## _cr12211

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### Background and recent growth developments
- GDP growth slowed markedly in 2011 and turned negative in 2012Q1.
- Growth slowed to 3.8 percent in 2011 after a strong rebound in 2010 led by agriculture.
- Non‑agricultural sector expanded by less than 3 percent in 2011.
- The non‑agricultural output gap turned negative in 2011Q3, reaching about -1 percent in the last quarter of 2011.
- Unemployment declined slightly to about 5½ percent in 2011.
- Underemployment remained high, at above 20 percent.
- A severe drought in late 2011–early 2012 caused significant agricultural losses (e.g., soybeans).
- High frequency indicators suggest GDP contracted by over 3 percent (y/y) in 2012Q1, while non‑agricultural activity grew at close to 4½ percent.

### Inflation dynamics
- Headline inflation: peaked at over 10 percent (y/y) in early 2011; eased to 5 percent at year‑end 2011; fell to 3¼ percent in April 2012.
- Core inflation: 6¼ percent in April 2012.
- One‑off factor: new law introducing obligatory social security contributions for private schools contributed about ½ percentage points to the increase in core inflation since December 2011.
- Decline in inflation mainly reflects lower food inflation, partly from a large reduction in meat prices following the export ban.
- Despite a negative output gap, core inflation remained somewhat above the official target, reflecting mainly still strong domestic demand growth and one‑off factors.

### Credit growth, monetary tightening, and monetary conditions
- From mid‑2010 to August 2011 the central bank (BCP) raised the policy rate by 800 bps to 8½ percent.
- Credit growth decelerated from 43 percent at end‑2010 to 19 percent in April 2012.
- Growth of credit in U.S. dollars experienced an even stronger deceleration.
- BCP policy rate cuts: reduced by 200 bps between November 2011 and February, and by an additional 25 bps in May (to 6¼ percent).
- Real policy rate remained positive at around 1¼ percent but was below its neutral level.
- Monetary conditions index (MCI) presented is a weighted average of the real interest rate and the real exchange rate.
- Excess liquidity noted as a structural problem complicating monetary policy implementation and limiting effectiveness.

### Exchange rate, FX intervention, and reserves
- The guaraní appreciated by 14 percent in real effective terms during 2011.
- External current account deficit declined to 1¼ percent of GDP in 2011 (from 3½ percent of GDP in 2010).
- Net international reserves increased by 1½ percent of GDP in 2011, to about 24 percent of GDP.
- Central bank intervened on both sides of the FX market during 2011 and intervened in 2012Q1 to (i) withdraw an unexpected large liquidity injection by the government and (ii) stem strong depreciation pressures following the drought.
- FX intervention in 2011–12 appears to have limited exchange rate flexibility.
- Exchange rate assessment:
  - CGER estimates indicate the guaraní was overvalued by about 9 percent at end-2011.
  - Other competitiveness indicators point to overvaluation of over 9 percent at end-2011.
  - Correlation between two external competitiveness measures considered was found to be -77 percent.
  - Referenced export markets account for 72 percent of Paraguayan exports; primary products considered represent 85 percent of Paraguay’s registered exports.
- Policy guidance: room for greater exchange rate flexibility; FX intervention should be limited to dealing with excessive volatility and preventing disorderly movements.

### Fiscal policy, public debt, and 2012 stimulus
- Fiscal policy slightly expansionary in 2011.
- Overall fiscal surplus declined by ½ percentage points, to 1 percent of GDP in 2011, driven by a large increase in primary spending (especially capital expenditures).
- Fiscal impulse (change in the structural primary balance) of about ¾ percent of GDP.
- General government debt fell below 14 percent of GDP.
- 2012 budget envisages sizeable fiscal loosening: mission projects headline and structural balances to weaken by 3¼ percent of non‑agricultural GDP (2 percent of total GDP).
- Staff projects real revenue to grow by 3½ percent in 2012, supported by increased electricity royalty payments from Brazil.
- Public sector wage increases growing by about 30 percent (mostly determined by congress).
- General government debt would rise to over 14 percent of GDP in 2012 but is projected to resume a declining trend in 2013.
- Projection: overall fiscal deficit projected at 2½ percent of GDP in 2012; fiscal impulse of 3¼ percent of non‑agricultural GDP expected to support non‑agricultural growth in 2012.

### Banking sector and financial stability
- Banking sector remained sound: profitability high and capital adequacy ratios strong.
- Nonperforming loans (NPLs) low at 2 percent in March but had risen over the last year.
- Provisions to NPLs have declined in aggregate; provisioning regulations tightened by the central bank; changes in NPL composition explain some provision declines.
- More stringent provisioning measures and higher capital requirements became effective in January 2012.
- Program to bolster prudential and regulatory framework of the cooperative sector is being implemented.
- Congress approved legislation to shift public sector deposits from commercial banks to a state‑owned bank; these deposits amount to about 6 percent of GDP. Initiative on hold as the BCP filed a suit with the Supreme Court.
- Risks to financial stability:
  - Agricultural contraction and spillovers could raise NPLs, though farmer buffers from high profits in recent years limit this risk.
  - Potential abrupt shifting of public sector deposits to a state‑owned bank poses a risk to liquidity distribution and financial stability.

### Staff macroeconomic outlook (baseline projections)
- 2012: Staff projects real GDP to fall by 1½ percent, driven by a decline in agricultural activity of about 25 percent.
- 2012: Staff projects the non‑agricultural sector to expand by 4¼ percent (compared to potential growth of 4½ percent), with a slightly negative output gap in 2012.
- 2013: Agricultural expansion of 8½ percent projected; GDP expanding by 8½ percent in 2013 before stabilizing around potential over the medium term.
- Inflation expected to remain at about 5 percent in 2012.
- External current account projected to rise above 3 percent of GDP in 2012 (temporary deterioration) and to stabilize at around 1¼ percent of GDP over the medium term after 2013 recovery.
- Net international reserves (millions of U.S. dollars): 2,864 (2008); 3,861 (2009); 4,168 (2010); 4,984 (2011); 5,184 (2012); 5,515 (2013).
- Stock in months of next year imports of goods and services: 4.6 (2008); 4.3 (2009); 3.9 (2010); 4.7 (2011); 4.3 (2012); 4.4 (2013).
- Projection table highlights:
  - Real GDP: 5.8 (2008); -3.8 (2009); 15.0 (2010); 3.8 (2011); -1.5 (2012); 8.5 (2013).
  - Consumer prices (end of period): 7.5 (2008); 1.9 (2009); 7.2 (2010); 4.9 (2011); 5.0 (2012); 5.0 (2013).
  - Credit to private sector: 49.3 (2008); 24.1 (2009); 42.9 (2010); 26.3 (2011); 18.2 (2012); 24.2 (2013).
  - Current account (percent of GDP): -1.9 (2008); 0.5 (2009); -3.4 (2010); -1.2 (2011); -3.1 (2012); -1.3 (2013).
  - Central government overall balance (percent of GDP): 2.5 (2008); 0.6 (2009); 1.5 (2010); 0.9 (2011); -2.5 (2012); -2.0 (2013).
  - Consolidated public debt (percent of GDP): 23.1 (2008); 23.0 (2009); 18.6 (2010); 18.0 (2011); 19.6 (2012); 19.0 (2013).

### Risks to the outlook (likelihoods, impacts, channels)
- Growth and inflation risks:
  - Main short‑term domestic risk: drought spillovers to domestic demand stronger than estimated.
  - A 10 percent decline in agriculture is estimated to reduce non‑agricultural activity by 0.8–1.0 percent.
  - For 2013, risks to growth and inflation are tilted to the upside (stronger agricultural rebound and stronger non‑agricultural expansion).
- Financial sector risks:
  - Agricultural contraction and spillovers could raise NPLs; banks generally have relatively strong capital and reserve buffers.
  - Potential abrupt shifting of public sector deposits to a state‑owned bank poses liquidity and stability risks.
- Fiscal risks:
  - With general elections in 2013 and congressional powers to increase expenditures, downside fiscal risks dominate in the near term.
  - A weaker fiscal stance could raise the external current account deficit, inflation, and depreciate the exchange rate, potentially fueling second‑round inflationary pressures.
- Medium‑term external risks:
  - Include a large decline in commodity prices and substantially weaker external demand; staff view probability as low to medium but with significant potential impact.
- Annex 1 selected stress-test and debt entries:
  - Baseline public sector debt (selected series): 21.7 18.9 17.9 15.0 13.6 14.2 13.4 13.1 11.7 11.2 10.9.
  - Primary deficit (selected series): -2.6 -3.0 -0.9 -0.8 -0.8 1.2 0.4 -0.9 -1.4 -1.7 -0.5.
  - Key macro/fiscal baseline assumptions:
    - Real GDP growth (percent): 6.8 5.8 -3.8 15.0 3.8 -1.5 8.5 4.6 4.7 4.7 4.7.
    - Average nominal interest rate on public debt (percent): 4.1 3.8 4.5 3.2 2.6 2.7 3.0 3.4 3.2 3.2 3.1.
    - Inflation rate (GDP deflator, percent): 10.2 13.1 -0.1 6.7 6.5 9.1 4.5 4.8 5.4 5.6 6.2.

### Policy recommendations (monetary, fiscal, financial sector, structural)
- Monetary policy:
  - Avoid easing monetary policy further and stand ready to tighten if inflationary pressures resurface.
  - Conditions to ease rates further: clear signs of weaker-than-anticipated non-agricultural growth or significant decline in external demand and clear softening in core inflation dynamics.
  - BCP should be ready to tighten in a timely manner as 2013 approaches when meat prices reverse.
  - Encourage greater exchange rate flexibility; allow some depreciation to cushion supply shocks.
- Liquidity management:
  - Encourage move to average reserve requirements as soon as feasible.
  - Consider issuing long-term paper to absorb liquidity if unexpected spikes reappear.
  - Improve communication and coordination between the BCP and the Ministry of Finance to avoid large, unexpected changes in public deposits at the central bank.
- Fiscal policy:
  - Avoid further relaxation of fiscal policy in 2012 and start withdrawing fiscal stimulus next year (2013).
  - Protect fiscal buffers built in recent years.
  - Permanent large increase in public sector wages in 2012 would crowd out needed capital spending.
- Financial sector monitoring and macro‑prudential measures:
  - Fill information gaps on currency mismatches by borrowers; adequate loan classification by sector and maturity; developments in real estate markets.
  - Move forward with higher provisioning for foreign-currency loans.
  - Evaluate higher capital requirements for foreign-currency lending.
  - Introduce dynamic provisioning.
  - Implement full program to strengthen regulation and supervision for cooperatives and set up a safety net for the sector.
- Tax and structural reforms:
  - Implement the Personal Income Tax (PIT) as soon as possible; later strengthen PIT by limiting overly generous deductions.
  - Improve agricultural taxation: close generous deductions and loopholes; bring cooperatives under IMAGRO; consider a sales tax on agricultural products levied at the first stage at a low rate; caution against export taxes.
  - Increase tax contribution of the financial sector: broaden the base and raise VAT on financial transactions progressively (one percentage point per year) to the general rate.
  - Use public-private partnerships for infrastructure while assessing fiscal contingencies.
  - Reform state-owned enterprises to improve efficiency and reduce contingent fiscal liabilities.
  - Raise schooling and human capital; reform labor market institutions.
- Monetary framework and IT transition:
  - Continue implementing steps toward an inflation-targeting regime; envisaged completion before end-2013.
  - Steps taken: adopting a 14-day rate as the policy rate, producing a bi-annual inflation report, and improving communications.
  - Further actions: move to average reserve requirements; implement BCP recapitalization (2010 law); improve monetary framework, operations, liquidity forecasting, and FX operations.
  - Box 6 implementation status highlights:
    - Allow averaging of reserve requirements: Pending.
    - Recapitalize the BCP with marketable securities: Pending.
    - Use 14-day rate as policy rate (policy simplification): Completed.
    - Limit FX intervention to extreme volatility: In progress.

### Long-term growth constraints and recommendations
- Potential growth estimated at about 4½ percent.
- Key constraints:
  - Investment below 19 percent of GDP.
  - Large deficiencies in ports, river transport, utilities, and roads.
  - Relatively low levels of human capital and low schooling indicators.
  - Weak business climate: Paraguay ranks 102 of 183 in Ease of Doing Business.
  - Labor market rigidities (minimum wage about ½ of average value added; paid leave and redundancy notice periods above regional norms).
- Policy priorities:
  - Increase investment ratio and competitiveness to raise potential growth.
  - Improve public enterprise monitoring and performance.
  - Strengthen pension system: perform actuarial assessment; homogenize and strengthen regulation and supervision; plan broader reform toward sustainability and portability.

### Natural Real Interest Rate and exchange rate flexibility (boxed findings)
- Box 1 — NRIR:
  - Consumption-smoothing model suggests NRIR around 3¾ percent: under standard assumptions (discount factors between 0.97 and 0.99; coefficients of relative risk aversion in the 1.0–2.0 range), NRIR between 2.2 and 5.4, average 3.8—below the 4½ estimated potential output growth.
  - UIP-based measure suggests NRIR around 3 percent: for assumed long-run real appreciation between zero and one percent per annum, NRIR between 2.5 and 3.5 percent, average 3.0 percent.
  - Assumptions: U.S. long-run inflation of 2 percent; Paraguay’s inflation target of 5 percent; a country risk premium of 3½ percent; an exchange rate premium of 2 percent; and 2 percent NRIR for the U.S.
- Box 2 — Exchange rate flexibility/resistance:
  - Indicators (EMP and RI) show BCP tended to resist exchange market pressures in recent years; resistance grew during most of 2007–08, decreased late-2010 and part of 2011, then increased again in 2012Q1.
  - Since late 2011, the BCP has resisted almost entirely exchange market pressures against negative supply shocks.
  - Overall, exchange rate flexibility decreased in Paraguay over the last year, reversing a trend that had started in late 2009.

### Risk Assessment Matrix (selected entries)
- External risks:
  - Large decline in soy prices: Relative Likelihood: Staff assessment: Low to medium; Expected impact: Staff assessment: Medium to large.
  - Substantially weaker external demand: Relative Likelihood: Low to medium; Expected impact: Medium to large.
- Domestic risks:
  - Spillovers from agriculture stronger than estimated: Relative Likelihood: Low; Expected impact: Low to medium.
  - Persistent intense droughts (extended over two years): Relative Likelihood: Low; Expected impact: Medium to large.
  - Further fiscal relaxation: Relative Likelihood: Medium; Expected impact: Medium.
  - Higher inflation (drivers): Relative Likelihood / Drivers: Medium; Expected impact: Low (inflation likely to remain single digits but anchoring expectations could take longer).
- Policy implications and buffers:
  - Fiscal and monetary policy can play a stabilizing role under external price or demand shocks.
  - Strong buffers exist at various levels (BCP, farmers, banks), but some individual bank buffers might become strained under large/prolonged shocks.
  - A larger fiscal expansion risks complicating the BCP’s ability to meet the inflation target and could widen the current account and pressure the guaraní.

_International Monetary Fund — 2012 Article IV Report: Paraguay (selected sections; source: _cr12211_)._

### 1.  The Natural Real Interest Rate _____________________________________________________________  20

### 1.  The Natural Real Interest Rate

### Background and recent growth developments
- GDP growth slowed markedly in 2011 and turned negative in 2012Q1.
- Growth slowed to 3.8 percent in 2011 after a strong rebound in 2010 led by agriculture.
- Non‑agricultural sector expanded by less than 3 percent in 2011.
- The non‑agricultural output gap turned negative in 2011Q3, reaching about -1 percent in the last quarter of 2011.
- Unemployment declined slightly to about 5½ percent in 2011.
- Underemployment remained high, at above 20 percent.
- A severe drought in late 2011–early 2012 caused significant agricultural losses (e.g., soybeans).
- High frequency indicators suggest GDP contracted by over 3 percent (y/y) in 2012Q1, while non‑agricultural activity grew at close to 4½ percent.

### Inflation dynamics
- Headline inflation peaked at over 10 percent (y/y) in early 2011, eased to 5 percent (the central bank target) at year‑end 2011, and fell further to 3¼ percent in April 2012.
- Decline in inflation mainly reflects lower food inflation, partly from a large reduction in meat prices following the export ban.
- Core inflation remained relatively high: 6¼ percent in April 2012.
- One‑off factor: a new law introducing obligatory social security contributions for private schools contributed about ½ percentage points to the increase in core inflation since December 2011.
- Despite a negative output gap, core inflation remained somewhat above the official target, reflecting mainly still strong domestic demand growth and one‑off factors.

### Credit growth, monetary tightening, and monetary conditions
- From mid‑2010 to August 2011 the central bank (BCP) raised the policy rate by 800 bps to 8½ percent.
- Credit growth decelerated from 43 percent at end‑2010 to 19 percent in April 2012.
- Growth of credit in U.S. dollars experienced an even stronger deceleration.
- The BCP began cutting interest rates in late 2011: reduced the policy rate by 200 bps between November 2011 and February, and by an additional 25 bps in May (to 6¼ percent).
- The real policy rate remained positive at around 1¼ percent but was below its neutral level.
- The monetary conditions index (MCI) presented is a weighted average of the real interest rate and the real exchange rate.

### Exchange rate and reserves
- The guaraní appreciated by 14 percent in real effective terms during 2011.
- The external current account deficit declined to 1¼ percent of GDP in 2011 (from 3½ percent of GDP in 2010).
- Improvement reflected better terms of trade, a stronger services account (mainly electricity royalty payments by Brazil and Argentina), and higher worker remittances.
- Net international reserves increased by 1½ percent of GDP in 2011, to about 24 percent of GDP.
- The central bank intervened on both sides of the market during 2011 to limit excessive exchange rate volatility and intervened in 2012Q1 to (i) withdraw an unexpected large liquidity injection by the government and (ii) stem strong depreciation pressures following the drought.
- FX intervention in 2011–12 appears to have limited exchange rate flexibility.

### Fiscal policy and public debt
- Fiscal policy was slightly expansionary in 2011.
- The overall fiscal surplus declined by ½ percentage points, to 1 percent of GDP in 2011, driven by a large increase in primary spending (especially capital expenditures).
- This implied a fiscal impulse (change in the structural primary balance) of about ¾ percent of GDP.
- Revenue growth decelerated but remained strong, supported by continued improvements in tax administration.
- General government debt fell below 14 percent of GDP.
- The 2012 budget envisages a sizeable fiscal loosening: the mission projects headline and structural balances to weaken by 3¼ percent of non‑agricultural GDP (2 percent of total GDP).
- Staff projects real revenue to grow by 3½ percent in 2012, supported by increased electricity royalty payments from Brazil.
- Public sector wage increases are growing by about 30 percent (mostly determined by congress).
- General government debt would rise to over 14 percent of GDP in 2012 but is projected to resume a declining trend in 2013.

### Banking sector and financial stability
- The banking sector remained sound: profitability high and capital adequacy ratios strong.
- Nonperforming loans (NPLs) were low at 2 percent in March but had risen over the last year.
- Provisions to NPLs and provisioning regulations: provisions have declined in aggregate, but provisioning regulations were tightened by the central bank; changes in NPL composition (higher share of recently overdue loans) explain some provision declines.
- More stringent provisioning measures and higher capital requirements became effective in January 2012.
- A program to bolster the prudential and regulatory framework of the cooperative sector is being implemented.
- Congress approved legislation to shift public sector deposits from commercial banks to a state‑owned bank; these deposits amount to about 6 percent of GDP. The initiative is on hold as the BCP filed a suit with the Supreme Court.

### Staff macroeconomic outlook (baseline projections)
- 2012: Staff projects real GDP to fall by 1½ percent, driven by a decline in agricultural activity of about 25 percent.
- Staff projects the non‑agricultural sector to expand by 4¼ percent in 2012 (compared to potential growth of 4½ percent), with a slightly negative output gap in 2012.
- 2013: Normalization of weather conditions expected to lead to an agricultural expansion of 8½ percent in 2013, with GDP expanding by 8½ percent in 2013 before stabilizing around potential over the medium term.
- Inflation expected to remain at about 5 percent in 2012.
- External current account projected to rise above 3 percent of GDP in 2012 (temporary deterioration) and to stabilize at around 1¼ percent of GDP over the medium term after 2013 recovery.
- The 2012 fiscal stimulus is projected to be withdrawn only slowly; government accounts remain in deficit through 2014.

### Risks to the outlook
- Growth and inflation risks:
  - Main short‑term domestic risk is drought spillovers to domestic demand that could be stronger than estimated.
  - A 10 percent decline in agriculture is estimated to reduce non‑agricultural activity by 0.8–1.0 percent.
  - For 2013, risks to growth and inflation are tilted to the upside (stronger agricultural rebound and stronger non‑agricultural expansion).
- Financial sector risks:
  - Agricultural contraction and spillovers could raise NPLs, though farmer buffers from high profits in recent years limit this risk.
  - Banks have relatively strong capital and reserve buffers.
  - The potential abrupt shifting of public sector deposits to a state‑owned bank poses a risk to liquidity distribution and financial stability.
- Fiscal risks:
  - With general elections in 2013 and congressional powers to increase expenditures, downside fiscal risks dominate in the near term.
  - A weaker fiscal stance could raise the external current account deficit, inflation, and depreciate the exchange rate, potentially fueling second‑round inflationary pressures.
- Medium‑term external risks:
  - Include a large decline in commodity prices and substantially weaker external demand; currently viewed as low to medium probability but with significant potential impact on Paraguay’s open, commodity‑dependent economy.
  - Such shocks would weaken the external current account, put pressure on the guaraní, and raise inflation even as activity weakens—placing pressure on the financial system.

_International Monetary Fund — 2012 Article IV Report: Paraguay (excerpt)._

### 14.      Focus of the consultation. The 2012 consultation focused on (i) macroeconomic and

### _cr12211 - 14.      Focus of the consultation

### Focus of the consultation (paragraph 14)
- The 2012 consultation focused on:
  - (i) macroeconomic and financial policies needed to maintain stability against the backdrop of supply shocks;
  - (ii) improving the tax system to raise the revenue ratio to help fund higher spending on basic social and infrastructure needs; and
  - (iii) increasing long-term growth and other structural issues.

### Implementation of past Fund policy advice (paragraph 15 and following)
- Priorities from the previous Article IV consultation (IMF Country Report 11/238):
  - Gear short-run policies toward moderating domestic demand pressures and returning to a more balanced growth path to reduce inflation, contain the external current account deficit, and preserve financial stability.
  - Advance implementation of structural reforms in the monetary, fiscal, and financial sectors.
- Progress and gaps:
  - Progress: monetary tightening moderated domestic demand growth and lowered inflation amid a substantial deceleration in credit growth; advances in financial sector reforms and in strengthening the monetary framework.
  - Lagging: fiscal reforms (e.g., fiscal framework and tax reform), in part due to the government’s lack of a majority in congress.

### A. Near-Term Macroeconomic and Financial Sector Policies (paragraphs 16–22)
- Policy objectives:
  - Keep inflation in line with the official target and the external current account deficit under control, while protecting financial stability.
- Monetary policy guidance:
  - Recommended to avoid easing monetary policy further and to stand ready to tighten if recent inflation dynamics reverse.
  - Current policy rate described as below its neutral level but broadly consistent with a negative output gap in the non-agricultural sector and meeting the BCP inflation target in 2012, given subdued food inflation.
  - Conditions to ease rates further: clear signs of weaker-than-anticipated non-agricultural growth or significant decline in external demand and clear softening in core inflation dynamics.
  - Inflationary pressures likely to increase as 2013 approaches once the beef export ban is lifted and economic activity recovers; BCP should be ready to tighten accordingly.
  - The BCP signaled that the policy rate had reached a minimum in the current easing cycle and signaled an increase in rates towards 2012Q4.
- Exchange rate policy:
  - Room for greater exchange rate flexibility.
  - FX intervention should be limited to dealing with excessive volatility and preventing disorderly movements.
  - Some depreciation at the current juncture would help cushion the drought’s impact; with a strong agricultural rebound in 2013, pressures for the guaraní to strengthen might arise and limited FX intervention could smooth sharp movements, but staff stressed not resisting the trend.
- Liquidity management:
  - Excess liquidity is a structural problem complicating monetary policy implementation and limiting effectiveness, especially as BCP moves towards an inflation targeting regime.
  - Encourage move to average reserves requirements as soon as feasible; BCP indicated implementation later this year once a new payments system is in place.
  - Consider issuing long-term paper to absorb liquidity if unexpected spikes reappear, given reliance on FX operations can have unintended exchange rate consequences.
  - Improve communication and coordination between the BCP and the Ministry of Finance to avoid large, unexpected changes in public deposits at the central bank.
- Fiscal stance:
  - Avoid further relaxation of fiscal policy in 2012 and start withdrawing fiscal stimulus next year.
  - Fiscal policy already provides a strong stimulus in 2012; adding more could undermine the central bank’s ability to meet the inflation target and widen the external current account deficit.
  - Protect fiscal buffers built in recent years; if activity weakens significantly, the first line of defense should be monetary policy.
  - Permanent large increase in public sector wages in 2012 would crowd out needed capital spending.
- Macro-prudential and financial sector monitoring:
  - Important information gaps: extent of currency mismatches by borrowers; adequate loan classification by sector and maturity; developments in real estate markets.
  - Recommendations:
    - Fill information gaps as soon as feasible.
    - Move forward with higher provisioning for foreign-currency loans.
    - Evaluate higher capital requirements for foreign-currency lending.
    - Introduce dynamic provisioning.
- Exchange rate alignment:
  - Estimates based on CGER and measures of external competitiveness suggest the guaraní was overvalued by less than 10 percent at end-2011; methodologies point consistently to an overvaluation of around that magnitude.

### B. Improving the Tax System (paragraphs 23–26)
- Rationale:
  - Paraguay needs to raise its tax ratio to support upgrading basic infrastructure, improving social indicators, and reducing poverty.
  - Tax ratio is one of the lowest in Latin America despite solid revenue growth; insufficient public resources hinder long-run growth and contribute to low human development and high poverty incidence.
- Personal Income Tax (PIT):
  - Staff supported implementing the PIT originally approved in 2004 but repeatedly postponed by congress.
  - Short-run implementation prospects improved after the lower house approved enactment in early May; senate expected to consider the bill soon with a favorable outcome anticipated.
  - While the current PIT law has shortcomings, implement it as soon as possible: will increase revenues and tax equity marginally in the short run and contribute to reducing informality.
  - Authorities agreed to later enhance the PIT by limiting overly generous deductions.
- Agricultural taxation:
  - Agriculture accounts for over 20 percent of GDP but its share of tax revenues is negligible.
  - Supported recent changes: limiting VAT credits against IMAGRO liabilities and broadening the IMAGRO base.
  - Welcomed plans to bring cooperatives under IMAGRO and limit overly generous deductions.
  - Recommended further trimming of deductions, closing loopholes, unifying taxation regimes in the sector.
  - Cautioned against introducing export taxes; instead recommended adopting a sales tax on agricultural products levied at the first stage in the transaction chain at a low rate.
- Financial sector taxation:
  - Financial sector considered under-taxed due to exemptions and a low VAT rate (5 percent, compared to the 10 percent general rate).
  - Recommended progressively raising (one percentage point per year) the VAT on financial transactions to the general rate level.
  - Suggested bringing the cooperative sector under corporate income tax and eliminating exemptions on interest and capital gains on stocks and public debt holdings.
  - Authorities agreed with these recommendations.

### C. Long-Term Growth and Other Structural Issues (paragraphs 27–30)
- Potential growth:
  - Paraguay’s potential growth estimated at about 4½ percent, broadly in line with regional levels.
  - Per capita income is considerably lower than neighbors, suggesting scope for higher potential growth through raising the investment ratio, increasing competitiveness, and boosting productivity.
- Constraints to growth:
  - Infrastructure shortcomings, relatively low levels of human capital, a weak business climate, and labor market inefficiencies.
  - Staff encouraged the authorities to work on a strategy to ease these constraints and supported efforts to improve public enterprise monitoring and performance.
- Pension system:
  - Current public pension system comprises multiple pay-as-you-go, defined-benefit schemes governed by separate laws and covering less than 20 percent of the working-age population.
  - Aggregate system generates a small cash surplus, but several regimes have sizable cash flow deficits covered by the central government.
  - Lack of comprehensive data on liabilities and assets due to weak reporting requirements.
  - Mission stressed the need for a proper actuarial assessment and welcomed plans to homogenize and strengthen regulation and supervision, including creating a superintendency of pensions with World Bank support.
  - Authorities plan a broader reform toward a modern and encompassing pensions system based on sustainability and portability principles, aiming to reduce contingent liabilities.
- Financial sector reform progress:
  - Advances in strengthening regulation and supervision of cooperatives and creating a financial safety net for the sector.
  - Little progress on governance reform.
  - Plans for implementing a new payments system later this year supported.
  - Discussions supported to set up a high-level committee to strengthen cooperation and coordination among regulators.
  - Bank and BCP legislation reforms likely to move more slowly due to lack of congressional majority; these reforms would facilitate updating prudential requirements and support risk-based supervision, aligning capital definition and loan classification with international standards.
- Inflation-targeting regime:
  - BCP continuing the process of adopting an inflation-targeting (IT) regime with an envisaged completion before end-2013.
  - Steps taken: adopting a 14-day rate as the policy rate, producing a bi-annual inflation report, and improving communications.
  - Encouraged to implement recommendations from recent MCM technical assistance on monetary framework and operations, liquidity management and forecasting, and FX operations.
  - Team reiterated recommendation to recapitalize the central bank by implementing the 2010 recapitalization law.

### Staff appraisal (paragraphs 31–34)
- Growth projections and outlook:
  - A severe drought will lead to a contraction in 2012; GDP projected to fall by 1½ percent in 2012, driven by the agricultural sector.
  - With drought over and supportive policies, growth expected to resume in the second quarter and accelerate in the second half of 2012.
  - Non-agricultural sector should grow close to potential, with the output gap remaining negative.
  - As weather normalizes and agriculture recovers, GDP projected to expand by 8½ percent in 2013.
- Appropriateness of current policy mix:
  - Current policy mix broadly appropriate for 2012: stimulative monetary stance with policy rate below neutral supporting robust credit growth; fiscal policy providing strong stimulus with an impulse of over 3 percent of non-agricultural GDP.
  - This mix is broadly consistent with meeting the BCP inflation target (5 percent) in 2012 and helps offset the drought’s impact on the non-agricultural sector.
  - Permanent large increase in public wages in 2012 precludes better allocation of scarce budgetary resources and crowds out needed public investment.
  - Heavy FX intervention in 2012Q1 appears to have prevented the guaraní from depreciating, which would have helped cushion the drought’s effects.
- Policy recommendations and risks:
  - Important not to relax policies further; stand ready to tighten if inflationary pressures resurface.
  - With non-agricultural GDP close to potential, further monetary and fiscal stimuli will likely fuel inflationary pressures and widen the external current account deficit.
  - If weaker-than-anticipated non-agricultural growth appears, monetary policy should be the first line of defense.
  - Expectation of rising inflationary pressures as 2013 approaches when meat prices reverse; BCP should be ready to tighten in a timely manner while allowing sufficient exchange rate flexibility.
  - Fiscal policy should start withdrawing the significant stimulus provided in 2012.
  - Close important information gaps in the financial sector (currency mismatches, loan classification, real estate prices) to enhance monitoring.
  - Implement plans for higher provisioning for foreign-currency loans.
  - Concern: congress’s initiative to abruptly move public sector deposits from commercial banks to a state-owned bank poses a risk to financial stability; appropriate alternatives should be considered.

*Source: _cr12211 - 14. Focus of the consultation (Paraguay 2012 Article IV Report).*

### 35.      A higher tax ratio would help address significant deficiencies in infrastructure and

### _cr12211 - 35.      A higher tax ratio would help address significant deficiencies in infrastructure and

### Tax revenue and tax policy
- Paraguay has one of the lowest tax ratios in the region.
- Higher tax revenues would support: 
  - improvement of basic infrastructure,
  - financing higher levels of social spending and human capital,
  - poverty reduction.
- Staff welcomes the authorities’ efforts to implement the PIT as soon as possible.
- Policy recommendations:
  - Strengthen the PIT by limiting overly generous deductions.
  - Improve income taxation in agriculture by closing generous deductions and significant loopholes that drive very low revenue collections.
  - Increase the tax contribution of the financial sector by broadening the base and raising the VAT rate on financial transactions, which is only half the general rate.

### Constraints to long-run growth
- Staff finds room for higher long-run growth given Paraguay’s income level, but identifies key constraints:
  - Large infrastructure gaps and low investment (investment is low by regional standards, below 19 percent of GDP).
  - Relatively low levels of human capital and low schooling indicators compared with neighbors.
  - Weak business climate; Paraguay ranks 102 of 183 in the World Bank’s Ease of Doing Business.
  - Low efficiency in sectors with strong public enterprise presence; need improved monitoring and performance of public enterprises and enactment of appropriate legislation.
- Policy suggestions:
  - Use public-private partnerships to support infrastructure improvements while carefully assessing fiscal contingencies.
  - Reform state-owned enterprises (cement, utilities) to improve efficiency and reduce contingent fiscal liabilities.
  - Raise schooling and human capital to attract higher volumes and higher value-added FDI and reduce inequality and poverty.
  - Reform labor market institutions to reduce production costs and increase competitiveness.

### Financial sector reforms and supervision
- Progress on structural financial sector reforms is welcomed; staff encourages continuation of the reform agenda.
- Ongoing program elements:
  - Bolster regulation and supervision.
  - Set up a safety net for cooperatives.
  - Implement a new payments system.
- Policy recommendations:
  - Set up promptly a high-level committee of regulators.
  - Implement reforms to banking and BCP legislation as soon as feasible to support more effective risk-based supervision and align prudential regulations with international standards.
  - Implement planned reforms to the pension system, including strengthening its regulation and supervision.
  - Complete full implementation of the program to strengthen the sector and the overall financial system.

### Monetary policy framework and transition to inflation targeting (IT)
- Authorities’ efforts to support IT implementation are welcome but further advances are required to transition to full-fledged IT.
- Recent BCP steps include establishment of a single monetary policy rate and publication of bi-annual monetary policy reports.
- Further required areas of advance:
  - Monetary framework enhancements.
  - Monetary and FX operations.
  - Moving to average reserve requirements to help reduce excess liquidity, foster the interbank market, and improve the monetary transmission mechanism.
  - Implementing the BCP recapitalization to strengthen monetary policy.
  - Improved communication and coordination between the BCP and the Ministry of Finance to facilitate liquidity management and forecasting.

### Recommendation on consultation cycle
- It is recommended that the next Article IV consultation takes place on the standard 12-month cycle.

### Box 1 — Natural Real Interest Rate (NRIR) in Paraguay
- Two theoretical measures presented:
  - Consumption-smoothing model with a risk-free real rate: suggests a NRIR for Paraguay of around 3¾ percent.
    - Under standard assumptions (discount factors between 0.97 and 0.99; coefficients of relative risk aversion in the 1.0–2.0 range), the NRIR would be between 2.2 and 5.4, with an average value of 3.8—below the 4½ estimated potential output growth.
  - Uncovered interest parity (UIP) based measure: suggests a NRIR around 3 percent.
    - For assumed long-run real appreciation between zero and one percent per annum, the NRIR is estimated to lie between 2.5 and 3.5 percent, with an average of 3.0 percent.
- Assumptions noted: U.S. long-run inflation of 2 percent; Paraguay’s inflation target of 5 percent; a country risk premium of 3½ percent; an exchange rate premium of 2 percent; and 2 percent NRIR for the U.S.

### Box 2 — Exchange rate flexibility and central bank resistance
- Indicators constructed: exchange market pressures (EMP) and resistance index (RI), with RI normalized to the 0-1 range (zero for pure flex, one for pegs).
- Findings:
  - The BCP has tended to resist exchange market pressures in recent years.
  - Resistance grew during most of 2007–08 amid strong appreciation pressures.
  - Resistance decreased somewhat during late-2010 and part of 2011, aiding inflation containment, then increased again in 2012Q1.
  - Since late 2011, the BCP has resisted almost entirely exchange market pressures against negative supply shocks (drought and foot-and-mouth disease).
  - Overall, measured by the RI, exchange rate flexibility decreased in Paraguay over the last year, reversing a trend that had started in late 2009.

### Box 3 — Exchange rate assessment
- CGER estimates indicate the guaraní was overvalued by about 9 percent at end-2011.
- The guaraní appreciated by 14 percent in real effective terms during 2011, reflecting a moderate nominal strengthening and an inflation rate exceeding that of trading partners.
- Other competitiveness indicators (relative prices and market shares for primary products) also indicate overvaluation of over 9 percent at end-2011.
- Correlation between the two external competitiveness measures considered was found to be -77  percent.
- Export market coverage: the referenced markets (Brazil, Argentina, Uruguay, Chile, Russia, Germany, and Switzerland) account for 72 percent of Paraguayan exports; primary products considered represent 85 percent of Paraguay’s registered exports.

### Box 4 — Constraints to long-term growth (highlights)
- Investment and infrastructure:
  - Investment below 19 percent of GDP.
  - Large deficiencies in ports, river transport, utilities, and roads.
- Competitiveness and ease of doing business:
  - Paraguay ranks 102 of 183 in Ease of Doing Business.
- Human capital development:
  - Marginal return to education among the highest in Latin America.
  - Net school enrollment ratios shown as low relative to neighbors (chart referenced).
- Labor markets:
  - Minimum wage in Paraguay is about ½ of average value added, versus a Latin American average of 32 percent.
  - Days of paid annual leave—30 after 10 years of service—about one third higher than the regional norm.
  - Notice periods on redundancy dismissal (some 7½ salary weeks) are more than twice the regional average.

### Box 5 — Status of implementation of main recommendations from the 2010 FSAP (summary)
- Financial institutions soundness and vulnerabilities:
  - Actions include adopting capital ratio definition following Basel Accords (Basel I), introducing forward-looking provisioning, and enhancing regulatory approach to renewed/refinanced/restructured operations.
  - Status: Partially completed / Pending / In progress (varied by item).
- Payment and security settlement systems:
  - Approve draft payment system law; complete implementation of new payment system including real-time gross settlements, security repository, and automated clearing house.
  - Status: Completed / Near completion (varied by item).
- Financial sector oversight:
  - Amend legal framework to empower the BCP; align cooperatives’ prudential framework with banking standards; strengthen INCOOP governance; set up a committee of all regulators at the highest level.
  - Status: Pending / In progress (varied by item).
- Financial safety net and crisis resolution:
  - Strengthen FGD contingency funding; set up liquidity assistance facility for cooperatives; set up deposit insurance scheme for cooperatives.
  - Status: Pending / In progress (varied by item).

*IMF: Paraguay 2012 Article IV Report (selected sections summarized).*

### Box 6: Migration to IT Regime—Status of Implementation of MCM

### Box 6: Migration to IT Regime—Status of Implementation of MCM

### A. Monetary Policy Framework
- Recommendation: Focus Monetary Policy Committee (MPC) meetings only on monetary policy discussions, using developments in other areas only as inputs for such discussions.  
  - Status: In progress
- Recommendation: Align the schedules for MPC meetings and the release of the CPI information.  
  - Status: Completed
- Recommendation: Establish a dedicated task force to lead the implementation of IT by the targeted timeline.  
  - Status: Pending
- Recommendation: Focus MPC statements on movements in the BCP reference interest rates. Deal with statements on FX interventions separately.  
  - Status: Completed
- Recommendation: Improve communication through regular contact with journalists, economists, and other stakeholders.  
  - Status: In progress
- Recommendation: Produce a forward-looking Inflation Report to improve policy communication.  
  - Status: Completed
- Recommendation: Develop a formal projection framework that includes, inter alia, exploring the implications of risks and uncertainties. Integrate projections in a framework with two types of cycles: a complete cycle associated with the release of the national accounts, and a short cycle for the other months.  
  - Status: Completed
- Recommendation: Set up independent units for the cycle of projections, including: monitoring data; short-term projections; medium/long term projections; and reporting.  
  - Status: In progress

### B. Monetary Operations, and Liquidity Management and Forecasting
- Recommendation: Allow averaging of reserve requirements.  
  - Status: Pending
- Recommendation: Allow the constitution of required reserves only in dollars for foreign currency deposits.  
  - Status: Completed
- Recommendation: Recapitalize the BCP with marketable securities to, inter alia, facilitate the use of repo transactions to manage short term liquidity.  
  - Status: Pending
- Recommendation: Focus policy actions on a short-term interest rate by using the 14-day rate as the policy rate to simplify the operational framework and eventually move to an overnight rate.  
  - Status: Completed
- Recommendation: Improve price discovery in auctions for IRMs of over 14-day terms and create market benchmarks to develop a yield curve and extend the term structure of liquidity absorption.  
  - Status: In progress
- Recommendation: Use fine tuning repo and deposit operations.  
  - Status: Pending
- Recommendation: Consolidate FLIR as a standing facility to complement short term liquidity management and the use of average reserves; phase out the interbank liquidity management window.  
  - Status: Pending
- Recommendation: Regularly exchange forward-looking information with the Ministry of Finance; Minimize same-day transactions by the government or the BCP to reduce volatility on daily liquidity projections.  
  - Status: In progress
- Recommendation: Elaborate long-term liquidity projections based on available information and the monetary program to control systemic liquidity over the long run.  
  - Status: Pending

### C. Foreign Exchange Operations
- Recommendation: Limit FX intervention to situations of extreme volatility or strong market distortions. Reduce the frequency of FX interventions gradually (for a proper learning period).  
  - Status: In progress
- Recommendation: Further strengthen communication on FX policy; start the calculation of a daily interbank fixing for the exchange rate.  
  - Status: In progress
- Recommendation: Use daily transaction reports to build intraday and daily reports.  
  - Status: Completed

*Source: _cr12211 - Box 6: Migration to IT Regime—Status of Implementation of MCM*

### Annex 1. Paraguay: Risk Assessment Matrix

### Annex 1. Paraguay: Risk Assessment Matrix

### External risks: likelihood, impact, and channels
- Large decline in soy prices  
  - Relative Likelihood of realization in the next 1-3 years: Staff assessment: Low to medium  
  - Expected impact on economy if risk is realized: Staff assessment: Medium to large  
  - Key channels and consequences:  
    - A slow recovery of the global economy might adversely affect commodity prices.  
    - A large increase in U.S. interest rates or a strong deceleration in the Chinese economy could induce a moderation in demand-driven global price increases.  
    - The external current account would worsen and strong pressures on the exchange rate could arise.  
    - If accompanied by a large decline in soy production (about 50 percent of agriculture), lower prices will drag down growth, including via spillovers to the non-agro economy.  
    - The financial sector might observe an increase in NPLs, which would be large only to the extent that the shock is sufficiently persistent.  
    - Fiscal and monetary policies could help sustain domestic demand.

- Substantially weaker external demand  
  - Relative Likelihood: Staff assessment: Low to medium  
  - Expected impact: Staff assessment: Medium to large  
  - Key channels and consequences:  
    - The probability of a much weaker external demand than currently envisaged seems to range from low to medium.  
    - Effects similar to a collapse in the world price for soy.  
    - A large and broad based decline in external demand would affect primarily the agricultural sector but would impact also the rest of the economy both directly and indirectly.

### Domestic risks: likelihood, impact, and channels
- Spillovers from agriculture to rest of the economy stronger than currently estimated  
  - Relative Likelihood: Staff assessment: Low  
  - Expected impact: Staff assessment: Low to medium  
  - Key channels and consequences:  
    - If spillovers to the non-agricultural sector are stronger than currently estimated, domestic demand would decelerate more strongly than currently anticipated, resulting in lower non-agricultural growth.  
    - This would impact the financial sector and the fiscal accounts more strongly: lower domestic demand and non-agricultural growth would hurt employment and incomes; given weaker buffers in the non-agricultural sector, NPLs would be higher than in the baseline; tax revenue growth would be negatively affected.

- Persistent intense droughts (extended over two years)  
  - Relative Likelihood: Staff assessment: Low  
  - Expected impact: Staff assessment: Medium to large  
  - Key channels and consequences:  
    - The probability of two consecutive intense droughts is low; were they to materialize, economic activity would experience a more prolonged decline, amplifying the shock.  
    - A more prolonged economic contraction would impact the financial sector more strongly—including indirectly through spillovers to the rest of the economy—increasing NPLs.  
    - Lower export earnings could put the guaraní under strong pressure and lead to a large depreciation, which could generate sizeable balance sheet effects and inflationary pressures.  
    - Strong buffers at various levels (by the BCP, farmers, and banks) would help deal with depreciation pressures and potential financial sector stress from higher NPLs and balance sheet effects. However, some individual bank buffers might become strained.

- Further fiscal relaxation  
  - Relative Likelihood: Staff assessment: Medium  
  - Expected impact: Staff assessment: Medium  
  - Key channels and consequences:  
    - Congress tends to use its powers to increase spending without proper funding, and there are political pressures to make the current stance of fiscal policy more expansionary. Going forward, congress could limit the ability of the Ministry of Finance to control spending through the Financial Plan.  
    - While fiscal buffers are strong, a larger fiscal expansion would make it harder for the BCP to meet the inflation target.  
    - It would widen further the current account deficit, and could put pressure on the guaraní. In addition to fueling inflation, this could produce balance sheet effects, with negative implications for the financial system.  
    - A weakening of the fiscal framework could have long-lasting consequences for fiscal discipline and the public finances, rising debt and eroding current buffers, and could limit space for needed infrastructure expenditures to bolster potential growth.

- Higher inflation  
  - Relative Likelihood / Drivers: Staff assessment: Medium  
    - Pressures to relax macroeconomic policies could increase ahead of the elections. With relatively weakly anchored inflation expectations and a still developing inflation targeting regime, inflation could increase above the central bank’s target.  
    - High openness to trade and strong pass-through implies a potentially significant price impact from exchange rate depreciation.  
  - Expected impact on economy if realized: Staff assessment: Low  
    - While a setback, inflation will likely remain on the low side (single digits).  
    - Anchoring inflation expectations and establishing strong central bank inflation credentials would take longer than currently envisaged.

### Debt sustainability and stress-test scenarios (highlights)
- Public debt dynamics: baseline and scenario notes (selected items from the Public Sector Debt Sustainability Framework table)  
  - Baseline: Public sector debt (selected series shown in the source): 21.7 18.9 17.9 15.0 13.6 14.2 13.4 13.1 11.7 11.2 10.9  
  - Change in public sector debt (selected series): -5.9 -2.8 -1.0 -3.0 -1.4 0.6 -0.8 -0.2 -1.4 -0.5 -0.4  
  - Primary deficit (selected series): -2.6 -3.0 -0.9 -0.8 -0.8 1.2 0.4 -0.9 -1.4 -1.7 -0.5  
  - Public sector debt-to-revenue ratio (selected series): 67.8 61.6 54.6 50.4 42.2 41.4 39.7 40.0 36.1 34.9 34.0  
  - Gross financing need (in percent of GDP, selected): 1.5 0.2 3.1 1.7 2.2 3.9 2.7 1.3 0.5 0.2 0.8  
  - Scenario with no policy change (constant primary balance) in 2011-2017 (selected): 13.6 12.0 10.2 9.6 9.1 7.8 6.5

- Debt sustainability shocks illustrated in Figures (descriptive highlights from scenarios):  
  - Individual shocks used in bound tests include permanent one-half standard deviation shocks to growth and interest rates, permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance, a one-time real depreciation of 30 percent, and contingent liabilities shocks (10 percent of GDP) in 2012.  
  - Example scenario entries in charts:  
    - Real depreciation and contingent liabilities shocks: 30% depreciation (one-time) and contingent liabilities shock.  
    - Interest rate shock scenarios show substantial upward movement in debt under shock relative to baseline (figures in the source: e.g., i-rate shock 12.5, Baseline 10.9; elsewhere i-rate shock 22.9, Baseline 22.5, reflecting different panels and debt measures).

### Key macroeconomic and fiscal baseline assumptions (as presented)
- Real GDP growth (in percent): 6.8 5.8 -3.8 15.0 3.8 -1.5 8.5 4.6 4.7 4.7 4.7
- Average nominal interest rate on public debt (in percent): 4.1 3.8 4.5 3.2 2.6 2.7 3.0 3.4 3.2 3.2 3.1
- Average real interest rate (nominal rate minus change in GDP deflator, in percent): -6.1 -9.3 4.6 -3.5 -3.9 -6.3 -1.5 -1.4 -2.3 -2.4 -3.1
- Inflation rate (GDP deflator, in percent): 10.2 13.1 -0.1 6.7 6.5 9.1 4.5 4.8 5.4 5.6 6.2
- Growth of real primary spending (deflated by GDP deflator, in percent): -0.6 -0.4 10.7 3.9 13.2 11.0 4.2 -1.6 1.5 3.0 7.6
- Primary deficit (in percent of GDP): -2.6 -3.0 -0.9 -0.8 -0.8 1.2 0.4 -0.9 -1.4 -1.7 -0.5

### Policy implications and buffers noted
- Fiscal and monetary policy can play a stabilizing role under external price or demand shocks by sustaining domestic demand.  
- Strong buffers exist at various levels (by the BCP, farmers, and banks) that would help absorb shocks such as droughts or export earnings declines, though some individual bank buffers might become strained under large/prolonged shocks.  
- A larger fiscal expansion risks complicating the central bank’s ability to meet the inflation target, widening the current account deficit, pressuring the guaraní, and producing balance sheet effects with negative implications for the financial system.  
- Anchoring inflation expectations and strengthening central bank credibility are important, as higher inflation episodes—while expected to remain in the single digits in a setback—would take longer to resolve under a weaker inflation-targeting regime.

*Source: Annex 1. Paraguay: Risk Assessment Matrix (from the 2012 Article IV Report).*

### 2011. He is based in Lima, Peru.

### ANNEX 2. WORLD BANK-FUND COLLABORATION

### Meetings and assessment of recent shocks
- Fund and Bank Paraguay teams met in September 2011 and April 2012 to exchange views and discuss work plans.
- Main macroeconomic challenge: responding appropriately to supply shocks (an outbreak of foot and mouth disease and a drought).
- Limits of macro policy: supply shocks have direct effects on agriculture that policies can do little to mitigate; policy response should be limited to addressing spillovers to the rest of the economy and ensuring inflation remains under control.
- Sector projections and macro outlook:
  - Non-agro sector projected to grow by over 4 percent in 2012.
  - Agricultural activity projected to fall by 25 percent in 2012.
  - Overall economy projected to contract by 1½ percent in 2012.
  - Domestic demand projected to decelerate but remain robust due to a significant relaxation of fiscal policy and stimulative monetary conditions.
  - Inflation projected at around 5 percent (the authorities’ target), aided by subdued local food and global commodity prices.

### Policy implications and financial stability
- Policy priorities:
  - Keep inflation in line with the official target.
  - Keep the external current account deficit under control.
  - Protect financial stability.
- With the non-agricultural sector operating close to capacity, there is virtually no space to relax macroeconomic policies further.
- Exchange rate policy:
  - Exchange rate flexibility allowing some depreciation of the guaraní should help absorb supply shock effects.
- Financial sector resilience:
  - Risks from agricultural contraction judged limited because farmers have large buffers from very high profits in recent years.
  - Banks have relatively strong capital and loss-related reserve cushions and should manage a moderate rise in NPLs.
  - Recent moderation of credit growth has reduced the risk of a credit bubble.
- Ongoing needs:
  - Keep credit growth under control.
  - Continue strengthening financial sector regulation and supervision.

### Identified "macrocritical" reform areas
- Tax reform:
  - Implement the personal income tax.
  - Reform agribusiness taxation.
  - Scope to raise taxation on the financial sector.
  - Continue recent improvements in tax administration to raise revenues.
- Fiscal framework:
  - Further strengthen the fiscal framework, including improved public financial management.
- Financial system:
  - Progress on banking legislation to strengthen regulation and supervision and to align prudential norms with international standards.
  - Fully implement program to strengthen regulation and supervision for cooperatives and establish a safety net for the sector.
- Monetary framework:
  - Continue strengthening the monetary framework, FX and monetary operations to support transition to an inflation targeting regime by the central bank (BCP).

### Division of labor between Bank and Fund
- Fund responsibilities:
  - Continue providing technical assistance (TA) on tax reform and revenue administration.
  - Continue TA to strengthen public financial management.
  - Continue TA to strengthen the monetary framework and operations to support BCP’s transition to an inflation targeting regime.
  - Provide TA on development of a national AML/CFT strategy.
  - Provide TA on stress-testing for cooperatives.
- Bank responsibilities (with Fund support where indicated):
  - With Fund’s support (MCM), provide TA on medium-term debt strategy to reduce domestic debt servicing costs and promote development of a domestic government debt market.
  - Study effects of royalty transfers on municipalities.
  - Provide TA on improving measurement of poverty and income inequality; work on teenage pregnancy and a study on inequality.
  - Provide TA on education programs, social assistance, rural and agricultural development.
  - Continue advisory services to improve the pension system.
  - Provide TA on public expenditure, including fiscal policy in volatile environments, efficiency of public expenditure, tax revenues, fiscal policy and equity, and commodity prices and fiscal policy.
  - Support government on the 2004 tax reform and development.
  - Initiate a new Development Policy Lending program to promote financial and social inclusion.
  - Provide TA on conditional cash transfers and on education programs (continuing).

### Work programs (provisional timing)
- Bank work program highlights:
  - Public expenditure review: Summer 2012 (mission), Winter 2013 (expected delivery).
  - TA on medium-term debt strategy: Fall 2012 (mission), Winter 2013 (delivery).
  - TA on pension system reform: November 2012 (mission), Winter 2013 (delivery).
  - TA on poverty and income inequality: Fall 2012 (mission and delivery).
  - TA on impact of royalty transfers on municipalities: Fall 2012 (mission and delivery).
  - Work on gender: Mid-2012 (mission), Fall 2012 (delivery).
  - Study on inequality: Late 2012 (mission), Late 2013 (delivery).
  - New DPL: Mid-2012 (mission), Late 2012 or 2013 (delivery).
  - TA on education programs and conditional cash transfers: Continuing.
- Fund work program highlights:
  - Staff visits to review macroeconomic and financial sector developments: November 2012 (mission and delivery).
  - Article IV Consultation: May 2012 (mission), June 2012 (delivery).
  - TA on national AML/CFT strategy development: Fall 2012 (mission).
  - TA on public financial management: Spring 2013 (mission), Winter 2013 / Summer 2013 (delivery timing entries indicate ongoing sequencing).
  - TA on revenue administration: Fall 2012 (mission), Winter 2013 (delivery).
  - TA on stress-testing for cooperatives: Winter 2013 (mission and delivery).

---

### ANNEX 3. STATISTICAL ISSUES

### General assessment
- Data provision to the Fund has some shortcomings but is broadly adequate for surveillance.
- Country is a GDDS participant.
- A data ROSC mission occurred in January–February 2006; authorities’ response and the mission’s recommendations were published on June 30, 2006.

### A. Real sector
- National accounts:
  - Estimates released in 2005 broadly consistent with 1993 SNA guidelines.
  - No comprehensive regular program for data collection through economic censuses and surveys; industrial survey in 2002; an economic census is currently being undertaken.
  - Insufficient source data for nonfinancial services, household consumption, and changes in inventories.
  - Major concerns:
    - 1994 reference year needs updating.
    - Excessive use of fixed coefficients for value added and household consumption.
    - Changes in inventories obtained residually.
    - Informal activities not monitored.
    - Supply and use tables compiled only until 1997.
  - Periodicity of annual GDP meets GDDS recommendations, but timeliness does not because data are disseminated with a lag of 9 months.
  - STA missions on quarterly national accounts (QNA): August 2007, August 2008, November 2009, and March–April 2011.
  - Revision of national accounts base year and compilation of supporting basic data tentatively scheduled for 2013, to be completed within 3 years.
  - STA November 2009 mission assisted in outlining a work program for updating the national accounts’ base year.
- Price indices:
  - CPI and PPI reported regularly and timely.
  - Since January 2008, BCP uses a new CPI based on the 2005–06 household budget survey.
  - CPI geographic coverage limited to Greater Asunción; expenditure weights representative of urban household consumption patterns.
  - PPI base weight period is December 1995; basket of 150 items not fully representative of current national output; electricity, water, and gas not covered.
- Labor and wages:
  - Regular household survey introduced in 1998 improved employment and unemployment statistics.
  - Since 2010, employment/unemployment data released quarterly covering Asunción area only.
  - Last available quarterly observation is Q1 2012; annual data for 2011 not yet released.
  - Wage indices updated twice a year.
- Resources:
  - Data ROSC found resources insufficient for real sector statistics and constrain development and full adoption of 1993 SNA.
  - Authorities addressing resource shortcomings in the context of new CPI compilation and provisional QNA series.

### B. Fiscal sector
- Government finance statistics (GFS):
  - GFS used internally and for reporting to WHD broadly consistent with GFSM 1986 recommendations.
  - Authorities have not prepared a plan to migrate to GFSM 2001.
  - Monthly data available for central administration (budgetary central government).
  - Asset position of social security system available on a daily basis.
  - Central administration statistics include Postal Service Directorate (a nonfinancial public corporation).
  - Nonfinancial public sector statistics include data of financial public corporations—four employer social insurance schemes treated as financial corporations in monetary and financial accounts.
- Debt and reporting issues:
  - Data on medium- and long-term external debt reliable and available monthly.
  - Domestic debt data available on request but need full integration with external debt database.
  - Deficiencies remain in recording short-term supplier and commercial credit of the public sector.
  - Discrepancy exists in fiscal data reported by monetary and fiscal authorities; measures being taken to increase transparency.
- Publication:
  - Annual general government data for 2009 reported for publication in 2010 GFS Yearbook.
  - Since 1994 no outstanding debt data and no breakdowns for expenditure by function have been provided for publication in the GFS Yearbook.
  - Monthly and quarterly data are not reported for publication in IFS.

### C. Money and banking sectors
- Monetary data system:
  - Paraguay completed establishment of a unified compilation and reporting system for monetary data to harmonize internal use, reporting to STA, and operational monitoring.
  - Revision of classification criteria reduced discrepancies in interbank positions.
- Credit cooperatives:
  - Data on credit cooperatives, accounting for around ¼ of deposits and loans of the banking sector, have been reported to the BCP monthly since January 2011.
  - BCP, with STA assistance, plans to include monthly data of the 20 largest credit cooperatives in the monetary survey during 2012.
- Supervision:
  - Superintendency of Banks publishes a detailed report on financial system soundness.

### D. External sector
- Balance of payments and IIP:
  - Classification follows Balance of Payments Manual, 5th edition.
  - Quarterly and annual BOP and IIP data available from 2001 onwards on the central bank website and reported once a year to STA for IFS publication.
  - Improvements made in quality of capital flow data, especially FDI coverage, and in recording external debt transactions.
  - Central bank special studies improved estimation methods for remittances and unregistered trade, but serious deficiencies remain.

*Source: 2012 ARTICLE IV REPORT—INFORMATIONAL ANNEX PARAGUAY*

### 9.      Also, there are deficiencies in the area of private capital outflows, which are difficult to

### _cr12211 - 9.      Also, there are deficiencies in the area of private capital outflows, which are difficult to

### Data gaps and statistical issues
- Deficiencies exist in capturing private capital outflows due to Paraguay’s open capital account.
- An STA mission on Balance of Payments Statistics assisted the BCP in November 2006 to implement recommendations of the ROSC mission.
- Mission focus areas:
  - Assessing the surveys used to capture data on services, direct investment, nonfinancial private sector portfolio investment, and other investment.
  - Reviewing and updating the statistical techniques used to calculate unrecorded trade.
  - Reassessing the treatment of the binational hydroelectric energy enterprises in the external sector accounts.
  - Reviewing and preparing a preliminary template for reporting data on international reserves and foreign currency liquidity.

### Macroeconomic developments (background and 2011–2012)
- Growth and agricultural shock:
  - GDP growth decelerated to 3.8 percent in 2011 and turned negative in 2012Q1.
  - Severe drought in late 2011–early 2012 caused large losses in the agricultural sector; key export products affected (e.g., soybeans).
- Inflation and core inflation:
  - Inflation peaked in early 2011 (over 10 percent y/y), eased to 5 percent at year-end 2011, and fell to 3¼ percent in April 2012.
  - Decline driven mainly by lower food inflation (meat price reductions after export ban), tighter monetary conditions, and appreciation of the guaraní.
  - Core inflation remained relatively high, above the mid-point of the official target range.
- Credit and financial conditions:
  - Credit growth moderated to 19 percent in April 2012 (43 percent at end-2010).
  - Growth of credit in U.S. dollars decelerated faster due to primary sector problems and reduced FX earnings.
  - Domestic demand growth moderated and financial sector risks diminished.
- Monetary policy:
  - BCP cut policy rate by 200 bps between November 2011 and February 2012, and by an additional 25 bps in May (to 6¼ percent).
  - Real policy rate around 1¼ percent, below neutral, consistent with negative output gap.
- External sector and reserves:
  - External current account deficit declined to 1¼ percent of GDP in 2011 (from 3½ percent of GDP in 2010).
  - Net international reserves increased by 1½ percent of GDP in 2011 (to 24 percent of GDP).
  - BCP intervened on both sides of the FX market during 2011 and 2012 to limit excessive exchange rate volatility.
- Fiscal developments:
  - Overall fiscal surplus declined by ½ percentage points to 1 percent of GDP in 2011 due to a large increase in primary spending (especially capital expenditures).
  - Fiscal impulse (change in structural primary balance) of ¾ percent of non-agricultural GDP.
  - Public debt declined, with general government debt below 14 percent of GDP.
- Banking sector:
  - Profitability high; capital adequacy ratios strong.
  - NPLs low (2 percent in March) but have risen over the last year.
  - More stringent provisioning measures and higher capital requirements effective January 2012.
  - Program to bolster prudential and regulatory framework of cooperatives being implemented.
  - Legislation to shift public sector deposits from commercial banks to a state-owned bank poses risk; initiative on hold pending BCP suit to Supreme Court.

### Projections and macro outlook (IMF staff projections)
- Real GDP:
  - Projected to decrease by 1½ percent in 2012; projected to grow 8.5 percent in 2013.
  - Contraction driven by strong agricultural sector downturn; non-agricultural sector expected close-to-potential expansion.
- External current account and reserves:
  - External current account expected to widen to over 3 percent of GDP in 2012.
  - Net international reserves (in millions of U.S. dollars): 2,864 (2008); 3,861 (2009); 4,168 (2010); 4,984 (2011); 5,184 (2012); 5,515 (2013).
  - Stock in months of next year imports of goods and services: 4.6 (2008); 4.3 (2009); 3.9 (2010); 4.7 (2011); 4.3 (2012); 4.4 (2013).
  - Stock over total external short term debt: 2.9 (2008); 3.5 (2009); 3.4 (2010); 3.9 (2011); 4.1 (2012); 4.3 (2013).
- Fiscal outcomes:
  - Overall fiscal deficit projected at 2½ percent of GDP in 2012.
  - Fiscal impulse: strong fiscal impulse of 3¼ percent of non-agricultural GDP expected to support non-agricultural growth in 2012.
- Selected projection table highlights (annual percent change or percent of GDP where indicated):
  - Real GDP: 5.8 (2008); -3.8 (2009); 15.0 (2010); 3.8 (2011); -1.5 (2012); 8.5 (2013).
  - Nominal GDP: 19.7 (2008); -4.0 (2009); 22.8 (2010); 10.5 (2011); 7.4 (2012); 13.4 (2013).
  - Consumer prices (end of period): 7.5 (2008); 1.9 (2009); 7.2 (2010); 4.9 (2011); 5.0 (2012); 5.0 (2013).
  - Credit to private sector: 49.3 (2008); 24.1 (2009); 42.9 (2010); 26.3 (2011); 18.2 (2012); 24.2 (2013).
  - Current account (percent of GDP): -1.9 (2008); 0.5 (2009); -3.4 (2010); -1.2 (2011); -3.1 (2012); -1.3 (2013).
  - Trade balance (percent of GDP): -6.3 (2008); -7.3 (2009); -7.4 (2010); -7.8 (2011); -9.4 (2012); -6.4 (2013).
  - Gross domestic investment (percent of GDP): 18.1 (2008); 15.5 (2009); 17.7 (2010); 19.3 (2011); 19.1 (2012); 18.5 (2013).
  - Central government revenues (percent of GDP): 17.3 (2008); 19.7 (2009); 18.7 (2010); 19.8 (2011); 20.1 (2012); 20.0 (2013).
  - Central government expenditures (percent of GDP): 14.8 (2008); 19.1 (2009); 17.3 (2010); 19.0 (2011); 22.6 (2012); 21.9 (2013).
  - Central government overall balance (percent of GDP): 2.5 (2008); 0.6 (2009); 1.5 (2010); 0.9 (2011); -2.5 (2012); -2.0 (2013).
  - Consolidated public debt (percent of GDP): 23.1 (2008); 23.0 (2009); 18.6 (2010); 18.0 (2011); 19.6 (2012); 19.0 (2013).
  - o/w external (percent of GDP): 16.7 (2008); 15.3 (2009); 12.8 (2010); 11.8 (2011); 11.9 (2012); 11.0 (2013).
  - o/w domestic (percent of GDP): 2.2 (2008); 2.7 (2009); 2.2 (2010); 1.8 (2011); 2.3 (2012); 2.4 (2013).
  - LRM (percent of GDP): 4.2 (2008); 5.0 (2009); 3.6 (2010); 4.3 (2011); 5.4 (2012); 5.6 (2013).

### Executive Board assessment and policy recommendations
- Short-term outlook:
  - Directors noted projected contraction in 2012 due to severe drought and expected rapid turnaround with strong growth in 2013 as weather normalizes and domestic demand remains robust.
- Monetary and exchange rate policy:
  - Current policy mix considered appropriately supportive of activity and consistent with the inflation target in 2012.
  - Directors stressed importance of not relaxing macroeconomic policies further given non-agricultural sector is operating close to capacity.
  - Recommended being ready to tighten monetary policy if warranted, allow the exchange rate to adjust flexibly, and begin withdrawing fiscal stimulus in 2013.
- Fiscal policy and taxation:
  - Commended authorities for fiscal prudence; supported plans to mobilize tax revenue for infrastructure and social spending.
  - Priorities: expedite implementation of the personal income tax and limit exemptions; strengthen agricultural taxation and tax administration.
  - Suggested broadening the financial sector’s tax base and increasing its low VAT rate.
  - Urged improving allocation of scarce budgetary resources and containing current expenditure growth given large public sector wage increases crowding out investment.
- Monetary framework and central bank:
  - Welcomed steps toward adopting an inflation targeting regime.
  - Encouraged enhanced liquidity management, strengthening monetary framework and operations, recapitalization of the central bank, and improved communication/coordination between central bank and Ministry of Finance.
- Financial sector reforms and supervision:
  - Commended progress implementing 2010 FSAP recommendations and upgrading AML/CFT framework.
  - Emphasized addressing information gaps for financial sector monitoring and greater use of macro-prudential tools.
  - Recommended improving banking legislation, setting up a high-level committee of regulators, and strengthening regulation and supervision for cooperatives.
  - Expressed concern over legislation to move sizeable public sector deposits to a state-owned bank; called for consideration of alternatives to avoid adverse effects on commercial banks’ funding and liquidity.
- Long-term growth and structural policies:
  - Called for efforts to raise growth potential and living standards through a long-term strategy for infrastructure, human capital, and overall economic efficiency.
  - Welcomed efforts to enhance monitoring and performance of state-owned enterprises.

*Source: Paraguay — 2012 Article IV report informational annex and Public Information Notice (PIN) No. 12/85 (as of May 21, 2012 and July 20, 2012)*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2012/_cr12211.pdf_