PARAGUAY: BEYOND MACROECONOMIC STABILITY ACHIEVEMENTS AND CHALLENGES The pictures in this book are from the Central Bank of Paraguay building complex, inaugurated on November 5, 1984. The images highlight its modern architecture: spaces formed by lines, angles and curves, textures and shapes contrasts and the excellent use of natural light. This architectural work with modern and rational style presents simple geometric shapes, orthogonal structures and predominance of exposed concrete, glass and aluminum. Likewise, the prevalence of open floor plans, free façade and rooftop gardens stresses Le Corbusier’s considerations. Paraguay: Beyond macroeconomic stability. Achievements and challenges ISBN 978-99967-735-2-5 Printed in Paraguay. First edition: September, 2016 First edition of the Spanish version: March of 2016 Printed by Servipress Coordinating Team: Viviana Garay Estepa, Natalia Cristina Escobar Rivarola, Jazmín Gustale Gill and Felipe González Soley. Edition of the Spanish version: Andrés Benítez Ruiz Diaz and Maria J. Peralta Heisecke Translation: Ana Laura Arias Design and layout: Karina Palleros Cover and interior photographs: Karina Palleros Translation Editing Team: Carolina Avello León, César Carvallo Canas, Enzo Casabianca Laterza, Irene Cristina Escribá, Zulma Espinola González, Viviana Garay Estepa, Felipe González Soley, Juan Manuel Gustale, Ángel Lille González, Luis Carlos Matto, Edgar Mendoza Cáceres, Maria Rosa Ortellado, Fernando Rivarola Angulo, Ana Laura Rojas, Sebastian Romero Robertti. Any views expressed in this document are solely those of the authors and so cannot be taken to represent those of the Central Bank of Paraguay. In application of the Intellectual Property Code, any full or partial reproduction or representation for any use what so ever is prohibited without the prior agreement of the holders of the rights. 2 | PARAGUAY: BEYOND MACROECONOMIC STABILITY Presentation Thegolden years for Latin America and Paraguay have come to an end. A recent IMF study points out that, due to poor prospects for commodity prices, the growth of commodity-exporting economies could slow down even further in coming years. According to this research, the recent drop in prices could potentially cut back the growth rate of commodity exporting countries by one percentage point per year. The study also concludes that the slowdown is not just cyclical, but that it also has a structural component, given that investment—and, consequently, potential output— tends to grow at lower rates among exporting countries during slumps of commodity prices. Over the past twelve years, Paraguay has benefited from tailwinds that helped the economy grow at an average rate close to 5%. All of this was supported by prudent macroeconomic policies (fiscal and monetary), a key factor in the country’s shift in sovereign credit rating from a situation of selective default to currently being one step away from investment grade. However, in the new global scenario, macroeconomic stability – although a necessary condition – will not suffice to sustain high growth rates and achieve higher income and welfare levels. Therefore, to continue building a better future, Paraguay needs to design and implement public policies that are sustainable over time, and are not solely limited to the monetary and fiscal front. For instance, it will now be essential to redouble efforts to promote financial inclusion based on the stable and solid growth of the financial system; to improve the quality of infrastructure and public services; to deepen the stock market; to prioritize the quality of institutions; to adjust the management of international reserves to international best practices; to modernize the regulatory framework of the financial system; and to seek greater diversification and complexity of our production structure. Our quest for these reforms motivated the publication of this book titled Paraguay: Beyond Macroeconomic Stability, with two objectives in mind. On one hand, to describe and document Paraguay’s long road towards macroeconomic stability. On the other hand, through critical and prospective lens, to discuss some of the challenges that lie ahead in achieving growth above the regional average, PARAGUAY: BEYOND MACROECONOMIC STABILITY | 3 supported by a more efficient and inclusive financial system. Naturally, the list of issues covered in this second part is limited, but the topics reviewed are among the most relevant. The Board of the Central Bank of Paraguay looks forward to this publication’s contribution in the enhancement of knowledge on the Paraguayan economy, serving to value the importance of macroeconomic stability, and becoming a useful tool in discussing public policies that must be implemented in Paraguay. Asuncion, March 2016 Carlos Fernández Valdovinos 4 | PARAGUAY: BEYOND MACROECONOMIC STABILITY PROLOGUE 7 PART 1: Recent achievements 11 A Decade of Stability 12 Jorge Corvalán Mendoza Monetary and Fiscal Policy Coordination 28 Daniel Correa Ramírez Sustainable Effectiveness of Monetary Policy 52 Carlos Carvallo Spalding PART 2: Challenges 77 Quid Pro Quo: Productivity and Economic Growth (I) 78 Carlos Fernández Valdovinos Quid Pro Quo: Productivity and Economic Growth (II) 100 Carlos Fernández Valdovinos Financial Inclusion 128 Santiago Peña Palacios Main implications of the legislative amendments proposed 151 by the Central Bank of Paraguay (BCP) Ernesto Velázquez Argaña Where Is the Paraguayan Financial System Headed? 173 José Insfrán Pelozo Deepening the Securities Market 197 Rafael Lara Valenzuela International Reserve Administration 211 Roland Holst Wenninger About the authors 230 CONTENTS PARAGUAY: BEYOND MACROECONOMIC STABILITY | 5 6 | PARAGUAY: BEYOND MACROECONOMIC STABILITY PrologUE Felipe Larraín B.1 Paraguay has experienced numerous episodes of high volatility in its path towards economic growth, some of them brought about by its high economic openness and strong reliance on the agricultural sector. In consequence, the GDP has become significantly vulnerable to fluctuations in the international prices of such products, and may sometimes be severely affected by said shocks. However, while some volatility is caused by variations in international export prices, macroeconomic institutionality takes also a share of the responsibility. For instance, fiscal policy in the past was rather pro-cyclical: in times of negative shocks, the fiscal authorities could have reacted to the fall in tax revenues by shrinking public spending, thereby also worsening the drop in GDP levels. Fiscal institutions are, however –and on a more positive note–, currently undergoing a process of revision and improvement, especially as of the implementation of the 2013 Law on Fiscal Responsibility. This book aims to show how Paraguay is shifting, in several dimensions, towards a new and improved economic institutionality. As detailed by the authors, this process has developed over a decade and covers fiscal, monetary and financial institutional frameworks. Such improvements in economic institutionality go beyond helping in the reduction of volatility in economic growth. Moreover, macroeconomic stability is a necessary, albeit insufficient, condition in stimulating economic growth. Facing greater levels of stability and less uncertainty, private investment tends to become more dynamic, spurring national growth at higher rates. Let’s consider an example on how an improved institutional framework may affect economic growth. As long as there is a responsible fiscal management, implying that tax authorities save in years of economic expansion and dis-save in times of recession, creating fund with liquid assets to be used in the latter case, the risk premium required for the issuance of public debt is likely to decline, acting as benchmark for the rest of the economy. This phenomenon is clearly represented by the Chilean economy in the last decade resulting in lower interest rates for the economy and boosting investment. 1 Director, Latin American Center for Economic and Social Policies (CLAPES UC) and Senior Lecturer, PUC Chile. Former Finance Minister of Chile (2010-2014). PARAGUAY: BEYOND MACROECONOMIC STABILITY | 7 This book seeks to illustrate the country’s efforts in improving its economic institutionality and stability, thereby facing higher economic growth rates, as well as the possibility of higher levels of employment, wages and tax revenues, all resulting from greater economic dynamism in the near future. The book covers practically all the institutions relevant for financial markets and economic growth, boarding topics such as fiscal and monetary policies, financial inclusion, the stock market and management of international reserves. Recent advances are also discussed, as well as the next steps required to move forward with the Paraguayan institutional framework. Within the first part of the book, the chapter “A Decade of Stability”, by Jorge Corvalán is dedicated to a discussion on the main reforms in Paraguayan institutional improvements since the last decade, based on three pillars: the fiscal, monetary and financial sectors. Next, Correa, Colman and Tello analyze how to improve coordination between the fiscal and monetary institutional frameworks, while Carlos Carvallo describes the implementation process of inflation-targeting scheme and how an efficient fiscal policy has been crucial in the advent of the recent monetary management success. At the beginning of the second part, Carlos Fernández discusses productivity and economic growth,