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Paraguay and the IMF
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On July 30, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Paraguay.1
The Paraguayan economy is beginning to emerge from a long period of slow growth. The regional crisis, problems with drought and foot-and-mouth disease in agriculture, and a banking crisis, all contributed to a drop of 2.3 percent in GDP in 2002. There was a sharp depreciation of the exchange rate in 2002 and inflation accelerated, reaching 20 percent in early 2003. A bumper harvest produced positive GDP growth of an estimated 2.6 percent in 2003. Banking system deposits recovered, the exchange rate appreciated against the dollar, and inflation eased to 9 percent at year-end.
In 2004, the economy has stabilized but growth remains modest. A late season drought depressed output of soy, the largest export crop, reducing expected agricultural output growth to near zero, but nonagricultural output is recovering. The guaraní has strengthened by 4 percent against the dollar so far in 2004. The strong guaraní contributed to a sharp fall in inflation. Year-on-year inflation through June was 5.5 percent, with inflation for the year as a whole expected at around 4-5 percent.
The fiscal situation has improved markedly since the new government took office in August 2003. The consolidated balance of the nonfinancial public sector moved from a deficit of 3.1 percent of GDP in 2002 to balance in 2003. The primary balance improved from a deficit of 1.3 percent of GDP in 2002 to a surplus of 2.4 percent in 2003. The government has made significant progress in clearing substantial public sector payments arrears.
Monetary policy has been geared toward a flexible exchange rate regime since the de facto currency peg was abandoned in 2001. Official reserves rose by US$342 million—to US$983 million—during 2003. Base money growth accelerated sharply in 2003, as the economy began to remonetize after the banking crises. Interest rates on Central Bank bills have declined from their peak of 33 percent in August 2002, reaching 13 percent by December 2003.
Executive Board Assessment
Directors praised Paraguay's strong economic performance over the past year, with growth rebounding and a sharp decline in inflation. The vulnerability of the economy has been reduced and the country's credit rating improved, as the authorities increased international reserves, resolved external payments difficulties, and embarked on courageous fiscal and structural reforms. In particular, Directors welcomed the approval of the Administrative Reorganization and Fiscal Adjustment Law and the Customs Code, and the government's strong determination to improve governance. They commended the authorities for the remarkable progress in raising the efficiency of tax and customs collections.
Directors agreed that important challenges nevertheless remain. They encouraged the authorities to continue to work for the timely passage of the Public Bank Reform Law, to institutionalize the progress achieved on fiscal sustainability, and to further deepen the reform effort in areas that are critical to raising Paraguay's growth performance.
Directors considered that the Administrative Reorganization and Fiscal Adjustment Law, along with the additional measures announced by the authorities, provides a sound basis for balanced budgets in the medium term by raising new revenue, broadening the value-added tax (VAT) and income tax base, eliminating exemptions, and strengthening tax administration. Full implementation of these measures will also help generate resources for a much-needed increase in capital investment and social spending. Directors commended the authorities for raising the efficiency of tax and customs collections, as evidenced by the strong increase in revenue so far in 2004—with no increase in tax rates. They urged the authorities to institutionalize these gains by restructuring the tax and customs authorities, and ensuring that they have the resources needed to carry out fully their responsibilities as defined in the new law.
Directors welcomed the authorities' tight control of current expenditures and urged continued prudence, in particular on wage increases. They also stressed that new capital investment and social spending should be of high quality and well prioritized. Directors encouraged the authorities to remain firm on resisting pressures for increased spending to stimulate demand, as this would likely endanger fiscal stability without supporting sustainable increases in growth. Looking ahead, the authorities should undertake a full-fledged public expenditure reform, including civil service reform, which will be critical to ensuring long-term sustainability.
Directors welcomed the progress in eliminating domestic and external payments arrears, while urging the authorities to further improve debt monitoring and cash flow procedures, and to resolve disputed arrears. Directors also welcomed the improvement in the outlook for public enterprises, but noted that cash flow problems in some of them underscore the need for continued restructuring. They encouraged the authorities to permit private investment and management of the public enterprises, and take further measures to improve their governance and transparency, including through timely completion of the audits of public entities.
Directors welcomed the improvement in the management of monetary policy, as reflected in the marked decline in inflation and the increase in international reserves. They encouraged the authorities to continue with preparations for inflation targeting while noting that the ground must be well-prepared before a move in that direction. In this context, they urged the authorities to clarify their monetary policy objectives by limiting their interventions in the foreign exchange market and giving freer play to market forces in determining the exchange rate. They also encouraged legislation to strengthen the formal independence of the central bank as well as further development of market-based instruments to facilitate the conduct of monetary policy. Directors noted that banking system risks have eased, although the level of nonperforming loans remains high. They stressed that public banking reform, including passage by congress of the Public Bank Reform Law, remains crucial to further strengthen the system. The authorities also need to work toward approval of comprehensive banking legislation, extension of a supervisory regime to cooperatives, and mandatory introduction of international risk classifications for all banks. Directors supported the authorities' request for an FSAP. They commended the authorities' AML/CFT efforts, and looked forward to the timely enactment of legislation in this area.
Directors observed that a deepening of the reform effort will be needed to raise Paraguay's growth potential and make faster progress, with international support, toward the Millennium Development Goals. Building on recent commendable progress in strengthening governance, further efforts are needed to address corruption, reform the judicial system, and restructure the public sector to increase its professionalism and transparency, and reduce its size and scope. Programs to promote human capital development will also play an important role in increasing productivity and growth. Directors welcomed the authorities' commitment to maintaining an open exchange and trade system, and encouraged them to undertake additional actions to capture unregistered trade.
IMF EXTERNAL RELATIONS DEPARTMENT