Key Issues

In the past two decades, Paraguay has seen strong growth and a sharp reduction in poverty. Strong GDP growth was the result of sound macro policies (with low inflation and low fiscal deficits and debt) and an agricultural commodity price boom which spilled over to the non-tradable sector. Growth was not just high but also volatile, as bad weather shocks led to poor harvests, which spill over to the broader economy.

In early 2020, Paraguay was rebounding strongly from another weather shock, and full-year growth was forecast at over 4 percent. In 2019, bad weather had reduced the harvest, and GDP growth had come to a near standstill. A recovery started in the second half of 2019 and gathered strength in early 2020—in February economic activity was 7 percent higher than a year earlier.

The Covid-19 epidemic halted the recovery. An early lockdown—which kept the death toll among the lowest in the region—led to a sharp contraction in economic activity, with April activity levels at 20 percent below those in February. Women, informal sector workers, and workers in the service sector were particularly hard hit; while children were severely affected by the closing of the schools until the end of 2020.

Swift and forceful government action helped contain the health, social and economic impact of the crisis. To mitigate the health impact, the government quickly expanded medical resources. To alleviate the social impact the government started two new and temporary social assistance programs and temporarily expanded a third. And to dampen the economic impact, the government increased investment and other spending, while the central bank lowered interest rates, increased liquidity provision, and allowed banks to renew, refinance and restructure loans without penalty.

Staff now projects real GDP to shrink by about 1 percent in 2020 and to rebound by 4 percent in 2021, but downside risks are significant. The relatively modest decline compared with other countries in the region is the result of the rebound in agriculture. Near-term risks are dominated by the economic impact of the Covid-19 epidemic. Weather poses another risk: the current la Niña could reduce the harvest, with spillovers to the rest of the economy.

Two subsequent shocks have raised the fiscal deficit to 6½ percent of GDP, well above the ceiling set by the Fiscal Responsibility Law (FRL). Last year, when parliament approved an exemption clause that allows the deficit to exceed the FRL ceiling in “case of an economic downturn”, a decline in tax revenues and an increase in government investment had raised the deficit to 3 percent of GDP. This year, the deficit was slated to return to the ceiling, but a combination of falling tax revenues and emergency measures instead led to its further increase.

The government plans to reduce the deficit to 4 percent of GDP in 2021 and gradually return to the FRL limit by 2024, but if downside risks materialize, the reduction of the deficit in 2021 will need to be scaled back. The expiration of the temporary Covid-19 related expenses in and of itself would reduce government expenses by 3 percent of GDP. It is important to keep fiscal policy under review so as not to withdraw fiscal support prematurely. If the Covid-19 epidemic were to significantly worsen, more spending would be needed, including for health care and for social protection of vulnerable workers. If the current La Niña cycle were to reduce the harvest and economic growth, tax revenues would likely disappoint. In all these cases, it would be important to protect investment; and the reduction of the deficit in 2021 would need to be commensurately smaller.

To foster growth, Paraguay will not only need to continue with its policies focused on macro-economic stability, but also improve governance, the business climate, and human capital. Paraguay scores poorly on these indicators, not only compared with advanced countries, but also with emerging market countries, including in the region. Income inequality, which has been falling but remains high, may need to be reduced further, while risks emanating from climate change also need to be addressed.

The government’s “Economic Recovery Plan” is appropriately focused on these issues. The plan aims to strengthen the recovery in 2020 and 2021 by boosting public investment spending, ensuring sufficient financing for the private sector, and removing supply-side bottlenecks; protect the vulnerable by further raising social benefit spending this year; and implement a new Fiscal Responsibility Law. In addition, the plan contains many reform proposals but also includes many reforms to improve governance and increase efficiency of public spending; improve the business climate; and facilitate new business creation and formalization of existing businesses.

The banking sector is stable, but the impact of the crisis remains to be seen. NPL ratios are low and capital adequacy ratio is high. However, official statistics may not yet show the impact of the crisis, as loans that fell due were allowed to be rolled over at a lower capital weight.

Approved By

Patricia Alonso-Gamo (WHD) and Sanjaya Panth (SPR)