The FINANCIAL — On July 24, 2017, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Paraguay, and considered and endorsed the staff appraisal without a meeting.
Background
Despite a more challenging external environment, Paraguay has grown robustly. The economy gained momentum towards the end of 2016 and expanded by 6½ percent (y/y) during the first quarter of 2017. The ongoing economic expansion appears to be broadening across sectors, though private credit growth remains weak. On the supply side, robust growth reflects a record soy harvest, booming construction activity, and a rebound in the maquila industry. On the demand side, private investment and consumption have strengthened, alongside public investment. Inflation remains below the newly lowered target of 4 percent, though underlying inflationary pressures are rising.
Monetary policy remains accommodative, following two policy rate cuts in mid-2016, given well-anchored inflation expectations and sluggish credit growth. Fiscal policy has been characterized by restraint in current expenditures and a shift towards capital spending. The fiscal deficit outturn of 1.4 percent of GDP last year complied with the Fiscal Responsibility Law (FRL), implying a policy tightening.
Real GDP growth is projected to reach 4.2 percent in 2017, reflecting a more moderate pace of activity in the second half of the year. Investment will likely be a crucial driver of growth, as major infrastructure projects are undertaken. Consumption growth should also strengthen further. Given stronger domestic demand, the current account surplus is expected to narrow this year to 1.2 percent of GDP from 1.7 percent last year, despite solid export growth. Over the medium term, real GDP growth is expected to remain near potential of just below 4 percent. Risks around the outlook are to the downside, especially from heightened political uncertainty in Brazil.
Executive Board Assessment
Despite a more challenging external environment, Paraguay has grown faster than others in the region and momentum is broadening. Above-potential growth around 4 percent in 2016 and this year is well above main trading partners in the region and the Latin-American average. Part of this growth is also due to catch-up with levels of income per capita in other emerging markets and owes to a continued improvement in productive capacity, diversification of markets and strengthening of institutions. In addition, more recently, some positive supply shocks, mostly related to climate worked as tailwinds in agriculture and electricity, but signs are that economic momentum is broadening to other sectors as well as domestic demand.
The policy mix has been adequate and broadly supportive of activity but monetary accommodation should be gradually removed. Fiscal policy is expected to be neutral this year, maintaining the compositional shift towards capital spending and adhering to the FRL on the basis of budget outturns. Monetary policy has been appropriately accommodative to support the recovery towards the end of last year. However, as underlying inflation pressures rise and bank credit growth resumes, monetary policy accommodation should be gradually removed to maintain low inflation. The external position is now assessed to be stronger than implied by fundamentals and desirable policies. Draining excess liquidity through additional issuance of BCP paper (IRMs) and selling dollar reserves would help better align targeted policy rates with interbank rates, according to IMF.
The authorities have strived to comply with the FRL, but there is room for further fiscal reforms. The 2017 budget culminated in an unprecedented presidential veto, highlighting the need to strengthen the budget process and to reform the Public Financial Management (PFM) framework. To enhance the credibility of the fiscal anchor, it would be desirable to modify the assessment of FRL compliance to include the execution stage as well as the budget approval stage. The pension and health system also faces near- and longer-term imbalances and needs to be reformed.
Regarding monetary policy, the IT framework is serving Paraguay well but can be further strengthened. In addition to tighter operation of the policy corridor, predictability of foreign exchange operations could also be strengthened, given that dollar sales have not always been implemented as announced. Discretionary interventions in the foreign exchange market should continue to be limited to exceptional circumstances such as disorderly market conditions. In addition, high credit dollarization continues to limit the BCP’s ability to affect market interest rates. Finally, greater use of forward-looking policy guidance in public statements could enhance central bank communications and improve predictability of monetary policy.
The financial sector appears sound, though banks need to continue strengthening their balance sheets after a decade of rapid credit growth. The banking system remains profitable and reported capital ratios appear comfortable but the ongoing adjustment in bank balance sheets will take more time to complete. Broad-based measures of loan quality deteriorated over the year and remain at elevated levels. In response, banks have increased provisioning and NPLs remain manageable. There are signs that credit from unregulated non-traditional lenders is growing, but this remains a small fraction of credit.
The authorities have made important progress on introducing risk-based bank supervision, ratifying a new banking law in December 2016. However, the law is only part of a broader agenda to strengthen financial sector oversight that needs to advance. Authorities should make additional progress in crucial initiatives including: revisions to the BCP organic charter; establishment of a financial stability council; implementation of deposit insurance for savings and loan cooperatives; and integrating financial information through a single credit bureau. Furthermore, approving legislation regarding the Sociedades Anonimas and bearer securities in line with international standards should enhance entity transparency and could help safeguard correspondent banking relationships.
The authorities have advanced their structural reform agenda but further progress is needed. Progress has been achieved in several areas of the National Development Plan (NDP) with strategic infrastructure projects underway. Transparency and tax administration have been strengthened in several dimensions. However, additional effort should be made in removing institutional barriers in combating tax evasion and stepping up investment in transportation as well as electricity transmission and distribution, given large infrastructure gaps. In addition, to secure gains in terms of reduced inequality in the past decade, stronger implementation of the NDP priorities in education, training and expansion of conditional cash transfers will be needed. A tax reform that rebalances away from indirect taxation and maintains low income tax rates but limits deductions could improve progressivity and help finance these initiatives to promote more inclusive growth.
Data for surveillance is being strengthened. Paraguay recently implemented an enhanced general data dissemination (e-GDDS) system to make essential macroeconomic data available. Executive Directors encouraged the authorities to complete the remaining few steps to satisfy the higher special data dissemination or SDDS standards.
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