Chapter 6. Partnerships: Resourcing Paraguay’s development agenda1

This chapter describes how Paraguay’s network of partnerships with external and domestic entities generates financing to support its development agenda. It examines public finances and the scope to increase the resources available for the public sector, focusing on the potential to improve the performance of Paraguay’s public finance framework, including how to recalibrate expenditure towards areas that offer greater developmental returns, such as infrastructure, while maintaining fiscal sustainability. The chapter then examines the availability of resources for private-sector firms, through foreign direct investment (FDI) and financing from the domestic financial system, and the potential for a more effective domestic banking system. The focus throughout is on the resources that are, or could be, available for development activities, rather than how those financing flows have been used.

Sufficient flows of financing are needed to enable both the public and private sectors to drive national development. This chapter assesses the availability of financing flows that could support investment and other activities by both the public and private sectors. Financing for development activities can come from several different sources, both domestic and foreign. Given their nature, there can be a significant degree of substitutability between public and private sources of financing flows – for example, credit from the banking sector for the domestic private sector can also be absorbed by the public sector, or foreign direct investment (FDI) can be used to fund investment in public infrastructure. This chapter describes the financing flows for development activities that have been available to Paraguay in recent years, comparing these flows with the benchmark economies. It highlights areas where flows may be expanded or more effectively mobilised, in support of expanded development activities. The chapter also analyses the sustainability of different dimensions of these flows.

Development financing flows are those that are likely to be sustained into the longer term. This chapter focuses on those flows. Development financing should allow for the purchase of physical, productive assets, or those that are associated with ongoing and recurrent activities, such as remittances, or through all forms of taxation and other public revenues. It excludes financing flows that show a tendency to reverse, especially at shorter horizons, such as portfolio flows, or investments that are not for real assets with ongoing productive or developmental output, such as those in existing equities rather than new issues.

The remainder of this chapter is organised as it follows. First, it presents an overview of the country’s financial flows available for development, considering both public and private financing sources. Second, it focuses on public resources, and in particular the structure of public revenues and expenditures in Paraguay compared to benchmark economies, as well as the fiscal balance that is sustainable into the medium term. Third, it analyses private financing and shows that the private sector is constrained by structural constraints within the domestic financial sector and limited mobilisation of FDI. It also shows the evolution of remittance flows, although these are relatively modest. Finally, it highlights where Paraguay might be able to expand the role of its private and public partnerships (PPPs) to support national development.

Paraguay’s financial flows are low compared to those of benchmark economies and they are below those of OECD economies

International studies seek to highlight which flows and policies can contribute most to supporting financing for development. In support of implementation of the sustainable development goals (SDGs), the Addis Abba Action Agenda on Financing for Development describes the importance of a range of domestic and external sources of financing flows to enable development activities by both the public and private sectors. Other international organisations have sought to identify the policies that can improve their availability for emerging economies (World Bank, 2013; ECLAC, 2016a). Some flows are of the greatest importance for enabling development activities, and a policy agenda is required on how to maximise these flows and their effects, for example by improving tax administration, or by strengthening the linkages between FDI and domestic firms (Box 6.1). As a landlocked country, Paraguay faces particular challenges in structurally transforming its economy, harnessing benefits from international trade, and developing efficient transport and transit systems (United Nations, 2014). They should be considered in designing a financial strategy for Paraguay.

Box 6.1. Financing flows for development activities

Effective national development plans seek to mobilise the full range of resources available so as that the public and private sectors can invest and transform the structure of the economy and the well-being of the country’s people. Development plans need estimates of the overall financial resources that the country can mobilise to realise its ambitions, and of how the country can make the most of these resources. This assessment is fundamental to the prioritisation of the development agenda, and is necessary to ensure that the development programme is sustainable.

The assessment focuses on the resources that could be available to support developmental investments and operations, rather than how they are used. As far as possible, this assessment should also account for the resources that are potentially available, rather than those that are, in practice, applied. Each of these flows is defined in terms of the size of the flow of resources, rather than the stock of resources that have already been provided. The main sources of financing support the investment and operations of private and of public actors respectively.

Resources for public sector development activities. A country’s financing for development is generally dominated by the revenue mobilisation capacities of its public sector. Across most countries, including the benchmark economies, the public sector controls the most significant volumes of financing that can be allocated to development activities. Although the ratio of fiscal revenues to gross domestic product (GDP) remains low in emerging economies compared to OECD economies, fiscal revenues compared to private flows remain substantial, highlighting the need to increase private flows for development. The following comments describe broader trends that are illustrated in Figure 6.1.

1. The mobilisation of domestic resources through taxes and other forms of public revenue. The effectiveness, efficiency and progressiveness of the tax system are essential for successful domestic resource mobilisation. Most of each country’s development financing flows are mobilised through the national budget. In the case of Latin America, taxes and social security contributions are close to 23% of GDP (OECD/ECLAC/CIAT/IDB, 2017). The scale of this financing is determined by the revenues that a country is able to raise from its own resources, less budgeted expenditure that is already earmarked and cannot be reallocated towards other developmental activities. In the short to medium term, non-discretionary expenditures are usually limited to payroll and interest expenditures, given that debt contracts and public-sector employment contracts cannot be adjusted in the short term. This concept of nationally mobilised revenues less non-discretionary expenditure can be termed “fiscal space”. As the horizon becomes longer-term, all the budget is effectively discretionary and can be reallocated.

2. Improving the efficiency and effectiveness of spending, and so expanding budgetary resources available for development. This may include reallocating spending to support national development objectives, by cutting poorly targeted or distortionary subsidies, or increasing expenditure efficiency by improving public procurement and public finance management systems.

The difference between own-source revenues and non-discretionary expenditure generates the concept of the “fiscal space” that may be available for the public sector to finance development objectives. In practice, this observation reflects the narrow definition of non-discretionary expenditure. In addition to payroll and interest payments, many countries (especially those with larger public sectors) may have components of expenditure that may not be readily reallocated; for example, countries may have significant transfers or other social payments, or they may fund activities that in other contexts are provided by the private sector. It may not be feasible to adjust these payments, especially while improving development outcomes.

3. Sustainable debt financing of the public-sector deficit. A prudent approach may be to maintain a sustainable level of public debt linked to the factors that can be used to service that debt (e.g. GDP, government revenues or exports). The sustainability of deficit financing will be linked with debt sustainability assessments.

4. Official development assistance (ODA), defined broadly to account for all forms of concessional flows, which can be used for certain development investments and over which the recipient government exerts only a degree of influence. Across the benchmark economies, ODA flows are a trivial source of financing for development by the public sector. The limited role of ODA financing is evident even when using a relatively broad definition, that includes the value of the concessionality of concessional lending. This metric does not record the quality or efficiency with which those financing flows are used. The modest volumes of ODA are likely to have significant benefits for development, given the associated processes intended to ensure that they are allocated to high-impact development activities.

Financing the contribution of private sector investments and operations to national development:

5. Domestic private sector investments, which are generally financed through the domestic banking system. These investments by businesses, especially small and medium-sized enterprises (SMEs), may be using credit borrowed by households, so it is important to include credit to all the private sector. Domestic credit flows make differing contributions to financing lending, largely linked to the state of the domestic banking system. In some countries, the amount of domestic plus non-resident lending to the private sector is declining as a share of GDP. This means that the banking system is reducing the amount of financing available for development activities by the private sector, and is generally observed in countries that had earlier experienced credit booms that turned out to be unsustainable.

In some countries, there is a large gap between the amount of financing actually provided to the private sector and the amount that would be expected given the level of financial depth. Proxies for credit to the private sector include income levels and the share of deposits in the domestic banking system. Among the benchmark economies, some have domestic financial systems that generate far greater levels of financing to the private sector than might be expected. This measure gives an approximation estimate on the funds that could be available if the financial sector were operating effectively. Thus, this can represent a measure of the amount of financing that could potentially be provided, relative to current conditions.

The contribution of the change in stock market capitalisation also varies significantly across countries, which is unlikely to reflect contributions to the financing available for the private sector. Changes in stock market capitalisation reflect also changes in the value of the companies that are listed. These changes can mean little in terms of the amount of financing that these companies are able to access, and it is not clear that this indicator alone is an effective indicator of the mobilisation of financing for productive private investments.

6. Foreign direct investment (FDI) can encourage investment in new, innovative or more efficient production modes and in the process can raise the productivity of domestic actors, depending on the business and regulatory environments. These flows do not include portfolio or offshore bank credits, given that the latter flows tend to be short-term and subject to rapid reversals. Higher-income countries are more likely to observe negative net foreign direct investment (FDI) inflows, while lower-income countries observe the opposite. The negative net inflows of FDI may reflect the maturity of earlier direct investments, for example as the owners of the investments repatriate the dividends generated by them. It also reflects a lack of new investment opportunities. In contrast, emerging markets may offer greater scope for new investment opportunities, while existing reinvestments in existing investments may continue.

7. Migrants’ remittances generally contribute mainly to domestic consumption and household investment. A key factor for these transfers is their transaction costs. In some benchmark economies, net remittances are negative, reflecting the size of immigrants in these countries’ labour markets and the salaries that these immigrants repatriate to their native countries. Apart from the poorest of the benchmark economies, even where net remittances are positive, their amount is modest.

8. Philanthropy and international partnerships usually work for the provision of global public goods or strive to address cross-cutting development issues. The values of these flows are likely to be less substantial for individual countries, and may be subsumed within ODA.

The distinction between public and private flows can be somewhat artificial, given that countries are increasingly blending the two. For example, countries may be using private FDI to fund public infrastructure projects through the structure of public-private partnerships (PPPs). The overall assessment must account for such blending.

Sources: Based on United Nations (2015), and authors’ analysis of data from IMF (2017a), IMF (2017b); IMF (2016a), World Bank (2017) and World Bank (2016a).

Paraguay’s financing flows available for development are low among the comparison countries and remain below OECD benchmark countries (Figure 6.1). On the public side, the available fiscal space (public revenues less committed expenditures) is small. Thanks to the implementation of the Fiscal Responsibility Law (FRL), Paraguay’s public deficit remains one the lowest among benchmark countries and in the Latin American region. The FRL establishes a ceiling of 1.5% of GDP (or 1% average over a three-year period) on the government’s fiscal deficit, limits any increase in annual expenditures to 4% in real terms and provides that wage increases in the public sector must be in line with increases in the minimum wage. When implemented in 2015, parliament increased the expenditures beyond those proposed by the central government, but excluded expenditures in infrastructure financed by international bond issuances from the calculation of the fiscal deficit for the purposes of the FRL (MH, 2016). In this sense, the low levels of deficit contemplated in the law could be challenging for increasing public investment (see Chapter 2).

The small fiscal space may be explained by both the low level of tax revenues (see following section) and the high level of non-discretionary expenditure2 (51% of the total). It is worth noting that steps to reduce non-discretionary expenses are well under way. Measures to limit public wage growth, a hiring freeze and the reallocation of existing resources within the public sector to improve performance and productivity are being implemented to assure compliance with the Fiscal Responsibility Law’s targets.

For the private sector, net FDI inflows generate a smaller flow of financing than in many other benchmark economies. Indeed, the ratio of FDI to GDP in Paraguay (close to 1%) is considerably lower than for the rest of benchmark countries. Both the public and private sectors make modest use of debt financing (Figure 6.1). For the public sector this reflects efforts to maintain debt sustainability while for the private sector this may reflect a more cautious lending position, possibly linked to the country’s recent financial history. These trends are broadly consistent with the patterns observed across countries described in Box 6.1. However, it is noticeable that credit to the private sector (2.6%) is higher than in other benchmark countries. Remittance flows in Paraguay (2% of GDP) are higher than in most countries in the comparison group, although these figures do not subtract outward remittance flows. In all the total financing capacity from private sources in Paraguay (close to 6% of GDP) is relatively low when compared to other countries.

Public financing flows suggest there is room to improve the level and composition of the taxation system

Total public revenues in Paraguay, are low in comparison with benchmark countries and given Paraguay’s GDP per capita. This is partly explained by the lower tax rates of Paraguay compared to other economies. The largest share of public financing for development comes from fiscal space (see Box 6.1 for the definition of fiscal space employed), reflecting a solid public revenue base, although with high non-discretionary expenditures. Indeed, non-discretionary expenditure in Paraguay represents almost half of total revenues (Figure 6.2). ODA inflows are greater in Paraguay than for other countries in the region. Salaries and grants alone accounted for 12.1% of GDP in 2015 and 11.2% in 2016. The fiscal framework appears sustainable, although current infrastructure needs could create risks around the future sustainability of public debt.

Paraguay’s fiscal space overall is relatively low in comparison with benchmark countries. But its mix is unusual in some respects. Public revenues are unusually reliant on non-tax revenues, which have contributed to offsetting fiscal budget imbalances in recent years. Non-tax revenues are the compensations and royalties that Paraguay receives from the Itaipú and Yacyreta hydroelectric plants. Royalties from these binational hydroelectric plants have averaged 2.9% of GDP since 2000 (OECD/ECLAC/CIAT/IDB, 2017; see Chapter 2). While a renegotiation of the Yacyretá treaty is pending approval, a clause from the Itaipú Treaty, which ends in 2023, could allow Paraguay to sell energy at market prices, which would represent a significant increase in revenues.

Tax collection is low and efforts to fight evasion could be strengthened

Total tax revenues, as a share of GDP, continue to be low and concentrated in indirect taxes. Since 2000 tax revenues in Paraguay have increased by 5.4 percentage points of GDP, a rate higher than the growth of 4.9% of GDP in Latin America during the same period. Despite recent improvements, tax-to-GDP ratios continue to be low, 17.9% of GDP in 2015, relative to Latin America and OECD averages of 22.8% and 34.3% respectively (Figure 6.3). Paraguay’s main sources of total revenues are taxes on the consumption of goods and services (mainly value added tax [VAT], excise taxes and taxes on foreign trade), and social security contributions. These groups of taxes and contributions represent 83% of total tax revenues, a proportion that is 18 and 24 percentage points higher than in Latin America and OECD economies respectively (Figure 6.4). In the context of trade deceleration, the increase in tax revenues has been driven by taxes on domestic activity which have compensated falls in taxes on foreign trade (including VAT levied on imports). While the latter fell from 6.5% of GDP in 2011 to 5% of GDP in 2016, revenues from all taxes on domestic activity increased from 6.0% of GDP to 7.5% in 2016 and social security contributions increased from 3.8% of GDP to 4.6% in 2016.

Total tax revenues rely on VAT (56% of total tax revenue) while the personal income tax (PIT) is, in its current form, an administrative aid to foster formalisation and VAT compliance. VAT is the main tax collected and the tax that has shown significant growth. In 2000 it accounted for 43% of total taxes, increasing to 50% of total tax revenue in 2016. Several reforms to VAT help explain this increase. In 2014 VAT was expanded and levied on the agricultural sector, although at a lower rate of 5%, with the possibility of setting differentiated rates between 5% and 10% (Law 5061/13), which might raise control difficulties for the tax administration, as these need to differentiate amongst distinct goods, altering the normal value chain, to apply the appropriate rate.

Personal income tax, which dates from a law enacted in 2004 and was finally enforced in 2012, raises little revenue (1.1% of tax revenues in 2016) and serves mainly the purpose of encouraging formalisation by allowing numerous deductions on all kinds of invoiced expenditures. The contribution of the PIT to total tax revenues is lower than in benchmark countries (Figure 6.5). Furthermore, the high levels of lower threshold for the PIT schedule ensure that a great proportion of the population is exempt from any liability. This threshold was set at the equivalent of 120 annual minimum wages in 2012 and is set gradually to decrease until it reaches the equivalent of 36 annual minimum wages by 2019 (8% tax rate for 36-120 annual minimum wages, 10% tax for income higher than 120 annual minimum wages) (OECD/IDB/The World Bank, 2014). Some measures to limit deductions have been established (Decree No. 6560/16), improving the revenue-raising prospects of the tax in the long-run.

The potential of the personal income tax has yet to be realised. In its current state it is inefficient as it increases administrative costs while raising few tax revenues. Paraguay’s tax wedge, the difference between labour costs and an average worker’s take-home pay, is 20.9% of labour costs. The tax wedge is comprised of the personal income tax and mandatory social security contributions paid by employee and employer. Paraguay’s total tax wedge is lower than the Latin America and OECD averages of 21.7% and 35.9% of labour costs respectively. The tax wedge difference with OECD economies is entirely explained by the personal income tax, which is not levied at the average wage level or at the highest levels of income deciles (OECD/IDB/CIAT, 2016). The sum of standard allowances and exempted amounts provided by the current tax code is 1.95 times higher for individuals in the 10th income decile, effectively voiding the PIT’s capacity to raise revenue (Barreix, Benítez and Pecho, 2017).

Improving other sources of tax revenues is critical to ensuring an adequate supply of funds for capital expenditures. The recent introduction of the tax on profits from agricultural activities in 2014 (Impuesto a las Rentas de las Actividades Agropecuarias, IRAGRO) yielded 0.2% of GDP in additional revenues by 2015. However, other sources of revenues have diminished. Taxes on foreign trade and excise taxes have declined by 0.4% and 0.2% of GDP during the last five years, in part because of a slowdown in the re-export trade, the zero tariffs within Mercosur as well as other trade agreements. The tax on profits from commercial, industrial or services activities (Impuesto sobre la Renta Comercial, Industrial o de Servicios, IRACIS) remained steady at 2.4% of GDP during this period.

Non-tax revenues have contributed to offsetting the fiscal budget imbalances. Non-tax revenues are the compensations and royalties that Paraguay receives from the Itaipú and Yacyreta hydroelectric plants (OECD/ECLAC/CIAT/IDB, 2017). Royalties and compensation payments from these binational hydroelectric plants have averaged 2.9% of GDP since 2000. However, these non-tax revenues decreased from around 26% of public revenues in 2001 to 11% in 2016. Furthermore, these sources of funds are susceptible to shifts in electricity production and demand, given Argentina and Brazil’s economic volatility, and are projected to decrease in the medium term because of higher energy consumption in Paraguay. This underlines the need to improve revenue collection as sources based on tax revenues tend to be more stable over time.

Efforts to broaden the tax base should be further accompanied by the strengthening of the tax administration. Recent efforts to broaden the tax base through the enforcement of a personal income tax, extending VAT to agricultural products and co-operative associations, and the levying of new agricultural tax on profits from this sector will be ineffective if institutional frameworks, legal mechanisms and procedures to improve tax compliance and enforcement are not improved. The introduction of taxpayer registries, organisational improvements and audit strategies are good steps to curb evasion.

VAT evasion was reduced from 36.7% in 2012 to 30.9% in 2014, still higher than the evasion rate in Latin America (25.9%) (Giménez et al., 2017). Paraguay’s revenue authority (Subsecretaría de Estado de Tributación, SET) has made good progress in strengthening institutional frameworks, administrative capacity, introducing taxpayer registries, control measures, and dismantling tax evasion schemes, but further improvements are needed. The SET authorities have emphasised the challenges and constraints that undermine tax compliance such as understaffing and unsatisfactory training of current staff (around 1 000 SET officials and 700 000 tax payers). Budget constraints also limit hiring additional staff, thus requiring the use of technology to make procedures more efficient, for instance exploring the option of exerting better control through electronic invoicing. Additional steps include legislation to increase the chances of an audit and sanctions given that the current probability and cost of being detected are low (SET, 2016). Nevertheless, the enforcement and efficiency of the law might be undermined by long legal procedures and the judicial system’s lack of enforcement capacity. Paraguay’s recent commitment to the Global Forum on Transparency and Exchange of Information for Tax Purposes in the fight against tax avoidance and its membership of the Inclusive Framework on Base Erosion and Profit Shifting (BEPS) are welcome. The latter provides governments with the tools to ensure that profits are taxed where economic activities are performed and where value is created. These tools also give businesses greater certainty about the application of international tax rules and standardising compliance requirements.

Tax expenditures are mainly concentrated in VAT and exemptions granted within the corporate income tax. Total tax expenditures were estimated around 1.92% of GDP in 2014, and most of the foregone revenue is concentrated in the VAT regime (1.36% of GDP). The VAT regime foregoes revenue by exempting fuels, private education and health services. Losses also arise from taxing goods and services in the basic consumer basket of goods and medicines at a lower rate (5%). The corporate income tax losses are less than 10% of the collection of the tax, exonerations are of smaller magnitude and it has a broad base but still amounts to 0.22% of GDP. In the case of personal income tax, the main factors behind tax expenditure are incomes that are not yet included in the tax base given the law’s implementation schedule (0.13% of GDP). Exemptions from customs tariffs represent the remaining 0.2% of GDP (CIAT/SET/GIZ, 2015).

As in the case with other countries in the region, reducing compliance burdens in Paraguay can increase tax effort and public financing space, without imposing significant additional costs for payers. The tax system could be simplified, for example, by reducing the number of payments or streamlining administrative processes. Paraguay has made significant efforts in this direction (see Chapter 2). Simplifying compliance may increase collection, by reducing the scope for non-compliance and by encouraging greater declarations. Lower compliance costs may also contribute to reducing the size of the informal sector. Reducing compliance costs and strengthening collection could contribute to raising tax revenues and would bring tax receipts to the growth-supporting “tipping point”, and can create the additional resources needed for increasing investment in Paraguay.

Limited non-discretionary public expenditures suggest that reallocating spending could improve developmental outcomes. Public expenditure allocations in Paraguay suggest there is a reduced scope for resources to be reallocated towards development priorities. Of total expenditure of between 16% and 18% of GDP over the past five years, the ratio of current expenditure to investment in 2016 has remained unbalanced, reaching 85% to 15% in 2016 (OFIP/CADEP, 2017). Salaries and wages still represent a high proportion of current expenditure (50% in 2016), even if it decreased slightly when comparing to previous years, whereas social security contributions have remained constant, in relative terms, in the expenditure structure. This share of GDP allocated to non-discretionary public expenditure is low relative to the other benchmark economies, even if capital expenditure and investment increased faster than current expenditure (20% against 3.2%) between 2015 and 2016.

Private financing flows are still low, but start to consolidate in the form of external investment and a sound financial sector

Overall, private financing equivalent to 5.5% of GDP for activities that were potentially developmental was available over 2013-15, compared with 11.8% of GDP for the public sector (highlighted above). These flows were generated by FDI (1.1%), remittances (1.6%) and the contribution of the domestic financial sector (2.6%).

Although FDI inflows dominate the financing available for private sector activities, they remain low when compared to other benchmark countries. FDI inflows averaged close to 1% of GDP over 2013-15 (WDI, 2017). External financing is therefore lower than for other comparison countries, whereas remittances contributed to a non-negligible share of private financing flows. Compared to benchmark economies, Paraguay exhibited relatively low private flows in the period 2013-15 (Figure 6.6).

Foreign direct investment inflows are growing, but could finance larger-scale activities

Paraguay was in 2015 the country with the second lowest share of FDI inflows as a proportion of GDP in the region, accounting for only 1.16% of GDP (WDI, 2017; Figure 6.7, Panel A). Being a small open economy, this is a modest share when compared to other small economies in the region such as Costa Rica or Panama. Moreover, Paraguay’s foreign direct investments represent only 0.2% of the Latin America’s total FDI. However, the overall trend of FDI inflows over the past five years is positive. Net FDI inflows to Paraguay averaged close to 1.8% of GDP over the period 2010-15, an improvement when compared to previous periods. FDI in Paraguay is centred on a number of sector-strategic hubs and usually associated with the employment of skilled labour. Most of the projects are concentrated in the east of the country. Although traditionally low, FDI in Paraguay has gained some prominence in recent years, as a result of the government’s strategy for improving the investment framework, which has been successful in tapping international investment directed towards specific industries. Triggering factors to attract investment to Paraguay are the country’s access to natural resources, low labour costs in comparison to its neighbours and the extremely favourable tax structure. Such sectors as the automotive, agro-business and telecommunications have received major investments recently and, in the near future, inward FDI should continue to be favoured by developing infrastructure projects.

FDI inflows finance the current account deficit, which is small by regional standards. Paraguay’s current account deficit, below 2% of GDP in 2015, has remained small; low commodity prices have allowed the country and other net energy importers, to keep it that way (OECD/ECLAC/CAF, 2016). The fact that Paraguay can finance its deficit through direct investment suggests that these deficits are more sustainable than would be the case if they were financed through shorter-term capital flows (Figure 6.7, Panel B). Still, a larger FDI participation would allow for more than the mere financing of the external deficit, becoming a sustainable financing source in areas such as infrastructure.

Paraguay’s FDI stock has grown at a rapid pace, while the origin of foreign investment has shifted considerably over the past decade. Over the period 2003-15, the average growth of Paraguay’s FDI stock was 15.1%. Overall, Latin American and the Caribbean have been losing ground as recipients of FDI, which accounts for 3.3% of the region’s GDP (ECLAC, 2016b). Paraguay has not been the exception, and the country experienced significant contraction in FDI stocks after the 2008 financial crisis, following the recovery of the U.S. and other industrialised economies. Estimated FDI stock contraction in 2015 was of 18%. It is possible that these falls might be due to the cyclical nature of FDI, as in the preceding year net FDI flows had increased by 63% (BCP, 2017b). Together with the volatility of FDI inflows, the composition of investment by country has also changed (Figure 6.8). While in 2003, inward FDI in Paraguay came predominantly from the United States, a different pattern can be observed during the past decade: while the United States and Brazil remain the country’s largest foreign investors, the US participation in Paraguay’s FDI fell from 38% in 2003 to 27% in 2015, while Brazil’s share rose from 11% to 19%. In addition, European economies such as Spain and the Netherlands have been gradually increasing their share of investment, accounting respectively for 9% and 5% of the country’s FDI stock in 2015. Overall, the diversification of FDI sources for Paraguay signals a positive development towards the consolidation of an investment strategy.

In terms of FDI stock distribution, the tertiary sector has consistently been the largest recipient in relative terms, although the secondary sector has been increasing its share in recent years (Figure 6.9, Panel A). Within the primary sector, which includes primary products and manufacturing of primary goods, oil processing accounted for more than 50% of foreign investment in 2015, followed by beverages and tobacco (15%) and livestock (12%,) (Figure 6.9, Panel B). Noticeably, only 11% of the investment stock in the primary sector is destined for agriculture. In the secondary sector, which includes non-agricultural processing and industries, more than 50% of the investment is accounted for by the chemical production industry (56%), followed by paper (12%) and textiles (11%). As for the tertiary sector, which involves services, they have been concentrated in financial intermediation (56%), communications (12%) and retail (4%).

The structure of foreign investment in Paraguay suggests it could be improved in the future. Net FDI inflows in Paraguay have seen an increasing role for reinvested earnings, and a fall in intercompany loans and capital contributions (Figure 6.10). In some countries, the absence of a pool of incoming investments could underline the existence of a risk for external solvency. Indeed, Paraguay’s current structure of direct investment inflows suggests that a greater repatriation of profits could shift net direct investment inflows to negative, generating challenges for financing other development activities and Paraguay’s overall external accounts. A comparison with other countries in the region such as Chile, Colombia and Brazil, indicates a lower proportion of reinvested earnings in FDI, with a high share for equity capital and intercompany loans. Rebalancing the components of Paraguay’s FDI structure, by bringing new projects for investment and depending less on established projects, could be part of the medium-term government strategy for investment attraction.

In Paraguay, FDI adds little value in terms of job creation

While the efforts for attracting investment to Paraguay are remarkable, the effect of these efforts on employment creation is still modest. Indeed, the industries with the highest levels of job creation in 2015 received relatively small amounts of foreign investment, as were the cases of the industries of business services, electronic components and food and tobacco. A notable exception is the case of the automotive sector, where employment creation continues to be substantial. On the other hand, firms with the highest levels of foreign investment (warehousing and storage, real estate and renewable energy) seemed to have had little value added in terms of job creation (Figure 6.11). A second stage of Paraguay’s investment strategy could be to insist in incorporating employment creation as one of the priorities for investment attraction.

Paraguay has made significant efforts to consolidate an investment promotion strategy

The recent increase in FDI flows has been partially driven by Paraguay’s efforts to create an attractive regulatory framework for foreign investment. The current investment framework draws on Paraguay’s comparative advantages, based on a competitive tax regime, a young labour force, low labour costs, low-cost clean electricity, a strategic location relative to other countries in the region. Having a simplified tax regime, together with some of the benefits provided by the Mercosur agreement, has created further incentives for countries such as Brazil and Argentina to increase their share of investment in the country. Government efforts to attract investment include special regulations and fiscal regimes such as the tax incentive scheme for national and foreign capital investment (Law No. 60/90), the maquila regime, the zonas francas regime and the law on guarantees for investments and the promotion of employment and socio-economic development (Law No. 5.542/2015). The latter, for instance, guarantees to beneficiaries the invariability of the income tax rate for a period of ten years, which could be extended to 15 or up to 20 years. A legal framework for public procurement has also been developed under the category of tender with financing by the provider (Law N° 5074/2013) and by the PPP Law (Law 5102/2013, see Chapter 2). This framework has stimulated investment of foreign capital and constitutes a major part of Paraguay’s investment strategy.

Today, there are few restrictions on foreign investment in Paraguay. One of them includes acquisition of land close to the border (less than 50 km). Investments considered to have “high social content” (e.g. investments in deprived areas that will generate employment, provide added value for primary industries and are environmentally sustainable), will be exempt from the 5% of the income tax for the distribution and remittance of profits. Another important advantage for Paraguay is the generalised system of preferences Plus (SGP +), through which it can export around 6 500 products with zero tariff. Paraguay is the only Mercosur country with this status. Still, greater efforts are required to transform these benefits into more investment in high-productivity sectors. Investment regimes could also consider potential effects on the domestic industry over the long term, as competition between domestic and foreign industries has increased in some sectors (e.g. construction, metal-working), with foreign firms outperforming Paraguayan ones.

Measures to attract investment, diversify production and boost trade integration are being implemented by the Paraguayan authorities as part of their structural transformation strategy. Efforts to attract investment to encourage productive diversification have been concentrated in three main sectors: first, the investment strategy aims to contribute to transforming Paraguay into an efficient and sustainable food producer by promoting innovation and added value in primary sectors. To this end, programmes to attract investments for the insertion of Paraguay into new value chains (for instance, supporting rice production for the Arab market and chicken production directed at the Chinese market) and to add value to specific niche-products (e.g. organic food, craft beer, manioc flour) are being implemented. Second, the strategy aims to transform Paraguay into a factory for the region, through the use of different investment attraction instruments; the number of maquiladoras has increased significantly (from 46 firms in 2013 to 126 in 2016). The sectors with greatest dynamism are automotive parts, plastics, textiles, and footwear. Third, Paraguay’s investment strategy is also embedded in the infrastructure development plan, in particular to transform the Hidrovía Paraná-Paraguay into a 24 hours route. The Ministry of Industry and Commerce (MIC) envisages the potential creation of clusters around these investments. In addition, with the support of the Inter-American Development Bank (IDB) and the Red de Exportaciones e Inversiones (REDIEX), the internationalisation of Paraguayan companies has been promoted through funds to support the development of exporting companies in strategic sectors (food, manufacturing, logistics). Although not a central part of it, Paraguay’s strategy has focused on the development of the industrial sector, although the services sector, highly linked to agricultural production, has received some support, with more than 5 000 jobs created in the Asunción area (DGEEC, 2016).

The financial system should be further developed and become more inclusive

Paraguay’s financial system is still being developed, becoming slightly more concentrated and with a lower foreign participation. It is currently composed of 17 commercial banks, including a public bank (Banco Nacional de Fomento), ten financial institutions, 89 co-operatives, 41 institutional investors, and 35 other institutions. Commercial banks in Paraguay hold the largest proportion of assets followed by savings and credit co-operatives. In December 2015 commercial banks accounted for about 73% of total assets, while credit and savings co-operatives accounted for 8% and institutional investors (e.g. insurance companies, the Instituto de Previsión Social and pension funds) represented about 15%. In the last decades there has been a decrease in the number of foreign-owned institutions in the banking system. Of the total assets held by banks, about 52% are held by banks that are majority locally owned, followed by 38% held by banks that are majority foreign owned, 5.7% from banks under state ownership (Banco Nacional de Fomento) and 3.8% in branches of foreign banks (BCP, 2016).

The country has a dual financial supervisory system. The Superintendence of Banks is the regulatory agency that oversees commercial banks, financial institutions, exchange bureaux and other deposit institutions. Co-operatives are regulated and supervised by the National Co-operative Institute (INCOOP). INCOOP enforcement power should be strengthened and supervision must be risk-based. There is deposit insurance for banks and financial institutions but not yet for members of credit co-operatives. Efforts to introduce legislation to establish a guarantees fund are in progress. In respect of financial regulation, the OECD General Guidance on a Policy Framework for Effective and Efficient Financial Regulation and the High-Level Principles on Financial Consumer Protection set out principles that should be considered. Some of these principles suggest that financial regulation should warrant a precautionary approach, be oriented to risks, seek to align incentives of participants with policy objectives, and ensure that all identified market failures and needs are properly addressed (OECD, 2010). In addition, financial consumer protection should be an integral part of the legal framework, regulation should reflect the characteristics of financial products, be responsive to new products, and providers of financial services providers should be appropriately regulated and supervised. In this direction, the Central bank is working on two projects, one for publishing financial costs and another to strengthen consumer protection norms for financial institutions.

Paraguay’s capital markets are embryonic but could gain ground as a financing source. The country’s stock exchange has seen a considerable growth in recent years, particularly in the corporate bond market. Financial institutions and private individuals are increasingly trading fixed-income securities, and for the first time in 2016 the secondary bond market surpassed the primary market (52% vs 48% of the total market). About 60% of securities are issued in guaraní (PYG) and the remaining 40% in dollars. The equity market remains less developed. The regulatory framework for the securities market, under the responsibility of the Comisión Nacional de Valores, is developing. In terms of integration, since 2017, the Comisión Nacional de Valores is an associate member of the International Organization of Securities Commissions (IOSCO), and some regional agreements have been signed by Asunción’s stock exchange, such as with Montevideo’s Stock Exchange.

The financial system is relatively solid when compared to benchmark countries. Banks are well capitalised, with sufficient access to sources of deposit financing and are highly profitable (Figure 6.14). The minimum requirements of capital adequacy are fulfilled with a ratio of regulatory capital to risk-weighted assets of around 18% in 2016 while the ratio for Latin America is around 15% and the minimum required is 12%. Most of the financial system funding comes from internal sources such as deposits. Customer deposits to total loans account for 94% which is high, although lower than the average in the region. In terms of liquidity in the banking system to meet cash demand, the liquid assets to total assets ratio has decreased slightly in recent years. Profitability indicators, measuring the efficiency of the financial system in Paraguay regarding the use of assets and capital are amongst the highest, compared to the regional average, and other benchmark countries (Figure 6.12, Panel C). However, both the return on assets (ROA) and the return on equity (ROE) have declined in recent years. Likewise, while the ratio of non-interest expenses to total gross income is low compared to other benchmark countries, it has increased considerably in recent years, rising from 24.5% in 2012 to 38% by 2016.

Although the number of banks has been reduced in the last decades, Paraguay’s banking sector concentration level is not excessive and still competitive. A standard measure of bank concentration (the Herfindahl-Hirschman index), estimated with the assets of commercial banks and financial institutions results in 1 020.6 by June 2016, indicating a low level of concentration (1 500 to 2 500 indicates moderate concentration, higher than 2 500 indicates a high level of concentration) (BCP, 2016). Research for the 2000-12 period indicates a certain level of competition in the banking sector given that banks are willing to reduce margins by increasing market share; for each increase of 1 percentage point in the market share, the effective interest rate margin decreases by 0.0326 percentage points. However, there is little variation among banking providers and Paraguay remains a high-priced and high-profit market. New incentives and measures to encourage competition in the sector could help to reduce such interest rate margins.

Paraguay’s interest rate spreads (16%) continue to be among the highest in the region (7%) and in comparison to the benchmark countries. Spreads increased at the beginning of the 2000s as a result of banking crises but as a result of regulation reforms margins followed a downward trend after that. However, they remain consistently high relative to other countries (Figure 6.13). Margins reflect risk-taking, regulatory costs and operating costs, among other factors. Failure to access complete information on customers increases credit risk, requiring higher-rate margins. Improving the quality and availability of credit information would promote financial deepening and inclusion by helping to reduce credit risk premiums and hence, spreads.

Credit growth has accelerated in recent years. Expansion of banking credit has been substantial (around 26% average growth over 2005-15 relative to 8% average growth over 1994-2004) and present in all economic sectors during the last years reflecting mostly macroeconomic fundamentals and the deepening and stability of the banking system. After peaking in 2015, credit growth has moderated as economic activity has slowed and financial conditions have become less favourable. The share of banking credit to private sector relative to GDP rose from about 11% in 2005 to 43% by 2015 on average (Figure 6.14, Panel A). The economic sectors that got the largest share of credit from commercial banks (by June 2016) were agriculture (22.8%), wholesale commerce (15.7%), and consumption (14.2%). Financial institutions provide a larger share of loans to consumption (25.3%) rather than to agriculture (16.5%) (BCP, 2016). Almost half of the credit provided by the national development bank (BNF) is in the form of consumer loans. There are also some signs that credit from unregulated non-traditional lenders is growing, but this remains a small fraction of credit (IMF, 2017c).

Credit quality has been deteriorating in certain sectors and attention should be concentrated on monitoring non-performing loans. The ratio of non-performing loans to total gross loans of commercial banks increased in recent years from around 1.2% at the end of 2010, to around 2.8% by the end of 2016 (BCP, 2017), a little higher than the Latin America average but lower than in countries such as Brazil or Peru. This increase in non-performing loans is observed as well in financial institutions (5.7% by end of 2016) and savings and credit co-operatives (10.1% by June 2016) (Figure 6.14, Panel B). Another indicator of credit quality deterioration is the increase in renewed, refinanced, restructured (RRR) loans as a proportion of total loans from 14.4% in June 2015 to 18.6% in June 2016, reflecting a weaker economic context as well as a decline in the international price of commodities and exports that affected the repayment capacity of producers. Authorities responded with transitional measures to support the agricultural sector through the renegotiation of credits (BCP, 2016).

The provision of long-term financing in Paraguay is hampered by a shortage of long-term deposits. The largest share of deposits (50%) is kept in cheque accounts, 16% in on-demand deposits, 0.3% in term savings and 34% in certificates of savings deposits. Likewise, the survey on the credit situation carried out by the Central Bank shows that one of the main reasons that make it difficult to grant long-term loans is the scarcity of long-term deposits (45%), followed by the lack of guarantees (21%), other activities with higher profitability, and shortage of long-term projects (BCP, 2017a). This phenomenon has been partially tackled through the role of public financial institutions, like AFD, that provide today credit lines for long-term financing, mainly for housing and SMEs.

Dollarization of the economy has decreased in the last decades but the level of dollarization is still high and has recently increased. In all 47.6% of credits are denominated in dollars and 48% of deposits. The agricultural sector tends to take credit in dollars (86.1% of total credits) as well as the exports sector (74.2% of total credits). On the other hand, families tend to take credits in guaranís (95.1% of total credits) for consumption. Credit granted in dollars to agents that do not generate foreign exchange amounted to 12% of the portfolio of banks and financial institutions in dollars by June 2016 (BCP, 2016).

In spite of the rapid growth in credit, financial inclusion is still very low and unequal in the country. Comparable data from 2011 show that the percentage of adults with an account at a financial institution in Paraguay is around 22%, much lower than in other Latin American and benchmark countries (Figure 6.15). Financial access in the country is unequal given that rural areas, lower-income households and small and medium-sized enterprises still do not have access to loans or other financial services. For instance, only 5.2% of the poorest 40% adults have an account in a financial institution compared to 33% for the richest 60%. Results from the 2013 Financial Inclusion Survey showed that five out of every ten adults in Paraguay are financially excluded (Gobierno Nacional, 2014) and only 29% adults have an account in a formal financial institution (the LAC average was 39% in 2011). Co-operatives play a key role in providing formal banking services as they had approximately 58% of all formal accounts in the country (EIF, 2014). Likewise, 19% of adults have an account in a co-operative, 12% in a bank and 2% in other institutions. In terms of coverage, 33%, or 73, of the country’s 224 districts did not have any presence of banks through branches, bank agents or automated teller machines (ATMs) (BIRF/Banco Mundial, 2014). Surprisingly, few adults give as a primary reason why they do not have a bank account that financial institutions are too far away. Interestingly, 28% of adults used mobile money services and 10% say they will use it within six months (EIF, 2014). Over the past three years, access to information technologies, such as the terminales de punto de venta (points of sale –POS), is contributing to reduce the financing gap in rural areas.

Access to formal credit is still limited. In all, 34% of adults claim to have applied for a loan in the last year; 22% through a formal financial institution (13% at a co-operative and 8% at a commercial bank). Only 7% of adults reported having borrowed money to start a business. Among those who own a business, only 18% borrowed from a co-operative, 9% from banks, and 5% from a credit house. Likewise, loans to micro and small enterprises are still insufficient. Only 27% of all micro and small enterprises (formal and informal) took out loans and only 16% of agricultural microenterprises (formal and informal) borrowed. Products available in the market are not necessarily designed to meet the needs of these firms while furthermore micro-enterprises tend to be informal and often lack the necessary documentation. Co-operatives offer loans to 70% of urban microenterprises taking loans and 27% of agricultural microenterprises (EIF, 2014).

Lowering the costs and documentation requirements for opening accounts and obtaining loans while ensuring a correct risk assessment would significantly contribute to facilitating financial access. The lack of money and of the documentation required seem to be the main barriers to financial inclusion in Paraguay; 51% of individuals without bank accounts reported the lack of money as the main reason for not having an account, followed by lack of documentation (24% of individuals). Lack of documentation is an important constraint for those who are unemployed or informal, affecting informal small and medium enterprises in the same way.

Government efforts to boost financial access continue but much more needs to be done. The government launched a Financial Inclusion National Strategy in 2014 aiming to achieve the financial inclusion of 100% of households by 2030 (Gobierno Nacional, 2014). A survey of financial capacity is being implemented to underlie this strategy. In this context, several regulatory changes have been introduced, such as a new regulation on electronic payments as well as basic savings accounts and usage of accounts for wage payments. In addition, the Ministry of Industry and Commerce, together with the Industrial Paraguayan Union and Itaipú Binational, signed in 2015 an agreement to support microenterprises by providing financial resources (USD 200 000 to be provided as seed capital) and technical guidance for young entrepreneurs (Itaipú, 2015). Likewise, the World Bank’s International Finance Corporation (IFC) will provide a USD 90 million loan to Banco Itaú Paraguay SA to expand SME access to finance. In terms of financial literacy, the government launched a campaign “Más vale saber. Educación de Bolsillo” (“Better to know: education in the pocket!”) with the objective of providing information to the public about the proper use of financial tools as well as the rights and obligations of the financial sector. This campaign is much in line with the OECD Good Practices on Financial Education and Awareness Relating to Credit which represents a useful guide for governments seeking to develop financial education and awareness of credit programmes. Within the education system, the subject of “economic and financial education” has been introduced in the last year of high school. Reference material for this subject has been created and 190 000 teachers have been trained in using it. A “guide for the financial education of young people and adults” has been created, and is used by agencies for training. The guide focuses specifically on vulnerable populations. Further measures to enable individuals to know where to look for information, take informed decisions, develop skills of financial planning, etc. would enhance social and economic growth when complemented by prudential regulation and consumer protection (OECD, 2005).

The role of development banks should be strengthened

Strengthening the role of public financial institutions is crucial to boosting access to formal credit, mainly for SMEs and small agricultural producers, as Paraguay lags behind other countries in the region. For this purpose, public institutions must develop new financial products specifically designed for those that cannot access credit from private institutions. There are a few public financial institutions in Paraguay specialised in different segments: Agencia Financiera de Desarrollo (AFD), Banco Nacional de Fomento (BNF), Crédito Agrícola de Habilitación, Fondo Ganadero and Secretaría Nacional de la Vivienda y el Hábitat.

The Agencia Financiera de Desarollo (AFD) founded in 2005 is the only “second tier, or second floor” public bank (this is, one that, instead of lending directly to firms, grants credit indirectly through another bank) that provides credit to complement the funding structure of first floor entities to enable the execution of medium and long-term development programmes, with funds coming from loans with a state guarantee, donations, budget allocations, bonds issuance and its own capital (Law 2640, 2005). AFD is the only channel through which public sector loans are made to intermediary financial institutions. Some of the products provided by AFD are focused on housing, micro, small and medium enterprises, education, livestock, agriculture and infrastructure equipment, etc. AFD has met and exceeded its annual goals in terms of approved credits, increasing the amount from USD 86 million in 2015 to USD 244 million by 2016. The share of credits with terms of three or more years increased as well, from 23% in 2010 to 43% by 2016. Most of the credit provided is channelled to the housing sector (about 31%) followed by services (20%), SMEs (17%), agriculture and livestock sector (12%) (AFD, 2015). Despite these improvements, its contribution to financing SMEs has been small. Funds provided through MICREDITO and PROPYME programmes reached 1.7% and 5.4% of funds approved by June 2014 (BIRF/Banco Mundial, 2014).

The role of Banco Nacional de Fomento (BNF) to facilitate financial inclusion should be strengthened. The main function of BNF is the financial inclusion of those that cannot access funding sources through other institutions as well as promoting and financing projects to promote agriculture, livestock, forestry, industry and commerce. The BNF was created in 1961, experiencing several losses in the past because of inefficient management practices. However, organic and functional restructuring started in 2003, enabling its gradual recovery. It is a medium-sized institution in the market with around 5% of the financial market assets. It has more than 50 branches and offers a range of savings and credit products; it also processes the payment of salaries to public employees as well as benefits to beneficiaries of social programmes. In this sense and to facilitate financial inclusion, BNF should take advantage of the extensive presence of its geographical network, the large number of branches and ATMs and its extension to rural areas (MH/BID, 2010). On the other hand, the BNF is still less efficient than private banks; it maintains an excessively high liquidity ratio (76% while private banks’ average ratio is 47%); and its personnel and administrative costs are high (3.4% of personnel expenses versus deposits compared to 2.2% in private sector banks; administrative costs are 6.3% of deposits in the BNF compared to 4.9% in private sector banks) (BIRF/Banco Mundial, 2014). The recent reform to the Charter of the National Development Bank is intended to tackle previous inefficiencies, improve corporate governance and give the bank a more prominent role in providing financial support.

Development banks in Paraguay, mainly AFD and BNF, have been increasing their role in providing credit. However, relative to other countries in the region, their loan portfolio is still low (Figure 6.16). To strengthen their lending capacity and coverage, development banks should address several challenges. Innovative financial products specifically designed for different segments of the market should be developed while a minimum profitability should be guaranteed. Transparency and good practices of corporate governance would also prove important to ensure efficient management of financial resources. A strong and clear regulation that allows banks to finance subnational and municipal projects is also required. All of this should be accompanied by measures that incentivise financial intermediaries to reach targeted sectors (ALIDE, 2015) and by appropriate regulations that allow smaller cooperatives and financial institutions to operate with AFD funds and allow for greater channelling of financial resources (BIRF/Banco Mundial, 2014). Expanding the use of information technologies to speed up the process for granting loans through the two development banks could also be improved.

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Notes

← 1. The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities. The use of such data by the OECD is without prejudice to the status of the Golan Heights, East Jerusalem and Israeli settlements in the West Bank under the terms of international law.

← 2. Payroll and interest payments are considered non-discretionary in this chapter (see Box 6.1).