A history of war due to its location

Paraguay is a small landlocked country, sandwiched between two regional superpowers: Argentina and Brazil. To no one’s surprise, both countries compete for influence in Paraguay. In the 19th century tensions led to a bitter and disastrous war, and between 1864 and 1870 the Triple Alliance (which comprises Argentina, Brazil and Uruguay) enacted one of the bloodiest wars in Latin American history against Paraguay. In the end, Paraguay lost 140,000 km2 of territory, and according to some records up to 90% of its male population. Another war with another neighbouring country erupted in the 1930s: this time Bolivia was attempting to control the arid Chaco region. Since then, Paraguay has been focusing on economic integration with its neighbouring countries. An important example is its membership of Mercosur, a South American trade bloc with Argentina, Brazil, Paraguay and Uruguay as full members. Furthermore, Paraguay has built hydroelectric dams together with Brazil and Argentina on its Paraná River, which has helped the country to foster good relations in the region. Therefore, the risk of interstate war nowadays is low.

There is political stability, but re-election ambitions could trigger unrest

The ruling Colorado Party (Partido Colorado, PC) has a strong grip on political power. The party has ruled Paraguay for most of the last 71 years, including 34 years under the dictatorship of General Alfredo Stroessner. Its reign was only interrupted recently by a five-year interregnum (between 2008 and 2013) when a leftist coalition of opposition parties won the elections, before then-President Fernando Lugo was impeached and ousted from power in 2012 in what neighbouring countries denounced as a coup.
The current President – Mario Abdo Benítez – is part of the PC and assumed office last year. Benítez has committed to maintaining the pro-business policy and cautious macroeconomic policies and combatting the high level of corruption. The government is relatively stable, but Benítez faces four important challenges that render policy-making difficult. Firstly, the government does not enjoy a legislative majority. Hence, it needs to co-operate with opposition groups to pass reforms. Secondly, Benítez does not have unconditional support within his party. The ruling party is divided following the wish of former President Cartes (2013-2018) to pursue constitutional changes that would permit re-election, which has been prohibited since the end of the Stroessner dictatorship (1954 -1989). Not unsurprisingly, the attempt of Cartes in 2017 to pursue constitutional changes led to violent protests, which only ended when Cartes stated he would no longer seek re-election. However, Cartes retains his ambition to seek re-election in 2023 and new attempts to change the constitution could trigger potentially violent protests. Furthermore, Cartes also has considerable political influence, so given that Benítez is against re-election, the rivalry between Cartes and Benítez is mounting, which in turn increases the likelihood of the PC fracturing further. Thirdly, land distribution is a serious issue in Paraguay. Less than 3% of the population controls 85% of the land, illustrating the fact that Paraguay is one of the most unequal countries in terms of land distribution in Latin America. Conflict and protests over land ownership flare up regularly, hence political stability is likely to be tested although it is unlikely to be derailed by the issue. Lastly, the government is also likely to be faced with terrorism from the guerrilla movement the Paraguayan People’s Army, a small organisation which is carrying out attacks in the north of the country. However, the peril is too small to threaten government survival.

The fastest-growing country in the region

Paraguay has been one of the fastest-growing countries in the region in the past decade. With an average annual real GDP growth rate of 4.5% versus 1.75% for Latin America, the country has clearly outperformed its neighbours. The strong performance is related to several factors. Firstly, strong real GDP growth is the result of a bounce-back from a severe banking crisis in the late 1990s. Secondly, the country has enacted good macroeconomic policies, which were enabled by several IMF programmes between 2003 and 2008. Thirdly, the country could be driven by a boom in agricultural commodity prices – it has been able to more than double its sowing areas compared to 15 years ago. The robust real GDP growth of about 4% in the past four years is especially remarkable given that two of its biggest trading partners, Brazil and Argentina, have been suffering from major recessions. As shown in Graph 1, Brazil suffered a recession in 2015 and 2016, while Argentina recorded negative growth in 2014 and 2018. This year a healthy real GDP growth of 3.5% is expected in Paraguay, down from 3.7% in 2018 as drought is likely to affect the soybean harvest. In the coming years, robust real GDP growth is expected to be around 4%, although external shocks, particularly severe droughts, low agriculture prices and negative developments in neighbouring countries could wreak havoc on growth rates.

The external balance is vulnerable to droughts, Brazil and Chinese pig culling

From an external perspective, in the past 15 years Paraguay has mainly recorded current account surpluses. Only in 4 out of 15 years was a rather small current account deficit noted, although the current account balance will slip into negative territory this year with a minor deficit of 0.8% of GDP. This is due to reduced soy exports following a drought in the country. As of 2020, the current account balance is expected to increase to around 0.5% of GDP, reflecting the expected rebound in soybean production and a likely modest regional recovery.

Analysing the current account balance in more detail (see Graph 2), we can see that almost 50% of current account receipts come from food. In this category, soy is the main export product, accounting for almost a third of export revenues. Worldwide, Paraguay is in fact the world’s fourth largest soybean exporter. Hence it shouldn’t come as a surprise that soy largely explains the movement of the current account balance. The second largest source of current account revenues is hydroelectricity, accounting for almost a fifth of current account receipts. Paraguay operates two binational hydroelectric dams. The Itaipu dam, the largest hydroelectric plant in the world, is operated with Brazil, and can compete with China’s Three Gorges dam in terms of annual production. Yacyretá, the second largest hydroelectric facility in the country, is operated with Argentina. As Paraguay produces more electricity than it can consume, it sells its overcapacity to its neighbouring countries.

The current account balance is vulnerable to weather shocks, because the agricultural sector and hydroelectricity are both vulnerable to droughts. Furthermore, a negative shock to commodity prices would also affect the current account balance dramatically. Although Paraguay and China have no diplomatic relations, soybeans flow through to China through re-exports from Uruguay and Argentina, and therefore Paraguay is also vulnerable to negative developments in China, the largest importer of soy bean globally. It is, however, worth noting that China is likely to lower its demand for the crop in the coming months, firstly because a widespread outbreak of African swine flu in the country has led to large-scale pig culling, and soybean is an important part of their diet, and secondly because Chinese economic growth could slow down more quickly than expected due to the intensification of the trade war with the USA. On the other hand, a potential trade deal between the USA and China is not without risks. As the USA is the largest exporter of soybean to China, agriculture is likely to play an important role in a potential trade deal between the two countries.
Slow Brazilian growth could also have a negative impact on the current account balance. Export destinations have diversified over time, but Brazil still accounts for roughly a third of Paraguay’s export products. Furthermore, potential changes in the current preferential treatment for Paraguayan exports from the Brazilian government could also negatively impact the current account balance.

Is Paraguay the China of South America?

The country is trying to diversify away from its agricultural and hydroelectricity sectors, and hopes to become a low-cost manufacturing hub in the region, as China is for the world. It has low wages, cheap electricity and the second lowest taxation level in the Americas. Moreover, it has a history of macroeconomic stability, and thus the country is attractive for Brazilian businesses relocating plants, especially in the maquiladora sector, and is significant in relation to Brazil’s car industry. The sector has been growing rapidly in recent years, with average annual export growth of over 20%. However, the share is still small as it accounts for only 4% of export revenues. According to the IMF, it will take consistent expansion at the current rate over the next 15 to 30 years for the sector to rival the traditional export sectors in terms of their economic significance. To become more attractive, the country needs to eradicate its high corruption levels (Paraguay is ranked 132 out of 180 countries on the Corruption Perceptions Index 2018), and the somewhat weak institutions remain a serious concern for investors. Lastly, policies that focus on improving transport infrastructure could also be helpful. According to the IMF, total infrastructure investment needs are USD 1 billion to USD 3 billion per year (3% to 8% of GDP).

Sound public finances but dependent on energy revenues

Paraguay has sound public finances. The country kept a conservative and countercyclical fiscal policy during the commodity price boom, and thus it was able to avoid the boom-bust cycle that most of its neighbouring countries experienced. In the coming years a small fiscal deficit is expected, close to the ceiling of 1.5% of GDP under the Fiscal Responsibility Law. The country has enshrined the limits of government spending and fiscal deficit into law, which lowers the risk of future fiscal unsustainability significantly. A prudent fiscal policy in past years has reduced the consolidated public-sector debt from 52.6% of GDP in 2003 to 21.6% of GDP at the end of 2018, which is a low level and in fact the lowest level in South America. Looking ahead, public debt is expected to remain relatively stable and low, at roughly 22% of GDP. However, public debt issued in foreign currency has increased considerably since 2012, and at the end of 2018, 81% of public-sector debt was external debt denominated in foreign currency. As such, the country has increased its vulnerability to exchange rate shocks. The high infrastructure need also represents a risk for the evolution of public debt.

The government relies significantly on hydroelectricity revenues. The Itaipu and Yacyretá hydroelectric plants account for roughly 15% of government income, and thus a weather shock will also negatively affect public finances. However, more fiscal revenue could become available as of 2023, when the binational loan for building the binational hydroelectric plant is paid off – Paraguay borrowed heavily from Brazil to build the binational plant. Under the 1973 Treaty, both countries agreed to pay equal amounts for the construction, while each country owns half of the energy produced. Paraguay uses less than half of Itaipu’s electricity production that it is entitled to, but since sales to third countries are banned, it exports the remainder to Brazil at production cost (which is lower than the regional price). Paraguay also needs to service the debt of the Itaipu dam to Brazil. So in essence, it pays off the debt through electricity exports. Currently, two thirds of the revenue from the dam pays off the debt for its original construction. In the coming years, the renegotiation of the 50-year Itaipu Treaty with Brazil is likely to be tough because Brazil will demand a lower sale price of hydroelectricity to both countries, whereas Paraguay already enjoys the lowest electricity tariffs in Mercosur and wants to maintain the existing prices. The ability to sell to third countries is likely to be another of Paraguay’s demands, which Brazil is opposed to. It remains to be seen how the negotiations between the two countries will play out.

External debt levels on the decline despite the high risk appetite of the financial markets

External debt declined from a very high 284% of GDP in 2003 to a moderate 39.4% at the end of 2018. The reduction in external debt was the result of the amortisation of the debt from the binational hydroelectric plant. Going forward, external debt is expected to continue to fall, in line with the reduction of the binational hydroelectric loan. When the loan is paid off in 2023, it is expected that external debt will have declined to less than 30% of GDP. Short-term external debt has also decreased in relative terms since 2003 – when it stood at an extremely high level – to a stable but still elevated level. External debt service has been moderate; however, external debt and external debt service may increase again depending on the government’s appetite to tap the financial markets. On the one hand, the government has an incentive to borrow on the financial markets as it sees large infrastructure gaps, but on the other hand, investors’ risk appetite towards Paraguay has been large, despite relatively higher global risk aversion, thanks to Paraguay’s low government debt.

A healthier banking sector but with a high dollarisation

The health of the banking sector has been restored after the banking crisis in the late 1990s. According to the IMF, the banking sector is well capitalised, liquid and profitable. Nevertheless, as in many countries in Latin America, the Paraguayan financial system is relatively highly aligned with the US dollar. Foreign-exchange-denominated liabilities accounted for 48.1% of total liabilities at the end of 2018, and along with the floating exchange-rate regime, a huge depreciation of the Paraguayan guaraní vis-à-vis the US dollar could impact banks and borrowers’ balance sheets. That being said, the Central Bank of Paraguay is attempting to smoothen out exchange-rate volatility through the use of foreign exchange reserves (which stood at roughly seven months of import cover in April 2019, a comfortable buffer). Lastly, weather-related shocks could also affect the sector due to the bank’s relatively high lending to the agricultural sector.

Upgrade from 5/7 to 4/7 for medium-/long-term political risk

On the back of favourable developments, Credendo has decided to upgrade the medium-/long-term political risk classification from 5/7 to 4/7. Primarily, the country has displayed robust economic growth despite serious external headwinds in recent years, and the vast improvement in external debt has improved the country’s solvency. In addition, public finances are sound, with small fiscal deficits and reduced and low public debt. Lastly, the country enjoys relative political stability and there is a stable outlook. However, reliance on soybean and Brazil, the re-election ambitions of former President Cartes and droughts are still the main risk drivers in the medium term.

Analyst: Jolyn Debuysscher – j.debuysscher@credendo.com