarantee, and the pending issuance of regulations on procedures.

Paraguay: The Cooperative Sector

The cooperative sector, with 20 percent of financial assets, plays an important economic and social role in Paraguay. Three types of cooperatives—financial, production, and other cooperatives—exist. Financial cooperatives provide micro-credit to its members. The production cooperatives finance agricultural and dairy products, and other cooperatives provide goods, services, and employment. There are about 820 registered cooperatives, out of which 525 are financial cooperatives and 200 are production cooperatives. However, preliminary data show that more than half of the cooperatives have ceased operations.

The largest 25 financial cooperatives, with 356,000 members, accounted for 80 percent of financial cooperative assets in 2002. These institutions are highly liquid, with a CAR of 34 percent. With the excess liquidity, financial cooperatives tend to finance production cooperatives.

Figure 1.
Figure 1.

Financial Institutions Market Share

Citation: IMF Staff Country Reports 2006, 078; 10.5089/9781451832471.002.A001

Source: INCOOP, Superintendency of Banks, and IMF staff estimates.

The assets of the largest 25 financial cooperatives have more than doubled since 1998. Because of several banking crises, the public started to shift savings from the banking system to the cooperative sector. Consequently, some cooperatives began to provide services that previously were offered only by banks, except for checking accounts and foreign exchange operations. In contrast to banks, cooperatives conduct most of their operations in local currency.

The cooperatives can pay more attractive interest rates than other financial institutions because they are exempt from VAT and from legal reserve requirements. While cooperatives pay 4–8 percent on sight deposits, banks pay about 2 percent. Moreover, the higher interest rates on fixed-term deposits in the cooperatives encouraged the public to place their financing at longer-term maturities. Only 23 percent of banking deposits are placed at fixed term, whereas 60 percent of cooperative deposits are at fixed terms. Moreover, lending interest rates in the cooperatives are about 10 percentage points lower than in banks.

Until recently, financial activities of cooperatives have been partially unregulated and unsupervised. The supervisory authority for cooperatives, INCOOP, has begun to take steps to introduce supervision of cooperatives by March 2005. It has requested assistance from the World Council of Credit Unions, the German Cooperative Federation, the World Bank, and the superintendency of banks on the following issues:

  • Implementing prudential norms

  • Designing balance sheets

  • Incorporating the cooperatives into the credit rating agency

  • Providing training

  • Implementing money laundering regulations

  • Setting a deposit insurance guarantee

INCOOP expects to approve the new regulations and norms in line with international best practices for cooperatives by mid-December and to start their gradual implementation by beginning of 2005.

Table 1.

Paraguay: Quantitative Performance Criteria

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The target is adjusted upward by 30 percent of the overperformance in tax revenues for 2005 as specified in the TMU.

Cumulative flows from the beginning of the corresponding calendar year.

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

These performance criteria will not apply in 2005.

Measured on a continuous basis.

Table 2.

Paraguay: Structural Conditionality for the Third and Fourth Review Under the Program

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Sources: Paraguayan authorities; and Fund staff estimates.SB = structural benchmarksPC = performance criteria
Table 3.

Paraguay: Selected Economic Indicators, 2001–05

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Sources: Paraguayan authorities; and Fund staff estimates.

Revised program (Country Report No.05/59).

For 2004, information through August.

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

Foreign currency items are valued at a constant exchange rate.

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 the nonfinancial public sector and the central bank.

Revised program (Country Report No. 05/59).

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.

Table 5.

Paraguay: Central Government Operations

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Sources: Ministry of Finance; and Fund staff estimates.

Revised Program (Country Report No. 05/59).

Includes receipts from the binational hydroelectric plants Itaipu and grants.

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

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

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.

Revised Program (Country Report No. 05/59).

Assumes quasi fiscal deficit of central bank entirely financed.