Statement by Javier Silva-Ruete, Alternate Executive Director for Paraguay and Luis Enrique Salgueiro, Advisor to Executive Director

The authorities’ program for 2003–05, supported by the previous Stand-By Arrangement (SBA), successfully stabilized the economy despite difficult conditions. A new economic program for 2006–08 is needed to consolidate macroeconomic stability, address remaining vulnerabilities, and create the conditions for higher growth. In the context of a benign environment, inflation fell significantly to 2¾ percent in 2004—the lowest inflation rate since the early 1970s. The return of capital flight in 2004 satisfied increases in the demand for money and generated a rapid growth of monetary aggregates.


The authorities’ program for 2003–05, supported by the previous Stand-By Arrangement (SBA), successfully stabilized the economy despite difficult conditions. A new economic program for 2006–08 is needed to consolidate macroeconomic stability, address remaining vulnerabilities, and create the conditions for higher growth. In the context of a benign environment, inflation fell significantly to 2¾ percent in 2004—the lowest inflation rate since the early 1970s. The return of capital flight in 2004 satisfied increases in the demand for money and generated a rapid growth of monetary aggregates.

May 31, 2006

1. The authorities would like to thank the staff for a well-written and comprehensive report, which recognizes their intention to reinforce macroeconomic stability and press forward with the structural reform agenda to ensure sustainable growth.

Recent Economic Developments

2. In 2004, Paraguay experienced the best macroeconomic results in a decade. The economy grew by 4 percent, driven by livestock production, telecommunications, and commerce. Despite this high GDP growth, inflation decreased to 2¾ percent—the lowest rate since 1970. In 2005 the economy faced several shocks—including an extended drought, higher international oil prices and a rapid strengthening of the Brazilian real—which led to a reduction in the pace of growth to 3 percent and inflationary pressures. The harsh drought severely affected the agricultural sector, especially the soybean crops, which is one of the most dynamic and important economic sectors of Paraguay.

3. During the first half of 2005, as a result of the Brazilian real appreciation, domestic prices of Brazilian imports rose rapidly leading to inflationary pressures. At the same time, higher Brazilian demand for local goods (mostly dairy products) put upward pressure on domestic prices. Additionally, higher exports of meat—which grew by 57.5% in 2005—caused a shortage of domestic supply leading to a higher trend of inflation during 2005. Increases in international oil prices resulted in adjustments in the domestic price of hydrocarbons. These exogenous factors explained half of the 9.9 percent inflation rate in 2005. The monetary authorities reacted to these higher inflationary pressures adjusting the interest rate of Letras de Regulación Monetaria, during the second half of 2005 by 250 basic points which led to lower Central Bank credit. These quick responses of monetary policy allowed to address all the quantitative monetary targets of the precautionary Stand By Agreement and paved the road to disinflation during 2006.

4. On the fiscal front, the authorities adopted prudent policies to ensure macroeconomic stability. They are committed to persisting in their fiscal consolidation efforts under the program. The Treasury reached surpluses in 2004—for the first time in a decade—and in 2005. The latter surplus—which amounted to over ½ percent of GDP—exceeded program expectations due to strong tax collections (despite lower rates of companies’ income taxes), low investment project implementation, and across-the-board expenditure cuts made in the last quarter of 2005 to help address inflationary concerns. There are early indications of a further strengthening in tax collections during the first quarter of 2006.

5. The small current account surplus in 2004 deteriorated into a deficit of 2½ percent of GDP in 2005, mostly due to a rapid growth in oil imports. Notwithstanding, a surge in private capital inflows resulted in a balance of payments surplus and a record high level of international reserves in 2005 (US$1.3 billion).

6. Regarding the structural reform agenda, under the previous program the government reached significant achievements, especially the passage of laws on fiscal adjustment, customs, banking resolution, public pensions, and second-tier public banking. The overall evaluation of the previous Stand By Agreement with the IMF is that the Government of Paraguay has successfully implemented the reform agenda of this Agreement and addressed all the quantitative targets of the program. As a result, Paraguayan macroeconomic management has substantially improved during the last two years.

Fiscal Policy

7. The fiscal authorities consider that the 2 percent deficit foreseen in the approved 2006 budget is inconsistent with the objectives of reducing inflation and the public debt burden. In this regard, the Ministry of Finance will adopt a strict financial plan, in accordance with the financial administration law, to bring the 2006 budget to an executable position. The 2006 financial plan provides for an increase in public investment from about 4 percent of GDP in 2005 to over 4¼ percent of GDP in 2006. In the event of revenue over-performance, additional resources will be directed to increase public investment and social spending to alleviate extreme poverty. The authorities agreed with the staff that fiscal targets could be relaxed in the context of the program reviews, if additional capital spending on high quality projects is identified, provided it is accompanied with adequate financing and does not jeopardize macroeconomic stability.

8. An eventual fall in taxes will be offset by other elements of the fiscal adjustment law, such as the introduction of the personal income tax, which will be implemented gradually over the next few years. Notwithstanding, during the first quarter of 2006 taxes are increasing at rates of 8 percent compared to the same period of 2005. The authorities are committed to achieving the fiscal objectives under the program. Therefore, they will keep a tight control on current expenditure, while protecting social spending and supporting public capital spending. They plan to cut budget expenditures by about 1¾ percent of GDP through the strict implementation of a financial plan. This includes: (i) reducing allowances for senior public servants; (ii) lowering over-time outlays; (iii) eliminating hiring of temporary workers; (iv) freezing positions in the first four months; (v) phasing in salary increases during the year; and (vi) restricting the purchase of goods and services which are not critical.

9. Over the past two years, tax collections have increased by over 1½ percent of GDP. Additional tax collection gains are expected over the medium-term through the full implementation of the 2004 tax reform (fiscal adjustment law) and sustained strengthening of the tax administration office, which should continue to increase revenue collections from Paraguay’s large informal sector. The objective of the fiscal adjustment law of 2004 was to simplify the tax system and broaden the tax base. The law eliminated most exemptions from the corporate income tax and reduced its rate, broadened the base of the VAT, introduced a new personal income tax (to be phased in over time), and established a new agricultural income tax to replace the previous IMAGRO tax. It also adjusted certain excise tax rates and strengthened the tax administration’s enforcement powers.

10. In order to ease budgetary financing constraints, the public sector faces increasing amortizations in the next few years, arising mostly from the repayment of obligations restructured in 2004. While deposits at the Central Bank are sufficient to meet these obligations, this would put undue pressure on monetary policy. Therefore, the authorities will explore ways to reorganize the government bond market, which has been closed for some time. The broad objective will be to maintain a sustainable level of public debt and prevent negative net domestic and external financing.

11. In addition, in order to preserve the recent improvements in revenue collections, the authorities will prepare a new tax code to modernize and standardize tax practices and rationalize tax exemptions. They will be a draft code approved by the economic cabinet by end-December 2006, and will request technical assistance from the Fund for this purpose.

12. A realistic price policy for public enterprises, together with efficiency gains, will permit moderate surpluses. These would cover expected losses of the Central Bank, yielding a balanced position for the consolidated public sector. This prudent fiscal stance, together with faster economic growth, would reduce the public debt-to-GDP ratio towards 30 percent by the end of the decade.

13. In order to rationalize budgetary processes by improving planning and design, as well as incorporating macroeconomic constraints, the authorities will design an action plan to strengthen public financial management, including the introduction of a more effective expenditure control system at the commitment level for the Central Administration and the rationalization of the Treasury account system by end-June 2006.

Monetary Policy

14. Although Paraguay is experiencing higher inflationary pressures, the authorities are committed to reducing inflation to a low single digit in 2006 and maintaining a flexible exchange rate regime. In this regard, the monetary program’s main objective for 2006 is to bring inflation down to 7 percent. Therefore, they plan to gradually reduce currency growth from 17½ percent in 2005 to 8½ percent at the end of 2006, which is significantly lower than projected nominal GDP growth. The Central Bank of Paraguay has tightened monetary policies during the first quarter of 2006 hiking interest rates further by 375 basis points, to 10½ percent, in two stages, in February and April 2006. To additionally reduce inflationary pressures, foreign exchange policies were adjusted to allow a freer floating of the Guarani. In the first quarter of 2006, the significant and continuous upward trend of year-on-year inflation was due to the meat domestic supply shortage and the increase of very volatile prices of fruits and vegetables. Notwithstanding, during the last months the tighter monetary policies have began to bring results and annual inflation rates have started to converge to the Central Bank’s target for 2006.

15. Paraguay’s monetary policy framework anticipates a US$20 million increase in net Central Bank international reserves (NIR), equivalent to 4¼ percent of currency. The net domestic assets of the Central Bank (NDA) will expand by about 4¼ percent of currency, as the public sector is expected to use its deposits at the Central Bank, that is to say about 6½ percent of currency. In this context, the authorities will expand open market operations with banks, which will gradually limit currency growth to 8½ percent at the end of 2006.

16. The authorities are aware of the negative impact of Central Bank losses on the effectiveness of monetary policy. These losses are associated with non-performing assets—mostly old Treasury and public companies loans but also the result of rescue operations during the recent financial crises—and the current burden of paying interest rates on Letras de Regulación Monetaria. These losses are undermining the balance sheet of the Central Bank. Given these circumstances, the new Central Bank management adopted revenue-enhancing measures and moderated expenditures to reduce losses by 2/3 in 2005. During 2006 increasing sterilization efforts and higher interest rates would lead to more capital losses which are estimated at around ¾ of GDP. The authorities are focusing on designing a strategy to strengthen the Central Bank’s financial position by end2006. They acknowledge the technical assistance already provided by the Fund in this field. The government reform agenda includes to specifically address this issue in order to elaborate a law by end-December 2006 and submit it to Congress in April 2007, at most. This law will strengthen the Central Bank’s financial position and guarantee a greater monetary policy soundness for medium and long term prospects.

17. Although external vulnerabilities remain, the authorities are confident that the balance of payments will continue to be under control, since the main part of the deficit will be covered by private capital inflows, mostly foreign direct investment. At the same time, the expected level of net international reserves is envisaged to cover about 3½ months of imports. Despite the remaining vulnerabilities, mainly due to commodity price shocks and drought, there is no impending balance of payment gap.

Structural and Financial Reforms

18. The authorities are clearly committed to move forward with structural reforms with the aim of improving the business climate and promote investment and growth. In this regard, the public sector reform includes a strengthening of the institutional framework for tax collection to safeguard the recent improvements in this area. They will prepare a new tax code to modernize and standardize tax practices, as well as to rationalize tax exemptions. In addition, this will contribute to converting it into an effective financial management tool geared to strengthen public financial management and set up a more effective expenditure control system.

19. On the financial side, the government is fully confident that the strengthening and restructuring of the systemically-important state-owned National Development Bank (BNF) will contribute to reducing financial system vulnerabilities. The BNF has been making significant progress over the last two years in improving its financial position through a combination of undistributed profits and recovery of non-performing loans (NPL). In this respect, the BNF should reach a capital-adequacy ratio (CAR) of 5 percent by end-June 2006 and 10 percent by end-December 2006.

20. The monetary authorities recently completed a study that identified the legal weaknesses in banking regulations. The response will be a legal plan—required changes in banking legislation—and an operational plan to be implemented by the Central Bank aiming to correct these loopholes in the prudential regulatory framework.

21. The government will implement close monitoring of management of state-owned enterprises, mainly the National Electricity Company (ANDE), the Petroleum Company (PETROPAR), the Cement Industry (INC), the Telephone Company (COPACO), and the Water and Sewage Company (ESSAP) by end-September 2006, and for the National Aerospace Authority (DINAC) and the National Port Authority (ANNP) during 2007. The strategy will rely on relevant financial and managerial performance indicators, which will be reviewed and published quarterly by the Planning Ministry (STP).

22. The authorities consider that a key element of a better investment climate is having a level playing field for private companies. This idea leads to a strong commitment to fight informality and combat corruption. In order to further improve the investment climate and facilitate higher sustainable growth, the authorities are determined to take the necessary steps to simplify procedures for company registration and licensing regulations, promoting the development of small and medium enterprises, supporting exporters and foreign investors through one–stop shops, improving dispute resolutions and enforcement of judicial decisions, and strengthening public institutions certifying product quality.

23. The government is committed to provide a better infrastructure to increase the medium and long term financing of private companies. To address this important issue, the authorities are planning to mobilize medium and long-term financial resources through a new second-tier Public Financial Institution, the Development Financial Agency (AFD) which recently began its operations.

24. Extreme poverty alleviation is at the top of the authorities’ agenda. In this regard, the government intends to improve the quality of social spending by setting up a conditioned cash-transfer system for low-income families. It is expected that this strategy will benefit almost 7,000 families in 2006. In addition, to reach the most vulnerable groups and to avoid indiscriminate subsidies, the government is realigning domestic and international prices and plans to create focalized subsidies for the public transportation system.

Closing Remarks

25. The authorities are strongly committed to achieving further progress towards their ambitious economic objectives. They wish to thank the Fund’s continuing support and cooperation in meeting the significant economic and social challenges facing Paraguay. The authorities evaluate the previous precautionary Stand By Agreement as a crucial factor of the success that the macroeconomic management that Paraguay is experiencing and hopes that the joint efforts of the Government of Paraguay and the Fund will bring a sustainable path of greater growth and equity for the nation of Paraguay.