Document of The World Bank FOR OFFICIAL USE ONLY INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PROGRAM DOCUMENT FOR A PROPOSED LOAN

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY Report No PY INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PROGRAM DOCUMENT FOR A PROPOSED LOAN IN THE AMOUNT OF US$100 MILLION TO THE REPUBLIC OF PARAGUAY FOR A PUBLIC SECTOR DEVELOPMENT POLICY LOAN November 3, 2011 Poverty Reduction and Economic Management Argentina, Paraguay and Uruguay Country Management Unit Latin America and the Caribbean Region This document is being made publicly available prior to Board consideration. This does not imply a presumed outcome. This document may be updated following Board consideration and the updated document would be made publicly available in accordance with the Bank s policy on Access to Information.

2 PARAGUAY - GOVERNMENT FISCAL YEAR January 1 December 31 CURRENCY EQUIVALENTS (Exchange Rate Effective as of October 25, 2011) Guaraní 4,175 US$ 1.00 Weights and Measures Metric System ABBREVIATIONS AND ACRONYMS AGPE ANDE BCP CCT CEP COPACO CPI CPS CNEP DGEP DPL EC ERSSAN ESSAP FSAP FY GDP Gs. IADB ICR IFA IFI IMAGRO IMF LAFE LTU MECIP OECD OP/BP PDPL Internal Audit Office of the Executive Power (Auditoría General del Poder Ejecutivo) National Electricity Administration (Administración Nacional de Electricidad) Central Bank of Paraguay (Banco Central de Paraguay) Conditional Cash Transfer Council for State-Owned Enterprises (Consejo de Empresas Públicas) Paraguayan Communications Company (Compañía Paraguaya de Comunicaciones) Consumer Price Index Country Partnership Strategy National Council of State-Owned Enterprises (Consejo Nacional de Empresas Públicas) Directorate of State-Owned Enterprises (Dirección General de Empresas Públicas) Development Policy Loan European Commission Regulatory Entity for Sanitation Services (Ente Regulador de Servicios Sanitarios) Sanitation Services Company of Paraguay (Empresa de Servicios Sanitarios del Paraguay) Financial Sector Assessment Program Fiscal Year Gross Domestic Product Guaraníes (Paraguayan local currency) Inter-American Development Bank Implementation Completion Report Integrated Fiduciary Assessment International Financial Institution Agricultural Income Tax (Impuesto a la Renta de Actividades Agropecuarias) International Monetary Fund Financial Administration Law (Ley de Administración Financiera) Large Taxpayer Unit Paraguayan Standard Model of Internal Control (Modelo Estándar de Control Interno del Paraguay) Organization for Economic Co-operation and Development Operational Policy/Bank Procedure Programmatic Development Policy Loan ii

3 PEES PEFA PETROPAR PFM SBA SEAM SET SIAF SOEs SSEI UMEP USAID VAT WB y-o-y Strategic Economic and Social Plan (Plan Estratégico Económico y Social) Public Expenditure and Financial Accountability Paraguayan Oil Company (Petróleos Paraguayos) Public Financial Management Stand-By Arrangement Secretariat for Environment (Secretaría del Ambiente) Undersecretariat of Taxes (Subsecretaría de Estado de Tributación) Integrated Financial Management Information System (Sistema Integrado de Administración Financiera) State-Owned Enterprises Under-Secretariat of Economics and Integration (Sub-Secretaria de Economía e Integración) SOE Monitoring Unit (Unidad de Monitoreo de Empresas Públicas) United States Agency for International Development Value-Added Tax World Bank Year-on-year Vice President: Country Director: Sector Director Sector Manager: Sector Leader: Task Team Leaders: Pamela Cox Penelope Brook Rodrigo A. Chaves Arturo Herrera Zafer Mustafaoglu Alexandre Arrobbio & Friederike Koehler-Geib iii

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5 REPUBLIC OF PARAGUAY PUBLIC SECTOR DEVELOPMENT POLICY LOAN TABLE OF CONTENTS LOAN AND PROGRAM SUMMARY... V I. INTRODUCTION... 1 II. COUNTRY CONTEXT... 1 A. POLITICAL CONTEXT... 1 B. ECONOMIC CONTEXT... 1 C. RECENT ECONOMIC DEVELOPMENTS IN PARAGUAY... 7 D. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY... 8 III. THE GOVERNMENT S PROGRAM AND PARTICIPATORY PROCESSES IV. BANK SUPPORT TO THE GOVERNMENT S PROGRAM A. LINK TO CPS B. COLLABORATION WITH THE IMF AND OTHER DONORS C. RELATIONSHIP TO OTHER BANK OPERATIONS D. LESSONS LEARNED E. ANALYTICAL UNDERPINNINGS V. THE PROPOSED OPERATION A. OPERATION DESCRIPTION B. POLICY AREAS VI. OPERATION IMPLEMENTATION A. POVERTY AND SOCIAL IMPACTS B. ENVIRONMENTAL ASPECTS C. IMPLEMENTATION, MONITORING, AND EVALUATION D. FIDUCIARY ASPECTS E. DISBURSEMENTS AND AUDITING F. RISKS AND RISK MITIGATION ANNEXES ANNEX 1: LETTER OF DEVELOPMENT POLICY ANNEX 2: POLICY MATRIX ANNEX 3: FUND RELATIONS NOTE ANNEX 4: DEBT SUSTAINABILITY ANALYSIS ANNEX 5: COUNTRY AT A GLANCE ACKNOWLEDGEMENTS The Public Sector Development Policy Loan (PSDPL) was prepared by a World Bank team led by Alexandre Arrobbio and Friederike (Fritzi) Koehler-Geib (Task Team Leaders). Jasmin Chakeri took a leading role in the preparation of this operation in its earlier stages. The team included Rossana Polastri, Raul Junquera, Francis Fragano, Carolina Díaz-Bonilla, Federico Guala, Alejandro Guerrero Ruiz, Fanny Weiner, Patrick Rittenauer, Apostolos Apostolou, Mariano Lafuente, Natalia Bavio, Jorge Alva-Luperdi, Victor Ordoñez, Mercy Mataro Sabai, Tarsila Ortenzio Velloso, Antonio Velandia Rubiano, Patricia Holt, Jimena Garrote, Daniela Veronica Felcman, Ruth González Llamas, Graciela Sanchez Martinez, Rocio Manrique, and Mariela Álvarez. The peer reviewers were Nick Manning, Henri Fortin, Daniel Alvarez, and Rajeev Swami. The team gratefully acknowledges the support and guidance of Penelope Brook, Rodrigo A. Chaves, Zafer Mustafaoglu, Arturo Herrera Gutierrez, Auguste Tano Kouame, Bruce Courtney, Rossana Polastri, Tatiana Proskuryakova, May Cabilas Olalia, Peter G. Moll, Reynaldo Pastor, Lisandro Abrego (IMF), Nicolas Magud (IMF), Camila Perez Marulanda (IMF), Volodymyr Tulin (IMF), Luis de la Plaza, Lawrence Bouton, Barbara Mierau-Klein, Rafael Rofman, Lizmara Kirchner, Miguel Vargas Ramírez, Ignacio Urrutia, Juan Buchenau, Ilka Funke, Mariano Cortes, Gloria Duré, Karem Edwards, Débora Aquino, Telma Alvarenga. The team acknowledges and is grateful for the collaboration of the Paraguayan authorities. iv

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7 LOAN AND PROGRAM SUMMARY REPUBLIC OF PARAGUAY PUBLIC SECTOR DEVELOPMENT POLICY LOAN Borrower Republic of Paraguay Implementing Ministry of Finance Agency Financing Data IBRD Loan Amount: US$100 million Operation type Stand-alone DPL Main Policy The proposed Public Sector Development Policy Loan (PSDPL) is intended to Areas support the Government of Paraguay in implementing its reform program to improve the public sector. The loan supports three areas of policy reform: State-Owned Enterprises Oversight; Central Administration Internal Financial Control and Internal Audit; Key Outcome Indicators Program Tax System. State-Owned Enterprises Oversight SOEs financial operations are carried out in a transparent manner and are subject to scrutiny by the Government and civil society. Target: online publishing of SOEs audited financial statements. Timely delivery of SOEs audited financial statements. Target: SOEs audited financial statements are available no later than June 30 of the following year. Recovery of 20% of the past-due debt accumulated by Central Administration entities with SOEs. (Baseline 2010: 0% of the certified aggregated amount of debt was reimbursed (Gs.365 billion)). Rate of timely payments reaches 80% for basic services provided to the State by SOEs (Electricity, Telecommunication, Water). (Baseline Jan-Jun 2010: 51%) At least 5 SOEs have established targets that can be monitored on a regular basis by UMEP. The number of hours of power outage as measured by hs/year per user has dropped to 11 hours (Baseline: 2010: 11.2 hs/year per user) The coverage of ESSAP water access as measured by the percentage of households in urban areas with access to water has increased to 89.2% (Baseline January 2010: 79.4%). The percentage of user complaints to ESSAP has decreased to 18% (Baseline 2010: 19%). Fixed telephone line installation time has decreased to 17 days (Baseline 2010: 20 days). Central Administration Internal Financial Control PEFA Indicators for internal control and internal audit (PI-20 and PI-21) for 50% of the ministries are rated C, which shows: (i) A more comprehensive set of internal control rules, and (ii) A broader coverage and quality of internal audit function and a higher extent of management response to internal audit findings. (Baseline: 2008 Integrated Fiduciary Assessment rating for PI-20 and PI-21: D+) Tax System Tax-to-GDP ratio is at least 13.8%. (Baseline 2010:13.4%) Ratio of audits of large tax payers that result in additional assessment exceeds 70%. (Baseline 2010: 55%) The overall development objective of the proposed PSDPL is to contribute to v

8 Development Objective(s) and Contribution to CPS Risks and Risk Mitigation Operation ID the effectiveness and efficiency of the public sector. This is expected to be reached via the following specific objectives: (i) exerting effective Oversight of SOEs; (ii) improving Central Administration s internal financial control; and (iii) strengthening the Tax System. Contribution to the CPS: The proposed DPL is fully consistent with the current World Bank Group CPS ( ): two out of the three cross-cutting themes addressed by the CPS program governance, poverty reduction, and equitable growth are supported by the PSDPL. There are three significant risks to the program supported by the PSDPL: an Economic and Financial Risk; a Political Risk; and an Institutional Capacity and Reform Implementation Risk. Economic. The Paraguayan economy grew by 15 percent in 2010, marking an impressive recovery from the international financial crisis. However, the country remains highly vulnerable to regional and global economic fluctuations and to weather-related shocks. At the same time, the country is exposed to overheating including inflation pressures, fast private sector credit growth, and a widening current account deficit. The economy is also exposed to exchange rate risk due to the continued high dollarization of the financial system and a large share of foreign denominated public sector debt. Mitigation: The government is implementing prudent fiscal management, including efforts to increase tax revenues in the medium-term and improve expenditure execution; monetary policy is being tightened and macro-prudential measures are being taken to contain private sector credit growth. To this end the government engages in technical assistance with the IMF on financial regulation and supervision, including the cooperatives sector; the country s external debt is low and managed prudently; flexible exchange rate policy and a sufficient buffer of international reserves provides a cushion for shocks. Political. Entering into the second half of its term, the Government s political alliance is still fragmented and does not hold a majority of seats in Congress. There is thus a risk of congressional bottlenecks when enacting new legal frameworks associated with the reform program. Although selected measures for the operation do not include the adoption of any laws, it is estimated that a significant political risk for this operation remains given the implications of supported reforms in the political economy. There is also a political risk associated to potential resistances to reform programs, such as for instance in the case of SOEs. Mitigation: The Government is carefully planning the submission of laws to Congress to optimize information dissemination and probability of adoption. Also, it usually works on building consensus around reform actions. The Presidency and the Ministry of Finance are ensuring consistency and coordination with institutions directly implementing reform actions. Finally, gradual approaches and effective communication with reform stakeholders were also undertaken by the Government. Institutional capacity and reform implementation. Weak human resource capacity in the public sector, as well as limited inter-institutional cooperation could put the success of the Government reform program at risk. Mitigation: The program is focused on a limited number of inter-related policy areas that are implemented by Government units with stronger capacities, such as the UMEP for the SOE component. In addition, these areas are supported by external technical assistance: internal control reform is supported by the USAID Umbral Program; the SOE Oversight is supported by Bank technical assistance. P vi

9 I. INTRODUCTION 1. The proposed US$100 million Public Sector Development Policy Loan (PSDPL) to Paraguay is aimed at supporting fiscal management and public sector reforms. This Development Policy Loan (DPL) supports the Government reform plans and builds upon the significant achievements in several areas of a previous programmatic DPL in The operation was conceived within the context of the FY09-13 Country Partnership Strategy (CPS) to support the implementation of the Government Reform Plans. Building on the dialogue developed in partnership with the Government, the Bank intends to contribute to the Government Plan s overall objective of achieving sustainable and more equitable growth by providing direct support to three of its pillars: (i) macroeconomic policy; (ii) state-owned enterprises (SOEs); and (iii) state modernization. 1 This DPL focuses on three program components: (i) State oversight of State-Owned Enterprises; (ii) Public Sector Financial Control (Central Administration); and (iii) the Tax System. A. Political Context II. COUNTRY CONTEXT 3. Three years into its mandate, the Government of President Lugo has made progress in the execution of key themes of the Government Plan. Paraguay has strengthened its economic growth and was the fastest growing country in Latin America in There has been an important increase in private investment and a marked turn-around in agriculture, industry and construction. The financial sector has weathered the global crisis well. Faced with economic recession in 2009, the Government was able to boost public spending in the context of a counter-cyclical stimulus package while maintaining progress in medium-term reforms such as tax administration and oversight of state-owned enterprises. In addition, the Government successfully re-negotiated the treaty related to the allocation of revenues from Itaipu 2, entailing an increase of US$240 million additional royalties on top of the US$120 million under the old treaty. There have also been advances in the health care sector with achievements such as free access to primary health care. 4. The Government now has two years remaining in which to advance the reform agenda and consolidate previous achievements; without a majority in congress this will be a challenging task. The Government is planning to consolidate reforms already achieved in such areas as public financial management, tax administration, and oversight of state-owned enterprises. The Government intends to create a development fund and a counter-cyclical stabilization fund with the additional revenues from Itaipu. The Government also expects to see additional progress in improving public service delivery and fiscal risk management. In order to advance on these issues, the Government will need to build solid a consensus in Congress during B. Economic Context 5. Paraguay is a small open economy that has undergone an economic turn-around, yet challenges remain. Paraguay is a landlocked lower middle income country in South 1 See Section III of this document regarding the Government Plan (PEES). 2 Royalties from the hydroelectric power plants on the Paraná River at the Brazil-Paraguay border, which represent a significant proportion of public revenue. 1

10 America with a population of 6.3 million and real per capita income of US$1,663 in Paraguay s economy strongly depends on its upper middle income MERCOSUR neighbors to where it sends almost 50 percent of its goods and services exports. Since 2003, Paraguay has experienced an economic turn-around which the 2009 crisis interrupted only temporarily. Despite this development, Paraguay still faces structural challenges related to the economic and public sector context. Macroeconomic context 6. Paraguay s economic turn-around started in 2003, based on favorable external conditions and an economic stabilization program. The country s economy stagnated in the late 1990s and early 2000s as the result of a domestic banking crisis and the negative fallout from the economic turbulence experienced by the Southern Cone. Since 2003, strong external demand resulted in fast export growth which in turn translated into a strong recovery of private consumption and investment. In terms of sectors, trade and services contributed most to growth (2.2 percent per year on average between ) followed by the export oriented agribusiness sector (1.8 percent per year on average). Between 2003 and 2008, average annual real GDP growth exceeded 4.6 percent, contrasting with an average of 2.7 percent for the preceding two decades. 7. At the core of the Government s stabilization program was a fiscal consolidation program that allowed for the reduction of the debt-to-gdp ratio and also kept inflation in check. The Government engaged in a tax and customs reforms in 2004 with the aim of formalizing the economy. Since then, the Government generated continuous and increasing primary fiscal surpluses, averaging 2 percent of GDP between 2003 and The surpluses resulted from relatively stable revenues at around 18 percent of GDP (including tax collections that have stabilized at about 12 percent since 2004 and royalties from the two hydroelectric power plants at Itaipu and Yacyreta) and primary spending that grew at a slower rate. Based on the combination of continuous surpluses and solid economic growth, central government debt as a percentage of GDP fell from 54 percent of GDP in 2002 to 18 percent in 2008 (Figure 1). Additionally, sound fiscal policies together with the Central Bank s focus on price stability resulted in single-digit inflation most years. 60% Figure 1: Central Government debt (% of GDP) 40% 20% 0% Domestic Bilateral IRBD Other multilateral Source: Staff calculations based on data from Ministry of Finance and Central Bank 2

11 Table 1: Key macroeconomic indicators and medium-term outlook Paraguay: Macroeconomic Indicators Actual Projections (in percent, unless otherwise indicated) National accounts Real GDP growth (%) GDP (current US$ billion) External sector Current account balance (% of GDP) Trade balance of goods and services (% of GDP) Exports of goods and services (% of GDP) Imports of goods and services (% of GDP) Exports of goods and services (% real change) Imports of goods and services (% real change) Remittances (US$ billion) Remittances (% of GDP) FDI (net, US$ billion) FDI (net, % of GDP) Prices CPI (% change, end of period) Avg. exchange rate (LCU/US$) REER (2005=100, + = appreciation) Merchandise terms of trade (2000=100) Reserves coverage of imports (months) Reserves (% of GDP) Labor market (%) Unemployment rate Fiscal (% of GDP)** Revenues of which: Tax revenues Expenditures of which: Net lending of which: Current expenditures including: Wages and salaries of which: Capital Expenditures Primary balance (deficit (-)/surplus (+)) Interest payments Overall fiscal balance (deficit (-)/surplus (+)) Savings and investment (% of GDP) Gross domestic investment Gross national savings Foreign savings Indebtedness (% of GDP)** Public sector gross debt of which FX-denominated * Central government ** excl. Central Bank debt Source: Government and staff estimates and projections based on RMSM-X model. 8. The 2009 crisis temporarily interrupted Paraguay s economic turn-around. A severe drought exacerbated the impact of the international economic crisis in Paraguay, 3

12 triggering a 3.8 percent real contraction of the economy in The agricultural sector was hit most. Its production fell by an estimated 23.8 percent in real terms, primarily as a result of the prolonged drought earlier in the year (Figure 2). In terms of aggregate demand, private investment fell by 13 percent and household consumption by 2.9 percent in Despite a significant fall in export revenues, Paraguay s external position remained stable, based on the drop of imports, a less than expected drop in remittances, and a relatively stable Guaraní throughout 2009 (Figure 3). The financial sector also proved relatively resilient, after it had previously recovered from the banking crisis. There was no wide-spread credit crunch, even though credit growth to the private sector slowed down significantly to 33 percent in 2009 down from a peak of 75 percent year-on-year (y-o-y) growth in May 2008 during the credit boom. The share of foreign currency denominated loans remained more or less stable at a high of 40 percent of the loan portfolio. Yet, foreign currency deposit growth accelerated sharply from around 10 percent y-o-y in earlier years to a brief peak of 60 percent in July In addition, the already high share of short-term deposits rose slightly to 70 percent in Overall, the quality of banks loan portfolios remained adequate, and liquidity and capitalization levels were sufficient. 3 Figure 2: Real GDP growth by economic sector Figure 3: Real GDP growth by demand component 20.0% 18.0% 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% -8.0% -10.0% 2008 Q Q Q Q Q Q1 Agriculture Industry and Mining Construction GDP Growth (value added) 2009 Q Q Q Q Q Q1 Cattle, Forest and Fishing Gas, electricity, water Trade and Services 2011 Q1 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% -10% 2008 Q Q Q Q Q Q2 Private consumption Investment 2009 Q Q Q Q Q Q4 Public consumption Net exports 2011 Q1 Source: Central Bank 9. The Government s policy response was instrumental in containing the impact of the crisis, and the macroeconomic framework remained appropriate. The Government s Anti-Crisis Plan, which was presented to Congress in January 2009, included measures aimed at: providing a fiscal stimulus through expanded public spending programs; ensuring sufficient liquidity in the financial system; ensuring access to financing for the productive sectors; and accelerating the mobilization of external resources. 4 At the same time, the Government has also remained committed to the prudent macroeconomic policies laid out in the Government s Strategic Economic and Social Plan. Concretely, the Government s Anti-Crisis Plan boosted public consumption and investment with current expenditure up by 2.8 percent of GDP relative to 2008 and capital expenditure up by 1.9 percent. The increase in current expenditure included 3 For a more detailed description see World Bank (2010): Financial Sector Assessment Program Update Paraguay, November. 4 See Annex 4. 4

13 the expansion of the conditional cash transfer program as well as other social programs. Despite the increase in spending, the fiscal balance closed in surplus due to an increase in tax revenues. Despite the increase in spending and a fall in economic activity, the fiscal balance closed in surplus due to an increase in tax revenues, underlining the positive impact of the tax administration reforms of recent years. Also, the Central Bank drastically reduced its reference rates in 2009, remaining below 2 percent during the second half of the year. In addition, it lowered legal reserve requirements to zero percent for local currency deposits of one year or more, and foreign currency deposits of 541 days or more. Finally, in March 2009, it introduced an emergency liquidity facility available to all banks. 5 Economic Structural Challenges 9. Reducing poverty and inequality remains a top priority and challenge. Moderate and extreme poverty levels fell significantly during recent years, yet have remained at comparatively high levels. Total poverty fell from 49.7 percent in 2002 to 34.7 percent in The reduction of extreme poverty has been more volatile; it oscillated between 24.4 percent in 2002 to 16.5 percent in In 2010, extreme poverty rose from 18.8 percent to 19.4 percent despite the strong economic growth. Extreme poverty remains particularly prevalent in rural areas with an incidence of 32.4 percent, compared to 10.3 percent in urban areas (Figure 4 & 5). 10. Despite record growth in 2010, extreme poverty increased. This suggests that extremely poor households did not benefit. In particular, the incidence of rural extreme poverty remained constant between 2009 and 2010, while urban extreme poverty increased by 1 percentage point. Initial analyses suggest that Paraguayans at the low end of the income distribution were negatively affected by sticky nominal wages at the same time as international food prices surged. The positive effects of high growth seem not to have reached them. In 2010, extraordinarily strong meat and soy production were main drivers for growth, products that small-scale and subsistence farmers do not produce. Inequality increased as well; the Gini coefficient of income distribution moved up from in 2009 to in 2010, one of the highest in Latin America. The wealthiest 10 percent hold 41.1 percent of the nation s income while the poorest 10 percent hold merely Economic informality is both a challenge and an impediment to sustained growth in Paraguay. A 2008 IMF study estimated the size of the Paraguayan informal economy at around 70 percent of formal GDP. It also identified labor rigidities as a significant factor contributing to this result. 6 Sizable informal activities combined with public sector performance induce high transaction costs, divert the allocation of resources away from key social investments, and reduce the quality and quantity of basic public services. 5 The Government has been collaborating with the World Bank to identify areas where the crisis management framework can be further strengthened, in particular with regards to the banking sector and pension supervision. 6 International Monetary Fund WP/08/102: Measuring the Informal Economy in Latin America and the Caribbean. 5

14 Figure 4: Total poverty incidence* Figure 5: Incidence of extreme poverty** Urban Rural Urban Rural Source: Staff calculations based on household survey data using new methodology. * Total poverty incidence is defined as the percentage of the population living below the poverty line (urban poverty line 2010: Gs.376,753 or US$82.05 a month; and metropolitan poverty line for Asunción 2010: Gs.525,960 or US$ a month; versus rural poverty line 2010: Gs.325,707 or US$70.93 a month). ** Extreme poverty incidence is defined as the percentage of the population living below the extreme poverty line (urban extreme poverty line 2010: Gs.243,662 or US$53.06 a month; and metropolitan extreme poverty line for Asunción 2010: Gs.317,510 or US$69.14 a month; versus rural extreme poverty line 2010: Gs.225,470 or US$49.10 a month). 12. Furthermore, sustainable economic growth is impacted by low expenditure execution. Total expenditure execution in Paraguay is low by international standards. It amounted to 84.8 percent in 2010, compared to 86.9 percent in 2009 (current expenditure execution declined by 1 percentage point to 92.5 in 2010 relative to the previous year, and capital expenditure execution declined by almost 7 percentage points to 64.2 percent). The deteriorating trend in expenditure execution continued in 2011 with capital expenditure execution rates amounting to 23.7 percent in July 2011 compared to 27.6 in July Some contingent fiscal risks remain in SOEs that might bind public resources when needed. Public enterprises generated operating surpluses of around 1 percent of GDP in recent years and are projected to do so again in the coming years. Yet, total debt of the four largest SOEs represents around 6 percent of GDP. In the past, comprehensive financial information on SOEs was not publicly available, although recent SOEs reforms have allowed for more transparency and financial monitoring, including the publication of annual audits. This helped to reveal existing financial challenges. For instance, the 2010 audit of the oil company PETROPAR (Petróleos Paraguayos) showed that the company had two times more liabilities than assets, mostly because of payment arrears to foreign suppliers. At the end of 2010, the company also had Gs.1.7 trillion (1.9 percent of GDP) in debt to foreign suppliers. Under the current oil price mechanism, domestic prices for fuel do not reflect international oil prices; the company s fortunes thus depend to a large extent on the price of the oil products that it imports, almost exclusively from the Venezuelan Oil Company PDVSA (Petróleos de Venezuela S.A.). Public Sector Structural Challenges 14. Paraguay s public sector performance remains a key challenge for equitable growth and development. Stronger public sector performance could have enhanced further equitable growth and development through more effective public policies, regulations, and service delivery. Significant opportunities for improvement remain in areas such as financial 6

15 control; institutional reorganization and development; introducing basics for results-based management frameworks; and tax administration. At the same time, there is a need to ensure the sustainability of the public sector reforms that have been initiated. Areas that offer opportunities of improvement and impact upon public sector performance include: Public Service and SOEs: Paraguayan SOEs provide essential goods and services, including oil, water, telecommunications and electricity. Their performance in terms of service delivery and management could be significantly improved. For example, in 2010, only 43.5 percent of urban households under the responsibility of the water SOE had sewage coverage, and electricity production still experiences 32.6 percent production technical loss. Internal control: Effectiveness of internal control procedures and practices as well as limited institutional capacities impacts on accountability and use of public resources for their intended purpose. Tax Administration: Tax administration capacities are limited, and this impacts on the capability to collect taxes and implement existing tax policies, in turn restricting available resources for public policies and service delivery. 15. These challenges are deeply seated in a number of structural constraints which render public sector reforms in Paraguay more complex. These constraints include: Discretionary practices in the public sector. Improving efficiency, effectiveness and transparency and reducing discretionary practices remain a structural challenge for Paraguay public sector, which the administration has inherited. Role of Congress. The Constitution of 1992 and other major organic laws, give the Legislature a strong role within Paraguay s division of powers, which include attributes that are usually associated with the Executive, inter alia, the authority to increase budget expenditures, approval for externally financed projects, and influence in determining public sector wages. This situation together with party fragmentation of Congress hinders the ability of the Executive to undertake reform initiatives. C. Recent Economic Developments in Paraguay 16. In 2010, the Paraguayan economy rebounded strongly based on an agricultural export boom that carried over to the rest of the economy. Paraguay s 15 percent real growth rate in 2010 marks the country s highest growth on record and indicated a strong recovery from the 2009 recession. Real exports grew by 35.3 percent in Soy and meat were the most important export goods, accounting for almost 39 percent and 18 percent respectively of the total, and contributing to export growth with over 30 and 6 percent respectively. Increased agricultural export revenues translated into additional disposable income, which bolstered domestic demand. Private consumption contributed 6.8 percent to real growth followed by investment with a 4.2 percent contribution. In terms of sectors, the agriculture sector contributed most to overall growth (8 percent), followed by trade and services (5 percent). Despite strong growth, the construction sector contributed little to overall growth (0.5 percent) since its share in the economy remains low. 18. With fast economic growth, the Paraguayan economy has shown signs of overheating. Capacity constraints and a surge in international commodity prices have lead to significant inflation pressures in Paraguay. Consumer price inflation picked up strongly in the second half of At the end of the year, Consumer Price Index (CPI) inflation reached 7.2 7

16 percent, close to the upper bound of the Central Bank s target band of 5 percent +/- 2.5 percentage points. As of March 2011 Headline CPI inflation reached 10.3 percent, before retreating to 8.8 percent in August In addition, private sector credit has expanded rapidly. Its growth rate averaged 36 percent y-o-y throughout 2010, based on record low interest rates at the beginning of the year. The Central Bank responded to elevated inflation and credit growth by raising interest rates by 850 basis points between May 2010 and mid-september As a consequence, credit growth peaked at 44 percent y-o-y in October 2010 and then flattened out, it remained at elevated levels until February 2011 (40 percent y-o-y). In March 2011 private credit growth began to fall significantly. As of July 2011, it stood at 23 percent y-o-y. In addition, the Central Bank also raised reserve requirements and brought them back up to precrisis levels in April and 4 percentage points for domestic and foreign currency deposits respectively. 19. The country s current account position weakened based on strong domestic demand growth, while the overall external position remained relatively unchanged. Paraguay s current account balance turned into a deficit of 3.2 percent of GDP in On the basis of strong domestic demand, imports grew rapidly, so that net exports contributed less to real growth than domestic demand aggregates. Over a third of imports were capital goods that potentially facilitate higher growth in the medium term. In addition to rapid import growth, remittances continued to drop in 2010 explaining the current account deficit. However, on the basis of strong foreign direct inflows, the Central Bank continued to accumulate international reserves. International reserves reached US$4.2 billion (or 23 percent of GDP) by the end of 2010 and continued to increase throughout As of end July 2011, the Guaraní appreciated by 16.5 percent relative to the US Dollar compared to end Improved terms of trade, strong foreign direct investment inflows, and seasonal liquidation of export proceeds are the main factors behind this rise. 20. Fiscal policy remained expansionary in 2010, yet the fiscal balance remained in surplus due to strong revenue collection. Total public expenditures remained above pre-crisis levels relative to GDP in 2010, based on sustained attention to social programs and an effort to keep up public investment. The continued expansion of conditional cash transfer programs, the non-contributory pensions, increased health expenditures, and infrastructure spending all explain, to a large extent, an increase of 8.9 percent of total expenditure in nominal terms that translated into a 1.8 percentage point decrease relative to GDP. Total expenditure amounted to 17.8 percent of GDP in Capital expenditure declined by 0.8 percentage points of GDP in 2010 and reached 3.8 percent of GDP. At the same time, booming economic growth led to a significant increase in tax collection in Overall, total revenues in 2010 reached 19.2 percent of GDP. As of July 2011, revenues were still growing at an accelerating rate of 19.7 percent (nominal y-o-y). D. Macroeconomic Outlook and Debt Sustainability Short and medium-term growth outlook 21. Under the baseline scenario, economic growth is expected to slow down in 2011 but to remain above long-term trend growth. Based on a return of agricultural growth to more normal levels and tighter monetary conditions, growth is expected to slow to 5.5 percent in The soy crop in 2011 is even expected to surpass the record numbers for This, together with high international commodity prices, explains the above trend growth. If credit 8

17 growth remains higher than expected and it is accompanied by higher domestic demand, growth could be higher still in the short-run. The current, fast expansion of credit also involves the risk of an abrupt deceleration, which poses a down-side risk to growth in the medium-term. 22. In terms of down side risks, Paraguay is exposed to fluctuations in international demand and commodity prices through its strong dependence on agricultural exports. To account for this risk the debt sustainability analysis shows a scenario that is consistent with a significant slowdown in the global economy. In the medium term, growth is expected to revert to its trend of around 4 percent. 23. Inflation is expected to remain above the Central Bank s target range until CPI inflation is expected to reach over 10 percent y-o-y, well above the Central Bank s target band of 5 percent (+/- 2.5pp). This development hinges on the economy s signs of overheating (e.g. hitting capacity constraints in the construction sector), and continuously high international commodity prices. With growth reverting to trend growth and commodity prices moderating, inflation is expected to return to a level within the target range by If growth remains stronger in line with international commodity prices, inflation pressures could remain strong. 24. The current account deficit could worsen further in 2011 and then slowly improve in the medium term. The current account is projected to worsen as imports recover, to around -4.0 percent of GDP in The current account deficit is expected to be financed through capital inflows as foreign direct investment increases and companies repatriate profits. With lower economic growth and subsiding commodity prices the current account deficit is expected to moderate over the medium-term. 25. Driven by a robust economic recovery, the fiscal balance is expected to show a modest overall surplus in 2011 that will slip into deficit as presidential elections get closer. For 2011, an overall surplus of 0.3 percent is projected. The budget foresees a continued fiscal stimulus, with spending projected to be around 19.8 percent of GDP. This includes a continued effort to maintain higher levels of capital expenditure. On the revenue side, customs and import-related VAT revenues are expected to recover to pre-crisis levels. Tax revenues have increased to 13.4 percent of GDP in 2010 from 13.0 percent in They are expected to reach 14.1 percent in 2011 and 14.0 percent in 2012 under the baseline scenario. These increases are expected to be caused by continued improvements in tax administration, tax policy, increases in the profits of domestic companies and imports. Other revenues, especially royalties from Yacyreta and Itaipu (which are denominated in US$), are projected to increase in the medium term, as an agreement with Brazil on the increase in Itaipu royalties becomes effective. The proposed increase in royalties for energy sold to Brazil was approved by the Brazilian House of Representatives and still has to be approved by the Brazilian Senate. The increase would imply US$360 million in royalties instead of US$120 million. 26. Financing needs are expected to be manageable. Gross financing needs are projected to increase from US$259 million in 2011 to US$349 million in 2013, 1.2 percent of GDP in both cases. The financing needs stem to a large extent from total amortizations that peak at US$317 million in 2011 and then subside to US$217 million in 2013 (Table 2). In 2012 and 2013 modest primary deficits of 0.3 and 0.2 percent of GDP respectively, add to the financing needs. Disbursements of external loans are expected to reach US$283 million in 2012 and US$233 million in 2013, including new budget support. After abstaining from bond issuance in 2010, the Government is planning to issue domestic bonds in the amount of US$143 million 9

18 and US$116 million in 2012 and 2013 respectively. If all or part of the budget support operations are not approved by Congress in the course of 2012 or 2013, the Government has some room to increase the issuance of domestic bonds and/or use part of the net public sector deposits with the Central Bank, these amounted to US$1.04 billion as of September 12, In 2010 alone, the Government deposited US$314 million, including US$100 million of the Inter-American Development Bank (IADB), which have not yet been spent. Table 2: Medium-term financing scenario (US$ million) Financing needs Primary surplus/deficit Amortizations Domestic External Multilateral Bilateral Interest payments Financing Sources Disbursements External Multilaterals o/w new budget support 1/ Bilaterals Domestic bonds Use of public sector deposits at Central Bank Financing gap / 2010: IADB (US$100million), Corporacion Andina de Formento (CAF) (US$45.2 million); 2012: PSDPL (US$100 million); 2013: IADB (US$75 million), the authorities also expressed interest in further World Bank funding in that year. Source: Government and staff estimates Debt sustainability analysis 27. Paraguay s debt burden and debt servicing indicators are manageable under reasonable assumptions. Under the baseline scenario, public debt levels will remain sustainable. Central government debt is projected to decrease from an estimated 16.5 percent of GDP in 2010 to 12.3 percent in 2011, and to then gradually fall to 10.5 percent by Sensitivity analyses suggest that the main vulnerabilities of Paraguay s fiscal accounts stem from low growth and a depreciation in the exchange rate, since a large share of public debt is denominated in foreign currency. If the economy grew on average 1.8 percentage points less than under the baseline scenario throughout the projection period, debt levels would reach 14.6 percent by The annual budget law usually authorizes the issuance of domestic bonds up to US$250 or US$300 million. 10

19 28. An additional scenario indicates that debt levels would remain sustainable under the assumption of a significant slow-down in global growth and the impact of the foot and mouth disease in Recent estimates, including those of market analysts, suggest that growth in an average Latin American country could potentially drop by 2 percentage points in the case of the materialization of a drop of 5 percent in growth in China. Such a potential reduction of growth in China would be one potential realization of the looming risks on global economic activity. Taking this risk into account, one scenario shows debt development under a 3 percent growth slow-down in Paraguay in This scenario would be consistent with the assumed slow-down in growth in China for that year together with a negative impact of foot and mouth disease. The scenario further assumes a recovery in Also in this case, debt levels are expected to remain sustainable reaching 12.5 percent in Finally, a one-time 30 percent exchange rate depreciation in 2011, would cause the debt-to-gdp ratio to deteriorate rapidly to 18.3 in 2011, falling to 17.7 in 2012 and remaining volatile thereafter. 29. Contingent liabilities also pose a risk. Total debt of the four largest SOEs represent around 6 percent of GDP and all SOEs represent 30 percent of total public expenditure. If Government had to cover debt and/or deficits of these entities, in a negative scenario, a shock of around 10 percent of GDP could occur. Such a contingent liability shock of 10 percent of GDP over the baseline would have a significant impact on debt levels, pushing them up to 19.7 percent by the end of the projected period. However, the Government has taken measures to mitigate this risk employing SOE oversight reform, which is supported by this operation. 30. There are a number of downside risks to the baseline macroeconomic scenario. While the immediate threat from uncertain weather conditions and the attendant lower agricultural production in 2011 appear to have passed, Paraguay remains primarily vulnerable to external factors. The slow recovery in developed economies and the demand impact on emerging economies pose a risk to Paraguay, particularly through its exposure to Brazil and Argentina. The main concern in the medium term is the high cost of energy, especially oil, and the high price of other raw materials. Slower growth in Argentina and Brazil, as well as in Paraguay s other main export markets, could negatively impact the pace of economic growth. In addition, Paraguay s heavy dependence on agriculture means that its economic prospects are vulnerable to climatic factors such as droughts, extreme temperature swings and floods. A potentially abrupt deceleration of the fast expansion of credit is a domestic risk factor Notwithstanding certain downside risks to the economic outlook, Paraguay s macroeconomic framework is deemed adequate for this proposed loan. In particular, the low debt-to-gdp ratio and the prudent fiscal policy management throughout the economic downturn suggest a low level of risk for this operation. Based on very low debt-to-gdp ratio, Paraguay seems to have the fiscal space to maintain spending even under the assumption of severe shocks to economic growth. Medium-term borrowing requirements are manageable, given the Government s fiscal position and planned levels of multilateral financing. Monetary and exchange rate policy management is also supportive of macroeconomic and financial stability. If tail risks to global and domestic growth materialize, the expectation is that the Government would take appropriate measures and that multilateral financing could provide additional contingent financing to mitigate such risks. 8 See World Bank (2010): Financial Sector Assessment Program Update Paraguay, November for an in depth analysis of the current credit expansion, involved risks, and policy options to address it. 11

20 III. THE GOVERNMENT S PROGRAM AND PARTICIPATORY PROCESSES 32. The overall objective of the Government Plan, presented in September 2008, was to achieve more sustainable and equitable growth for Paraguay through six strategic objectives: (i) fostering growth with a focus on employment generation and improved income distribution, while preserving a sound macroeconomic framework; (ii) strengthening Government institutions to improve the rule of law, policy making, and the delivery of services; (iii) improving the efficiency of public sector social expenditures while focusing on extreme poverty alleviation; (iv) promoting the diversification of the production structure, through the optimal use of national energy and human resources while safeguarding the environment; (v) fostering economic development and ensuring broader citizen participation; and (vi) supporting decentralized development. These objectives were planned to be achieved through the implementation of the eight strategic pillars of the Government Plan (Plan Estratégico Económico y Social - PEES) As the economic crisis unfolded, the Government adapted its priorities to the changing circumstances through the 2009 Anti-Crisis Plan. Following the economic deceleration, which started in Q4 2008, the Government launched its 2009 Anti-Crisis Plan, aimed at smoothing the impact of the international economic crisis on unemployment and poverty. Despite the dramatic economic downturn, the Plan ensured that the private sector continued to have access to credit and that an increasing share of the extreme poor was covered by the social safety net Priorities from the Government Program have now shifted back to longer-term challenges, including public sector strengthening. Post-crisis priorities are to pursue the goals of the 2008 Government Plan with three main strategic dimensions: social development and poverty reduction; economic growth with a focus on competitiveness and private sector development; and public sector strengthening. 35. Public sector strengthening is now focused on public finance and supports both consolidation of previous achievements and progress of the reform agenda. On the one hand, the Government plans to consolidate achievements in: (i) revenue mobilization, through continued strengthening of the tax administration and efforts to introduce a personal income tax; (ii) expenditure management, with emphasis on budget execution, internal control and audit functions, and SOEs oversight; and (iii) strengthening public finance institutional framework through legal changes and clarification of responsibilities. On the other hand, the Government is contemplating advancing the reform agenda in fiscal risk management and public investment. Within public investment, policy actions will be strongly related to the management of additional public revenues from Itaipu royalties. To this end, the Government envisages creating a counter-cyclical stabilization fund and a special development fund. The latter will be exclusively dedicated to investment in highways, health, education, research and development. In addition, a Public Investment Directorate will be established at the Ministry of Finance to enhance management and coordination with the Technical Planning Secretariat These eight pillars were: (i) stable and consistent macroeconomic policy framework; (ii) strengthened financial sector; (iii) effective provision of services by state-owned enterprises (SOEs); (iv) modernization of the State; (v) enhanced productivity and competitiveness; (vi) comprehensive land reform; (vii) employment generation and poverty alleviation; and (viii) promote infrastructure development. Source: PEES. 10 See Annex Law No

21 Regarding fiscal risk management, the Government will implement a new debt management strategy; enhance fiscal control of local governments and decentralize public entities; it will also strengthen supervision and monitoring of cooperatives. Participatory Process and Consultations 36. The Government s reform program is an outcome of extensive consultations with stakeholders. The Government has worked together with civil society and relevant actors in the policy areas covered by the PSDPL. Prior to assuming office, the Government widely disseminated its strategy, with particular attention to public sector reform. This strategy was made accessible on the Ministry of Finance website. At the same time, the Government developed an inter-ministerial dialogue on these topics. The priorities defined as a result of these consultations are consistent with current reforms related to SOE oversight, Internal Control, and Tax System. 37. In addition to these initial consultations, current reforms targeted by this program benefitted from specific consultations. With regard to SOE oversight, workshops and conferences were held with members of Congress and the media in order to disseminate and explain the objectives and scope of the reform. Constant communication and consultation were also established with representatives from SOEs. In the area of internal control, a continuous process of consultation and setting-up of committees was developed in parallel to the design and implementation of the new internal control framework. 38. During PSDPL implementation, the Government also envisages continuing consultations with the civil society, with a focus on the social monitoring of SOEs service delivery indicators. The Government, through UMEP, is considering introducing mechanisms for information exchange with citizens regarding the evolution of performance indicators on public services provided by the SOEs. These actions could reinforce the monitoring and oversight of SOEs, and generate a demand-side request for sustaining the reform process. A. Link to CPS IV. BANK SUPPORT TO THE GOVERNMENT S PROGRAM 39. The Public Sector DPL (PSDPL) is supporting the governance and equitable growth objectives of the CPS. Two out of the three cross-cutting themes addressed by the Country Partnership Strategy (CPS) (Report No , discussed by the Executive Directors on May 5, 2009 ) governance, poverty reduction, and equitable growth are supported by the PSDPL. On the one hand, the PSDPL serves as a central instrument through which the CPS provides direct support to the governance theme. On the other hand, the PSDPL contributes to the sustainable growth objectives of the CPS by supporting tax revenue objectives. There are also strong synergies between this Development Policy Loan (DPL) and several other Bank operations in Paraguay. Finally, the PSDPL is expected to continue to play a key role in donor coordination, as evidenced in the cooperation for the preparation of the previous Public Sector Programmatic DPL See IV.3. Collaboration with the IMF and other Donors. 13

22 Table 3: Link between the PSDPL Components and CPS Outcomes PSDPL Components Corresponding CPS Outcome State-Owned Enterprises Finances and operations of SOEs are transparent and subject to greater Oversight scrutiny by Government and civil society. Central Administration Increased effectiveness of internal control and internal audit function Public Sector Financial (upgrade PEFA indicators for internal control and internal audit, PI-20 & PI- Control 21). Tax System Increased tax-to-gdp ratio (Baseline: 11.8% (avg ) Target: 12.7% (2013)) B. Collaboration with the IMF and Other Donors 40. Since Paraguay s successful completion of two consecutive Stand-By Arrangements (SBA) with the IMF in August 2008, no new IMF program has been requested. Macroeconomic performance under the SBAs, which supported the previous Government s economic reform program, was strong. All outcomes under the second program, except inflation, exceeded program targets. The SBAs also targeted structural measures in four areas: (i) public sector reforms; 13 (ii) financial sector reforms; 14 (iii) pro-growth reforms, including strengthening the management of SOEs; and (iv) improving the social safety net by expanding coverage of the conditional cash transfer program. Most of the structural benchmarks were met, although there were delays in the implementation of results-based management contracts with some of the SOEs. The IMF maintains an open dialogue with the authorities, and IMF staff conducted annual Article IV missions in March 2009, April 2010, and June The IMF also has a number of technical assistance activities in Paraguay, including: financial soundness of the cooperatives sector, energy subsidies, banking supervision, and monetary policy. A joint Financial Sector Assessment Program visited Paraguay in November Based on this, a Financial System Stability Assessment 15 was published in July The Bank and IMF teams consult each other through regular meetings and bi-annual country-team level consultations. 41. Preparation of the PSDPL provides the opportunity to strengthen donor coordination on related policy areas. Building on the 2009 Bank First Public Sector Programmatic DPL (P113457, Loan 7700-PY), which represented a significant proportion of the multi-donor program supporting the 2009 Anti-Crisis Plan, the PSDPL is fostering International Finance Corporation (IFI) and multi-donor support to public finance reforms in Paraguay. On the one hand, the Bank and IADB are leading the work on public finance and fiscal management through complementary development policy programs with distinct and complementary policy areas. On the other hand, with regard to the area of Internal Control of the Central Administration, PSDPL budgetary support and USAID Umbral Technical Assistance are mutually supportive. C. Relationship to Other Bank Operations 42. The current operation builds on the previous public sector programmatic development policy loan series that started in The programmatic series was prepared in the context of an in-coming government and an uncertain economic outlook; it was 13 Including financial management, public investment system, tax and customs administration and pension reform. 14 Ensuring an adequate capitalization of private and public banks and the Central Bank, also improving the regulatory framework for financial institutions. 15 IMF Country Report No 11/

23 conceived to support the Government Plan for public sector reforms and the Anti-Crisis Plan for the most part. This three-loan series supported the Government program and the Anti-Crisis Plan via four components: internal financial control, oversight of SOEs, efficiency of public expenditure, and civil service reform. The first operation (First Public Sector Programmatic DPL (P113457, Loan 7700-PY), was successfully executed during the first semester of However, the triggers for the second operation were completed not long after the two-year period authorized between the board dates of two operations in programmatic series, and hence the series could not be continued. 43. Despite the termination of the programmatic series, outcome indicators were achieved faster than expected, and many indicators from the previously planned PDPL2 and PDPL3 were met. Despite the slower reform pace, the Government remained committed and cooperated with the Bank, which led to achieving indicators before deadline, and the fulfillment of numerous triggers from PDPL2 and PDPL The Government requested World Bank support for its reform effort representing a streamlined continuation of the efforts supported by the previous programmatic DPL series. The government reform program now focuses on the oversight of SOEs, internal control, and the tax system. The program has adapted to the changing environment, Paraguay came out of the crisis following a strong recovery in In addition, it has been adjusted to focus on the most successful areas of reform. Given both the need for streamlining the reform program on most successful policy areas and the normative requirements of programmatic DPLs, particularly in terms of duration limits between each programmatic loan, the Government has now requested a stand-alone operation, but indicated its commitment to continue reforms in the medium term (see Annex 1). 45. The PSDPL is also linked to a number of projects in Paraguay through its focus on governance. The PSDPL addresses governance challenges associated with the management of SOEs and strengthens the Government s internal control function. Other projects contribute to strengthening good governance practices in specific sectors: (i) The Water and Sanitation Sector Modernization Project (P095235, Loan No PY) promotes institutional-based and social accountability activities, improving corporate governance of the water company ESSAP (Empresa de Servicios Sanitarios del Paraguay) and consolidating the sector governance and regulatory framework; (ii) the Energy Sector Strengthening Project (P114971, Loan No PY) enhances overall business related processes at ANDE (Administración Nacional de Electricidad) and its environmental, social and internal auditing units in particular, with the goal of increasing transparency of planning, execution, and evaluation processes; 17 (iii) the Road Maintenance Project (P082026, Loan No PY) that elevates the profile of activities towards increased transparency within the Ministry of Public Works and Communication primarily with the help of an electronic tool to implement and monitor the Improved Governance Control Framework; and (iv) the Sustainable Agriculture and Rural Development 16 See Implementation Completion Report (Report No: ICR ) on the First Public Sector Programmatic DPL, Annex 7 and The proposed PSDPL is complementary to the Energy Sector project because it supports the adoption of a management contract with ANDE, and the establishment of a Dashboard Panel electronically connecting the SOE Monitoring Unit (UMEP) to ANDE, in order to monitor indicators on financial performance, quality of customer services, corporate resources, technical losses (distribution/transmission), and other performance indicators agreed under ANDE s management contract. 15

24 Project (PRODERS) (P088799, Loan No PY) supports agricultural development by reaffirming leadership and coordination of different public sector agencies in provision of services to producers and indigenous communities. 46. Complementarities also exist between the PSDPL and programmatic non-lending technical assistance foreseen in the CPS. The programmatic non-lending technical assistance for public sector reform is building on the dialogue developed by the PSDPL, with the purpose of providing advisory services and the transfer of know-how needed by the Government to achieve its public sector reform goals. The technical assistance program includes a recently approved Bank-executed Spanish Trust Fund Paraguay Enhancing Public Sector Effectiveness SFLAC (P120699), which supports the Government on SOEs reforms. Table 4: Support from other Donors and IFIs on policy areas covered by the PSDPL PSDPL Component Development Policy Lending Technical Assistance State Owned Enterprises Oversight WB WB Central Adm. Internal Control WB USAID Umbral Program Tax System WB IMF D. Lessons Learned 47. Previous development policy operations suggest that adapting to country context and strong national ownership is critical for smooth implementation. The 2003 Economic Recovery Adjustment Loan (P086543, Loan No PY) provided a quick response to the Government s financing needs, while at the same time taking advantage of the momentum for reform. 18 Its successful implementation was due to strong national ownership; consensus among political actors as well as international financial entities; and balance between political feasibility and depth of reform. Similarly, in the case of Paraguay s Programmatic DPL I approved in 2009, ownership led directly to: the achievement of the PDO; fostered the country s dialog on development priorities; and made it possible to adapt to internal and external changes affecting the program s implementation. Careful assessment of the program s support across a wide range of constituencies, including NGOs, IFIs, and other stakeholders, conducted during the preparation stage played a critical role in helping to correctly gauge political risk. 48. Sustained engagement on the part of the Bank is key to supporting reform processes over the medium and long term. As in most countries, Paraguay s path toward reform has been long and uneven. Some pieces of legislation which form the cornerstone of the reform process were approved a decade ago, including the Financial Administration Law (1999) and the Tax Reform Act (2004). Likewise, the reforms supported under the 2003 Economic Recovery Adjustment Loan (P086543, Loan No PY) and the 2005 Financial Sector Adjustment Loan (P039994, Loan No PY) provided the foundation for the reforms supported under the Programmatic DPL I. Although momentum for reform subsided during the late 2000s, the Bank continued its engagement with Paraguay s Ministry of Finance through fiduciary assessments and other non-operational tasks. This sustained engagement made it possible for the Bank to respond quickly and effectively to the new administration s request for support of its reform program under programmatic DPL I. 18 The loan covered five policy areas: (i) fiscal stabilization; (ii) tax policy; (iii) public administration and anticorruption; (iv) financial sector; and (v) public sector pension fund. 16

25 49. In the context of Paraguay, continuation of medium-term reforms should focus primarily on areas where there is consensus and clear leadership for change. With the support of strong political will, the Ministry of Finance is actively promoting a well-defined set of reforms that are both technically and politically feasible. Yet, the political support needed to carry out a broad civil service reform is still lacking. E. Analytical Underpinnings 50. The proposed PSDPL is based on a series of analytical studies including those undertaken by the Bank; lessons learned from the previous DPL; and reports prepared jointly with other donors. The substantial body of analytical work has provided the basis for an in-depth dialogue with the Government and has supported, jointly with the Government Plan, the design of the PSDPL. Table 5 shows the links between the policy areas and the macroeconomic framework included in the PSDPL as well as the main findings and recommendations of the analytical work. PSDPL Policy Area Oversight of State Owned Enterprises Central Admin. Internal Control Table 5: Links between the PSDPL and Prior Analytical Work Analytical Work OECD Survey on Corporate Governance of SOEs in Member States (2005) The survey showed that the general trend for organization of the ownership function was to move from the decentralized model still valid in Paraguay where ministries supervise SOEs related to their respective sectors, to the centralized model whereby a single entity acts as the SOE shareholder on behalf of the State. In all OECD countries, SOEs are audited annually by an international private audit firm and their financial statements are public. Finally, SOEs are usually public corporations and the regulatory framework is controlled by independent agencies. Bank Report on the Observance of Standards and Codes (ROSC) for Accounting and Auditing (2006) Auditing standards for SOEs are extremely limited; most notably annual audits in accordance with international standards are not mandatory; Audited financial statements of SOEs are not required to be published. Understanding Sector Performance: The Case of Utilities in LAC (2009) The LAC survey showed that the strength of SOE s corporate governance in Paraguay was low in comparative terms, although it was increasing in terms of legal soundness and transparency. In addition, Paraguay scored highest in the Region in performance orientation, and CEP was singled out as one of the few initial examples of centralized responsibilities in the SOEs oversight in LAC. Implementation Completion Report: First Public Sector Programmatic DPL (2011) The ICR shows that the Government has succeeded in creating since 2008 an institutional framework to oversee the performance and financial soundness of SOEs, by: introducing resultsbased management contracts for the major SOEs; enhancing rationality in budget allocations for SOEs; improving transparency regarding their financial management; and initiating actions to correct the debt balance in favor of SOEs. The government has also submitted a draft Law to Congress in order to consolidate this institutional framework. Integrated Fiduciary Assessment (IFA, 2008) & Non-Lending Technical Assistance IFA Action Plan Follow-up (2008), jointly prepared by the Bank, IADB and the European Commission (EC) Control effectiveness is Paraguay s main financial management and procurement issue. Main problems identified in this area include: (i) internal control shortcomings in most expenditure categories; (ii) ineffective internal audit function; and (iii) a weak control environment. Tax System IMF Tax Policy and Tax Administration Assessments (September 2008) In the area of tax administration, priorities include implementing an effective human resources policy; strengthening the tax audit function; and reorganizing the Large Taxpayer Unit. In turn, proposed tax policy measures aim at increasing tax pressure and tax equity by completing and improving the efficiency of taxes defined by the 2004 Fiscal Adjustment Law. 17

26 A. Operation Description V. THE PROPOSED OPERATION 51. The overall development objective of the proposed PSDPL is to contribute to the effectiveness and efficiency of the public sector. This is expected to be reached via the following specific objectives: (i) exerting effective Oversight of SOEs; (ii) improving Central Administration s internal financial control; and (iii) strengthening the Tax System. 52. The PSDPL (US$100 million) is a stand-alone DPL expected to be executed in FY12. The PSDPL includes three components: SOEs oversight; public sector financial control in the Central Administration; and Tax System. The policy matrix for the Program, including the prior actions, and key outcomes indicators, is presented in Annex The scope of the PSDPL was determined by building on lessons learned from previous operations, particularly from Programmatic DPL1. Expected achievements will build on the active reform agenda of the Government, and on the successes from the previous DPL. 19 These program components and actions have been selected with the country s most relevant development challenges in mind, as well as priorities communicated by the Government. They also consider both structural institutional constraints and the current political context. Aware of implementation difficulties to previous reform efforts, prior actions and triggers were defined with the Government in order to maintain flexibility and to minimize the risk of potential political gridlock. 54. The operation has a direct link to the Government Plan (Plan Estratégico Económico y Social - PEES). The operation directly supports Government plans to consolidate previous achievements in reforming revenue mobilization; internal control and audit functions; and SOEs oversight. 55. The proposed PSDPL program incorporates current good practice guidelines. These practices for development policy lending are outlined in Operation Policy/Bank Procedure (OP/BP) 8.60, Development Policy Lending, as summarized in Box 1. While maintenance of a satisfactory macroeconomic framework is not an explicit prior action or a trigger for DPLs, it is a fundamental requirement for DPL lending under OP Main successful reforms supported by the previous operation included: SOEs oversight reform, internal financial control, and tax system strengthening. 18

27 PSDPL Policy Areas SOEs Oversight Central Admin. Internal Control Tax System Corresponding CPS Outcomes Finances and operations of SOEs are transparent and subject to greater scrutiny by Government and civil society. Increased effectiveness of internal control and internal audit function (upgrade PEFA indicators for internal control and internal audit, PI-20 and PI-21). Increased tax-to-gdp ratio (Baseline: 11.8% (avg ) Target: 12.7% (2013)) Table 6: PSDPL Outcomes and links with CPS PSDPL Key Outcome Indicators SOEs financial operations are carried out in a transparent manner and are subject to scrutiny by the Government and civil society. Target: online publishing of SOEs audited financial statements. Timely delivery of SOEs audited financial statements. Target: SOEs audited financial statements are available no later than June 30 of the following year. Recovery of 20% of the past-due debt accumulated by Central Administration entities with SOEs. (Baseline 2010: 0% of the certified aggregated amount of debt was reimbursed (Gs 365 billion). Rate of timely payments reaches 80% for basic services provided to the State by SOEs (Electricity, Telecommunication, and Water). (Baseline Jan-Jun 2010: 51%) At least 5 SOEs have established targets that can be monitored on a regular basis by UMEP. The number of hours of power outage as measured by hs/year per user has declined to 11 hours (Baseline: 2010: 11.2 hs/year per user) The coverage of ESSAP water access as measured by the percentage of households in urban areas with access to water has increased to 89.2% (Baseline January 2010: 79.4%). The percentage of user complaints to ESSAP has decreased to 18% (Baseline 2010: 19%). Fixed telephone lines installation time has decreased to 17 days (Baseline 2010: 20 days). PEFA Indicators for internal control and internal audit (PI-20 and PI- 21) for 50% of the ministries are rated C, which shows: (i) A more comprehensive set of internal control rules, and (ii) a broader coverage and quality of internal audit function and a higher degree of management response to internal audit findings. (Baseline: 2008 Integrated Fiduciary Assessment rating for PI-20 and PI-21: D+) Tax-to-GDP ratio is at least at 13.8%. (Baseline 2010:13.4 percent) Ratio of audits of large tax payers that result in additional assessment exceeds 70%. (Baseline 2010: 55%) 19

28 Box 1. Good Practice Principles on Conditionality Principle 1: Reinforce Country Ownership Ownership has been a critical aspect of both the design and the implementation of this program. The Bank has actively cooperated with the Government since President Lugo won elections in April To this end, the Bank presented a set of policy notes to the authorities in June Since 2008, the Bank has provided technical assistance in oversight of SOEs, which has been instrumental to the current reform achievements. Also, while the Executive could not advance at the expected pace due to legislative challenges, alternative solutions were implemented in targeted policy areas, showing government commitment to the objectives of reforms being supported by the PSDPL. Finally, PSDPL components are aligned with the pillars of the Government s Strategic Economic and Social Plan for Principle 2: Agree upfront with the Government and other financing partners on a clear division of labor On macroeconomic and fiscal issues, the Bank and the IMF coordinate regularly, but there is currently no active IMF program. In addition, the previous PDPLI became a significant part of a multi-donor funding package supporting the Government s 2009 Anti-Crisis Plan, and the policy areas covered by the loan received additional support from IFI/donor technical assistance programs spelled out in section IV.3. Development stakeholders coordinated their actions to ensure clear division of labor and complementary actions. Of particular note: for the areas under the auspices of the PSDPL, development policy lending is covered by the Bank while TA is covered by the Bank for SOEs, USAID/UMBRAL for Internal Audit and Control, and IMF for Tax System. Finally, the PSDPL is deepening the reform of some policy areas covered by the previous DPL, and it will consequently enjoy the same level of inter-institutional coordination in terms of priorities and actions. Principle 3: Customize the components and structure of the operation to country circumstances The operation supports an important part of the Government s reform program; the scope and sequencing of PSDPL prior actions and targets are based on a realistic assessment of in-country capacity for completing the reforms. This assessment was carried out in consultation with the Government. The DPL has been structured so as to accompany the reform process to the next stage, it also has built-in flexibility to allow it to respond to any internal or external changes which may shape the reform agenda. Principle 4: Choose only results-based actions as conditions for disbursement The policy matrix contains 9 prior actions for the PSDPL. These were identified following an assessment of their importance for progress in the individual reform areas. Principle 5: Conduct transparent progress reviews conducive to performance-based financial support The program matrix includes clearly defined outcome indicators, which have verified baseline values and can be tracked through existing systems and processes. B. Policy Areas Component I: SOEs Oversight 56. The Government program has made significant strides in addressing the SOEs challenge by improving state oversight. The size and performance of SOEs represent a significant challenge for Paraguay s economy, from an institutional as well as from a political economic point of view. The Government has therefore made SOEs oversight a priority in its public sector reform program. Three main areas have been addressed: the institutional framework for oversight of SOEs; financial transparency; and results-based management. Since the end of 2008, the Government has achieved strong results, it has been assisted in its efforts by the Bank (technical and financial assistance), by regional peer institutions, and by the OECD. Given Paraguay s track record in SOE reform, this could be viewed as a clear success of the present government. Current achievements include the establishment of an effective institutional framework; the attempt to consolidate this framework through the adoption of a specific law; the publication of annual audited financial statements of SOEs; the adoption of results-based agreements between SOEs and the State. The present section provides information on sector challenges; implementation of the various aspects of the reform; description of selected prior actions; and outcome indicators. 20

29 57. SOE size and performance represent a significant challenge for Paraguay s economy and service delivery effectiveness. Paraguayan SOEs account for around 30 percent of Public Sector expenditures and provide essential goods and services, including oil, water, telecommunications and electricity. Their performance in terms of service delivery and management could be significantly improved. For example, in 2010, only 43.5 percent of urban households under the responsibility of the water SOE had sewage provision, electricity production still experiences 32.6 percent technical loss. This poor performance is due, to a large extent, to the institutional limitations that prevailed until 2008 and include: ineffective oversight of the institutional framework, non-disclosure of audited financial statements, asymmetric financial information and a partial regulatory framework for utilities. Enterprise Sector Legal Status ANDE ANNP CAPASA COPACO Electricity River Transport / Harbor Management Beverage Production Telecommunicati on Table 7: Paraguay Non Financial SOEs Under Management Contract* Public Sector Decentralized Entity Public Sector Decentralized Entity 2010 SOE Expenditure (Mill. USD) 2010 % Total SOE Expenditures YES 1, % NO % Public Corporation NO % Public Corporation YES % ESSAP Water Public Corporation YES % National Civil Public Sector DINAC Aeronautic NO % Decentralized Entity Directorate FEPASA Railway Lines Public Corporation NO No Activity nil INC Cement Public Sector Production Decentralized Entity YES % PETROPAR Oil Public Sector Decentralized Entity YES 1, % TOTAL 2, % Note: In 2010, SOE total expenditures represent the equivalent of 30 percent of public sector total expenditure and 62 percent of Central Administration total expenditure. 58. Beyond operational aspects, the SOE sector represented a challenge to the political economy. Before the reform process, the political economy of SOE oversight was characterized by fragmented responsibilities between different Government actors, with overlapping functions and responsibilities. There was also asymmetric information between SOE management on the one hand and Government and civil society on the other. There was no available information on the performance or the financial situation of SOEs; there were limited vertical accountability mechanisms; and a limited number of channels for civil society participation in the oversight of SOEs. There was also no clear incentive for SOE management to change the status quo. 59. The Government designed a reform program for SOE oversight based on three pillars: institutional framework; financial transparency; and results-based management. Given the critical role of SOEs in Paraguay, the Government has targeted SOE oversight as one of the key priorities of its public sector reform program. Reforms and measures in this area are focused on three key aspects: (i) creating an adequate institutional framework for SOE 21

30 oversight and ownership based on regional examples and good practice; (ii) increasing transparency by strengthening audit and financial management of SOEs and by publishing annual financial statements; and (iii) introducing the fundamentals of results-based management in the largest SOEs, with a view to improving service delivery performance. 60. Factors that contributed to the success of this reform include: realism, flexibility, identification of stakeholder consensus, and caution for political economy challenges. First, over the last three years, the Government showed realism and pragmatism in implementing this reform. Starting with a broader scope and more ambitious targets, the program was narrowed down during the crisis. In particular, it decided to focus more exclusively on the oversight of SOEs reform and drop the establishment of an overall regulatory model, given public sector technical capacities and the ability to handle the political economy and institutional challenges. Second, the Government intended to generate consensus around the reform of oversight of SOEs. This was achieved by, broad consultation on institutional design and legal documents with international experts, peer institutions from the region and OECD countries. Extensive communication with civil society, the Congress and the media via conferences, press articles and dialogue with stakeholders was carried out. Finally, with an inclusive and non-confrontational approach, the Government managed to progressively gain support from SOE management and representatives from Congress. Subcomponent Institutional Framework for State Oversight of SOEs 61. The institutional settings established in 2008 include a supervisory body and a technical monitoring unit, which defined the road-map for SOEs oversight. The Interministerial Council of SOEs (CEP) and the SOEs Monitoring Unit (UMEP) were established as a result of a reform plan aimed at strengthening the institutionalization of SOEs ownership function. In 2009, CEP s inter-institutional board 20 agreed on strategic priorities, which included (i) improving financial management of SOEs; (ii) consolidating the institutional framework for effective supervision of SOEs performance, investment plans, and aggregate fiscal risk; (iii) aligning SOEs budget management to the Government s fiscal program; and (iv) providing adequate human resources and training to the Monitoring Unit. In this respect, UMEP the technical advisory body under CEP was staffed by highly professional personnel, paving the way for rapid progress in During , progress was impressive on CEP/UMEP institutional strengthening, given Paraguay s context and structural constraints. In a background of limited capacity and low-paced institutional responsiveness, the ability to combine CEP s fast inter-institutional decision-making capacity with the professional and technical monitoring of UMEP created a responsive, technically-sound SOE supervisory body. The Board of CEP meets every two weeks, and its agenda is jointly prepared by CEP s executive secretary and technical inputs provided by UMEP. CEP s Board is able to make expedited executive decisions, which are implemented and monitored by UMEP s specialized staff. This process has been sequenced through the design and follow-up of CEP multi-annual strategic plan. 63. The professional quality and commitment of UMEP s managerial and technical staff have significantly contributed to the institutional strengthening of SOE oversight. 20 The board of CEP includes the Ministers of Finance, Industry and Trade, and Public Works, as well as the State Attorney. 22

31 UMEP staff members are qualified, professional and highly motivated. One or two persons are assigned to closely monitor each SOE, and have progressively developed technical knowledge, thus becoming specialists in their assigned sectors. In 2009, UMEP s staff received extensive training in topics including financial analysis, procurement, management, negotiation, strategic planning, and comparative experiences from other countries on SOE oversight. 64. This institutional strengthening was guided and supported by the adoption of UMEP s functional manual in November 2010, selected as PSDPL prior action. Initially started on an empirical basis and supported by Bank technical assistance, institutional strengthening of the framework for oversight of SOEs was implemented through the preparation of a series of strategic planning documents, and by the adoption by decree of UMEP s organizational and functional manual. This provided a clear definition of responsibilities of UMEP s management and staff, and also allowed UMEP to work with a strategic focus. 65. In addition, a draft law was submitted to Congress in December 2010 to strengthen the sustainability of CEP/UMEP; this key measure was selected as PSDPL prior action. Although the final outcome depends on the adoption by Congress, this measure is significant and supports the Government commitment to sustain SOE oversight reform. It is a major step in ensuring the continuity of the new institutional framework because the current decree, which established CEP/UMEP could be more easily reversed In addition, this measure is substantial for the following reasons: Ownership and commitment to institutional reform. The preparation of this draft law generated a very fruitful dialogue within the executive. It helped relevant actors take enhanced ownership of this reform and it increased awareness about the need to strengthen the sustainability of the institutional framework through the adoption of a new law. Gradual and consensus building law drafting. The draft law is simple and provides key definitions and scope for CEP/UMEP, while decrees and resolutions define detailed implementation. This is deliberate to ensure broader consensus and higher probability of adoption. Communication adapted to Context. As mentioned above, aspects of communication and political economy have been taken into account. The law was presented in December 2010, after disseminating information about the reform and working on building up a consensus, including through the organization of an international conference. 66. The new law is expected to provide a stronger legal backing for CEP/UMEP than current decrees. In the proposed law, the CEP will be denominated National Council of State- Owned Enterprises (CNEP). The law will substitute the 2008 decree which established CEP, and will specify CNEP s composition, role, governing principles, and interaction with other Government institutions. Like CEP, CNEP will be made up of the Ministers of Finance, Public Works, Industry, and the State Attorney. It will organize the SOE portfolio to maximize the achievement of SOEs objectives through the institutionalization of monitoring, evaluation and control mechanisms. 21 In a similar move, UMEP will be taking the title of General Directorate 21 Specifically, CNEP will be in charge of (i) providing technical and strategic policy advice to the Government regarding the SOE portfolio; (ii) advising the President of the Republic in the appointment and removal of SOE directors; (iii) reviewing SOEs planning processes to ensure achievement of results; (iv) reviewing SOEs draft budgets; (v) promoting coordination between SOEs; and (vi) recommending the direct intervention on SOE 23

32 of State-Owned Enterprises (DGEP). It will continue to provide technical support to CNEP, like UMEP with CEP now. The law is also confer on DGEP control activities that are currently carried out by UMEP such as use of the balance scorecard control panel; review of SOEs audit reports; and investment programs. 67. The strategy for submitting the draft law aims at building consensus and takes into account Paraguay Congress specifics, even though this requires a longer process. In Paraguay, this type of law requires the sequential adoption by Senate and then by Chamber of Deputies, but submission to the review of Congress Technical Commissions is not compulsory. However, the Government decided to submit the draft to four internal Senate Committees 22, before the vote of the Senate, given that recommendations of approval by Commissions contribute to a higher likelihood of enacting the draft. Favorable recommendations were received from the Commissions of Finance in May 2011, and the Commission of Economy in August Once the Senate will have adopted the draft law, the Government is planning to submit it to 3 Commissions for the Chamber of Deputies, following a similar strategy. Although this approach takes longer than a mere submission to Senate and Chamber of Deputies, it generates a transparent and more thorough dialogue between Executive and Legislative, which broadens the support for reforms and the probability of law adoption. 68. These achievements have been obtained in a comparatively short period of time, which sets the groundwork for a more ambitious medium-term strategy. This strategy is building on prior actions, which included the provision of an enhanced legal backing for the new organizational structure for CEP and UMEP, and to better define specific functions and operational responsibilities for each management sector within UMEP, also clarification of specific functions and operational responsibilities for each management sector within UMEP, i.e, the planning and implementation of SOE monitoring mechanisms; oversight of the SOE portfolio using management tools, planning, studies and regulation. This new organizational framework will solidify institutional foundations to increase financial transparency and a results-based management of SOEs, the two main goals of the Government Program. Subcomponent Transparency, Audit, and Financial Management 69. Since 2010, CEP has required SOEs to hire professional audit firms, to provide these audits to UMEP, and to publish them; the implementation of these audits has been selected as a prior action for this operation. While they had already initiated a collection of existing audits of 2008 financial statements, CEP and UMEP requested independent annual audits for SOEs in 2010; submission of financial reports to CEP and UMEP, and their subsequent publication. UMEP also established an audit follow-up mechanism including field visits, letters highlighting audit main findings and recommendations, also a warning report to the Minister of Finance, if needed, to discuss the content in the next CEP meeting. Audited financial statements of SOEs are published in the Ministry of Finance s website. 23 As of June 2011, all SOEs had already signed their respective external audit contracts for 2010 financial statements with independent audit firms according to procedures established by UMEP and management to the President in extreme situations. It will comprise the Ministers of Finance, Public Works, Industry, and the State Attorney. The CEP will exert centralized institutional responsibilities on SOE oversight, and will be allowed to issue resolutions affecting the management of SOEs, as well as submit draft decrees for presidential approval. 22 The selected Committees are: Finance, Economy, Public Works, and Legislation

33 National Public Procurement Law (No.2051/03). Four have concluded and published their audits, and the remaining four are expected to do so before the end of These measures help to increase SOEs financial management soundness, and provide a venue for civil society and the media to exert an additional oversight of SOEs. 70. Addressing the question of State payment arrears to SOEs is another key transparency and fiduciary initiative taken by the Government. By the end of 2009, four main Paraguayan SOEs, responsible for the delivery of utilities and basic goods (ESSAP, ANDE, COPACO and PETROPAR) claimed cumulated payment arrears by the Central Administration in the amount of US$110 million. 25 The Central Administration had indeed budgetary problems to ensure timely payments to SOEs for services rendered, and the Ministry of Finance considered this as a priority for the state governance of SOEs. 71. In 2010, preliminary steps were taken to set up an inter-institutional commission to validate the debt amount; those were selected as a prior actions. As a result of the SOEs claim, CEP created an inter-institutional technical commission in 2010 to calculate accurate, legitimate estimates on accrued debits and credits held between the SOEs and Central Administration. By June 2011, 99 percent of payment arrears between SOEs and Central Administration had been validated. 26 The Government is considering different options to include repayment mechanisms within the budget in order to reduce the accrued debt by 50 percent within the next two years. Although there may be a risk that this type of debt repayment mechanism could be achieved by methods such as increasing subsidies. This risk is however, considered to be unrealistic since the Government has shown strong commitment to leading this initiative, and the current efforts to increase transparency is mitigating this risk. 72. As of 2010, the Government established budget mechanisms to ensure Central Administration s timely payment to SOEs for public services, which has been selected as prior action. Under the leadership of CEP, UMEP has collected and analyzed monthly SOEs invoices to public sector entities. Resources for utility services have been budgeted on the basis of these estimates. As a result, a comparison between budgeted and out-turn data extracted by the integrated accountancy system of SIAF (SICO) indicates a clear increase in the timely payment of basic services provided by ESSAP, COPACO and ANDE by Central Administration entities. Specifically, payment of SOE-provided services jumped from 27 percent in 2008 to 87 percent by The selected prior actions of this subcomponent strongly support key outcome indicators related to SOEs financial transparency. Indicators for this subcomponent measure (i) the transparency of SOEs financial operations; (ii) the timely delivery of audit reports; (iii) SOEs recovery ratio of payment arrears; and (iv) the rate of increase of timely payment for public services by the Central Administration. There is a strong link between these 24 The improvement of timeliness and quality of audit reports is a medium-to-long term objective. Time and further institutional development of UMEP and CEP will be critical in order to sustain this process and achieve even greater SOE financial transparency and control. It is expected that audit timeliness will progressively improve due to the adoption and acceptance of practices such as annual audits of SOEs financial statements; and UMEP follow-up of those audits. 25 According to SOEs reported data, collected by the UMEP. 26 Validation requires the certified agreement between the SOE, the corresponding entity of the Central Administration, and an independent consulting firm hired to calculate outstanding payment arrears. 25

34 indicators and the prior actions of this subcomponent, all support transparency and sound financial management of SOEs. Subcomponent SOEs Results-Based Management 74. The Government Program also aimed to introduce a results-based framework, to help increase SOEs performance in service delivery. The Government s strategy included the introduction of performance management contracts and setting up a new accountability mechanism, which involved CEP and the President itself. This was enhanced by technological capabilities within UMEP to monitor indicators on SOEs performance. 75. The CEP made important progress in monitoring the performance of SOEs through the introduction of results-based management contracts, which serve as prior action for this operation. UMEP defined a standardized model of SOE performance management contract and identified a monitoring approach. CEP worked with five major SOEs representing around 80 percent of total SOE-consolidated expenditures to agree on their medium-term strategic objectives and targets. 27 The standardized three-year performance management contract signed between CEP and each SOE typically includes targets for service delivery, and financial and treasury business services. It is usually jointly prepared by technical teams from each SOE and UMEP. Contract provisions also include monthly and quarterly monitoring mechanisms, as well as the fulfillment of annual audit requirements. 76. UMEP recently established a balanced scorecard monitoring SOEs economic, financial and technical performance; this measure has been selected as prior action. UMEP developed an automated tool providing an online connection with SOEs management systems and producing a dashboard matrix of around 20 indicators for each SOE under a performance management contract. For each indicator, the dashboard provides targets and a regular progress update, potential underperformance can be flagged and SOEs performance is regularly monitored. Performance information from this dashboard system is reported to CEP and the President of Republic, and helps to improve decision-making and performance assessment processes. 77. A high-level accountability mechanism has been established to complement the monitoring of SOEs performance. A high-level meeting made up of CEP and Heads of SOEs meets quarterly to examine targets agreed in SOEs performance contracts. A status report is subsequently prepared and submitted to the President of Republic who calls a meeting of CEP and Heads of SOE to discuss their results. This framework provides a very powerful accountability mechanism for performance, and it is expected that these measures will contribute to the medium term objective of improving SOE service delivery by increasing managerial responsiveness to the Government s priorities. 78. The selected prior actions of this subcomponent strongly support the key outcome indicators related to the introduction of SOE results-based management. The indicators for this subcomponent measure (i) implementation of a set of performance indicators and their regular monitoring; and (ii) public service performance in terms of number of hours of power outage per year; water access coverage by ESSAP; percentage of user complaints to the water company ESSAP; and time required to install fixed telephone lines. The selected prior actions 27 ANDE, COPACO, ESSAP, INC, and PETROPAR had signed their performance management contracts during

35 have been instrumental in designing and monitoring these indicators: these indicators were determined by the results-based management contracts and the balanced scorecards allow for regular and effective monitoring by UMEP. Box 2: Prior Actions and Key Outcome Indicators SOEs Oversight Institutional Framework for Government Ownership of State Enterprises Prior Actions The Government has strengthened the institutional framework associated with SOE management through: (i) the submission to Congress of a law draft proposing the legal establishment of the CEP and the UMEP Completed; and (ii) the approval by CEP of the UMEP s Organizational-Operational Manual. Completed. Transparency, Audit, & Financial Management Prior Actions CEP ensures greater transparency in SOE management via implementation of annual external audits, elaborated according to CEP standards. Completed. The Government has developed a strategy to liquidate expenditure payment arrears and ensure timely payment of basic services by Central Administration entities to SOEs, which includes: (i) the creation of an Inter-institutional Technical Commission made up of the Ministry of Finance, the State Attorney General, and the SOEs. Completed; (ii) the validation of expenditure payment arrears between Central Administration and the SOEs. Completed; and (ii) the Government has established specific mechanisms to ensure timely payment of services provided by SOEs to Central Administration entities. Completed. Key Outcome Indicators SOEs financial operations are carried out in a transparent manner and are subject to scrutiny by the Government and civil society. Target: online publishing of SOEs audited financial statements. Timely delivery of SOEs audited financial statements. Target: SOEs audited financial statements are available no later than June 30 of the following year. Recovery of 20% of the past-due debt accumulated by Central Administration entities with SOEs. (Baseline 2010: 0% of the certified aggregated amount of debt was reimbursed (Gs.365 billion). Rate of timely payments reaches 80% for basic services provided to the State by SOEs (Electricity, Telecommunication, and Water). (Baseline Jan-Jun 2010: 51%) SOE s Results-Based Management Prior Actions The Government has introduced a results-based framework, aimed at increasing SOEs service delivery capacities. At least 5 SOEs, representing around 80% of consolidated SOE expenditures, have signed their respective performance management contracts, which include standardized management procedures and financial targets. Completed. UMEP has recently established a balanced scorecard that connects it directly to SOEs economic, financial and technical follow-up indicators. Completed. Key Outcome Indicators At least 5 SOEs have established targets that can be monitored on a regular basis by UMEP. The number of hours of power outage as measured by hs/year per user has dropped to 11 hours (Baseline: 2010: 11.2 hs/year per user) The coverage of ESSAP water access as measured by the percentage of households in urban areas with access to water has increased to 89.2% (Baseline January 2010: 79.4%). The percentage of user complaints to ESSAP has decreased to 18% (Baseline 2010: 19%). Installation time for fixed telephone lines has decreased to 17 days (Baseline 2010: 20 days) 79. Overall, the Government is on track to achieve the medium-term outcome indicators. First, publication and dissemination of SOEs annual audited financial statements are already in place. The Government has also successfully elaborated standard rules and procedures pursuing the contracting of independent audit firms. Second, the recent validation of Central Administration utility payment arrears, and the establishment of an inter-institutional technical commission indicates progress towards their gradual cancellation. Third, significant advances have also been made in timely payment of these services. Finally, the definition of medium-term financial and performance targets for the five major SOEs, representing almost 27

36 80 percent of total SOE-consolidated expenditures, is expected to have a medium-term impact on the efficiency and effectiveness of public service delivery. Outcome indicators on service delivery in specific sectors were chosen to further incentivize the continuation of monitoring efforts, even if targeted improvements are not large as for example in the electricity sector. Challenges Ahead and Medium Term Framework 80. For the next two years, challenges ahead are focused on consolidating achievements through enhancing sustainability and further improving audit timeliness. Continuous capacity building combined with the adoption of the law consolidating the oversight institutional framework could contribute to achieving sustainable results. Furthermore, feasible improvements could be achieved in financial transparency of SOEs. The delivery of audit reports is still experiencing significant delays, although the Government has achieved publication of audited SOEs financial statements. Delivery of audit reports could be the next target for the Government in improving transparency of SOEs management. Achieving sustained adequate payment of services to SOEs, and netting payment arrears would be important achievements, and would provide a positive conclusion to the current phase of reform of SOE oversight. 81. Over the longer term, efficient service delivery and transparency in Paraguay would benefit from strengthening the regulatory framework and the auditing profession. The Government has achieved limited progress on strengthening the regulatory framework. Given capacity constraints and the technical and political complexity of this topic, this issue could be contemplated on a medium-term perspective. Similarly, strengthening the accounting and auditing profession in Paraguay could contribute to a stronger control environment. Component II: Central Administration Internal Financial Control 82. Improving the effectiveness of Central Administration s internal financial control is a priority of the Government Public Sector Program. Given the ineffectiveness of internal control procedures and the limited institutional capacities, the Government believes that addressing these issues would help improve accountability and ensure that funds are used for their intended purposes. It believes that it would further contribute to the enhancement of the public sector s overall reliability and credibility. 83. Prevailing internal control procedures were ineffective during the first half of the 2000s. The control framework for payroll was limited by the absence of a proper payroll calculation system, and there was a high risk that payroll calculations from spending units did not reflect the actual number of days worked by civil servants. In the case of non-salary expenditures, internal control constituted a mere formality and relied exclusively on the spending units systems. This was compounded by the absence of a norm enabling implementation of the integrated system for goods and services (SIABYS) and also by a lack of integration between the different systems that made up the integrated state resources management system (SIARE) Despite reform efforts, it has been challenging to establish internal control and audit systems effectively in the public sector in Paraguay. While the 1999 Financial 28 The SIARE includes the SIAF for PFM, the SINARH for human resources, and the SIABYS. However, the latter still lacks a legal framework, indispensable for the reinforcement of the existing procurement system. 28

37 Administration Law established public sector internal control systems, internal audit institutional framework was established by decree in By their operational effectiveness remained limited. First, the institutional capacities of both the Internal Audit Office (Auditoría General del Poder Ejecutivo - AGPE) and the spending units Internal Audit Units (AIIs) were undermined by organizational limitations and a lack of well-trained personnel. Second, there was an absence of internal audit manuals and standardized norms, as well as any legally defined sanctions regime. AIIs were insufficiently staffed, and experience and skills were not always adequate. Recruitment procedures were not based on competitive processes and job requirements were not properly defined. 85. In , Paraguay Integrated Fiduciary Assessment (Report No PY) identified internal audit as a key public financial management challenge, which triggered Government and IFIs reaction. The report observed that the coverage and quality of the internal audit function was negatively affected by the absence of systems and methodology; there were issues with the frequency and the distribution of reports; and internal audit recommendations were usually ignored. As a result, the Government initiated a program focusing on the expansion of financial management information systems; the implementation of a standardized internal control framework and strengthening of the internal audit function; and the improvement of the control environment through strengthening and harmonization of the financial and administration directorates of spending units. 86. Subsequently, the Government decided to strengthen the internal audit function, with the help of the Umbral Program. Achievements made towards strengthening the internal audit function included: the adoption of a decree in late 2007 which redefined the role, organization and attributions of the AGPE; increase of AGPE s human resource capacity; and delivery of intensive training and development jointly with the Supreme Audit Institution of a Government audit manual. 87. After the 2008 presidential elections, internal control remains a priority, and a standardized internal control called MECIP framework was adopted. This framework was introduced by Decree 962/08, and aimed at sustaining the continued improvement of public institutions by strengthening internal control practices and capabilities. Using a systemic and unifying approach, MECIP introduced the basis for a permanent control structure within the country s public entities and its underlying principles. 88. These actions were critical to further strengthen the internal control framework and the internal audit function throughout the Central Administration. The USAIDsupported Umbral program provided technical assistance and intensive training to ensure adequate and gradual implementation of MECIP. In a first phase, implementation support focused on five ministries, 29 the General Comptroller s Office and the Internal Audit Office (AGPE). The second phase of the Umbral Program, initiated in 2010, extended to five other key Central Administration institutions Advances in the effectiveness of the Central Administration s internal and financial control are already very significant. AGPE has notably expanded its coverage, 29 Ministries of Agriculture, Finance, Public Works, Health, and Education. 30 The additional five institutions were the Ministry of the Interior, National Congress, Office of the Attorney General, the Supreme Court, and the National Customs Office. 29

38 increasing the institutions being audited from 70 to 100 between 2008 and At the same time, the quality of internal control has increased, as shown by the following achievements: On average, the level of implementation of Institutional Audit Units work plans increased from 74 to 77 percent between 2009 and 2010, reports are regularly issued and submitted to relevant authorities. On average, the level of implementation of Self-Improvement Plans aimed to address weaknesses detected by internal and external controls increased from 57 to 64.5 percent between 2009 and On average, the percentage of recommendations made by internal and external auditors that have been successfully addressed increased from 48 to 69.5 percent between 2009 and A comprehensive set of internal procedures (MECIP) has been implemented in the central administration, and contributed to strengthening administrative integrity and effectiveness. No penalties are applied to institutions lagging behind in the implementation of MECIP or their self-improvement plans, or if they fail to address the observations made by internal and external auditors. However, on a semi-annual basis the AGPE presents an Internal Control Report to the President of Paraguay, who, in turn, discusses it with the heads of the institutions and government entities. This practice has resulted in heightened visibility of financial management and increased accountability for compliance with internal controls. 90. Throughout 2010, the gradual implementation of MECIP made solid advances, and MECIP adoption and deepening was selected as a prior action for this operation. Around 2,000 Government civil servants from the 12 institutions that are part of the Umbral program received training and technical assistance for the implementation of MECIP. Meanwhile, MECIP implementation and development in the five original ministries has been pursued. 31 Overall, 50 training sessions and workshops were delivered to higher management staff, internal auditors, MECIP implementation teams and, as part of a train-the-trainer module, to staff from the Comptroller s Office and the AGPE. Table 8: Paraguay Internal Financial Control Achievements Internal Financial Control Main Actions Implemented Number of institutions being controlled by AGPE Percentage of institutions implementing MECIP (%) * 66% 89% Percentage of institutions in which progress made in the MECIP Implementation Plan is acceptable or better * 2% 79% Achieved Outcomes Overall percentage of implementation of annual Internal Control Work Plans at the institutional level 74% 77% Overall percentage of implementation of the Self-improvement Plans at the institutional level (%) 57% 64.5% Percentage of recommendations made by internal and external auditors that have been successfully addressed at the institutional level (%) 48% 69.5% Note I: Data marked with an asterisk indicate data from to the second semester; otherwise, it is the annual average. Source: AGPE (2011). 91. These improvements are reflected in the 2011 PEFA, showing an upward trend in Paraguay s internal control and auditing, and confirming that the achievement of the 31 Ministries of Agriculture, Finance, Public Works, Health, and Education. 30

39 outcome indicator is likely. The overall rating for PI-20 (Effectiveness of internal controls over non-personnel expenditures) and PI-21 (Effectiveness of the internal audit) is expected to be C for the ongoing 2010 PEFA assessment. 32 Significant improvements observed in the areas of internal control and internal audit have allowed for an increase in the PEFA score for these two indicators from the D+ rating obtained in the same indicators for the 2008 IFA. PI-20 score increased because internal control procedures and rules are more comprehensive, thanks to the introduction of MECIP. PI-21 score increased because of a higher coverage of a more effective internal audit function, and a higher extent of management response to internal audit findings. Table 9: Comparative PEFA Scoring 2008/2011 for Indicators 20&21 Dimension Rating 2008 PI 20: Internal Control Effectiveness of expenditure commitment controls. C C Comprehensiveness, relevance and understanding of other internal control rules/ procedures. D C Degree of compliance with rules for processing and recording transaction. C C PI 21: Internal Audit Coverage and quality of the internal audit function D C Frequency and distribution of reports C C Extent of management response to internal audit findings D C Challenges Ahead and Medium Term Framework Rating Further implementation of MECIP will require time, as well as continuous political and financial support. MECIP is expected to gradually introduce a series of activities in addition to human resources training. These will include the design of institutional and operative plans and programs, and the development of policies based on risk analysis and citizenship accountability. Further, MECIP is intended to be implemented gradually throughout the Paraguayan public sector, which is a fairly ambitious goal given the baseline status of standard internal control practices in the country. Strong political and financial support will be required to achieve this. The recent upgrading of the Office of the Executive s Internal Auditor (AGPE) to ministerial level, accompanied by a significant increase of its budget and intensive human resources training shows that there is the political will to support this matter. Box 3: Prior Actions and Key Outcome Indicators - Central Administration Internal Financial Control Prior Actions Five ministries, representing approximately 70% of Central Administration s overall budget, have established internal control committees, internal control norms, and have trained staff to implement the MECIP. Their respective internal audit units (AIIs) have an adequate number of employees Completed. Key Outcome Indicators PEFA Indicators for internal control and internal audit (PI-20 and PI-21) for 50% of the ministries are rated C, which shows: (i) A more comprehensive set of internal control rules, and (ii) A broader coverage and quality of internal audit function and a higher extent of management response to internal audit findings. (Baseline: 2008 Integrated Fiduciary Assessment rating for PI-20 and PI-21: D+) 32 The 2010 PEFA was funded and implemented by the EU with a joint quality control from EU, World Bank and IADB. The 2010 draft report has already been reviewed by the three institutions and the PEFA Secretariat. It has been submitted to the Government, and is in the process of being published. EU representatives gave their agreement to the disclosure of the 2010 PEFA rating for indicators PI20 and 21 and the text of this footnote. 31

40 Component III: Tax System 93. The Government has achieved significant progress in reforming the tax system, particularly addressing the key challenge of low tax revenue. Paraguay s tax-to-gdp ratio reached an average of 12 percent of GDP between 2004 and 2009, up from 9 percent in the 1990s. The current tax-to-gdp ratio still represents one of the lowest ratios in the region and only 51 percent of its estimated tax potential. 33 As a result, expenditures including social expenditures are lower in Paraguay than in most Latin American neighbors and public service delivery is lagging. To address low tax revenues, the Government implemented a comprehensive tax reform in 2004 aimed at simplifying and increasing the efficiency of the Paraguayan tax system. As a result the active tax payer base and revenues increased. More recently, the Government has shifted its reform effort to increasing the efficiency of its large tax payers unit. This is another important step as it allows for further increases in tax revenues in the medium term and also allows for pilot reforms which can be rolled out to other parts of the tax base. Despite achievements, challenges remain and require continued reform effort. 94. Paraguay s tax system is characterized by a number of structural challenges that limit the state s ability to raise revenues. The system relies heavily on indirect taxes and is characterized by structural and political obstacles to improve tax equity. Indirect taxes primarily the VAT, excise taxes and customs duties account for 80 percent of tax collections. The corporate income tax (IRACIS) is the only significant direct tax in Paraguay, accounting for around 16 percent of total tax collection. Indirect taxes tend to be more regressive than direct taxes. 34 Structural and political obstacles are clearly demonstrated by the light taxation of the agriculture sector and the still outstanding introduction of a personal income tax. The agricultural sector still only generates around 0.2 percent of total tax revenue despite accounting for around 20 percent of GDP, as it benefits from VAT exemptions on its agricultural products. 35 The introduction of a personal income tax has so far not passed Congress. In addition, Paraguay s tax system also suffers from a widespread culture of tax evasion associated with the informal economy. 95. Relevance and significance of changes to Paraguay s tax system have to be evaluated in the light of the country s political economy challenges. The ability to reform the tax system may be affected by overall public sector limitations, the role of Congress, and the potential resistance from interest groups. The delay in implementing personal income tax illustrates these challenges, the adoption of the draft law was postponed several times by Congress in recent years. It became effective in January 2010, but has been postponed once again by Congress until In 2004, the Government initiated a comprehensive tax reform aimed at simplifying the tax system and increasing its efficiency. As a first step the Government approved the Fiscal Adjustment Law, which consisted of ambitious reform measures to strengthen tax policy. The main objectives of the reforms were to formalize economic activity and to gradually increase the progressiveness of the Paraguayan tax system. Changes in tax policy included: the broadening of the tax base for VAT and for agricultural income tax 33 Tax potential is measured based on the country s economic, geographic, demographic, social, and institutional characteristics. IMF (2009), Diagnόstico del Sistema Impositivo Vigente en See Goñi, Lόpez, and Servén (2008), Fiscal Redistribution and Income Inequality in Latin America. 35 IMF, Report of the Technical Assistance Mission on Tax Policy, September

41 (IMAGRO) through the elimination of several loopholes and exemptions; the increase of rates and number of excises; and the introduction of two new income taxes: the personal income tax and an income tax for small corporate taxpayers. Corporate income tax rates were reduced from 30 percent to 10 percent over a two-year period, and the base for this tax was broadened. 97. Meanwhile the Government also engaged in a range of tax administration measures designed to boost tax revenues. In a first phase of the modernization of the Paraguayan tax administration, the Undersecretariat of Taxes (SET) adopted an information technology platform that supports core tax administration processes such as taxpayer register, single taxpayer account, and tax returns processing. This has been rolled out to its regional offices. In addition, services to taxpayers have improved: there is now telephone assistance and online access. As a result of these significant measures, the number of active individual taxpayers increased from 200,243 in 2005 to 408,656 in 2010; and the number of active registered corporations increased from 24,248 in 2005 to 48,998 in 2010, i.e., it has more than doubled in five years. 98. More recently, reform focus has shifted towards improving the performance of the large taxpayer unit (LTU), given this segment s importance in terms of revenue and tax compliance risk. LTU reform is critical because it may lead to significant tax revenue yields and can be used to pilot key processes that can be rolled out to other taxpayer segments and functional areas. In Paraguay, the 500 largest taxpayers contribute almost 80 percent of total tax collections and the largest 100 account for more than half of all tax collections. 36 Focusing reforms on the efficiency of the LTU is therefore indicated. Around the world LTUs have become an increasingly strategic organizational tool to initiate the reform of low-performing tax administrations. 37 The Government s focus on large tax payers shows its commitment to shift from improving basic core processes to a second generation of reforms. The reforms of the audit function of large tax payers in the LTUs can later on be rolled out to the rest of the tax base. Tax administration in Paraguay has traditionally been weak, especially with regards to audit and control functions, and recent focus on the LTU has opened an important window to effectively begin addressing this challenge. 99. Strengthening the LTU s audit capacity is a key component of this reform effort and has been selected as prior action for this operation. The Government implemented two measures in this context: in 2010 SET issued a joint resolution with the Superintendencia de Bancos allowing the audit of financial institutions, for the first time, including those classified as large taxpayers. 38 In addition, it implemented a training program for auditors of the LTU. In an environment where low capacity has constrained the Government s ability to perform its audit and control function, basic training is a significant first step The increase in tax audits performed by the LTU in represents a second significant step, and has also been selected as a prior action. The SET managed to double the number of audits on large taxpayers from 20 in 2008 to 40 in In 2010, a total of 32 audits on large taxpayers were initiated, including 2 highly specialized cases. 39 The relevance 36 Based on 2008 data. 37 W. McCarten (2004). Focusing on the Few: The Role of Large Taxpayer Units in the Revenue Strategies of Developing Countries. Mimeo. 38 Resolución General 36/ A bank and an agro-exporting firm. 33

42 of this step becomes even more apparent in the light of several years without audits due to a lack of transparency and adequately trained auditors In , the Government complemented LTU reforms with issuing taxcompliance certificates; another prior action for this operation. The measure of issuing certificates is an important reform step towards transparency and tax compliance. 40 The authorities demonstrated their commitment by issuing 122,609 certificates in 2009, and another 280,105 in Certificates can easily be requested either on-line (accessing the tax management system Marangatu) or at SET customer-service platforms. An important feature of the certificates is that taxpayers with payment arrears or delays in the submission of their tax statements are not eligible for the certificate. These certificates are mainly required as a precondition for engaging in contracts with the public sector Other recent reforms include increasing the number of VAT-withholding agents and revising tax incentives and exemptions. Other reform measures include increasing the number of VAT-withholding agents designated by the tax authority - usually exporters and other large businesses - from 98 in 2008 to 754 in This has lead to a substantial increase in tax collection. 41 Furthermore, the SET started reviewing the current system of tax incentives and exemptions, by targeting specific sectors. Most notably: (i) The General Directorate of Tax Audit reviewed 22 requests for VAT credits claimed against the agricultural income tax (IMAGRO) in 2009, amounting to Gs.58 billion; (ii) the SET included five companies under the maquila regime in the internal control process in 2010; and (iii) the SET specified procedures required for determining tax refunds, according to current legal dispositions The selected prior actions strongly support the key outcome indicators of the tax component of the reform plan, which are well on track for completion. Key outcome indicators for the tax component are that (i) the tax-to-gdp ratio remain above 14 percent; (ii) the ratio of stop-filers among large tax payers has to remain below 3 percent; and (iii) the ratio of audits of large tax payers that result in additional assessment exceeds 70 percent. 43 The improvement of capacity and execution of audit at the LTU and the issuance of tax-compliance certificates are likely to generate higher tax revenues in the medium term. The tax-to-gdp ratio is not an optimal indicator of the Government s tax effort for two reasons. First, the supported reforms will take time to translate into higher tax revenues as they are geared to improve basic core processes which take time to yield results. Second, many factors influence the tax-to-gdp ratio which does not exclusively measure the results of the supported reforms. A better indicator would be an estimate of the tax gap. However, such measure is unrealistic in the context of Paraguay with its capacity constraints. To keep track of the tax effort, therefore the tax-to-gdp ratio is the best available measure and is complemented with additional measures. The stop-filer ratio reflects the efficiency of audit and control, as the incentive to not present income tax decreases with a higher probability of detection. In addition, the rate of audits that result in additional assessment reflects the efficiency of the selection process of the audits. 40 In the years 2008 and 2009 SET published three resolutions ( Resoluciones Generales from SET 8/08, 16/09 and 23/09) introducing the requirement of tax-compliance certificates associated with the issuance of car license plates, registration of real estate, etc. 41 VAT revenues collected through withholding agents increased from Gs.97 billion in 2008 to Gs.448 billion in 2009 and Gs.707 billion in Resolución General from SET 52/ Stop-filers are tax payers that do not present tax returns when due. 34

43 Challenges Ahead and Medium Term Framework 104. Despite progress achieved over the past five years, improving the tax system remains a challenge for reform in Paraguay. A favorable trend was clearly observed over the past few years, seen in the significant increase in the number of active taxpayers; the gradual decentralization of tax services; and the upgrading of computational and management technologies. However, continued effort is needed to further improve tax administration and tax policy in the medium- to long-term. Concretely, efficiency of the LTU unit needs to improve further. Most importantly, an LTU strategy is needed for specialized training in advanced audit methods, international taxation, and particular sectors. In addition, audit selection needs to be improved to take into account risk criteria. Furthermore, pilot reforms for large tax payers have to be rolled out to medium sized tax payers. Finally, introducing a personal income tax (IRP) remains an outstanding reform effort that would potentially contribute to increased tax revenue and improved equity and transparency of the tax system. Box 4: Prior Actions and Key Outcome Indicators - Tax System Prior Actions SET has strengthened its audit capacities for large taxpayers through: (i) the issuance of a resolution by SET and the Superintendencia de Bancos to allow for the audit of financial institutions classified as large taxpayers. Completed; and (ii) the implementation of a training program for auditors from the large taxpayers unit (DGGC). Completed. SET has significantly increased the number of large taxpayers subject to tax audits (Baseline: 2008= 20) through: (i) 40 audits in 2009 Completed; (ii) 32 specialized audits of large enterprises in 2010, including two highly specialized ones. Completed. Tax Certificates. SET issued 122,609 tax-compliance certificates in 2009, and 280,105 certificates in 2010.Completed. Key Outcome indicator: Tax-to-GDP ratio is at least at 13.8%. (Baseline 2010:13.4 percent) Ratio of audits of large tax payers that result in additional assessment exceeds 70%. (Baseline 2010: 55%) A. Poverty and Social Impacts VI. OPERATION IMPLEMENTATION 105. The actions supported under the PSDPL are expected to entail indirect positive poverty and social impacts. While the operation does not directly address social sector reforms, the supported reforms on the oversight and management of SOEs and of the tax system are likely to generate indirect positive impacts. In contrast, the reforms on improving central administration internal financial control are likely to have a negligible effect on poverty reduction and social matters Improving the oversight and management of SOEs is likely to positively impact the delivery of basic services, thereby improving the living standard of the poor. SOEs in Paraguay provide basic services like water, sanitation, electricity, and are involved in the provision of commodities such as petrol and diesel fuel. Access to electricity and clean water is not universal in Paraguay. Around 98 percent of households had access to electricity in 2008, although in many cases this entailed intermittent access of a few hours per day. The number of households with clean water amounted only to 68 percent in Improved SOE oversight 44 World Bank (2010): Paraguay: Estudio de Pobreza Determinantes y Desafíos para la Reducción de la Pobreza, Washington DC. Report No PY 35

44 is likely to increase the efficiency of public service delivery and as a consequence has the potential to increase number of households with electricity and particularly clean water. In addition, higher efficiency of the state owned petrol processing SOE, PETROPAR, is likely to lower production cost and hence lead to a decrease in petrol and diesel fuel prices for end consumers. These are important cost factors for public transportation, which is extensively used by the poor. Improved use of public funds also has the potential to free up resources for the Government s pro-poor policies The Government has demonstrated its commitment to improving social inclusion and benefiting the poor with the help of SOEs. The Government has initiated concrete measures in the SOE sector e.g., the Water and Sanitation Sector Modernization Project (Loan No PY) supported by the World Bank. Another example is the Government s focus on large users in the electricity sector, where higher efficiency of SOE oversight of is expected to generate higher revenues. This will allow maintaining current tariffs for the next five years, a measure that ensures that the poor will not be negatively impacted Tax system reforms are expected to positively impact poverty reduction and social development indicators through maintaining macroeconomic stability and increasing social sector spending. In the medium term the supported tax system reforms are likely to help the Government generate higher tax revenues. This will help to maintain macroeconomic stability and free public sector resources The Government has demonstrated strong commitment to social sector development with the help of social expenditure during recent years. Additional resources generated with the help of the tax system reform are likely to contribute to social sector development given the Government s commitment to the social agenda in recent years, as part of the Government s Strategic Economic and Social Plan. In the crisis year 2009 social expenditures grew by 26 percent relative to the previous year, representing 51 percent of total expenditure or 11 percent of GDP. In 2010, social expenditures increased by further 6 percent, representing 50 percent of total expenditure, or 9.5 percent of GDP In particular, the expansion of the Government s conditional cash transfer program (CCT) Tekoporá has benefited the poor. The number of beneficiaries increased from 13,679 in 2008, to 83,106 in 2010, and as of March 2011, reached 98,653. An incidence analysis using micro-simulations carried out in the context of the World Bank s 2010 poverty assessment indicates that 80 percent of the beneficiaries of Paraguay s CCT programs would be concentrated within the poorest 15 percent of the population if the CCT s targeting instrument were perfectly implemented. No beneficiary of CCT programs would be found in the upper half of the income distribution. B. Environmental Aspects 111. The specific policies supported by the PSDPL are not expected to significantly impact the environment, forests or other natural resources. The policies are limited to monitoring the performance of SOE s and no direct investments are supported. The 45 Micro-simulations were used due to the lack of information on coverage of the CCT program in the Permanent Household Survey in World Bank (2010): Paraguay: Estudio de Pobreza Determinantes y Desafíos para la Reducción de la Pobreza, Washington DC. Report No PY 36

45 environmental licensing and management of SOE s is regulated under Paraguay s environmental institutional and policy framework as defined under Laws 1561 of 2000, 3679 of 2008 (institutional framework), and Law 294 of 1993 (on environmental assessment) among others. The institutional framework consists of the Secretariat for Environment (SEAM) and the National Environment Council which are responsible for defining environmental policy and monitoring the environment as defined by Law SEAM has limited capacity and insufficient coordination with other ministries and SOE's in regard to infrastructure projects, especially in the areas of water and electricity. These shortcomings may result in delays at planning, licensing, and construction stages which could have an impact on overall efficiency in the provision of public services. However, the Water and Sanitation Sector Modernization (P095235, Loan No PY) includes a specific sub-component to strengthen the Water Resources and the Environmental Licensing Directorates of SEAM. In addition, to the extent that improvements in the management of SOEs supported by the PSDPL are successful, Paraguay s national institutional capacity to identify and address environmental policy and regulatory issues will be strengthened. The Energy Sector Strengthening Project (P114971, Loan No PY) includes capacity strengthening for ANDE that aims to improve capacity for environmental assessment and management of potential impacts from infrastructure investments in this sector. C. Implementation, Monitoring, and Evaluation 113. The Paraguayan Government has agreed to regularly monitor progress under the PSDPL. The Bank and the Ministry of Finance agreed on the relevance of establishing effective monitoring and evaluation activities to ensure adequate follow up of PSDPL implementation. The Government is carrying out these activities using two interrelated channels. First, the Under-Secretariat of Economics and Integration (SSEI) from the Ministry of Finance is responsible for coordinating implementation and monitoring activities of this DPL. Second, the institution responsible 47 for each policy area is accountable for achieving relevant prior actions The Government and the Bank will use the following data sources to assess progress under the PSDPL program: Public sector budget monitoring and execution reports from the Ministry of Finance, including reports on revenue collection. Economic Team s quarterly monitoring reports of the implementation of the Strategic Economic and Social Plan ( ). Financial plan execution report from the Ministry of Finance. Central Bank reports and analysis of key macroeconomic variables. Reviews and analyses of laws and implementing regulations from the World Bank and other stakeholders. Government Internal audit reports. Reports by the Council for SOEs. World Bank supervision missions and reports. World Bank DPL Implementation Completion Report (to be prepared upon project closure). 47 These institutions are: CEP for the SOE Component; AGPE for the Internal Audit Component; and SET for the Tax Component. 37

46 D. Fiduciary Aspects 115. According to the IFA 48, Paraguay s public financial management (PFM) remains weak and represents a high risk. The three main PFM challenges are related to improvements in: budget process efficiency; fiscal transparency; and control effectiveness. 49 The common features underlying each of these challenges is their connection to Paraguay s political and institutional context and the difficulty in addressing their technical dimension without adopting broader governance changes The Government remains committed to addressing PFM and particularly control effectiveness issues. This commitment is most clearly evidenced in (i) the reforms recently initiated with the assistance of USAID programs Umbral I and II, and (ii) through outcomes reached through the 2009 Programmatic DPL, including prior actions agreed within the framework of PSDPL, aimed at strengthening effectiveness of public financial control The latest IMF safeguards assessment of foreign exchange control environment of the Central Bank of Paraguay was performed in October The report states that while the Central Bank has made some progress in strengthening the safeguard framework since the 2003 safeguard assessment, vulnerabilities remain in areas such as financial and program data reporting to the Fund. However, according to the assessment, the current foreign exchange control environment within the Central Bank is satisfactory. An unqualified audit opinion of the Central Bank financial statements for the year 2010 has been published. The auditors reported a deviation from the International Financial Reporting Standards (IFRS) on the Financial Statements that according to the auditors could result in material adjustments if IFRS were fully adopted. However, based on the review of the audited financial statements and previous DPL external audit report, nothing came to the attention of the Bank that would indicate that the BCP control environment into which the loan proceeds will flow is other than adequate under the proposed arrangements. Arrangements are in place to mitigate identified risks. Budget Transparency 118. The annual budget is publicly accessible through the Ministry of Finance website. In the fiscal year 2009, the Ministry of Finance also issued a quarterly report on budget execution, which was published on their website. 51 Furthermore, the audited annual financial statements are submitted to Congress and being made public subsequent to their approval. E. Disbursements and Auditing 119. The Bank would make the single loan disbursement to a dedicated account that forms part of the country's official foreign exchange reserves at the Central Bank of Paraguay. The disbursement would be made upon the Bank's assessment on satisfactory compliance of prior actions agreed and compliance with the adequacy of the Borrower s macroeconomic policy framework. Disbursement will not be linked to any specific purchases 48 Paraguay Integrated Fiduciary Assessment Report dated April 1, 2008 (Report No PY). 49 More recent analytical work on Paraguay PFM lead by the European Commission (EC) is underway and the report has not yet been issued. 50 As indicated in the Economic Context Section of this document, governance and public sector efficiency encounter broad challenges related in particular with discretionary practices, politicization and lack of transparency in the public sector as well as economic informality

47 and no procurement requirements would be needed. Once the Loan is approved by the Board of Executive Directors, the Borrower would open and maintain two dedicated deposit accounts, one in US Dollars and one in Guaraníes for the Borrower s use. The Bank will disburse the proceeds of the Loan into the foreign currency deposit account. Upon each deposit into the foreign currency account, the Borrower would deposit an equivalent amount into the local currency deposit account. If the proceeds of the Loan or any part thereof are used for ineligible purposes, as defined in the Loan Agreement, the Bank will require the Borrower to either return the amount to the deposit account for use for eligible purposes or refund the amount directly to the Bank. The deposit account in US Dollars would be maintained in the Central Bank and its transactions and balances fully incorporated into the Borrower s accounting records and financial statements, via the integrated financial management system The legal agreement will include the following clauses: (i) a clause for the provision of a written confirmation that the amount of the loan has been credited to an account that is available to finance budgeted expenditures, and (ii) an audit clause for the submission of an audit report of the Deposit Account at the request of the Bank. F. Risks and Risk Mitigation 121. There are three significant risks to the program supported by the PSDPL. These risks are Economic and Financial Risk; Political Risk; and Institutional Capacity and Reform Implementation Risk. Economic and Financial Risk 122. Despite economic growth of 15 percent in 2010, Paraguay remains highly vulnerable to regional and global economic fluctuations and to weather-related shocks. At the same time, the country is exposed to overheating pressures including inflation pressures, fast private sector credit growth, and a widening current account deficit. The economy is also exposed to exchange rate risk due to the remaining high dollarization of the financial system and a large share of foreign denominated public sector debt In terms of mitigation measures, the Government is implementing prudent fiscal management, including efforts to increase tax revenues in the medium term and improve expenditure execution; monetary policy is being tightened and macro-prudential measures are being taken to contain private sector credit growth. To this end the government engages in technical assistance with the IMF on financial regulation and supervision including in the cooperatives sector. The external debt is low and managed prudently; flexible exchange rate policy and a sufficient buffer of international reserves provide a cushion for shocks. Political Risk 124. Entering into the second half of its term, the Government s political alliance is still fragmented and does not hold a majority of seats in Congress. There is thus a risk of congressional bottlenecks when enacting new legal frameworks associated with the reform program. Although selected measures for the operation do not include the adoption of any laws, it is estimated that the political risk for this operation is high given the implications of supported reforms in the political economy There is also a political risk associated to potential resistances to reform programs, such as for instance in the case of SOEs. In the context of Paraguay s current development of 39

48 public administration and plurality of actors in the process of decision-making, the type of proposed reforms can generate some political economy challenges during the implementation. That was particularly the case of the SOE sector, where the actions to introduce SOE financial transparency generated an initial resistance by the largest SOE In terms of mitigation measures, the government is enhancing communication with regards to reform implementation. The Government is carefully planning the submission of laws to Congress to optimize information dissemination and probability of their adoption. It also usually works on building consensus around reform actions. The Presidency and the Ministry of Finance are ensuring consistency and coordination with institutions by directly implementing reform actions. Finally, gradual approaches and effective communication strategies with stakeholders of reform processes were also undertaken by the Government. Institutional Capacity and Reform Implementation 127. The sustainability risk for the PSDPL objectives is due to the limited capacity of Paraguay s public sector and its insufficient inter-institutional coordination. The prior actions for this PSDPL require an intensive path of activities. Weak human resource capacity in the public sector, as well as limited inter-institutional cooperation could put the success of hte Government s reform program at risk This risk is mitigated through a focused approach on a limited number of reform areas, realistic targets, and mobilization of existing capacities. The program is focused on a limited number of inter-related policy areas that are implemented by Government units with stronger capacities, such as for instance the UMEP for the SOE component. In addition, these areas are supported by external technical assistance: internal control reform is supported by the USAID Umbral Program, and the SOE Oversight is supported by Bank technical assistance. 40

49 ANNEXES Annex 1: Letter of Development Policy 41

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55 LETTER OF DEVELOPMENT POLICY UNOFFICIAL TRANSLATION MINISTRY OF FINANCE FISCAL TRANSPARENCY & ACCOUNTABILITY FOR DEVELOPMENT BICENTENNIAL OF NATIONAL INDEPENDENCE October 26, 2011 Asunción M.F. No Mr. ROBERT ZOELLICK, PRESIDENT, WORLD BANK WASHINGTON D.C , USA Re: Development Policy Letter Public Sector Development Policy Loan Dear Mr. Zoellick: The Government of President Fernando Lugo, that took office on August 15, 2008, is keeping its commitment with the priority and strategic objectives established three years ago, and focusing on poverty reduction, economic growth, and greater transparency in public sector management and corruption prevention. The Government s objectives stemmed from an in-depth diagnosis and analysis of the country s economic and social situation which revealed that economic growth in the last few years was not being translated into increased welfare for broad sectors of the population. Further to Paraguay successful recovery from 2009 crisis, supported by the Government s Anti-Crisis Plan approved in January 2009, there is an opportunity to focus again on mediumterm reforms, with a view to targeting key priorities for Paraguay. State Modernization is a Government top priority to enhance public sector capacity and to promote the economic and social development of the country. In particular, the Government has already allocated significant resources and expressed a firm commitment to strengthen critical areas of public sector management, such as the management of state-owned enterprises (SOEs), which represent an important proportion of public expenditure and provide basic public services; tax administration which provides resources to support government programs; and internal control and accountability which improves the efficacy and integrity of financial management of the State. 47

56 The purpose of this Letter is to present the objectives and actions relating to the Public Sector Development Policy Loan (DPL) involving support to consolidate the reforms arising from the Economic & Social Strategic Plan (presented in August 2008) and financed with the previous Loan, as well as building on prior achievements to advance in new areas of public sector management. I. Economic & Social Strategic Plan of the Government The Paraguayan Government objective is to achieve more sustainable and equitable economic growth through four strategic goals: (i) promoting growth with a focus on employment generation and improved income distribution, while preserving a sound macroeconomic framework; (ii) strengthening Government institutions to improve policy making and deliver better public services; (iii) increasing the efficiency of social expenditures, focusing on extreme poverty alleviation; and (iv) fostering economic development with broader citizen participation. These objectives are supported by eight (8) strategic pillars that address the country s economic, social, and institutional challenges in a comprehensive manner. These eight pillars are: Maintaining consistent macroeconomic policies to ensure stability and provide a predictable context for economic decision-making. Developing a sound and secure financial system providing quality services to all economic actors without exclusions. Improving SOEs through more professional, more efficient and transparent management. Modernizing the public administration in order to facilitate access of the entire population to public services. Introducing comprehensive land reform fostering the reactivation of family agriculture. Promoting infrastructure development. Strengthening competitiveness and improvement of the business and investment climate. Promoting job-generation, the fight against poverty and all forms of social exclusion. II. Objectives of the Strengthening of Public Sector Management Within the framework of the Strategic Plan, strengthening public sector is fundamental in the Paraguayan context. A more professionalized transparent and sustainable public sector, able to provide more effective services, is indeed a prerequisite to reaching inclusive development in Paraguay. One key challenge in strengthening public sector is to increase the efficiency of resource management, including restructuring government institutions, strengthening internal control effectiveness and transparency, and gradually introducing a professional and merit-based civil service system. Another critical public sector challenge is to improve the effectiveness of the public service delivery by SOEs through a more effective State oversight and improvement of their business and financial management. A third fundamental challenge for public sector reform is to improve fiscal management, including improving tax administration, strengthening debt management, enhancing fiscal discipline, and managing more efficiently and transparently public expenditure. 48

57 III. Public Sector Management Programs with the Public Sector Development Policy Loan (DPL) Below we present the areas of implementation of the US$100 million World Bank Public Sector Development Policy Loan (DPL). These areas relate to the above mentioned Public Sector Management Program. In particular, the Government of Paraguay is planning to consolidate recent advances on three major issues: SOE Oversight; Internal Financial Control of the Central Administration; and Strengthening of Tax Administration. III.1 SOE Oversight Improvement in the efficiency and transparency of SOEs and the delivery of related public services requires an effective State oversight of the SOE portfolio. This component aims at addressing the low access to and quality of services delivered by SOEs, and the need to enhance their transparency and financial management. Over the last three years, the Government has significantly advanced in establishing an institutional framework and technical capacities for a more effective monitoring of SOEs. The creation of the SOE Council (CEP, acronyms in Spanish), technically supported by SOE Monitoring Unit (UMEP, acronyms in Spanish), has strengthened the Government s decisionmaking process regarding these enterprises; increased their financial transparency; and introduced the fundamentals for a results-based management public service delivery by major SOEs. More recently, and related to this loan, the Government has continued improving SOE oversight by: (i) strengthening the institutional framework; (ii) enhancing transparency in SOE management; (iii) ensuring adequate payment of public services provided to the Central Administration, as well as liquidation of pending payment arrears; and (iv) developing a results-based management framework regarding SOE service delivery. The measures recently adopted in these four areas include: Institutional framework regarding SOE oversight. On the one hand, there is a legal strengthening of the Inter-ministerial Council of SOEs and UMEP through the Government submission of a draft Law to Congress promoting the legal sustainability of these institutions. On the other hand, the CEP has approved an operational and organizational manual for UMEP. Financial transparency. Greater financial transparency is being promoted through the publication of SOEs audited financial statements. Payment of public services by Central Administration. The Government has developed a strategy to, on the one hand, ensure timely payment of services delivered to the Government by SOEs, and on the other hand, liquidate payment arrears of basic services provided to Central Administration entities by SOEs. Measures related to this strategy include: the creation of an Inter-institutional Technical Commission composed by the Ministry of Finance, the State General Attorney, and the SOEs; the validation of payment arrears between the Central Administration and the SOEs; and the establishment of specific mechanisms by the Government to ensure timely payment of services provided by SOEs to Central Administration entities. Development of a results-based management framework for services provided by SOEs. In this regard, the Government and 5 SOEs have signed their respective performance 49

58 management contracts, which include standardized management procedures and financial targets, and are monitored by UMEP. Also, UMEP has recently established a balanced scorecard that connects it directly to economic, financial and technical follow-up indicators of SOEs. III.2 Internal Financial Control of Central Administration A continuous improvement in internal control and financial management effectiveness of the Central Administration is one of the specific goals of the Government s Public Sector Management Program, linked to the strategic objective of Modernization of the State. Such improvement is expected to have a significant impact on the accountability and use of public funds. In this regard, the Government has established the following priorities: (i) comprehensive coverage of the integrated financial information systems for all entities, as well as full integration with the financial management subsystems; (ii) strengthening of internal control through greater professionalization of the internal auditing function, and establishment of a new standardized internal control framework for the Central Administration (MECIP, acronyms in Spanish); and (iii) progressing in the professionalization of the Central Administration s Financial Administration Units (UAFs). Directly related to this loan, the Government has adopted the following measures aimed at strengthening internal control: Establishment of the internal control framework (MECIP). The Government has undertake initiatives to adopt the MECIP for the Ministries of Agriculture, Finance, Public Works, Health, and Education, and to adequately staff their Internal Auditing Units. III.3 Tax System Strengthening tax administration and tax collection capacity is another important area supported by the Government Program. Measures recently adopted include: Strengthening auditing capacities for large taxpayers. In particular, two measures have contributed to this objective: (i) the modification of the legal framework (a decree issued by both the State Under-Secretariat for Taxation and the Superintendencia de Bancos) to allow financial entities to be classified as large taxpayers and, in this way, enable their auditing under the arrangement for large taxpayers; and (ii) the implementation of training for auditors at the Directorate of the State Under-Secretariat for Taxation (SET, acronyms in Spanish). Increasing the number of audits to large taxpayers. The SET has significantly increased the number of audited large taxpayers, among other measures aimed at increasing the formalization of corporate taxpayers. Establishment of tax compliance certificates: The SET issued 122,609 tax compliance certificates in 2009 and 280,105 in

59 IV. Medium-term Objectives In the medium term, the Government has planned to keep reinforcing SOE oversight, while making additional efforts in fiscal management. Among others, the following objectives are particularly important: Working on a second phase of tax reforms. The focus will be on increasing tax efficiency of the Large Taxpayers Unit, with the possibility of introducing measures that could be rolled over to all taxpayers. Increasing public debt management efficiency. Consolidating good practices in SOEs financial transparency and management, supporting these measures with actions to improve basic service delivery, as well as to control fiscal risk and ensure SOEs sustainability. The Government will focus on improving the timely availability of financial information on state-owned enterprises and on the quality of their financial statements. Beyond these improvements in public sector management, these measures will allow the Government to consolidate its poverty reduction and infrastructure investment programs, which are fundamental in the development of Paraguay. The support of the World Bank will be essential to implement the abovementioned actions and to support the ambitious strategic objectives that the Government has set for itself. I take this opportunity to greet you with my highest consideration. DIONISIO BORDA MINISTER OF FINANCE GOVERNOR FOR PARAGUAY 51

60 Annex 2: Policy Matrix Goals Prior Actions/Targets for Board Approval DPL Program Key Outcome Indicators (End of 2012) 1. SOEs Oversight SOEs financial operations are carried out in a The Government has strengthened the institutional framework associated with SOE transparent manner and are subject to management through: (i) the submission to Congress of a law draft proposing the scrutiny by the Government and civil society. legal establishment of the CEP and the UMEP Completed; and (ii) the approval by Target: online publishing of SOEs audited CEP of the UMEP s Organizational-Operational Manual. Completed financial statements. Timely delivery of SOEs audited financial statements are available no later than June 30 CEP ensures greater transparency in SOE management via implementation of of the following year. Target: SOEs audited annual external audits, elaborated according to CEP standards. Completed. financial statements. The Government has developed a strategy to liquidate expenditure payment arrears Recovery of 20% of the past-due debt and ensure the timely payment of basic services by Central Administration entities accumulated by Central Administration to SOEs, which includes: (i) the creation of an Inter-institutional Technical entities with SOEs.(Baseline 2010: 0% of the Commission composed by the Ministry of Finance, the State Attorney General, and certified aggregated amount of debt was the SOEs. Completed; (ii) the validation of expenditure payment arrears between reimbursed (Gs 365 billion) the Central Administration and the SOEs. Completed; and (iii) the Government has Rate of timely payments reaches 80% for established specific mechanisms to ensure timely payment of services provided by basic services provided to the State by SOEs SOEs to Central Administration entities. Completed. (Electricity, Telecommunication, and Water). (Baseline Jan-Jun 2010: 51%) 1.1 Establishing Institutional Framework for Government Ownership of SOEs 1.2 Exerting Effective SOE Oversight 1.3 Introducing SOE s Results- Based Management The Government has introduced a results-based framework, aimed at increasing SOEs service delivery capacities. At least 5 SOEs, representing around 80% of consolidated SOE expenditures, have signed their respective performance management contracts, which include standardized management procedures and financial targets. Completed. UMEP has recently established a balanced scorecard that connects it directly to SOEs economic, financial and technical follow-up indicators. Completed. At least 5 SOEs have established targets that can be monitored in a regular basis by UMEP. The number of hours of power outage as measured by hs/year per user has declined to 11 hours (Baseline: 2010: 11.2 hs/year per user) The coverage of ESSAP water access as measured by the percentage of households in urban areas with access to water has increased to 89.2% (Baseline 2010: 79.4%). The percentage of user complaints to ESSAP has decreased to 18% (Baseline 2010: 19%). Fixed telephone lines installation time has decreased to 17 days (Baseline 2010: 20 days) 52

61 Goals Prior Actions/Targets for Board Approval DPL Program Key Outcome Indicators (End of 2012) 2. Central Administration Internal Financial Control & Audit PEFA Indicators for internal control and internal audit (PI-20 and PI-21) for 50% of the ministries are rated C, which shows: (i) A more Improving Central Five ministries, representing approximately 70% of Central Administration s comprehensive set of internal control rules, and Administration overall budget, have established internal control committees, internal control (ii) a broader coverage and quality of internal Internal Financial norms, and have trained staff to implement the MECIP. Their respective internal audit function and a higher extent of Control audit units (AIIs) have an adequate number of employees. Completed. management response to internal audit findings. (Baseline: 2008 Integrated Fiduciary Assessment rating for PI-20 and PI-21: D+) 3. Tax System Improving the tax system SET has strengthened its audit capacities for large taxpayers through: (i) the issuance of a resolution by SET and the Superintendencia de Bancos to allow for the audit of financial institutions classified as large taxpayers. Completed; and (ii) the implementation of a training program for auditors from the large taxpayers unit (DGGC). Completed. SET has significantly increased the number of large taxpayers subject to tax audits (Baseline: 2008= 20) through: (i) 40 audits in 2009; (ii) 32 specialized audits of large enterprises in 2010, including two highly specialized ones. Completed. Tax Certificates. SET issued 122,609 tax-compliance certificates in 2009, and 280,105 certificates in Completed. Tax-to-GDP ratio is at least at 13.8%. (Baseline 2010:13.4 percent) Ratio of audits of large tax payers that result in additional assessment exceeds 70 %. (Baseline 2010: 55%) Medium-Term Fiscal & Economic Management Reform Prospects Reform Area Tax System Debt Management SOEs Oversight Medium-Term Fiscal Management Reform Prospects Continue efforts to increase tax revenue collection improvement through tax administration strengthening. Further improve efficiency of fiscal and debt management functions. Ensure continuation and sustainability of SOE oversight reforms. Develop a consolidated contingent fiscal risk assessment. Consolidate audit practices, with a focus on transparency and timeliness. Tentatively expand good oversight practices in other potential sectors such as state-owned financial sector. 53

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67 Annex 4: Debt Sustainability Analysis 1. The debt sustainability analysis is performed on the basis of two methodological approaches. The deterministic approach presents the evolution of main determinants of public debt over time. The stochastic approach shows how the main determinants of public debt are affected by stochastic shocks. 2. A favorable medium-term macroeconomic framework would help preserve a stable path for Paraguay s public debt in The baseline for the debt sustainability analysis is conservative. Fiscal accounts are expected to deteriorate slightly in although at sustainable levels. Under these assumptions, central government gross debt is projected to decline from 20.0 percent of GDP in 2009 to 11.5 percent of GDP in The baseline scenario is based on the assumption of an average primary surplus of 0.1 percent during Fiscal prudence, economic growth and exchange rate stability are critical for continued improvement in public debt indicators. For the baseline scenario, it was found that during 2008 and 2010 exchange rate appreciation, fiscal adjustment (primary surplus) and continuing healthy growth played a significant role in reducing the debt-to-gdp ratio. Table A4. 1. Central Government Debt Sustainability (baseline scenario) Central government (% of GDP) o/w foreign currency-denominated Key assumptions Actual Projections Real GDP growth (%) Primary balance (% of GDP) Overall balance (% of GDP) Growth of real primary spending (%) Average nominal interest rate (%) Exchange rate (Gs/US$), eop Source: Central Bank of Paraguay, MEF, and World Bank staff projections. 4. Following a deterministic approach to the debt sustainability analysis, it can be found that adverse shocks could temporarily reverse the favorable debt trends observed under the baseline scenario. Various stress tests to evaluate the behavior of the central government debt ratio under different scenarios have been considered. For example, a onetime 30 percent exchange rate depreciation in This shock would cause the debt-to-gdp ratio to deteriorate rapidly to 18.4 in 2011, going back to 17.1 in 2012 and remaining volatile thereafter. 59

68 Table A4. 2 Gross Public Debt: Alternative Scenarios and Bound Tests, (in percent of GDP) Source: World Bank staff projections. 5. Stochastic simulations are then run to assess the impact of volatility and uncertainty on debt sustainability. Actual Table A4.3. Paraguay: Central Government Debt Sustainability Framework, (in percent of GDP, unless otherwise indicated) Baseline A. Alternative Scenarios A1. Key variables are at their historical averages in / A2. No policy change (constant primary balance) in B. Bound Tests Projections B1. Real interest rate is at baseline plus one standard deviations B2. Real GDP growth is at baseline minus one-half standard deviation B3. Primary balance is at baseline minus one-half standard deviation B4. Combination of B1-B3 using one-quarter standard deviation shocks B5. One time 30 percent real depreciation in / B6. 10 percent of GDP increase in other debt-creating flows in B7. Real GDP growth is at baseline minus 3% in 2012 (global slow-down scenario) Projections Central government debt 1/ o/w foreign-currency denominated Change in public sector debt Identified debt-creating flows (4+7+12) Primary deficit Revenue and grants Primary (noninterest) expenditure Automatic debt dynamics 2/ Contribution from interest rate/growth differential 3/ Of which contribution from real interest rate Of which contribution from real GDP growth Contribution from exchange rate depreciation 4/ Denominator = 1+g+p+gp Other identified debt-creating flows Privatization receipts (negative) Recognition of implicit or contingent liabilities Other (specify, e.g. bank recapitalization) Residual, including asset changes (2-3) Central government debt-to-revenue ratio 1/ Gross financing need 5/ in billions of U.S. dollars Key Macroeconomic and Fiscal Assumptions Nominal GDP (local currency) 24,737 26,466 29,105 35,666 41,522 46,169 52,270 61,512 73,622 70,705 86,808 99, , , ,346 Real GDP growth (in percent) Average nominal interest rate on public debt (in percent) 6/ Average real interest rate (nominal rate minus change in GDP deflator, in percent) Nominal appreciation (increase in US dollar value of local currency, in percent) Inflation rate (GDP deflator, in percent) Growth of real primary spending (deflated by GDP deflator, in percent) Primary deficit / Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used. 2/ Derived as [(r - p(1+g) - g + ae(1+r)]/(1+g+p+gp)) times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar). 3/ The real interest rate contribution is derived from the denominator in footnote 2/ as r - π (1+g) and the real growth contribution as -g. 4/ The exchange rate contribution is derived from the numerator in footnote 2/ as ae(1+r). 5/ Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period. 6/ Derived as nominal interest expenditure divided by previous period debt stock. 60

69 7/ The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP. 8/ The implied change in other key variables under this scenario is discussed in the text. 9/ Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator). 10/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year. Figure A.4.1: Central Government Sustainability (Altnernative Scenarios) 1/ (% of GDP) A.1: B as eline and his to ric al s c enario s A.2: Interes t rate s ho c k Baselin e A.3: G ro wth s ho c k Baselin e Histo rical G ro w th s h o c k Bas elin e Baselin e i-rate s h o c k A.4: P rim ary b alanc e s ho c k and no p o lic y c hang e s c enario N o p o lic y c hange PB s h o ck A.5: Co m b ined s ho c k 2/ A.6: Real d ep rec iatio n and c o nting ent liab ilities s ho c k 3/ Bas elin e Com bined s h o ck co n tin gen t liab ilities Baselin e 30 % d ep r 50 A.7: G ro wth s ho c k (3% in 2012) 4/ Bas elin e G ro w th s h o c k 10 Sources: Central Bank, World Bank staff estimates. 1/ Individual ndividual shocks shocks are permanent are permanent one-half one-half standard standard deviation deviation shocks. shocks. 2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance. 3/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2009, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator). 4/ One-time 3% GDP shock in 2012 (2% due global economic slowdown plus 1% due to foot and mouth disease in Paraguay) 61

70 Annex 5: Country at a Glance 62