Paraguay special report 2014: Providing a solid base

Paraguay's economy is dependent on commodities: primary goods accounted for 24% of GDP in 2013, and agriculture 18%. This leads to volatility in GDP growth, especially in recent years, when a poor harvest in 2012 led to a contraction in GDP of 1.2%, but growth bounced back last year with a 13.6% increase in GDP. Moody’s estimates that growth in 2014 will be 4.8%, which is in line with the average for the past 10 years. That figure is strong, especially within the context of a wider economic slowdown, but comes from a low base.

How can Paraguay’s GDP volatility be reduced?

What is more important than volatility per se, is its effects on the economy. Volatility is a function of the economy’s reliance on the agricultural sector but the two key issues for the central bank are: does this sector impact the country’s fiscal position? Or does it negatively affect the financial sector? In both cases, the answer is no. Agricultural producers make enough margins to withstand any years of downturn and even after two bad years NPLs didn’t rise and we didn’t see any contagion from agriculture to other sectors or to the financial system. Also, the agriculture industry is not a big source of tax revenues - I am not saying that is necessarily a good thing but at least it doesn’t create fiscal problems.

There are things we can do to reduce volatility, and one of those is to diversify. Diversification is easy to say but difficult to implement, but the government is focusing on developing the construction sector and widening the economy’s industrial base. For the past 10 years our GDP has averaged 4.8% but I think that, in the medium term, trend growth of about 7% is achievable given improvements in investment in both infrastructure and technology.

The country plans radically to increase investment in infrastructure. What are the central bank’s views on funding this programme?

Today we have external debt of less than 10% of nominal GDP, and 3% domestic debt. Total debt is 12% of GDP. The IMF says that for emerging market countries a ratio of 60% is manageable. However my concern is not so much the ratio but how we get there. We are now at very low levels but that doesn’t mean we have to jump to 60% in five years – that would create a problem of liquidity when we get to repayment. We clearly have room to add debt. I don’t have a specific number in mind and it depends upon how fast we can implement infrastructure spending. What is more important is the need to be intelligent about how much we add and for what reasons. We need to be careful about the use of the proceeds. A country with so many infrastructure needs cannot afford a policy of no debt but we need to see it as an investment that, if we solve some logistics problems, will increase productivity across all sectors of the economy.

The central bank has been building up its FX reserves and the currency has been one of the region’s most stable. Is this a key policy goal?

The central bank is very aware that the best contribution we can give to the economy and to the people of Paraguay are the stable conditions that encourage the private sector to commit to the investment that is needed to create rent, increase employment and reduce poverty. Macro-economic stability is the basis for everything else – we are not going to put what we have achieved in the last 10 years in jeopardy. We just celebrated the 70th anniversary of our currency, which is an incredible achievement in a region that has been characterized by episodes of hyper-inflation. We are committed to a stable economy and currency and we are improving our monetary policy in line with that aim.

With regards to our reserves, I would like to emphasize the cushion that this [currently $7 billion including the recent sovereign issue, which corresponds to 22.6% of GDP] provides when we face external shocks. We have a flexible exchange rate – we are not shadowing the dollar – but it is important to have a level of reserves that is sufficient to deal with excess volatility. We are now a net creditor, our net reserves are 2.2 times our foreign debt and that puts us in a comfortable position. As well as demonstrating our ability to withstand external shocks it is also important to show foreign investors when they are thinking of bringing money to Paraguay that they can take money out whenever they wish. There is no restriction on capital leaving the country and we have sufficient reserves to ensure that free flow of capital.

Was the 2011 introduction of an inflation-targeting regime part of this drive for stability? 

Yes – that has achieved even lower and less volatile inflation than we had before. It wasn’t a serious problem in the past but now – with our target of 5% within a band of 2% – it has improved even further and has been averaging 4.6% since we introduced the target. And we are going to reduce the target below 5%, which will put us more in line with other serious central banks. I don’t want to commit to a time for that change in the inflation target [in January this year the bank lowered the bands from 2.5% to 2%] because the most important thing is to make that commitment only when we have certainty that we can meet that target. More important than the announcement is the bank’s credibility that it will comply.

And the new fiscal laws [which limit deficits to 1.5% of GDP and annual government spending increases to 4%] aims to boost the country’s international credibility?

We have had fiscal surpluses in eight of the last 10 years. That helps a lot with the central bank’s price control policy and even though we have had deficits in recent years [1.8% of GDP in 2012 and 1.9% in 2013] they have been very easily financed and haven’t created any major distortions in controlling inflation. Probably more important than the deficit discipline is the constraint it imposes on the pace of increase in current spending.

How well positioned is Paraguay’s financial system for the desired inflow of capital and businesses from abroad?

The financial system is key for our development and our growth strategy. We had a financial crisis [in 1995] that proved to be very costly in terms of fiscal resources and in terms of confidence of the public and credibility in the central bank. Since then the financial system has been in calm waters but we have to make sure that we continue in this ordered way. Like the economy, the financial system is quite new and, at about 45% of GDP in terms of credit and deposits, there is still room for growth. But we have to be smart about how we grow – this growth could be a major contributor to the country’s strategy but we have make sure the system remains stable and profitable – we don’t want any crisis.

What are you doing to prevent any issues, such as credit bubbles in the housing sector?

The central bank is currently working on modernizing legislation that is needed to put Paraguay’s financial system in line with international best practices. We will soon present this draft law for a new central bank charter and a law for financial entities, which will enable us to get closer to Basle II and Basle III. Our current 1995 law was about 20% compliant with Basle II – with recent improvements in regulation we are about 60% compliant but this new law will take us to about 95% compliance.

But the system is well capitalized at the moment?

Yes, capitalization is not the problem. Basle demands about 8% of risk-weighted assets and at the moment the Paraguay financial system holds about 17% - even if you just take tier one it is about 11%. As a matter of fact we have a minimum capital requirement of 10% so it is not a question of capitalization or solvency. The new law will provide the central bank with the flexibility to change some of the key credit ratios if we were to need to – we just want to have the tools in order to prevent any developments that could lead to a bubble or a crisis at some point in the future.