Abstract
This Selected Issues paper analyzes the spillover effects of key external shocks on Paraguay. It presents an overview of Paraguay’s major economic and financial linkages with the rest world, and quantifies the spillover effects of key external factors on the Paraguayan economy, using a vector autoregression approach. The empirical results suggest that global shocks have a significant impact on Paraguay’s growth rate. The paper also highlights that output and exchange rate shocks stemming from Brazil and Argentina are also important, even after controlling for global factors.
Global and Regional Spillovers: How Important for Paraguay?1
A. Introduction
1. Paraguay has experienced high but volatile growth in the recent decade, amid large exposures to external shocks. Economic growth in Paraguay has averaged 4.8 percent p.a. since 2004, though this remarkable record has been accompanied by significant output volatility, the second-highest in the region. As a small open economy with a large primary sector, Paraguay faces various risks, including weather-related shocks, changes in global commodity and financial markets, and developments in its trading partners, including its large neighbors, Brazil and Argentina. At the current juncture, marked by falling commodity prices and subdued growth prospects for South America, it is particularly important to understand closely Paraguay’s foreign linkages and assess its resilience to key external shocks.
Growth Volatility in Latin America, 2004-13
(Standard deviation of real GDP growth, percent)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: IMF, World Economic Outlook; and IMF staff calculations.Growth Volatility in Latin America, 2004-13
(Standard deviation of real GDP growth, percent)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: IMF, World Economic Outlook; and IMF staff calculations.Growth Volatility in Latin America, 2004-13
(Standard deviation of real GDP growth, percent)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: IMF, World Economic Outlook; and IMF staff calculations.2. This paper tries to analyze the spillover effects of key external shocks on Paraguay. Following an overview of Paraguay’s major economic and financial linkages with the rest world, this paper quantifies the spillover effects of key external factors on the Paraguayan economy, using a vector autoregression (VAR) approach. The empirical results suggest that global shocks have a significant impact on Paraguay’s growth rate. Output and exchange rate shocks stemming from Brazil and Argentina are also important, even after controlling for global factors.
B. Mapping the Linkages
Trade Openness in Latin America, 2013
(Imports and exports, in percent of GDP)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: IMF, World Economic Outlook; and IMF staff calculations.Trade Openness in Latin America, 2013
(Imports and exports, in percent of GDP)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: IMF, World Economic Outlook; and IMF staff calculations.Trade Openness in Latin America, 2013
(Imports and exports, in percent of GDP)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: IMF, World Economic Outlook; and IMF staff calculations.3. Given Paraguay’s high degree of trade openness, trade appears to be the primary channel for transmitting external shocks. Foreign trade has grown rapidly over the last decade, with total exports and imports at almost 95 percent of GDP in 2013, among the highest in the region. Trade is also highly concentrated, making the economy vulnerable to shocks from key trading partners and commodity markets. In that regard, developments in its major export destinations (notably Brazil) and price changes for its major export products (especially soy, grains, and meat) are of particular importance.2
4. Although direct financial exposures are relatively limited, external financial shocks could conceivably affect Paraguay through foreign bank lending, dollarization, and FDI. Direct portfolio inflows into local financial markets are negligible, as there are virtually no investable assets, although the recent issuance of two large international sovereign bonds has created an opening for US$-denominated portfolio investment. Meanwhile, foreign banks (notably from Brazil and Spain) currently hold gross claims of almost 25 percent of GDP on Paraguay, the bulk of which through local subsidiaries with a domestic deposit funding base.3 These claims (notably those linked to Brazilian banks) fluctuated considerably during the global financial crisis, indicating a potential role in transmitting external shocks. Paraguay’s high level of financial dollarization creates an additional potential channel for spillovers, including from U.S. monetary shocks. Effects are likely to be muted, however, by the relatively large gap and weak correlation between local US$ interest rates and the U.S. equivalent, and by existing liquidity buffers, including reserve requirements. Lastly, FDI, though modest in scale, has also been affected by home-country developments in the recent past, as difficult economic conditions in Argentina and Brazil have reportedly fuelled investment flows into Paraguay.
International Banks’ Claims on Paraguay
(In percent of GDP)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: Bank for International Settlements; and IMF staff calculations.Note: Consolidated gross foreign claims of BIS-reporting banks on immediate borrower basis by nationality of reporting bank.International Banks’ Claims on Paraguay
(In percent of GDP)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: Bank for International Settlements; and IMF staff calculations.Note: Consolidated gross foreign claims of BIS-reporting banks on immediate borrower basis by nationality of reporting bank.International Banks’ Claims on Paraguay
(In percent of GDP)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: Bank for International Settlements; and IMF staff calculations.Note: Consolidated gross foreign claims of BIS-reporting banks on immediate borrower basis by nationality of reporting bank.
Dollarization of Loans and Deposits
(In percent of total)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: Central Bank of Paraguay; and IMF staff calculations.Note: Computed at constant November 2014 exchange rate.Dollarization of Loans and Deposits
(In percent of total)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: Central Bank of Paraguay; and IMF staff calculations.Note: Computed at constant November 2014 exchange rate.Dollarization of Loans and Deposits
(In percent of total)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: Central Bank of Paraguay; and IMF staff calculations.Note: Computed at constant November 2014 exchange rate.
FDI Inflows by Source Country
(In percent of GDP)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: Central Bank of Paraguay; and IMF staff calculations.FDI Inflows by Source Country
(In percent of GDP)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: Central Bank of Paraguay; and IMF staff calculations.FDI Inflows by Source Country
(In percent of GDP)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: Central Bank of Paraguay; and IMF staff calculations.
Paraguay FX Lending Rate vs. 10-Year U.S. Treasury Yield
(In percent)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: Central Bank of Paraguay; and IMF staff calculations.Paraguay FX Lending Rate vs. 10-Year U.S. Treasury Yield
(In percent)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: Central Bank of Paraguay; and IMF staff calculations.Paraguay FX Lending Rate vs. 10-Year U.S. Treasury Yield
(In percent)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: Central Bank of Paraguay; and IMF staff calculations.5. Overall, linkages with Brazil are particularly strong. Paraguay’s output growth is highly correlated with Brazil, its largest trading partner, which accounts for 30 percent of registered exports and the bulk of re-exports. Recently, Brazil’s weak growth and currency depreciation has dampened demand for re-exports, contributing to slower activity in Ciudad del Este, Paraguay’s main hub for cross-border trading. Financial ties are also close, with the presence of a large Brazilian bank (Itau) accounting for about one-sixth of total bank credit. However, Paraguay has also been seen to benefit from weaker business confidence in Brazil, notably through rising FDI inflows into the fast-growing maquila industry, which attracts Brazilian companies with its relatively low cost base and favorable tax and regulatory regime.
Exports to Brazil and Brazil GDP Growth
(In percent, yoy)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: Haver; and IMF staff estimates.Exports to Brazil and Brazil GDP Growth
(In percent, yoy)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: Haver; and IMF staff estimates.Exports to Brazil and Brazil GDP Growth
(In percent, yoy)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: Haver; and IMF staff estimates.6. Recent spillovers from Argentina have mainly been transmitted through surging contraband imports. Argentina’s export taxes and foreign exchange market controls have created strong incentives for contraband trade. Since mid-2012, contraband exports to Paraguay appear to have proliferated, alongside the widening gap between the official and informal market exchange rate of the peso. For the most part, the contraband (especially foodstuffs and household goods) displaces legal imports, as domestic production in Paraguay is limited. However, businesses involved in the formal distribution and retail chain have been negatively affected, while consumers have benefited from lower prices. Separately, anecdotal evidence suggests that Argentine capital flows to Paraguay have increased, notably into the real estate market.
Argentine Peso Exchange Rate Gap vs. Paraguay Supermarket Sales, 2012–14
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: National authorities; and IMF staff estimates.Argentine Peso Exchange Rate Gap vs. Paraguay Supermarket Sales, 2012–14
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: National authorities; and IMF staff estimates.Argentine Peso Exchange Rate Gap vs. Paraguay Supermarket Sales, 2012–14
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Sources: National authorities; and IMF staff estimates.C. Quantifying the Impact: A VAR Approach
7. A standard VAR model is explored to quantify the spillover effects of major external shocks. This empirical approach allows one to identify the dynamic response of Paraguay’s output to major shocks and determine the relative importance of different external factors. The model includes three main categories of exogenous variables: global, regional, and domestic factors. Global factors comprise: global demand, proxied by a weighted average of G7 and China real GDP; international financial conditions, measured by the VIX volatility index and the 10-year U.S. Treasury bond yield; and a Paraguay-specific net commodity price index as calculated in Gruss (2014). Regional factors include Brazil’s and Argentina’s real GDP as well as the bilateral real and peso (using the informal, or “blue”, market rate) exchange rates against the guaraní. The relevant domestic variable is Paraguay’s real GDP, though core GDP (i.e., GDP excluding the agricultural and electricity sectors) is considered as a robustness check. The model is estimated using quarterly data from 1997Q1 through 2014Q2, with two lags, and all variables expressed in quarter-on-quarter growth (seasonally adjusted for GDP), except for the VIX and U.S. interest rate, which are expressed in levels. The reduced form errors are orthogonalized by Choleski decomposition, with the ordering of the variables as listed above. This implies that global and regional factors do not respond instantly to changes in Paraguay’s GDP, while the latter may be affected by contemporaneous changes in external conditions.
8. Global shocks appear to have significant effects on Paraguay’s GDP growth. Figure 1 shows the dynamic response of Paraguay’s GDP growth to a one-standard deviation shock to global factors. The main results are as follows:
A global output shock has a relatively large and rapid impact on Paraguay’s output, with the peak response occurring on impact and some persistence for about a year. As a “rule of thumb”, a one percent drop in global GDP growth appears to reduce Paraguay’s GDP growth by 1.1 percent within the same quarter.
Changes in global financial conditions also significantly affect Paraguay’s economy, though the delayed response (one quarter after the shock) suggests that the transmission essentially runs through global output, rather than direct financial channels. A one-standard deviation shock to VIX (increase by 7.9 points) and the U.S. long term interest rate (increase by 1.3 percentage points) would cause a cumulative decline in Paraguay’s growth of about 0.5 and 0.3 percentage points, respectively, over one year.
The impact of commodity price shocks seems to be statistically weaker, but is still economically significant. Specifically, a 10 percent drop in Paraguay’s net commodity price index is estimated to reduce GDP growth by 0.6 percentage points over one year.
Impulse Response of Paraguay’s GDP to Global and Regional Shocks
(One-standard deviation adverse shock)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Note: GDP growth response (y-axis, in percent) to one-standard deviation adverse shock ± 1 standard errors. Time horizon in quarters. Adverse shock defined as lower trading partner growth, higher VIX and U.S. interest rates, lower commodity prices, and trading partner currency depreciation.Impulse Response of Paraguay’s GDP to Global and Regional Shocks
(One-standard deviation adverse shock)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Note: GDP growth response (y-axis, in percent) to one-standard deviation adverse shock ± 1 standard errors. Time horizon in quarters. Adverse shock defined as lower trading partner growth, higher VIX and U.S. interest rates, lower commodity prices, and trading partner currency depreciation.Impulse Response of Paraguay’s GDP to Global and Regional Shocks
(One-standard deviation adverse shock)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Note: GDP growth response (y-axis, in percent) to one-standard deviation adverse shock ± 1 standard errors. Time horizon in quarters. Adverse shock defined as lower trading partner growth, higher VIX and U.S. interest rates, lower commodity prices, and trading partner currency depreciation.9. Brazil’s economic importance is manifest both through direct spillovers from Brazil-specific shocks and through the transmission of global shocks. Idiosyncratic shocks to Brazil’s GDP are found to have a significant impact on Paraguay’s output even after controlling for global factors, with a one percentage point drop in Brazil’s GDP growth leading to a 0.5 percentage points decline in Paraguay’s GDP growth. Similarly, a 10 percent real depreciation of the Brazilian real against the guaraní would reduce Paraguay’s growth by 0.4 percentage points within one year. Given Brazil’s large economic size and high degree of financial integration with the world, its impact on Paraguay is not limited to such direct spillovers, but it also propagates and potentially amplifies the effect of global output and financial shocks. Following Adler and Sosa (2012), we identify such amplification effects by controlling for Brazil-specific factors as exogenous variables in the VAR. The estimation results confirm that Brazil indeed amplifies the impact of global shocks on Paraguay, especially during the initial periods after the shock.
Output Response to Global Output Shock
(One-standard deviation shock, 8 quarters)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Output Response to Global Output Shock
(One-standard deviation shock, 8 quarters)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Output Response to Global Output Shock
(One-standard deviation shock, 8 quarters)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
10. Argentine output shocks also have significant effects on Paraguay’s GDP, while peso exchange rate shocks appear to affect core GDP. A one percentage point Argentine output shock results in a 0.4 percentage points decline in Paraguay’s GDP growth within one year, while the impact of peso exchange rate depreciation appears to be insignificant. However, the spillover effects of peso exchange rate shocks appear to be much larger on Paraguay’s core GDP growth, which is found to decline by 0.6 percentage points in response to a 10 percent depreciation of the bilateral real exchange rate. This result is consistent with the fact that the recent sharp peso depreciation mainly affects the domestic retail service sector, a significant part of core GDP, through a surge in contraband imports.
Core GDP Response to Argentine Exchange Rate Depreciation Shock
(One-standard deviation shock)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Core GDP Response to Argentine Exchange Rate Depreciation Shock
(One-standard deviation shock)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
Core GDP Response to Argentine Exchange Rate Depreciation Shock
(One-standard deviation shock)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A001
References
Adler, G., and S. Sosa, 2012, “Spillovers from Large Neighbors in Latin America.” Regional Economic Outlook, Western Hemisphere, April (Washington: International Monetary Fund).
F. Yépez., J., 2014, “A Path to Financial De-dollarization in Paraguay”, Selected Issues Paper (Washington: International Monetary Fund).
F. Han, 2014, “Measuring External Risks for Peru: Insights from a Macroeconomic Model for a Small Open and Partially Dollarized Economy”, IMF Working Paper 14/161 (Washington: International Monetary Fund).
B. Gruss, 2014, “After the Boom-Commodity Prices and Economic Growth in Latin America and the Caribbean, IMF Working Paper 14/154 (Washington: International Monetary Fund).
International Monetary Fund, 2011, “The United States Spillover Report” (Washington).
Podpiera, J. and V. Tulin, 2012, “External Financial Shocks: How Important for Paraguay?”, Selected Issues Paper (Washington: International Monetary Fund).
Sosa, S., 2010, “The Influence of ‘Big Brothers’: How Important are Regional Factors for Uruguay?”, IMF Working Paper 10/60 (Washington: International Monetary Fund).
