Recent Economic Developments

2. After the approval of the previous Stand-By Arrangement in 2003, the Paraguayan economy has shown significant economic progress, which has been broadly satisfactory and paved the way for further macroeconomic achievements. In particular, we concur with the staff’s view that macroeconomic outcomes have been underpinned by a disciplined and coordinated fiscal and monetary policy. Consequently, the most important results were a near doubling of the long-term average real GDP growth after the 2002 financial crisis and the reduced level of extreme poverty. In fact, the estimated GDP growth was around 4 percent in 2006, which was better than projected and mainly driven by a significant increase in services, manufacturing, the agricultural sector—which is recovering after severe drought—, beef exports, and private investment in telecommunications.

3. Despite higher volatility in 2006, a prudent monetary policy allowed core inflation to fall from 10 percent in 2005 to 7 percent in 2006, in line with the objective under the program. Headline inflation increased from 10 percent in 2005 to 12½ percent in 2006 as a result of supply shocks, namely stricter sanitary control in imported fruits and vegetables and increased beef exports which pushed up domestic prices, leading to a 12-month rate of 7 percent in May 2007. Although the large foreign exchange inflows—and consequently the necessary placements of Central Bank bills (LRM) to sterilize the foreign exchange excess in 2006 and the first five months of 2007—forced increases in the value of the currency, the Central Bank was skillful in putting a stop to the rapid appreciation, while also containing currency growth. In addition, the large foreign exchange inflow from royalties associated with the two bi-national hydroelectric plants strengthened the external position and took the Central Bank to a peak of international reserves, to US$ 2.1 billion by end-May 2007.

4. On the fiscal front, prudent policies adopted in recent years reflected a stronger financial level, as a result of improved tax collections and controlled current expenditure. These were possible thanks to the implementation of a disciplined financial plan which resulted in a primary surplus of 1½ percent of GDP in 2006. In this regard, the authorities have prepared a tax procedure code which was approved by the economic cabinet in December 2006. The financial plan not only put financial issues in order, but also helped to regularize payments, eliminate arrears, and—its most important achievement—decrease the public debt-to-GDP ratio from around 70 percent in 2002 to an estimated 27½ percent in 2006. Public enterprises have adhered to this effort by signing a results-oriented management contract aimed to improve public services and financial ratios.

5. In the context of improved and sustained macroeconomic stability, the financial system, although in a smaller proportion, is recovering by restarting lending operations to the private sector, which grew by 18 percent in 2006, as dollarization fell from 65 percent of assets and liabilities in 2002 to almost 50 percent in 2006. Similarly, the banking system has lengthened the maturity of assets and liabilities and strengthened their position, reaching a capital adequacy ratio (CAR) of 20 percent, which is over the established minimum of 10 percent. The National Development Bank (BNF) has also regained its solvency over a short period, reaching a CAR under the IMF standard of 8½ percent in June 2006 (against a 5 percent target) and 18½ percent in December 2006 (against a 10 percent target) thanks to higher asset recovery and undistributed profits.

6. Regarding social reforms, the government has also reached significant achievements, such as decreasing the overall poverty index from almost 50 percent of the population in 2002 to 40 percent in 2005. Social investments have also contributed to progress in education, with illiteracy rates declining from 10 percent in 1995 to 4 percent in 2005.

Fiscal Policy

7. The fiscal authorities are committed to maintaining macroeconomic stability as a way to increase growth and reduce poverty. Along these lines, they are implementing several measures aimed to strengthen fiscal sustainability. In the short term, they are putting in practice a financial plan approved in March 2007 aimed to achieve a broader fiscal balance for 2007 by restraining current expenditure, while giving further opportunity for capital spending.

8. In the medium term, the authorities are cognizant of the need to improve fiscal policy flexibility and fiscal institutions, as well as promoting fiscal sustainability to facilitate their goal of achieving long-term growth and poverty alleviation through better social spending and infrastructure investment. In this regard, an agreement has been reached and several reforms are on track, such as enhancing the institutional framework of tax and customs administration to consolidate recent revenue gains. In fact, the strategy pursued by the government is to gradually increase the tax base and enhance administrative tax efficiency to enhance the tax-to-GDP ratio. In addition, strengthening public financial management to improve expenditure efficiency and control, reducing budget rigidities to allow further flexibility, rationalizing the civil service to improve service delivery; and reforming the pension regime to increase coverage and secure financial, complement the strategy.

9. In line with the identified weaknesses, the authorities have already drafted a tax procedures code and the implementing regulations are being prepared. In the same vein, in order to address current rigidities, improve control, rationalize expenditure and budgetary processes, and incorporate macroeconomic constraints, the Ministry of Finance will design an expenditure control system at the Central Government level, which will improve efficiency and quality in spending, as well as strengthening public financial management. Consistent with this purpose, the reduction in the number of accounts to a single one is currently in process, for which further assistance from the IMF is being requested. In this regard, in order to increase efficiency and priorities in capital expenditure, a public sector investment system will be designed with assistance from the IADB. Likewise, to complement the measures adopted in the past, an action plan aimed to ensure long-term solvency in pension systems will be developed.

10. In the same vein, public enterprises are following a management program based on results, and scheduled ratios by contract will be published by the Public Enterprises Supervising Council. This program plays an important role not only to contribute to providing better services, but also to set a productivity benchmark for the economy as a whole.

11. Turning to the funds budgeted in social investments, the government increased the budget by 12¾ percent by May 2007, which currently represents 46.7 percent of total public spending. In addition, there was an increase of 18.3 percent in the health sector, and also an increase of 8.2 percent in education. Given the important role that public investment and poverty alleviation programs play in the government agenda, and as long as macroeconomic conditions allow absorption, higher-than-targeted levels of capital and targeted social expenditures will be supported.

12. As mentioned previously, one important achievement was the decrease in the public debt-to-GDP ratio, which reached 71¾ percent in 2002, mainly because of the large fiscal imbalances at that time and a depreciated currency which increased the burden of the debt. After an adequate fiscal adjustment effort, payments and arrears were regularized and the public debt burden was reduced to GDP to 27½ percent in 2006. The government has stated that additional debt would be considered only in very favourable conditions.

13. With the objective to preserve stability in an intensive and important electoral moment for democratic consolidation, the fiscal and monetary authorities have launched an accord to which all socio-economic sectors are committed to contributing to guarantee a smooth transition and deliver to the next government (2008) a country with stronger institutions, less poverty, and a more stable economy in a context of a sustainable growth. A low and controlled inflation is a public good that affects the whole population. Therefore, coordination between fiscal and monetary policy will be the key purpose of this agreement.

Monetary Policy

14. The monetary authorities’ key objective is to reach a core inflation of 5 percent by limiting currency growth to 12 percent, while maintaining control on net domestic assets around 20 percent by placements of LRM and holding an accumulation of 33 percent of currency in international reserves. Although core inflation was 7 percent at end-2006 and the 12-month rate of inflation fell to around 6 percent in April 2007, which is very auspicious, the monetary authorities think that it would be more prudent to establish a range between 2½ and 7½ percent for 2007. Consistent with this objective and with an expected growth rate of 4-5 percent, as well as a moderate strengthening in real money demand, the Central Bank will maintain a reasonable level of growth of monetary aggregates.

15. During the first five months of 2007, Paraguay has experienced large inflows of foreign exchange, mainly from the royalties of the two bi-national hydroelectric plants, which has forced the Central Bank to make large purchases of foreign exchange in order to avoid a sudden appreciation of the currency—which in turn forced an increase in its placements of LRM to sterilize liquidity excess. Although the monetary authorities have significantly reduced LRM interest rates to discourage further inflows, there is still interest in these instruments, which indeed could facilitate the control of currency expansion by the Central Bank in the near future, as monetary costs would be lower.

16. Regarding the latter, it is important to mention that the monetary authorities are addressing the negative income position of the Central Bank and are currently designing a strategy to strengthen the financial position in coordination with the Ministry of Finance. Although this structural reform has taken longer than envisaged, the authorities would like to reiterate their commitment and the Ministry of Finance will prepare a legislation to send to Congress with the legal and budgetary strategy by September 2007. The resulting law will strengthen the Central Bank’s financial position and guarantee improved monetary policy.

17. Although external vulnerabilities remain, the authorities are confident that the balance of payments will be kept under control, since against the current account deficit, the capital and financial account surplus in terms of GDP has more than doubled in 2006 and is projected to continue in this line. At the same time, the expected level of net international reserves is still strong, while the coverage remains around three months of imports. It is also expected that exports will continue to perform well, thanks to gains in productivity, namely beef and crops, especially soy, which is recovering after the drought.

Financial and Structural Reforms

18. Turning to the financial sector, the BNF has recovered as CAR surpassed the expected conditionality. In order to consolidate the BNF’s financial position gained so far, the authorities intend to limit future political interference with the banks’ lending policies and are developing a medium-term business strategy aimed to reduce operating costs, increase asset recovery, improve credit and risk management practices, and enhance internal controls.

19. Having missed the structural benchmark on implementing regulatory measures, the authorities have proposed three new supervision improvements. In this regard, the Central Bank will reach a consensus with the banking community on a new version of resolution 8/03 to upgrade credit requirements, loan classification and provisioning. With assistance from the IMF, the Central Bank will design an ambitious plan to address weaknesses in the regulatory and supervisory frameworks of the banking system, which will aim to increase observance to around 80 percent of the Basel Core Principles of Banking Supervision. In addition, prudential regulations will be strengthened in critical supervising areas, such as capital requirements calculation, better rules for provisioning, streamlining administrative sanctions proceedings, rationalizing rules on open net foreign exchange positions and the public reporting on the financial position of banks.

20. An important and increasing portion of the financial system corresponds to cooperatives. Therefore, to reduce vulnerabilities and regulatory differences with the rest of the financial institutions, the supervisory institution INCOOP will develop an effective supervisory and regulatory framework for financial issues and will also strengthen the monitoring framework by compiling monetary statistics and its incorporation within the Central Bank’s monetary statistics.

21. In order to facilitate transactions and mobilize financial resources, as well as improve the management of monetary policy and liquidity in the financial system, the Central Bank will prepare a draft payments system law to be approved by the economic cabinet by end- September 2007. In addition, although capital markets are in the early stages and with the intention to promote domestic savings and improve its allocation into productive investment projects, the Ministry of Finance, in coordination with the Central Bank, will design a strategy for the development of capital markets, which will consider legal and institutional demands.

22. Extreme poverty alleviation represents the authorities’ main concern. In this vein, a cash transfer program to help families in extreme poverty has been implemented, which has reached over 8,800 families, more than its first objective of 7,000 families. This program primarily provides health and education services and the Ministry of Social Action, responsible for this coverage, intends to broaden it to 15,000 families by December 2007.

23. The authorities are committed to moving forward with structural reforms with the aim of improving the business climate and promoting investment and growth. In this regard, the government agrees with the staff that an improvement in the investment climate will lead to a higher level of foreign and domestic investment; therefore, the Ministry of Industry would be implementing a master plan created to promote investment by September of this year.

Closing Remarks

24. Our authorities would like to thank the IMF for their support in consecutive programs and for their invaluable efforts and insightful advice. These programs have allowed Paraguay to set a firm commitment to crucial reforms. Most importantly, a solid and coordinated economic policy framework was (and still is) fundamental for economic recovery and poverty alleviation, while creating improved and favorable conditions through fiscal and monetary sectors to enhance productivity. At this stage, Paraguay is still facing important challenges that need to be addressed. However, the authorities are confident that cooperation with the Fund will be crucial to fulfill these endeavors.