AN ECONOMIC ASSESSMENT OF DUARTE'S TENURE

UNCLAS ASUNCION 000043

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TAGS: ECON EFIN PGOV PREL PA
SUBJECT: AN ECONOMIC ASSESSMENT OF DUARTE'S TENURE


1. (U) SUMMARY: President Duarte,s 2003-2007 economic
performance yielded mixed results. Macroeconomic stability
was achieved but a rigid expenditure structure, a visible
bias to support current expenses instead of public
investments, and a political rather than an economic spending
rationale undermined the economic impact of stability. Public
sector reforms significantly improved revenue collections but
failed to address, among other issues, the lack of
predictability in the judicial system and the inefficiency of
state-owned companies. Paraguay registered impressive
economic growth rates but most of the growth is attributed to
exogenous factors (good weather, high commodity prices, and
increasing remittances). The country,s competitiveness
declined, unemployment increased and, extreme poverty levels
deteriorated. The next (August 2008) government will have to
deal with these challenges, but it does not need to reinvent
the wheel. It will need an economic policy framework that is
independent of specific interests, provides incentives to
improve the business environment, promotes private sector
growth (especially for small and medium size enterprises) and
maintains macro economic stability. END SUMMARY


2. (U) President Nicanor Duarte Futros, 2003-2008 economic
plan identified most of the country,s economic challenges
but had mixed results in the execution. Key challenges
recognized included: a small, open economy vulnerable to
external shocks (high oil prices) and exogenous factors
(international commodity prices, weather conditions); a
rapidly growing population coupled with urban migration and
intellectual immigration; high levels of income inequalities
and poverty; a non-competitive economy with incipient
industrial capacity; sluggish growth rates compared to the
region; high levels of unemployment and sub-employment where
informal small and medium enterprises (SMEs) comprised most
of the economy activity; a weak financial system; limited tax
revenue collections; poor infrastructure for essential
services (communications, electricity, water) and commercial
activity (roads, rail lines, river ports); and, a labor
market that is mostly uneducated and lacks training. (NOTE:
The economic plan failed to mention state-owned companies and
a weak judicial system as key factors sinking Paraguay,s
competitiveness. END NOTE). Duarte,s economic plan addressed
these challenges in a policy agenda that focused on
macroeconomic stability, structural reforms, economic growth,
and poverty reduction. These themes have defined the economic
hits and misses of Duarte,s tenure thus far.

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MACROECONOMIC STABILITY -- IS IT THE BIGGEST HIT?
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3. (U) In general terms, Duarte,s administration achieved
macroeconomic stability (NOTE: Consensus among local
economists is that Duarte,s hands-off approach--minimal
political interference in his cabinet,s economic
policies--largely contributed to results. END NOTE). From
2003 to 2007, the government exercised fiscal discipline and
fiscal expenditure increases were offset by higher revenue
collections. From a fiscal deficit of 3.2 percent of GDP in
2002, the country moved to a surplus of 0.5 percent of GDP in

2007. Though prices experienced upward pressure and several
inflationary swings during 2007, effective Central Bank
interventions controlled and brought down inflation to
targets at an average annual rate of 6.0 percent. As an
indicator of financial sector stability, total bank deposits
doubled to USD 3.5 billion from 2003 to 2007 with a 10.5
percent increase in Guarani deposits during the same period.
International reserves almost tripled from USD 983 million in
2003 to over USD 2.3 billion in 2007. External debt declined
11.2 percent from 2003 to 2.1 billion USD in 2007 and, the
country,s long-term sovereign debt risk rating, as reported
by S&P, improved from B- to B. Paraguay renewed May 2006 its
Stand-by Agreement with the International Monetary Fund (IMF)
and received a very positive review and outlook on the IMF,s
October 2007 revision.


4. (U) Undermining the economic impact of the achieved
macroeconomic stability is the administration,s rigid
expenditure structure, its evident bias to make larger
increments in current expenses instead of capital
investments, and its incapacity to adequately prioritize
investments based on economic returns. From 2003 to 2007,
the annual distribution of expenditures remained roughly 83
percent for current expenses (around 70 percent is directly
or indirectly related to personnel expenses) and 17 percent
for capital investments. For the first 10 months of 2007,
the 18.3 percent increase in current expenses (mostly for
government jobs) was three times higher than the accompanying
6.2 percent increase in public investments. For public
investments there is no real cost-benefit analysis. Though
always framed within a tight fiscal framework, priorities
often follow a political more than an economic return. Out
of 64,310 km only 4,234 km of roads were paved during
2003-2006; and, electricity shortages in a hydro-power rich
country are two examples of under-investment.


5. (U) The 2008 budget had a USD 300 million increase (10.7
percent),from USD 2.6 billion to USD 2.9 billion. According
to Minister of Finance Barreto, the increase had no clear
financing sources and pushed the fiscal surplus into a
deficit. Barreto gained approval January 2008 to cut roughly
USD 200 million. (NOTE: With this budget cut the government
appears serious in its intent to maintain fiscal disciple.
The cut, however, is counter-intuitive. Most of the
increments were planned for government salaries and benefits.
With elections this year, there are growing fiscal
pressures, through increments in current fiscal spending, to
use the government,s political patronage and get votes. It
is early to see if the cuts will hold. The budget is due for
revision and adjustment May 2008. END NOTE).

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STRUCTURAL REFORMS - MORE MISSES THAN HITS
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6. (U) Perhaps the most important achievement of Duarte,s
structural reforms was the tax reform which simplified the
code, expanded the taxpayer base, and increased revenues.
From USD 582 million in 2003 to USD 1.4 billion in 2007 tax
revenues increased 145 percent. The number of taxpayers
increased 54 percent from 278,290 in 2003 to 429,851 in 2007.
Another public sector reform with modest results was the
reduction of illegally registered people in the pension
system. From 2003 to 2007, 14,700 illegally registered
individuals were removed from the pension system, saving the
government USD 47 million. The government missed the other
two public reform targets -- improving the quality of fiscal
expenditures and rationalizing the number of government
employees. The quality of fiscal expenditures, measured as
how expenses are allocated, deteriorated. The number of
government employees increased more than 15 percent from 2003
to 2007. (NOTE: Another public sector item in dire need of
reform but not addressed is the institutionalization of the
civil service. Most government jobs are still based on
political affiliation. END NOTE). Other reforms to improve
the business environment and promote private sector growth
yielded modest results: bank regulations and supervision were
strengthened; the number of procedures to export and register
new business was simplified; and, a new fund, Financial
Development Agency (AFD),facilitated the expansion of credit
to SMEs and low income housing through risk sharing
guarantees with commercial banks.


7. (U) The structural reforms excluded reforms to improve the
predictability and transparency of the judicial system and
failed to address the inefficiency of state-owned companies.
Paraguay,s judicial system is characterized by a lack of
independence and corruption. Efforts are needed to
strengthen the rule of law and make the judicial process more
transparent, unbiased and fair. Corruption, patronage and
bias are pervasive features of the current judicial system.
With regard to state-owned enterprises, powerful interest
groups oppose the attempts to privatize and reduce the role
of the government. Large state-owned companies (rail,
petroleum, cement, electricity, water, and basic and long
distance telephone services) employ thousands of potential
voters and are outlets for political patronage.

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ECONOMIC GROWTH UP - COMPETITIVENESS DOWN
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8. (U) Though 2007,s impressive 6.4 percent GDP growth rate
to USD 12.8 billion is Paraguay,s highest in over 20 years,
growth is tied and highly vulnerable to exogenous factors.
Growing world demand for commodities combined with high
prices and favorable weather to support Paraguay,s
commodity-based export expansion. Agriculture production
drove 66 percent of 2007 GDP growth rate. Soy and
soy-related products (54.1 percent),cereals (11.6 percent)
and meat (10.9 percent),represent 76.7 percent of 2007 USD
3.3 billion registered exports. On the external side, a high
internal consumption fueled by current expenditures and
remittances (over USD 250 million in 2007 according to the
Central Bank of Paraguay) also significantly contributed to
the GDP growth rate. (NOTE: An Inter-American Development
Bank,s study estimated Paraguay,s 2006 remittances at USD
650 million. Local economists 2007 estimates are at USD 800
million or around 6 percent of GDP. END NOTE).


9. (U) Mechanized agriculture production increased cultivated
land area and yields per hectare. In 2007 the yields for soy
increased 56 percent reaching 2.68 kilogram per hectare and
production totaled 6.5 million tons, 71 percent more than

2006. For 2008 the commodity export market outlook is
positive. Soy production fields expanded 10 percent and,
while it is early in the cycle, there have been adequate rain
levels. Farmers are already selling soy production for
shipment in May 2008 at an average of USD 270 per ton (farm
gate prices). Similarly, meat prices are at sustained high
levels for key export markets (USD 3,500 per ton for Chile
and USD 2,214 per ton in Russia) and, the expectation is that
growing global demand will continue to drive prices up.


10. (U) According to the World Economic Forum 2007 Global
Competitiveness Index (GCI),Paraguay has one of the least
competitive economies in the world. It ranks 121 out of 131
countries. Only Guyana (126) ranks lower in Latin America.
Except for macroeconomic stability, Paraguay,s
competitiveness is undermined by poor infrastructure, low
institutional capacity, scarce trained labor, limited
predictability in the regulatory and legal framework, and
market distortions from state-owned enterprises in the supply
of essential services (electricity and communications).

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NOT EVERYONE IS A WINNER
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11. (U) Income inequalities, extreme poverty, and
unemployment marked Paraguay,s 2003 to 2007 growth. The
percentage of people living in poverty increased to 42
percent in 2006 from 38.2 percent in 2005, with extreme
poverty growing from 15.5 percent to 21 percent. Most of
Paraguay,s growth benefited the capital intensive
agribusiness and pushed migration of unemployed rural workers
to urban centers. Mechanized agricultural production
supported the commodity export expansion but did not generate
jobs. Labor intensive crops such as cotton experienced
production volume declines of 55.1 percent in 2007. Total
unemployment (open plus hidden unemployment) increased from
9.4 percent in 2005 to 11.3 percent in 2006 and,
under-employment reached 24 percent in 2006. 58 percent of
5.9 million Paraguayan reside in urban areas, mainly
Asuncion. The expansion of mechanized agribusiness will
continue to displace workers. (NOTE: The next government
needs to accompany this production shift with policies to
encourage the growth of SMEs, especially along the agro value
chain. Though there are incentives to promote "maquilas",
Paraguay lacks a coherent policy to encourage and sustain
investment projects of labor intensive manufacturing
industries. END NOTE).

12.(U) COMMENT: Overall, the economic performance of
Duarte,s 2003-2007 tenure is below average and the next
government will have to deal with conditions similar to those
in existence when Duarte took office in 2003. The benefits
of Paraguay,s macroeconomic stability and explosive growth
did not reach the majority of the population. Powerful
interests groups continue to reap most of the gains. As
unemployment and sub-employment raises more people leave the
country, a disfranchised feeling, amid all the talks of
economic growth, exists and, the perceived lack of economic
opportunities pervades the economy. Sustained growth largely
depends on macroeconomic stability and the next government
does not need to reinvent the wheel. It will need, however,
an economic policy framework that is independent of specific
interests, prioritizes economic infrastructure, improves the
judicial system, attracts foreign investment, privatizes
state-owned enterprises, promotes private sector growth
(especially SMEs) and maintains the achieved macroeconomic
stability.

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