Mission Concluding Statement 

Paraguay: Staff Concluding Statement of the 2019 Article IV Mission

March 6, 2019

Paraguay has grown rapidly in the past decade and a half, contributing to a sharp drop in poverty. Prudent macro policies, with low inflation and low government deficits, played an important role. Vulnerabilities have declined, with a significant reduction of both external and public debt. The key challenge going forward will be to sustain this rapid growth, as the factors that have propelled it in the past—including the boom in agriculture commodity prices—may provide less support going forward. Improving the business climate and governance will be key to continued convergence to higher living standards.

Near-term Outlook

GDP grew by around 3¾ percent in 2018, driven by strong domestic demand, fueled by a rebound in credit growth, while the contribution of net exports was negative. But growth was uneven. A strong first half of the year was followed by a weaker second half, as Paraguay felt spillovers from regional financial turbulence. The crisis in Argentina led to an increase in risk aversion toward the region, which contributed to a depreciation of the guarani against the dollar, although by less than the depreciation experienced by neighboring countries. As a result, the guaraní appreciated sharply vis-à-vis the Argentinean peso and the Brazilian real. The impact was felt in a sharp drop in tourism and cross-border trade. Weather-related shocks in agriculture also contributed to the slowdown in growth.

For 2019, growth is expected to reach around 3½ percent. Growth is being affected by a drought early in the planting season, which will reduce the soybean harvest. This should be partially offset by a pickup of tourism and cross-border trade, which will benefit from the unwinding of the real exchange rate shock that occurred in 2018.

Risks to growth are broadly balanced. Developments in neighboring countries will be key; agricultural commodity prices are another risk factor. The strength of domestic demand is also uncertain and will depend on the recovery of government investment, now that the transition to a new government is completed.

The continued commitment of the new government to the fiscal responsibility law is welcome. Fiscal policy in 2019 will be neutral, with the deficit changing little from that in 2018. Nontax revenue estimates in the budget appear—as in previous years—overly optimistic and reaching the target will necessitate containing expenditure—as has been done in the past.

The monetary policy rate was on hold in 2018, and both GDP growth and GDP levels remained broadly in line with potential. Inflation fell to 3.2 percent by the end of the year, the result of the decline in oil prices, and the reduction in prices of imports from neighboring countries. In February 2019, the BCP cut the monetary policy rate from 5¼ to 5 percent, citing uncertainty about the external environment and incipient weakening of domestic demand.

The current monetary policy stance appears appropriate. Year-on-year Inflation should move back to 4 percent by year’s end (the middle of the central bank’s target range), as last year’s real exchange rate appreciation reverses.

Exchange rate flexibility should help to absorb shocks. Exchange rate intervention should continue to aim at preventing disorderly market conditions and mitigating excess volatility only.

Longer-term Growth Challenges

Paraguay has grown rapidly, with real GDP growing by an average 4½ percent annually in the past decade and a half, well above the Latin America average. This has contributed to a sharp decrease in poverty rates, from 58 percent in 2002 to 26 percent currently. Nonetheless, poverty remains high by regional standards.

Rapid growth was partly the result of a bounce-back from the crisis in the late 1990s and prudent macro-economic policies. Inflation and exchange rate volatility came down as the central bank shifted to inflation targeting, while prudent fiscal policy reduced public debt from 52 percent in 2002 to around 20 percent currently. Fiscal policy remained conservative during the commodity price boom. As a result, Paraguay did not go through the boom-bust that its neighboring countries experienced.

The global agricultural commodity price boom, which led to a sharp expansion of agricultural exports, also played an important role. In dollar terms, agricultural exports are now 5 times what they were in 2003. Sowing areas for the main crops are 2½ times what they were fifteen years go. The surge in commodity prices spilled over to the non-tradable sector through an appreciation of the real exchange rate, which boosted incomes. The rapid growth in incomes led to a surge in domestic demand.

In some respects, the economy looks very different from fifteen years ago. The share of electricity and water has fallen by two thirds, to 8 percent of GDP. The share of services is now almost 50 percent of GDP. Exports have diversified, and external vulnerabilities have declined—total external debt of the private and public sector has fallen from almost 200 percent of GDP in 2002 to 40 percent currently.

The key question going forward is how to maintain rapid growth of real incomes. Paraguay’s economy is still heavily dependent on the agriculture sector. But agricultural prices are already off previous highs and may decline further as global demand slows. And agricultural land cannot continue to expand at the same rate as in the past.

Future growth will increasingly need to come from the non-agriculture/non-electricity export sector, which is growing rapidly, but is still small. For this, higher private sector investment is needed, including from abroad.

Improving the Business Climate and Governance

Low taxes and low energy prices are important attractions of Paraguay for domestic and foreign investors, but these are offset by a weak business climate and governance.

A better business climate and improved governance would help facilitate diversification and productivity growth. Compared to other countries in the Western Hemisphere and Europe, Paraguay scores relatively weak on business climate and governance indicators. Cross country data show that there is a strong link between the value of these indicators and GDP per capita.

Policies that focus on improving transport infrastructure, rule of law and the quality of education would be particularly helpful. The mission estimates that reforms in these areas would not only have the largest impact on growth, but also have the most support from the private sector.

In this context, the mission welcomes the new government initiatives to increase the ease of doing business. These include legislation to simplify the process of small business registration, a new bankruptcy law, and legislation to allow companies to use moveable assets as collaterals. The government is also seeking to get rid of outdated bureaucratic procedures for businesses and to increase digitization in government services. To facilitate higher competition in key industries, the National Commission for Competition has been revived, which is tasked with combating monopolies and improving the transparency of industry regulations.

Fiscal Policy

Prudent fiscal policies in the past 15 years have reduced the debt-to-GDP ratio. But fiscal space is limited, as the deficit is close to the 1.5 percent ceiling under the Fiscal Responsibility Law.

While fiscal space is limited, spending needs are large. To create room for the investment needed for some of the identified reform areas, revenues (which are low by international standards) need to be increased.

Current headline tax rates are low, but effective tax rates are even lower. The personal income tax rate is 10 percent, but this tax yields only 0.1 percent of GDP. Reducing exemptions and deductions and improving tax compliance will raise effective tax rates, even if headline rates remain unchanged. The mission looks forward to the proposals of the tax commission that is tasked with modernizing and simplifying the tax system.

There should also be some room to reprioritize expenditure within the existing envelope.

Spending levels in Paraguay are low compared with other countries, but spending composition is lopsided, with a high share of government expenditure going to wages, while there is a need to increase infrastructure and social spending, including health and education. Indeed, the government wage bill in Paraguay is similar as a percent of GDP to that in other countries in the region—even though the role of the government is much smaller. The mission looks forward to the upcoming recommendations of the expenditure review commission.

Financial Sector

Financial soundness indicators show the banking sector is well capitalized and profitable, and risk-based supervision is progressing. Supervision of financial cooperatives should continue to be strengthened.

There is scope to improve supervision of the casas de credito and casas comerciales; supervision standards for this sector should be adopted quickly.

It remains important to establish a pension fund supervisor. Currently, pension funds administer the public’s trusted money under a few, overly rigid rules, but without oversight. Supervision would mitigate risks, allow pension funds to invest in a wider range of assets and facilitate the development of a domestic capital market.

Restoring the long-term sustainability of the pension system is another challenge that should be tackled now, before the demographic windfall dissipates. This can be achieved through timely and gentle parametric adjustments to pension age, benefits and contribution rates.

Implementing all these structural reforms and continuing with prudent macroeconomic policies would allow Paraguay to continue growing rapidly and improving living standards for all Paraguayans.

We would like to thank the government for its warm hospitality.