PARAGUAY: IMF MISSION BRIEFS AMBASSADOR

UNCLAS SECTION 01 OF 04 ASUNCION 000621

SIPDIS

STATE FOR WHA/BSC, WHA/EPSC, EB/IFD/OMA
STATE PASS TO USTR FOR SCRONIN, LYANG
USAID FOR AA/LAC ADOLFO FRANCO
TREASURY FOR OSIA MAUREEN WAFER
COMMERCE ITA SARAH COOK
NSC FOR MIKE DEMPSEY
SOUTHCOM FOR POLAD
US SOUTHERN COMMAND MIAMI, FLORIDA

E.O. 12958: N/A
TAGS: ECON EFIN ETRD PINR PA
SUBJECT: PARAGUAY: IMF MISSION BRIEFS AMBASSADOR


1. Summary: On May 3, the Ambassador received the
visiting IMF team, here for the fifth review of
Paraguays Standy-by Arrangement. The program remains on
track quantitatively, but faces some continued delays on
the structural reform front. The Mission Chief was not
overly concerned since, in his opinion, the GOPs reform
program was overly ambitious. The team commented that,
,
according to Finance Minister Borda, his relationship
with President Duarte is better than ever. Borda appears
to be keeping the fiscal deficit in line with program
targets despite the large deficit implicit in the budget
approved by Congress. The team was pleased with the
nomination of an IMF economist, Monica Perez, to take
over the Central Bank, and expressed their belief that
relations between Perez and Borda will be excellent. The
financial sector remains reluctant to lend, in part due
to very low recovery rates on bad loans driven by poor
regulation. The team felt that the key to increasing
Paraguays growth is robust structural reform and
positioning the country as a low-cost supplier for
Mercosur. The team was concerned about a threat received
by the IMFs technical advisor to Customs, which caused
him to depart the country. End Summary.


2. On May 3, the Ambassador hosted at his residence the
visiting IMF delegation, led by new mission chief
f
Alejandro Santos. The two-week mission to prepare the
fifth review of Paraguays Stand-by Arrangement is due to
conclude around May 11. IMF resident representative Luis
Duran, DCM, USAID Mission Director and Economic Counselor
also attended. During the wide-ranging discussion the
team expressed satisfaction with the GOPs sound
macroeconomic management, but noted that significant
structural reforms will be necessary to break Paraguay
out of its low-growth doldrums.

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BORDA, THE PRESIDENT AND THE BUDGET
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3. The Ambassador asked Santos about how he saw Bordas
standing with President Duarte. Borda told the team that
his relationship with the President has never been
better. Neither Duran nor Santos said they saw any signs
of micromanagement on the part of President Duarte, who
appears to have delegated significant authority for
economic policy to Borda and the rest of the Economic
Cabinet.

.


4. The team was cautiously optimistic that Borda, whom
they characterized as extremely cautious with spending,
could succeed in meeting the program target of a small
(half percent of GDP) deficit this year, despite the
unrealistic budget passed by Congress with its implicit
2.5% of GDP deficit. The two principal tactics are the
use of a financial plan (provided for in Paraguayan law
to more closely align revenues and expenditures) and the
Ministry of Finances Central Unit for Public Investment
(UCIP) to control public investment. The latter should
be fairly easy according to the team, since capacity
constraints make it difficult to effect budgeted
investment in any case. The first quarter results were
quite strong, with an overall surplus, suggesting that
Borda is on the right track.

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ON AN IMF ECONOMIST AS THE NEW CENTRAL BANK PRESIDENT
-------------- --------------

-


5. Monica Perez, President Duartes choice to succeed
Gabriel Gonzalez as President of the Central Bank (BCP),
is an IMF economist who most recently worked on the
Nicaragua team. The team was naturally pleased, and in
fact honored that one of their own was chosen to lead
the BCP. Duran said he knew her and Santos said she is a
top notch economist. Santos said her relations with
Borda are excellent as far as they know. While Perezs
family has a personal relationship with the Presidents
family, all agreed that her selection was a significant
signal from President Duarte about his commitment to
sound economic policy. He had a universe of options,
including non-technical political allies, but chose an
IMF economist, despite the existence of factions that
view the IMF as a problem for Paraguay.

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FINANCIAL SECTOR ISSUES
--------------


6. Financial sector intermediation remains a problem for
Paraguay. Real interest rates remain extremely high, and
and
despite the macroeconomic stability in Paraguay and the
region in recent years, financial sector demand for
liquidity remains strong. In response to the
Ambassadors question about the possible effects of
rising global interest rates, the teams financial sector
expert downplayed the impact. With real interest rates
so high, some increase in global rates will probably not
have a major effect. Financial institutions are driven
more by sentiment, and many firms self-finance, even now.


7. A Financial Sector Assessment Program (FSAP) team
visited Paraguay in late April and found significant
legal problems related to collateral recuperation.
Impediments are such that banks can expect recovery rates
near zero in most cases, a factor that clearly
contributes to banks reluctance to lend. Santos
commented on the need to create a capital market. Most
bonds remain paper-based, to include paper coupons that
must be signed by Minister Borda himself. Santos cited
ed
the dematerialization of bonds (allowing book-entry
issuance and trading of bonds) as a priority to deepen
local capital markets. Note: bond dematerialization is a
priority of Treasurys Resident Debt Advisor. End note.


8. When asked about the regulation of cooperatives, now
overseen by the National Institute of Cooperatives
(INCOOP) rather than the Superintendent of Banks as
originally preferred by the IMF, Santos remarked that
there is always room to improve. Nevertheless, INCOOP
has been willing to work with the World Bank and a global
organization of credit unions and is improving. The Fund
noted that the top 5 cooperatives have about 80% of the
cooperative sectors assets, making it possible to
minimize the systemic risk by focusing on a relatively
few institutions.

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STRUCTURAL REFORMS
--------------


9. Santos was relatively sanguine about structural
reforms, remarking that they have their own pace and
given their long-term focus, delays of several months are
e
understandable and not deleterious. He acknowledged,
though, that not all his colleagues share his view.
Audits of Paraguays State-Owned Enterprises (SOEs) are
behind schedule, but progressing. Delays were caused in
part by resistance from the Controller General, who
considered it unconstitutional for the Ministry of
Finance to be undertaking audits of SOEs. Finance won
the day, but the Ministry is just now receiving bids for
several of the audits.


10. Santos also took the view that Congress ought to be
respected, and its outputs accepted. If not ideal, the
task is to find a way to make the best of them. The team
noted that in most countries, they find themselves
prodding Finance Ministers to pick up the pace, whereas
they find Borda to be overly ambitious and often feel the
need to inject some reality into his plans. Certain
reforms, such as comprehensive banking legislation, are
languishing in part because Congress has been overloaded
with reform projects.

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THE PATH TO FASTER GROWTH
--------------


11. Paraguay has stabilized macroeconomically, and 2004
was one of the best years (high growth and low inflation)
in decades. However, per capita income barely improved.
As the Ambassador noted, Paraguays growth rate was below
the world average and significantly below the average for
Latin America. Santos remarked that stability for
Paraguay isnt enough. Reform of the largest public bank
(the BNF) is a top IMF reform priority, but in the teams
view, structural reforms to make Paraguay attractive to
Foreign Direct Investment (FDI) are the key to shifting
upward the growth potential of Paraguays economy.


12. Privatization of the SOEs is a principal avenue for
attracting FDI and the technology that would accompany
it. Paraguay is poor because productivity is low and not
increasing. Other examples of important issues affecting
Paraguays attractiveness for FDI include a rigid labor
market and judicial insecurity. The team thought that
that
Paraguay should make a stronger play for secure access to
the Brazilian and Argentine markets. With secure access
and Paraguays lower taxes and labor costs, the country
should be able to attract FDI, especially from Brazil and
Argentina. Comment: Paraguayan officials and
businesspeople charge that Brazil, in particular, used
varied means to preclude Paraguayan exports from gaining
a foothold in the Brazilian market and competing with
Brazilian producers. End comment.

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THREAT RECEIVED BY IMF TECHNICAL ADVISOR
--------------


13. The team was concerned about the recent departure of
IMF technical advisor to Paraguayan Customs, Ives Soler,
who is a French customs investigator. At a party on
April 27, an unidentified man approached Soler and warned
him he should be careful. Soler had received veiled
threats in the past and, after consulting with IMF
headquarters, decided to depart the country. He is not
expected to return, a significant loss for Paraguayan
Customs. Soler had been doing excellent work with
Customs and was a colleague of Treasurys Resident
Enforcement Advisor.


14. The team had raised the issue with Minister Borda,
who promised a thorough investigation. The Ambassador
urged the Fund to follow through and demand appropriate
action to minimize the chances that Solers departure
will be seen as a success for intimidation tactics.
Santos noted that customs revenues had increased on the
order of $400 million under the Duarte administration and
that prices had not risen commensurately, implying a
major hit to corrupt officials and tax evaders. Comment:
As reform efforts take stronger hold, we may see more
examples of intimidation tactics. End comment.

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NEXT STEPS
--------------


15. Santos was vague about the prospects for a follow-on
program. Borda has asked for one, but serious
discussions have not yet begun, and the President has not
t
yet signaled his support (nor his disapproval). Santos
noted that macroeconomic stability, the IMFs specialty,
has been achieved here. Nevertheless, Borda and others
argue that the Funds presence acts as a catalyst for the
reform process.

KEANE
E