Public Information Notice No. 03/39

Public Information Notice: IMF Concludes 2002 Article IV Consultation with Paraguay

March 27, 2003

On March 10, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Paraguay.¹

Background

Paraguay's economic performance in recent years has been characterized by slow economic growth and increasing unemployment and poverty rates. This stagnation reflects structural impediments to growth, exacerbated by external and domestic shocks. In 2002, the economy fell into its worst recession in decades, with real GDP down by 2½ percent, according to official estimates, or 4½ percent, according to staff estimates, while inflation accelerated to 14½ percent. The decline reflected a combination of factors, including the worsening external environment, a drought and the outbreak of foot-and-mouth disease, and political uncertainties which hampered economic policy making. The banking system was seriously affected by the recession and by contagion from the regional crisis, with the collapse of the third-largest bank triggering sizable deposit outflows. The guarani depreciated by 34 percent vis-à-vis the U.S. dollar, although in real effective terms it declined by only 2½ percent due to the sharp decline of neighboring currencies.

The public finances also deteriorated sharply in 2002. The consolidated public sector deficit increased to 3 percent of GDP, mainly because of weak tax revenues, higher capital spending, and financial difficulties in key public enterprises. Severe financing constraints led to sizable arrears by early 2003, including to multilateral lenders. Repeated attempts by the government to adopt a comprehensive adjustment and reform program with multilateral support failed, mainly because of the lack of domestic consensus in the increasingly politicized environment before national elections scheduled for April 2003.

Paraguay faces a difficult economic outlook in 2003. While better climatic conditions in agriculture and some stability in Argentina will keep GDP from falling as sharply as in 2002, continuing domestic policy uncertainty and the effects of foot-and-mouth disease are expected to depress growth.² With the new administration scheduled to take office on August 15, the policy making environment may improve. If the new authorities move decisively to implement sound economic policies, an economic recovery could start late in the year. Inflation will edge up further reflecting pass-through from continued depreciation of the exchange rate.

Executive Board Assessment

Executive Directors observed that Paraguay had suffered large adverse shocks in 2002, which had been exacerbated by long-standing domestic vulnerabilities and impediments to growth. A drought, the outbreak of foot-and-mouth disease, and contagion from the regional crisis had caused a sharp decline in output, with adverse effects on the public finances and the banking system. Structural weaknesses, including serious governance problems, inefficient public enterprises, a weak tax effort, and inefficient government spending are key factors behind Paraguay's record of low growth and its vulnerability to external shocks.

To address these structural weaknesses, restore macroeconomic stability, and set Paraguay on a path of sustainable growth, Directors recommended the adoption of a comprehensive program of fiscal and structural reforms. The strategy should center on restoring fiscal sustainability, improving the efficiency of the public sector, strengthening the banking sector, and improving governance and fighting corruption. Directors encouraged the new government following the April 2003 elections to garner the broad political consensus and ownership required to formulate a strong adjustment program and push forward the reform process. However, given the very difficult present economic situation, policy efforts should get under way even before the election.

Directors expressed concern about the sharp deterioration of Paraguay's fiscal situation and rising public debt burden, which has resulted, inter alia, in the accumulation of large payments arrears. While Directors took note of the authorities' efforts to limit the deterioration through administrative means, they urged the authorities to adopt a comprehensive and balanced package of measures to correct the fiscal imbalance on a sustainable basis. Such a package would have to include measures to strengthen tax administration and the revenue effort more generally, as well as appropriate spending restraint. Directors also emphasized the need to reform the public employees' pension plan. Directors regretted Paraguay's build up of arrears with the Inter-American Development Bank and the World Bank, and encouraged the authorities to quickly normalize relations with the international financial community.

Directors observed that the adjustment effort should also include the public enterprises. They noted that timely adjustment of fuel and electricity prices to fully reflect their dollar costs is key to the health of those enterprises as well as to the government's cash flow. Directors stressed the need to consider reviving the privatization program as soon as a transparent framework can be put in place. They suggested that, if outright sale of enterprises proves difficult in the near term, the authorities should explore other means to improve public enterprises' operations, such as better pricing structures and private management contracts. Directors also suggested that the authorities develop reorganization plans for each enterprise to improve efficiency, in order to pave the way for eventual privatization.

Directors noted that monetary policy had responded pragmatically to the difficulties faced in 2002. They urged the authorities to strengthen the operational framework of monetary policy, establish a clear nominal anchor, and increase the central bank's operational independence. Directors recommended less intervention by the central bank in the foreign exchange market, to allow the flexibility of the exchange rate to help cushion shocks and to husband reserves for backing up deposits in the highly-dollarized banking system. Directors encouraged the authorities to work toward prudent macroeconomic policies and banking system reforms, which would allow for a decline of dollarization over time. Directors recommended that the authorities review the requirement to move public sector deposits to the central bank in light of the risks posed to the banking system. A few Directors noted, however, that consolidation of public sector balances at the central bank could be considered desirable, and that any liquidity issues that might arise would need to be addressed through other instruments.

Directors commended the authorities for their prompt and effective intervention in Banco Alemán, while noting that important gaps remain in the framework for bank resolution. They recommended that these gaps be filled through early adoption of draft laws on bank resolution and on public banking. Directors encouraged the authorities to strengthen regulation and supervisory practices, monitor the situation of banks closely, and more generally take a proactive stance in response to any difficulties. In particular, Directors expressed concern about the precarious financial situation of the National Development Bank (BNF). They urged the authorities to implement, without further delay, a comprehensive restructuring and reform of the bank, along the lines of the program designed last year with the support of the Inter-American Development Bank and the World Bank. Directors urged the authorities to step up their efforts to address money laundering and terrorist financing.

Directors encouraged the authorities to maintain Paraguay's relatively open trade regime. They stressed that tariff increases should be viewed only as a last resort on the fiscal front, and recommended that trade concerns be resolved within Mercosur and WTO dispute resolution procedures.

Directors noted the improvements made in operational safeguards at the central bank, and encouraged the authorities to implement the recommendations set forth in the recent safeguards assessment report prepared by IMF staff.

Directors considered data provision by the authorities as adequate for surveillance purposes, although they noted that important data deficiencies remain. They urged the authorities to address those deficiencies, especially in the national accounts, the public enterprise, and social security sectors, and in the data on external trade and capital flows.