Paraguay aims to balance fiscal prudence with more flexibility

PRESS RELEASE from Fitch

Fitch Ratings-London/New York-01 October 2020: Paraguay’s 2021 budget and proposed new fiscal rules demonstrate a desire to balance growth and fiscal priorities while anchoring medium-term fiscal expectations, Fitch Ratings says. Resilient growth and relatively prudent fiscal settings have supported Paraguay’s sovereign rating at ‘BB+’/Stable during the coronavirus pandemic, but near-term deficit reduction targets may prove difficult to achieve.

The recent 2021 budget aims to reduce the central government deficit by just over 3 pp of GDP to 4.1% from 7.2%. This would be consistent with the government’s earlier pledge to reduce it to 1.5% in 2024 - the limit set in the existing Fiscal Responsibility Law (FRL). The government introduced a fiscal package worth close to 5.5% of GDP in response to the pandemic this year, which will lead to a 2020 deficit much higher than the FRL limit. The FRL’s escape clause went into effect last year, which allows a deficit of up to 3% of GDP in an economic shock such as 2019’s recession (after weather severely disrupted agriculture and hydro-electric power generation).

The government plans to send a proposal to Congress to allow a three-year deviation from the FRL and a gradual return to the 1.5% of GDP limit. Changes will also be proposed to the FRL in Congress in mid-October. These would change the limit on annual increases in current primary expenditure to average inflation plus 2% instead of the current cap of 4%; would extend the time to revert to a 1.5% of GDP deficit when escape clauses are used to three years from one; and would introduce a debt ceiling. The government was reviewing the FRL before the coronavirus crisis after using the escape clause last year.

Prudent and consistent policymaking, including the introduction of inflation targeting and the FRL over the past decade, is a key factor supporting Paraguay’s rating. We believe the proposed FRL changes would allow greater flexibility for countercyclical policies, given Paraguay’s moderate debt burden. Low inflation should limit the scope for increasing current expenditure. And while the debt ceiling will be proposed at either 35% or 40% of GDP, higher than Paraguay’s debt ratio, this would still be lower than the ‘BB’ rating category median (forecast at 59.9% in 2020).

GDP contraction and pandemic spending will push debt-to-GDP 8 pp higher in 2020 from 2019 to nearly
30%. The government plans to reduce the deficit by allowing some transitory spending from the pandemic response to lapse, maintaining a wage freeze and implementing tax reforms passed last year that expects to yield 0.7% of GDP by 2024, although these will take effect more gradually than originally envisaged.

Last year’s recession has been followed by a resilient economic performance in 2020 despite the pandemic. Fitch has revised its real GDP forecast for 2020 to a fall of just 1.1% from 5.5% after better than expected data showed that the agriculture and hydroelectric power sectors rebounding strongly. However, our much smaller forecast contraction this year will have a knock-on effect in 2021, when we now expect a more modest 3.5% GDP rebound, down from our previous 5% forecast. The government forecasts an economic contraction of 3.5% this year and 5% growth in 2021.

Differing growth forecasts result in divergent deficit forecasts, with Fitch forecasting a narrower 2020 central government deficit (6.6% of GDP). Our lower 2021 growth projection implies weaker tax revenues and less dramatic consolidation than government projections. We forecast next year’s deficit to narrow by 1.2 pp of GDP to 5.4% of GDP. Fiscal outturns will also depend on how effectively other planned measures, including civil service and development bank reform, reduce expenditure and boost growth.