2007 Article IV Consultation and Second and Third Reviews Under the Stand-By Arrangement: Staff Report; Public Information Notice and Press Release on the Executive Board Discussion; and Statement by the Executive Director for Paraguay.

Raising growth on a sustainable basis and addressing widespread poverty are the main challenges for Paraguay. The macroeconomic program for 2007 aims at raising growth and reducing inflation. IMF staff recommends that the next Article IV Consultation continues within the 24-month cycle, and supports completion of the second and third Stand-by Arrangement (SBA) reviews. After the 2002 financial crisis, growth has rebounded to almost twice its long-term average, per capita income surged to its highest level in 8 years, and extreme poverty has been reduced by almost one third.


Raising growth on a sustainable basis and addressing widespread poverty are the main challenges for Paraguay. The macroeconomic program for 2007 aims at raising growth and reducing inflation. IMF staff recommends that the next Article IV Consultation continues within the 24-month cycle, and supports completion of the second and third Stand-by Arrangement (SBA) reviews. After the 2002 financial crisis, growth has rebounded to almost twice its long-term average, per capita income surged to its highest level in 8 years, and extreme poverty has been reduced by almost one third.

I. Achievements and Prospects

1. Accomplishments. Following a decade of stagnation and instability and a quarter century of declining living standards, Paraguay has experienced some of the best macroeconomic outcomes in recent years. After the 2002 financial crisis, growth rebounded to almost twice its long-term average, per capita income surged to its highest level in 8 years, and extreme poverty was reduced by almost one third. An appropriate fiscal adjustment effort helped regularize payments, eliminate arrears, and reduce the debt-to-GDP ratio by one half. This effort was accompanied by a cautious monetary policy, which limited core inflation, strengthened the guaraní and tripled international reserves.

Paraguay: Long-Term Performance

article image
Sources: Paraguayan authorities.

End of period.

2. Reforms. Since 2003, the country implemented a number of initiatives aimed at modernizing the economy, reducing impediments to growth, and improving deep-rooted governance issues. The reforms include: (i) the fiscal adjustment law (which introduced the personal income tax, eliminated tax exemptions and broadened the tax base); (ii) the customs code (which strengthened the autonomy of customs); (iii) the banking resolution law (which set up the deposit guarantee fund); (iv) the public pension fund law (which introduced a parametric reform on this fund); and (v) the second tier-public banking law (which created the Financial Development Agency to intermediate long-term funds provided by donors). Evidence of improved governance comes from a sharp improvement in tax administration and revenue collections, a rapid recovery of non-performing loans at the National Development Bank (BNF), and the enactment of a strict procurement law.1

3. Outlook. International and regional prospects remain favorable, facilitating an expansion of Paraguayan exports and supporting the ongoing economic recovery. An end to a three-year drought is expected to be translated into good crops, especially soybeans.

4. Risks. The main external risk is a sudden change in the favorable global and regional environment due to an abrupt slowdown in U.S. growth, tighter conditions in financial markets, and a disorderly unwinding of global imbalances. The balance of payments remains vulnerable to risks affecting the burgeoning beef export sector (such as an outbreak of foot-and-mouth disease) or, more generally, from the spillover of shocks from the much larger neighboring countries. The most serious domestic risk is the possibility of political stalemate and policy impasse in the pre-electoral period. Presidential elections are scheduled for April 2008.

II. Trends and Developments

A. Economic Conditions

5. Growth. The expansion that began in 2003 continued through 2006, as real GDP rose about 4 percent, surpassing the program objective of 3½ percent. On the supply side, services and manufacturing rose significantly, while agricultural output began to recover, as the effects of the prolonged drought waned. On the demand side, growth was driven by a dynamic export sector (particularly beef) and an increase in private investment (especially in telecommunications). Economic activity remained buoyant in the first quarter of 2007, driven by good crops.


Paraguay: Economic Activity Indicators

Citation: IMF Staff Country Reports 2008, 183; 10.5089/9781451832556.002.A001

6. Inflation. It has been quite volatile given the economy’s high vulnerability to external shocks.2 Efforts to reduce inflation continued in 2006 with mixed results. While core inflation (excluding fruits and vegetables) fell from 10 percent in 2005 to 7 percent (in line with the program objective), headline inflation increased from 10 percent in 2005 to 12½ percent. Two shortterm factors explain this increase: (i) stricter application of sanitary controls on imports of vegetables, which reduced supplies and increased vegetable prices by almost 100 percent; and (ii) increased access to beef markets abroad, which raised domestic beef prices by over 30 percent. The supply shocks unwound in the first five months of 2007 (as sanitary controls were relaxed and domestic beef supplies increased in response to higher prices), and the 12-month rate of headline inflation fell to about 7 percent in May 2007.


Paraguay: Decomposition of Inflation

Citation: IMF Staff Country Reports 2008, 183; 10.5089/9781451832556.002.A001

7. Debt Sustainability. The consolidated public debt-to-GDP ratio increased almost fourfold in the second half of the 1990’s and reached over 70 percent by 2002, owing to large fiscal imbalances, a depressed economy and a depreciated currency. One of the major accomplishments of the current administration has been to put the public finances on a sound footing and the debt-to-GDP ratio on a declining path through an orderly process of adjustment, assisted by a strengthening of the economy and the guaraní. Over the last four years, the consolidated public debt-to-GDP ratio fell one half to about 35 percent in 2006.


Paraguay: Consolidated Public Debt

Citation: IMF Staff Country Reports 2008, 183; 10.5089/9781451832556.002.A001

8. Fiscal Performance. The public finances improved considerably in the last few years, mainly through higher tax collections and efforts to rein in current spending. The overall public balance showed a small surplus in 2006 (0.1 percent of GDP), compared with a balanced position envisaged in the program. Tax collections continued to be buoyant and current expenditures remained under control by the implementation of a strict financial plan, the freezing of new positions, and some under-execution of capital expenditures. Fiscal discipline continued during the first quarter of 2007.


Paraguay: Fiscal Performance

Central Government Overall Balance in Percent of GDP

Citation: IMF Staff Country Reports 2008, 183; 10.5089/9781451832556.002.A001

9. Monetary Conditions. The main challenge after the 2002 crisis has been the return of large foreign exchange inflows and their management. Improvements in the external position and the Central Bank’s purchases of surplus foreign exchange from the binational hydroelectric plants 3 led to an increase in international reserve of US$400 million in 2006 (85 percent of currency), despite an 18 percent appreciation of the guaraní against the U.S. dollar. Large placements of Central Bank bills (LRMs) were necessary to contain the increase in currency to some 15 percent in 2006. The strong external position continued during the first five months of 2007, and the Central Bank raised its pace of foreign exchange intervention to avoid an abrupt appreciation of the currency. The main source of the foreign exchange inflows switched from binational hydroelectric plants in 2006 to the private sector in 2007. However, as intervention was only sterilized in part, currency growth rose to over 20 percent by end-May 2007, creating a potential liquidity overhang.


Paraguay: Contributors to Currency Growth

Citation: IMF Staff Country Reports 2008, 183; 10.5089/9781451832556.002.A001

Figure 1.
Figure 1.

Paraguay: Emerging Recovery

Growth accelerated in 2006, led by higher exports and domestic demand, while a relatively higher inflation rate was the result mainly of supply shocks.

Citation: IMF Staff Country Reports 2008, 183; 10.5089/9781451832556.002.A001

Sources: Paraguayan authorities and Fund staff estimates.
Figure 2.
Figure 2.

Paraguay: Enhancing Fiscal Policy

Significant progress has been made in addressing fiscal imbalances. The challenge is to preserve fiscal sustainability and create the fiscal space to meet essential social and infrastructure spending needs.

Citation: IMF Staff Country Reports 2008, 183; 10.5089/9781451832556.002.A001

Sources: Paraguayan authorities and Fund staff estimates.

10. Financial Intermediation. Banks have resumed lending activities taking advantage of improved macroeconomic conditions after the credit crunch of 2002. Credit to the private sector grew by 18 percent in 2006, reaching 13½ percent of GDP. Improved market confidence and the stronger guaraní have led to a marked decline in dollarization from over 65 percent of assets and liabilities in 2002 to less than 50 percent in 2006.


Paraguay: Dollarization

Citation: IMF Staff Country Reports 2008, 183; 10.5089/9781451832556.002.A001

11. Banking Soundness. Banks have strengthened their financial position over the last few years, with capital adequacy ratios at 20 percent—well above the regulatory minimum of 10 percent. Even the National Development Bank (BNF), one of the weakest banks after the 2002 crisis, regained its solvency in 2006. However, the situation still needs to be carefully monitored as accounting practices and regulations remain weak. Non-performing loans significantly declined to 5 percent in 2006, profitability recovered, and liquidity ratios remained comfortable.


Paraguay: Nonperforming Loans

Citation: IMF Staff Country Reports 2008, 183; 10.5089/9781451832556.002.A001

12. External Sector. The external position has improved greatly in recent years, supported by a benign international and regional environment and a reflow of previous capital flight. This allowed the Central Bank to raise international reserves from US$0.6 billion at end-2002 to over US$2 billion by end-May 2007, while the guaraní strengthened by 35 percent against the U.S. dollar. During 2006, the overall external position improved further, despite a deterioration of the current account (due to a surge in import demand), as the capital account remained strong. Binational hydroelectric plants were a driving force in generating a large foreign exchange surplus. Foreign exchange inflows continued in early 2007.


Paraguay: Sources of Foreign Exchange

Citation: IMF Staff Country Reports 2008, 183; 10.5089/9781451832556.002.A001

B. Social Situation

13. Status. Following a sharp rise during the period of economic stagnation, the overall poverty index decreased from almost 50 percent of the population in 2002 to less than 40 percent in 2005. Social investment increased substantially during the past ten years, helping achieve significant progress in education—with illiteracy rates falling from almost 10 percent in 1995 to 4 percent in 2005—and improving health infrastructure. However, social spending (at about 10 percent of GDP), is still somewhat low by Latin American standards, limiting health services coverage, particularly in rural areas.


Paraguay: Poverty Indices

Citation: IMF Staff Country Reports 2008, 183; 10.5089/9781451832556.002.A001

C. Political Environment

14. Elections. Preparations have started in earnest for the April 2008 general elections. Nomination of presidential candidates by their parties is expected in late 2007. Congress, which is controlled by the opposition, is likely to intensify its opposition to government initiatives as has happened over the past year. 4 Expenditure pressures may increase towards the end of the year given the pre-electoral period. Nonetheless, there are demands from the business community to ensure that the economy is “insulated” from undue political pressures.

III. Performance Under the Program

15. Implementation. The program remains broadly on track despite the start of the electoral period as the authorities pursued sound policies, and the external environment remained favorable. This section reports on performance under the second review (i.e., end-September 2006 targets) and the third review (i.e., end-December 2006 targets). The reviews have been delayed as the new leadership of the Central Bank needed time to reassess the envisaged reforms in the financial sector. 5

16. Macroeconomic Program 2006. The overall fiscal targets for 2006 were observed as a solid revenue performance continued, notwithstanding strong expenditure pressures in the last quarter of 2006. The public wage bill target for 2006 was also met despite Congressional approval in late 2006 of a supplementary budget (which increased the wage bill by almost 0.2 percent of GDP), thereby raising expenditure pressures and budget rigidities for 2007. The credit and international reserve targets for 2006 were observed with considerable margins as the Central Bank sterilized the bulk of large foreign exchange inflows. Monetary policy was assisted by the strong fiscal policy and efforts to reduce the losses of the Central Bank of Paraguay.6 However, the abundance of foreign exchange complicated monetary management and generated a currency expansion of over 15 percent. These problems intensified in early 2007.

Figure 3.
Figure 3.

Paraguay: Coping with the Monetary Effects of Reserves Inflows

The strong balance of payments has complicated monetary management. The BCP has so far taken a balanced stance, through a mixture of nominal exchange rate appreciation and reserves accumulation with sterilization. However, currency growth continues to be high and could become a source of inflationary pressures.

Citation: IMF Staff Country Reports 2008, 183; 10.5089/9781451832556.002.A001

Sources: Paraguayan Authorities and Fund staff estimates.
Figure 4.
Figure 4.

Paraguay: Strenghtening the Banking and Financial Systems

The financial system is recovering after several years of financial distress that dramatically reduced the size of the banking system. The macroeconomic stability of recent years provides a window of opportunity to address key remaining vulnerabilities that would be an obstacle to growth.

Citation: IMF Staff Country Reports 2008, 183; 10.5089/9781451832556.002.A001

Sources: Paraguayan Authorities and Fund staff estimates.

17. Structural Reform 2006. The authorities observed all structural performance criteria and most of the structural benchmarks for the second and third program reviews.

  • BNF. The audited balance sheet showed a capital adequacy ratio (CAR) of 8½ percent in June 2006 (against a 5 percent target) and 18½ percent in December 2006 (against a 10 percent target), owing to high asset recovery and undistributed profits.

  • Investment climate. The authorities submitted a plan to improve the investment climate that aims at removing impediments to establishing private enterprises, strengthening property rights, and enhancing competitiveness.

  • Tax code. The authorities prepared a tax procedure code that aims at strengthening procedures and penalties related to tax collections and providing better legal and regulatory capacity to the revenue collecting agencies. The draft code was already discussed with private sector experts.

  • Public enterprises. Result-oriented management contracts were signed with ANDE, COPACO, ESSAP, INC and PETROPAR to improve the provision of public services, the management of the companies and their financial position.

  • Conditional cash transfers. This program, which conditions household transfers to the children’s attendance to school and visits to health centers, covered over 8,800 poor families, against a target of 7,000, and enhanced the provision of education and health services to families living under extreme poverty.7

  • Banks. The strategy for banking reform experienced a serious setback. The introduction of a key Central Bank regulation (resolution 8/03) was postponed by more than 1½ years (to August 2008) after strong opposition from banks and their borrowers, deteriorating significantly the climate for reform in this area.8 Given these difficulties, the authorities could not implement program conditionality related to additional prudential regulations nor send to Congress amendments to the banking law. The authorities propose to reinvigorate the reform efforts in this area with a new approach (see the section on financial sector policies for 2007).

  • BCP. While significant progress has been made in finding a solution to the financial situation of the Central Bank, the strategy to strengthen its balance sheet has not been finalized. Consequently, the authorities did not send the legal and budgetary implication of such strategy to Congress. The authorities are requesting to reset these benchmarks.

  • Fuel Issues. With fluctuations in international oil prices, domestic price adjustments, and the appreciation of the guaraní, diesel subsidies have been reduced significantly in line with policy intentions to liberalize the diesel price.9

Paraguay: Structural Conditionality for 2006/07

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Sources: Paraguayan authorities and Fund staff; PC=performance criterion.

18. External Issues 2006. The authorities reiterated their commitment to eliminate PETROPAR arrears by September 2007; these amounted to almost US$30 million at end-2006. Some progress was made in dealing with the debts in dispute.10

Figure 5.
Figure 5.

Paraguay: Balance of Payments Developments

A benign external environment has produced a favorable balance of payments in the last few years. The external position was particularly good in 2006 driven by high foreign direct investment.

Citation: IMF Staff Country Reports 2008, 183; 10.5089/9781451832556.002.A001

Sources: Paraguayan Authorities and Fund staff estimates.

IV. Policy Discussions and the 2007 Program

19. Focus. The Article IV consultation discussions focused on the main economic problems facing the authorities: low growth and widespread poverty. To address these problems, five reform areas were identified: (i) strengthening macroeconomic management; (ii) reinforcing fiscal institutions; (iii) tackling financial weaknesses; (iv) developing a pro-growth policy agenda; and (v) designing an effective poverty reduction policy. To help address these issues, the staff prepared selected issues papers in each of these areas. The papers were discussed with the authorities in seminars during the December 2006 mission (in collaboration with the World Bank and IDB staffs). The policy priorities that emerged from those discussions were used to shape the authorities’ macroeconomic policies and structural reform agenda for 2007. These policies and reforms are consistent with the medium-term framework presented in the May 2006 program (Country Report No. 06/302).

Paraguay: Macroeconomic Framework

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Sources: Paraguayan authorities; and staff estimates

A. Strengthening Macroeconomic Management

20. Macroeconomic Stability. There was broad agreement that continued strengthening of the fiscal and monetary frameworks is needed to entrench macroeconomic stability and create the conditions for faster growth and poverty reduction. The authorities stressed their commitment to maintaining macroeconomic stability, but noted that this task would be more demanding in the forthcoming pre-electoral period. The authorities’ program aims at raising real GDP growth to the 4–5 percent range in 2007 and 2008, while reducing core inflation to 5 percent (within a +/-2½ percent range) in 2007 and 3 percent in 2008. Key elements of the program include (Box 1) (¶6):11, 12

  • Fiscal Policy 2007. The authorities are strengthening their ability to conduct countercyclical fiscal policies, while preserving fiscal sustainability, and therefore are targeting broad fiscal balance for 2007. This would imply a tightening of policy relative to the approved budget (¶7).13 Continued application of the fiscal adjustment law, and restraint in current spending through a financial plan approved in March 2007 will make room for increasing capital spending while maintaining overall balance at the Treasury level. The staff encouraged the authorities to save one-half of any revenue over-performance to strengthen their fiscal position even further while using the reminder of the over-performance to step up social spending and poverty reduction programs. However, the authorities believed that it will be difficult to increase public savings further in the current political environment. The rest of the public sector will maintain a small surplus to compensate for the projected central bank losses and permit achieving a balanced position of the consolidated public sector (¶10).14 The authorities are expected to make further progress in 2007 towards their objective of a consolidated public debt of no more than 30 percent of GDP (Box 2).

  • Monetary Policy 2007. The objective for 2007 is to reduce core inflation to 5 percent through a monetary program that limits the growth of currency issue to 12 percent, which is consistent with a modest recovery in real money demand (¶11). To this end, the Central Bank will maintain a tight credit policy stance by reducing its net domestic assets by some 20 percent of currency through the active placement of “Letras de Regulacion Monetaria”, while at the same time tolerating a large build-up in international reserves of 33 percent of currency. This credit-reserve mix was designed to accommodate a large influx of foreign exchange observed in the first four months of 2007. The authorities feared that a significant part of these amounts were temporary private capital flows and decided to intervene to prevent an abrupt appreciation of the currency. They also reduced significantly interest rates on the benchmark LRMs by over 600 basis points to about 4½ percent to discourage further inflows. While real interest rates are still positive in the short-run, nominal interest rates may need to be raised in the next months to maintain domestic credit within program limits and achieve the core inflation objective. Foreign exchange inflows fell significantly by end-April 2007 (¶12). Over the medium term the authorities intend to reduce inflation to industrial country levels.

  • Exchange Rate Policy 2007. The authorities will maintain a flexible exchange rate with intervention aimed at achieving their net international reserve target as well as smoothing out large and/or seasonal transactions (¶12). The staff considers that Paraguay’s floating exchange rate regime is appropriate in light of the need to absorb shocks. The recent strengthening of the guaraní comes after a sharp real depreciation during the 2002 crisis, and there is currently no conclusive evidence of large exchange rate misalignments; in real effective terms, the guaraní is only slightly appreciated relative to the average of the last 10 years. However, econometric studies indicate that on the basis of past behavior, the guaraní may be somewhat overvalued (between 6 to 8 percent) (Box 3). However, the strengthening of the current account and the higher foreign direct investment may signal some shift in the equilibrium real exchange rate. The staff believes that it is too early to tell if the inflows of the last few months were due to temporary capital inflows (a regional phenomenon) or more permanent improvements in the current account, and suggested to the authorities to monitor closely the situation and be prepared to allow the guaraní to appreciate if there is conclusive evidence that the fundamentals have strengthened.

  • External Sector 2007. The current account deficit as a percent of GDP is projected to fall slightly in 2007 mostly due to improvements in the trade balance as Paraguay will continue to benefit from strong agricultural exports. The capital account is projected to show another large surplus, mainly owing to foreign direct investment.

  • Medium-Term Scenario. The scenario presented in the staff report for the SBA request (Country Report No. 06/302) remains valid in view of the authorities’ commitment to continue pursuing prudent macroeconomic policies and implementing structural reforms to sustain growth, supported by favorable external conditions. Prudent macroeconomic policies should aim at increasing public resources to reduce poverty and improve infrastructure, and broad-based economic reforms should help entrench stability, and sustain medium-term growth by encouraging private investment, and augmenting productivity. Under this scenario, real GDP growth would rise to 5 percent by 2010, while price and financial stability would be maintained. Continued fiscal consolidation would permit a decline of the public debt to-GDP ratio to just over 20 percent by 2012 (see Appendix 5 for a debt sustainability analysis).

Paraguay: The Focus of Macroeconomic Policies

Assessing the cyclical position of the economy is essential to avoid policies that exacerbate economic fluctuations. Different methodologies can be used to estimate the output gap. A key policy objective is to conduct counter-cyclical policies to minimize the variability of output. Other important considerations are debt sustainability for fiscal policy and price stability for monetary policy.

The economy appears to be above its potential after coming out of a long period of stagnation and instability. Since the high-growth episode in the 1970s with average growth of 7.7 percent, Paraguay has experienced very poor performance culminating in a decade of stagnation with recurrent crises in the late 1990s. However, since 2003, the average rate of growth has recovered to 3.5 percent. In addition, the recent growth period seems to be associated with less volatility. Various methodologies to estimate the output gap (Cobb-Douglas production function, Okun’s Law, or statistical filters such as Hodrick Prescott filter or the “Ideal” Pass filter) suggest that the economy is currently above its long-term trend (see Chapter I in the companion Selected Issues Paper).

Although mildly countercyclical, fiscal policy needs to be strengthened to better “lean against the wind.” Fiscal policy was assessed using the fiscal impulse methodology. Fiscal policy was broadly neutral in the early 1990s and supportive of growth during the protracted crises of the late 1990s. During 2000–04, fiscal policy was on average countercyclical and contributed significantly to the reduction of the debt ratio. However, in 2005–06, despite the high point in the business cycle, fiscal policy was not as strong as a proper countercyclical policy would have dictated (although this reflects in part increased public investment).


Fiscal Impulse and Output Gap

Citation: IMF Staff Country Reports 2008, 183; 10.5089/9781451832556.002.A001

Monetary policy was geared more toward stabilizing the exchange rate but recently more emphasis has been given to controlling inflation. The previous focus on the exchange rate as a policy objective reflects the high degree of dollarization of both assets and liabilities and the high exchange rate pass-through to inflation. Estimation of a Taylor rule augmented by open economy variables shows that the policy interest rate has responded to changes in the exchange rate or to the level of net international reserves, with lower reserves leading the country to be more defensive in terms of interest rate. This behavior is similar to some extent to that in other highly dollarized economies, and contrasts with lowly dollarized economies where the monetary rule responds to the traditional determinants of inflation and output gap. In 2005–06, however, a change too recent to be captured in regression analysis, interest rates were raised to respond to inflationary pressures. Over the medium-run, Paraguay would gain from pursuing consistently a monetary policy more focused on inflation.


Interest Rate, Inflation, and Exchange Rate

Citation: IMF Staff Country Reports 2008, 183; 10.5089/9781451832556.002.A001

Paraguay: Fiscal Program 1/

(In percent of GDP)

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Sources: Paraguayan authorities; and staff estimates

Central Government.

Paraguay: Monetary Program 1/

(In percent of currency the previous period)

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Sources: Paraguayan authorities; and Fund staff estimates.

Central Bank Accounts.

Paraguay: Fiscal Challenges

An ambitious fiscal reform agenda needs to be put in place to support growth and poverty reduction. The medium-term fiscal agenda should consolidate recent improvements in public finances and deepen the reform in a number of areas, including by: (i) locking in revenue gains; (ii) reorienting expenditure and reducing rigidities; and (iii) strengthening budgetary procedures and expenditure financial management (see Chapter II on fiscal reform in the companion Selected Issues Paper).

Revenues. The tax revenue-to-GDP ratio has been relatively low compared to other countries in the region, although it has improved in recent years. A tax reform aimed at creating a more effective and revenue generating tax system was approved in 2004. The government’s tax strategy is to increase the tax-to-GDP ratio gradually by broadening the tax base (applying moderate rates), and enhancing administrative tax efficiency. The authorities have introduced tax and customs administration reforms focused on enforcement and compliance, with technical support from the Fund and other international institutions. These achievements need to be supplemented by additional efforts to strengthen revenue administration and improve revenue performance further. The legal ambiguity of the civil service law regarding the career system of civil servants is delaying needed reforms in human resource for Customs and the Tax Office.


Latin American Countries: Tax Revenues and Per–Capita GDP

Citation: IMF Staff Country Reports 2008, 183; 10.5089/9781451832556.002.A001

Expenditures. Key objectives of an expenditure policy will be to reduce further budget rigidity and enhance spending efficiency. To accomplish these objectives, it would be important to link wage increases to productivity improvements, adopt attrition policies, reduce government contribution to pensions, restrict revenue earmarking, enhance efficiency in the use of public resources (i.e., by strengthening public investment criteria), and set hard budget constraints to the judicial and legislative branches. The wage bill is relatively high, and claims almost 80 percent of tax revenue and more than 40 percent of general government spending. The pension system coverage is low by regional standards for both active workers and the elderly, but the budgetary transfers to the system are relatively large. There is no independent capacity to evaluate investment projects and to assist in its prioritization, causing the capital budget to be spread too thin.

Budget. The Public Financial Management system has some weaknesses. The budget process needs to enhance transparency, discipline, realism, and accountability, as well as its legal framework. The lack of realism in the budget translates in systematic over-budgeting at the budget formulation stage which leads to a high degree of uncertainty about the stance of fiscal policy. It is important to establish a medium-term framework to improve budget preparation, prioritization, and sustainability.


Central Government: Deviations Between Budgets and Outturns

(in percent Of GDP)

Citation: IMF Staff Country Reports 2008, 183; 10.5089/9781451832556.002.A001


Paraguay: Real Effective Exchange Rate

Citation: IMF Staff Country Reports 2008, 183; 10.5089/9781451832556.002.A001

Paraguay: Balance of Payments

(In percent of GDP)

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Sources: Paraguayan authorities; and Fund staff estimates.

General government only.

Includes errors and omissions

Paraguay: Is the Exchange Rate Misaligned?

An update of a standard model to assess the REER against its fundamentals shows similar econometric results.1 The model includes traditional determinants of equilibrium exchange rate (EER). Better terms of trade and higher net foreign assets lead to appreciations of the EER through wealth effects. Trade openness increases competition in tradable goods, thus depreciating the EER, while an improvement in the fiscal balance has the same impact through a reduction of the demand for nontradable goods. Productivity increase in the tradable sector raises the relative price of nontradable goods, thus raising the EER (the Balassa-Samuelson effect). Finally, an increase in capital inflows (reflected in a deterioration in the current account) may cause an appreciation of the EER as the demand for nontradables increases. Minor changes were made to the model, such as broadening the terms of trade beyond soybeans and cotton, to include cereals and beef, which have became important export items. The model has been re-estimated to include the latest data 1980–2006 (see table). Unlike Benelli, the REER of Argentina and Brazil have been omitted as these likely reflect effects already captured by other variables. The explanatory variables all have the expected sign and the coefficients are broadly similar to those of the earlier Benelli study.

Estimation of Equilibrium REER Equation 1/

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OLS estimates. Given some non–stationary variables, standard deviations are only indicative but OLS estimates are consistent.

As a percent of GDP.

However, the results suggest that the undervaluation of the REER following the 2002 crisis has been corrected, and that the REER may currently be stronger than suggested by its fundamentals. The figure below presents the regression residuals (i.e., short-term misalignment) as well as the deviations in the REER implied by the regression coefficient when the fundamentals are evaluated at their long term trend values (computed by applying the Hodrick-Prescott filter to each series) (i.e., long-term misalignment). The results are broadly similar. For end-2006 the model points to a possible small overvaluation of 6 to 8 percent. As the figure suggests, part of the 12 percent REER appreciation in 2006 is not reflected in its fundamentals, which remained broadly unchanged. In addition, in the first quarter of 2007, the REER appreciated further. However, while the model does not explain intra-year variations, part of the recent appreciation could be explained by structural changes that are not yet adequately reflected in the data series (such as increased productivity in agroindustrial sectors, improved terms of trade, higher NFA, and better GDP growth prospects).


Real Exchange Rate Misalignment

(Estimated from Equilibrium Relationship)

Citation: IMF Staff Country Reports 2008, 183; 10.5089/9781451832556.002.A001

1 “Equilibrium Exchange Rate in Paraguay” by Roberto Benelli, Selected Issues Paper, IMF, 2004.

B. Reinforcing Fiscal Institutions

21. Medium-Term Institutional Reform. In view of Paraguay’s institutional weaknesses, there was agreement on the need for a medium-term reform of fiscal institutions to promote fiscal sustainability, improve the flexibility of fiscal policy, and support long-term growth potential by better targeting social spending and infrastructure investment. Work in most of these areas has already begun, and will continue over the next years. The reforms include: (i) enhancing the institutional framework of tax and customs administrations to consolidate recent revenue gains and support additional revenue mobilization; (ii) strengthening public financial management, in particular the budget framework, to improve expenditure efficiency and control; (iii) reducing budget rigidities to permit a more flexible expenditure allocation process; (iv) rationalizing the civil service to improve service delivery; and (v) reforming the pensions regime to increase coverage and secure financial sustainability (Box 2).15

22. 2007 Institutional Fiscal Policies. In view of the discussions and the challenges ahead, the authorities are focusing their efforts in 2007 on institutional fiscal policies in four areas:16

  • Tax code. The authorities are strengthening the institutional framework for tax collection. In particular, they have recently drafted a tax procedures code, and they are preparing the implementing regulations (¶14).17 This involves the drafting of legal provisions to develop new streamlined compliance control procedures. The staff encouraged the authorities to reach a consensus within civil society before submitting a draft tax code to Congress, and then work with the relevant commission to explain the policies and ensure its approval.

  • Pension reform. In view of the low coverage, lack of regulation, fragmented structure of the pension system, and the need to minimize contingent liabilities, the authorities will develop a pension reform plan aimed at addressing these concerns and ensuring the long-term solvency of the pension system (¶15). The staff recommended that the plan be followed by a parametric reform of the whole system.

  • Expenditure control. To strengthen the ability of the Ministry of Finance to limit expenditures, the authorities will establish an expenditure control system at the commitment level for the Executive Branch (¶15). This reform is key to improving the quality of spending and eliminating the practice of reaching fiscal objectives by under-executing capital expenditures, while identifying remaining outstanding obligations. The staff stressed the need to implement a Treasury single account, to enhance expenditure control; the authorities are in the process of reducing the number of public accounts with a view to achieve the single account.

  • Public investment. To achieve a better integration between the long-term objectives of specific sectors and the investment projects being selected, the Ministry of Finance will design a public sector investment system that ensures that programs reflect government priorities, improves prioritization and efficiency, maximizes investment return, and removes budget rigidities (¶15).

Paraguay: Fiscal Structural Benchmarks for 2007

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Sources: Paraguayan authorities and Fund staff.

C. Tackling Financial System Weaknesses

23. Strengthening the Financial System. The authorities agreed that the low intermediation capacity of the financial system hinders economic growth, and are considering a wide range of reforms that are in line with the recommendations made by the 2005 FSAP. These include: (i) strengthening the financial position of the Central Bank; (ii) improving the framework for monetary operations; (iii) upgrading banking regulation and supervision; (iv) restructuring public banks (especially BNF); (v) strengthening the regulation and supervision of financial cooperatives; (vi) developing domestic capital markets; and (vii) enhancing the payment system.18

24. 2007 Financial Sector Policies. The authorities stressed their commitment to address the shortcomings of the financial system, and regretted recent setbacks in the implementation of the financial sector reform agenda. They noted that implementation of some reforms will take longer than anticipated because of the complex political landscape in 2007, and therefore their efforts will concentrate on the following areas:

  • Monetary authority. The authorities are determined to address the Central Bank’s negative income position, and are designing a strategy to strengthen the financial position of the Central Bank. They intend to submit to Congress a bill with the legal and budgetary implications of the strategy by September 2007 (¶18). This financial exercise will allow the Central Bank to focus more on monetary policy issues rather than the implication of its actions on the balance sheet.

  • National Development Bank. The authorities intend to continue their efforts to strengthen the national development bank (BNF) and minimize its potentially systemic risk. To consolidate further BNF’s financial position, and limit future political interference with the bank’s lending policies, the authorities are developing a medium-term business strategy to refocus its operations, reduce operating costs, increase asset recovery, improve credit and risk management practices, and enhance internal controls (¶17). The staff encouraged the authorities to include in the plan a clear timetable and the need for some downsizing.

  • Payments system. To address weaknesses in the payments system, facilitate the development of capital markets, and mobilize financial resources, the Central Bank is preparing a draft law to revamp the payments system (¶16). Furthermore, the authorities will intensify their efforts to put in place a real-time gross settlement system (RTGS) and an automatic clearing house (ACH).

  • Capital markets. The authorities agreed that the financial strengthening of the Central Bank will provide opportunities for developing capital markets. They are designing a comprehensive strategy for the development of capital markets, including by promoting the domestic securities market and strengthening the public debt management system (¶19).

  • Cooperatives. The authorities believe that a strengthening of the regulatory, supervisory and monitoring framework for the largest cooperatives is key to the financial sector reform. The objective is to reduce the difference in the regulatory framework for different kinds of financial institutions and to minimize systemic financial vulnerabilities and distortions (¶16).

  • Commercial banks. The Central Bank has developed a new approach to upgrading banking regulation and supervision, addressing remaining weaknesses identified in the FSAP exercise. This approach includes: (i) designing a strengthened strategy to achieve at least 80 percent of the Basel Core Principles for banking supervision over the medium-term (consistent with best practice in the region); (ii) approving a modified resolution 8/03—which seeks to strengthen bank’s loan classification and provisioning requirements—to become effective by January 1, 2008 (see Appendix 4); and (iii) implementing prudential regulations in line with the Central Bank’s operational plan (¶16).

Paraguay: Financial Structural Benchmarks for 2007

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Sources: Paraguayan authorities and Fund staff.

D. Developing a Pro-Growth Policy Agenda

25. Raising Productivity. The authorities pointed to progress made in the last few years, and stressed that achievement of permanent gains in potential output growth through raising productivity is part of their medium-term, broad-based agenda aimed at boosting per-capita income growth.19

26. 2007 Growth Policies. The authorities noted that their efforts in 2007 will focus on two areas:

  • Investment climate. The authorities expressed concern about the low level of private investment in the economy. To address this problem, they will implement the action plan designed in the fall of 2006, which aims at removing disincentives for investment, and enhancing the business and investment climate (¶20). The authorities’ plan rests on five main pillars: (i) facilitate enterprise creation; (ii) strengthen land property rights; (iii) create a one-stop window for exporters; (iv) reinforce the competitiveness of the export sector; and (v) improve the mechanism for reimbursing VAT.

  • Public enterprises. The staff noted that a significant factor for the low growth rates of the last decade was the drag caused by the inefficient state-owned enterprise sector. The authorities acknowledged the uneven performance of the state-owned enterprises and confirmed their intention to successfully implement management contracts with these enterprises signed in December 2006 (¶21).20

Paraguay: Pro-Growth Structural Benchmarks for 2007

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Sources: Paraguayan authorities and Fund staff.

E. Towards an Effective Poverty Reduction Policy

27. Poverty Alleviation. Poverty remains a serious problem with one in three people living below the poverty line and one in six people living in conditions of extreme poverty. Poverty alleviation programs have had a limited impact in raising living standards of the poor because of institutional limitations and weaknesses in design. Against this backdrop, the authorities are looking to strengthen poverty alleviation programs, with improved targeting and control mechanisms and sufficient budgetary allocations to ensure their implementation. The staff welcomed these intentions and recommended (after consultations with the World Bank and the IDB) that the authorities’ efforts to reduce poverty be comprehensive, integrating work in education, health and the provision of basic services like water and electricity.21

28. 2007 Poverty Policies. The authorities are determined to continue reducing poverty and viewed economic growth as the most effective contributor to achieve sustainable poverty alleviation, but agreed on the need for direct measures to address the most immediate needs of the population living in extreme poverty. They highlighted the conditional cash transfer program (CCT) as the most important of such measures. They intend to increase the coverage of their CCT program from 8,800 families in 2006 to 15,000 during 2007 (¶22). The staff encouraged the authorities to sharpen their poverty alleviation policy further.

Paraguay: Poverty Structural Benchmarks for 2007

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Sources: Paraguayan authorities and Fund staff.

V. Program Issues

29. Conditionality. The structure of quantitative performance criteria is the same as last year’s program. Conditionality for 2008 will be set at the time of the fifth review (expected for late 2007). The program envisages the implementation of measures associated with benchmarks not met in 2006, as follows:

  • Central bank’s balance sheet strengthening. Reset the benchmark on the design of a strategy to strengthen the financial position of the Central Bank to June 2007.

  • Implications of strategy on central bank strengthening. Reset the benchmark on sending to Congress the budgetary and legal implications of the above mentioned strategy to September 2007.

  • Prudential regulations. Change the previous benchmark on implementing regulatory measures to strengthen the financial system (including sending to Congress amendments to the banking law) for a new approach. The new formulation will include three new benchmarks: (i) design a strategy to increase compliance with Basel Core Principles of banking supervision to 80 percent by end-June 2007; (ii) approve a modified resolution 8/03 by end-September 2007, which will become effective by January 1st, 2008; and (iii) implement prudential regulations according to the Central Bank’s operational plan by end-December 2007.

30. Rephasing. The original schedule of purchases envisaged the completion of three additional purchases by June 2007 associated with the second, third, and fourth program reviews respectively. These reviews have not been completed as scheduled because it took longer than expected to agree on financial policies for 2007. However, one of these purchases (fourth review) was linked to conditionality in 2007 that had not yet been established. For that reason, only two reviews are proposed to be completed, and one purchase needs to be rephased. In particular, it is proposed that the purchase associated with end-March 2007 targets (SDR 6 million) be split by augmenting the purchase associated with end-September 2007 targets (by SDR 3½ million), and the one associated with the end-December 2007 targets (by SDR 2½ million). The authorities intend to continue treating the arrangement as precautionary.

31. Access. In view of the significant improvement in their external position, the authorities are considering requesting a reduction in access under this arrangement in the context of the next program review.

32. Adjustor. An adjustor to the overall balance of the central government equivalent to the direct transfers or interest costs associated with the financial strengthening of the central bank is proposed.22 This adjustor does not modify the consolidated public sector fiscal target.

VI. Staff Appraisal

33. Achievements. After a prolonged decline in per-capita income, Paraguay has implemented critical reforms in the last few years that have reversed the decline and started to reduce poverty. Paraguay’s achievements include: (i) the beginning of a growth process with rates well above historical averages; (ii) fiscal discipline and placement of the public debt on a sustainable path; (iii) the rapid buildup of international reserves in the context of a strengthened currency; and (iv) the speedy recovery of the financial system after the 2002 crisis. While these are major accomplishments, Paraguay faces significant challenges such as the need to entrench macroeconomic stability and intensify reforms to establish the conditions for sustained growth, and to address a number of vulnerabilities. The authorities are determined to address these challenges with sound policies and a high degree of ownership.

34. Fiscal policy. The authorities’ intention to achieve overall fiscal balance in 2007 and to implement the necessary expenditure cuts with respect to the budget approved by Congress is commendable. The authorities have been able to maintain fiscal discipline despite a difficult political environment and intense expenditure pressures. For the fourth consecutive year, the Ministry of Finance had to resort to the use of a financial plan to conduct fiscal policy given tensions with the approved budget. The situation became more complicated at the end of 2006 after Congress approved a supplementary budget to satisfy demands from the Judicial Branch. To improve the conduct and transparency of fiscal policy, it is therefore important to strengthen the budgetary framework and to establish overall limits that cannot be breached. The gains in tax administration need to be locked in, and the authorities’ efforts to design and adopt a modern tax code are welcome.

35. Monetary policy. The proposed monetary program is appropriate and the inflation and reserves objectives of the monetary program are ambitious but achievable. The Central Bank has struck a balance between allowing an appreciation of the guaraní and accumulating reserves. Close monitoring of developments will continue to be important, as the authorities will need to respond promptly to signs of inflationary pressures and/or monetary imbalances.

36. Financial system. While significant progress has been made towards enhancing the health of the financial system, the staff is disappointed that the political climate has delayed the much-needed financial sector reform, particularly the strengthening of bank regulation through resolution 8/03 and amendments to the banking law that would have reduced identified weaknesses. The authorities’ plan to regain momentum in this area is welcome, and they are urged to implement the measures envisaged in their redesigned financial sector reform. With banks having record high profits and record low non-performing loans, this appears to be the best possible time to implement such reforms. These efforts need to be reinforced by the necessary amendments to the banking law, as soon as political circumstances permit.

37. Structural reform. The authorities are encouraged to maintain the momentum of reform and to implement the ambitious reform agenda for 2007 in order to improve productivity and thereby achieve sustained growth. The reform agenda is appropriately multipronged given the challenges ahead. The authorities’ determination to implement structural reforms in several areas is commendable and they are advised to maintain the same level of commitment and dynamism in pursuing this agenda.

38. Risks. While there are several international and regional risks, the main risk in the short-run is the pressures to loosen policies in the pre-electoral period. The authorities have been successful in fending off political pressures to increase expenditures in the past, and this effort will need to continue, as the presidential race begins.

39. Reviews. The staff supports completion of second and third reviews under the SBA in light of the good performance and strong ownership of the program.

40. Consultation. The staff proposes that the next Article IV consultation takes place within the 24-month cycle.

Table 1.

Paraguay: Quantitative Program Targets for 2006

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Cumulative flows from the beginning of the calendar year.

For 2007 adjusted downward for any cash transfer or payment of interest costs on securities used to strengthen the financial position of the Central Bank.

Stocks. NIR is adjusted upward (downward) for any increase (decrease) in reserve requirement for foreign currency deposits (above pre-specified amounts) and upward by the amount of any program disbursements. Similarly, the NDA target will be adjusted downward (upward) following the adjustment in the NIR.

Table 2.

Paraguay: Structural Conditionality Under the Program for 2006

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SB = structural benchmarks; PC = performance criteria.

Table 3.

Paraguay: Selected Economic and Social Indicators

I. Social and Demographic Indicators
Area (thousand sq. km)407Income Distribution
By highest 20 percent of households (per61
By highest 20 percent of households (perc2
Population (2005)
Total (in millions-2004)5.7
Rate of increase (percent a year)1.9Health
Density (per per 1,000 people1.1
Unemployment10.9Access to a water source (percent)80
Access to a sanitation facility (percent)86
Population charcteristics (2004)
Life expectancy at birth (years)70.6
Crude birth rate (per thousand)29.7Education (2003; in percent)
Crude death rate (per thousand)5.0Male literacy rate (percent)94
Infant mortality (per thousand live birth)21.0Female literacy rate (percent)94
Primary school enrollment (percent)106
Secondary school enrollment (percent)63

Sources: Paraguayan authorities; and Fund staff estimates.

Revised GDP growth rates and GDP ratios reflects the use of a new national account data recently published by the authorities. However, program GDP ratios were not revised.

INS calculations of real effective exchange rates.

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

Nonfinancial Public Sector. Based on end-of-period exchange rate conversion of U.S. dollar-denominated debt.

Includes Central Bank Bills (LRMs).

Foreign currency items are valued at a constant exchange rate.

Table 4.

Paraguay: Central Government Operations

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Sources: Ministry of Finance; and Fund staff estimates.

Excludes banks’ holdings of government bonds.

Includes receipts from the binational hydroelectric plants Itaipu and Yacyreta, 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.