Document of The World Bank

FOR OFFICIAL USE ONLY Public Disclosure Authorized Report No. 47712-PY

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

PROGRAM DOCUMENT

FOR A PROPOSED

Public Disclosure Authorized FIRST PUBLIC SECTOR PROGRAMMATIC DEVELOPMENT POLICY LOAN

IN THE AMOUNT OF US$lOO MILLION

TO

THE REPUBLIC OF PARAGUAY Public Disclosure Authorized March 31,2009

Poverty Reduction and Economic Management Argentina, Chile, Paraguay and Uruguay Country Management Unit Latin America and the Caribbean Region Public Disclosure Authorized

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. REPUBLIC OF PARAGUAY FIRST PUBLIC SECTOR PROGRAMMATIC DEVELOPMENTPOLICY LOAN

Paraguay - Government Fiscal Year January 1 - December 3 1

Currency Equivalents

Weights and Measures Metric System

ABBREVIATION AND ACRONYMS AAA Analytical and Advisory Activities AGPE Auditoria General del Poder Ejecutivo (Internal Audit Ofice of the Executive Power) AI1 Auditoria Institucional Interna (Institutional Interal Audit) ANDE Administracidn Nacional de Electricidad (National Power Authority) ANN7 Administracidn Nacional de Administracidn y Puertos (National Port Authority) ANTELCO Adminstracidn Nacional de Telecomunicaciones (National Telecom Administration) APC Alianza Patridtica para el Cambio (Patriotic Alliance for Change) BCP Banco Central de Paraguay (Paraguay’s Central Bank) CAPASA Caiias Paraguayas Sociedad Anonima CAS Country Assistance Strategy CEDLAS Centro de Estudios Distributivos, Laborales y Sociales (Center for Distributive, Labor and Social Studies) CEP Consejo de Empresas Publicas (Council for State-Owned Enterprises) CGR Contraloria General de la Republica (National Comptroller General) CLYFSA Compaiiia de Luz y Fuerza Sociedad Andnima (Electricity Company) CONATEL Comision Nacional de Telecomunicaciones (National Telecommunication Commission) COPACO Compafiia Paraguaya de Comunicaciones Sociedad Anhima (Paraguay Communications Company) CORPOSANA State water company cos0 Committee ofSponsoring Organizations oftheTreadway Commission CPI Consumer Price Index CPS Country Partnership Strategy DDO Deferred Drawdown Option DGEEC Direccidn General de Estadisticas, Encuestas y Censos (General Directorate for Statistics, Surveys and Census) DGT Direccih General del Tesoro (General Treasury Directorate) DINAC Direccion Nacional de Aeroniutica Civil (National Aerospace Authority) DNA Direccidn Nacional de Aduanas (National Customs Office) DPL Development Policy Loan EC European Commission ERSSAN Ente Regulador de Servicios Sanitarios (Sanitation Regulator) ESSAP Ente Regulador de Servicios Sanitarios (Water Supply and Sewarage Authority) FOR OFFICIAL USE ONLY FCCAL State national railway FEPASA Ferrocarriles del Paraguay Sociedad Anonima (Paraguay Railways) FLOMERPASA Flota Mercante Paraguaya Sociedad Anonima FOCEM Fondo para la Convergencia Estructural del MERCOSUR (MERCOSUR Structural Convergence Fund) FY Fiscal Year GDP Gross Domestic Product GDPP General Directorate for Public Procurement GNI Gross National Income Gs. Guaranies (Paraguay local currency) GTZ German Organization for Technical Cooperation HHRR Human Resources HRM Human Resources Management IDB Inter-American Development Bank IFA Integrated Fiduciary Assessment IF1 International Financial Institution IGR Institutional and Governance Review IMAGRO Impuesto a la Renta de Actividades Agropecuarias (Agricultural Income Tax) IMF International Monetary Fund INC Industria Nacional del Cement0 (National Cement Industry) INTOSAI International Organization of Supreme Audit Institutions IRACIS Impuesto a la Renta Comercial y de Sewicios (Corporate Income Tax) IRP Impuesto a la Renta Personal (Personal Income Tax) JICA Japan International Cooperation Agency LAFE Ley de Administracidn Financiera (Financial Administration Law) LAPSA Lineas Adreas Paraguayas Sociedad Andnima (Paraguay Airlines) LTU Large Tax Payer Unit M&E Monitoring and Evaluation MDA Ministries, Departments and Agencies MDG Millenium Development Goals MECIP Modelo Estandar de Control Interno del Paraguay (Paraguay Standard Model of Internal Control) MERCOSUR Mercado Comun del Sur (Southern Common Market) MIDEPLAN Ministerio de PlanQ3cacidn de Chile (Minister of Planning of Chile) MOF Ministry of Finance NDP National Development Program OECD Organization for Economic Co-operation and Development OPBP Operation Policy/Bank Procedure PA1 Plan Anual de Inversidn (Annual Investment Plan) PC Partido Colorado (Colorado Political Party) PDPL Programmatic Development Policy Loan PEFA Public Expenditure and Financial Accountability PETROPAR Petrdleos Paraguayos (Paraguayan Oils) PFM Public Financial Management PIP Programa de Inversidn Publica (Public Investment Program) PR Procurement ROSC Report on the Observance of Standards and Codes SBA Stand-By Arrangements SENASA Sewicio Nacional de Saneamiento Ambiental SET Subsecretaria de Estado de Tributacidn (Undersecretariat of Taxes) SFP Secretaria de la Funcion Publica (Public Administration Secretariat) SIABYS Sistema Integrado de Administracidn de Bienes y Sewicios (Integrated Goods and Sewices Management System)

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization. SIAF Sistema Integrado de Administracibn Financiera (Integrated Financial Magement Information System) SIARE Sistema Integrado de Administracibn de Recursos del Estado (Integrated System of State Resources) SICCA Sistema Integrado de Control de Cumplimiento de la Carrera Administrativa (Integrated Compliance Control of Administrative Carrer) SIC0 Sistema Integrado de Contabilidad (Integrated Accounting System) SICP Sistema Integrado de las Contrataciones Publicas (Integrated Public Procurement System) SIGADE Debt Management System SINARH Sistema Integrado Nacional de Recursos Humanos (National Integrated Human Resources System) SIPP Sistema Integrado de Programacion Presupuestaria (Integrated System of Budget Programming) SISPLAN Sistema de Planijkacibn (Planning System) SITE Accounting System SNIP Sistema Nacional de Inversion Publica (National Public Investment System) SOEs State-Owned Entrerprises STP Secretaria Tdcnica de Planeamiento (Technical Secretariat of Planning) TI Transparency International TSA Treasuvy Single Account UAF Unidad de Administracibn Fianciera (Financial Management Unit) UNACE Partido Unibn Nacional de Ciudadanos Eticos (National Union of Ethical Citizens Party) uoc Unidad Operativa de Contrataciones (Operational Procurement Units) USAID United States Agency for International Development VAT Value-Added Tax WE3 World Bank WI World Bank Institute WHO World Health Organization

Vice President: Pamela Cox Country Director: Pedro Alba Sector Director Marcel0 Giugale Sector Manager: Nick Manning Task Team Leader: Alexandre Arrobbio Co-Task Team Leader: Jasmin Chakeri ACKNOWLEDGEMENTS

The First Public Sector Programmatic Development Policy Loan (PDLPI) was prepared by a World Bank team led by Alexandre Arrobbio (Task Team Leader), Jasmin Chakeri (Co-Task Team Leader), and including Henri Fortin, Jeffrey Rime, Enrique Fanta, Mariano Lafuente, Maria del Carmen Mifioso, Mariangeles Sabella, Fernando Lorenzo, Federico Guala, Marcelo Barg, AngClica Vanoli, Patricia Holt, and Mariela Alvarez.

The team gratefully acknowledges the support and guidance of Pedro Alba, Nick Manning, Marcelo Giugale, Todd Crawford, Rodrigo Chaves, Lily Chu, David Yuravlivker, Felipe Saez, Rossana Polastri, Alejandro Santos (IMF), Patricia Alonso-Gam0 (IMF), Montford Mlachila (IMF), Andrea Lemgruber (IMF), Ricardo Varsano (IMF), Luis de la Plaza, Patricia Mackenzie, Ed Mountfield, Barbara Mierau-Klein, Genevieve Boyreau, Robert Ragland Davis, Reynaldo Pastor, Ariel Fiszbein, Rafael Rofman, Juan Martin Moreno, AndrCs Pizarro, Verhica Raffo, Maria Angelica Sotomayor, Marco Arena, Peter Hansen, Graciela Sanchez Martinez, Maria Masutti, Pedro Luis Rodriguez, Gloria Dure, Karem Edwards and the reviewers of the Regional Operations Committee who provided valuable comments.

The peer reviewers were Jim Parks, Tony Verheijen, Robert Beschel and Rajeev Swami.

The team acknowledges and is grateful for the collaboration of the Paraguayan authorities.

REPUBLIC OF PARAGUAY PROGRAMMATICDEVELOPMENT POLICY LOAN TABLE OF CONTENTS I. INTRODUCTION...... 1 I1. COUNTRY CONTEXT ...... 1 Political Context ...... 1 Structural Constraints ...... 2 Recent Economic Developments ...... 3 I11. THE GOVERNMENT’S PROGRAM ...... 11 IV. BANK SUPPORT TO THE GOVERNMENT’S PROGRAM ...... 12 Link to CPS ...... 12 Relationship to Other Bank Operations...... 13 Collaboration with the IMF and Other Donors ...... 13 Lessons Learned ...... 14 Analytical Underpinnings ...... 15 V . THE PROPOSED OPERATION...... 16 Operation Description ...... 16 Policy Areas ...... 18 Component I:Tax System ...... 18 Component 11: Public Sector Financial Control ...... 19 Component 111: Expenditure Management ...... 23 Component IV: Human Resources Management ...... 25 VI. OPERATION IMPLEMENTATION ...... 27 Poverty and Social Impact ...... 27 Environmental Aspects ...... 28 Participation ...... 29 Implementation, Monitoring, and Evaluation ...... 29 Fiduciary Arrangements ...... 30 Disbursements and Audit ...... 31 Risks and Risk Mitigation...... 31 Annex 1: Letter of Development Policy ...... 34 Annex 2: Matrix of the Government Plan to be supported by the PDPL Series ...... 49 Annex 3: IMF Assessment Letter ...... 53 Annex 4: Composition ofthe Alianza Patriotica Para el Cambio...... 54 Annex 5: Political Risk Assessment - January 2009 ...... 55 Annex 6: Debt Sustainability Analysis ...... 57 Annex 7: Public Sector Overview ...... 59 Annex 8: Analytical Underpinnings ...... 61 Annex 9: Tax System - Detailed Diagnostic and Government Priorities...... 64 Annex 10: Public Sector Financial Control - Central Administration Internal Control - Detailed Diagnostic and Government Priorities...... 69 Annex 11 : Public Sector Financial Control - Effective Oversight of SOEs - Detailed Diagnostic and Government Priorities ...... 74 Annex 12: Expenditure Management -Detailed Diagnostic and Government Priorities ...... 81 Annex 13: Human Resources Management - Detailed Diagnostic and Government Priorities ... 90 Annex 14: Country at a Glance ...... 96 Annex 15: Government’s Anti-Crisis Plan and 2009 Financing Scenario ...... 98

REPUBLIC OF PARAGUAY PROGRAMMATIC DEVELOPMENT POLICY LOAN

LOAN AND PROGRAM SUMMARY

Borrower Republic ofParaguay Implementing Ministry ofFinance Agency Financing Data IBRD Loan Amount: US$lOO million Terms: Fixed spread loan (FSL) in US dollars with level repayment ofprincipal, comrnitment- linked, payable in 27 years, including an 8 year grace period, with all conversion options available. The front-end fee is 0.25 percent of the principal amount, payable out of loan proceeds. Operation Type First operation in a planned series ofthree programmatic DPLs. Main Policy Areas The proposed First Programmatic Development Policy Loan (PDPL) is intended to support the Government ofParaguay in implementing (i)its reform program to improve the public sector; and (ii)the 2009 anti-crisis plan aimed at smoothing the impact ofthe current international economic crisis on unemployment and poverty. The loan supports four areas ofpolicy reform: TaxSystem;

0 Public Sector Financial Control; Expenditure Management; Human Resources Management. Key Outcome Tax System Indicators TadGDP ratio increases by at least 0.9% ofGDP (Baseline (average 2004-2008): 11.9%) (20 12/13) Public Sector Financial Control The PEFA indicators for internal control and internal audit (PI-20 and PI-21) for 50 percent ofthe ministies and Secretariats are rated C (Baseline: 2008 Integrated Fiduciary Assessment rating for PI-20 and PI-2 1: D+) Finances and operations ofSOEs are transparent and subject to greater scrutiny by Government and civil society.

Expenditure Management Improvements are verified in the coverage ofthe social safety net through the increase of beneficiaries ofconditional cash transfers from Tekopora Program to 100,000 families in extreme poverty (Baseline: 2008 = 18,000). The quality ofpublic infrastructure is improved: periodic maintenance ofpaved roads (Baseline: 2008= 25% ofthe total network; Target: 2012= 50% of the total network

Human Resources Management Personnel recruitment and promotions are based on merit and professional skills.

Program In the short term, the DPL has the objective of(i) safeguarding the proportion ofbudgeted Development social expenditure during execution, as a contibution ofthe anti-crisis plan; and (ii)paving the Objective(s) and way for the reform process in the areas supported by the loan. Contribution to In the medium term, reforms supported by the proposed loan series will improve the CAS responsiveness and the credibility ofParaguay Public Sector through: Strengthening tax collections and improving the equity ofthe tax system; Improving the effectiveness ofinternal financial control for the Central Adrmnistration through the establishment ofa standardized internal control framework, and a professional and independent internal audit function; D Ensuring the State exert an effective oversight on state-owned enterprises (SOEs) through: the establishment of a consolidated institution acting as shareholder ofSOEs on behalf of the State; the adoption oftransparent and effective financial and business management rules for the SOEs; and the establishment ofa single independent regulatory agency; Improving the efficiency and equity ofsocial and capital expenditure with a view to better deliver public services; 0 Contributing to the professionalization ofthe civil service through the adoption ofmerit- based rules ofrecruitment and promotion ofcivil servants. Risks and Risk The risks associated with the PDPL are considered high. However, there is no risk ofnon- Mitigation compliance with the prior actions for the PDPL I,as they have already been carried out by the Government.

Economic risks are high. Given the Paraguayan economy’s sensitivity to regional and global shocks and the current international crisis, there is a high risk that the economic situation will deteriorate. A further decrease in the demand for Paraguay’s exports, as well as the effects of the ongoing drought, may generate a further slow down in economic activity. It could also provoke an increase in non-performing loans from the agriculture sector and put pressure on the financial system. Lower growth could also result in a higher fiscal deficit, given the presence of high fiscal rigidities and limited space for higher tax collection in the short run. Finally, there is a significant exchange rate risk as a large share ofpublic sector debt is denominated in foreign currency and dollarization ofthe financial system remains high. Mitigation measures could include (i)a fiscal expansion to mitigate the impact ofthe crisis on aggregate demand, currently under implementation with the Government’s anti-crisis package; and (ii)on the financial and monetary side, a flexible exchange rate policy, and additional measures form the Central Bank to ensure sufficient liquidity in the financial system to prevent a credit crunch.

Political risks are high. The administration’s political alliance is relatively fragmented and does not benefit from a majority ofseats in Congress.

Managerial and sustainability risks are high. The compounded effect of the limited capacities of public sector human resources and the insufficient inter-institutional coordination represents a high risk for successfully implementing the Government’s reform program. In addition, reforms of SOEs and the civil service will require legal changes and generating majorities in Congress. Mitigating measures could include enhanced dialogue between the political and social stakeholders of the Government reform plan, and financial and technical support from International Financial Institutions and donors. Operation ID P113457 REPUBLIC OF PARAGUAY PROGRAMMATIC DEVELOPMENT POLICY LOAN I. INTRODUCTION 1. The proposed US$lOO million Programmatic Development Policy Loan I (PDPL I) to the Republic of Paraguay is the first in a planned series of three operations aimed at supporting fiscal management and public sector reforms. The programmatic series as envisaged under the FY09-FY 13 Country Partnership Strategy (CPS) would total US$200 million, representing approximately 40 percent ofthe indicative CPS envelope. These three loans are expected to be executed sequentially between FY09 and FY 11, with tentative envelopes of US$lOO million for the PDPL I,followed by US$50 million for each of the two subsequent loans.

2. The operation has been conceived within the context of the FYO9-13 CPS to support the implementation of the Government Plan and the anti-crisis plan. Building on the dialogue developed with the Government, the Bank intends to contribute through this operation to the Government Plan’s overall objective of achieving sustainable and more equitable growth by providing direct support to three of its pillars: (i)macroeconomic policy; (ii)state-owned enterprises (SOEs); and (iii)state modernization. The Bank operation will also be included in the International Financial Institutions (IFIs) contingency package totaling US$300 million, which is one ofthe components ofthe anti-crisis plan’ aiming at creating fiscal space to soften the impact of the crisis through an increase in public investment and prioritized social expenditures. The operation will focus on four program components: (i)tax system; (ii)public sector financial control (Central Administration and SOEs); (iii)expenditure management; and (iv) human resources management.

11. COUNTRY CONTEXT 3. The election of Mr. Lug0 as president could provide both opportunities for change and major challenges for Paraguay. Upon assuming office in August 2008, the administration signaled its commitment to achieve a sustainable and equitable economic growth path, improve governance and reduce corruption, while addressing the urgent needs of Paraguay’s most vulnerable groups. However, the Government ‘.will confront significant challenges in pursuing these goals due to the political context, the effects of the international financial and economic crisis, and Paraguay’s specific structural and institutional constraints.

Political Context 4. After 61 years of leadership by the Colorado Party (PC), the election of Mr. Lug0 as President of the Republic leading the Alianza Patribtica para el Cambio (APC) represents a consolidation of democracy in Paraguay. Mr. Lug0 initiated his political mobilization in 2006, federating a number of mainly rural political parties and social movements2 into the Alianza Patribtica para el Cumbio (APC). Thereafter, he set up an alliance with the Liberal Party (PLRA), one ofthe main opposition parties. Finally, in August 2008, after running on a platform of commitment to traditional moral values, increased governance, and rooting out corruption,

’ The official name ofthe plan is “Economic Revitalization Plan” (Plan de Reactivacidn Econdmica). ’ See Annex 4 for the composition of the APC 1 Mr. Lugo’s APC won the presidential elections, overtaking the PC party’s candidate with a 10 percent margin of vote^.^

5. Mr. Lugo’s political alliance did not obtain a majority of seats in either of the two chambers of Congress. The Government coalition obtained 33 seats in the lower Chamber (41.4 percent) and 17 seats in the Senate (37.8 percent). Therefore, passage of each new law will likely entail broader coalition building efforts.

Structural Constraints 6. Paraguay’s public sector performance is poor and characterized by weak planning, policy implementation and service delivery. The public sector’s weak performance is clearly evidenced in its poor track record in social sector delivery, for instance in the prevention of epidemic diseases and reduction of infant mortality, as well as its difficulty in executing capital expenditure^.^ The causes of this poor performance have been examined in several analytical studies, undertaken by the Bank and other IFIs and donors, and are well known to the Government. There are many opportunities for improvement in areas ranging from (i)policy planning, (ii)resource allocation and budget execution: (iii)monitoring and evaluation; (iv) financial control; (v) institutional re-organization and development, and (vi) professionalization and depolitization ofthe civil service to name a few. However, the challenges to reforming the public sector go well beyond sheer political will and external assistance as they are deeply seated in a series ofstructural institutional constraints.

7. The legislative branch is endowed with a strong role within Paraguay’s division of powers, including attributions more usually held by the Executive. The National Constitution of 1992 inaugurated a new institutional framework for democratic Government in Paraguay. Inspired by the end of 35 consecutive years of dictatorship, this Constitution delegated strong power to the Legislature including, inter alia, influence over the determination ofindividual civil servant salaries and the control over the approval process for externally financed projects.’ In addition, per the Financial Administration Law (LAFE), the Legislature likewise has authority to increase total budgeted expenditures.6 The scope of legislative powers compounded with party fragmentation in Congress significantly undermines overall Government effectiveness, particularly as regards the Executive’s ability to embark on reform initiatives.

8. Government effectiveness in Paraguay is likewise affected by the prevalence of a clientelistic bureaucracy, and by the lack of inter-institutional coordination. On the one hand, the appointment and promotion of civil servants is politicized; there are notorious salary distortions and arbitrariness that negatively affect incentives; while a significant proportion of civil servants demonstrate low professional skills. On the other hand, inter-institutional coordination mostly takes place at the Minister or General Director levels and rarely involves lower level positions. The absence of adequate formal mechanisms for inter-institutional communication and coordination frequently leads to institutional duplication and overlap.

9. The present legal framework regulating the State makes change particularly difficult. There is no clear legal hierarchy of laws, which allows for annual budget laws to frequently breach LAFE provisions. Furthermore, weak compliance with legislative requirements as well as low technical quality of law drafting in many cases lead to partial

3 Mr. Lug0 obtained 766,502 votes, representing 40.9 percent out of a total of 1,874,127; while Ms. Ovelar obtained 30.6 percent. 4 On average the public sector has posted a 40 percent under-executionof expenditures throughout the last four years. 5 Even small non-refundable grants are being subject to this approval scheme. 6 Provided that new sources of revenue are identified. 2 implementation ofreform initiatives. This is illustrated, for example, by the incomplete and slow implementation of key legislation such as the Civil Service Law’ and the Fiscal Adjustment Law.’

10. High economic informality is a key impediment to reducing poverty and achieving sustained growth. Using a dataset of 32 Latin American and Caribbean countries during the early 2000s, a recent IMF study estimated the size of the Paraguayan informal economy at around 70 percent of formal GDP. It also identified labor rigidities as a significant factor contributing to this result.’ Sizable informal activities combined with low efficiency and corrupt practices embedded in the public sector induce high transaction costs, divert the allocation of resources away from key social investments, and erode the quality (and quantity) ofbasic public services. This, in turn, exacerbates the highly unequal distribution of income in Paraguay, and impose considerable disincentives to private investment (both domestic and foreign), thereby limiting economic growth prospects.

11. In response to the above structural and institutional restrictions, several reforms have been proposed over the last 20 years, the scope of which have been limited due to the political constraints which characterize Paraguay’s public sector. Significant institutional improvements were introduced during the early 1990s in the wake of the new Constitutional framework, such as a simplified tax scheme, the designation of a new Supreme Court of Justice, and the approval of a Financial Administrative Law of the State (LAFE). However, major subsequent public sector reform initiatives to address high levels of inefficiency and ineffectiveness, high politicization and widespread corruption within the public sector were systematically blocked, including civil service reform, the privatization of loss-making state- owned enterprises (SOEs), and more recently, the tax reform introduced in 2004.

Recent Economic Developments Economic Developments and Outlook

The Period of Economic Recovevy 2003-2007 Figure 2.2: Real GDP growth (annual % change) 12. Between 2003 and 2007, Paraguay experienced its biggest economic expansion since the 1970s, supported by a favorable external environment and sound macroeconomic policies. The country underwent a period of economic stagnation in the late 1990s and early 2000s which resulted from a domestic banking crisis and the negative fallout from the economic turbulence experienced by the Southern Cone at the time. The economic turnaround, which began in 2003, was supported by the favorable external environment, especially strong demand for Paraguay’s exports, and Source: Central Bank. an economic stabilization program, implemented by the previous administration which assumed office in 2003. As a result, average annual GDP growth reached over 4 percent between 2003 and 2007, and per capita GNI recovered to the 1997 pre-crisis levels.

7 Law 1626 of 2000. 8 Law 2421 of 2004. 9 International Monetary Fund WP/08/102: “Measuring the Informal Economy in Latin America and the Caribbean”. 3 Table 2.3: Paraguay: Key macroeconomic indicators 2004 2005 2006 2007 Real GDP growth ("h) 4.1 2.9 4.3 6.8 GDP per capita (US$) 1,205 1,267 1,546 1,997 CPI inflation (eop, % change) 2.8 9.9 12.5 6.0 Central government primary balance (% of GDP) 2.7 2.0 1.5 1.8 Central government overall balance (% of GDP) 1.6 0.8 0.5 1.o Current account (% of GDP) 2.1 0.2 1.3 0.8 Real effective exchange date (2000=100) 127.7 145.3 127.3 117.9

Source: Central Bank, Ministerio de Hacienda, IMF and Bank staffestimates.

13. This period of rapid growth was fuelled by a recovery in domestic consumption and investment. Private consumption recovered strongly and became the main driver of growth, accounting for 4.8 out of the 6.8 percent growth in 2007. Between 2005 and 2007, investment also recovered, increasing by an average of 8 percent a year. Exports were boosted by high international commodity prices. The production of soy, which accounts for 40 percent of total exports, more than doubled between 2001 and 2008. Agriculture grew at an average annual rate of seven percent in real terms, more than any other sector. The service sector also performed strongly, driven by trade, transport and communication. At the same time, imports grew even faster boosted by domestic demand, resulting in negative net exports.

14. Strong economic growth and improved tax collections boosted Government revenue. The 2004 tax and customs reforms were primarily designed to support the formalization of the economy. While tax revenue remain significantly below the levels observed in comparable middle-income countries, tax collections increased from 10.3 to 11.9 percent of GDP between 2003 and 2004 and have stabilized at around 12 percent since then." Total revenue - which also includes grants and royalties from the two hydroelectric power plants at Itaipu and Yacyreta - has remained stable at around 18 percent. With primary spending contained between 16 and 17 percent ofGDP, it was possible to achieve an average primary surplus of2 percent ofGDP up to 2007. The fiscal surplus initially contributed to the overall stabilization of the economy following the crisis, and, once growth recovered, signaled the Government's commitment to reduce public debt and accumulate savings.

15. Public debt levels are low. Sound fiscal Figure 2.3: Public debt policies, lower interest rates, higher growth and (% of GDP) the stronger guarani all contributed to a fall in 70% public debt. The public debt to GDP ratio, 60% including domestic debt by both the Government 50% and the Central Bank of Paraguay (BCP), 40% 30% decreased rapidly from over 60 percent of GDP 20% in 2002 to just over 30 percent in 2007 (Figure 10%

2.3)." Close to 70 percent of this debt is 0% external, of which 90 percent is owed to 2002 2003 2004 2005 2006 2007 E World Bank mer multilateral (mainiylPDB) multilateral and bilateral creditors, with the rest 0 Bilateral 0 mer elemal consistin of debt of the state-owned electricity I rn Domestic(ind. Cenhl Bankdebt) % company and commercial credit to SOEs. The Source: Staffcalculations bused on data from profile of Central Government debt is favorable Ministerio de Hacienda and Central Bunk.

10 With the exception of 2007, when tax revenues temporarily fell to 1 1.4 percent ofGDP. 11 While the Government's debt has been falling rapidly in recent years, the BCP accumulated debt through the issuance of significant amounts of sterilization bills. 12 Owed to Brazilian and Argentine state banks in the context of the binational hydroelectric power plants Itaipu (Brazil) and Yacyreta (Argentina). 4 because about 33 percent has a fixed interest rate (most of it at 3 percent or less) - while the remaining two-thirds that carries variable interest rates is owed to multilateral and bilateral creditors under generally benign conditions.

16. Paraguay’s external position strengthened in the period up to 2007. The current account has been in surplus since 2002, fkelled by high international prices of Paraguay’s exports, especially soy and meat. Since 2003, the surplus has remained at roughly 1 to 2 percent ofGDP, compared to an average deficit of4 percent ofGDP between 1997 and 2001. The strong rise in international commodities prices that began in 2007 resulted in a surge in foreign exchange inflows; coupled with higher remittances and royalties from the two hydroelectric plants - which put pressure on the guarani to appreciate from Gs.5,300/US$ at the end of2006 to below Gs.4,000/US$ in mid-2008. Between June 2007 and June 2008, the BCP accumulated US$1 billion in international reserves in an effort to contain the appreciation ofthe guaraniI3 (see Figure 2.6).

17. The financial sector recovered from the crisis in the early 2000s. The level of financial intermediation has improved, banks’ non-performing loans have been reduced to 1.1 . percent of total loans and the average capital adequacy ratio for the banking system is at 16.8 percent, which is above the regulatory floor of 10 percent.14 Credit to the private sector has been growing - 46 percent in nominal terms in 2008 (through September) - with banks accounting for 60 percent of total credit, and cooperatives and financial enterprises for the rest. Dollarization remains high but is on a declining trend: 39 percent ofbank credits to the private sector are now denominated in US dollars, down from 47 percent in 2005.

18. Despite progress in recent years, poverty and inequality remain high relative to other Latin American countries. Incidence ofmoderate poverty peaked at 46 percent in 2002, and has since then fallen to 35.6 percent. Extreme poverty has fallen from 21.7 to 19.4 percent during the same period (Figure 2.4).15 This fall suggests that the recent economic growth has been to some extent pro-poor. Despite this positive trend, poverty levels are now only back at the levels observed in the late 199Os, suggesting that poverty remains a structural problem. While moderate poverty used to be a primarily rural phenomenon, it has become more prevalent in urban areas in recent years.16 At 0.55, Paraguay’s Gini coefficient of income distribution is the fourth highest in Latin America (Figure 2.5). The richest 10 percent of the population accounts for between 42 and 47 percent oftotal income. Similarly,. inequality in land distribution is among the highest in the world. Reducing poverty and inequality in a sustained manner thus remains an important challenge, particularly with regards to access to productive assets, possibilities to accumulate human capital, and labor market opportunities.

13 The appreciation was due to increased foreign exchange inflows resulting from strong exports, higher remittances, and royalties from the hydroelectric power plants. 14 Even though the regulatory floor is above the Basel minimum of 8 percent of risk-weighted assets, it should be noted that Paraguay does not fully observe international capital adequacy standards. As a consequence, the ratio presented here tends to exaggerate the capital cushion of banks. 15 Extreme poverty increased slightly between 2006 and 2007, due to rising food prices. 16 This trend will need to be confirmed once the revised methodology for calculating poverty is in place. The World Bank is providing technical assistance to the National Statistics Institute for a revision of this methodology. 5 Figure 2.4: Poverty Incidence Figure 2.5: Inequality and extreme poverty

500 - %.ry CW. P-?JJY Prim. ::::350 - m. 0 300 - G"Nm.l. &.or 250 - * LAC 200- .%. IhrW 14 9 150 - 8 -..I R 13 0 cw. 32 100 - h!a- 13 8 50 - E S&v.lor 00, , Rru C& Ra bqabn. uupuw 20 VruD*l.

04W 0420 0440 0480 0480 05W 0520 0540 0560 0580 Source: Staff calculations based on household survey data.

Effects of the Ongoing International Financial Crisis 19. The administration's macroeconomic policy framework is appropriate. The administration is committed to continue implementing prudent macroeconomic policies, and is focusing on fiscal sustainability, improved competitiveness and equitable growth - as laid out in the Government's Strategic Economic and Social Plan for 2008-13 presented in September 2008. A key objective ofthe Plan is to create fiscal space, particularly on the revenue side, to dedicate more resources to priority spending programs, especially those aimed at reducing poverty. In order to achieve this, the Government is committed to maintaining inflation within single digits, gradually increasing tax collections through better administration and the introduction of new taxes, and improving the efficiency of public spending. The plan also envisages important reforms to SOEs that would help address the contingent liabilities that these companies represent.

20. At the same time, the unfavorable current external environment presents an important challenge for the Government's poverty reduction strategy. As a small open economy with limited access to international financial markets, Paraguay will be affected by the ongoing financial crisis primarily on the real side. Falling commodities prices and a decline in global demand for Paraguay's exports represent the main transmission channels and will especially affect the agriculture sector, a key driver of growth. The price of soy, one of Paraguay's main exports, has already fallen 42 percent since its peak in July 2008, and there are indications that demand for meat in some of Paraguay's main export markets has begun to decline. The harvest of other crops will also be affected by the ongoing drought in the region. With 32 percent of the workforce employed in this sector, unemployment is likely to increase, although both soy and meat production are less labor-intensive than other agricultural activities. Accompanied by a fall in remittances, which provide an important income source especially for poorer families, higher unemployment could lead to increased poverty rates.' *

17 For a more detailed treatment ofSOE issues, see Annex 1 1. 18 The fall in food prices would partially offset this effect. The uptick in extreme poverty in 2007 was most likely due to the strong increase in global food prices. 6 21. The effects of the crisis on Figure 2.6: Exchange rate and international reserves Paraguay's currency have already I become apparent. Mirroring the I 7.000 ,3.m devaluation of the Brazilian real as 6.000 3,000

investors fled to safety, the guarani 5.000 2,500 depreciated sharply in recent 4,000 2.m months. Accordingly, in October the BCP opted to sell international 3.000 1,m reserves to contain the slide in the 2,000 1,000 guarani (Figure 2.6). Since then, the 1.ow 500

currency has stabilized at around 0 0 Gs.5,000/US$. Although the BCP's intervention led to a loss of US$460 international resews (right axis) -Gs/US$ (le?, axis) million in international reserves, the foreign exchange cushion remains Source: BCP. comfortable and well above historical levels at US$2.8 billion (equivalent to 3.7 months of imports or 8.6 times the country's short-term external amortizations).

22. The current account has begun to deteriorate, but there are no signs of an impending balance of payments crisis. With trade representing the main transmission channel of the crisis, Paraguay's terms of trade have fallen as prices of its main exports continue to decline. Since exports are highly concentrated in a small number ofagricultural commodities, the decline in prices has had a noticeable effect on the trade balance, which - according to preliminary estimates - fell further into deficit in 2008, not least because imports continued to grow strongly throughout most ofthe year. As a result, a current account deficit of2.2 percent of GDP is estimated for 2008. This figure is projected to worsen moderately to 3.1 percent in 2009, reflecting a continued strong fall in commodity prices accompanied by lower oil prices and slowing domestic demand, which are in turn expected to also drive down imports. Another transmission channel is the fall in remittances as a result of the economic slowdown in countries hosting Paraguayan workers (especially the US, Spain and Argentina).lg The current account is thus projected to stay in deficit in the medium term. While there are no signs of ongoing or imminent large-scale capital flight2', foreign direct investment is expected to fall from the relatively high levels observed in recent years.

23. The deterioration in the real sector presents a significant risk for the financial sector. Credit grew rapidly between mid-2007 and mid-2008, raising some concerns over the quality ofbanks' credit portfolio. As a result, credit risk now constitutes the primary threat to the banking system. The expected economic slowdown will be more acute in agriculture (which accounts for 26 percent of outstanding bank credit) and the services sector. This may lead to an increase in non-performing loans, which currently account for only 1 percent of banks' loan portfolio. Preliminary estimates suggest that banks could withstand a moderate deterioration in their loan portfolio.

24. Although there is no liquidity crisis at present, banks have begun to prepare for an uncertain market. Banks have been improving their liquidity by reducing both their securities positions (instruments of monetary regulation) as well as lending. Multinational companies, which play a big role in financing agricultural activities, have also reduced their lending to

19 In 2008, remittances - as recorded in the balance of payments - amounted to US$200 million, approximately 2 percent of GDP. 20 Paraguay receives virtually no foreign portfolio investment. 7 suppliers in Paraguay. The potential decrease in liquidity in the economy and in the financial system is thus a reason for concern, as a segment of domestic firms may not be able to finance their working capital and medium or long-term investments.21 This generates high risks since productive activities, already committed, would not be executed next year, thus amplifying the economic slowdown.

25. The outlook for the non-banking financial sector is uncertain. Cooperatives in particular play a much more important roles in Paraguay’s financial system than in other Latin American countries. They account for 23 percent of total loans in the system and for 16 percent of total deposits22 and are strongly interlinked with the banking system through loans and deposits. As a result, a major crisis in the cooperatives sector could quickly become systemic. Unlike banks, financial cooperatives fall under the supervision of the National Institute of Cooperatives (INCOOP), whose supervision capacity is still weak. In addition, the regulations applied to cooperatives are weaker than those applicable to the banking sector, and cooperatives are not covered by the insurance deposit scheme. Information about the sector is scarce, outdated, and ofuncertain reliability, making it difficult to adequately assess potential risks.

Macroeconomic Outlook 26. Under a baseline scenario, economic growth will fall from an estimated 5.8 percent in 2008 to -0.5 percent in 2009, in line with global and regional growth forecasts. On the supply side, the growth reduction will result primarily from a fall in agricultural production caused by a decrease in soy and other agricultural commodity prices as well as reduced yields owing to the severe ongoing drought. Activity in other sectors, especially livestock production and re-exports ofmanufactured goods to Brazil, is also projected to slow down significantly. On the demand side, a slowdown in private consumption and private investment is expected in the short run, which will be compensated only partially by higher public spending as the Government implements its anti-crisis program. Exports and imports are projected to recover (albeit at lower levels than prior to the crisis) beginning in 2010. As a result, the current account is expected to improve but remain in deficit throughout the projection period. In the medium term, as global growth recovers, Paraguay is expected to converge towards a long-term growth rate of 4.5 percent (Table 2.4). Key assumptions for this baseline scenario are (i)the successful implementation ofthe Government’s priority spending programs in 2009 and the maintenance of higher levels of public investment; (ii)the recovery in global economic growth beginning in 2010; and (iii)a gradual recovery in commodity prices.

21 Estimates suggest that the unmet financing needs of the agriculture sector for the current season could be in the US$200-400 range. 22 Data as of June 2008. 8 Table 2.4: Medium term macroeconomic outlook (baseline) Est. Proj. 2008 2009 2010 2011 2012 2013 Real sector Real GDP growth (%) 5.8 -0.5 1.5 3.0 4.5 4.5 Gross domestic investment (% of GDP) 17.6 15.7 16.2 17.0 17.4 18.0 GDP (US$ million) 15,421 14,277 14,290 14,581 15,237 15,923 GDP per capita (US%) 2,477 2,254 2,218 2,224 2,284 2,346 Central government finances (% of GDP) Revenue 17.9 16.6 17.2 17.7 18.3 19.2 olw tax revenue 12.2 10.8 11.0 11.6 12.3 13.2 Expenditure 15.1 18.2 18.8 19.0 19.0 19.4 Primary balance 3.4 -1 .o -0.9 -0.5 0.1 0.5 Overall balance 2.8 -1.6 -1.7 -1.2 -0.7 -0.3 External sector Current account (% of GDP) -2.2 -3.1 -2.9 -2.6 -2.8 -2.9 Exports of goods (fob, % growth) 45.3 -18.1 2.9 6.4 5.8 5.8 Imports of goods (cif, % growth) 45.4 -15.4 1.8 5.0 5.9 6.0 Real exchange rate (% change) 10.9 -8.7 -2.4 -0.9 -0.4 -0.4 Key assumptions Commodity prices (DEC, % change) POL and other energy 39.7 -47.2 7.4 8.1 7.4 7.4

SOY 36.1 -25.4 -1.3 1.3 -0.3 -0.3 Meat 20.6 -17.1 1.9 1.8 1.8 1.8 Remittances (% growth) -7.0 -20.0 0.0 3.0 3.0 3 .O Source: Government and stafj'estimates and projections based on RMSM-X model.

27. Tax revenues will decrease in the short run as a result of the fall in trade. Revenue from import tariffs, which in 2008 represented 12 percent oftotal 2007 tax revenues, will fall, as will export-related revenue from the VAT as well as from excise taxes on hel.23 Collections from other taxes will grow more slowly as economic activity decelerates. Under the baseline scenario, tax revenues are expected to fall from 12.2 percent of GDP in 2008 to 10.8 percent in 2009, before recovering again in 2010. This recovery is expected to be supported by continued improvements in tax administration and tax policy. Total revenues will fall less as non-tax revenues are likely to increase, especially royalties from Yacyreta and Itaipu (which are denominated in US$). In addition to the exchange rate effect, the projections take into account additional royalties from Yacyreta in the amount of US$120 million based on a recently signed agreement.

28. Spending will increase, in line with the Government's plans to boost social programs and public investment, and the public sector wage increases mandated by Congress. Expenditure performance proved extremely low in 2008, especially with regard to capital spending, of which less than 50 percent was actually executed. The 2009 budget proposes an important expansion of social spending, and public investment is set to double, from Gs. 1,200 billion to Gs.2,400 billion (equivalent to 3.1 percent of GDP). Priority programs center on housing, an expansion of the conditional cash transfer program to cover 100,000 families (approximately two-thirds of all households living in extreme poverty), and land reform. In addition, Congress imposed a 5 percent salary increase for most public servants. An overall increase in spending from 15.1 percent to 18.2 percent is projected for 2009, subsequently stabilizing around 19 percent ofGDP.

29. The baseline scenario foresees a modest primary deficit for 2009 which will gradually improve as tax revenue recovers. Assuming that the Government is capable of implementing the ambitious spending goals set for this year, 2009 is projected to close with a

23 Paraguay does not levy any export taxes. 9 primary deficit of 1 percent of GDP. With principal repayments of 2.1 percent of GDP, and programmed disbursement of approved external loans reaching 1.3 percent of GDP, the remaining financing gap for 2009 is projected to be around US$350-380 million. Closing this gap will require substantial new (fast-disbursing) lending from Paraguay’s international development partners, as domestic options to issue long-term debt are limited.24 The proposed US$lOO million loan would be a crucial element of the Government’s financing plan. Another US$200 million are expected to be financed by other donors including the IDB, CAF and JICA.25 The Central Government also has close to US$700 million in deposits in the BCP, part ofwhich could be applied towards the financing gap if necessary.26

30. Paraguay’s debt burden and debt servicing indicators are manageable under reasonable assumptions. Under the baseline scenario, public debt levels will remain sustainable. Public debt27would increase from 19.3 percent of GDP in 2008 to 22.9 percent in 2010, and would then gradually fall to 19.1 percent by 2013. Under an alternative scenario in which the primary deficit expected for 2009 is maintained throughout the projection period, debt levels would be higher at 22.5 percent in 2013. Sensitivity analyses suggest that the main vulnerabilities of Paraguay’s fiscal accounts stem from low growth and a depreciation in the exchange rate, as a large share of public debt is denominated in foreign currency. Contingent liabilities - such as a major recapitalization ofbanks or SOEs - also pose a risk. If the economy grew on average 1.6 percentage points less than under the baseline scenario throughout the projection period, debt levels would reach 23.4 percent by 2013. A contingent liability shock or a 30 percent real depreciation over the baseline would have a much greater impact on debt levels, pushing them up to 29 percent by the end of the projection period. The details of this debt sustainability analysis are included in Annex 6.

31. There are important downside risks to the baseline macroeconomic scenario. The simulation of an alternative scenario suggests that an even more pronounced fall in commodity prices and a stronger reduction in Paraguay’s agricultural production resulting from the ongoing drought and/or a credit squeeze would have important effects on growth. The main assumptions for this simulation are as follows: (i)commodity prices for soy fall by an additional 10 percentage points in 2009 compared to the baseline scenario and continue depressed in 2010; (ii) the production of soy, wheat, corn and meat declines an additional 10 percentage points; (iii) remittances from Paraguayan workers abroad fall by 50 percent. Under this scenario, economic growth would fall to -2 percent and the current account deficit could increase to 5 percent of GDP in 2009 and 2010 (Table 2.5).28 The exchange rate depreciation would be even more pronounced than under the baseline scenario. This simulation suggests that Paraguay’s vulnerability to external factors remains high.

24 Domestic Government bonds are of short maturity (3 years) and are bought primarily by domestic banks. 25 In addition, the Government is planning to accelerate the approval of new IFIs’ investement loans. For more details on the 2009 financing scenario, see Annex 15. 26 Extensive use of these deposits would, however, have monetary implications. 27 Including debt by SOEs but excluding BCP debt. 28 The impact on the current account is dampened somewhat because imports will fall in response to lower domestic demand. 10 Table 2.5 Alternative macroeconomic scenario ’ 2009 2010 2011 2012 2013 Real GDP growth (YO) -2.0 0.5 2.5 3.0 4.5 Central government primary balance (YOof GDP) -1.6 -1 .o -0.7 -0.1 0.3 Current account (YOof GDP) -5.0 -4.9 -4.4 -3.2 -2.7 Exports ofgoods (fob, Yo growth) -24.2 2.2 6.3 5.8 5.8 Imports ofgoods (cif, % growth) -19.3 1.2 4.3 3.2 4.8 Real exchange rate (% change) -10.8 -3.1 -1.5 -0.6 -0.6

Source: Staflprojections based on RMSM-X model. 111. THE GOVERNMENT’S PROGRAM 32. The overall objective of the Government Plan, presented in September 2008, is to reach a more sustainable and equitable growth for Paraguay through four strategic objectives: (i)fostering growth with a focus on employment generation and improved income distribution while preserving a sound macroeconomic framework; (ii)strengthening Government institutions to improve the rule of law, policy making, and the delivery of services; (iii) improving the efficiency ofpublic sector social expenditures while focusing on extreme poverty alleviation; (iv) fostering economic development ensuring broader citizen participation. The Plan has been extensively disseminated and expressly supported by the President in several presidential addresses. It is also expected to formally constitute the cornerstone of the Government’s Program.

33. The Government Plan includes seven strategic pillars that address, in a comprehensive manner, relevant economic, social, and institutional challenges. Table 2.7 details the main objectives and actions foreseen for each ofthese pillars.

Table 2.7: The Seven Pillars of the Government Plan Stable macroeconomic policy framework, by controlling inflationary pressures and maintaining a sound fiscal stance through an increase in the tax burden, prudent management ofpublic debt, and a political agreement with Congress to address national priorities while maintaining fiscal discipline. Strengthened financial sector, by improving the efficiency and transparency of financial intermediation, including the supervision of the operations of financial cooperatives; broadening credit access; and generating middle- to long-term instruments to finance job-creating investments; Effective provision of services by state-owned enterprises (SOEs), through enhanced State oversight, improved business management, and increased private sector participation. Modernization of the State, by increasing the efficiency of State resource management, including the reengineering of State institutions; strengthening the effectiveness and transparency ofpublic financial control; and gradually introducing a merit-based and professional civil service. Enhanced productivity and competitiveness, by increasing physical infrastructure and logistics coverage, as well as training of human resources to achieve a more industrialized and diversified economy, with a focus on small & medium enterprise (SME) development, while assuring better access for Paraguayan products to international markets. Comprehensive land reform, by strengthening rural household agricultural units as providers of food security and sovereign; establishing new rural communities in accordance with pre-electoral agreements between the Government and rural social organizations; and providing better infrastructure and more equitable public services for rural areas. Employment generation and poverty alleviation, by generating better and more equitable employment opportunities, whle curbing chld labor; promoting SMEs job creation and labor-intensive public investment; and ensuring more equitable access to public services.

34. The Government adapted its Plan to prevailing economic and political developments. Several underlying assumptions and specific targets of the Government Plan were modified amid sudden and significant changes in the international economy and local political developments which have taken place over the last three months. For instance, the 2009 growth and revenue projections have already been reduced and the Government is now 11 considering alternative options with respect to its original plan to reach a political agreement with Congress. Despite these adjustments, the Government has signaled its willingness to fight to retain the overall objective of its Plan. Given the foregoing, the Government’s ability to keep its ”promise” will hinge on its ability to effectively and efficiently direct political decision-making, policy sequencing and targeting, and administrative management.

35. In light of the evident deceleration of the economy, the Government has announced its intention to implement an anti-crisis plan for 2009.*’ The plan consists of a set of monetary and fiscal policies: (i)injection of liquidity into the financial system; (ii)fiscal expansion to safeguard priority social and investment spending programs; (iii)provision of financing to the productive sectors through the second-tier state-owned development agency Agencia Financiera de Desarrollo (AFD); and (iv) mobilization of financing to ensure adequate resources for the plan, including approximately US300million in fast-disbursing IF1 loans and lines of credit to the AFD.30The fiscal measures are targeted to buffer the economy from the global slowdown. The plan thus aims to serve as an umbrella that will allow the Government to pursue its priorities of reducing poverty and ensuring employment amid the unfavorable economic en~ironment.~’Obtaining Congressional approval ofthe financing package ofthis Plan by April of this year will be paramount for the Government to move forward with the implementation ofits strategic objectives.

IV. BANK SUPPORT TO THE GOVERNMENT’S PROGRAM Link to CPS 36. This programmatic series of DPLs is a centerpiece of the 2009-2013 CPS. The three cross-cutting themes addressed by the CPS program - governance, poverty reduction, equitable growth - are supported by the series ofPDPLs. First, with up to 40 percent ofthe CPS envelope, the PDPLs will serve as the main instrument through which the CPS will provide direct support to the governance theme. Second, the PDPLs will contribute to the poverty reduction and sustainable growth objectives of the CPS by supporting both macro-fiscal stability and fiscal space through increased tax revenue and higher social and capital expenditures - which is critical in the context ofthe current global economic crisis. Third, there are strong synergies between the PDPLs and several other Bank operations in Paraguay. Finally, the PDPLs are expected to play a key role in donor coordination, as evidenced in the recent cooperation for the preparation of the PDPL Ipackage.32

37. In parallel with the PDPL I, the CPS is on track for Board consideration in May 2009. The CPS proposes to devote up to 40 percent of the US500 million FY09-13 indicative base case lending envelope to the series of Governance and Fiscal Management PDPLs. The program for the first two years of the CPS period also includes US$65 million for two pre- identified investment lending operations: Secondary Education Project; and Land Access and Administration Project. Programmatic non-lending activities will be focused on governance, poverty reduction, and growth. Governance programmatic non-lending advisory services will be intertwined with the PDPLs and will support achievement ofPDPLs actions and targets.

*’The anti-crisis plan is fonnally called “Economic Revitalization Plan” (Plan de Reactivacidn Econdmica). 30 The Bank would contribute to the financing of this anti-crisis plan through the PDPL I(USrSlOO million). The remaining US$200 million would be financed jointly by IDB, CAF and JICA. 3 1 See Annex 15 for more details on the plan. 32 See IV.3. Collaboration with the IMF and Other Donors. 12 PDPL I Component Corresponding CPS Outcome 1. Tax System Increased tax-to-GDP ratio (Baseline: 1 1.9% (avg 2004-08) Target: 12.8% (2013)) 2. Public Sector Financial Control (Central Increased effectiveness of internal control and internal audit function Administration and SOEs) (ugrade PEFA indicators for internal control and internal audit, PI- 20 and PI-21). Finances and operations of SOEs are transparent and subject to greater scrutiny by Government and civil society. 3. Expenditure Management Increase coverage for the conditional cash transfer program (Baseline: 2008: 18,000; Target: 100,000 in 2013) 4. Human Resources Management (HRM) Personnel recruitment and promotions are based on merit and professional skills.

Relationship to Other Bank Operations 38. The PDPL has strong synergies with the Road Infrastructure Project and the Water and Sanitation Sector Modernization Project. First, the three programs support the promotion of economic and equitable growth through public investment and the improvement of public service delivery to citizens. Second, the strengthening of the SOE sector is supported by the PDPL and the water sector project, as the latter foresees support to restructure the water company ESSAP and the sector’s regulatory agency. Third, the PDPL and the roads project both contribute to improving the execution of investment in infrastructure maintenance through the introduction ofbudget monitoring in~truments.~~

39. Complementarities also exist between the PDPL and the Public Expenditure Review (PER) and programmatic non-lending technical assistance foreseen in the CPS. The programmatic non-lending technical assistance will build on the dialogue developed by the PDPL I,with the purpose ofproviding advisory services and transfer ofknow-how needed by the Government to achieve its public sector reform goals.

Collaboration with the IMF and Other Donors 40. Paraguay successfully completed two consecutive Stand-By Arrangements (SBA) with the IMF in August 2008. Macroeconomic performance under the SBAs, which supported the previous Government’s economic reform program, was strong, with all outcomes (except inflation) under the second program exceeding program targets. The SBA also foresaw structural measures in four areas: (i)public sector reforms;34 (ii)financial sector reforms;35 (iii)pro-growth reforms, including strengthening the management of SOEs; and (iv) improving the social safety net by expanding coverage of the conditional cash transfer program. Most of the structural benchmarks were met, although there were delays in the implementation of results-oriented management contracts with some ofthe SOEs.

41. The authorities have not requested a new IMF program. While the Fund maintains an open dialogue with the authorities, there has not been a formal mission since the administration assumed office, except the Article IV consultation mission that has taken place in March 2009. The Bank and Fund teams consult each other regularly, through team meetings and in the virtual forum of the joint Bank-Fund collaboration website.

33 These two operations incorporated Governance components: the Road Infrastructure Project includes a Governance Action Plan, and the Water Sector Project foresees governance measures in terms of ESSAP governance and transparent financial management and procurement. 34 Including financial management, public investment system, tax and customs administration and pension reform. 35 Ensuring an adequate capitalization of private and public banks as well as the BCP and improving the regulatory framework for financial institutions. 13 42. Preparation of the PDPLs provides the opportunity to strengthen donor coordination on related policy areas. The PDPL Irepresents a significant proportion of the multi-donor program supporting the 2009 anti-crisis plan. The World Bank, IDB, JICA, and CAF are planning to co-finance the US$300 million emergency package. While the Bank and IDB are leading the work on distinct and complementary olicy areas, CAF and JICA are expected to provide further support to these policy areas.’ In addition, the programmatic approach ofthe PDPLs provides the Government and relevant development stakeholders with a roadmap to undertake reforms in the areas identified in the matrix in a sequenced and coordinated manner.37

Lessons Learned 43. The 2003 DPL provided a quick response to the Government’s financing needs, while at the same time taking advantage of the momentum for reform. The loan and the CAS were jointly presented to the Board within 4 months of the Government’s taking office, thus providing timely support to the new reform agenda.38 The lessons learned presented in the Implementation Completion Report (ICR) include the importance of strong national ownership of the operation; the beneficial role played by coalitions of support (both among political actors as well as international financial entities, in this case the IMF); and the delicate balance between political feasibility and depth ofreform.

44. The 2005 Financial Sector Adjustment Loan (FSAL) is also highly relevant for the proposed DPL. The loan only became effective in November 2006 due to delays in Congressional approval.39 The outcome of the first operation was considered moderately unsatisfactory. Accordingly, the Bank opted against proceeding with the second adjustment loan, due to the limited prospects of achieving sustained financial sector reforms. The ICR stresses that the design of the project was too ambitious given Paraguay’s political reality, including important capacity constraints and the antagonistic relationship between the Executive and the Legislature. For those reforms requiring legislative changes, the lessons learned suggest that it is important to adequately assess the existing political climate and the likelihood of Congressional approval, and to leave sufficient flexibility with regard to prior actions for subsequent operations. The ICR also suggests that it would be better to tackle a smaller number of selected changes, rather than a comprehensive reform ofsectoral reg~lation.~’

36 The Bank PDPL is expected to be the first operation of the multi-donor package to be approved and disbursed. 37 Each policy area supported by the PDPL currently benefit from a donor/IFI technical assistance program, including: IMF technical assistance on tax policy and administration; the USAID/Umbral Program and an IDB investment lending operation for public financial control; Bank and IDB funded technical assistance for the reform of the SOE sector; (in addition to the multi- donor anti-crisis package) two Bank investment loans (transport and water sectors) and an IDB investment loan for expenditure management; and, for the civil service reform, technical assistance from JICA and an IDB investment lending operation. 38 The loan covered five policy areas: (i)fiscal stabilization; (ii)tax policy; (iii)public administration and anti-comption; (iv) financial sector; and (v) public sector pension fund. 39 The loan’s objective was to strengthen the Government’s capacity to prevent the contagion effects of banking crises by addressing the weaknesses in the financial system. 40 First Programmatic Financial Sector Adjustment Loan - Implementation Completion Report (2007). 14 Analytical Underpinnings 45. The proposed PDPL is based on a series of analytical studies including those undertaken by the Bank, and reports prepared jointly with other donors. The substantial body of analytical work has provided the basis for an in-depth dialogue with the Government and has supported, jointly with the Government Plan, the design of the PDPL. Table 4.3 below shows the links between the policy areas and macro-economic framework included in the PDPL and the main findings and recommendations of this analytical work. Annex 8 also gives more details on the analytical work.

Table 4.3: Links between the PDPL and Prior Analytical Work PDPL Policy Area Analytical Work Macroeconomic Bank Policy Note on macroeconomic and fiscal policy (June 2008) Framework To achieve the Government’s key objectives (creating fiscal space for sustained investment aimed at enhancing growth and reducing poverty, while maintaining overall macroeconomic stability), fiscal policy would need to serve as a strategic tool anchored in a medium-term framework, rather than a reaction to the annual budget negotiationswith Congress. Recommendations also .included: (i) Strengthening revenue mobilization through better tax administration and the implementation of the Fiscal Adjustment Law; (ii)Controlling personnel spending through the articulation of a clear public sector wage policy; (iii)Improving expenditure efficiency through reforms ofthe budget process and the public investment program in particular. Tax System IMF Tax Policy and Tax Administration Assessments (September 2008) In the area of Tax Administration, priorities include implementing an effective human resources policy; strengthening the tax audit function; and re-organization of the Large Taxpayer Unit. In turn, proposed Tax Policy measures aim at increasing the tax pressure and tax equity by completing and improving the efficiency of taxes defined by the 2004 Fiscal Adequacy Law. Public Sector Integrated Fiduciary Assessment (IFA, 2008) & Non Lending Technical Assistance IFA Action Financial Control - Plan Follow-up (2008)’ jointly prepared by the Bank, IDB and the EC Internal Control for Control effectiveness is Paraguay’s main financial management and procurement issue. Main problems the Central identified in this area include: (i)internal control shortcomings in most expenditure categories; (ii) Administration ineffective internal audit function; and (iii)a weak control environment. Public Sector Bank Report on the Observance of Standards and Codes (ROSC) for Accounting and Auditing Financial Control - (2006) Oversight of State *Auditing standards for SOEs are extremely limited; in particular, annual audits in accordance with Owned Enterprises international standards are not mandatory; *Audited financial statements of SOEs are not required to be published. OECD Survey on Corporate Governance of SOEs in Member States (2005) The survey shows that the general trend for the organization of the ownership function was to move from the decentralized model - still valid in Paraguay- where ministries supervise SOEs related to their respective sectors, to the centralized model whereby a single entity acts as the SOE shareholder on behalf of the State. In all OECD countries, SOEs are audited annually by an international private audit firm and their financial statements are public. Finally, SOEs are usually public corporations and the regulatory framework is controlled by independent agencies. Expenditure IFA (2008) and Policy Note on Public Investment (2008) Management *Budget &edibility Ad efficiency affected by deficiencies in the areas of execution of budgeted expenditures; multi-year perspective in fiscal planning; and financial planning of annual cash flows; *Recommendations include: (i)the approval of a decree establishing a new conceptual and institutional framework for the ruling, organization and functioning of the National Public Investment System (SNIP), ensuring better coordination and a fluid communication between Ministry of Finance and STP; and (ii) a simplification of the process for approval of external grants and loans. Bank Transport Sector Assessment (2008): provides an overview of the institutional and resource challenges impacting the performance of transport sector investments in Paraguay. Bank Water Policy Note (2008) and project under preparation: provide the analytical basis for water sector. Bank study on Defining a Strategy for Social Protection Policy (2004): offers an inventory of existing programs and an analysis of the shortcomings of the current social protection system. Conditional Cash Transfers: Reducing Present and Future Poverty published by the Bank in 2009: it provides an extensive analysis of CCT programs in a variety of countries and provides extensive information on policy and design options relevant to Paraguay’s Tekopora program. United Nations’ International Poverty Center Evaluation of the Tekopora Program Human Resources Public Expenditure Review (2005) and Policy Note on Public Employment and Wage Bill (2008): Management (HRM) Need for strengthening the institutional framework of human resources management, achieving a consolidated control over the wage bill and gradually eliminating distortions in salaries and allowances. 15 V. THE PROPOSED OPERATION Operation Description 46. The overall development objective of the proposed Programmatic Development Policy Loan (PDPL) is to contribute to the effectiveness and efficiency of the public sector, while maintaining a stable macroeconomic policy framework. This will be achieved by: (i) improving revenue collections and the equity of the tax system; (ii)improving the effectiveness of Central Administration internal financial control; (iii)exerting effective SOE oversight to ensure sound and transparent financial management; (iv) improving the efficiency and equity of social and capital expenditures; and (v) contributing to the professionalization of the civil service. Those objectives are inter-related and address three main public sector outcomes: revenue stability, accountability, and public sector efficiency. Building on the lessons learned from previous operations, expected achievements are limited in scope, except for the area ofstate control of SOEs, and have been selected for their feasibility in terms ofpolitical space, maturity ofthe reform, and capacity. Few legal changes have been proposed and they have been analyzed with the Government in terms ofthe possibility to build a consensus around them.

47. The PDPL includes a series of three operations to be executed sequentially between FYO9 and FY11. Their respective tentative envelopes are US$lOO million for the PDPL Iand US$50 for each ofthe two subsequent loans. The PDPL includes four components: tax system; public sector financial control, covering Central Administration internal financial control and SOEs oversight; expenditure management; and human resources management. The policy matrix for the Program, including the prior actions for PDPL I, the appraisal triggers for the other operations, and the medium-term indicators, are presented in Annex 2.

Box 5.1: Expected medium-term outcomes by 2012-2013 Policy Area Supported I PDPL Medium-Term Outcome by the PDPL 1. Tax System Tax/GDP ratio increases at least 0.9% (Baseline (average 2004-2008): 1 1.9%). 2. Public Sector Financial Control Central The PEFA indicators for internal control and internal audit (PI-20 and PI-21) for 50 percent of Administration the ministries and Secretariats are rated C (Baseline: 2008 Integrated Fiduciary Assessment Internal Control rating for PI-20 and PI-21: D+) SOE Oversight Finances and operations of SOEs are transparent and subject to greater scrutiny by Government and civil society. PETROPAR current expenditures are reduced by 20% (Baseline: 2008: Gs. 4,278 billion). The share of capital expenditure over total expenditure increases for ESSAP from 8.5% (2008 baseline) to 20%, and for ANDE from 10.6% (2008 baseline) to 20%. 3. Expenditure Improvements are verified in the coverage of the social safety net through the increase of management beneficiariesof conditional cash transfers from Tekopora Program to 100,000 families in extreme poverty (Baseline: 2008 = 18,000) The quality ofpublic infrastructure is improved: periodic maintenance of paved roads (Baseline: 2008= 25% of the total network; Target: 2012= 50% of the total network). 4. Human Resources Personnel recruitment and promotions are based on merit and professional skills. Management

48. The operation has a direct link to the Government Plan. The operation aims to contribute to the Government Plan’s overall objective of achieving sustainable and more equitable growth through direct support to three of its pillars: (i)macroeconomic policy; (ii) state-owned enterprises; and (iii)state modernization. Addressing these three pillars will also have an impact on all seven strategic pillars of the Government Plan, in terms of policy responsiveness and effective delivery ofpublic service. Beyond the Government Plan, the areas 16 covered by the PDPL are relevant to Paraguay’s broader development challenge. The PIIPL could also be used as a Government tool for policy planning, inter-ministerial coordination, and monitoring of progress through its horizontal scope, the design of targets, indicators, and medium-term outcomes. It could likewise contribute to ensuring better coordination of IF1 and donor technical assistance for the fulfillment ofthose targets.

Strategic Pillars of Key Targets of the Stratgje PUPL Compbncnts Government Pian Pillars

Stable Macrwcononiic (‘ontrolling Inflationary Tax System policy ti-dme work + Prcssures Maintaining sound tiscol stance + Strengthened financial through increased tax burden sector and prudent debt inanagemetit

Effective Provision of + Restore Central Adniinistntion Services by SOEs Oversight on SOLS Public Sector Financial Control : Modernization nf the State Strengtheiiing financial control \r. e Catrai Administration + Public Financial Control SOEsoversight iinprobe Public Sector l~tiicienc):to achieve wtw \ ObJectiVeS Enhanced Productivity and Expenditure Mmgement Competitiveness L , Gradually Professionalize Civil Comprrhensive Land Service Reiorm t iuman Resources Emplojment Generation and Mansgement Poveny Alleviation

49. This programmatic operation takes into account Paraguay’s contextual and structural factors by providing support to feasible prior actions. Project components and actions have been selected considering the country’s most relevant development challenges and also take into consideration both structural institutional constraints and the current political context. In particular, prior actions and triggers were agreed with the Government by acknowledging the obstacles to implementation of former reform efforts, maintaining flexibility and also trying to minimize the risk ofpotential political gridlock. Maintenance of a satisfactory macroeconomic framework is not explicitly a prior action for the proposed operation or a trigger for subsequent operations in the series but, under OP 8.60, is nonetheless a fundamental requirement for development policy lending. The proposed PDPL program incorporates current good practice guidelines for development policy lending outlined in Operation Policy/Bank Procedure (OP/BP) 8.60, Development Policy Lending, as summarized in Box 5.2.

17 Box 5.2. Good Practice Principles on Conditionality Principle 1: Reinforce Country Ownership The Bank has actively cooperated with the Government since President Lugo’s victory in April 2008, including through the presentation to the then-President elect and his team of a set of policy notes (covering a wide range of issues crucial for Paraguay’s development) in June 2008. Project components are aligned with the pillars of the Government’s strategic economic and social plan for 2009-2013, which has been disseminated widely since the Government took office in August 2008. Principle 2: Agree upfront with the Government and otherfinancingpartners on a clear division of labor On macroeconomic and fiscal issues, the Bank and the Fund coordinate regularly, but there is currently no active Fund program. In addition, the PDPL is a significant part of a multi-donor funding package supporting the 2009 anti-crisis plan of the Government. Each PDPL policy area receives support from IFI/donor technical assistance programs spelled out in section IV.3. Development stakeholders coordinated their actions to ensure clear division of labor and complementary actions. Principle 3: Customize the components and structure of the operation to country circumstances The operation supports an important part of the Government’s reform program; the scope and sequencing of the programmatic series are based on a realistic assessment - reached in consultation with the Government- of the country’s capacity to implement these reforms. The programmatic series is structured in such a way as to accompany the reform process throughout the government’s terms in office, and to provide flexibility to respond to changes in the internal and external environment shaping the reform agenda. Principle 4: Choose only actions critical for achieving results as conditionsfor disbursement The policy matrix contains six prior actions for the first operation. These prior actions were chosen based on an assessment of their importance for progress in the individual reform areas. Principle 5: Conduct transparent progress reviews conducive to predictable andperformance-basedfinancial support The program matrix includes clearly defined outcome indicators, which have verified baseline values and can be tracked through existing systems and processes. Policy Areas Component I: Tax System 50. The Government’s goal is to improve the tax system in order to finance its strategic social priorities in the medium term. The Government has therefore planned a series of measures geared towards gradually improving the equity of the system and increasing revenues, while remaining conscious of chronic and structural obstacles to change and considering the economic slowdown related to the international crisis. Annex 9 provides additional details on the diagnostic and Government plan for the tax system.

5 1. Currently, Paraguay’s tax system yields collections well below the regional average and relies heavily on indirect taxes. At around 12 percent ofGDP, Paraguay’s tax-to-GDP ratio is lower than that of comparable lower middle-income countries in Latin America, and only represents an estimated 51 percent of its tax potential.41 Indirect taxes - primarily the VAT, excise taxes and customs duties - account for 80 percent of tax collections. The corporate income tax (IRACIS) is the only significant direct tax in Paraguay, accounting for around 16 percent of total tax collection. Indirect taxes tend to be more regressive than direct taxes.42 The structural and political obstacles to improved tax equity are clearly demonstrated by the low revenues from the agriculture sector which, while accounting for close to 20 percent of GDP, only generates 0.2 percent oftotal tax revenue and benefits from VAT exemptions ofagricultural products.43

52. The Government Plan envisages a number of structural measures that would make Paraguay’s tax system more equitable and would, in the medium- to long-run, contribute to higher tax revenues. There is a growing consensus that Paraguay’s tax receipts are excessively low, and that those who benefit from the status quo are not the most disadvantaged. Consequently, the Government is working on building consensus to advance on two fronts simultaneously: on the one hand, increase tax efficiency to boost collection; on the other,

41 Tax potential is measured based on the country’s economic, geographic, demographic, social and institutional characteristics. IMF (2009), Diagnostic0 del Sistema Impositivo Vigente en 2008. 42 See, for instance, Goiii, Lopez and ServCn (2008), Fiscal Redistribution and Income Inequality in Latin America. 43 IMF(2008). 18 increase the overall fairness and equity of the tax system, focusing on both higher taxation of some specific sectors, such as agriculture, and more effective control of tax evasion and fraud, especially for large enterprises.

53. Paraguayan society’s chronic resistance to increasing taxes poses a major challenge to the proposed reform. This is particularly critical in the case ofthe proposed measures, which affect groups with strong lobbying power, such as large landowners. The Government has adopted a flexible and gradual approach to limit the impact of such resistance. First, a dialogue has been established to reassure targeted sectors. Second, most of the measures do not require legal changes and consist of reversing exemptions or modifying the mode of collection. Third, the number ofmeasures is limited and their implementation sequenced over the next four years. Finally, the Government will rely on significant improvements in the tax audit function to increase compliance, while limiting changes in tax policy. zxSystem Actions to be taken prior to Board presentation of PDPL I Government has-derogated the Govision that allowed big landowners to use what they paid for VAT as fiscal credit against the agricultural income tax.- Completed Government has adopted decree to designate exporters and large businesses as withholding agents of the VAT. 45 Completed Triggers for PDPL I1 SET doubles the number of large taxpayers46subject to tax audits (Baseline: 2008= 20) Indicative medium-term actions Establish mandatory IMAGRO withholding mechanisms to reduce evasion and strengthen tax collection. Establish clear criteria for new muquilu regime concessions. Medium-term indicators (2012/13) TadGDP ratio increases at least 0.9 percentage points4’ by 2013.48Baseline: average 2004-2008 = 11.9 percent.

Component 11: Public Sector Financial Control Central Administration Internal Financial Control 54. Improving the effectiveness of the Central Administration’s internal fmancial control is a priority of the Government Plan, improving accountability and ensuring the use of funds for their intended purposes. The main actions proposed by the Government for this purpose are the improvement ofthe integrated financial management system; the implementation ofa standardized internal control framework and strengthening ofthe internal audit function; and the further professionalization and harmonization of financial administration units (UAFs) ofthe spending units. Annex 10 provides additional details on the diagnostic and reform plans for the Central Administration’s internal financial control.

55. Previaling internal control procedures are ineffective in practice. The control framework for payroll is limited by the absence of a proper payroll calculation system, and there is a high risk that payroll calculations from spending units do not reflect the actual number of

44 The recent issuance of Decree No. 238/08 derogated the provision introduced temporarily by Decree 5069/05 that allowed big landowners to use what they paid for VAT as fiscal credit against IMAGRO, the agricultural income tax. According to Government estimates, resulting tax collections from this change could trigger a 0.75 increase in the tax-to-GDP ratio from 201 1 onward, when current accrued VAT credits are expected to be close to zero. 45 As established by SET Resolution No. 7, issued on December 29, 2008. The measure became effective on January 1, 2009, and coverage will be expanded to over 600 firms beginning in January 2010 46 Mainly exporting firms. 47 Impact of individual measures estimated by State Secretariat of Taxes (SET): (i)Elimination of credits on VAT deduction from IMAGRO: 0.75% of GDP from 201 1; (ii)Designation of 114 large firms as withholding agents of the VAT: 0.15% of GDP from 2010. 48 A more significant increase in tax revenues will be difficult to achieve given the likely effects of the global economic crisis on revenues in 2009-10. Under the baseline projections, tax revenue will fall from 12.2 percent of GDP in 2008 to 10.8 percent in 2009, as a result of a reduction primarily in import tariffs, fuel taxes and import-derived VAT. 19 days worked by civil servants. In the case ofnon-salary expenditures, internal control constitutes a mere formality and relies exclusively on the spending units’ systems. This is compounded by the absence of a norm enabling implementation of the integrated system for goods and services (SLABYS) and also by a lack of integration between different systems that make up the integrated state resources management system (SIARE).~’

56. The institutional capacities of both the Internal Audit Office (AGPE) and the spending units’ Internal Audit Units (AIIs) are undermined by organizational limitations and a lack of well-trained human resources. AGPE and AI1 reports have currently little impact due to the lack of internal audit manuals and standardized norms in line with international standards5’, and the absence of a legally defined sanctions regime. Internal Audit Units are also insufficiently staffed, and staff experience and skills are not always adequate. Staff recruitment procedures are not based on competitive processes and job requirements are not properly defined. These factors undermine the independence ofinternal audit institutions.

57. The Government is pursuing the financial control reform process initiated in 2007 in parallel with the implementation of the IFA action plan and the Umbral program. The Government identified three main priorities to address financial control and Public Financial Management weaknesses: (i)expansion of financial management information systems to all spending units, including the implementation of additional modules related to payroll and goods and services and the full integration of sub-systems; (ii)implementation of a standardized internal control framework and strengthening of the internal audit function; and (iii) improvement of the control environment through strengthening and harmonization of the financial and administration directorates ofspending units.

58. The strengthening of the internal audit function and the establishment of a standardized internal control framework are being addressed jointly with the support of the USAID-sponsored Umbral Program. Achievements made to date towards strengthening the internal audit function include the adoption ofa decree in late 2007 which redefined the role, organization and attributions of the AGPE; increase ofAGPE’s human resources; and delivery of intensive training and development jointly with the CGR ofa new Government audit manual.

59. Since AIIs depend on the authority of their respective spending unit and the AGPE has traditionally had a lower rank than Ministries, support from the Presidency and the Ministry of Hacienda is considered critical. The inability to make clear, high-level commitments and the absence of comprehensive IF1 or donor programs for the sector during 1999-2006 resulted in stagnation in this area. Since 2007, both the implementation ofthe Umbral Program and the commitment of the Presidency, as evidenced in the adoption of decrees strengthening AGPE’s authority, have generated progress. This support is complemented by the Ministry of Finance’s expressed commitment to provide the budget space necessary to finance internal audit staff increases. These factors have put in place the preconditions for further progress in this area.

49 The SIARE includes the SIAF for PFM, the SINARH for human resources, and the SIABYS. However, the latter still lacks a legal framework, indispensable for the reinforcement of the existing procurement system. 50 Including the lack of formal procedures for addressing internal audit findings. 20 Box 5.4: Prior actions and triggers - Central Administration Internal Financial Control Actions to be taken prior to Board presentation of PDPL I Government has (i)issued a decree to upgrade the Office ofthe Executive’s Internal Auditor (AGPE) to ministerial level and to give AGPE the authority to establish a standard internal control model (MECIP) and determine the criteria for the selection of internal auditors throughout the Central Administration; and (ii)adopted the MECIP as the internal control model to be used by all public entities. Completed. Triggers for PDPL I1 Two ministries have established internal control committees, internal control norms, and trained staff to implement the MECIP; and their respective internal audit units (Ab) have the number of employees and competitive hiring processes required by AGPE. Indicative medium-term actions Three additional ministries have established internal control committees, internal control norms, and trained staff to implement the MECIP; and their respective internal audit units (AIIs) have the number of employees and competitive hiring processes required by AGPE. Medium-term indicators (2012/13) The PEFA Indicators for internal control and internal audit (PI-20 and PI-21) for 50 percent of the ministries (50 percent of the Government ministries) are rated C (Baseline: 2008 Integrated Fiduciary Assessment rating for PI-20 and PI-21: D+)

Effective Oversight of SOEs 60. Establishing effective State oversight of SOEs and improving their governance is one of the major pillars of the Government Plan. The Government has a medium-term goal of establishing a new institutional framework to ensure (i)adequate ownership supervision of SOEs; (ii)effective regulatory control on tariffs and technical quality ofutility services; and (iii) transparent SOE reporting of financial management, business planning and investments. Annex 11 provides additional details on the diagnostic and reform plans for State.oversight of SOEs.

61. The current ownership arrangements for SOEs are decentralized and their corporatization is partial. Decisions on SOE ownership are made by relevant sector ministries or the State Attorney’s Office, and the resulting decentralized arrangements5* do not clearly separate the ownership function from other State functions, particularly those related to the regulatory role and industrial policys2, resulting in a lack of clear definition of responsibilities. Corporatization of SOEs remains partial; most are still functioning as administrative decentralized entities or directorates carrying out commercial activities. Finally, there are no clear rules to regulate financial relationships between SOEs and the Central Administration, in particular with respect to both actual amounts transferred by SOEs to the Treasury, and payments of utility services by the Central Administration. The sum of these factors undermines SOE performance and ac~ountability.~~

62. Financial information on SOEs is weak and insufficiently regulated, which undercuts the State’s control over SOE financial management and investment targets. Paraguay’s Supreme Audit Institution (CGR) does not set accounting or auditing standards for SOEs, nor do public financial management laws provide specific procedures and standards for SOEs. The external audit of SOEs is solely carried out by the CGR, and contrary to international common practices, SOEs are not subject to mandatory external audits according to international standards. SOEs are also not required to publish annual financial statements. In this context, decisions regarding financial reporting by SOEs fall squarely within the powers of each institution’s management.

5 1 The two other main types of ownership organization are: the dual model, the most prevalent, where the responsibility is shared between the sector ministry and a ‘central’ ministry or entity; and the centralized model, in which ownership responsibility is centralized within one main ministry -usually the Ministry of Finance, and which recently has been on the increase. Source: ‘Corporate Governance of State-Owned Enterprises - a survey ofOECD countries’, OECD, 2005 52 As a result, many countries, particularly from the OECD, have move towards a more centralized ownership organization, whereby SOEs are put under the responsibility of one ministry, in most cases the Ministry of Finance. 53 However, it should be noted that progress was made with regards to the management monitoring system based on the balanced scorecard methodology recommended by IMF. 21 63. The regulatory framework for utilities is not comprehensive and its effectiveness is limited. Overall, there is no clear functional separation between policy formulation and execution, and between regulation and service provision. For the oil and energy sector, the regulatory framework is not clearly defined and lacks regulatory bodies, while the existing regulatory framework for the water sector is not effective.

64. The Government intents to consolidate the ownership structure under a Holding Agency for SOEs. The consolidation process was initiated during,the last quarter of 2008 with the strengthening of the SOE Council established in 2006. Formally led by the Ministry of Finance, this new inter-ministerial co~ncil’~(CEP) has an extended mandate, and an administrative body was created to improve its responsiveness.” The second step will consist of legal adjustments within the next 12 months to convert the CEP into the Holding Agency for SOEs and to clarify SOE reporting lines with this Agency. The Agency will act as the shareholder of the SOEs on behalf of the Government, and will supervise SOE corporate governance as well as their financial and business management. The centralization of of SOE oversight and the authority granted to the Holding is expected to significantly improve control over SOE activities and results.

65. The Government is also increasing the overall transparency of SOE finances and management. The Government intends to achieve this objective by expanding performance contracts under a new monitoring framework, requiring annual external audits in accordance with international standards, and throup tighter regulation ofthe financial relationship between SOEs and the Central Administration.’

66. The creation of a consolidated regulatory agency is the third area of reform planned for the SOE sector. This new agency will be responsible for regulating tariffs and controlling quality standards underlying the provision oftelectrical power, oil, telecom, and water services.

67. As a first step towards implementing these reforms, the Government intends to strengthen key capacities. The CEP monitoring unit needs to rapidly develop mechanisms to undertake effective information analyses and business monitoring of SOEs. Similarly, the preparatory tasks for the establishment ofthe new regulatory body will need to be initiated in the next few months. International technical assistance is expected to support the establishment of a group ofreform experts, critical to timely achievement these two objectives.

68. Second, the Government is working on strengthening reform consensus. The inter- institutional agreement between CEP members, which spells out the main objectives of the reform, is critical to move the SOE agenda forward and develop a bilateral dialogue with each SOE. Broader consensus, in particular with Congress, is to be obtained through dialogue centered on the adoption ofthe anti-crisis plan and the PDPL.

54 The Council includes the Ministries of Finance, Public Work, and Industry and Trade. 55 This administrative body - CEP Monitoring Unit - counts with fifteen staff and its mandate has been defined by decree. 56 Plans will also be made to ensure that in the medium-term, financial reporting is done on the basis of International Financial Reporting Standards. 22 Box 5.5: Prior actions and triggers - Effective Oversight of SOEs Actions to be taken prior to Board presentation of DPL-I Government has issued decree to establish a Council for State Owned Enterprises (CEP) to ensure, inter alia, (i) public sector oversight of SOEs, and (ii)the definition of a Government policy for SOE reform. completed Ministries of Finance, Public Works and Industry and Trade, and the State Attorney’s Office have signed an inter- institutional agreement, defining the strategic areas to improve the corporate governance of SOEs. completed Triggers for DPL-I1 A Holding Agency of SOEs is legally established to replace CEP. It has the authority to: (i)elaborate SOE corporate governance, including the criteria for appointment and removal of high rank personnel; (ii)redesign management evaluation mechanisms; (iii) design a system of investment planning, and (iv) evaluate the financial situation of each SOE. The Holding Agency ensures that, beginning in 2010, all SOEs are subject to annual external audits by international audit firms, which are required to be prepared according to CEP/Holding standards, and published. For the case of PETROPAR, the audit should also include the 2008 Financial Statements. A consolidated and independent Regulatory Agency is established. This Agency is in charge of regulating tariffs and controlling quality standards appropriate for the provision of the following services: electrical power, oil, telecom, and water. Indicative medium-term actions The Holding Agency establishes performance evaluation mechanisms, standardized financial management rules and financial targets for SOEs. The Ministry of Finance establishes clear rules with respect to transfers and payments between SOEs and the Central Administration. This includes rules to determine the appropriateness and the actual amount of transfers from SOEs to the Treasury; and payments on utility services from the Central Administration to SOEs have been identified and their regularizationhas been initiated. Medium-term indicators (2012/13) The PEFA Indicators for internal control and internal audit (PI-20 and PI-21) for 50 percent of the ministries are rated C (Baseline: 2008 Integrated Fiduciary Assessment rating for PI-20 and PI-21: D+) Appropriate scrutiny by Government and civil society of SOEs’ finances and operations obtained through (i)the annual publication of audited financial statements; and (ii)the definition of medium-term financial targets for SOEs by the Holding. 2008 Baseline: none of these targets are fulfilled. Component 111: Expenditure Management 69. Social and capital expenditures are considered critical priorities of the Government’s anti-crisis plan. While poverty reduction remains a key challenge and the quality of public infrastructure is an impediment to economic growth, social and capital expenditures in Paraguay are still low by regional standards, and chronic lack of budget predictability and under-execution negatively impacts the performance of public service delivery. Given the potential impact ofthe current international economic crisis, the Government intends as a first priority to safeguard social expenditure while gradually addressing structural challenges related to allocation and execution of capital and social expenditures. Annex 12 provides additional details on the diagnostic and reform plans for expenditure management.

70. Despite high poverty levels, social spending remains relatively low compared to other Latin American countries. As a share of GDP, Paraguay spent about half as much as Uruguay and one-third less than Brazil in 2005/06. As a share of total spending, social expenditures in Paraguay were also among the lowest in the region. However, in recent years there has been an effort to increase social spending. While the average share of social spending in total expenditures was 42 percent between 2002 and 2006, this figure rose to 49 percent between 2007 and 2009.

71. Similarly, public investment as a share of GDP is below regional standards. Between 2004 and 2008 annual investment5’ by the Central Government reached, on average, 2.7 percent of GDP, setting Paraguay below the Latin American average of 4.5 percent. Even if other parts of the public sector (primarily SOEs) are included, total public investment only totaled 3.7-4.2 percent of GDP annually. While public investment on average represented 16 percent of total spending between 2004 and 2008, more investment is needed if Paraguay is to succeed in

57 Investment here is defined as inversion fisica. 23 meeting serious infrastructure challenges, particularly in the transport and water and sanitation sectors.

72. The budget process is negatively affected by a substantial lack of predictability. The Congress - which enjoys wide powers to increase the budget - tends to increase current expenditure items (typically salaries); ’*the Executive, in turn, tends to limit actual execution to cash availability through the Financial Plan, adjusting capital and non-salary current expenditures below previously proposed amounts. Over the last few years, the Financial Plan has consistently allocated lower resources to capital expenditures than both the budget law and original draft budget. The consequence is that managers ofpriority programs have limited ability to predict their available resources, which undermines the efficiency ofprogram implementation.

73. The limited budgets for capital expenditures are under-utilized. Between 2005 and 2008, total expenditures were on average under-executed by 14 percent and capital expenditures by 40 percent. As indicated in the previous paragraph, one reason for the gap between budgeted and executed capital expenditures stems from the tensions between Congress and the Executive with respect to defining final budgetary allocations. Wide-scale under-execution of budgeted capital expenditures can also be attributed to severe weaknesses in Paraguay’s public investment process as well as significant delays in procurement and sizable payments arrears.

74. Social expenditures, and ultimately the programs they underpin, are negatively impacted by the wide array of public agencies with overlapping objectives which manage social sector programs. While a significant share of social assistance programs (including Tekopora) is managed by the Presidential Agency for Social Assistance (SAS) or the National Office ofCharity and Social Assistance (DIBEN), related programs are managed by seven other institutions, ranging from the Paraguayan Institute of Indigenous People to the Ministry of Education.

75. The Government’s priority in the short term is to address the potential impact of the international crisis on poverty by safeguarding budget increases for social expenditures. Poverty alleviation and equitable economic growth constitute the Government’s main priorities, a fact which is amply reflected in the 2009 draft budget submitted to Congress in autumn 2008.’’ However, given the potential impact of the recent international crisis on the economy and the poor and the budget increase adopted by Congress6’, the Government designed an anti-crisis financing plan to secure social expenditures and maintain the proportion ofcapital expenditures adopted in the budget6’ Although this plan does not address the structural aspects that undermine social and capital expenditures, budget predictability and maintaining a higher volume of social and capital expenditures are critical to smooth the crisis’ impact upon employment and poverty.

76. The Government’s medium-term objectives in terms of public investment and social expenditure objectives combine sector-specific reforms and horizontal measures. Regarding social expenditures, the Governrnent intends to expand priority programs such as the Tekopora program, which will require strengthening SAS’ capacity, and to streamline the social sector institutions. In the area of public investment, the Government first plans to strengthen the water sector both through institutiona reforms and increased investments; and second, to implement a

58 Without necessary identifying additional sources of revenues. 59 The new Government, and in particular the Ministry of Finance and the economic team worked intensively in August- September 2008 to ensure the budget would reflect the priorities of the program campaign. 60 Essentiallybecause of salary increases. 61 See Section I1 on ‘Recent Economic Developments’, and the required financing gap to safeguard those expenditures. 24 new conceptual and institutional framework for the System of National Public Investment (SNIP) under the leadership of the Technical Planning Secretariat (STP). Finally, the Government plans to modify budget classification to improve the identification and monitoring of investments related to public infrastructure maintenance.

77. Government activities in this area will require careful political management and more efficient inter-institutional coordination. The fact that poverty alleviation was singled out as the main objective ofthe new administration has unleashed high voter expectations in this regard, the achievement of which will be critical to maintaining its credibility. Meanwhile, its lack ofa majority in Congress could reduce its ability to implement significant changes.

Box 5.7: Prior actions and triggers - Expenditure Management Actions to be taken prior to Board presentation of DPL-I D Ministry of Finance maintains in the 2009 Financial Plan the increased proportion of social spending (including for social safety net programs) over total Central Administration expenditures mandated in the 2009 budget (as compared to the 2008 budget), focusing on social programs that have been proven to be efficient and equitable. (baseline: budget line #300: 2008 = 49%; target: 2009: over 50%) Written confirmation received from Minister; financialplan still to be received Triggers for DPL-I1 D Ministry of Finance safeguards the proportion of social expenditures (including social safety net programs) over total expenditures in the 2010 Financial Plan, focusing on social programs that have been proven to be efficient and equitable; it will also safeguard the proportion of public investment over total 2010 budgeted expenditures. . m The execution of the 2009 Financial Plan is consistent with budgeted social expenditure priorities. Budget execution represents at least 90% of what was foreseen in the Financial Plan (budget line # 300). m Ministry of Finance establishes specific budget categories for maintenance expenditures to improve the monitoring of infrastructure spending. This measure is linked to the technical assistance provided by the Bank-funded road sector investment loan. Indicative medium-term actions The execution of the 2010 Financial Plan is consistent with budgeted social expenditure priorities.

D At least three ministries have aligned their pre-investment activities with their sector strategy and the priorities of the Government Plan. b Institutional measures are taken to reduce duplication and overlap in the implementation and oversight of social spending programs. Medium-term indicators (2012/13) b Improvementsare verified in the coverage of the social safety net through the increase of conditioned transfers from Tekopora Program to 100,000 families in extreme poverty (Baseline: 2008 = 18,000). b The quality of public infrastructure is improved: periodic maintenance of paved roads (Baseline: 2008= 25% of the total network; Target: 2012= 50% of the total network).

Component I V: Human Resources Managem en t 78. The Government identified some modest steps in civil service reform as key priorities. The Government is committed to addressing the high level of politization which characterizes Paraguay’s civil services as well as its poor performance, by establishing a more meritocratic and professional civil service. Annex 13 provides additional details on the diagnostic and reform plans for the state oversight ofSOEs.

79. Paraguay’s HRM performance has been among the weakest in Latin America. Regional studies have classified Paraguay’s civil service under the category of clientelistic bureaucracy62,characterized by substantially politicized appointments, weak technical capacity, poor incentives, informality and lack of uniformity in its remuneration policies. According to the quality of public administration index63, Paraguay lags behind other clientelistic bureaucracies with lower GDP per capita (PPP) such as Guatemala, Nicaragua, Ecuador, Bolivia and Jamaica. Such HRh4 weaknesses undermine the effectiveness of public policies as well as the country’s institutions.

62 This typology defined three categories of Bureaucracies: Merit-Based; Administrative; and Clientelist, with the weakest characteristics. Source: Echebamia (2007). 63 Source: Echebarria (2007) 25 80. Paraguay’s institutional framework for human resources management has been fragmented for decades. Paraguay has not had a central authority able to effectively enforce existing laws and regulations related to public sector employee recruitment, selection, promotion, dismissal and pay. Sector ministries, unions and Congress have often circumvented the control of the Ministry of Finance (MOF) and the Public Administration Secretariat (SFP) for recruitment processes, promotions and particularly during salary negotiations.

8 1. Notorious salary distortions and arbitrariness in the assignment of allowances undermine the effectiveness of public policies. Paraguay has significant vertical64 and horizontal65 salary distortions, together with an excessive number of personnel subcategories.66 The high disconnect between responsibility and economic incentives and significant discretion in the distribution of personnel allowances also add to the complexity and lack of transparency of Paraguay’s pay system. These distortions represent a strong disincentive for public employees, negatively impacting the overall effectiveness ofpublic policies.

82. The prevailing civil service legal framework presents weaknesses and its enforcement is limited. The current civil service law is extensive,. covering the three levels of Government and three branches of power, and established the SFP and its mandate. However, there have been appeals to the Supreme Court regarding the constitutionality of several articles. Ultimately, the Supreme Court agreed that some ofthese articles were unconstitutional, thereby limiting the enforceability of the law.67 In addition, the Executive has yet to adopt secondary legislation that sets out important provisions of the law such as the definition of a career-based system.

83. The Government plans first to strengthen the SFP via capacity development and by expanding interactions with other institutions and stakeholders. The SFP intends to strengthen its capacities in terms of human resources and training, systems, and data collection procedures. The SFP is in parallel joining efforts with the Ministry of Hacienda to achieve a more consolidated public sector human resources management.68 The SFP is also strengthening its role as the central human resources mana ement agency, in particular by reinforcing its control over new recruitments and promotions.6$

84. The Government intends to reform the current Civil Service Law No. 1626/00 in a subsequent stage. The revised legislation will include, inter alia. provisions necessary to: guarantee the establishment of a professional and politically neutral civil service; define the institutions empowered to manage and monitor civil servants; and ensure the existence ofmerit- based and competitive entry selection and promotion. This reform will represent a major step towards introducing merit-based principles in Paraguay’s civil service. Preparation of the new law is also expected to generate broad consensus among political and union stakeholders.

64 Disconnect between hierarchy and remuneration 65 Positions with similar responsibilities,but with different remuneration 66 Personnel subcategories increased from 285 in 2005 to 435 in 2007, of which 82 subcategories only included one person. See: Policy Note on Public Employment and Wage Bill, World Bank, 2008 67 The articles of the civil service law 1626/2000 non-complying with the Constitution include: article 14-b; 16-f; 17; 42; 61; 143. 68 The Presidential Decree 22312008 adopted in 2008 assigns both institutions the responsibility to work jointly to avoid cases of double remuneration for civil servants. Both institutions likewise share a wage bill modeling tool and work together on other initiatives such as the design and implementation of the unified HRh4 control system (SICCA). 69 To this end, SFP resolution 50/2008 was passed in autumn 2008 and provides that all Central Administration selection and promotion procedures for permanent personnel be authorized by SFP and subject to merit-based guidelines (Projects under consideration also include applying merit-based rules for the recruitment of contracted personnel). This will be rendered possible by the definition of staff profiles and mandatory requirements for civil service positions. 26 85. Government plans also include the introduction of a professional civil service career system. With the support of an IDB TAL, which is currently under implementation, the SFP plans to establish a career-based civil service system. Its implementation will consist of designing human resources policies supporting merit-based recruitment and promotion; implementing those policies and delivering intensive training; and further strengthening the role and capacities ofthe SPF and human resources units ofspending units.

86. There are risks associated with the civil service reform. There is a risk of wage bill increases resulting from negotiations for the introduction of merit-based practices and career system. Sequencing ofthis reform and securing cooperation between the Ministry of Finance and the Public Administration Secretariat will be critical to ensure progre~s.~'The Ministry of Finance is considering the merits of dropping this reform if it implies a wage bill increase of above 15 percent for the following fiscal year. The sustainability of this reform will likewise depend on the adoption of a series of legal documents at a time when the Government does not have a majority in Congress. It is therefore crucial that the Executive pursue extensive outreach and dialogue within the Government and with unions and political parties to foster progressive and increasing ownership ofthe reform objectives.

Box 5.8: Prior actions and triggers - Human Resources Management Triggers for PDPL 11 D The Civil Service Law is reformed in order to strengthen public servants' professionalism and political neutrality, and also to redefine the scope of public administration, =.well as the rights, obligations, and procedures associated to recruitment, promotion and removal of public servants. (Presentation of the drat? law to Congress) Indicative medium-term actions m Government introduces competitive and transparent process for recruitment and promotion of civil servants, and the Civil Service Secretariat is overseeing those processes. 71 To ensure that the Government is provided the maximum room to maneuver during this difficult consensus building process, the trigger for the second operation is expected to entail the submission of changes to laws by Government to the Congress, while it is anticipatedthat triggers for the third operation will consist of adopting measures underlying the transparent recruitment and promotion of civil servants. In the event that the passage of legal changes were to confront political impasse^'^, the option of pursuing medium-term objectives via the PDPL 111 triggers would be considered. Medium-term indicators (2012/13) Personnel recruitment and promotions are based on merit and professional skills. Target: the following criteria are applied to 100 percent of new recruitment: (i)written job requirement; (ii)publication of the job advertisement; (iii)competitive and transparent criteria of selection; and (iv) SFP control of the recruitment process. 2008 Baseline: none of the above procedures are currently in place.

VI. OPERATION IMPLEMENTATION Poverty and Social Impact 87. The tax policy reforms supported under the PDPL I are not likely to have significant effects on the poor. First, the elimination of the VAT deductions from the agricultural income tax (IMAGRO) will only apply to those producers with a minimum of 300 (in the more fertile eastern region) or 1,500 hectares (in the dryer western region), representing only 2 percent of all farms. These deductions would continue to apply to medium-sized farms (14 percent), while owners ofproperties totaling less than 20 hectares in eastern Paraguay, and 100 hectares in western Paraguay, or 84 percent of all farms, are exempt fkom the IMAGRO alt~gether.~~Increased revenues from the IMAGRO could in fact benefit the poorest, as 50 percent of revenue collected is earmarked for the Rural Development and Land Administration

70 Especially given the current international economic crisis coupled with the size of the public sector wage bill -approximately 40 percent of total Central Government expenditures. 71 These rules do not require legal change and include (i)for recruitment, inclusion of job requirements, transparent and competitive selection process, and SFP control; (ii)for promotion transparent criteria of promotion and SFP control. 72 For instance if those legal changes imply a wage bill increase of more than 15 percent. 73 Based on the latest available National Agricultural Census. 27 Agency (INDERT), which is in charge of agrarian land purchase, distribution and support services to resettled beneficiaries. Second, the expansion of the VAT withholding scheme to the 114 largest firms of the country would not affect poorer taxpayers.

88. Analytical work will be undertaken by the Government to assess the poverty and equity impact of tax policy actions supported under subsequent DPLs of the proposed program. The increase in the audits of large taxpayers (trigger for PDPL 11) and the establishment ofa mandatory IMAGRO withholding mechanism (indicative medium-term action for PDPL 111) are not likely to have a significant impact on the poor, as these are administrative measures primarily affecting large taxpayers. In the case ofthe change in regulations governing the rnuquilu regime oftax incentives for re-export businesses (indicative medium-term action for PDPL 111), the Government will analyze which industries would experience the highest benefits to employment, and estimate the potential poverty and equity impact ofthis measure. This work will be supported by the programmatic public sector or poverty non-lending assistance envisaged within the framework of the CPS.

89. The increase in social and investment spending foreseen for the program period is likely to have significant beneficial impacts on overall poverty and equity. These spending programs are expected to soften the impact of the global economic crisis on the most vulnerable, while also helping to address more structural issues related to poverty and inequality. The key social program to benefit from a higher public spending envelope is the conditional cash transfer program (Tekopora). The program targets the extreme poor in rural areas. An impact evaluation carried out in 2007 shows that the program had a positive effect on household food consumption, school attendance and visits to local health centers. The increase in household per capita income led to a drop in the incidence of extreme poverty among beneficiaries of at least 17 percentage points.74 However, coverage is currently limited to 18,000 families out of an estimated 150,000 extreme poor. At the request of the Government, an ongoing World Bank poverty assessment is analyzing the impact of the program on poverty and inequality. Results are expected to be available in the coming months and will feed into the design of the program’s expansion. Other social programs of high priority for the Government include housing, primary health care, and land reform, all ofwhich are designed primarily to benefit the poor. Land reform in particular is key to addressing inequity, as the Gini coefficient for land distribution is among the highest in the world. There are currently around 100,000 families in the categories oflandless workers and micro-landholders. The 2009 budget foresees the acquisition and distribution of almost 18,000 hectares ofland, and the regularization ofthe settlements of27,000 families.

90. Measures related to financial control effectiveness, supervision of SOEs and civil service reform, are not likely to have significant direct poverty or equity effects. Rather, it is expected that in the medium-run, these measures will have positive indirect effects to the extent that they contribute to better use of public fimds and improved service delivery, and that they free up valuable resources for pro-poor policies.

Environmental Aspects 91. The specific policies supported by the proposed PDPL I are not expected to significantly impact the environment, forests or other natural resources. However, to the extent that measures supported by the PDPL Iprogram are successful, over time, in improving effectiveness and ‘ efficiency of public sector, Paraguay’s national institutional capacity to identify and address environmental policy and regulatory issues will be strengthened. Paraguay’s

74 International Poverty Center (2008), Achievements and Shortfalls of Conditional Cash Transfers: Impact Evaluation of Paraguay’s Tekopora Programme. 28 environmental institutional and policy framework is defined under Law 1561 of 2000 and Law 3679 of 2008. The institutional framework consists of the Secretariat for Environment and the National Environment Council which are responsible for defining the environment policy and monitoring the environment system defined by Law 1561.

Participation 92. The Government has worked together with civil society and relevant actors in the policy areas covered by the PDPL. Prior to assuming office and especially in the context ofthe presentation and results of its 1OO-day plan, the Government widely disseminated its strategy, particularly as regards macroeconomic policy and public sector reform. This strategy is accessible to citizen comments at the Ministry of Finance website. With regard to civil service reform, the results of the first 100 days of the administration were presented in November 2008 at the International Civil Service Symposi~m.’~

93. The Government has also initiated intensive inter-ministerial dialogue centered on policy areas covered by the PDPL. First, the PDPL program was discussed and agreed between the National Economic Team of the Government and the President. Second, the Ministry of Finance is maintaining an on-going dialogue on this program with each related ministry, which in turn expands the program’s dissemination to respective sector stakeholders. For instance, the SFP has initiated a series of seminars on the reform of the civil service law with union and Congressional representatives. The Ministry of Finance is also disseminating the FA public financial management action plan throughout the Central Administration. Third, these participation activities are aimed at promoting an ongoing dialogue and monitoring process of PDPL implementation.

94. The anti-crisis plan of January 2009 has also been disseminated widely to the public. The Government has widely disseminated the anti-crisis plan through the press and initiated a dialogue with Congressional representatives and political parties. This dialogue, which will be pursued through April 2009, will also allow the Government to build a political consensus on the content of the public sector reform program supported by the PDPL. Finally, multi-donor support to the anti-crisis plan is promoting donor inter-action and coordination.

Implementation, Monitoring, and Evaluation 95. The Government and the Bank will use the following data sources to assess progress under the PDPL program: 0 Public sector budget monitoring and execution reports from the Ministry of Finance, including reports on revenue collection 0 Financial plan execution report from the Ministry ofFinance 0 BCP reports and analysis ofkey macroeconomic variables 0 Reviews and analyses of laws and implementing regulations from the World Bank and other stakeholders Internal audit reports 0 Reports by the Council for SOEs 0 Reports by the Public Administration Agency (SFP) 0 World Bank supervision missions and reports

75 The symposium was attended by President Lug0 as well as the human resources managers of the Central Administration and representatives from civil service unions. 29 96. The Paraguayan Government and the Bank have agreed to regularly monitor progress under the PDPL program, including during periodic CPS implementation reviews. Discussions will be held with the Ministry ofFinance, the main counterpart agency for the loan, which will be responsible for the overall monitoring and evaluation ofthe loan and for collecting data necessary to assess implementation progress from appropriate sources. Other agencies that will play an important role in this process are the Central Bank, the Public Administration Agency (SFP), the Council for SOEs, the Technical Secretariat for Planning (STP) and the Internal Audit Agency. The CPS review will focus on complying with the agreed triggers for continued policy-based lending, in particular, maintenance of a satisfactory macroeconomic framework and progress on the overall structural program.

Fiduciary Arrangements 97. Overall, Paraguay’s public financial management (PFM) remains weak and represents a high risk. The three main PFM challenges identified by IFA are related to improvements in: budget process efficiency, fiscal transparency, and control effectiveness. The common features underlying each ofthese challenges is their linkage to Paraguay’s political and institutional context and the difficulty in addressing their technical dimension without adopting broader governance changes.

98. Despite recent Government efforts, the limited degree of control system effectiveness continues to pose one of the country’s biggest PFM challenge. First, shortcomings in the internal control framework and procedures weaken performance in most expenditure categories related to salaries, goods and services. Second, although it has significantly improved over the last two years, the internal audit function continues to be undermined by the lack oftrained staff, harmonized norms and procedures. Third, external audits are still subject to weaknesses such as limited effectiveness of follow ups to audit recommendations. Finally, the control environment is weak due to an overall lack of accountability and the high level of discretion given to senior management by insufficient and inadequate human resources policies and work practices. This is compounded by the lack of internal control standards and procedures for the public sector, and in some cases by their disconnection from the financial management integrated systems (SIAF). 99. The Government is committed to address PFM and particularly control effectiveness issues. This commitment is most clearly evidenced in (i)the reforms recently initiated with the assistance of the USAID UmbruZ program, and (ii)through the prior actions and outcomes agreed within the framework of the PDPL, that expressly target strengthening of public financial control effectiveness, and improving overall efficiency in the allocation and execution ofbudget resources.

100. The IMF completed an update of the safeguards assessment of Central Banks in October 2006. In the case of Paraguay, the report states that while the Central Bank has made some progress in strengthening the safeguard framework since the 2003 safeguard assessment, vulnerabilities remain in certain areas such as financial and program data reporting to the Fund. However, according to the assessment, the current foreign exchange control environment within the central bank is satisfactory. According to the IMF 2007 Article IV Consultation, although significant progress has been made towards enhancing the health of the financial system, the much needed financial sector reform, in particular the strengthening of bank regulation and banking law, has not taken place.

30 Disbursements and Audit 101. Given the level of PFM risk and the weaknesses identified in the control environment surrounding Central Bank operations, and in accordance with Bank policies and procedures for DPLs, the Bank has identified the need for additional fiduciary arrangements to mitigate the potential reputational risk that loan proceeds be used for unintended purposes. As explained earlier, these additional fiduciary arrangements call for: (a) the establishment ofa dedicated deposit account at the Central Bank whereby loan proceeds will be deposited by the Bank, (b) an audit of the dedicated deposit account to be undertaken within four months ofthe disbursement ofloan proceeds, according to international audits standards and terms ofreference acceptable to the Bank.

102. More specifically, disbursement arrangements for the proposed loan will follow Bank disbursement procedures for DPLs~~and will take into account additional fiduciary arrangements described in (a) in above paragraph: once the loan is approved by the Board and becomes effective, the proceeds of the loan will be deposited by the Bank in the dedicated deposit account in the Central Bank of Paraguay at the request of the Borrower. The Borrower shall ensure that such funds be included in the country’s budget and subject to the country’s normal PFM processes.

103. The dedicated deposit account will be audited according to Bank policies and procedures and should follow the approach outlined in the relevant Bank g~idelines.~~The audit should be carried out within four month of the single tranche disbursement and the scope should cover (a) the accuracy of the summary of transactions of the dedicated account, and (b) accuracy of exchange rate conversions. If the proceeds of the loan are used for ineligible purposes (the “negative list”) as defined in the Development Loan Agreement, the Bank will require the Borrower to promptly upon notice from the Bank refund an amount equal to the amount ofsaid payment. Amounts refunded to the Bank upon such request shall be cancelled.

Risks and Risk Mitigation Economic and Financial Risks 104. A further deterioration in the external environment could have negative effects on Paraguay’s economy beyond those foreseen in the baseline projections. Vulnerabilities are particularly high with regards to the economic situation ofParaguay’s two large neighbors: even though there has been progress in diversifying export markets, Argentina and Brazil still account for 26 percent of all exports. If the decline in demand for Paraguay’s soy and meat exports is greater than anticipated, economic growth may slow down even further. An increase in non- performing loans as a result of a decline in agricultural production would put pressure on the financial system, which could ultimately result in important fiscal costs. In the presence of relatively high fiscal rigidities and limited space for higher tax collections in the short run, lower growth could also result in a higher than expected fiscal deficit. There is also a significant exchange rate risk, as a large share ofpublic sector debt is denominated in foreign currency and dollarization of the financial system remains high. However, as the debt sustainability analysis shows, the fiscal risks are manageable, and the financial sector is currently more robust than it has been in years. Overall, continued prudent macroeconomic management will be critical to reduce the impact ofexternal shocks. It would also be important to continue strengthening ofthe

76 As set out in OP 8.60 77 Annual Financial Reporting and Auditing for World Bank-Financed Activities 31 financial system, including through better supervision and regulation especially of the cooperatives which represent a significant risk.

Political Risk 105. The overall political risk for this operation is high. Mr. Lugo’s Government may lose its political margin of maneuver to implement its program, and therefore progressively lose its political credibility and support. As mentioned in section 11, the administration’s political alliance is relatively fragmented and does not benefit from a majority of seats in Congress.

Managerial Risk 106. The sustainability risk for the PDPL objectives is high, given the above-mentioned political risk, and the structural constraints of Paraguay’s public sector. The indicative triggers for PDPL I1 and PDPL I11 include legal changes and require an intensive path of activities. The current lack of majority in Congress coupled with limited capacities of the public administration represents the main managerial risks that could prevent implementation of those actions. Given that the objective of the proposed measures directly supports the government’s anti-crisis plan, the government’s ability and capacity to implement those measures is not expected to be negatively affected by the crisis. The table below details the political and managerial risk by policy area and suggests mitigating measures.

32 m m

I ."8 73 nx Annex 1: Letter of Development Policy

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41 LETTEROF DEVELOPMENTPOLICY

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Asuncion, March 25,2009 Mr. Robert Zoellick President World Bank Washington, DC 20433 U.S.A.

Ref.: Development Policy Letter -Public Sector Programmatic Development Policy Loan

Dear Mr. Zoellick:

The Government of President Fernando Lugo, which took office on August 15, 2008, has determined as its priority and strategic objectives poverty reduction, employment generation through economic growth, execution of a program of public investment to boost growth, transparency in public sector management and the fight against corruption. These objectives are based on a thorough diagnostic and analysis of the country’s economic and social conditions, which indicate that the economic growth registered over the last five years has not been translated into an improvement in the welfare of a large share of the population, especially of rural families that do not take part in modern agriculture and that have not benefited directly from the increase in the price of the main commodities exported by Paraguay (meat and soy) in the last years (Exp. M.H. No. 6248/2009).

This Letter aims to present to the objectives and actions related to the Public Sector Programmatic Development Policy Loan (PDPL), which is based on the Government’s Strategic Economic and Social Plan 2008-2013, presented in August 2008, and the Government’s Anti Crisis Plan, introduced in January 2009.

The Government‘s Strategic Economic and Social Plan

The Paraguayan Government has set as its objective the achievement ofmore sustainable and equitable economic growth. In order to achieve this objective, four strategic goals have been established: (i)promoting growth with a focus on employment generation and improved income distribution, while preserving a sound macroeconomic framework; (ii)strengthening Government institutions to improve policy making and deliver better public services; (iii) increasing the efficiency of social expenditures, focusing on extreme poverty alleviation; and (iv) fostering economic development with broader citizen participation.

These objectives are supported by seven strategic pillars that address the country’s economic, social, and institutional challenges in a comprehensive manner:

Maintenance of a stable macroeconomic policy framework, through the control of inflationary pressures, an increase in tax collections, and prudent management of public debt.

42 0 Adjustment of the financial sector to support broad-based economic growth, in order to achieve an increase in access to medium- and long-term credit and a stronger orientation towards small- and medium-sized enterprises (SMEs). In this context it is necessary to emphasize the key role of the Financial Development Agency (Agencia Financiera de Desarrollo, AFD), as a second tier bank, which has managed to redirect financial resources to key sectors such as livestock, agriculture, micro-enterprises and housing, promoting improvements in the efficiency and transparency of financial intermediation. 0 Effective provision of public services by state-owned enterprises (SOEs), through enhanced State oversight, improved business and financial management, and increased private sector participation in their modernization. 0 Modernization of the State, through an increase in the efficiency of resource management, including the reengineering of public institutions, strengthening effectiveness and transparency of internal financial control, and gradually introducing a merit-based and professional civil service. 0 Productivity and competitiveness, through improvements in physical infrastructure and human resources capacity, to promote an economy that is more industrialized, diversified and better integrated into international markets. The Government is promoting a new model of financing of basic infrastructure through a draft law that would speed up the concession ofinfrastructure works to the private sector. 0 Comprehensive land reform and revitalization of family agriculture, through the improvement and widening of agriculture extension services to strengthen rural establishments as providers of food that would guarantee food security and sovereignty; and of the promotion of farmer participation in order to strengthen the social fabric ofcommunities, addressing in particular age and gender issues, as well as territorial, social and cultural aspects related to indigenous groups. 0 Employment generation and the fight against poverty, through the development of an intensive labor training plan, and the creation of employment opportunities for youth, women and families living in poverty. The Government also plans, on the one hand, to improve the organization ofinstitutions and programs geared towards poverty reduction; and on the other, to strengthen the fight against extreme poverty, including social protection and economic inclusion.

The Government’s Anti Crisis Plan

As a result of the international crisis and the sudden negative change in external conditions, the Government officially announced on January 15, 2009, its intention to implement an Anti Crisis Plan. The Plan would boost the Government’s priorities in the face of the unfavorable economic climate which is expected as a consequence ofthe global economic slowdown. The Plan foresees the use of savings and domestic credit and, predominantly, external financing, for a total amount of US$461 million, of which US$300 million consist of fast-disbursing loans from multilateral and bilateral financial institutions. The plan was primarily designed as a countercyclical fiscal tool that would allow the Government to soften the impact ofthe crisis on unemployment and on the most vulnerable social groups. Specifically, the resources originating from external loans will be used to maintain the level of public spending, especially social expenditures already approved by the National Congress for 2009.

43 The objectives ofthe Anti Crisis Plan are consistent with the medium- and long-term strategic objectives defined in the Government’s Strategic Economic and Social Plan. The plan aims to: (i)safeguard employment through a higher rate of execution of public works and the allocation of credit to the private sector, while preserving macroeconomic equilibrium; (ii) protect the most vulnerable sectors through the expansion of the conditional cash transfer program and the full financing of the Government’s social policies (education and health); (iii)promote credit lines for SMEs and family-based agricultural businesses; and (iv) provide liquidity to the financial system and ensure its overall soundness.

Description of the Government’s programs and priorities in the areas of public sector management included in the Programmatic Development Policy Loan (PDPL)

Below we present the areas ofimplementation ofthe Programmatic Development Policy Loan (PDPL), to be financed by the World Bank in the amount ofUS$lOO million. These areas are linked to the strategic objective ofState Modernization defined in the Government’s Strategic Economic and Social Plan, and have been selected taking into account the need to strengthen public social expenditures and the Anti Crisis Plan.

Macroeconomic Stability

It is the Government’s strategic goal to maintain and strengthen economic growth, broadening employment opportunities, improving the distribution of income, and protecting the environment, without endangering macroeconomic stability. Consequently, the Government has targeted a primary fiscal deficit of 1 percent of GDP, which is consistent with the preservation of fiscal stability and the sustainability ofpublic debt in the medium term. The Government has also committed to maintaining price stability, orienting fiscal and monetary policies towards the fulfillment ofthe medium-term target inflation rate of around 7.5 percent (annual).

With respect to external accounts, under the scenario foreseen for the next years, the Government expects a current account deficit of the balance of payments, as a natural consequence of the worsening of Paraguay’s terms of trade, the fall in remittances from Paraguayans working abroad, the increase in public debt, and the reduced external demand. This deficit is estimated to remain below 3 percent of GDP, which is considered compatible with the sustainability ofeconomic growth over the medium term.

Tax System

The strengthening of Paraguay’s tax system, including an increase in the tax burden, is a necessary condition to move forward with the implementation of the main strategic development objectives defined by the new Government within a framework of fiscal responsibility and prudence.

In the short term, measures will focus on improving tax administration and on correcting distortions affecting the existing tax system. In this context, the Ministry of Finance has issued Decree No. 238108, which foresees the elimination of fiscal credits through value- added tax (VAT) deductions from the agricultural income tax (IMAGRO) for the case oflarge landowners. This would bring the revenue impact of the IMAGRO on par with that of the commercial, industrial and service income tax. The Government has also decreed an increase 44 in the number of VAT withholding agents from January 2009, with a special emphasis on large taxpayers.

Considering both the expected impact of the economic slowdown and the structural limitations faced by Paraguay to advance on tax reform, the Government has introduced two medium-term targets. One is to move ahead with the implementation of the Personal Income Tax (IRP), which became effective in 2009.

The other is to move ahead with the implementation of measures to strengthen tax administration, making it more efficient and transparent. Some of the planned measures are related to strengthened tax audit and control, focusing on large taxpayers. Other measures are related to improvements in the management of specific taxes, for example, the establishment of mandatory withholding mechanisms to reduce evasion and increase the collections from the IMAGRO, and the optimization ofthe process ofnew maquila regime concessions.

Through the application of the above-mentioned measures, the Government will aim to improve the equity and efficiency of the tax system, increasing the tax-to-GDP ratio by at least 1 percentage point by 2012-13.

Public Sector Financial Control & Financial Administration

Improving the effectiveness ofthe Central Administration’s internal financial control is one of the specific targets defined in the Government’s Strategic Economic and Social Plan under the strategic objective of State Modernization. It is expected that such an improvement would have a significant impact in terms of accountability and the use of public resources for their intended purposes.

In this regard, the Government has defined three main lines of action in order to improve the effectiveness of internal control: (i)the expansion of integrated financial management and information systems to all spending units, including the implementation ofadditional modules related to payroll and good and services, and the full integration of sub-systems; (ii)the strengthening of the role of internal audit in terms of professionalism and independence, accompanied by the establishment of a standardized internal control framework for the Central Administration; and (iii)an increased professionalization and harmonization of financial administration units (UAFs) ofthe Central Administration.

The achievements made with regards to the strengthening ofthe internal audit function, which was supported by the Umbral Program of the United States Agency for International Development (USAID), include the adoption of a decree that redefined the role, organization and attributions of the Internal Audit Office of the Executive (AGPE); increased AGPE’s human resources; developed intensive training; and contributed, jointly with the Comptroller General ofthe Republic, to the preparation ofa new audit manual.

Furthermore, a standard and comprehensive model of internal control (MECIP) has been designed in accordance with international practices, i.e. introducing new concepts such as risk-based approach, self-assessment and independent evaluation. The implementation ofthe MECIP will be supported by an internal control committee in each spending unit. In December 2008 a decree was issued granting AGPE the authority to implement MECIP,

45 which is expected to bring Paraguay’s Central Administration in line with international standards for internal control.

Through the gradual progress in the implementation of these measures, the Government expects to achieve in the medium term an improvement in the effectiveness of the Central Administration internal control, which should be reflected in the fulfillment of mandatory AGPE requirements for the hiring of different positions for internal audit units (AIIs), the implementation of MECIP in at least half of all Ministries and Secretariats of the Executive Power, and an increase in the proportion ofcases in which follow-up actions to internal audit recommendations are implemented.

Effectiveness in the provision of public services by SOEs

The Government’s Strategic Economic and Social Plan has defined as one of its strategic pillars the establishment of effective oversight and improvements in the efficiency of SOEs, which implies more effective State control. This pillar addresses the low coverage and quality of some services, as well as the lack of transparency and weak financial management of the companies.

As a first response to this situation, the SOE Council (CEP) was created, whose main function is to define policies and management strategies of public services, to ensure proper public sector oversight of SOEs, and to coordinate actions relating to outsourcing, concessions, capitalization and other forms of integrating the private sector in the administration ofpublic enterprises. Furthermore, the Government recently realized an inter-institutional agreement between the Ministries of Finance, Public Work, and Industry and Trade, and the State Attorney’s Office, which is designed to contribute to the improvement in corporate governance ofpublic enterprises, and to a more effective oversight ofthem.

In the medium term, the Government plans to pursue the following measures: (i)restructuring and modernization of SOEs, in line with the authorities established in the framework of the CEP; (ii)introduction of regulations for the creation of a Holding Agency of SOEs; (iii) definition of guidelines for SOE budget management, compatible with the Government’s fiscal and financial program; (iv) establishment of a consolidated and independent Regulatory Agency, in charge of regulating tariffs and controlling quality standards for the provision of the following services: electricity, oil, telecom, and water; and of undertaking measures to move forward with independent and transparent audits, and, eventually, standardized mechanisms of financial and performance evaluation; and (v) the modification of SOE organic laws to harmonize them with the creation of the Holding Agency and also with the regulatory framework imposed by the Regulatory Agency. The Government will also promote the deregulation and liberalization of the internet services market, which was initiated in March 2009 with the liberalization ofdata transmission services.

The impact of measures implemented will be reflected, on the one hand, in increased management transparency, through annual audits financed by each SOEs and prepared according to CEP standards; and on the other, in a clearer definition of responsibilities between the functions ofshareholder control, regulatory control, sector policy and operational management.

46 Public Expenditure Management

The strengthening ofState institutions in order to achieve better public service delivery and to make public investment and social expenditures more efficient is one of the Government’s priority objectives in its strategy against moderate and extreme poverty.

In the short term, the Government has committed to safeguarding in the 2009 Financial Plan the proportion ofbudgeted social spending, and to improving the quality ofpublic investment.

The Government’s medium term strategy for improving the efficiency and equity of public expenditures is based on three strategic axes. The first axis is oriented towards improving public expenditure allocation, which includes measures related to the strengthening of the process of public investment, the start of pre-investment activities, and the introduction of specific budget categories linked to infrastructure maintenance spending.

The second axis aims to improve the execution of capital expenditures, through the application of measures oriented towards strengthening and streamlining procurement processes.

The third and last axis of the Government’s strategy is related to institutional reengineering, which aims to strengthen the coordination among institutions managing investment and social expenditures, especially those aimed at fighting extreme poverty, to avoid duplication of activities in a context ofscarce resources.

Through the application of these measures, the Government hopes to gradually improve the efficiency and quality ofthe provision ofbasic social services, which would in turn allow for greater coverage of the most vulnerable groups. By the end of its mandate, the Government plans to expand the coverage of the social safety net through a significant increase in the number of beneficiaries of the Tekopora Program of conditional cash transfers, targeting families living in extreme poverty, and to also improve the quality of public infrastructure, through the periodic maintenance ofnational roads.

Public Sector Human Resources Management

The professionalization of the civil service is another important objective defined in the Government’s Strategic Economic and Social Plan in the area of State Modernization. In this sense, the three main lines of action planned by the Government to fulfill its objective of professionalizing the civil service are: (i)the strengthening of the Civil Service Secretariat (SFP) as an institution of horizontal control for human resources management throughout the public sector to be achieved in the short term; (ii)the establishment of the principle of meritocracy for recruitment and promotion of civil servants; and (iii)the introduction of a public service career, in the medium term. In parallel with these three lines of action, the Government will also promote the reform of the Civil Service Law to strengthen professionalization ofcivil servants.

In the medium term, the Government hopes to establish the principle of meritocracy for recruitment and promotion of civil servants, through the definition of adequate requirements for each position, and of competitive and transparent processes, including the open

47 publication ofvacancies and the strengthening ofthe human resources control function on the part ofthe SFP.

Finally, the Government is committed to continuing to lay the foundations for a sustainable economy, based on socio-economic equity, by establishing the conditions that would enable the State to focus assistance on the most vulnerable sectors and to seek structural solutions through a Social Pact, which would facilitate the interaction with social groups and the private sector. The support of the World Bank is indispensable in order to carry out the above- mentioned actions and promote the ambitious strategic objectives that the Government has set for itself.

Yours sincerely,

SIGNED Dionisio Borda Minister ofFinance Governor for Paraguay

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e Annex 3: IMF Assessment Letter Paraguay-Assessment Letter to the World Bank March 3 1, 2009 This letter provides IMF staff assessment ofParaguay’s macroeconomic conditions and outlook based on the recently-concluded 2009 Article IV mission; the IMF Board is expected to conclude the consultation in May. The last Board assessment, at the time ofthe final review under the SBA on July 3 1, 2008, is available at httu://w~~.imf.ordextemal/uubs/cat/lonmes.cfin?sk=22231 .O.

Paraguay’s macroeconomic outlook has been negatively affected by the deterioration in the global environment. The economy grew by nearly 6 percent in 2008, but growth decelerated in the last quarter ofthe year. The agricultural sector has suffered from the decline in commodity prices, aggravated by the effects ofa drought. Economic growth in 2009 is expected to decelerate to around % percent. In part reflecting the weakening in the global environment, inflation in Paraguay is now on a firmly downward trend, and isprojected at 5% percent by end-2009, well within the Central Bank’s target range. The external current account deficit is expected to moderate to 1 percent ofGDP, largely as a result ofsignificantly lower imports, notwithstanding a decline in exports.

The government has reacted appropriately to the adverse economic conditions, including with the adoption of an Economic Reactivation plan. This plan, which encompasses policies to address both immediate challenges and medium-term structural weaknesses, includes: (i)a fiscal stimulus ofabout 3 percentage points ofGDP in 2009; (ii)steps to provide liquidity to the banking system to enhance lending; (iii)securing additional external financing from multilaterals (including contingent credit lines); and (iv) addressing key medium-term structural issues, including with respect to public financial management and financial sector reform. Paraguay’s floating exchange rate regime has continued to serve the country well, including by acting as a shock absorber to changes in the external environment.

The government’s fiscal stimulus plan will need to be implemented effectively. This plan focuses on public investment in infrastructure and well-targeted conditional cash transfers. Its full implementation would be consistent with an overall deficit of%-1 percent ofGDP in 2009, expected to be financed by disbursements from multilaterals and bilateral donors. Key to the success ofthe recovery program will be its effective and timely implementation, while transparent monitoring should help ensure that resources are spent efficiently. Efforts must continue to be deployed to protect against undue erosion in tax revenues by further improving tax administration and resisting tax concessions, especially given weak performance oftax revenues during the first two months ofthis year.

There are several remaining structural challenges that the government will need to address. In the financial sector, there is a need to strengthen financial oversight and regulation, particularly with respect to cooperatives and pension funds, and to buttress the financial viability ofthe central bank, to allow for a more effective conduct ofmonetary policy. On the fiscal front, measures to enhance the institutional capacity to implement the budget-especially the capital budget-should be pursued. There is a need also to consolidate the improvements in tax and customs administration achieved in recent years. Finally, the government needs to develop a viable business strategy for each ofthe state-owned enterprises and strengthen mechanisms for the oversight ofpoorly performing ones, especially INC and Petropar.

53 Annex 4: Composition of the Alianza Patriotica Para el Cambio

Political Parties

0 Partido Democrata Cristiano (Christian Democratic Party) 0 Partido Dem6crata Progresista (Progressive Democratic Party) 0 Partido Encuentro Nacional (National Union Party) 0 Partido Frente Amplio (BroadFront Party) 0 Partido Liberal Radical Autentico (Authentic Radical Liberal Party) 0 Partido Movimiento a1 Socialismo (Socialism Movement Party) 0 Partido Pais Solidario (Country Solidarity Party) 0 Partido Revolucionario Febrerista (Party of the February Revolution) 0 Partido Social Dem6crata (Social Democratic Party) 0 Partido Socialista Comunero (People Socialist Party)

Social Movements

"fiembyaty Guasu Luque 2008" ("2008 Conference of the City of Luque'y Bloque Social y Popular (Social and Popular Block) Colo'o Apytere (Colorado Nucleus) (ERES) Movimiento Esperanza de Renovacibn Social (Movement for Hope of Social Rejuvenation) Fuerza Republicana (Republican Forces) Mujeres por la Alianza (Women for the Alliance) Resistencia Ciudadana Nacional (National Citizenship Resistance) Tekojoja (Alliance) Teta Pyahu (New Hope)

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sa 5 -.-c d % E Annex 6: Debt Sustainability Analysis Under the baseline scenario, public debt levels will increase moderately in the short run but will remain sustainable. With a projected primary deficit of around 1 percent of GDP in 2009-10, non-financial public sector (NFPS) debt is projected to rise from an estimated 19.3 percent of GDP in 2008 to 22.9 percent of GDP in 2010. The main factors driving this downward path are the low real interest rate and GDP growth, while the exchange rate depreciation and the fiscal deficits (in the short run) compensate for some of this by exerting upward pressure on the debt-to-GDP ratio.As the economy recovers and tax revenues bounce back, debt levels are expected to fall again beginning in 2011, reaching 19.1 percent in 2013 (Table A.6.1).

~ Table A.6.1: Public Sector Debt Sustainability (baseline scenario) Act. Est. Proj . 2007 2008 2009 2010 2011 2012 2013 Public sector debt (YOof GDP) 22.2 19.3 21.8 22.9 21.0 20.7 19.1 olw foreign currency-denominated 21.9 18.4 20.7 21.7 20.0 19.7 18.2 Key assumptions Real GDP growth (%) 6.8 5.8 -0.5 1.5 3.0 4.5 4.5 Primary balance (YOof GDP) 1.8 3.4 -1.0 -0.9 -0.5 0.1 0.5 Overall balance (% ofGDP) 1.0 2.8 -1.6 -1.7 -1.2 -0.7 -0.3 Growth ofreal primary spending (%) 0.9 -3.3 19.9 5.1 3.9 4.9 6.8

Average nominal interest rate (%) 3.4 3.3 4.5 3.9 3.8 4.1 4.0 Exchange rate (Gs/US$) 4,732 4,999 5,562 5,978 6,366 6,748 7,152 -r Source: Central Bank, World Bank staff estimates.

l9Defined as the mean value during between 1999 and 2008. 8o Defined as the maintenance of the 2009 primary balance throughout the projection period. 57 Both a one-time real depreciation of the exchange rate of 30 percent (beyond the depriation assumed in the baseline scenario), and a one-time contingent liability shock equivalent to 10 percent of GDP81would raise the debt level to 29 percent of GDP (scenario A.6) The simulation thus suggests that debt levels are most vulnerable to fluctuations in the exchange rate and to contingent liabilities of the public sector.

Figure A.6.1: Public Debt Sustainability (Altnernative Scenarios) I/ (% of GDP)

A.l: Baseline and historical scenarios A.2: Interest rate shock 50 . 650

-5 30.

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A.4: Primary balance shock and A.3: Growth shock no policy change scenario 50 50.

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Real depreciation and contingent liabilities A.5: Combined shock 2/ A.6: shock 50 31 50 - contingent 30 % depr

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Sources: Central Bank, World Bank staff estimates. 11 lndiwdual shocks are permanent one-half standard deviation shocks. 21 Permanent 114 standard deviation shocks applied to real interest rate, growth rate, and primary balance. 31 One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilitiesoccur in 2009, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar mlue of local currency) minus domestic inflation (based on GDP deflator).

'' Arising, for instance, from the need to recapitalize banks, financial cooperatives or SOEs. 58 Annex 7: Public Sector Overview The Paraguayan public sector comprises the Central Government and 232 municipalities and is one of the smallest public sectors in the region. The Central Government consists ofthe Central Administration plus 55 decentralized entities. In 2007, the Central Administration represented 5 1.4 percent of total consolidated public sector expenditures, and includes all agencies within the executive, legislative and judicial branches, as well as the Comptroller General ofthe Republic (CGR). Decentralized entities consolidate around half of Central Government spending, and include both commercial entities (state- owned enterprises and financial institutions) and non-commercial entities (17 departmental (regional) administrations, social security institutions, small pension funds, public universities, and regulatory entities). Finally, municipal resources are relatively small, representing 4 percent of total public sector expenditures in 2007, and are unevenly distributed. 41 percent of total municipal resources lie within the municipality of Asuncion. Overall, Paraguay's Government accounts for less than 17 percent of GDP (2005), making it one ofthe smallest in Latin America, as illustrated by the figure below.82

Graph A.7.1: Government spending in selected Latin Table A.7.1: Paraguay's Public Sector expenditures American countries (2005, YOof GDP) by level of Government (YOof total expenditures, 2007)

Central Administration 51.4% Decentralized Entities 44.6% Decentralized Government Agencies 2.6% SOEs 24.8% Social Security Agencies 8.1% Public Financial Entities 5.6% Universities 2.3% Departmental Administrations 1.2% Municipalities 4.0% TOTAL 100%

Source: Ministry of Finance and World Development Indicators

Since the establishment of democracy in the early 199Os, total Government spending has expanded, with a clear bias towards current social expenditures. Although a relatively large share of public expenditures goes to the social sectorsg3, in economic terms spending primarily goes to finance the wages and pension benefits ofthese sectors. Moreover, between 1990 and 2008, wages and salaries grew from 3 percent to 7.5 percent of GDP. The Central Administration comprises approximately 160,000 public employees, including 3 8,000 civil servants plus other public sector employees with special status such as teachers, medical staff and policemen. Whereas the Civil Service Lawg4 regulates the status of civil servants, employees with special status are regulated by specific legislations.

82 See World Bank Report No. 32797,2006 83 Which mainly includes health, education, and pensions. 84 Law No 1626 from year 2000. 59 The management of Central Government expenditures and revenues is regulated by the Financial Administration Law (LAFE). The LAFE covers activities related to budgeting, accounting, registry and reporting, control, and debt management. It assigns responsibilities for coordinating and supervising the budget process to the Ministry of Finance, while budget implementation is decentralized to spending units. The use of the Integrated Financial Management System (SIAF) throughout the Central Government, as required by the LAFE, enables the Ministry of Finance to supervise budget execution. Central Administration spending units are responsible for internal control within their administration, and the internal audit function is covered by the Institutional Internal Audit (AII) ofeach spending unit, under the coordination ofthe Internal Audit Office ofthe Government (AGPE).

Although the municipalities enjoy fiscal autonomy over the approval of their own budgets as well as the management of their own assets and resources, they rely heavily on transfers from the Central Government. Municipalities in Paraguay are responsible for a limited range of public services, including some health and education functions. Transfers from the Central Government are determined by different sharing mechanisms applied to royalties from the hydropower plants jointly owned with Brazil and Argentina, the value added tax (VAT), the tax on lotteries, and the property tax.85 Current legislation entitles municipalities to obtain a growing share of royalties, which represents their main source of revenue, over time, but overall transfers to both departments and municipalities still represent a relatively low share ofconsolidated public expenditures.86

85 This is a case of“reverse transfer”, since the tax is first collected locally, and then 15 percent ofthe revenues is transferred to MoF for redistribution among the country’s poorer municipalities in equal parts. 86 4.0 percent as of2007. 60 Annex 8: Analytical Underpinnings Macroeconomic Framework An analysis of macroeconomic and fiscal policy was undertaken as part of the Policy Notes presented to the president-elect and his team in June 2008.87 The note on fiscal policy examined the challenges associated with creating fiscal space for sustained investment aimed at enhancing growth and reducing poverty, while maintaining overall macroeconomic stability. To achieve the Government’s key objectives, fiscal policy would need to serve as a strategic tool anchored in a medium-term fi-amework, rather than a reaction to the annual budget negotiations with Congress. Specific measures proposed in the note include strengthening revenue mobilization through better tax administration and the implementation of the Fiscal Adjustment Law; controlling personnel spending through the articulation of a clear public sector wage policy; and improving expenditure efficiency through reforms ofthe budget process and the public investment program in particular.

Tax System The IMF undertook an analysis of Paraguay’s tax policy as well as tax and customs administration in September 2008. According to the tax administration report, significant progress was made between 2005 and 2008 in the areas of information technology, organizational structure, and strategic planning. However, the State Secretariat of Taxes does not have an effective human resources policy, and the existing tax audit function is ineffective. The tax policy diagnostic provides an analysis of the design and performance of individual taxes and proposes a program ofreforms aimed at increasing the tax pressure over the medium term. The Government’s plan to improve the tax system is consistent with these IMF recommendations.

Public Sector Financial Control - Internal Control for the Central Administration The Bank has led the donor community in assisting Paraguay to improve the transparency and effectiveness of financial control in the public sector. The DPL program draws on the recent Integrated Fiduciary Assessment (FA, 2008) and the non-lending technical assistance FAAction Plan Follow-Up (2008), both jointly prepared with the IDB and the European Commission and agreed in close coordination with the Ministry ofFinance. The FA identified control effectiveness as Paraguay’s main financial management and procurement issue, and the subsequent technical assistance supported the Government in defining main priority actions. The main problems identified in this area include: (i)internal control shortcomings in most expenditure categories; (ii)ineffective internal audit function; and (iii)a weak control environment.

Public Sector Financial Control - Oversight of State Owned Enterprises The Bank undertook a Report on the Observance of Standards and Codes (ROSC) for Accounting and Auditing in 2006. The report stated that there was no legal definition of accounting standards for public corporations as well as for SOEs, and the accounting prescriptions included important areas of discrepancy with international financial reporting standards. Auditing standards for SOEs are extremely limited; in particular, annual audits in accordance with international standards are not mandatory. Audited financial statements of SOEs are not published. This is in distinct contrast to the situation in the OECD. An extensive

87 Paraguay - Opciones de Desarrollo Economico y Social. 61 survey of the corporate governance of state-owned enterprises in OECD countries showed that the general trend for the organization of the ownership function was to move from the decentralized model - still valid in Paraguay- where ministries supervise SOEs related to their respective sectors, to the centralized model whereby a single entity acts as the SOE shareholder on behalf of the State. In all OECD countries, SOEs are audited annually by an international private audit firm and their financial statements are public. Finally, SOEs are usually public corporations and the regulatory framework is controlled by independent agencies.

Expenditure Management Both the Integrated Fiduciary Assessment and the 2008 policy note on the Public Investment System diagnosed serious weaknesses in the area of public investment and efficiency of the budget process. The report stated that the credibility and efficiency of the budget process were affected by deficiencies in functions including: the ability to effectively execute budgeted expenditures; the multi-year perspective in fiscal planning; and the financial planning of annual cash flows. Policy note recommendations included: (i)the approval of a decree establishing a new conceptual and institutional framework for the ruling, organization and functioning of the National Public Investment System (SNIP), ensuring better coordination and a fluid communication between Ministry of Finance and STP; and (ii)a simplification ofthe process for approval ofexternal grants and loans.

A number of the sectoral Policy Notes also provide important analytical underpinnings for the expenditure management component of the PDPL I. The note on transport and logistics, as well as the follow-up Transport Sector Assessment provide an overview of the institutional and resource challenges impacting the performance of transport sector investments in Paraguay. Regarding the water and sanitation sector, a policy note and a project currently under preparation provided analysis. The note on social protection, combined with the 2004 study on DeJining a Strategy for Social Protection Policy, offers an inventory of existing programs and an analysis of the shortcomings of the current social protection system.

Considerable analytical work has been done on conditional cash transfer (CCT) in particular. A book entitled Conditional Cash Transfers: Reducing Present and Future Poverty has recently been published by the Bank and provides an extensive analysis of CCT programs in a range of countries, assessing their impact and providing extensive information on policy and design options and challenges relevant to the expansion and improvement of Paraguay’s Tekopora program. The United Nations’ International Poverty Center has published a number of studies focusing on Paraguay’s Tekopora program in particular, assessing its capacity constraints and transfer methods, and providing a preliminary evaluation ofits impact.

Human Resources Management (HRM) Analytical work has also been carried out in the area of human resources management. The Public Expenditure Review (2005) and more specifically the recent policy note on Public Employment and Wage Bill (2008), discussed with the then-incoming administration including President Lugo, analyzed in detail the situation of public sector human resources management in Paraguay. The policy note emphasized the need for strengthening the institutional framework of human resources management, achieving a consolidated control over the wage bill and gradually eliminating distortions in salaries and allowances.

62 The Bank has recently implemented innovative HRM tools in Paraguay. First, the Bank designed a wage bill modeling tool to enhance the Government’s analytical capacity related to the wage bill and HRM. Second, Paraguay was one ofthe few pilot countries for the implementation ofa HRM diagnostic instrument in June 2008. The main findings ofthis survey together with specific policy recommendations have been aggregated in the working paper Analysis of Datafrom Paraguay Actionable Governance Indicators - HMInstrument Application, to be delivered to the Government in 2009.

63 Annex 9: Tax System - Detailed Diagnostic and Government Priorities The Government’s goal is to improve the tax system in order to finance its strategic social priorities in the medium term. Conscious of chronic and structural obstacles to achieving progress on this front, and considering a likely economic slowdown related to the international crisis, the Government has planned a series of measures geared to gradually reinforce both tax policy and tax administration. In the short run, measures will focus on continuing efforts towards the improvement of tax administration and correcting distortions affecting existing taxes, such as the agricultural income tax (IMAGRO) and VAT. In the medium term, the Government expects to implement the personal income tax (IRP), adjust the rates of excise taxes on tobacco and alcohol products, and continue strengthening the tax administration.

Diagnostic Paraguay has a centralized tax system that relies heavily on indirect taxes. Roughly 85 percent of total tax collection originates from Customs and Large Taxpayers. The VAT, excise taxes and customs duties together account for 80 percent of tax collections of the Central Administration.88 The corporate income tax (IRACIS) is the only significant direct tax in Paraguay, accounting for around 16 percent of total tax colle~tion.~~There are two other direct taxes: the IMAGRO, which generates barely 0.2 percent oftotal tax revenues due to the VAT deductions granted to large landowners under a 2004 decree; and the personal income tax (IRP), which has formally been in effect since January 200990, but is not expected to yield significant revenue in the short- to medium-term due to its design and gradual phasing in. The figure and table A.9.1 show the proportion ofrevenues per tax in Paraguay and give regional comparative elements regarding tax burden.

Figure A.9.1: Tax revenue (YOof GDP) Table A.9.1: Tax revenue in selected lower middle-income countries (2006) Tax revenue I 14% ,I (Yo of GDP) 12%

10% Paraguay 12.1 El Salvador 13.4 8% Peru 13.5 8% Colombia 14.1 4% Bolivia 17.3 2%

0% 2000 2001 2002 2003 2024 2005 2006 2007

m Corporate lmme Tax rn Agricultural & Land Tax (IMAGRO) oCustom Dvties on Imports 0 Value-Added Tax Excise Duties on SeIectiw Consumption 8 Excise Duties m Fuel Stamp Taxes m Other Source: Ministerio de Hacienda and World Development Indicators.

Tax collection in Paraguay is low compared to other countries at similar income levels. At approximately 12 percent of GDP, the tax burden in Paraguay is relatively low by regional standards. A recent IMF assessment estimated, on the basis of 1996-2001 data, that Paraguay’s effective tax burden represents only 5 1 percent of the country’s overall potential

88 According to National Tax Revenue Office (SET) data. The VAT represented 49 percent of Central Administration tax revenues, this year, and excise & custom duties the remaining 3 1 percent. 89 A personal income tax was introduced as part ofthe 2004 tax reform, but implementation was blocked so far. 90 Congress may still vote for a further postponement ofthe implementation ofthe IRP. 64 tax collectiong1, which reveals levels of tax efficiency considerably below the regional average (70 percent), and above only two other Latin American countries-- Guatemala and Panama.92 The main reasons justifying this poor tax performance are linked to structural factors: (i)the country’s relatively low level of industrialization and development; (ii)the existence of a sizable informal economy as well as widespread tax evasion in the formal economy; and (iii)human resource and enforcement constraints (including endemic corruption) the sum of which result in low efficiency and effectiveness of the tax administration.

The 2003-2004 economic recovery facilitated the upturn in tax revenues. Figure A.9.1 shows a higher tax effort ofaround 2 percent ofGDP during these two years, due primarily to the recovery in receipts from the VAT, the IRACIS, excise taxes on fuel and customs duties.93 The boost in tax collections during this period responded fundamentally to the expansion of economic activity that followed the 2002 crisis.

In 2004 the Government approved the Fiscal Adjustment Law (Ley de Reordenamiento Administrutivo y Adecuacihn Fiscal), which consisted of ambitious reform measures to strengthen tax policy. The main objectives of this tax reform were to formalize economic activity and gradually increase the progressiveness ofthe Paraguayan tax system. Changes in tax policy included the broadening ofthe tax base for the VAT and for the IMAGRO through the elimination of several loopholes and exemptions; the increase of rates and number of excises; and the introduction of two new income taxes: the personal income tax and an income tax for small corporate taxpayers. Corporate income tax rates were consequently reduced from 30 to 10 percent over a two-year period, and the base for this tax was broadened.

In parallel, the Government began implementing a range of tax administration reforms designed to further boost tax revenues. The State Secretariat ofTaxes (SET) has adopted an information technology platform that integrates the main stages of tax administration, and which has already been rolled out to 14 out ofits 17 regional offices. Taxpayer services have improved as well, including telephone assistance and online access. As a result of these reforms, the number of taxpayers has increased from 251,000 in 2002 to 462,000 in 2008, thereby representing an 84 percent increase in 6 years.

The Government also introduced a new Customs Code (Law 2422/04) to strengthen the customs administration. The enactment of the Customs Code of 2004 had three underlying objectives: (i)greater efficiency; (ii)improved transparency; and (iii)better use of resources. The reform was aimed at professionalizing the customs administration, streamlining procedures, and strengthening administration of taxes on imported goods. The new Customs Code also grants budgetary and administrative autonomy to the customs administration - a key ingredient for successful administrative reform.

Tax evasion and fraud, however, remain key weaknesses. Little progress has been made in terms of improving audit and control. This is primarily attributable to human resource constraints, including deeply entrenched corrupt practices. In fact, SET today combines strengths with considerable weaknesses. On the one hand, it can be considered best regional practice in terms of its IT platform, building infrastructure, and taxpayer assistance; on the

9 1 Estimated on the basis of the country’s economic, geographic, demographic, social and institutional characteristics. 92 IMF (2009), Diagnostic0 del Sistema Impositivo Vigente en 2008. 93 The rate of the excise tax on fuel was increased in 2004 due to the evolution of international oil prices. 65 other, there is no strategy to detect tax fraud and to enforce sanctions. Although SET has put a large share of its auditors on leave from their regular duties, it has yet to recruit new staff for these positions. It widely agreed that a broader civil service reform, allowing for more flexible staff recruitment promotion and dismissal processes staff, as well as substantial upgrading and improved coherence ofthe salary structure, is pivotal to advancing significantly in this area.94 Similarly, in the case ofcustoms, evasion ofimport duties remains at very high levels, and the absence of an adequate employee rewards and sanctions scheme based on the principles of an “ethics code” plays a major role in explaining these poor results. Other factors include the use of inefficient procedures for control of merchandise flows, relying fundamentally on the use ofoperating manuals instead oftaking advantages ofmodem IT tools.95 The IDB has recently approved a US$9 million loan to help consolidate and deepen customs system modernization by establishing a more efficient organization, training staff and establishing more reliable procedures to strengthen customs duties collection capacity.

The revenue impact of the reforms has not fulfilled expectations. Despite the economic boom registered in recent years, tax collection has practically remained unchanged as a share ofGDP following the approval ofLaw 2421 in mid-2004.96 The high share ofindirect taxes in Paraguay’s tax structure has likewise remained practically unchanged. Although tax administration has improved, the impact on tax collection has so far been limited.

Government Plan and Implementation & Stakeholder Challenges

Government Plan The Government Plan envisages a number of structural measures that would make Paraguay’s tax system more equitable and, in the medium- to long-run, contribute to higher tax revenues. Increasing the relatively low tax burden of Paraguay emerges as a critical priority to finance the Government’s strategic priorities. There is growing consensus that Paraguay’s tax receipts are excessively low, and that those who benefit from the status quo are not the most disadvantaged. Consequently, the Government is working on building consensus to advance on two fronts simultaneously: on the one hand, increase tax efficiency, to boost collection; on the other, increase the overall fairness of the tax system, focusing on both higher taxation of some specific sectors, such as agriculture, and more effective control oftax evasion and fraud, especially for large enterprises.

In the short run, measures will focus on continuing efforts to improve tax administration and correct distortions affecting existing taxes. This includes the recent issuance ofDecree No. 238/08, which derogated the provision introduced temporarily by Decree No. 5069/05 that allowed big landowners to use what they paid for VAT as fiscal credit against IMAGRO, the agricultural income tax.97 It also includes an increase in the number ofwithholding agents for the VAT, focusing on large taxpayers - mainly exporters - where tax evasion is most rampant.98 Although VAT evasion has declined in recent years, from 66 percent in 2003 to 52

94 The SET has launched a voluntary early retirement program in 2007 and has reduced its number of employees from 1397 in 2005 to 1183 in September 2008. Of this latter amount, 345 are professionals (college degree or superior) and only 131 are temporarily contracted, the rest (89 percent) being permanent staff. 95 The most important customs information-system (SOFIA) is designed to provide with an outstanding functionality, making possible a fast and precise processing of transactions and fiscal accountancy for trade tax collections. However, in the case of Paraguay, the SOFIA system is not effectively used as a mean of controlling export and import processes. 96 This was partially due to the reduction in the VAT rate from 30 to IOpercent. 97 Expected fiscal impact: 0.75 percent of GDP from 201 1 - Estimation: Ministry of Finance and IMF. 98 Expected fiscal impact: 0.15 percent of GDP from 2010 - Estimation: Ministry of Finance and IMF. 66 percent in 200899, it remains high. Firms selected by SET as withholding agents will retain a fraction ofthe VAT on input purchases charged by sellers. They will likewise be obligated to fill out the respective tax forms declaring overall purchases, sales, as well as amounts withheld, which in turn will be used to calculate tax credits, on a monthly basis. The Government has also taken steps to strengthen the Tax Research and Fraud Detection Department, created by a SET resolution in December 2004 and established in 2006 as a department reporting directly to the Vice-Minister of SET. This department currently has 22 staff, 10 of which were recruited since May 2008 based on their high motivation and professionalism. loo

In the medium term, the Government expects to make permanent the personal income tax (IRP). The IRP was introduced via Law 2421/04, but postponed twice in the past due to intervention by Congress. Although the IRP automatically became effective on January 1, 2009, Congress is currently considering its further postponement to January 1, 2010.'0' The IRP would carry a 10 percent rate levied on personal income exceeding a given annual threshold amount'02, and its fiscal impact is expected to be gradual and indirect for three reasons: (i)the tax will be phased in gradually, beginning in the first year with taxpayers declaring a gross personal income equal to or above 120 times the minimum salary, with lower income brackets added gradually over a 7-year period; (ii)the tax includes several loopholes, such as exemptions of revenues originating from investments abroad; and (in taxpayers can deduct a wide range ofpersonal expenses in calculating their taxable income.""3

The Government also plans to modify current legislation to allow for the increase of excise tax rates. This measure will concentrate on consumption of selected products related to tobacco and alcohol, which are currently low relative to other countries in the region, as shown in the below table.lo4 This is in line the IMF's recent recommendation that excise rates should be increased and focused on fewer prod~cts."~Other key changes in tax policy - such as an effort to make the real estate tax more effective by adjusting fiscal values, updating the cadastre, and delegating the responsibility for collection fiom municipalities to the Central Government - are currently not foreseen as there is no clear and broad consensus on such reforms.

99 Report prepared by the UMBRAL program. 100 All are professionals who previously worked at the Jeroviaha Unit, a group of young people hired by the SET to verify - through simulated operations - that corresponding tax receipts are issued on regular purchases and sales. 101 The Senate obtained half a sanction last December for a new law to postpone implementation, and there might be a chance that this is finally the case after the lower chamber treats this law draft in March-April. The final result on this dispute between the Executive and the Legislative so far remains uncertain. 102 An 8 percent rate applies to taxpayers in the lowest income bracket. 103 This provision reflects the design ofthe IRP as primarily an instrument to advance the formalization ofeconomic activity and collections ofthe VAT. 104 Estimated fiscal impact: 0.1 percent ofGDP from 201 1 - Estimation: Ministry ofFinance and IMF. 105 IMF, "Diagnostic0 del Sistema Impositivo Pos Ley 242 1/04" September 2008. 67 Table A.9.2: Comparative rates on Excises on selected tobacco products and alcoholic beverages - MERCOSUR Country Members, 2008 (Rates in YO) Country Selected Items Paraguay Argentina Uruguay Cigarettes 12 60 70 Processed tobacco products 12 20 70 Beer 8 8 23.5 Wines 10 0 80 Whisky 10 20 80 Source: Under Secretariat of Tax (SET - Ministry of Finance of Paraguay

Measures planned by the Government to further reinforce tax administration include: (i)a significant increase in the number oftax audits, focusing on large firms, and strengthened audit procedures, including the hiring of new professional staff and the development of control methods for crossing tax information with other relevant data sources, such as merchandise flows, purchases of inputs, etc.; (ii)the re-establishment of mandatory withholdin mechanisms to reduce evasion and make early provisions for the collection of the IMAGRO;W6and (iii)optimization ofthe process ofnew maquila regime concessions.

Implementation & Stakeholder Challenges Paraguayan society's chronic resistance to increasing taxes poses a major challenge to the proposed reform. This is particularly critical in the case ofthe proposed measures, which affect groups with strong lobbying power, such as large landowners and sectors prone to smuggling, including tobacco production and sales. The Government has adopted a flexible and gradual approach to limit the im act of such resistance. First, a dialogue has been established to reassure targeted sectors." Second, most of the measures do not require legal changes and consist ofreverting exemptions or modifying the mode of collection. Third, the number of measures is limited and their implementation sequenced over the next four years. Finally, the Government will rely on significant improvements in the tax audit function to increase tax collection, while limiting changes in tax policy.

Improving the tax audit function requires that human resources challenges be addressed. In an effort to overcome this challenge, the Government has removed tax auditors who did not comply with job requirements and duties. The progressive replacement and strengthening ofhuman resources involved in the tax audit function will be difficult given the current incentive structure and broader civil service HR policies. One short-term solution could be to target tax audit resources to a limited number of large taxpayers. In the medium- term, it will be important to identify means to attract and retain qualified staff.

106 This measure will imply the derogation of Art. 7th from a Resolution from the SET (No. 449/05), which eliminated the obligation to pay in advance a share ofthe tax by cattle ranchers and fanners either when they sell cattle in livestock auctions or when they become suppliers offresh natural products to public sector entities. 107 For instance the excise rates increased at around 20 percent for tobacco and alcohol will remain low in regional relative terms - See Table 5.2. 68 Annex 10: Public Sector Financial Control - Central Administration Internal Control - Detailed Diagnostic and Government Priorities Improving the effectiveness of the Central Administration’s internal financial control is a priority of the Government Plan. Given the ineffectiveness of internal control, its reform would have a significant impact in terms of accountability and use of funds for their intended purposes. Such a reform would likewise contribute to enhancing the public sector’s overall reliability and credibility. Therefore the Government has defined three main lines of action as means of obtaining more effective financial control in the Central Administration over the medium term: (i)expansion of financial management information systems to all spending units;”* (ii)implementation of a standardized internal control framework -in line with international practice+ throughout all spending units, to ensure that the internal audit function is effective, professionalized and independent; and (iii)improvements to, and strengthening of, the control environment through further professionalization and harmonization offinancial administration units (UAFs) ofthe spending units.

Diagnostic Internal control procedures are ineffective in practice, both for payroll and for non- salary expenditures. The control framework for payroll is limited by the absence of a proper payroll calculation system, and there is a high risk that payroll calculations from spending units do not reflect the actual number of days worked by civil servants. In the case of non- salary expenditures, internal control constitutes a mere formality and relies exclusively on the spending units’ systems. This is compounded by the absence of a norm enabling implementation ofthe integrated system for goods and services (SLABYS) and also by a lack ofintegration between different systems that make up the integrated system of administration ofstate resources (SIARE).”~

Internal control is also negatively affected by the existence of recording and reporting limitations. Bank reconciliations provided by the spending units usually do not provide adequate information to justify differences between bank statements and accounting; and financial information on resources received by service delivery units such as schools. This undermines the Government’s ability to ensure that these resources are used for their intended purposes. Similarly, there is no financial information on capital expenditures to distinguish between new capital formation and maintenance investments, and information on Central Government fixed assets is incomplete.’ lo

The internal audit function is undertaken by the Institutional Internal Audit (MI) of each spending unit, under the coordination of the Office of the Executive’s Internal Auditor (AGPE), which responds directly to the President of Republic. Internal audits are ex-post and their scope formally includes a financial and performance audit. This organizational structure, as spelled out by the Financial Administration Law (LAFE), is consistent with regional and international practices and decentralizes the internal audit function in each institution through the AII, while ensuring harmonization and independence through the AGPE.

108 This also includes additional modules related to payroll and good & services; and assuring fully integration with other sub-systems. 109 The SIARE includes the SIAF for PFM, the SINARH for human resources, and the SIABYS. However, the latter still lacks a legal framework, indispensable for the reinforcement of the existing procurement system. 1 IO As reported by the Ministry ofFinance, Central Government’s consolidated financial statements covered only 53 percent of total assets in year 2006. 69 The institutional capacities of both the AGPE and the spending units' Internal Audit Units are undermined by organizational limitations and a lack of well-trained human resources. Also, internal audit manuals and norms are not standardized nor in line with international standards. Finally, in terms of effectiveness, both AGPE and AI1 reports exert a limited role in practice. This is partly due to the lack of formal procedures for addressing internal audit findings, and partly to the absence of a legally defined sanctions regime. These factors undermine the independence of internal audit institutions. The relevant authorities decided to address these challenges via a reform process initiated in 2007 via the USAID- sponsored Umbral program. AGPE's institutional capacities are not sufficient to effectively undertake its duties. Until 2006 AGPE was insufficiently staffed with scarcely 15 staff members, only four of which were career civil servants in 2006. Furthermore, until early 2008, and with the exception of the position ofAuditor General, its regulatory framework did not require a college degree nor provided restrictions on minimum years of relevant experience for the recruitment of staff members nor did it have human resources management or training systems."' With the support ofthe Umbral Program, AGPE's staff has both increased and.their capacity has been strengthened, although not yet to a level that will ensure effectiveness in undertaking its internal audit role throughout the Central Government. AGPE will need to overcome challenges in terms of planning its institutional development, providing leadership to AIIs, implementing internal control standards within the Central Administration, and reinforcing its working cooperation with the Comptroller General ofthe Republic (CGR).

Organizational and human resources issues similarly affect the MIS.Moreover, these are insufficiently staffed and staff experience and skills are not always adequate. Staff recruitment procedures are not based on competitive processes, and job requirements are not properly defined. Once staff is recruited, there is little to offer them in terms of career paths or structured training systems. Finally, AI1 staff recruitment is under the exclusive responsibility of spending units' management, which undercuts the professional independence of internal auditors. Given the public sector's weak control environment, the above-mentioned issues significantly weaken internal audit effectiveness.

Management's response to internal audit findings is limited. The impact of annual audit reports is limited in practice1l2, partly due to the absence of formal procedures for addressing internal audit findings, and partly to the absence of legally defined sanctions associated with detected irregularities.' l3Repetitive findings on non-updated inventories and lack of enforcement ofbasic procurement rules illustrate this ineffectiveness.' l4

Finally, the weak control environment is a further critical factor undermining the overall effectiveness of the public sector control system. Weaknesses in the control environment within Paraguay's public sector relate to deficiencies in accountability and the high level ofdiscretion given to senior management as a result of insufficient and inadequate personnel policies and work practices. This is compounded by the lack of internal control

111 In addition, AGPE hierarchical ranking below ministerial level till then end of 2007 was another institutional impediment. 112 As legally required, AIIs prepare an annual report and submit to their respective spending unit highest management and AGPE; in turn, the AGPE submits an annual report to the President ofthe Republic. 1 13 Although Law 1626 provides a classification of irregularities, there is no sanction regime associated to them. 114 Progress has been observed since 2007, as a result of the reform actions undertaken with the USAID support, but sustained efforts are needed in order to maintain this positive trend.

70 standards’ l5and procedures for the public sector, which in some cases are disconnected from the SIAF. This dimension, which is more directly related to broad governance aspects116, is difficult to address and limited progress has been made since it was identified in the 2004 Country Financial Accountability Assessment.

Government Plan and Implementation & Stakeholder Challenges Government Plan

The Government is pursuing the financial control reform process initiated in 2007 in parallel with the implementation of the IFA action plan and the Umbral program. As part of the implementation of the FA action plan, the Under-Secretariat of Financial Administration ofthe Ministry ofFinance designed a PFM Action Plan which prescribes three measures geared to the improvement of control effectiveness: (i)expansion of financial management information systems to all spending units, including the implementation of additional modules related to payroll and good and services and the full integration of sub- systems; (ii)implementation of a standardized internal control framework -in line with international practice+ in all spending units, combined with measures guaranteeing that internal audit function is professionalized and camed out independently, and that audit recommendations are taken into consideration; and (iii)improvement of the control environment through a strengthened professionalization and harmonization ofspending units’ UAFs, ensuring also their effective inter-institutional coordination with the Ministry of Finance and with internal audit institutions. The induction of the Action Plan was also supported by the PFM donor coordination mechanism’ l7established by the Under-secretariat ofFinancial Administration in the frame of the implementation ofthe FA’Saction plan.

Box A.10.1: Government PFMAction Plan: Control Effectiveness

Expansion and further Integration of Financial Management Information Systems Update and expand the coverage ofthe IntegratedFinancial Management System (SIAF); Reinforce SIAF integration with the other systems of the Public Administration; Design, develop and implement the Integrated Financial Management System application for good and services (SIABYS); Finalize the development and implementation of the human resources management system (SINARH), while consolidating and clarifying the responsibilities about payroll and personnel control within the Central Administration.: Standardization of Internal Control Framework & Professional Internal Audit Function Establish standardized internal control rules and norms; Redefine the role of the institutional internal audits (within MDAs) and the Office of the Executive’s Internal Auditor; Strengthen staff professional skills and competences through extensive training programs; Ensure adequate staffing of Internal Audit Institutions. Improved Control Environment: Staff Professionalization & Inter-institutional Coordination Reinforce the coordination between internal and external audit; Strengthen cooperation between the Office of the Executive’s Internal Auditor and the Ministry of Finance; Professionalize (career management, salaries and training) and standardize the Financial Administration Units (UAFs) of spending units; Promote inter-institutional coordination between the Ministry of Finance, the UAFs, and the audit institutions.

1 15 To provide the proper control environment within an organization, the International Organization of Supreme Audit Institutions (INTOSAI) has established internal control general standards for (1) reasonable assurance, (2) supportive attitude, (3) integrity and competence, (4) control objectives and (5) monitoring controls. 1 16 Those governance aspects include inter-alia financial management staff and internal auditors’ professionalization, institutional capacity and ethics, and inter-institutional Coordination. 1 17 Participating IFIs and Donors include: USAID, US Treasury, GTZ, JICA, EC, IDB, and the Bank 71 The expansion and upgrading of Integrated Information Management Systems have been initiated with the support of the Umbral Program. The main objectives of this program are to expand the coverage and the scope of SIAF; develop an application for goods and services (SIABYS); improve and expand the human resources management systems (SINARH); and ensure adequate integration among these systems. Umbral's current support is expected to be complemented by an IDB investment loan."'

The strengthening of the internal audit function and the establishment of a standardized internal control framework are being addressed jointly. In late 2006, this reform process was initiated through a series of ministerial assessments, extensive training, and technical assistance with the support of the US AID-sponsored Umbral Program. Achievements made to date towards strengthening the internal audit function include the adoption of a decree in late 2007 which redefined the role, organization and attributions of the AGPE. As mandated by the new legislation, AGPE has proceeded to exercise its authority to oversee selection and nomination processes for internal auditors ofthe spending units. It plans to increase its human resources by 60 percent in two years, provide for intensive training activities and has developed jointly with the CGR a new Government audit manual. Furthermore, a standard and comprehensive model of internal control (MECIP) has been designed following the principles ofthe COSO appr~ach"~,i.e., introducing new modem concepts such as risk-based approach, self-assessment, and independent evaluation. The implementation of the MECIP will be supported by the appointment of an internal control committee on each spending unit, by the elaboration of internal control manuals and implementation plans, and by appropriate staff training. In December 2008 a decree was issued granting AGPE the mandate to implement MECIP.

Challenges ahead include the implementation of the MECIP and further strengthening of institutional internal audits of spending units. Gradual adoption of MECIP by the Central Administration and subsequently throughout the Central Government will go a long way towards enhancing the overall effectiveness and harmonization of Paraguay's internal control system. Another key challenge to enhance the internal audit function is to strengthen their human resources via competitive and transparent recruitment, and improvements in staff technical skills.'*' Finally, the Government is expecting spending units to continue improving their responsiveness and subsequent follow-up actions to internal audit recommendations.

The Government further expects to complement these reform efforts with the standardization of Central Administration spending units' UAF procedures. This area will address the control environment challenge via staff capacity building, the introduction of competitive selection procedures, and better coordination with the Under-Secretariat of Financial Administration. Strengthening UAFs' human resources and organization will also contribute to the MECIP's effective implementation. Implementation & Stakeholder Challenges The implementation and upgrading of complex IT systems require strong project management, high technical skills, and predictability in the availability of funds. Given

1 18 PROFOMAF Loan 119 The COSO (Committee of Sponsoring Organizations of the Treadway Commission) approach takes a broad perspective of control and includes five major areas: Control Environment, Risk Assessment, Control Activities, Monitoring, Information and Communication. See also www.coso.org. 120 According to AGPE's Survey of Internal Audit staff needs per institution (November 2008), Institutional Internal Audit would need a staff increase of over 30 percent to be fully operational. 72 the capacity deficiencies of Paraguay’s Central Administration, high-level political commitment is a much less critical factor than sustained support from IFIs and donors. The capacity to manage complex projects is weak, due in particular to the lack ofhighly skilled IT staff and senior program managers, insufficient delegation of.responsibility below the level of Vice-Minister, and the absence of a formal pluri-functional project management committee. Finally, weaknesses in the ability to choose the right IF1 or donor instrument and fbnding mechanism, and to respond promptly to contractors also undercut the implementation and upgrading of information management systems. These weaknesses explain why improvements to the Central Administration’s management information system have been slow-paced since the adoption of the LAFE in 1999. To achieve its current objective, the Government intends to rely on the UmbraZ Program and an IDB investment loan, which is currently under preparation.

With respect to the reform of the internal audit function, since AIIs depend on the authority of their respective spending unit and the AGPE has traditionally had a lower rank than Ministries, support from the Presidency and the Ministry of Hacienda is considered critical. The inability to make clear, high-level commitments and the absence of comprehensive IF1 or donor programs for the sector during 1999- 2006 resulted in stagnation in this area. Since 2007, both the implementation ofthe UmbraZ Program and the commitment of the Presidency, as evidenced in the adoption of decrees strengthening AGPE’s authority, generated progress. This support is complemented by the Ministry of Finance’s expressed commitment to allow for the budget space necessary to finance internal audit staff increases. Preconditions are therefore met for further progress in this area.

Similar issues need to be addressed in order to improve the control environment, although associated preconditions are more challenging. The measures contemplated by the Government, in particular the professionalization and standardization of spending units’ UAFs, are led by the Under-Secretariat of Financial Administration from the Ministry of Finance, but require strong coordination between Ministry ofFinance and other ministries and with the AGPE. At the Ministry ofFinance, there is no directorate with effective and adequate resources to support the efforts of the Head of the Under-Secretariat of Financial Administration related to the standardization ofUAFs.

73 Annex 11 : Public Sector Financial Control - Effective Oversight of SOEs - Detailed Diagnostic and Government Priorities

Effective Oversight of SOEs Establishing effective State oversight of SOEs and improving their governance is one of the major pillars of the Government Plan. Given the SOEs' poor service delivery performance, their lack of financial and managerial transparency, and the ineffective institutional settings for managing this substantial proportion of public expenditures, the Government has a medium-term goal to establish a new institutional framework to ensure (i) adequate ownership supervision of SOEs; (ii)effective regulatory control upon tariffs and technical quality of utility services; and (iii)transparent SOEs reporting on financial management, business planning and investment.

Diagnostic There are a total of nine state-owned enterprises (SOEs) in Paraguay accounting for roughly 30 percent of Central Government expenditures. Most of these enterprises are State monopolies, in charge of the provision ofkey strategic goods and services -oil, water, telecommunication, electrical power- and also of more traditional manufacturing activities such as the production of beverages and cement. As illustrated in Figure A.ll.l, the consolidated expenditures of SOEs represent approximately 10 percent of GDP, which is significant by regional standards.

Figure A.ll.l: Relative Size of SOE sector in selected Latin American Countries -2006 data ...... , .

..I" __I.I" I" "1"- . . -. .__I___-.. . .. I

. . .. . _. ..._l_lll , , ,

I Paraguay Honduras Panama Argentina I

The service delivery and management performance of Paraguay's SOEs is characterized by limited efficiency and effectiveness. Service delivery is affected by market distortions created by the existence of State monopolies which sometimes set tariffs below operating costs. This, in turn, promotes the existence of undisclosed cross-subsidies within the public sector. Some SOEs are in fact financially insolvent and show a high level of debt and expenditure arrears. 12' Under-investment is another factor undermining service delivery and increasing the average costs of service,provision, as is the case of the water distribution company for urban areas, ESSAP. As a result, public service coverage is frequently limited, especially in rural areas. The management of SOEs is also generally weak, due fundamentally to: (i)a lack of strategic planning and unclear definition of specific objectives; (ii)the inexistence of adequate and modern systems for financial administration and control; and (iii) insufficient number of personnel in technical areas. These issues are compounded by limitations in corporate governance of SOEs, in particular prevailing regulatory and legal

~~ 121 The Government reports debt of US364 million (as of end-2008) for PETROPAR, the oil distribution SOE. This can in part be explained by the prevailing applicable tariff policy. 74 frameworks, the organization of the ownership function, and transparency and disclosure of information.

I Electricity: Controls the country’s entre electncity I No market including generation, distribution and Work Decentralized Entity transmission. The electricity coverage by ANDE is above 90%, leaving a marginal participation to private firms in the sector. Generation: ANDE operates a single hydroelectric dam, Acaray, and six thermal power plants, with total installed ANDE capacity of 220 megawatts (MW). It is also responsible for Paraguay’s share from Itaipu and Yacyreta. Transmission and distribution: ANDE operates 2,100 miles of transmission lines in the Interconnected National System, divided in 6 subsystems, and 670 miles of distribution lines. It is also responsible for all of the distribution, except for two small exceptions.”’ River Transport and Harbor Management NIA Ministry of Public Public Sector ANNP Work Decentralized Entity Beverage production NIA Ownership Public Corporation CAPASA Responsibility: State Attorney Office Telecommunication: with approximately 280,000 lines in Yes Ministry of Public Public Corporation service (out of a total installed capacity of 320,000) Work COPACO enjoys a monopoly on the. provision of fixed COPACO line and long distance telephony. It was corporatized in 2002, with 99% Government participation and was granted a long-term operating concession. m:main provider of water services to communities Yes Ownership Public Corporation above 10,000 inhabitants. Overall service coverage is Responsibility: State estimated at 43.5% of total country users.123It was also Attorney Office ESSAP restructured in 2002 as a corporation with 99% Government participation, and was granted a long-term I operating concession. National Civil Aeronautic Directorate NIA Ministry of Defense Public Sector DINAC Decentralized Entity FEPASA Railway Lines No Ownership Public Corporation (Ferrocamles Responsibility: State del Paraguay) Attorney Office Cement production NIA Ministry of Industry Public Sector INC and Trade Decentralized Entity Oil: commercialization of crude oil and petroleum Ministry of Industry Public Sector products. It operates as a State monopoly on sales and and Trade Decentralized Entity imports of these products, managing almost 80% of PETROPAR country overall crude oil store capacity. It also owns Paraguay’s sole refinery in Villa Elisa, and participates in the wholesale distribution, while the retail market is o erated b rivatel -owned as stations.

The regulatory framework for utilities is not comprehensive and its effectiveness is limited. Overall, there is no clear functional separation between policy formulation and execution, and between regulation and service provision. For the oil and energy sector, the regulatory framework is not clearly defined and lacks regulatory bodies, while the existing regulatory framework for the water sector is not effective. The regulatory and legal framework constitutes one ofthe critical components of effective SOE corporate governance, and is dedicated a specific section in the OECD guidelines on SOE corporate governance.

122 CLYFSA (Compailia de Luz y Fuerza, S.A.), which was awarded a concession to distribute and commercialize electricity in Villarrica, and the Empresas Distribuidoras Menonitas del Chaco Central. 123 Provision of water in small cities and the rural area is organized by SENASA (Servicio Nacional de Saneamiento Ambiental), public entity depending on the Ministry of Health 75 Box A.ll.l: Effective Legal and Regulatory Framework for SOEs - OECD Guiding Principle The legal and regulatory framework for SOEs should ensure a level-playing field in markets where SOEs and private sector companies compete in order to avoid market distortions. The framework should build on, and be fully compatible with, the OECD Principles ofCorporate Governance. There should be a clear separation between the State’s ownership function and other State functions that may influence conditions for SOEs, particularly with regards to market regulation; Governments should simplify and streamline the operational practices and the legal form under which SOEs operate; Any obligation and responsibility that an SOE is required to undertake in terms of public services beyond generally accepted nomshould be clearly mandated by law or regulation; SOEs should not be exempted from the application of general laws and regulations; The Legal and regulatory framework should allow sufficient flexibility for adjustments in the capital structure of SOEs when needed for achieving company objectives;

0 SOEs should face competitive conditions regarding access to finance. Source: OECD Guidelinesfor SOE Corporate Governance

In the water sector, responsibility for policy formulation lies with the Ministry of Public Works and Communications. The institutional framework is embodied in Law 1614/00 of 2000 which establishes a regulatory and tariff framework for the sector. This law called for the establishment of the Ente Regulador de Sewicios Sanitarios (ERSSAN), an autonomous entity entrusted with regulating the water sector. The law was originally designed in the expectation that private sector participation in the sector would increase substantially. This did not occur. In practice, the Ministry of Public Works and Communications has not developed sector policies, leaving a vacuum in this area. Although ERSSAN was created to regulate prospective private enterprises, it has proven ineffective in regulating the water supply and sewerage authority, ESSAP. Urban utility tariffs are generally set below the marginal cost and are adjusted infrequently. There is not too much tariff variation across users either. This practice leads to substantial operating losses making it impossible to finance the investments necessary to expand coverage and to improve service quality.

The telecommunications sector’s regulatory body, the National Telecommunication Commission (CONATEL), also falls under the auspices of the Ministry of Public Works and Communications. As per the Telecommunication Act (Law 642 of 1995), CONATEL’s purpose is to carry out “the State’s functions of promoting, controlling, and regulating telecommunications within the framework of an integrated policy for services, providers, users, technology, and industry”.

For the oil sector, the Executive determines the pricing policy. The strategy for setting oil prices involves determining a maximum price on diesel, which represents over 80 percent of the gas used in transportation. The cost of implementing this policy is absorbed by PETROPAR, subjecting the latter to significant financial imbalances. The commercialization of naftas in the retail market is driven by competitive forces with practically no Government control, and a wide range of informal arrangements have been proliferating, compromising the quality and quantity ofthe products commercialized.

Similarly, energy polic is formally defined and guided by the Ministry of Public Works and Communication’2< which is also responsible for the service provider ANDE.’25In practice, all energy responsibilities are concentrated in ANDE, the de facto electricity regulator and provider. ANDE also proposes a tariff structure, which is then analyzed and

124 Through the Vice-Ministry of Mines and Energy 125 As stated under Law 167193. 76 approved by the National Economic Team of the Executive. In November 2004, the Paraguayan Government approved Law 2501, which broadened the social tariff for electricity applied by ANDE. The social tariff is applied to residential users below a monthly consumption of 150 kWh. Currently, about 37 percent of total customers are subject to this tariff.

The ownership organization of SOEs is decentralized and their corporatization is partial. As shown in Table A.11.1, SOEs ownership depends either on relevant sector ministries or on the State Attorney’s Office. This decentralized organization’26 does not clearly separate the ownership function from other State functions, particularly those related to regulatory role and industrial policy’27, resulting in a lack of clear definition of responsibilities. Besides, corporatization of SOEs remains partial; most of them are still functioning as administrative decentralized entities or directorates carrying out commercial activities. Finally, there are no clear rules to regulate financial relationships between SOEs and the Central Administration, in particular with respect to both actual amounts transferred by SOEs to the Treasury, and payments ofutility services by the Central Administration. The sum ofthese factors undermines SOE performance and accountability.

Box A.11.2: State Acting as SOE owner - OECD Guiding Principles The State should act as an informed and active owner and establish a clear and consistent ownership policy, ensuring that the governance of SOEs is carried out in a transparent and accountable manner, with the necessary degree ofprofessionalism and effectiveness. The Government should develop and issue an ownership policy that defines the overall objectives of State ownership; The Government should not be involved in the day-to-day management of SOEs; The State should let SOE boards exercise their responsibilities and respect their independence;

0 The exercise of ownershp rights should be clearly identified within the State administration; The coordinating or ownership entity should be held accountable to representatives bodies such as the Parliament and have clearly defined relationshp with relevant public bodies; The State as an active owner should exercise its ownershp rights according to the legal structure of each company. Its prime responsibilities include: o Being represented at the general shareholders meetings and voting the State shares; o Establishing well structured and transparent board nomination processes in fully or majority owned SOEs, and actively participating in the nomination ofall SOEs’ boards; o Setting up reporting systems allowing regular monitoring and assessment of SOE performance; o When permitted by the legal system and the State’s level of ownership, maintaining continuous dialogue with external auditors and specific State control organs; Ensuring that remuneration schemes for SOE board members foster the long term interest of the company and can attract and motivate qualified professionals. urce: OECD Guidelinesfor SOE Corporate Governance

Financial information on SOEs is weak and insufficiently regulated, which undercuts the State’s control over SOE financial management and investment targets. Paraguay’s Supreme Audit Institution (CGR) does not set accounting or auditing standards for SOEs, nor do public financial management laws provide specific procedures and standards for SOEs. The external audit of SOEs is solely carried out by the CGR, and contrary to international

126 The two other main types of ownership organization are: the dual model, the most prevalent, where the responsibility is shared between the sector ministry and a ‘central’ ministry or entity; and the centralized model, in which ownership responsibility is centralized within one main ministry -usually the Ministry of Finance, and which recently has been on the increase. Source: ‘Corporate Governance of State-Owned Enterprises - a survey of OECD countries’, OECD, 2005 127 As a result, many countries, particularly from the OECD, have move towards a more centralized ownership organization, whereby SOEs are put under the responsibility of one ministry, in most cases the Ministry ofFinance. 77 common practices, SOEs are not subject to mandatory external audits according to international standards. SOEs are also not required to publish annual financial statements. In this context, decisions regarding financial reporting by SOEs fall squarely within the powers of each institution’s management. The 2006 Report on the Observance of Standards and Codes”’ reviewed the financial statements of four SOEs and concluded that there were asymmetries in the quality of the information as well as the accounting standards and practices employed. Under these conditions and given the other weaknesses identified in the diagnostic, exerting effective control over SOE financial management, planning and levels of investment is a critical issue for the State.

Box A.11.3: Transparency and Disclosure - OECD Guiding Principle I SOEs should observe high standards of transparency in accordance with the OECD Principles of Corporate Governance. The coordinating or ownership entity should develop consistent and aggregate reporting on state- owned enterprises and publish annually an aggregate report on SOEs; SOEs should develop efficient internal audit procedures and establish an internal audit function that is monitored by and report directly to the board and to the audit committee or the equivalent company organ; 0 SOEs, especially large ones, should be subject to an annual independent external audit based on international standards. The existence of specific State control procedures does not substitute for an independent external audit; SOEs should be subject to the same high quality accounting and auditing standards as listed companies. Large or listed SOEs should disclose financial and non-financial information according to high quality internationally recognized standards; SOEs should disclose material information on all matters described in the OECD Principles of Corporate Governance and in addition focus on areas of significant concern for the State as an owner and the general public Source: OECD Guidelinesfor SOE Corporate Governance

Previous attempts at reform include two privatization initiatives undertaken during the 1990s with IFI financing. The first initiative took place during the Wasmosy administration (1993-1998), and focused on a prioritized list of five public enterprises. Four of them were eventually privatized: an airline, Lineus Ae‘reus Puruguuyus SA (LAPSA); a steel-making plant (ACEPAR); a shipping line, Flotu Mercunte Puruguuyu (FLOMERPASA); and an alcohol plant, MAL. Except for the case of LAPSA, which was sold later to a Brazilian company (TAM), all of these former privatization experiences were unsatisfactory. Corruption charges were brought in relation to the shipping line company; the privatization agreement of ACEPAR was cancelled by the State in 2000 due to alleged under-investment by the private consortium in charge; and APAL declared bankruptcy in 2001 and was taken over by the State as a new corporation, CAPASA. The second privatization initiative took place in 1999 and focused on large utilities companies ANTELCO, the state-owned telecom company, CORPOSANA, the state-owned water company, and the state-owned national railway, FCCAL. Although a privatization Law was approved in 2000, granting the executive fast-track powers to privatize these companies129,new regulatory bodies were established, and ANTELCO was transformed into a public corporation (COPACO). These three companies are still property ofthe Paraguayan State.

Government Plan and Implementation C? Stakeholder Challenges

~~ 128 Bank Paraguay ROSC, 2006 129 The original draft law sent by the Executive was more ambitious and contemplated, for instance the privatization of the State oil company (PETROPAR), the State cement company (INC), and the State port authority (ANNP). 78 Government Plan

The Government reform plan for this sector is ambitious and covers ownership structure, transparent management of SOEs, and regulatory aspects. The Government's objective is to establish new institutions to improve the ownership structure of SOEs and to regulate utility sectors. New rules and practices are also planned to improve the financial and business management of these enterprises, and enable effective central administration supervision. This medium-term reform will require legal changes, difficult negotiations within the Government and with each SOE, and strengthening the overall monitoring capacity ofthe central administration.

The ownership structure is scheduled to be consolidated into a Holding of SOEs. This consolidation was initiated during the last quarter of 2008 with the strengthening of the SOE Council established in 2006. Formally led by the Ministry of Finance, this new inter- ministerial council'3o (CEP) has an extended mandate, and an administrative body was created to improve its re~ponsiveness.'~~The second step will consist of legal adjustments within the next 12 months to convert the CEP into the Holding of SOEs and to clarify the SOE reporting lines with this Holding. The Holding will act as the shareholder ofthe SOEs on behalf ofthe Government, and will supervise SOE corporate governance as well as their financial and business management. The centralization ofthe supervision ofSOEs and the authority granted to the Holding is expected to significantly improve the control ofSOE activities and results.

The second area of reform will be to increase the SOEs' financial and management transparency. The Government intends to achieve this objective through three main types of measures. First, the scope of current performance contracts will be expanded and their effectiveness improved. These contracts will be used as quasi-regulatory instruments to expand accounting and auditing requirements, and disclosure of corporate information. These contracts will also set new monitoring rules between each SOE and the CEP. The Monitoring Unit of the SOE Council is currently working on the preparation of the revised version of those contracts. Second, through these performance contracts, the Government is planning to require annual external audits in accordance with international standards. Third, clear rules will be established for regulating the financial relationship between SOEs and the Central Administration, in particular for the determination of amounts to be transferred from SOEs to Treasury and for Central Administration payments ofpublic service utilities. These measures will be consolidated with the establishment of the Holding and the related adjustment of individual SOEs' organic laws.

The creation of a consolidated regulatory agency is the third area of reform planned for the SOE sector. This new agency will be responsible for regulating tariffs and controlling quality standards for the provision of the following services: electrical power, oil, telecom, and water. The choice of a single regulatory body was motivated by the scarce resources that are available in terms of both technical expertise and administrative management, and the stronger authority given to the head of this body. The existing regulatory entities13* will become part of this new agency, which is expected to be established within the next 12 months.

130 The Council includes the Ministries of Finance, Public Work, and Industry and Trade. 131 This administrative body - CEP Monitoring Unit - has 15counts with fifteen staff and its mandate has been defined by decree. 132 CONATEL and ERSSAN 79 Government plans to strengthen the water sector also include the restructuring of ESSAP and the strengthening of the regulatory body ERSSAN. With the support of the Bank-funded Water and Sanitation Sector Modernization Project, this activity includes the establishment ofa board ofdirectors, the implementation ofnew service units for ESSAP, and the restructuring ofERSSAN’s functions.

The Government plan does not foresee the corporatization of PETROPAR and ANDE. Given the important reform agenda for the sector and the absence of a clear strategy for potential changes to PETROPAR and ANDE, the Government decided not to include the conversion ofits two most important SOEs into public corporations into its plan.’33

Implementation & Stakeholders Challenges First, the Government intends to strengthen capacities for the implementation of this reform. In particular, the CEP monitoring unit needs to rapidly develop mechanisms to undertake effective information analysis and business monitoring of SOEs. This is challenging given the lack of transparency of SOE business information and the traditional limitations of Paraguay’s public administration. Similarly, the preparatory tasks for the establishment of the new regulatory body will need to be initiated in the next few months. International technical assistance is foreseen for the establishment of a group of reform experts, critical to timely achievement these two objectives.

Second, the Government is working on consolidating its reform consensus. The inter- institutional agreement between CEP members, which spells out the main objectives of the reform, is critical to move the SOE agenda forward and develop a bilateral dialogue with each SOE. Broader consensus, in particular with Congress, is to be obtained through dialogue centered on the adoption of the anti-crisis plan and the PDPL. Adoption of the reform will also be facilitated by minimizing and grouping legal changes. While only two laws will be needed for the establishment of the Holding and the Regulatory Body, the adjustment of individual SOEs’ organic laws will be limited to provisions related to their relations with those two new institutions.

133 PETROPAR and ANDE jointly represent over 70 percent of the consolidated SOE budget. 80 Annex 12: Expenditure Management - Detailed Diagnostic and Government Priorities The Government treats social and capital expenditures as critical priorities of its anti- crisis plan. While reduction of poverty remains a key challenge and the quality of public infrastructure is an impediment to economic growth, social and capital expenditures in Paraguay are still low by regional standards, and chronic budget under-execution negatively impacts the performance ofpublic service delivery. Given the potential impact of the current international economic crisis, the Government intends as a first priority to safeguard social expenditure while gradually addressing structural challenges related to the allocation and execution ofcapital and social expenditures

Diagnostic Poverty & Social Expenditure The reduction of poverty and inequality remain key challenges for Paraguay. Despite overall improvements in recent years, the country's poverty rate remains above the levels observed in the late 1990s. Extreme poverty is still high in rural areas (24 percent), and is particularly concentrated among the self-employed engaged in small-scale farming. Moderate poverty, on the other hand, has become somewhat more prevalent in urban areas (36 percent). Similarly, the distribution of income remains highly inequitable-- the richest 10 percent of households concentrate between 42 and 46 percent of total income, making Paraguay one of the Latin American countries with the highest income inequality.

Overall, progress on social welfare has been insufficient. While some progress has been made in the past years, Paraguay lags behind key Millennium Development Goals, especially with regards to halving poverty rates and improving health outcomes (Table 5.3). This suggests that there is a considerable need for better services and infrastructure targeted at the poor, especially in rural areas where extreme poverty is concentrated.

Table A.12.1: Progress towards MDGs (selected indicators) Baseline (1990)* Latest (2005)A MDG Goal (2015) Extreme poverty rate 13.9 19.4 7 Elementary education completion rate 70 88 100 Registered infant mortality rate, per 1,000 live-boms 30.4 20 7.6 Under-5 mortality rate, per 1,000 live-boms 40 23 13.3 Registered maternal mortality rate, per 100,000 live-boms 150.1 170 37.5 Access to potable water 25.4 52.5 62.7 Note: *Except for access to potable water (1992) and extreme poverty (1995)). "Except for maternal mortality (2000), access to potable water (2002). extreme poverty and under-5 mortality (2007). Source: World Bank (2003), DGEEC, CEDLAS, WHO.

Social spending has been relatively low compared to other Latin American countries. As a share of GDP, Paraguay spent about half as much as Uruguay and one-third less than Brazil (Figure 5.4a) in 2005/06. As a share of total spending, social expenditures in Paraguay were also among the lowest in the region.

81 Figure A.12.1 Public social expenditure in selected Latin American countries (2005/06) (a) YOof GDP (b) YOof total public spending

18 0 , 16 0 7" 1 0 14 60 12 0 50 10 0 40 80 60 30 40 20 20 10 00 0

I Note: Expenditure data refers to Central Government only. Source: ECLAC However, in recent years there has been an effort to increase social spending. While the average share of social spending in total expenditures was 42 percent between 2002 and 2006, this figure rose to 49 percent between 2007 and 2009 (budget). The largest share of this spending is dedicated to education and culture, while social assistance programs have traditionally received the smallest share (Figure 5.4). Current spending represents the bulk of social expenditures (89 percent in 2007), primarily because of the weight of personnel spending in the health and education sectors.

Although more resources have been allocated to social assistance programs since 2005, there is a high degree of fragmentation. Social assistance spending tripled as a share of GDP between 2005 and 2007 due to the expansion of existing programs (regularization of settlements) and to the introduction of new programs (Tekopora, assistance to Chaco war veterans). However, since resources are divided among more than 35 programs, there is a high degree of fragmentation. 60 percent of social assistance spending is consumed by programs that are neither well defined nor well targeted. As a result, the Government's flagship Tekopora program only received 5 percent of social assistance spendin in 2007.'34 As of end-2008, the program covered 18,000 households in extreme poverty'.'', representing only 12 percent of the estimated total. Its coverage remains limited to municipalities in the poorest departments ofthe country.

Figure A.12.2: Social spending (YOof GDP)* Table A.12.2: Social assistance programs"

IO, 9 Share 8 Social safety net programs 15.5% 7 Conditional cash transfer program (Tekopora) 4.6% 8 Program for the reduction of child labor (Abrazo) 1.5% 5 Assistance to Chaco War veterans 9.4% 4 Social housing and regularization of settlements 26.5% 3 Program for the regularization of land and settlements 13.9% 2 Housing Construction 12.6% 1 Other programs 58.1% 0 TOTAL 100.0% 2002 2003 2m 2035 2m 2w7

0 Education ard cuiture 0 Socia secwity m Heakh S0cic.i aPsistmceS *Defined as all expenditure under the functional classi'jcation code 300. addition to 0, there are two other conditional cash transfer programs (PROPAIS and Nopotevo), which are however very small. Source: Ministry of Finance.

134Fore more information on social assistance programs, see the World Bank Policy Note Red de Proteccion y Seguridad Social. 135 This includes approximately 4,000 households covered under PROPAIS and 500 households under Nopotevo. 82 Public Investment for Road and Water Sectors

The poor quality of Paraguay's transport infrastructure is an impediment to economic growth and poverty alleviation. Given that over 80 percent of the total volume ofdomestic and international goods is transported by road136,the transport sector, and particularly the road network, plays a crucial role in ensuring that exports reach their markets. According to a 2006 study, the excess costs of Paraguay's logistics chain amount to US$330 milli~n.'~'This is caused to a large extent by issues related to the transport sector, including the lack of river dredging and the inadequate road condition^.'^^ The road network is also a critical factor for poverty alleviation, particularly in rural areas, by reducing the cost ofaccessing basic services and creating business opportunities for the poor. In fact, the quality of Paraguay's road network is poor by regional standard^'^', as there are only 4,000 km ofpaved roads out of a total network of60,000 km, and less than 20 percent ofthe non-paved road network is in good ~ondition.'~'

Deficiencies in the water sector also pose a serious challenge in terms of health and pollution. Over 80 percent of the urban population is served by a water connection network. In rural areas this share is only 44 percent. As far as sewerage connections are concerned, the share is much lower as only 15 percent of urban residents have access to a network sewerage connection. 14' The lack of adequate wastewater treatment results in untreated sewerage infiltration into drinking water supplies. This poses a serious public health and pollution problem, and affects Paraguay's ability to meet the Millennium Development Goals related to child mortality.

Public investment as a share of GDP is below regional standards. Between 2004 and 2008 annual ir~vestment'~~by the Central Government on average reached 2.7 percent of GDP, setting Paraguay below the Latin American average of 4.5 percent. Even if other parts of the public sector (primarily SOEs) are included, total public investment only totaled 3.7-4.2 percent of GDP annually. While public investment on average represented 16 percent oftotal spending between 2004 and 2008, more investment is needed if Paraguay is to succeed in meeting serious infrastructure challenges, particularly in the transport and water and sanitation sectors.

The state of Paraguay's transport infrastructure suggests that investment in the sector is insufficient and inadequately allocated. The case of investment in road infrastructure is particularly illustrative. Government policy in recent years has prioritized the construction of new roads over the maintenance and conservation of existing assets. However, road maintenance investment is below the minimum required. Over the last five years, the Ministry of Public Work allocated on average US$8 million to maintenance, US$l50 million ofwhich went to road investment, and less than half ofthat amount was actually used for maintenance purposes. When only the .minimum investments are considered, the maintenance gap is estimated conservatively at US$34 million per year. If this situation does not change,

136 Source: Transport Sector Evaluation - World Bank, 2008. 137 Equivalent to 4.3 percent of 2005 GDP. 138 USAID (2006): Impacto del Transporte y de la Logistica en el Comercio Intemacional del Paraguay. 139 As per the Bank Transport Sector Evaluation, Paraguay coverage of paved road (km/lOOO km2) is 7.3 while it ranges between 10 and 56 for Argentina, Brasil, Chile, Colombia, Mexico, and Uruguay. 140 Source: Transport Sector Evaluation - World Bank, 2008. 141 Encuesta Permanente de Hogares, 2006 (EPH-2006) Direccion General de Estadistica, Encuestas y Censos, Paraguay. 142 Investment here is defined as inversion fisica. 83 Paraguay will have to confront an ever increasing depreciation in road assets coupled with greater costs associated with the reconstruction of deteriorated infrastructure.143 The urgency of the situation is clearly illustrated in the fact that the Ministry of Public Works is confronting increasing demand to address the untreated unpaved road network, ranging from main roads to small rural roads, while 30 percent ofParaguay’s roads are currently considered to be in bad ~0ndition.l~~

Inappropriate levels of resource allocations to road maintenance, coupled with the Government’s inability to distinguish between specific allocations to capital and maintenance spending, undermine the ability to ensure adequate infrastructure quality. The budget classification for infrastructure investment is disaggregated in only two sub- categorie~’~~,primarily designed for capital spending. 14‘ However, budget resources for infrastructure maintenance are also allocated to these two sub-~ategories’~~,making almost impossible for the Ministry of Finance to measure and monitor investment for infrastructure maintenance.

Fiscal (1) (2) (3) (4) Deviation Year Budget Draft Budget Law Fin. Plan Out-turn\’ (YO) Out-turn Out-turn Out-turn (billion of Gs.) - - - I Budget Law Fin. Plan Budget Draft 2005 2,267 2,298 2,260 1,324 I 42% 41% 42% 2006 2,177 2,225 2,195 1,414 36% 36% 35% 2007 2,107 2,298 1,882 1,333 42% 29% 37% 2008 2,268 2,507 2,133 1,094 56% 49% 52%

143 See Road maintenance Project - World Bank, 2006 144 For more information, see the Policy Note on Logistics and Transport. 145 The Budget line for infrastructure investment (classification 500) is disaggregated into only two sub-categories: ‘Construction’ (520) and ‘Feasibility Studies’ (580). However, funds for maintenance works and their supervision are respectively incorporated into those two sub-categories, which are primarily designed for capital expansion. 146 Budget line #500 is disaggregated into sub-lines for construction (520) and for Feasibility Studies (#580) 147 Budget resources for maintenance works and supervision are respectively allocated to ‘Construction’ (520) and ‘Feasibility Studies’ (580). 84 allocated lower resources to capital expenditures than both the budget law and original draft budget. However, there are also significant deviations when comparing the out-turn ofcapital expenditures with the amounts allocated by the Financial Plan.

Wide-scale under-execution of budgeted capital expenditures can also be attributed to severe weaknesses in Paraguay’s public investment process. There are a wide range of reasons underlying this inherent and overriding weakness. One reason is the absence of a “National Development Program” with properly identified investment priorities, sequencing, targets and outcomes. A further impediment to efficient public investment planning and execution is attributed to the prevailing legal framework, which delegates main responsibilities to the Technical Secretariat of Planning (STP) -- a Government Secretariat that has yet to become fully operational due to human resources and technical capacity constraints. Additionally, pre-investment activities, which also delegated primarily to STP, are scarce, given the inexistence of institutional channels linking expenditure priorities to specific investment projects. The sum of these factors gives way to insufficient country ownership of investment initiatives, frequently relegating project preparation to the criteria and calendars ofIFIs and external donors. Moreover, externally financed investment projects are, to a large extent, disconnected from the preparation and approval ofthe national budget, as Congress accepts or rejects such projects on a case-by-case basis, regardless of the budget ~a1endar.l~~

There are also significant delays in procurement and sizable payments arrears. On the one hand, technical aspects related to procurement planning and monitoring contribute to under-execution. Specifically, there is no real-time monitoring of contract execution throughout the procurement stages’49, while a rigid relationship between the annual contracting plans and the budget persists. Furthermore, there are no formal procedures linking cash planning preparation to procurement planning, which in turn generates cash shortages and undermines timely payments to contractors. Likewise, although formally permitted, there is in practice little delegation ofauthority in contract processing. Finally, the stock ofpayment arrears from the Central Administration has averaged 8.4 percent of total executed expenditures from 2005-2008.’50

Institutional and Planning limitations Social Sector

Social expenditures, and ultimately the programs they underpin, are negatively impacted by the wide array of public agencies with overlapping objectives which manage social sector programs. While a significant share of social assistance programs (including Tekopora) is managed by the Presidential Agency for Social Assistance (SAS) or the National Office ofCharity and Social Assistance (DIBEN), related programs are managed by seven other institutions, ranging from the Paraguayan Institute ofIndigenous People to the Ministry of Education. Although the Social Cabinet is formally responsible for the overall coordination of these institutions, it has not been successful in consolidating the fragmented policy making and program implementation structures existing to date.

148 The plan of execution of a donor operation is usually distorted by an initial delay which frequently exceeds a nine month period between the respective IF1 and Congressional approval processes. Furthermore, annual rate ofproject implementation rates are low. Between 2004 and 2006, 42 percent of active lending operations at the Ministries of Agriculture, Education, Health, and Public Works extended their closing between 13 and 49 percent above their initial life-span. 149 (i)draw-up of technical specifications and documents, and (ii)processing ofprocurement 150 Data provided by the Directorate of Fiscal Studies - Under-Secretariat of Economic and Integration (SSEEI). 85 This is compounded by the limited human resources capacities of social sector agencies. While the health and education ministries are sizeable, State agencies in charge of social protection are extremely limited in terms of skilled human resources. For instance, the SAS has less than 50 civil servants and relies on the Presidency's Financial Management Unit (UAF) for its budget implementation. As a result, most ofthe existing programs are managed indirectly through NGOs that receive funds from those public agencies. The selection criteria for these organizations are not always transparent since no standardized mechanisms .for public bidding exist. Bidding and selection processes are usually more transparent in externally financed projects due to applicable fiduciary requirements governing externally financed procurement processes.

The effectiveness of programs such as Tekopora is negatively impacted by overlaps, lack of coordination, and limited implementation capacities within the various agencies. Given the Tekopora program's conditionalities in the health and education sectors, it would be important for SAS to cooperate closely with the relevant line ministries to ensure that such conditionalities are met. It bears mentioning that, at least in the initial phases ofthe program, little coordination was evidenced and no specific budget was provided to address the supply- side constraints, such as the availability of schools and health centers. Of course, there are other administrative factors that hamper program effectiveness, such as the choice of the transfer delivery mechanism, which consists of a mobile unit that visits districts without a set schedule thereby giving way to unpredictability and delays. The lack of a comprehensive monitoring and evaluation system makes regular Government assessment as to the effectiveness ofthe program diffic~lt.'~'

Box A.12.1: Main features of the Tekopora conditional cash transfers program The program, initiated in 2005, is targeted at extremely poor families with children aged 0-14 and pregnant women in rural areas. It uses a combination of geographic targeting and a quality of life index based on data from aficha hogar. Payments are made on a bi-monthly basis by mobile cashlers, paying a flat benefit of Gs.60,000 plus a variable component of Gs.30,000 per child. Participation in the program requires compliance with health and education conditions: regular vaccination and health checks for children; and school matriculation and attendance. A compliance department at SAS checks the information provided by the beneficiaries on a regular basis; compliance is estimated to be around 70 percent. Beneficiaries can participate in the program for up to 3 years.

Public infrastructure

Institutional arrangements for public infrastructure are negatively affecting the management of public investment. A key challenge for the transport sector is how to improve the Ministry of Public Work's ability to prepare and execute their budget. The Ministry ofPublic Works' priorities are restricted to rehabilitating a debilitated infrastructure. Accordingly, there is no clear definition of long-term policies. For instance, the work plan of the Highway DirectorateI5* of the Ministry is limited to a list of construction and re-paving projects which are neither based on specific studies nor economic evaluations. While investment planning is formally supposed to be camed out by the Planning Office of the Directorate, priority projects are directly established by the Minister and the Vice-Minister and planning is usually carried out within the context of multilateral lending operation^.'^^

151 IPC (2007). Confronting Capacity Constraints on Conditional Cash Transfers in Latin America: The Cases of El Salvador and Paraguay. See also Annex 12: A selection of shared experiences across countries - Conditional Cash Transfers (CCT) Programs. 152 There are two Road Directorates: one for primary and secondary roads and one for rural roads. 153 Most of investment projects are indeed financed by IF1 lending operations. 86 Budgeting is undertaken by the Vice-Ministry of Finance and Admini~tration’~~based on historical trends and without a link to strategic planning. There is likewise a lack of coordination among the different directorates of the Ministry. The level ofbudget execution for capital expenditure is low as a re~u1t.l~~Institutional arrangements in the water sectors are also characterized by limited coordination among the existing actors while their respective planning, control, and information management systems capacities are weak. The sum of these factors undermines overall budget execution and service delivery performance.

Government Plan & Implementation & Stakeholders Challenges Government Plan

The Government’s priority in the short term is to address the potential impact of the international crisis upon poverty by safeguarding budget increases for social expenditures. Poverty alleviation and equitable economic growth constitute the Government’s main priorities, a fact which is amply reflected in the 2009 draft budget submitted to Congress in autumn 2008.’56 However, given the potential impact of the recent international crisis upon the economy and the poor and the budget increase adopted by the Government had to design an anti-crisis financing plan to secure social expenditures and maintain the proportion of capital expenditures adopted in the budget. 158 Although this plan does not address the above-mentioned structural aspects negatively impacting social and capital public expenditures, it is critical to smooth the impact of the crisis upon employment and poverty by maintaining the volume of social and capital expenditure.

Medium-term Government targets aimed at improving the performance of social expenditure management include the expansion of the Tekopora program and streamlining of the institutional settings. The Government set ambitious targets for the Tekopora program and expects to increase its coverage from 18,000 to 100,000 families. This will require strengthening SAS’ capacity, as such rapid expansion of the conditional cash transfer program will no doubt pose important challenges to effective implementati~n.’~~The Government is likewise considering rationalizing and streamlining the institutional settings for the social assistance sector.

154 The Financial and Administration unit of the Ministry of Public Work is a Vice-Ministry and not a Directorate, like in other ministries. 155 55 percent over the last five years - Source: World Bank Transport Sector Evaluation, 2008. 156 The new Government, and in particular the Ministry of Finance and the economic team worked intensively in August- September 2008 to ensure the budget would reflect the priorities of the program campaign. 157 Essentially because of salary increases. 158 See Section I1 on ‘Recent Economic Developments’, and the required financing gap to safeguard those expenditures. 159 To support the expansion of Tekopora Program, the Government is considering using the resources from the IDB Investment Loan currently supporting SAS programs.

87 Box A.12.2: Selection of shared experiences across countries: Conditional Cash Transfers.(CCT) Programs Institutional Design Attention is focused on the clear defintion of lines ofauthority and accountability for the program. Targeting One ofthe most common targeting methodologies in Latin American Countries is the proxy means test6’; Attention is focused on possible exclusion errors (non-inclusion ofeligible households) that could be due for instance to transaction cost to get the benefit; inability to deliver the service related to the program that may exclude eligible families for the program; or lack of outreach and information. Conditionality Most programs recognize the trade-off between administrative burden and participation while setting the conditionality Management Information Systems The MIS systems are viewed as the “backbone” of CCT programs, and focus is made on the design ofthose systems. Internal Control Evaluation processes and correction mechanisms within programs allow to provide real-time feed-back on the quality ofprocesses and the needed remedial actions; Spot checks are perceived as efficient mechanisms for on-going program monitoring; Frequency ofverification is related to the capacity settings ofthe implementation entity. Accountability 0 Developing complaints and appeal mechanisms and promoting transparency through publication ofprogram data contribute to the accountability ofthe implementation entity. Based on: ‘Conditional Cash Transfers: Reducing Present and Future Poverty’ - Ariel Fiszbein, World Bank 2009; and ‘Control and Accountability Mechanisms in CCT Programs -A review of Programs in Latin America and the Caribbean - World Bank, 2007.

Medium-term Government objectives in terms of public investments combine sector- specific reforms and horizontal measures. First, the Government plans to strengthen the water sector through both reforms ofits institutional actors and increased investments. Second the Government intends to implement a new conceptual and institutional framework for the

System of National Public Investment (SNIP) under the leadership of the Technical Planning ’ Secretariat (STP). Third, budget classification will be modified to improve the identification and monitoring of investments related to public infrastructure maintenance. Finally, institutional measures are being considered to improve medium-term inter-ministerial coordination and streamline budget execution processes within ministries. 16’

The Government Plan also covers the budget execution issue. In fact, the need to address this issue was already considered in the 2008 Government public financial management (PFM) Action Plan that was prepared by the Ministry of Finance’s Under-Secretariat of Financial Administration. Within this context, two main areas were targeted: budget execution, and treasury and cash management.

160 This terms denotes a system in which scores for applicant households are generated from characteristics that are fairly easy to observe, for instance, the location and quality of the family’s dwelling, the durable goods they own, the demographic structure of the household, levels of education, and adult occupation. 161 For instance, the Ministry of Public Work is currently identifying opportunities to simplify administrative processes related to procurement with Bank support. 88 Box A.12.3: Government PFM Action Plan - Credibility and Efficiency of the Budgetary Process

'. ,L I Credib&tyan&Xfncieaeysf &e Budgetary Precess. ** LI i Budget Execution Strengthen the planning and budgeting capacity ofthe Financial and Administration Units ofspending units and their cooperation with Ministry ofFinance Introduce commitment phase to all expenditure categories defined in the LAFE Further delegate authorization ofpayments and contracts within spending units Streamline procurement processes Treasury and Cash Management Track down bottlenecks and adopt mitigating measures to reduce Central Administration's floating debt; Further reduce the number ofCentral Administration bank accounts Deepen efforts to flexibilize cash management through the integration of financial and cash plans Determine the floating debt corresponding to the whole Non Financial Public Sector, including in particular state-owned enterprises Adopt the Treasury Single Account and establish a cash management unit

Implementation & Stakeholders Challenges First, Government activities in this area will require careful political management. The fact that poverty alleviation has been singled out as the main objective of the administration has unleashed high voter expectation in this regard, the achievement ofwhich will be critical to maintaining its credibility. Meanwhile, its lack of a majority in Congress could reduce its ability to implement significant changes. As a result, the Government initiated in January 2009 a dialogue on social issues with Congress that focused on the adoption ofthe 2009 anti- crisis plan, and intends to better coordinate IFIs and donors activities through, inter alia, the implementation ofthe PDPL and the multi-donor program supporting the anti-crisis plan.

Second, more efficient social and capital expenditure management largely depends on inter-institutional coordination and capacities. The inter-institutional dimension ofthis area is critical and cannot be addressed in the short term.

89 Annex 13: Human Resources Management - Detailed Diagnostic and Government Priorities The Government Plan identified civil service reform as a key priority. In order to address the high level ofpolitization which characterizes Paraguay’s civil services as well as its poor performance, the Government expressed its strong commitment to establish a more meritocratic and professional civil service. The main short-term lines of actions to achieve this objective focus on strengthening the Public Administration Secretariat (SFP). Medium- term lines ofaction include the reform of the current Civil Service Law (No. 1626/00) and the introduction ofa civil service career system.

Diagnostic Paraguay’s HRM performance has been among the weakest in Latin America. Regional studies have classified Paraguay’s civil service under the category of clientelistic characterized by substantially politicized appointments, weak technical capacity, poor incentives, informality and lack of uniformity in its remuneration policies. According to the quality of public administration index’63, Paraguay lags behind other clientelistic bureaucracies with lower GDP per capita (PPP) such as Guatemala, Nicaragua, Ecuador, Bolivia and Jamaica, as shown in Figure A. 13.1.

Figure A.13.1: Quality of Public Administration and GDP per capita (ppp) for selected Latin American and the Caribbean countries 70

60

h 0 0 50 rI -0 X 40 -C .-e E 30

z.-0 20 n4

10

0 $0 $2,000 $4,000 $6,000 $8,000 $10,000 $12,000 $14,000 $16,000 GDP per capita (ppp) Source: Quality of Public Administration (Echebarria: 2007)

Paraguay’s weaknesses in HRM undermine the effectiveness of public policies as well as the country’s institutions. Despite considerable increases in public expenditures in the last decade, program delivery has been weak in key areas such as health and education. The

162 This typology defined three categories of Bureaucracies: Merit-Based; Administrative; and Clientelist, with the weakest characteristics - Source: Echebama (2007). 163 Source: Echebarria (2007)

90 country has one of the worst performances in Latin America in prevention of epidemic diseases and infant and maternal mortality. Budget increases in education have been allocated to cover recurrent expenditures, limiting investment spending and therefore reducing the sustainability of policies. In addition, citizen perception of the performance of public institutions continues to be more negative than other countries in the region.164

Paraguay’s institutional framework for human resources management has been fragmented for decades. The administration has not had a central authority able to effectively enforce existing laws and regulations related to public sector employees’ recruitment, selection, promotion, dismissal and pay. Sector ministries, unions and Congress have often circumvented the control of the Ministry of Finance (MOF) and the Public Administration Secretariat (SFP) for recruitment processes, promotions and particularly during salary negotiations, as shown in Figure A.13.2.

Figure A.13.2: Salary negotiation practices in Paraguay’s public sector

I Examples of Salary Negotiation Schemes Source: Policy Note on Public Employment and Wage Bill, World Bank, 2008

Notorious salary distortions and arbitrariness over the assignment of allowances negatively affect the effectiveness of public policies. Paraguay has significant vertical165and horizontal166 salary distortions, together with an excessive number of personnel subcategories. 16’ The high disconnect between responsibility and economic incentives and significant discretion in the distribution of personnel allowances also add to the complexity and lack of transparency of Paraguay’s pay system. These distortions represent a strong disincentive for public employees, negatively impacting the overall effectiveness of public policies.

The civil service legal framework presents weaknesses and its enforcement is limited. The current civil service law is extensive, covering the three levels of Government and three branches of power, and it established the SFP and its mandate. However, there have been

164 Source: Latinobarometro 2008 165 Disconnect between hierarchy and remuneration 166 Positions with similar responsibilities, but with different remuneration 167 Personnel subcategories increased from 285 in 2005 to 435 in 2007, of which 82 subcategories only included one person. See: Policy Note on Public Employment and Wage Bill, World Bank, 2008 91 appeals to the Supreme Court regarding the constitutionality of several articles. Ultimately, the Supreme Court did agree that some of these articles were unconstitutional, thereby limiting the enforceability ofthe law.I6* In addition, the Executive power still has not adopted the secondary legislation related to important provisions ofthe law such as the definition of a career-based system.

Finally, the lack of consolidated control over the wage bill represents a serious fiscal risk. Given that the wage bill represents approximately 40 percent of total Central Government expenditures, the limited control over setting salaries and additional remuneration policies minimizes any consolidated control over the wage bill. The mitigation ofthis risk after decades ofthe practices described above will require a gradual approach and a transition period that President Lugo’s administration is willing to start.

Previous governments failed to introduce ambitious HRM reforms. Clientelism, nepotism and patronage are deeply rooted in Paraguay’s public administration. According to SFP estimates, at the time the new Government assumed office, less than five percent of civil servants were hired based on merit. Previous administrations were only able to introduce minor HRM reforms, all strongly emphasizing legal instruments that did not hdamentally change the working culture and administrative practice^.'^^ In turn, there has never been any serious attempt to introduce a public sector wage bill policy and previous attempts to reform the Government’s pay scale have been reversed soon after being implemented through, inter alia, the creation ofnew categories by Congress.

International experience clearly indicates that improved human resources management in Paraguay will rely largely on the successful introduction of a meritocratic structure. Merit-based public service entails the appointment of the best candidate for any given job, as well as recruitment and promotion decisions based on explicit and specific merit rules that are publicly understood and can be changed if a breach is su~pected.”~However, to avoid rigidities and potentially increased fiscal burden, the introduction ofthe merit principle needs to be combined with improved performance. While most Latin American countries are transitioning from politicized to merit-based systems, OECD countries have consolidated merit-based systems. In order to overcome its current deficiencies, Paraguay’s civil service would need to gradually move from its current clientelist bureaucracy towards a merit-based model. The Table A. 13.1 presents how 18 Latin American Countries fit into this typology.

168 The articles of the civil service law 1626/2000 non-complying with the Constitution include: article 14-b; 16-f; 17; 42; 61; 143. 169 These legal instruments include: (i) Law 1506: Statute of Public Employees (1935); (ii)Law 200: Statute of Public Employees; (iii) Law 1626: Public Administration Law, which constitutionality has been questioned mainly due to its broad coverage (Executive, Legislative, and Judicial branches as well as the three levels of Government). 170 For instance, failure to appoint a candidate can be appealed and reviewed against explicit specifications for the position.

92 ca

These countries have established merit-based systems and a rational structure of incentives to support performance. 1 Public servants are recruited on the basis of merit, inserted into professional careers, and enjoy job stability. (This professionalization may lead to specific cultures, with a strong Merit Based which gives them an independent source of Bureaucracy esprit de corps, power.) 1 Performance incentives are based on an ordered system of wage Brazil, Chile High Capacity High - management with relative internal equity and processes to Independence improve wage competitiveness, as well as evaluation processes that have begun to relate individual performance to group and institutional performance. There are training systems with some degree of strategic content. 1 Work systems (career structures, job descriptions) are somewhat flexible. Formal merit rules exist, but are not consistently applied. Jobs are often gained for political reasons and incentives for performance are weak.

1 These countries have reorganized their wage system, but they still face problems of internal inequity and of salary competitiveness at Administrative management levels. Argentina, Colombia, Bureaucracy 1 They have also established performance evaluation systems, but Costa Rica, Mexico, these proven difficult to implement. Uruguay, and 1 Entry into the public service is based on formal qualification, but Low Capacity - High Venezuela Independence this has led in some countries to over-qualified public servants and in others to a "degree culture" which prevails over competence. . Work systems are somewhat inflexible: in many cases, job structures and descriptions are rigid and job manuals excessively formal. Appointments are substantially politicized. The technical capacity of thepublic service is very weak, reflecting poor incentives. Informality - bureaucratic behavior at odds with formal rules - is rife. In most of these countries, officials temporarily enter Government as political appointees, in exchange for political support (sometimes trade-union or professional-association appointees), Paraguay, and when Governments change, personnel changes are substantial. Clientelist Bolivia, Dominican 1 Remuneration policies are characterized by lack of uniformity, Bureaucracy Republic, Ecuador, lack of information, high levels of inequity, and no effectively El Salvador, applied performance evaluation. Even where public sector wages Guatemala, Low Capacity - Low are on average reasonably competitive with private sector wages, Honduras, Nicaragua, Independence some segments with low competitiveness persist due to the Panama, and Peru dispersion of the wage systems. . Workforces have very low professional skills. Jobs are defined without technical studies or simply not defined at all, training systems lack strategic content, and occupational systems are very rigid. Yet rigidity is often not a problem because there are no rules to prevent discretionary decisions. Source: adaptedfrom E' Lebarria - 2007 Government Plan and Implementation & Stakeholder Challenges Government Plan

Reforming Paraguay's civil service and HRM practices throughout the public sector constitute high priorities within the administration's agenda. Backed by widespread popular support and trust for the presidentl'l, the administration is committed to professionalize the civil service by introducing merit-based principles while ensuring better performance in public service delivery. To this end, main lines of action include strengthening

171 According to Latinobarometro 2008, Paraguay moved from the last place in 2007 to the first place in 2008 in the categories of trust in Government, Government approval and trust in political leadership. 93 the Public Administration Secretariat to ensure effective enforcement of human resources legislation; and, in a subsequent stage, reforming prevailing civil service legislation and introducing a civil service career system.

During the first stage, the Government plans to strengthen the SFP via capacity development and by expanding interactions with other institutions and stakeholders. Guided by the restructuring plan that was designed during the Government’s first 100 days, the Secretariat intends to strengthen its capacities in terms of human resources and training, systems, and data collection procedures. It is expected that prior actions in this area will also be supported by an IDB technical assistance loan. The Secretariat is in parallel actively interacting with other ministries. The SFP is joining efforts with the Ministry ofHacienda to achieve a more consolidated human resources management for the Paraguayan public sector. The recently adopted Presidential Decree 223/2008 assigns both institutions the responsibility to work jointly to avoid cases of double remuneration for civil servants. Both institutions likewise share a wage bill modeling tool and work together on other initiatives such as the design and implementation of the unified HRM control system (SICCA). The SFP is also strengthening its role as the central human resources management agency. After an initial measure ordering the revision or cancelation of contracts for political appointees and temporary personnel, the SFP intends to reinforce its control over new recruitments and promotions. To this end, SFP resolution 50/2008 was passed in autumn 2008 and provides that all Central Administration selection and promotion procedures for permanent personnel’72 be authorized by SFP and subject to merit-based guidelines. This will be rendered possible by the definition of staff profiles and mandatory requirements for civil service positions.

The Government plans to reform the current Civil Service Law No. 1626/00 in a subsequent stage. The revised legislation will include provisions necessary to: guarantee the establishment of a professional and politically neutral civil service; define the institutions empowered to manage and monitor civil servants; ensure the existence of merit-based and competitive entry selection and promotion; create a regime of duties for civil servants; and guarantee a range of rights, benefits, and other conditions of employment. The revised legislation will provide a definition of the scope of civil service.’73 It will also clearly define which institutions are empowered to make secondary legislation and where there is a need for common standards. Finally, it will make clear reference to how and by whom cost factors relevant to the civil service are to be dealt with in the context of the budgetary system. This reform will represent a major step towards a sustained introduction ofmerit-based principle in Paraguay’s civil service, and its preparation is also expected to generate a broad consensus with political and union stakeholders.

Government plans also include the introduction of a professional civil service career system. With the support of an IDB TAL, which is currently under implementation, the SFP plans to establish a career-based civil service system. Its implementation will consist of designing human resources policies supporting merit-based recruitment and promotion; implementing those policies and delivering intensive training for senior management and staff; and further strengthening the role and capacities ofthe SPF and human resources units ofspending units.

172 Projects under consideration also include applying merit-based rules for the recruitment of contracted personnel. 173 Categories ofemployees performing public functions to be subject to this law. 94 Implementation & Stakeholder Challenges

There is a fiscal risk associated with the civil service reform. There is a risk of wage bill increases resulting from negotiations for the introduction of merit-based practices and career system, as for sustainability and ownership purpose, the preparation ofthis reform will require a broad consensus with civil servants and their unions. This would be critical given the current international economic crisis coupled with the size of the public sector wage bill - approximately 40 percent of total Central Government expenditures. Sequencing of this reform and the cooperation between the Ministry of Finance and the Public Administration Secretariat will be critical to ensure progress. The effectiveness of this reform will also depend on the Government’s readiness to limit the scope ofthe reform in the event that sound management and economic principles are threatened. Accordingly, the Ministry of Finance is considering the merits of dropping this reform if it implies a wage bill increase of above 15 percent for the following fiscal year.

The need to generate broad political consensus will constitute an additional challenge. The sustainability ofthis reform will depend on the adoption of a series of legal documents at a time when the Government does not have a majority in Congress. As a result, it is crucial that the Executive pursue extensive outreach and dialogue within the Government, the unions and political parties to foster progressive and increasing ownership ofthe reform objectives.

95 Annex 14: Country at a Glance

Paraguay at a glance 2/20/09

Latin Lower- POVERTY and SOCIAL mlddle- America Development diamond' Paraguay 8 Carib. Income 2007 Population, mid-year (millions) 6.1 563 3,437 Life expectancy GNI per capita (Atlas method, US$) 1,710 5,540 1,887 GNI (Atlas method, US$ billions) 10.5 3,118 6,485 7 Average annual growth, 200107 Population (%) 1.9 1.3 1.1 Labor force (%) 3.6 2.1 1.5 primary Most recent estimate (latest year available, 200107) capita'1 I+ enro;: Poverty (% of population below national poverty line) 36 Urban population (Oh of total population) 58 78 42 Life expectancy at birth (years) 72 73 69 i Infant mortality (per 1,000 live births) 32 22 41 Child malnutrition (Oh of children under 5) 4 5 25 Access to improved water soune Access to an improved water source (% of population) 69 91 88 Literacy (Oh of population age 15+) 90 89 95 -Paraguay Gross primary enrollment (% of schooi-age population) 104 118 Ill Male 106 120 112 __ Lower-middle-income group Female 103 116 109 KEY ECONOMIC RATIOS and LONG-TERM TRENDS

1987 1997 2006 2007 Economic ratios. GDP (US$ billions) 3.5 8.9 9.3 12.2 Gross capital formationlGDP 25.1 26.5 19.6 18.0 Exports of goods and servicedGDP 26.4 44.0 53.7 50.9 Trade Gross domestic savingdGDP 16.5 11.7 15.1 15.0 Gross national savingdGDP 14.4 14.3 24.8 21.1 Current account balance/GDP -7.3 0.8 0.2 Domestic Capital Interest paymenWGDP 1.1 1.8 1.3 savings formation Total debtlGDP 27.7 36.9 29.1 Total debt service/exports 22.0 6.3 7.3 6.4 Present value of debtlGDP Present value of debtlexports Indebtedness 1987-97 199707 2008 2 007 2007-1 1 (average annual growth) -Paraguay GDP 3.6 1.8 4.3 6.8 4.2 GDP per capita 1.1 -0.2 2.4 4.8 2.2 Lowermiddle-income group Exports of goods and services 11.9 3.0 14.6 9.6 2.0

STRUCTURE of the ECONOMY

(% of GDP) 30 Agriculture 27.3 18.5 20.2 22.0 1 -- 27.3 18.5 2o1" T Industry 22.5 22.7 20.4 20.0 10 Manufacturing 14.1 15.4 13.7 12.8 0 Services 50.1 58.8 59.3 58.0 .10 Household final consumption expenditure 76.4 76.9 73.7 74.1 -20i General gov't final consumption expenditure 7.1 11.4 11.2 10.8 -GCF *GDP

1987-97 199707 2006 2007 I Growth of exports and Imports ('4 (average annual growth) I Agriculture 4.4 3.8 3.4 14.3 Industry 3.4 0.5 1.8 1.o Manufacturing 0.5 0.4 2.5 -1.2 Services 3.5 1.4 5.7 5.3 Household final consumption expenditure 3.9 0.6 1.3 11.6 General gov't final consumption expenditure 9.6 0.3 4.0 5.3 Gross capital formation 6.5 -1.3 19.8 -6.7 Imports of goods and services 14.0 0.4 16.5 10.8

Note: 2007 data are preliminaly estimates. The diamonds show four key indicators in the country (in bold) compared with its incomegroup average. If data are missing, the diamond will be incomplete.

96 Paramav

PRICES and GOVERNMENT FINANCE 1987 1997 2008 2007 lnflatlon Domestic prices (K) (% change) 125 I Consumer prices 21.8 6.9 9.6 8.1 Implicit GDP deflator 30.3 4.3 8.5 10.2 Government finance (% of GDP, includes current grants) Current revenue 8.1 18.9 18.3 17.6 Current budget balance 1.5 2.3 4.8 4.6 -GDP &Rator &CPI Overall surpluddeficit 0.7 -2.3 0.5 1.o lLzxLJ

TRADE 1987 1997 2006 2007 Export and Import levels (US$ mlll.) (US$ millions) Total exports (fob) 803 3,328 4,401 5,471 7.m T I Soy products 125 494 439 890 0.m Cotton 101 73 34 47 5.m Manufactures 450 2,239 2,495 2,688 4.m Total imports (cif) 1,049 4,192 5,022 6,027 3.m Food 532 1,252 533 451 2.m Fuel and energy 103 267 691 715 1.m Capital goods 14 928 1.754 2.577 0 Export price index (1994=100) 116 96 113 Import price index (1994=100) 128 126 153 Terms of bade (1994=100) 91 76 74

BALANCE of PAYMENTS 1987 1997 2006 2007 Current account balance to GDP (%) (US$ millions) Exports of goods and services 1,036 3,983 5.154 6,324 I Imports of goods and services 1,304 4,847 5,406 8,487 Resource balance -267 -864 -252 -1 63 Net income -93 33 -96 -184 Net current transfers 27 181 426 373 Current account balance -334 -850 78 26 Financing items (net) 347 867 309 70 1 Changes in net reserves -13 -218 -387 -727 Memo: Reserves including gold (US$ millions) 846 1,703 2,462 Conversion rate (DEC, /ocaVUS$) .. 2.177.9 5.835.5 5,032.7

EXTERNAL DEBT and RESOURCE FLOWS 1987 1997 2007 2006 :omposltlon of 2007 debt (US$ mlll.) (US8 millions) Total debt outstanding and disbursed 2,522 2,461 3,422 3,561 IBRD 372 143 234 217 IDA 44 33 19 18 Total debt service 239 279 421 450 IBRD 65 36 39 38 IDA 1 2 2 2 Composition of net resource flows Official grants 15 23 12 7 Official creditors 60 145 -15 -38 Private creditors 35 84 -10 61 Foreign direct investment (net inflows) 5 238 171 244 Portfolio equity (net inflows) 0 0 0 0 E: 592 World Bank pogram Commitments 0 40 74 30 .4. IBRD E - Bilateral

Disbursements 19 41 32 11 B - IDA D ~ Other multilalerai F - Private Principal repayments 37 28 28 29 IC-IMF G -Short-term Net flows -18 14 4 -18 Interest payments 30 11 13 11 Net transfers -48 3 -8 -29

DeVelODment Economics 2/ 17/09

97 Annex 15: Government’s Anti-Crisis Plan and 2009 Financing Scenario

Box A.15.1: Anti-CrisisEconomic Reactivation Plan The Plan consists of monetary, financial and fiscal measures:

1. Injection of liquidity in thefinancial system Beginning in October 2008, the BCP lowered reserve requirements in both domestic and foreign currency. It also lowered the interest rate on its monetary regulation instruments. Through these two measures, the BCP injected US$I80 million in liquidity into the system. It also established a short-term liquidity facility for banks.

2. Fiscal expansion The 2009 budget foresees a significant increase in social and capital spending to generate employment and soften the.impact ofthe crisis on the most vulnerable. This includes a significant expansion ofthe conditional cash transfer program and ofhousing construction. It also includes increased resources for the Govemment-run development banks to provide assistance to vulnerable farmers.

3. Programs to ensure availability of credit for the productive sectors The Agencia Financiera de Desarrollo (AFD), the public sector second-tier bank, will provide special credit lines to ensure the availability offinancing for the upcoming harvest and for exports, as well as for the next agricultural cycle.

4. Mobilization of resources Measures will be taken to speed up the approval by Congress ofexternally financed investment projects in the amount ofUS$105 million, and send an additional US285 million worth ofprojects to the Legislature. In addition, the Government has requested US$300 million in fast-disbursing loans from its development partners, and is considering accessing the US$500 million liquidity facility offered by the IDB. Finally, a number ofconcessions and public-private partnerslups are to be approved by Congress.

Box A.15.2: 2009 Financing Scenario (US$ million) 2009 Financing needs 306.6 Amortizations 306.6 Domestic , 60.7 External 246.0 Multilateral 151.8 Bilateral 94.2 Financing sources -71.8 Overall surplus/deficit -261.4 Disbursements 189.6 External 1/ 189.6 Multilaterals 118.5

IBRD 100.0 IDB 100.0 CAF 50.0 JlCA 50.0 New investment loans 3/ 50.0 Other 41 28.4 I/ Loans already approved by Congress. 2/ Fast-disbursing loans requested by Government, to be confirmed. 3/ Loans to be approved by Congress. 4/ Includes issuance of domestic bonds and the postponement of some bilateral debt service.

98 MAP SECTION

99

IBRD 33464R 62W 60W 58W 56W 54W

18S 18S

BOLIVIA

PARAGUAY

Capitán PabloPablo Lagerenza To Lagerenza Santa Fé 20S Puerto 20S Cerro León ALTO Bahía Negra (1,000 m)

General EugenioEugenio PARAGUAY To A. Garay A. Garay Boyuibe Fortín Madrejon Fuerte Olimpo

Fortín Carlos BRAZILB R A Z I L A. Lopez Puerto Tres Palmas To Fortín BOQUERON Campo Infante Rivarola Kilómetro Grande 160 o 22S MariscalMariscal c EstigarribiaEstigarribia a Puerto To Doctor h La Victoria Dourados Pedro P.P. PeñaPeña C Filadelfia n Puerto Pinasco AMAMBAY P i Pedro Juan lc a o m r Caballero a y o quidabá G A n Yby Yaú Verd Fortín e Leonida Escobar CONCEPCION Pozo Fortín Ávalos ConcectiónConcepción Capitán Sánchez Colorado Bado Fortín Monte Lindo General PRESIDENTE Díaz Fortín Teniente San Lima Rojas Silva P To a Pedro r 24S Las Lomitas HAYESH A Y E S a Salto del 24S g u SANS A N Guairá a CANENDIYÚ y

P PEDROP E D R O ilco Curuguaty ma Rosario yo

San A Villa N Hayes Estanislao Itaquayry A CORDILLERA CAAGUAZU R To Coronel ARGENTINAA R G E N T I N A Caacupé A Cascavel ASUNCIÓN Oviedo P Ita Ciudad del CENTRAL Paraguari Cerro Pero Este (842 m) O This map was produced by the Map Design Unit of The World Bank. To Villarrica T Formosa IRA L Santa The boundaries, colors, denominations and any other information UA A Rita Villa PARA- G Abaí 26S shown on this map do not imply, on the part of The World Bank 26S Group, any judgment on the legal status of any territory, or any Oliva Caazapá N A endorsement or acceptance of such boundaries. GUARI A P E Z A E A á M C n ra M San Juan a B I Bautista P U S ITAPUAI TA P U A I PARAGUAY Pilar C O San Ygnacio San Pedro Ú N del Paraná

Desmochado ES SELECTED CITIES AND TOWNS Coronel Encarnación Paraná Bogado DEPARTMENT CAPITALS To NATIONAL CAPITAL Santo Tomé RIVERS 28S PAN-AMERICAN HIGHWAY MAIN ROADS RAILROADS 0 50 100 150 Kilometers DEPARTMENT BOUNDARIES 0 50 100 Miles INTERNATIONAL BOUNDARIES 60W 58W 56W 54W

JULY 2006