## Paraguay: Corruption, Reform, and the Financial System

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### Reform program and policy framework
- The new administration of President Nicanor Duarte Frutos took office in August 2003 and signed a 15-month Stand-By Arrangement on December 15, 2003.
- Strategy focused on: restoring fiscal sustainability; improving public sector efficiency; strengthening the banking sector; improving governance; fighting corruption.
- Policy measures included a comprehensive and balanced fiscal package (measures to increase tax revenues and spending restraint), actions to correct financial problems in certain public enterprises, and reform of the public employees’ pension plan.

### Structural constraints and governance
- Long-standing structural problems identified as key impediments to growth:
  - Political instability during the 1990s (coup attempt, assassination of a vice-president, resignation of a president, interim presidency).
  - Serious governance problems: corruption, inefficiency, poor guarantees of property rights, and lack of transparency. Paraguay ranks consistently among the worst in perception of corruption surveys.
  - Weak banking system with multiple crises that reduced the total number of banks from 35 to 14.
  - Inefficient public enterprises in water, electricity, transport, telecommunications, petroleum, cement, and banking sectors.
  - Low and falling productivity due to poor human capital formation, inefficient public services, and governance problems.
  - High poverty and limited social protection: nearly half the population lives on less than US$2 per day; social spending per capita is one-fourth of the Latin American average.

### Recent macroeconomic performance and shocks
- Sharp recession followed by recovery:
  - GDP fell by 2.3 percent in 2002, driven by the regional crisis, drought and foot-and-mouth disease in agriculture, and a banking crisis.
  - Inflation accelerated to 20 percent in early 2003, then eased to 9 percent at year’s end.
  - A bumper harvest produced positive GDP growth of an estimated 2.6 percent in 2003.
  - The economy grew by almost 3 percent in 2004 despite a drought affecting soy production.
  - The nonagricultural economy remained stagnant during the initial recovery.

### Political economy for reform
- Political environment improved but remains fragile:
  - President Duarte Frutos advanced political and economic reforms despite not having a majority in the Senate and faces fragile congressional support.
  - Opposition parties often resist initiatives for political reasons; special-interest pressure and factions within the Colorado Party (who have benefited from patronage) pose additional obstacles to reform.
  - Reform efforts must confront pervasive governance problems that undermine public-sector efficiency and hinder change.

### Monetary policy and financial system developments
- Monetary policy:
  - Monetary policy has been geared toward a flexible exchange rate regime after the de facto currency peg was abandoned in 2001.
  - The Central Bank of Paraguay (BCP) limited domestic money supply growth mainly through sales of Letras de Regulación Monetaria (LRMs).
  - LRMs stock grew from PARG 300 billion at end-2001 to around PARG 1.6 trillion in mid-2004.
  - Interest rates on LRMs declined from a peak of 33 percent in August 2002 to 9½ percent by April 2004.
  - Base money growth accelerated sharply in 2003 as the economy remonetized after the banking crises.
  - Some de-dollarization occurred: share of deposits in foreign currency fell from 69 percent at end-2002 to 64 percent in mid-2004.

- Financial system:
  - Deposits largely recovered from the sharp drop in the 2002 banking crisis and continued to rise in 2004.
  - While the financial system improved, weaknesses persist (as detailed in subsequent chapters).

### Banking sector, credit, and liquidity
- Credit to the private sector fell by 4 percent in May 2004.
- Higher deposits and falling credit left banks in a highly liquid position.
- Much of this excess liquidity has been deposited in the central bank, contributing to the decline in the growth rate of base money.
- Nonperforming loan (NPL) ratios have begun to decline, although—at 13 percent for private banks—they remain high, while provisioning requirements are still low.
- Profitability of the banking system remains low, with several banks continuing to produce losses.
- Several banks have closed or reduced significantly their operations in Paraguay over the past two years.

### Fiscal situation and public finances
- The consolidated balance of the nonfinancial public sector (NFPS) moved from a deficit of 3.1 percent of GDP in 2002 to balance in 2003 and a higher-than-expected surplus of 2½ percent of GDP in 2004.
- The primary balance improved markedly, as interest payments as a percent of GDP stabilized owing to the sharp reduction in debt-service payments arrears and low international interest rates.
- Main features of the improvements in 2003:
  - (1) expenditures were tightly controlled throughout the year in the central government, and
  - (2) tax collections increased sharply beginning in August 2003, owing to leadership changes in tax and customs administrations.
- The recovery of the exchange rate from the steep decline in 2002 contributed to an improvement of public enterprises’ outlook.
- In the medium term, public finances are expected to improve further.
- The approval of the Public Pension Reform Law (the caja fiscal) is expected to generate savings on the order of ½ percent of GDP in transfer payments.

### Exchange rate developments and real exchange rate assessment
- During 2003, the guaraní appreciated by 13 percent against the dollar.
- The general decline of the dollar in the world left the appreciation of the guaraní in real effective terms at 9.5 percent.
- In the first half of 2004, the currency appreciated somewhat further, despite central bank intervention.
- After the depreciation experienced by the economy in 2001 and 2002, the guaraní does not appear overappreciated in real terms when the fundamentals of the economy are taken into account.

### Structural reform, anti-corruption, and governance measures
- Structural reform remained a key priority in the government’s program.
- The government has reformed the public sector pension system and has begun to develop a reform plan for the civil service.
- A census of employees has been conducted to detect phantom workers and those collecting double salaries.
- Measures to improve transparency and governance:
  - Passage of the Fiscal Adjustment Law, with its elimination of tax loopholes and strengthened tax administration, will reduce corruption in the tax system.
  - Approval of the new customs code should reduce corruption associated with international trade and smuggling; the code grants operational and financial autonomy to customs and greatly expands its powers of investigation and enforcement.
  - Independent audits of numerous public entities are under way.
  - The procurement reform approved by Congress in 2002 is fully functioning for all public sector agencies; purchases must be made through a public web-based bidding process, and some entities are already reporting significant savings in procurement costs.
- Financial sector governance and supervision:
  - The Bank Superintendency has made progress in applying new supervisory requirements.
  - Implementation of the new bank resolution law has begun, with the deposit guarantee fund operating.

*Source: Paraguay: Corruption, Reform, and the Financial System (IMF), Sections 1–2*

### Section 1

### Paraguay: Corruption, Reform, and the Financial System

### Reform program and policy framework
- The new administration of President Nicanor Duarte Frutos took office in August 2003 and signed a 15-month Stand-By Arrangement on December 15, 2003.  
- Strategy focused on: restoring fiscal sustainability; improving public sector efficiency; strengthening the banking sector; improving governance; fighting corruption.  
- Policy measures included a comprehensive and balanced fiscal package (measures to increase tax revenues and spending restraint), actions to correct financial problems in certain public enterprises, and reform of the public employees’ pension plan.

### Structural constraints and governance
- Long-standing structural problems identified as key impediments to growth:
  - Political instability during the 1990s (coup attempt, assassination of a vice-president, resignation of a president, interim presidency).  
  - Serious governance problems: corruption, inefficiency, poor guarantees of property rights, and lack of transparency. Paraguay ranks consistently among the worst in perception of corruption surveys.  
  - Weak banking system with multiple crises that reduced the total number of banks from 35 to 14.  
  - Inefficient public enterprises in water, electricity, transport, telecommunications, petroleum, cement, and banking sectors.  
  - Low and falling productivity due to poor human capital formation, inefficient public services, and governance problems.  
  - High poverty and limited social protection: nearly half the population lives on less than US$2 per day; social spending per capita is one-fourth of the Latin American average.

### Recent macroeconomic performance and shocks
- Sharp recession followed by recovery:
  - GDP fell by 2.3 percent in 2002, driven by the regional crisis, drought and foot-and-mouth disease in agriculture, and a banking crisis.  
  - Inflation accelerated to 20 percent in early 2003, then eased to 9 percent at year’s end.  
  - A bumper harvest produced positive GDP growth of an estimated 2.6 percent in 2003.  
  - The economy grew by almost 3 percent in 2004 despite a drought affecting soy production.  
  - The nonagricultural economy remained stagnant during the initial recovery.

### Political economy for reform
- Political environment improved but remains fragile:
  - President Duarte Frutos advanced political and economic reforms despite not having a majority in the Senate and faces fragile congressional support.  
  - Opposition parties often resist initiatives for political reasons; special-interest pressure and factions within the Colorado Party (who have benefited from patronage) pose additional obstacles to reform.  
  - Reform efforts must confront pervasive governance problems that undermine public-sector efficiency and hinder change.

### Monetary policy and financial system developments
- Monetary policy:
  - Monetary policy has been geared toward a flexible exchange rate regime after the de facto currency peg was abandoned in 2001.  
  - The Central Bank of Paraguay (BCP) limited domestic money supply growth mainly through sales of Letras de Regulación Monetaria (LRMs).
  - LRMs stock grew from PARG 300 billion at end-2001 to around PARG 1.6 trillion in mid-2004.  
  - Interest rates on LRMs declined from a peak of 33 percent in August 2002 to 9½ percent by April 2004.  
  - Base money growth accelerated sharply in 2003 as the economy remonetized after the banking crises.  
  - Some de-dollarization occurred: share of deposits in foreign currency fell from 69 percent at end-2002 to 64 percent in mid-2004.

- Financial system:
  - Deposits largely recovered from the sharp drop in the 2002 banking crisis and continued to rise in 2004.  
  - While the financial system improved, weaknesses persist (as detailed in subsequent chapters).

*Source: Paraguay: Corruption, Reform, and the Financial System (IMF), Section 1*

### Section 2

### PARAGUAY: CORRUPTION, REFORM, AND THE FINANCIAL SYSTEM

### Banking sector, credit, and liquidity
- Credit to the private sector fell by 4 percent in May 2004.
- Higher deposits and falling credit left banks in a highly liquid position.
- Much of this excess liquidity has been deposited in the central bank, contributing to the decline in the growth rate of base money.
- Nonperforming loan (NPL) ratios have begun to decline, although—at 13 percent for private banks—they remain high, while provisioning requirements are still low.
- Profitability of the banking system remains low, with several banks continuing to produce losses.
- Several banks have closed or reduced significantly their operations in Paraguay over the past two years.
- Chapter 2 examines the impact of the financial crises on private sector credit.

### Fiscal situation and public finances
- The consolidated balance of the nonfinancial public sector (NFPS) moved from a deficit of 3.1 percent of GDP in 2002 to balance in 2003 and a higher-than-expected surplus of 2½ percent of GDP in 2004.
- The primary balance improved markedly, as interest payments as a percent of GDP stabilized owing to the sharp reduction in debt-service payments arrears and low international interest rates.
- Main features of the improvements in 2003:
  - (1) expenditures were tightly controlled throughout the year in the central government, and
  - (2) tax collections increased sharply beginning in August 2003, owing to leadership changes in tax and customs administrations.
- The recovery of the exchange rate from the steep decline in 2002 contributed to an improvement of public enterprises’ outlook.
- In the medium term, public finances are expected to improve further.
- The approval of the Public Pension Reform Law (the caja fiscal) is expected to generate savings on the order of ½ percent of GDP in transfer payments.
- Chapter 3 assesses the reform of the caja fiscal.

### Exchange rate developments and real exchange rate assessment
- During 2003, the guaraní appreciated by 13 percent against the dollar.
- The general decline of the dollar in the world left the appreciation of the guaraní in real effective terms at 9.5 percent.
- In the first half of 2004, the currency appreciated somewhat further, despite central bank intervention.
- After the depreciation experienced by the economy in 2001 and 2002, the guaraní does not appear overappreciated in real terms when the fundamentals of the economy are taken into account.
- Chapter 4 estimates the long-term equilibrium real exchange rate at the end of 2003 and the misalignment in the real exchange rate.

### Structural reform, anti-corruption, and governance measures
- Structural reform remained a key priority in the government’s program.
- The government has reformed the public sector pension system and has begun to develop a reform plan for the civil service.
- A census of employees has been conducted to detect phantom workers and those collecting double salaries.
- Measures to improve transparency and governance:
  - Passage of the Fiscal Adjustment Law, with its elimination of tax loopholes and strengthened tax administration, will reduce corruption in the tax system.
  - Approval of the new customs code should reduce corruption associated with international trade and smuggling; the code grants operational and financial autonomy to customs and greatly expands its powers of investigation and enforcement.
  - Independent audits of numerous public entities are under way.
  - The procurement reform approved by Congress in 2002 is fully functioning for all public sector agencies; purchases must be made through a public web-based bidding process, and some entities are already reporting significant savings in procurement costs.
- Financial sector governance and supervision:
  - The Bank Superintendency has made progress in applying new supervisory requirements.
  - Implementation of the new bank resolution law has begun, with the deposit guarantee fund operating.

*Source: _reform - Section 2*

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_Source: https://www.imf.org/-/media/websites/imf/imported-publications/external/pubs/nft/2005/paraguay/_reform.pdf_