Paraguay’s fiscal rule proposal supports policy credibility

Recent data from Paraguay are consistent with our view that resilient growth and relatively prudent fiscal settings support the country’s sovereign credit profile, Fitch Ratings says. Plans to update the country’s fiscal rule show a continued commitment to maintaining the sustainability of public finances.

The 7.4% qoq increase in GDP in 3Q20 (seasonally adjusted) represented a healthy rebound following the 9.3% contraction in 2Q20. Recoveries in agriculture and beef production and hydro-power shown in data to November suggest moderate upside risk to our estimate that GDP fell by 1.1% last year (the smallest contraction in Latin America).

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Robust recovery in the latter part of 2020 means we have increased 2021 GDP forecast to 4.2% from 3.5%. The coronavirus pandemic still presents risks to the economy and public finances, in addition to longer-standing weather-related risks to agriculture; however, there was little disruption in January, the first month of the main harvest period running through March.

The 2020 central government fiscal deficit was 6.2% of GDP, according to preliminary figures from the Ministry of Finance, in line with our 6% forecast and compared with 2.8% in 2019. Spending grew by nearly 16%, mostly through efforts to combat the pandemic (estimated to have cost 2.8% oand re-activate the economy. These chiefly involved higher capital expenditures, which grew to 3.6% of GDP from 2.9% in 2019 and 2% in 2018.

Government revenues were hit by the pandemic but have recovered with economic growth. VAT revenues fell by 0.4% in 2020 due to the sharp decline in March to May but began to recover from June and recorded a monthly increase of 13% yoy in December.

The recovery in revenues suggests some upside to 2021 revenue projections and, coupled with a stronger GDP forecast, could mean the fiscal deficit narrows faster than we projected when we affirmed Paraguay’s ‘BB+’/Stable rating in December; however, the government has indicated its intent to increase healthcare spending to strengthen the system.

The rating benefits from Paraguay’s long track record of prudent fiscal policy that has delivered low deficits or surpluses over the last decade, keeping the debt burden well below the ‘BB’ category median (59.9%). Nevertheless, general government debt/GDP ended 2020 at 27.9%, up significantly from 20.2% in 2019 in part due to guarani depreciation. This highlights Paraguay’s dependence on external debt, which is nearly 89% of total general government debt.

Fiscal policy has been anchored by the Fiscal Responsibility Law (FRL), which was suspended to address the fiscal response Covid-19. The bill submitted to Congress to update the FRL proposes a debt limit of 40% of GDP and clarifies when the escape clause can be invoked. The fiscal deficit limit would remain at 1.5% of GDP and would fall to 1% if debt/GDP rose above 36%. But it would rise to 3% if growth fell below 75% of the annual average of the previous decade or due to a national emergency. The deficit would then have three years to return to 1.5% of GDP.

The government has committed to cut the deficit to 1.5% of GDP by 2024, consistent with its FRL proposal. It also wants to cap real current spending increases at 2% per year. However, further reforms to increase the tax take are unlikely during the remainder of President Mario Abdo Benitez’s term ending in 2023.

Nevertheless, the government’s early move to set out its planned adjustment path via reactivating and updating its rules-based fiscal framework reinforces policy credibility. We think the updated FRL would allow some flexibility to balance growth and fiscal priorities while anchoring medium-term fiscal expectations, as we noted when the changes were first proposed.