IMF Executive Board Concludes 2011 Article IV Consultation with ParaguayPublic Information Notice (PIN) No. 11/104
July 29, 2011
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.
On July 29, 2011 the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with Paraguay, and considered and endorsed the staff appraisal without a meeting on a lapse-of-time basis2.
Paraguay weathered the global crisis well, supported by an appropriate policy response. Countercyclical macroeconomic policy cushioned the effects of lower external demand. While GDP still contracted in 2009, this owed mainly to a severe drought. Growth rebounded strongly in 2010, with real GDP expanding at 15 percent, driven by a record crop, high credit growth, and favorable external conditions.
Reflecting the using up of slack capacity, overheating pressures have emerged. Inflation rose from 2 percent in 2009 to 8¾ percent in June 2011, driven by excess demand pressures and higher commodity prices. Despite very favorable terms of trade, the external current account weakened to 2¾ percent of GDP in 2010 (from near balance in 2009), reflecting very rapid import growth and a drop in remittances. With strong private capital inflows (notably foreign direct investment), however, the Central Bank (BCP) continued accumulating international reserves, which rose to US$4.2 billion (23 percent of GDP) at end-2010.
Against a backdrop of rising inflation and rapid credit growth, the BCP started tightening monetary policy in mid-2010, raising interest rates by 775 basis points over the last twelve months (375 basis points in 2011), starting from a level close to zero. Real policy rates, however, remain negative, while deposit and lending rates have increased only modestly in real terms. Credit growth has remained very high (40 percent y/y in May), especially credit in foreign currency (58 percent). The BCP also raised reserve requirements (RR) effective in May, bringing them back to their pre-crisis levels.
The BCP has allowed the guarani to appreciate substantially in recent months, while intervening in the foreign exchange (FX) market. As of end-May, the guarani had risen by over 10 percent vis-à-vis the U.S. dollar (13 percent in real effective terms) compared to end-2010. The appreciation reflects mainly improved terms of trade, higher private capital inflows, and seasonal liquidation of export proceeds. The BCP stepped up its purchases of FX in April, trying to contain appreciation pressures, but as the guarani stabilized, it reduced its intervention in May and did not intervene in June.
Fiscal policy remained countercyclical in 2010, while public debt continued on a declining path. Real growth of primary spending decelerated significantly, while tax revenue increased sharply reflecting strong activity and import growth, and improvements in administration. In cyclically-adjusted terms, the primary balance (excluding electricity royalties and grants) strengthened by 1½ percent of non-agricultural GDP, implying withdrawal of most of the stimulus provided in 2009. Public debt declined by over 4 percentage points to 19 percent of GDP.
The banking sector remains generally sound. The overall capital adequacy ratio for banks remains above the regulatory level, although it is somewhat lower (by about 3 percentage points) when Basel I definitions are used. The nonperforming loan (NLP) ratio is low (1½ percent in May) and declined slightly over the last year, but the level of NPLs is growing fast (17 percent y/y in May) and provisions are low. Profitability has remained very high. In late 2010, the Superintendency approved measures to strengthen financial system buffers, including higher generic provisions and minimum capital, which will become effective in January 2012.
In 2011, real GDP growth is projected at 6¾ percent, reflecting solid agricultural growth, stimulative macroeconomic conditions, and strong confidence. Inflation is projected to remain well above the BCP’s target range, at close to 10 percent for year-end. The external current account deficit would widen to 3¾ percent of GDP, led by strong import growth, a less favorable services account, and lower remittances. The overall fiscal balance is projected to swing into a deficit of ½ percent of GDP, implying a fiscal impulse of 1¼ percent of non-agricultural GDP.
Executive Board Assessment
In concluding the 2011 Article IV consultation with Paraguay, Executive Directors endorsed the staff’s appraisal, as follows:
An appropriate policy response helped Paraguay weather the global crisis. Countercyclical macroeconomic policy cushioned the effects of lower external demand. While GDP still contracted in 2009, this owed mainly to a severe drought and the nonagricultural sector still experience modest growth. Despite significant stimulus, public debt remained broadly unchanged, given the strong initial position of the fiscal accounts, while a flexible exchange rate regime helped a smooth external adjustment. The financial system was unscathed, with adequate capitalization and low NPLs.
The strong rebound of economic growth in 2010 has given rise to overheating pressures. GDP grew by 15 percent in 2010, reflecting a record harvest, strong credit growth, and favorable external conditions. Driven by excess demand pressures and higher commodity prices, inflation has risen sharply over the last year, while the external current account has deteriorated substantially, despite term-of-trade improvements. Fiscal policy was appropriately countercyclical in 2010, withdrawing most of the stimulus provided in 2009. Monetary policy remained accommodative, however, with real policy rates well in negative territory and abundant liquidity.
Macroeconomic policies are currently expansionary. Despite a large increase since mid-2010, real policy rates remain negative, while real deposit and lending rates have increased only modestly and credit growth is still very high. Reflecting strong expenditure growth, fiscal policy is being expansionary, with the structural primary balance projected to weaken by 1¼ percent of nonagricultural GDP in 2011. There is also the risk that the fiscal stance remains loose in 2012 as pressures to increase spending rise ahead of the 2013 general elections.
Policies need to adjust further to ensure a soft landing of the economy. Policies should be geared toward moderating domestic demand pressures and returning to a more balanced growth path, in order to reduce inflation, contain the external current account deficit, and preserve financial stability. Monetary policy tightening should continue without delay, with the menu of options including further increases in RR, particularly on foreign currency deposits. The fiscal stance should become at least neutral, but preferably countercyclical. To this end, constraining current expenditures and saving any revenue over-performance, including from the potential approval of revenue measures currently in congress, will be critical. It would also be important to avoid loosening the fiscal stance in 2012, given a positive output gap and an inflation rate above the BCP’s target. Broadening the use of macro-prudential policies (MaP) measures would help protect financial stability going forward while contributing to a faster reduction of credit growth.
The banking system remains sound, but there is a need to guard it against emerging risks. Bank financial soundness indictors are generally strong, including very high profitability. However, provisions are low overall and the level of NPLs is growing rapidly. Very high credit growth, particularly in foreign currency, and currency mismatches pose considerable risks that should be dealt with immediately. Macro-prudential measures, such as higher specific provisions and stricter limits on debt-to-income ratios, would help contain such risks and strengthen buffers. Developments in construction and mortgage lending, as well as in real estate markets, warrant close monitoring, including by improving the compilation of statistics. Staff welcomes the existing program to strengthen regulation and supervision and to set up a financial safety net in the cooperative sector. It encourages the authorities to also move forward with changes to legislation required for a more effective risk-based supervision for banks.
The monetary policy framework should be strengthened further to support the move to an IT regime. Many necessary components for this step are already in place, thanks to long-lasting and continued reforms and institutional strengthening at the BCP. Swift implementation of the recapitalization of the BCP and better liquidity management are also needed to further enhance the credibility of the central bank and increase the effectiveness of monetary policy. It would also be important for the BCP to strengthen and clarify its operational framework, including by limiting (and sterilizing) interventions in the FX market and thus sending a clearer signal that inflation is its main objective.
Higher tax revenues are needed to address important deficiencies in infrastructure and basic social services. Staff supports government efforts to implement the personal income tax without further delay and continue improving tax administration. It will also be essential to ensure sound management of increased revenues from Itaipú energy sales. Staff supports the authorities’ proposal to safeguard the additional revenues by placing them in a special fund, and suggests allocating a significant part of these revenues to build up a countercyclical reserve.
There is scope to strengthen the fiscal framework. Plans to expand the role of public-private partnerships (PPPs) in the provision of infrastructure services are welcome. It would be important to strengthen the legal framework governing concessions and develop a more comprehensive PPP framework, while increasing the MoF’s role in assessing and approving PPPs to achieve value for money and manage fiscal risks. There is also room to strengthen the medium-term fiscal framework (MTFF), including by integrating it to the budget, adopting a systematic reporting and assessment of fiscal risks, and setting up a medium-term expenditure framework. A fiscal rule targeting the structural primary balance (excluding revenue from electricity royalties and grants) could serve as an anchor for the MTFF and facilitate its integration to the budget.