Statement by Javier Silva-Ruete, Alternate Executive Director for Paraguay and Dimas Ayala, Advisor to Executive Director

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.

Abstract

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.

1. On behalf of the Paraguayan authorities, we would like to express our appreciation to the staff and management for their valuable advice and support in the design and implementation of Paraguay’s economic program. The comprehensive staff report provides a candid assessment of the program and the challenges ahead regarding macroeconomic policy and structural reforms.

2. Performance under the ambitious program initiated by the new government and supported by a 15-month Stand-By Arrangement (SBA) has been strong, albeit some delays in implementing the structural reform agenda in recent months. The strong ownership of the program and the broad political consensus obtained during the Government’s first year were important in passing key reforms, including the restructuring of the public sector’s pension fund, the modification of the tax and customs systems, the reprofiling of the public debt, and the introduction of a banking resolution law. In addition, prudent economic policies, and the permanent fight against corruption and tax evasion, were crucial in reinstating macroeconomic stability, laying the foundation for sustained GDP and employment growth, and significantly reducing poverty in the medium term.

3. Our authorities fully recognize the importance of implementing the remaining measures agreed with the Fund in order to consolidate the gains obtained so far and strengthen domestic and international confidence. To this end, the Government requests the extension of the Stand-By Arrangement after its expiration in March 2005, in order to allow more time for reforms to take place, and remains firmly committed to concluding the first phase of the reform agenda before September 2005.

4. Paraguay’s economic situation has improved markedly since the Government began implementing the program in December 2003, after a long period of economic stagnation. As in 2003, real GDP is also anticipated to grow in 2004, this time to an estimated 2.9 percent, even after suffering an unexpected drought early this year, which severely affected soy production—Paraguay’s main export crop—with an estimated cost of ½ to 1 percent of GDP. In addition, the external position continues to improve, and credit to the private sector is recovering.

5. Nine of the eleven quantitative performance criteria for end-August 2004 were met. Inflation has further decelerated, and the yearly figure is expected to be substantially below the 8 percent rate envisaged under the program. The fiscal surplus will be well above program targets. The authorities regret the non-observance of two performance criteria, and are taking corrective measures to avoid these kinds of deviations in the future. The slippages were (i) a delay in paying a bilateral creditor (by one day); and (ii) a very small deviation from the ceiling for the central administration’s wage bill, due to an unexpected wage increase granted by Congress to the judicial system. However, the greater-than-programmed central government surplus (3.6 percent of GDP as of August, vis-á-vis 1.6 percent envisaged under the program), thanks to strong revenue performance, more than offset the small deviation from the wage bill target.

6. Regarding structural performance criteria:

  • The audit of three public enterprises-an end-September performance criterion-was partially met. Two audits were completed, and the remaining one was subsequently established as a prior action for this review. The latter was met, although with some delay, given that the auditor requested a legal clarification; this, in turn, required an additional government assessment and a presidential decree.

  • The state banking system’s reform, originally set for October 2004, was postponed due to congressional delays. The strategy adopted henceforth by the Government has aimed at preventing a watering-down of the proposed legislation or wholesale rejection by Congress, where the ruling party lacks a majority. Thus, the authorities have considered it prudent to conduct the reform in two stages, beginning with the immediate restructuring of the second-tier public banks to improve the intermediation of external resources, followed by the restructuring of first-tier public banks. Regretfully, early this month, due mainly to political problems, Congress postponed again the approval of the first stage of the reform-a prior action for this review-until the third week of February 2004. However, Congressmen expressed their intention to consider both the first and second-tier public bank reform at the same time, in an extraordinary session. They believe reforming the state banking system is crucial to improve resource allocation. At the same time, they see the need for a wider assessment to ensure the success of this sensitive reform. Our authorities, and in particular President Duarte-Frutos, renew their firm commitment to the reform agenda, and in particular to conclude the public banking reform as envisaged. The authoritie’ determination is reflected in their ability to muster consensus for several key policies introduced since they took office 15 months ago.

7. Fiscal performance has been better than envisaged under the program, resulting especially from responsible policies-in particular, higher than programmed revenues due to a substantial improvement in tax and customs administration. The appointment of highly-qualified professionals to key government positions, as well as the implementation of wide-ranging administrative measures to combat tax evasion, have resulted in a sharp increase in collections. According to preliminary information, government revenues during the first ten months of this year rose by 32 percent, as compared to the same period last year. Moreover, the recently enacted Fiscal Reform law and Customs Code will be instrumental in further curtailing tax evasion and formalizing the economy, which are crucial elements for achieving greater revenue mobilization.

8. The 2005 fiscal budget submitted to Congress considers an increase in public investment—reduced substantially in 2004 as a result of fiscal consolidation efforts-to support higher GDP growth. However, the Government will carefully control expenditure to ensure an efficient use of resources and fiscal sustainability. In addition, a moderate wage increase after a three-year freeze, and the creation of the Rural Institute—aimed at addressing long-standing rural problems—are among a number of actions implemented by the Government to reduce poverty and raise living standards. At the same time, to partly offset these increases, the Government will streamline expenditures in other areas of the budget.

9. The Central Government’s 2005 fiscal deficit—projected to be around ½ percent of GDP—will be largely financed by already contracted external borrowing, while the balance for the consolidated public sector will be close to zero. Even though Congress passed additional expenditures earlier this month, the authorities express their commitment to adopt the necessary measures to maintain the original fiscal targets, which is consistent with the objective of significantly improving the debt structure over the medium term. A partial Presidential veto of measures approved by Congress as well as the implementation of a Fiscal Financial Plan—as in 2004—are among the alternatives the authorities are considering to make the budget consistent with their fiscal program.

10. The authoritie’ program and policies have also been successful in solving domestic and external public debt arrears, and in placing the debt-to-GDP ratio on a declining trend. After having risen to nearly 50 percent in 2002, the debt burden would decline to 39 percent at end-December 2004, and it is expected to reach 30 percent by 2009. On the other hand, the authorities are actively maintaining negotiations to resolve disputes with eventual creditors.

11. The continued implementation of prudent monetary policy has resulted in low inflation and higher than expected accumulation of international reserves. Twelve-month inflation as of November has dropped to 2.1 percent, from 9.9 percent a year earlier; and accumulated inflation stood at 1.1 percent, vis-á-vis 8.3 percent in the same period of last year. The yearly figure is expected to be around 2 percent, significantly below the program target of 8 percent. Inflation will pick up slightly in 2005, given higher oil prices, tariff increases, and eventual wage adjustments. However, our authorities expect inflation to remain below 6 percent. Given the high level of international reserves, which enhances the Central Bank’s ability to intervene in the market, and the historically low interest rates on Central Bank bills, our authorities concur with the staff in using exchange and interest rates flexibly to meet the inflation objective next year. Likewise, we would like to emphasize the Central Bank’s continuous efforts to implement the recommendations identified by MFD’s technical assistance missions to enhance the conduct of monetary and foreign exchange policies.

12. Our authorities continue to make progress in strengthening the financial system. The Deposit Guarantee Fund, approved in late 2003 as a prior action for the program, is now operational, while the new bank resolution legislation is being successfully implemented, after the recent intervention of a small financial institution by the supervisory authorities. Furthermore, important steps have been taken to implement the new regulations on bank’ asset classification and provisioning, aimed to bring prudential norms in line with international standards. In addition, just recently our authorities submitted to Congress a comprehensive legislative proposal to further improve banking supervision. Confidence in the banking system is improving, as evidenced by the continuous rise in deposits. Private credit is finally recovering, while the ratio of non-performing loans has dropped to 13.1 percent in October 2004, the lowest in 5 years, from 22.6 percent a year earlier. These factors have contributed to enhancing substantially the profitability of the banking system.

13. The reform of public banks include the Banco Nacional de Fomento (BNF), a state development institution that accumulated a high level on non-performing loans over several years of mismanagement. Thanks to the new management’s efforts, the bank’s financial health is already improving, and the Superintendence of Banks will continue to closely monitor its lending operations until completion of the reform.

14. On the structural front, albeit some delays in recent months, most of the elements of the reform program have been achieved in a short period of time, reflecting strong ownership and the Government’s commitment, in contrast with the lack of direction that unfortunately prevailed for many years. Our authorities renew their commitment to make steady progress with the remaining structural reforms, which lie at the core of their agenda. They concur with the staff that the new timetable for reforms would be more appropriate given Congres’ heavy agenda, but especially to provide more time to build the social and political consensus needed for the approval of sensitive and complex measures. Meanwhile, our authorities are consistently working to improve the efficiency and governance of public institutions through regular independent audits, improvements in public procurement, and measures to combat corruption. Likewise, they are actively developing a comprehensive plan for civil reform, and are committed to developing plans to enable private sector participation in some public enterprises by end-August 2005.

15. The Government acknowledges that its biggest challenge is to improve the country’s socio-economic conditions. In this vein, an ambitious economic strategy is being developed in consultation with the civil society, aimed at laying the basis for increasing agricultural and agro-industrial production, enhancing competitiveness, diversifying the economy, reducing inequalities, and improving the business environment. A broad participatory seminar was held last November, aimed at building consensus on the need to develop a sound economic program. In addition, our authorities will continue their efforts towards ensuring long-term macroeconomic stability, which they regard as crucial to achieve high and sustained growth, improve employment opportunities, and alleviate poverty. Continuous support from the Fund and the international community will be essential to underpin this process.