Asunción, Paraguay
April 11, 2001

Dear Mr. Köhler:

In 1999, the government of Paraguay formulated an action program for the period 1999-2003 aimed at addressing the economic and social problems that affect the country, increasing the efficiency of the economy, and opening the way for the resumption of economic growth on a sustainable basis. The government has already taken important measures, and has now specified, in consultation with the IMF staff, an economic program for 2001 to further the objectives of it's overall action program.

The attached memorandum of economic and financial policies describes the program for 2001, for which the government requests the continued monitoring by Fund staff. The government intends to keep the public informed about its policies and objectives, and will therefore publish this memorandum as well as report periodically on the progress made under the program, enhancing thereby the program's credibility and ensuring transparency.

The government is making substantive efforts to improve the coverage and timeliness of economic statistics, and will provide the IMF staff with the information necessary to monitor the program. In this context, the government will consult regularly with the IMF staff and keep it informed of the progress made in the implementation of the policies included in the program. Furthermore, a midterm review of program implementation is scheduled for July 2001.

Sincerely yours,

Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, DC

Attachment:
Memorandum of Economic and Financial Policies

I. Introduction

1. This memorandum describes the government's economic program for 2001, which was formulated in consultation with the staff of the International Monetary Fund. The government has requested the continued monitoring of its program by Fund staff, and intends to maintain the public informed about the program's content and the progress made in its implementation.

II. Recent Developments

2. Paraguay's growth performance over the last 20 years has been disappointing, with virtually no growth in real GDP per capita in this period. The country has suffered from a secular decline in terms of trade—by over 60 percent over the past two decades—owing in part to a dependence on exports of unprocessed agricultural commodities. GDP growth has been particularly weak during the last five years, averaging less than 1 percent a year compared with a population growth of 2½ percent. A banking crisis in 1995-98 led to lasting reductions in private sector credit and to high real interest rates. Partly as a consequence, private investment fell six years in a row. This was compounded by a 20 percent drop in the terms of trade between 1998 and 2000, and by the effects of the devaluation of the Brazilian real and a protracted recession in Argentina.

3. The economy remained stagnant during 2000, despite a strong fiscal stimulus during
1999-2000. Growth is expected to resume in 2001, with excellent weather conditions in late 2000 promising bumper harvests. Inflation was gradually lowered over the last decade, to almost 5 percent in 1999. During 2000, inflation edged up to 8.6 percent in December, mainly as a result of increases in fuel prices, public utility tariffs and a 15 percent raise in the minimum wage.

4. The public sector produced surpluses in the early 1990s, but its financial position eroded after 1995, to reach a deficit preliminarily estimated well in excess of 5 percent of GDP in 2000. Most of this deficit reflects a negative balance in the central government. While part of the deterioration was due to cyclical factors, as weak growth and a reduction of trade lowered tax revenues, higher spending remained the most important factor. Investment and capital transfers surged, financed in 1999 and 2000 by two important sources of external funds. In addition, the ratio of public sector wages to GDP increased from 8.4 percent in 1996 to 10.7 percent in 2000, largely reflecting a steady increase in the public sector workforce. Transfer payments to retired civil servants have also increased rapidly over the last five years, while interest payments began to pick up in 2000 as a result of the higher foreign debt.

5. At about 32 percent of GDP, Paraguay's external debt remains moderate. However, reflecting the widening public sector deficits, the level of external debt has risen fast since 1996, when it stood at 15 percent of GDP. Virtually all the outstanding debt is to multilateral agencies or foreign governments, and has a relatively long maturity, with over 80 percent of the outstanding amount maturing in ten years or more.

III. The Program for 2001

6. The government is determined to address the grave problems confronting the country, including in the economic structure, in attending to social needs, and in fighting corruption. Partly as a result of these problems, and also of adverse external developments, the financial situation has worsened markedly in recent years and requires immediate correction. The government's program aims to restore order to the public finances and allow the continuation of a prudent monetary policy, while making further progress in addressing deep seated structural problems, in order to create an environment conducive to higher growth over the medium term. To this end, the government has designed a medium term growth strategy that aims to foster competitiveness in the private sector and seeks to place the export sector as the main engine of growth. However, if external conditions continue to deteriorate, the resumption of growth, as well as the expected improvement of the current account, would probably not materialize as expected. Under such circumstances, the program and its targets would have to be adapted to the evolving situation in the world and in the region during the mid-term review.

7. In the program for 2001, real GDP is expected to grow at a rate of more than 2 percent, reflecting mainly a recovery in agricultural production and the positive effects on economic activity of a strengthening of private sector confidence. Notwithstanding the effects of the adjustment of public tariffs and of the depreciation of the exchange rate, the government expects to contain inflation in 2001 at a level similar to that attained in 2000. In the external area, increased output of the main agricultural export crops and the effects of the exchange rate adjustment are projected to result in a sharp reduction of the current account deficit.

A. Fiscal Policies

8. The financing of the public sector deficit registered in recent years has increased the public debt, taking away credit resources from the productive sectors, and thereby hampering the growth of the economy. The government, therefore, regards the restoration of balance to the public sector as a priority, and intends to exercise discipline in order to limit the central administration's deficit in 2001 to no more than G. 600 billion, about half the level registered in 2000. In terms of GDP, the deficit would decline from 4.5 percent to 2.0 percent. Given the seasonality of revenues and expenditures, the cumulative deficit during the year will not exceed G. 50 billion, G. 70 billion, and G. 170 billion at the end of the first¹, second, and third quarters, respectively. The corresponding targets, as measured from the financing side, and including the quasi-fiscal result of the central bank, are specified in Section I of the attached Technical Memorandum of Understanding (TMU). Moreover, the government intends to reduce the floating debt (arrears) in the execution of the budget, which at no point during the year will exceed the G. 380 billion carried over from the year 2000.

9. Revenues of the central government are expected to increase by around 0.3 percentage points of GDP between 2000 and 2001. The excise tax on diesel (which makes up 80 percent of the total fuel consumption) was increased in several steps from 5.5 percent in June 2000 to 14.1 percent in January 2001. At the same time, the tax base widened substantially, as the price of diesel was raised by over 100 percent. The full effect of these increases is expected to materialize in 2001.Yields on the profit tax of enterprises are set to improve, as the scope of a facility permitting banks to deduct increases in their required capital from profits, was limited. VAT revenues are expected to rise, as transport and personal services will be included in the tax base, and exemptions on goods in re-export trade are eliminated. Finally, net royalties from the Itaipú hydroelectric plant will increase, because the central government will not need in 2001 to compensate for payments arrears the electricity company was incurring before the adjustment of its tariffs (paragraph 13).

10. To strengthen the revenue base in the coming years, and contribute to equilibrium of the public finances while providing room to increase needed social spending, the government is preparing further measures in the tax area. The government intends to introduce a resolution modifying presumptive taxation in regard to the income tax and the VAT. The government will present draft legislation to Congress to widen the coverage of the VAT to personal services; impose the VAT on the import and distribution of oil products; increase excise taxes on luxury imports; concentrate the collection of the land tax (IMAGRO) on the 3000 largest landholdings; and reduce the scope of the tax exemptions granted to investors according to Law 60/90.

11. Expenditures of the central government are projected to decrease by around 2 percentage points of GDP. This reduction will be mainly the result of a tight budget passed in December 2000, and additional reforms aiming at creating a leaner and more cost-effective civil service. The current budget law includes provisions that permit a reduction of public sector employment, by requiring the elimination of all government vacancies existing at end 2000, and by ordering the elimination of an additional 10,000 government positions. Also, overtime pay will be reduced and public sector wages will be frozen in nominal terms. Spending on goods and services will also be curtailed, while interest payments are expected to benefit from lower LIBOR rates. Finally, capital spending will be scaled back from the extraordinary levels of 1999 and 2000, when the country spent the proceeds of two important sources of external funds.

12. Total external public debt rose to US$2,350 million at end 2000, including the external sources just mentioned, as well as arrears of the electricity company ANDE that were formalized in a long term loan. Net disbursements of foreign loans are not expected to exceed US$100 million in 2001, determining a target in the program for the stock of external public debt of US$2,450 million at end 2001, with intermediate quarterly targets as specified in Section IV of the attached TMU. Over the years, central government has issued around US$200 million in domestic debt, part of which remain in the public sector as assets of the social security system. The government is preparing a consolidation of the debt accounts so as to allow the monitoring of the total debt of the public sector. This work is expected to be concluded by June 2001.

13. The financial performance of the public enterprises is expected to improve this year as a result of tariff adjustments approved in the last quarter of 2000 and in early 2001. With a view towards its privatization, rates at the telephone company were restructured and aligned with those of international long distance and cellular competitors. Also looking towards private participation in the water and sanitation company, its rates were adjusted by 10 percent. Fuel prices were recently increased to reflect increases in oil prices (Paraguay imports 100 percent of its oil needs) and currency depreciation. Electricity rates will be increased by 2.6 percent per month from January to September 2001, to eliminate operational losses. The government will move to a system of more frequent adjustments of tariffs to reflect changes in operating costs. During 2001, it is expected that public enterprises will reduce their stock of debt and payments arrears.

14. During this year, the government will continue to intensify its efforts to improve tax administration, including implementation of recommendations of the 1999 FAD Tax Policy Mission. Over the past several months important strides have been made in this area, such as: the identification and removal of focal points of corruption in customs offices (as a result, customs tax receipts have already increased significantly); the designation of service providing agencies, such as credit card companies, real estate offices and trade companies, as fiscal agents for VAT collection on their clients' transactions; the closure of loopholes used by firms to evade their tax obligations by constituting themselves as nonprofit organizations; the narrowing of the scope of re-export trade and increased transparency of customs procedures applicable to it; the increase in the effective base for VAT collection from independent professionals; and the introduction of a "fiscal lottery" to provide incentives to consumers to request their VAT receipts. In the adoption of most of these measures, the government has sought prior agreements with affected sectors to elicit their cooperation in the tax collection effort. Although the government is confident that these measures will result in a significant increase in revenues, their potential has not been incorporated into the fiscal program's revenue projections.

B. Fiscal Structural Reforms

15. The reform of the state ranks among the government's main priorities. Last December, Congress approved Law 1626, modifying labor relations applicable to public sector employees. The objectives of the new legislation were: the unification of labor legislation applicable to all branches of the public sector; the establishment of clear parameters for a professional public sector career; improvements in controls on personnel appointments in the different branches of the public sector; the establishment of compulsory retirement parameters for all public sector employees (except for the military); the equalization of work hour requirements among different public sector agencies, and the rationalization of the use of remunerated overtime. Although Law 1626 does not eliminate present rigidities that impede the immediate reduction of the public sector work force, the government believes it goes a long way towards creating a more balanced application of labor regulations among all public sector employees, which should result in a more professional and dynamic public sector work force over the medium term. The new law has been judicially challenged by some affected sectors, and recently the Supreme Court has put an injunction on several important provisions of the law. The government is confident that it will find a satisfactory solution to this situation in the coming months.

16. Work is underway to close several government agencies, and studies are being conducted to restructure the central administration and the social security system. Congress has authorized budgetary resources only until June 2001 for entities that will be restructured, including the railroad, the National Housing Council (Conavi), the Municipal Development Institute (IDM), the National Indigenous People Institute (INDI), and Banco Nacional para la Vivienda (BNV). With financial assistance from the Inter American Development Bank, the government is preparing draft legislation for the reform of the Central Administration, as well as for the consolidation of the public financial institutions and the restructuring of the different social security agencies. While the restructuring of the Central Administration is to be completed within the next year, the reform of social security is expected to be a more lengthy process. In the meantime, however, the government will adopt the necessary measures to ensure that the Social Security Institute (IPS) continues to generate operating surpluses. Work is also underway on the preparation of the regulatory decrees for the concessions law, so as to permit the private management of road maintenance, the privatization of port and airport services, and the private operation of toll roads.

17. The government has pressed ahead with the privatization of the telecommunications and water and sanitation companies, ANTELCO and CORPOSANA. These two companies were transferred to the Reform Secretariat in the final months of 2000 in order to ensure an orderly transition from the public to the private sector during 2001. Regarding the telecommunications company, an international investment bank was chosen, through competitive bidding and with the assistance of the World Bank, to handle the privatization process, which was expected to be finalized in September 2001. Unfortunately, the winning investment bank recently withdrew its commitment, forcing the government to reopen the bidding process. This will probably delay the final privatization of ANTELCO by a few months. As to CORPOSANA, the process is underway to choose an investment bank to handle the incorporation of private investors to the company, which is expected to be finalized before the end of the year. The government has not included revenues from the sale of these enterprises in its projections for 2001 and, in any case, the government will consider such revenues as a financing item that will not justify increases in expenditure.

C. Financial Policies

18. The government is implementing a prudent monetary policy, aimed at maintaining the orderly financial conditions required for price stability and economic development. The Central Bank of Paraguay (BCP) will continue to conduct an active and independent monetary policy focused on lowering inflation and, given the need to preserve, and eventually strengthen, the level of international reserves, will allow the exchange rate to be determined by market forces. To attain these objectives, the program for 2001 specifies targets for the expansion of the net domestic assets, and the level of the net international reserves of the BCP. The increase in the net domestic assets will be limited to no more than G. 187 billion in 2001 and no loss of net international reserves will be allowed for the year as a whole. The corresponding quarterly targets are specified in Sections II and III respectively of the attached TMU.

19. The effects of the stagnation of the economy over several years have weighed heavily on the quality of banks' portfolio. Past due loans for the private banks increased from 9.3 percent of total loans at the end of 1999 to 11.8 percent at end 2000, while earnings declined from 2.2 percent of total assets to 1.4 percent of total assets over the same period. The increased risk perception reduced the banks' willingness to extend new loans. As a result, the banking sector remains highly liquid and should be well poised to finance the expansion of economic activity if the demand for loans increases with the improved economic climate. Low loan activity during 2000 permitted banks to concentrate on managing the quality of their portfolio, including strengthening loan provisions. The restructuring of significant volumes of loans in 2000 should lead to a moderate improvement in the quality of bank portfolios in 2001, and the expected pickup in economic activity should also help improve bank earnings and prospects.

20. The government will move towards a solution of the difficulties of Banco Nacional de Fomento that will respect the principles of maintaining adequate financing for small agricultural producers, protecting the payments system in rural areas, and minimizing the costs of this transition for both the bank and the state. To prevent the re-emergence of the factors that gave rise to the bank's difficulties, the solution to BNF's problems will have the following characteristics: a) the institution that will replace BNF will lend exclusively to small and medium sized producers only in agriculture, agro-industry and forestry: ² b) it will not have any special government guarantee; c) it will not have any privilege in the management of public sector deposits; d) it will be subject to the banking law and will be supervised by the banking superintendency; and e) it will not have any special tax advantages. The government will have a solution along the above lines defined by the time of the review of the staff monitored program (July 2001), with a view to its full implementation before the end of the year.

D. External Sector

21. The external current account deficit is expected to decline from US$315 million (4.2 percent of GDP) in 2000 to less than US$100 million (1.1 percent of GDP) in 2001. This improvement will partly reflect favorable harvest expectations for the two main export goods, soybean and cotton, which account for about 40 percent of total exports. Export volumes of both commodities are expected to grow by around 30 percent; with prices, however, expected to drop by 6 percent on average. Expected lower petroleum prices in 2001 should reduce the value of imports. Owing to the substantial reduction in the public sector deficit and an expected small real depreciation of the guaraní, competitiveness is expected to improve, promoting nontraditional exports and decreasing import volumes. On the other hand, the re-export business is expected to continue declining in 2001, reducing somewhat both export and import volumes. Net disbursement of foreign loans to the central government would fall by about US$40 million, while net international reserves are projected to remain constant in 2001, after a loss of US$218 million in 2000.

22. The government is committed to the process of implementing the external tariffs agreed among the members of MERCOSUR by January 1, 2006. Paraguay has removed tariffs on all goods, except sugar, imported from MERCOSUR. The sugar tariff remains pending agreement by the MERCOSUR partners on its final status. Paraguay is a moderately restricted economy. In 2000 exports and imports amounted to 40 and 46 percent of GDP respectively. Imports are not significantly hampered by nontariff trade restrictions and the government is seeking to obtain the removal of certain nontariff barriers affecting Paraguayan exports to its MERCOSUR partners.

E. Statistics

23. The Government of Paraguay is placing emphasis on strengthening the quality of its macroeconomic data. It has applied to join the GDDS, and for that purpose, a Fund multi-sector statistics mission visited Asunción in February 2001, and assisted the government in preparing metadata for posting on the IMF's DSSB. The government will nominate a GDDS Coordinator, and is aware that this is an essential step before posting. Paraguay had already received substantial technical assistance from the Fund during 2000 in the areas of balance of payments and monetary statistics. During the first semester of 2001, Paraguay will be able to compile and report its data according to the main principles of the new Monetary and Financial Statistics Manual. The government believes that substantial strides have been made in improving the quality and timeliness of fiscal data, particularly at the level of the central government. Shortcomings, however, persist in other areas of the public sector. Public enterprises and the social security system (IPS) continue to follow diverging accounting rules, and have so far not used the common computerized reporting system for the public sector, established by law 1535 in 2000. The central government is pressing for a speedy harmonization of accounting standards and will establish a uniform monthly reporting system during the first semester of 2001.

Technical Memorandum of Understanding

This memorandum presents a detailed definition of the variables included in the quantitative targets specified in the Memorandum of Economic and Financial Policies.

I. Cumulative Balance of the Central Administration ¹

Floor 2 (In billions of guaraníes)
Overall balance of the central administration and the result of BCP, from January 1, 2001 to:
March 31, 2001 (indicative)	-187
June 30, 2001	-303
September 30, 2001	-493
December 31, 2001	-711
1 As measured by the net financing requirement defined below. 2 Minimum cumulative balance.

1. The overall balance of the central administration (CA) is defined as the sum of the overall balances of the CA and the operating cash result (quasi-fiscal balance) of the Central Bank of Paraguay (BCP). For any given calendar quarter, the overall balance of the central administration is measured in guaraníes from below the line on the basis of information provided by the BCP as the sum of (i) its net domestic financing, (ii) its net external financing, and (iii) privatization proceeds as described below. Items denominated in foreign currency will be converted into guaraníes at the actual exchange rate. The target in this program incorporates the expected net changes in the floating debt of the central administration.

2. The CA net domestic financing comprises (i) the change in its net credits from the financial system excluding bonded debt; (ii) the change in its bonded debt (including bonds denominated in or indexed to foreign currencies) net of valuation changes; and (iii) its net asset transactions. Net external financing of the central administration is defined as the sum of (i) disbursements of project and nonproject loans, including securitization; (ii) proceeds from bond issues abroad; (iii) the net changes in short-term external debt; (iv) any change in arrears on external interest payments; minus (v) cash payments of principal on current maturities for bonds and loans; (vi) cash payments to settle any external arrears; and (vii) any prepayment of external debt. Privatization proceeds are defined as the cash payments received by the CA, net of changes in assets held abroad or at the BCP, converted to guaraníes at the actual market exchange rate of each transaction. Nonrecurring fees for concessions of public services, such as in the telecommunications sector, are treated as privatization proceeds. Proceeds from decapitalization of public enterprises will be considered as privatization. The result of the BCP is defined as interest earnings on gross international reserves (defined below) and on government bond holdings by the BCP, less interest paid, and less current expenditures of the BCP. For the purposes of the program, the costs of conducting monetary policy, i.e., the interest paid on Instrumentos de Regulación Monetaria (IRM) and call operations are excluded from the result of the BCP.

II. Cumulative changes in the net domestic assets (NDA) of the BCP

3. NDA of the BCP are defined as the difference between currency in circulation and the net international reserves (NIR) of the BCP (defined below), both measured on the basis of end-of-period data of the corresponding period. The NIR of the BCP are equal to the U.S. dollar value of gross international reserves of the BCP minus its gross reserve liabilities. Gross international reserves include BCP's holdings of gold, SDRs, Paraguay's reserve position at the IMF, foreign currency in the form of cash, deposits abroad, and Paraguay's net cash balance within the Latin America Trade Clearing System (ALADI); and exclude participation in international financial institutions (including Corporación Andina de Fomento (CAF), IADB, IBRD, Asociación Internacional de Fomento, and Bancos de Desarollo del Caribe), the holdings of nonconvertible currencies, and holdings of precious metals other than gold. Gross reserve liabilities of the BCP include all foreign currency-denominated liabilities of the BCP with original maturity of one year or less, and the use of Fund credit.

4. For the purpose of NIR calculation (a) dollar assets and liabilities will be valued at an Accounting Exchange rate of G. 3,545/US$; the gold holdings of the BCP will be valued at the accounting rate of US$270 per troy ounce; (b) liabilities to the IMF will be valued at US$1.3 per SDR; (c) gains or losses from gold-swaps and other operations will be excluded; and (d) non-U.S. dollar denominated foreign assets and liabilities will be converted into U.S. dollars at the market exchange rates of the respective currencies as of December 31, 2000. The ceiling on NDA will be adjusted upward (downward) by the equivalent in guaraníes of the downward (upward) adjustments made to the floor on the NIR of the BCP as described below.

III. Cumulative changes in the net international reserves (NIR) of the BCP

The floor will be adjusted upward by the amount of privatization proceeds held at the BCP.

IV. Stock of external debt of the public sector

This refers to the outstanding stock of external debt owed or guaranteed by the public sector including financing leases.³ Debt will be measured on a disbursement basis as reported by SIGADE and excludes reserve liabilities of the BCP. Debt in the form of leases will be calculated as the present value (at the inception of the lease) of all lease payments expected to be made during the period of the agreement excluding those payments that cover the operation, repair or maintenance of the property. The overall limit will be adjusted (1) upward (downward) by the upward (downward) revisions made to the actual debt stock at end-2000; (2) downward by the amount of debt held by public enterprises guaranteed by the central administration included in the SIGADE in the event these enterprises are privatized with their debt.

Structural Benchmarks

	Benchmark 4		Expected time of completion
1.	Modification of the presumptive taxation in regard to the income tax and the VAT (paragraph 10)		June 2001
2.	Presentation to Congress, among others, of legislation to widen the base of the VAT raise excise taxes on luxury goods, redefine the collection of the land tax and reduce tax exemptions under Law 60/90 (paragraph 10)		June 2001
3.	Privatization of ANTELCO and private participation in CORPOSANA (paragraph 17)		December 2001
4.	Definition of a solution strategy for the BNF (paragraph 20)		July 2001
5.	Full implementation of the solution for the BNF (paragraph 20)		December 2001
6.	Consolidation of debt accounts in the public sector (paragraph 12)		June 2001
7.	Harmonization of accounting standards across public sector (paragraph 23)		June 2001