IMF Executive Board Concludes 2012 Article IV Consultation with ParaguayPublic Information Notice (PIN) No. 12/85
July 20, 2012
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.
On June 22, 2012, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Paraguay.1
GDP growth slowed down markedly in 2011 and turned negative in 2012Q1. After a strong rebound in 2010, growth decelerated to 3.8 percent in 2011, reflecting both monetary tightening to contain inflationary pressures and country-specific supply shocks (cement shortages and an outbreak of foot-and-mouth disease followed by a beef export ban). A severe drought hit the country in late 2011-early 2012 causing large losses in the agricultural sector, especially for key export products (e.g., soybeans).
Inflation has declined below the central bank target, but core inflation has remained relatively high. After peaking in early 2011 (over 10 percent y/y), inflation began easing in the second half of 2011, reaching 5 percent (the central bank’s target) at year-end, and falling further to
3¼ percent in April 2012. This decline reflects mainly lower food inflation due to reductions in meat prices following the export ban, although tighter monetary conditions and a substantial appreciation of the guaraní also played a role in 2011. Despite a negative output gap, core inflation remained above the mid-point of the official target range, reflecting still strong domestic demand growth and one-off factors. On the back of monetary tightening, credit growth moderated to 19 percent in April 2012 (43 percent at end-2010). Growth of credit in U.S. dollars decelerated faster, though from a higher base, reflecting problems in the primary sector and reduced FX earnings. Against this background, domestic demand growth moderated and financial sector risks diminished.
The BCP began cutting interest rates in late 2011. It reduced the policy rate by 200 bps between November 2011 and February on the grounds of softening of inflation and risks from an uncertain global economic outlook, and by an additional 25 bps in May (to 6¼ percent), citing weakening domestic demand growth. The real policy rate, at around 1¼ percent, remains below its neutral level, which seems broadly consistent with the current negative output gap.
The current account deficit improved and international reserves continued to grow in 2011. The external current account deficit declined to 1¼ percent of GDP in 2011 (from 3½ percent of GDP in 2010) owing to better terms of trade, a stronger services account, and higher worker remittances. Strong capital inflows allowed the BCP to increase net international reserves by 1½ percent of GDP in 2011 (to 24 percent of GDP). Aiming at limiting excessive exchange rate volatility, the BCP continued to intervene on both sides of the market during 2011 and 2012.
Fiscal policy was slightly expansionary in 2011. The overall fiscal surplus declined by ½ percentage points to 1 percent of GDP, driven by a large increase in primary spending (especially capital expenditures). This implied a fiscal impulse (measured by the change in the structural primary balance) of ¾ percent of non-agricultural GDP. Revenue growth decelerated but remained strong, supported by continued improvements in tax administration. Public debt continued on a declining trend, with general government debt falling below 14 percent of GDP, one of the lowest in the region.
The banking sector has remained sound. Profitability is high and capital adequacy ratios remain strong. NPLs are low (2 percent in March), but have risen over the last year. More stringent provisioning measures and higher capital requirements became effective in January 2012, helping strengthen financial institutions’ buffers, while a program to bolster the prudential and regulatory framework of the cooperative sector is being implemented. Congress recently approved legislation to shift public sector deposits from commercial banks to a state-owned bank, which would pose a risk to financial stability. The initiative is on hold as the BCP has filed a suit with the Supreme Court challenging the legislation on constitutional grounds.
Real GDP is projected to decrease by 1½ percent in 2012. The strong contraction in the agricultural sector will be partially offset by a close-to-potential expansion in the non-agricultural sector. The latter, in turn will grow on the back of a strong fiscal impulse (3¼ percent of non-agricultural GDP), easy monetary conditions, and strong confidence. Lower agricultural exports will drive a widening of the external current account (to over 3 percent of GDP). Strong expenditure growth and a contracting GDP will result in an overall fiscal deficit of 2½ percent of GDP.
Executive Board Assessment
Directors noted that the Paraguayan economy is projected to contract this year as a result of a severe drought. However, a rapid turnaround in activity and strong growth next year are expected, on account of robust domestic demand, strong confidence, and normalization of weather conditions.
Directors agreed that the current mix of macroeconomic policies is appropriately supportive of economic activity and consistent with the inflation target in 2012. Noting that the non-agricultural sector is operating at close to capacity, Directors stressed the importance of not relaxing macroeconomic policies further. In light of the strong recovery expected for 2013, they also recommended that the authorities stand ready to tighten monetary policy if warranted, allow the exchange rate to adjust flexibly, and start withdrawing fiscal stimulus next year.
Directors commended the authorities for their fiscal prudence over the years. They supported plans to mobilize tax revenue for infrastructure and social spending. The priorities are to expedite the implementation of the personal income tax and limit exemptions, and further strengthen agricultural taxation and tax administration. Directors also saw scope for broadening the financial sector’s tax base and increasing its low VAT rate. Directors stressed the need to improve the allocation of scarce budgetary resources. Noting that the large increase in public sector wages will crowd out needed public investment, they called on the authorities to contain current expenditure growth.
Directors welcomed steps toward adopting an inflation targeting regime. They encouraged further efforts to enhance liquidity management and to strengthen the monetary framework and operations, including through the recapitalization of the central bank, and improved communication and coordination between the central bank and the Ministry of Finance.
Directors commended the authorities for the progress in implementing the 2010 FSAP recommendations and upgrading the AML/CFT framework. They emphasized the importance of addressing information gaps to improve financial sector monitoring, and recommended making greater use of macro-prudential tools. Further steps would also be needed to improve banking legislation, set up a high-level committee of regulators, and strengthen regulation and supervision for cooperatives. Directors expressed concern about legislation to abruptly shift to a state-owned bank sizeable public sector deposits kept at commercial banks. They noted that the measure has been put on hold and called on the authorities to consider appropriate alternatives to avoid adverse effects on the funding and liquidity of commercial banks.
Directors called for efforts to raise Paraguay’s growth potential and living standards. They encouraged the authorities to formulate a long-term strategy for improving infrastructure, human capital, and overall economic efficiency. Directors welcomed ongoing efforts to enhance the monitoring and performance of state-owned enterprises.