Real Sector Developments

Paraguay’s economic performance continued to show strong results as of end-June 2007, with solid growth, moderate inflation, and a higher-than-programmed public surplus. All performance criteria and benchmarks for this review were met, and the authorities expect to achieve the year-end program goals comfortably. According to new projections made by the authorities, and supported by the staff, real GDP growth could exceed 5 percent in 2007, due mostly to agriculture growth projected at 15 percent—with soybean as the main driving force—despite a declining contribution of livestock and services to growth. As emphasized in the staff report, this would be the highest rate of economic expansion since 1995.

The recent tightening of credit conditions in advanced economies did not have an impact on Paraguay, and the favorable outlook for growth in neighboring countries and the region suggests that present conditions will remain in place. Under these circumstances, the country’s expectations are to achieve sustainable growth and reduce poverty over the medium and long term, as a result of the authorities’ efforts to improve the investment climate and preserve macroeconomic stability.

Fiscal Developments

The good performance of fiscal revenue, sustained by both tax and non-tax revenues, will lead to a central government surplus of nearly 2 percent of GDP, well above expectations, according to end-June estimates. The surplus reflects the expansion of the economy, increased inflows from the hydroelectric bi-national entities, and a reduction in spending—mainly due to under-execution of the capital budget, which is expected to be reversed in the second half of the year. Despite some sources of concern for the second half of the year, notably the Congressional approval of salary increases for teachers and public sector employees, the newly appointed fiscal authorities have firmly declared their commitment to the program goals. In this regard, the large margins accumulated during the first semester of 2007 will be used to override expenditure pressures.

The 2008 budget submitted by the authorities to Congress maintains fiscal discipline, in spite of a slight deficit of about 0.5 percent of GDP, which according to historical rates of expenditure execution will not affect budgetary equilibrium. The budget includes a 10 percent increase for public employees whose salaries have remained stagnant over the past years. Another issue highlighted by the Paraguayan authorities and the staff is the inclusion in the budget—for the first time—of a multi-year fiscal framework, aimed at achieving fiscal balance over a mid-term period.

Regarding public enterprises, most of them were well-managed, which contributed to an overall good performance. However, the strong financial position of the oil refinery PETROPAR was adversely affected by the rise in international oil prices. However, the authorities declared that the profits generated by this entity during the first half of the year will offset the financial stress, and it will not compromise the commitment to reach a public sector balance by end-2007.

Monetary and Financial Developments

Headline inflation has been continuously dropping from 12.5 percent in 2006, although it remains volatile due to supply shocks. Nevertheless, core inflation fell to 5 percent at end-June 2007, in line with the program target. Following a spike in August 2007, the Central Bank reacted by increasing the interest rate by 50 basis points of its monetary instruments (LRM) to control monetary expansion. Nevertheless, as noted in the staff report, the recent decline in dollarization provides evidence of greater domestic money demand, surpassing program expectations. Accordingly, the estimate for currency growth by end-2007 was increased from 12 to 15 percent. In addition, demand has shifted to longer-maturity Central Bank monetary control instruments, reflecting greater confidence in the Paraguayan economy.

By the end of August 2007, international reserves rose to an unprecedented peak, despite the almost null intervention of the Central Bank in the foreign exchange market—a different behavior than in the first semester of the year, mainly because of moderating capital inflows. It is expected that the level of international reserves will remain strong, reaching more than $2.25 billion, equivalent to more than 3 months of imports.

Another outcome from the strengthening of the economy is the continued improvement of the financial system, which has expanded its operations and improved its performance. Capital adequacy ratios are around 20 percent, twice the minimum regulatory requirements. Banks’ profits increased over 35 percent by end-June 2007, due largely to the decline of non-performing loans, which currently are close to international standards.

External Developments

The current account deficit narrowed as of end-June 2007, thanks to higher export growth—mainly from high prices of agricultural commodities—and a slowdown in import growth. The strengthening of the balance of payments is in line with the projected improvement in the trade balance. The current account deficit is largely financed by a capital account surplus due to higher foreign direct investments, most of them related to inflows from the hydroelectric bi-national plants.

Regarding the exchange rate, the appreciation of the guarani is expected to continue. Although the Central Bank may intervene in the foreign exchange market to avoid fluctuations, significant interventions are not foreseen in the near future, except to prevent an abrupt appreciation of the currency. It is worth mentioning that in September, the guarani appreciated by approximately 3 percent with respect to the U.S. dollar.

We would also like to inform that the authorities continue to assess international disputed claims and work on resolution proposals.

Structural Reforms

The structural conditionalities for end-June were observed. The authorities submitted in a timely manner a medium-term strategy for the National Development Bank, aimed at reorienting its operations, improving its management, and reducing its operational costs. The plan will define the future of the bank and provide adequate cash flows to meet its goals. The authorities also presented a plan to adopt at least 80 percent of the Basel Core Principles of banking supervision over the medium term, acknowledging that about 24 percent of the principles are already in place, and 16 percent would be adopted by end-2007. For the remaining 40 percent, changes in the legal framework would be needed.

Another benchmark fulfilled was the presentation of a plan for strengthening the financial position of the Central Bank, including legal considerations, which require a reconciliation of accounts between the Ministry of Finance and the Central Bank, and a transfer to the latter equivalent to 0.2 percent of GDP per year to cover eventual losses derived from the use of monetary policy tools. Completion of this agreement has required extensive work and compromise from the fiscal and monetary authorities.

At the same time, we would like to comment on the benchmark regarding the approval of a modified prudential rule for banks’ loan classification and provisioning. Although the Central Bank resolution was approved on September 28, 2007, in a timely manner, the staff assesses this benchmark as non-observed, because its implementation was delayed until October 2008. The authorities do not concur with the staff’s appraisal, taking into account that the decision to defer the date for full implementation was taken after protracted negotiations with the productive and financial sectors, in order to ensure consensus and muster adequate support from these groups. Moreover, following technical procedures, since January 2008 the Superintendency of Banks will begin partial implementation of the norm and will require banks’ information disclosures and forms associated with the new resolution.

Changes to the Program/Closing Remarks

Taking into account that the external position of the country has been consistently strengthened and that external vulnerabilities have been reduced, the Paraguayan authorities have deemed it appropriate to request a reduction of access under the SBA, from 65 to 30 percent of quota. They also request a waiver of applicability for the end-September 2007 performance criteria.

The authorities are determined to continue working towards the completion of structural reforms aimed at improving the business climate, in order to promote investment and growth and reduce poverty. Also, Paraguay’s recent economic outcomes stand as evidence of the authorities’ commitment to macroeconomic discipline and coordination. Finally, they would like to thank the staff and Management for their continuous support and advice during the implementation of the program, and commit to keep the usual policy dialogue.