Press Release No. 16/201

IMF Executive Board Concludes 2016 Article IV Consultation with Paraguay

May 6, 2016

On April 29, 2016, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation¹ with Paraguay, and considered and endorsed the staff appraisal.

Paraguay’s economy remains relatively resilient against the backdrop of a regional slowdown. Growth is estimated at 3 percent in 2015, among the strongest in Latin America. This reflects a milder terms-of-trade shock relative to comparators; stable growth in investment and consumption; and modest fiscal stimulus. However, the economy experienced some loss of momentum over the past year. Growth below potential helps contain inflation pressures, including from past exchange rate depreciation. In the first two months of 2016, headline inflation was temporarily elevated, mainly due to volatile food prices. Since then, it has moderated below 5 percent in March and is expected to decline to the mid-point of the central bank’s target range (4.5 percent) over the course of 2016.

The external position deteriorated in 2015, due to a negative terms-of-trade shock and weakness in major trading partners. Furthermore, credit growth has moderated from a rapid pace, as economic activity has slowed and financial conditions have become less favorable. Credit quality has been deteriorating. Specifically, banks’ non performing loans have been rising, albeit from low levels, since mid-2015. Notwithstanding potential vulnerabilities from past rapid credit expansion, the financial system appears sound. Most banks posted positive net income in 2015, although profitability measures (returns on assets and equity) were in most cases below 2014 levels. Relative to the region, Paraguay’s banks compare favorably in terms of their balance sheets and profits.

Macroeconomic policies remain accommodative in light of subdued inflation and slower growth. Notwithstanding the BCP’s 25 basis point interest rate hike in January 2016, monetary policy continues to be somewhat accommodative, following an easing cycle in mid 2015. Meanwhile, fiscal policy has been supportive of economic activity. The fiscal deficit at the central government level is estimated to have reached 1.7 percent of GDP—marginally above the 1.5 percent ceiling set by the fiscal responsibility law (FRL).

Paraguay’s economy is expected to remain relatively resilient this year and next despite challenging external conditions. Staff expects solid growth near 3 percent in 2016 and 3.25 percent in 2017. Given favorable weather and strong yields, the soy harvest—Paraguay’s main agricultural crop—is likely to see strong growth from last year. Sound macroeconomic fundamentals, favorable demographics, lower cost of oil imports and a very competitive electricity sector are additional factors sustaining growth in the near-term. Lower credit demand from subdued investment plans and tighter credit conditions will contribute to slower, but still positive, credit growth in 2016, more in line with economic fundamentals.

Downside risks to growth have risen, mainly from the external side. A further slowdown in Brazil or deeper decline in agricultural commodity prices represents the major risks to the outlook. Domestically, rapid credit expansion in the banking system in the context of slower economic activity represents a potential macrofinancial vulnerability that could amplify the effects of adverse external shocks. Finally, limited capacity for administering and executing public investments also represents a downside risk to growth.

Executive Board Assessment²

Executive Directors commended the Paraguayan authorities for maintaining solid macroeconomic fundamentals, including low inflation, sustained growth and sound public finances. Nevertheless, Directors noted that downside risks to growth have risen, mainly from the external side. They emphasized the need to maintain macroeconomic stability and to strengthen implementation capacity and policy frameworks, address structural weaknesses, increase productivity, reduce poverty and promote inclusive growth.

Directors welcomed the authorities’ commitment to sound fiscal policy. They emphasized the need for continued efforts to mobilize revenue and contain current expenditure while making space for capital spending, especially on infrastructure. In this context, they welcomed the signs of increased effectiveness of the fiscal responsibility law, but noted the importance of fully internalizing it in the budget process to help establish a track record and bolster the credibility of the fiscal anchor. Directors stressed that if amendments to the law are sought, changes to grant flexibility should be balanced by safeguards which enhance its credibility and are communicated carefully.

Directors concurred that the moderately accommodative monetary policy stance remains appropriate given the uncertain international context and contained inflationary pressures. Monetary policy, coupled with a flexible exchange rate, should be the principal tool if growth were to weaken further, within the limits of meeting the central bank’s price stability objective. Limiting discretionary foreign exchange market interventions to exceptional circumstances of disorderly market conditions would reinforce the inflation targeting regime and reassure markets. Reforms to deepen interbank markets and improve liquidity management could help strengthen monetary policy transmission.

Directors considered the exchange rate and external position to be broadly in line with fundamentals. They noted that the ample international reserve cover is appropriate considering Paraguay’s openness, the level of dollarization, and vulnerability to shocks.

Directors agreed that the financial system appears to be sound, despite weaker economic growth and recent bank performance. In light of past rapid credit growth, vigilance over potential vulnerabilities remained critical to contain financial sector risks. Efforts to bolster the financial sector should include closely scrutinizing banks’ loan classification practices and strengthening supervision of the cooperative sector. Directors welcomed progress towards introducing risk-based supervision and encouraged the authorities to continue upgrading monitoring and analytical capacity and strengthen institutional arrangements to carry out these functions.

Directors commended the authorities for progress on implementing their structural reform agenda covered in the National Development Plan. Directors stressed that infrastructure remains a key priority, especially improving electricity distribution and transportation. They welcomed steps that have been taken to strengthen government transparency, including implementation of the Law of Free Access to Public Information.

Directors commended the authorities for their efforts to continue to strengthen anti-corruption and AML/CFT measures to improve the business climate. They welcomed recent passage of the law on asset declaration.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board.

² At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. An explanation of any qualifiers used in summings up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm.