Paraguay: Well Prepared for Shocks

President Horacio Cartes is pursuing an ambitious reform and investment program. (Photo: Paraguay Government)

Paraguay is well equipped to withstand external shocks


Most local pundits believe that during the administration of President Horacio Cartes the quality of economic management has improved sharply, with a number of highly educated and skilled individuals with private sector experience assuming critical roles within government. While this has contributed to change the popular perception of public service in the country, it is arguably only happening at the highest levels, with the further professionalization of government remaining a fundamental challenge.

Implementation capacity is limited. The Cartes administration is pursuing an ambitious reform and investment program to address critical infrastructure needs and other long-standing structural weaknesses. By most measures, however, implementation capacity remains quite limited, resulting in the long delay of many projects. Apart from potentially undermining the credibility of the government, which has issued substantial amounts of public debt to finance investment projects, failure to achieve their thorough implementation could also reduce the country’s medium-term growth potential, a double whammy, of sorts.

Economic activity remains buoyant. Real GDP grew a record 14.2 percent in 2013, as the agricultural sector rebounded from the previous year’s drought. The economy entered a soft spot early last year, but has since regained strength, with real GDP expanding 4.4 percent in full-year 2014, as agricultural output inched up offsetting a weather-related decline in electricity production (i.e. the main drag on growth). A recovery in electricity generation, lower oil prices, and the execution of infrastructure projects are expected to compensate for muted regional growth (especially in Brazil) and lower export prices (particularly soybean), causing the economy to expand around 4.5 percent in 2015, in line with potential, to post the highest growth rate in South America this year.

Fiscal revenues are growing at a very fast clip. According to preliminary estimates, government revenues surged 29.5 percent in the first four months of the year. While such an impressive outcome was partially offset by a 19.9 percent increase in expenditures during the same period, so far conditions are right for the Cartes administration to meet its stated goal of narrowing the deficit to 1.5 percent of GDP this year from 2.3 percent last year. While tax income (particularly VAT) remains the key revenue source, accounting for 85 percent of the total, royalties from the two hydroelectric plants contribute a sizable 11 percent of the total. Total revenues rose from 17.2 percent of GDP in 2013 to 18.2 percent in 2014 and are projected to increase to 18.7 percent this year.

Personal income tax has effectively become a tax on savings. After several years of delays, a personal income tax of 10 percent became effective in 2012. It is assessed on net income, i.e. the difference between revenues and expenditures, which means that if an individual can prove that he/she spent all the money he/she earned, he/she does not have to pay it. While its relative lenient assessment was intended to broaden the tax base by “formalizing” the economy, critics claim that the personal income tax has effectively become a tax on savings, something that in due time could elicit undesirable fiscal consequences as the population ages. Total income taxes currently represent less than 3 percent of GDP.

Commitment to meet fiscal targets remains firm. While the recently adopted Fiscal Responsibility Law (FRL) sets a deficit ceiling of 1.5 percent of GDP for 2015, the budget approved by congress calls for a deficit of 2.4 percent of GDP, as amendments introduced by the legislature authorize higher spending to be partially matched by, some believe, overstated revenue projections. Against this backdrop, the government has stressed the importance of respecting the FRL and has made it quite clear that it intends to comply with the 1.5 percent-of-GDP deficit ceiling by controlling current expenditure and fighting tax evasion, and to turn the FRL into a strong fiscal anchor. Interestingly, the recent depreciation of the guaraní (PYG) is expected to support overall fiscal performance, as the government has a natural hedge against a weaker currency from considerable USD inflows from the hydroelectric plants.

No external issuance is planned until 2016. Following the re-opening for an additional $280 million in late April to pay down existing debt of the $500 million 2023 global bond it placed in 2013, the government’s financing needs for 2015 have been fully covered. Since the government cannot issue any new debt without proper authorization from congress, it cannot execute any liability management operations without securing legislative approval first, which virtually rules out a surprise transaction during the remainder of the year. That being said, the government does plan to issue a new global bond for at least $500 million in 2016 to finance capex and roll over debt.

Hydroelectric plants continue to “turn water into dollars.” The production of two large hydroelectric plants, one operated jointly with Brazil (Itaipú) and the other with Argentina (Yacyretá), accounts for 10 percent of Paraguay’s GDP, 17 percent of its exports, and 11 percent of its fiscal revenues. By making more than 2 percent of GDP per year in royalty payments, the hydroelectric plants have become a steady source of income for the government. Moreover, once the $1 billion per year in payments made by Itaipú to Brazil’s Electrobras for the construction of the facility come to an end in 2023, the resulting savings will represent a massive windfall for the government, which it can invest in Itaipú-related capex or, as some have recommended, be utilized to establish a sovereign wealth fund.

Hydrocarbon discoveries could prompt a large positive shock. While lower oil prices have brought about significant benefits for Paraguay, as it imports its entire fuel needs, the recent discovery of hydrocarbons in the country could potentially trigger an even greater positive shock for the country. Since it is as yet unclear how large the deposits are or if they are commercially viable, however, further exploration is being undertaken. Should optimistic expectations be met and Paraguay become self-sufficient in terms of fuel, the economy would undoubtedly enter a new virtuous cycle.

Economic correlation to Brazil poses challenges, but also benefits. The Paraguayan economy is structurally correlated to the Brazilian economy. Indeed, Brazil is Paraguay’s largest trading partner, accounting for nearly 30 percent of its exports and the bulk of its re-exports. Accordingly, Brazil’s recent moderation in growth and currency depreciation have lessened demand for Paraguay’s products, contributing to temper activity in the country. The IMF recently estimated that a 1 percent drop in Brazilian growth reduces Paraguay’s output by 0.5 percent, and that a 10 percent real depreciation of the bilateral exchange rate has a similar effect. Not all is bad news, however, as, attracted by significantly (as much as 50 percent) lower operating costs (notably electricity and labor) and a favorable tax and regulatory regime, Brazilian companies have heavily invested in Paraguay’s maquila industry, which is dominated by auto parts and textiles, with the number of companies doubling over the past 20 months. Paraguay’s maquila regime is only 15 years old.

Franco Uccelli is Executive Director of Emerging Markets Research at JP Morgan. This column is based on a recent trip report. Republished with permission.