Monthly Overview / July 2019
In this month’s issue:
- Country Risk: Pakistan, Turkey, EU-Mercosur, China, Papua New Guinea
- Country Risk Updates: OECD premium categories, Paraguay
- Corporate News: S&P rating
Implementing the new IMF programme to get out of the crisis will be challenging
The IMF has approved a 39-month financial package worth USD 6 bn. It allows for an immediate first loan disbursement of around USD 1 bn. This comes in addition to a broad financing support provided in the previous months by Pakistan’s partners, namely Saudi Arabia and the United Arab Emirates (USD 5 bn) and China (USD 2.2 bn). Among the main targets, the programme foresees an ambitious fiscal consolidation together with heightened social spending, a more flexible exchange rate and an energy sector reform.
It had been expected for months and eventually could no longer be avoided. Six years after the previous one, Pakistan has been granted an IMF bailout – the 13th in 30 years. IMF conditions are tough and highlight how bad the economic and financial situations have become. Main economic indicators are even worse than in 2013 with large internal and external imbalances. The twin deficit is wide (the current account deficit amounted to 6.3% of GDP and the fiscal deficit to 6.4% of GDP in FY 2017/18), external debt has rapidly increased between 2013 and 2018 (from 116.7% to 180% of current account receipts), particularly external public debt to China – 25% of the total – whereas foreign exchange reserves have halved in the past two years. External loans from Pakistan’s allies and Pakistani rupee depreciations (equal to a loss of a third of its value against the US dollar over the past 12 months) have bought time but not stopped the negative trend in liquidity. Extra loans from Pakistan’s allies, the financing granted by the IMF and other multilaterals (e.g. ADB, World Bank) and an international bond issuance scheduled in the 4th quarter of 2019 should allow meeting external financing needs in the one-year outlook.
Still, the economic outlook is very challenging as economic hardness will continue in the short term before improving. As a result of the government austerity plan, GDP growth is expected to fall to a 10-year low at 2.4% in FY 2019/20 before gradually rising to higher levels (potentially 5% in the MLT). PM Khan’s budget 2019/20 complies with IMF targets and plans to raise extremely weak government revenues through a range of fiscal measures including a sharp increase in income tax. Controversial big hikes in utility prices have also been decided. As a result and also taking into account Pakistani rupee depreciation and higher oil prices, inflation pressures have increased to reach the double-digit area. Hence, the State Bank of Pakistan will maintain its monetary tightening after it has announced an extra hike of 100 basis points in its interest rate to 13.25% (from 6.50% one year ago). This environment is expected to continue in the second half-year of 2019 given the wide current account deficit and weak economic context.
Looking ahead, based on Pakistan’s previous IMF programmes, the biggest challenge will be to implement in full very unpopular austerity measures. At the moment, the government shows commitment to the IMF programme. However, fast-increasing living costs and popular anger about a perceived submission to foreign policies will certainly trigger large popular and anti-government protests in the upcoming weeks and months. This being said, the need to tackle the economic crisis and crucial army support should allow PM Khan to stay firm on his commitments in the near term. This will be essential to ensure external debt sustainability.
Further issues could complicate the government task in the one-year outlook. Pakistan is facing the risk of being put on the intergovernmental Financial Action Task Force’s (FTAF) blacklist for failing to sufficiently crack down money laundering and terrorism financing. Nonetheless, given the negative impact it could have on capital inflows and thus IMF financing, the IMF package, some recent anti-terrorist measures taken by Pakistan (e.g. the arrest of the group’s mastermind responsible for the 2008 Mumbai attacks) but also its involvement in current peace talks in Afghanistan are likely to put the country on the grey list. Another problem is the recent World Bank arbitration tribunal’s ruling urging Pakistan to pay indemnities of around USD 6 bn to the Tethyan Copper Company (a Canadian-Chilean joint venture) about a disputed mining lease in the Balochistan province. The Tethyan Copper Company and the Pakistan government have announced that they will negotiate an acceptable settlement. A third risk is the high risk of political violence as highlighted by Credendo’s classification 6/7. First domestically, with the rising IS threat in the restive Balochistan province which could undermine some major BRI-related infrastructure projects. Then externally, strained relations with India have persisted since February in Kashmir where possible violent unrest could revive the risk of tit-for-tat strikes.
Low liquidity and reliance on external funding remain Turkey’s Achilles heel
The gross foreign exchange reserves of Turkey are under continuous pressure even if they have increased compared to their low level recorded in September 2018 (cf. graph 1). In relative terms, they cover more than 3 months of imports, an adequate level on paper. The sharp import contraction in Q3 2018 partly explained this relatively favourable level as well as the current account surplus registered in Q3 and Q4 2018 after years in deficit (exports increased, but to a lesser extent). In Q1 2019, the current account balance moved back into deficit. Still, liquidity remains weak, as highlighted by Credendo’s short-term political risk classification in category 4/7. Other factors explaining this classification are the very high short-term external debt (at USD 120.6 bn in April 2019, according to the central bank of Turkey) and the fact that Turkey still has access to the international capital market (albeit at higher prices than before August 2018).
Foreign investors’ confidence is important
In this context, it is very important for Turkey to continue to attract enough capital inflows in order to avoid being in the same situation as in August 2018, when the lira depreciated sharply and gross foreign exchange reserves were under severe pressure. Domestic policies as well as global financial conditions – influenced among other things by the US monetary policy, evolution of trade tensions and geopolitical risks – are shaping foreign investors’ risk perception.
Regarding policies – that are under Turkey’s control –, some recent developments might trigger a spike in foreign investors’ risk aversion. Following the recent dismissal of the central bank governor by a presidential decree, it remains to be seen whether his successor will be able to gain the market confidence and pursue an independent monetary policy. Drilling in Northern Cyprus – a country recognised by Turkey but not by the EU – is also likely to alienate support from the EU. On the positive side, the EU response has been measured so far. Indeed, the EU suspended the envisaged EU-Turkey comprehensive air transport agreement, reduced the pre-accession assistance to Turkey for 2020 and asked the EIB to review its lending activity in Turkey. Last but not least, the delivery of surface-to-air missile system from Russia – that started on 12 July – led the US to suspend the delivery of F-35 jets to the NATO member and might be punished by US sanctions. The adoption of comprehensive sanctions by the US could have a devastating impact on investors’ confidence and thus lead to renewed pressure on the exchange rate and gross foreign exchange reserves.
Historic EU-Mercosur agreement to have large impact on both trading blocs…if ratified
On 28 June, the EU and Mercosur (an economic trade bloc comprising Argentina, Brazil, Paraguay and Uruguay) announced that they reached a huge trade deal. The agreement aims at cutting or removing trade tariffs as well as giving EU companies access to public tenders in the South American trade bloc. The deal even fully liberalises over 90% of trade between the two trade blocs over a 10-year transition period. Hence, duties on European goods exported to the Mercosur bloc should be cut by EUR 4 billion each year. Indeed, in terms of tariff reduction, it is the largest deal the EU ever struck. Moreover, it is the first trade deal outside the region for Mercosur since its launch in 1991. That being said, the agreement still needs to be ratified by both parties, requiring approval by national legislatures in the EU and South America.
The trade agreement is expected to have a significant impact. For Mercosur, the deal will help diversify its export markets away from China. Approval of the deal will likely boost real GDP growth in both blocs over the long term. However, the impact is likely to vary between sectors. Some sectors will benefit from the agreement through higher exports, while other sectors are likely to face stronger competition as the removed imports duties will no longer protect them.
The biggest winner of the agreement is expected to be the South American agribusiness sector (notably beef, poultry and sugar). Regarding beef, the agreement is not expected to lead to a significant increase in South American production. Indeed, Mercosur will only be allowed to export an extra 99,000 tons of beef to Europe at a reduced tariff of 7.5%. In comparison, the current regime allows 200,000 tons to be exported to the EU (of which 45,000 at a tariff of 40-45%), while Mercosur produced around 14,100,000 tons in 2018 and exported about 3,400,000 tons. The duty-free quota increase under the Mercosur-EU agreement therefore represents an increase of approximately 3% in overall Mercosur bloc exports. However, the impact will be felt by European producers. The increase in imports is equivalent to 27% of the 2018 EU beef imports and 1.2% of the European consumption. Regarding poultry exports to the EU, the additional 180,000 tons of duty-free exports are small when compared to Mercosur’s domestic production, but they account for 5% of Mercosur’s exports worldwide. Moreover, from a European point of view, this is equivalent to 25% of imports and 1.5% of domestic poultry consumption. Finally, regarding sugar, the agreement distinguished between countries. Brazil – the biggest sugar producer in the world – will not be given a more generous quota. Paraguay – the 57th largest sugar producer – will be allowed to export 10,000 tonnes of duty-free sugar to Europe (which is 7% of their domestic production and 12% of their exports). In general, the quota on sugar is insignificant for the European market (0.1% of the production and 0.7% of imports).
There are winners but also losers. The Brazilian steel industry is very sceptical with respect to the new agreement due to fears that EU steel products, made with cheap components from Europe, flow into the market. Moreover, Brazilian production costs are about 10% higher than foreign-steel production costs, the Brazilian market is almost oversupplied and has a low capacity utilisation. Hence, we can expect the sector to face serious difficulties and to possibly consolidate. The other sector that could be hit hard is the Mercosur’s long-protected automotive sector. In the case of the withdrawal of the tariffs on imports of cars (35%) and spare parts (14-18%), cars made in Europe would be much more competitive than locally produced cars. Argentina will be hit the most as its car industry’s lack of productivity is generally known.
The negotiations for the Mercosur-EU deal were one of the world’s longest-running trade negotiations as it took 20 years to conclude them. Nevertheless, the end is not in sight yet. The ratification of the agreement is likely to be a lengthy process, which might take years. Within Mercosur, the biggest potential challenge to the deal’s approval is Argentina. President Mauricio Macri will stand for re-election in October. He is facing a competitive challenge from the protectionist party headed by Alberto Fernández and former President Cristina Fernández de Kirchner. If they win the elections it is unlikely that the agreement will be ratified in Argentina. Within Europe, the new EU Parliament as well as opposition from farmers (mainly in France, Poland and Ireland) and environment concerns are also a source of uncertainty.
To conclude, if the free trade agreement gets signed, it will expand the importance of the agribusiness sector in South America through more diversified and stable export markets. The other side of the coin for the Mercosur bloc is the impending confrontation between European and the less competitive South American industrial goods (automotive, machinery and equipment). The key to the survival of these sectors will be improved competitiveness. If not, the sector is likely to gradually consolidate by the end of the 10-year transition period.
African swine fever: game changer in the global agribusiness sector
The African swine fever (ASF) is a disease originating in Africa that affects domestic and wild pigs. Although the disease does not harm humans (even when they consume contaminated meat), it is fatal for pigs, as it is highly contagious and quickly causes death. Since it entered China in August 2018, it has been ravaging the local pork industry, which counts 440 million pigs and is worth USD 128 billion. China is simply the biggest market for pork in the world (accounting for about 50% of the global pork production, consumption and livestock) and any disruption there can significantly impact the global pork industry and its related sectors. In 2019, the pig herd is expected to decrease by 20% compared to 2018 because of the deaths due to the disease but also due to mass slaughters.
Impact on the agribusiness sector
The first consequence concerns the pork price itself. To contain the spread of the disease, the Chinese government has taken a series of measures, the most important of which being the mass slaughter of contaminated pigs (or pigs suspected to be infected), with a financial compensation for the breeders of the slaughtered animals. At first, this measure had a depressive effect on pork prices in China. In fact, the breeders preferred to slaughter their pigs themselves and sell them as soon as possible rather than to inform the authorities of a (suspected) contamination, since they were not sure of receiving (sufficient) compensation. The pork market in China was therefore in surplus very quickly. However, given the scale of the contamination, markets are expecting a pork deficit in China later this year, which would finally have a positive impact on prices, both in China and abroad. Thus, between the beginning of March 2019, when the price of pork in China was the lowest, and 26 June, the price of pork increased by 22%, while pork futures in the US increased by 32% (see graph 1). The larger increase in the US is explained by the fact that markets expect Chinese demand for pork from abroad to increase sharply in the coming years (the Chinese imports of pork between August 2018 and June 2019 increased by 113%). This price increase pushes up the food price inflation in China.
The second consequence is that farmers do not rebuild their pork stocks out of fear of another contamination that would worsen their financial losses, despite the various support measures of the Chinese government. Given that these investments are necessary to return to pre-ASF pork production levels – which would take a few years – the sector is reducing its production capacity for the years to come. This will have three effects. The first one is that, in the medium term, the pork sector in China will consolidate and industrialise, allowing the emergence of new players that will act on a larger scale, be healthier and more competitive, and with better margins. The second one is that the Chinese production of pork should decrease proportionately more than the consumption, creating a shortfall filled by imports. The third one is that the Chinese should also redirect their choice of meat to alternatives such as chicken or beef, which should increase Chinese imports for these meats.
The third consequence is that the balance of the international market has changed. Thus, global pork production is expected to decrease by 4% in 2019 compared to 2018 (pulled down by China which should reduce its production by 10% in 2019, see graph 2), while, over the same period, global exports are expected to increase by 8% and China is expected to remain the largest importer of pork (with 25% of total imports), with a sharp increase of 41% in 2019, despite a fall in domestic consumption (graph 2). These imports are expected to come from Brazil, the world’s fourth largest producer after China, the European Union and the US (see graph 3). The latter should not take advantage of the increase in Chinese demand because of the trade war with China, which put tariffs on imports of pork from the US. Finally, these changes will not only be visible in the pork sector, but also in other meat types, such as chicken or beef, which are substitutes of pork.
Last but not least, the price implications for raw materials used as feed for pigs are also significant. The decline in pork production, both in China and worldwide, is already having an impact on the soybean price on international markets. Indeed, to supply its pork industry with feed, China imports an impressive amount of soybean – nearly 60% of global imports are Chinese. Therefore, a decline in the pork production in China means a downward pressure on soybean prices. The price of Chinese soybeans dropped by 12% between mid-August 2018 and the end of June, and by 20% between its peak in October 2018 and the end of June (graph 4). Brazil is impacted too. It is China’s largest soybean supplier (providing 75% of its imports) and soybean exports to China decreased by 31% in May 2019 compared to May 2018. The price of Brazilian soybeans was also impacted with a decrease of 9% between mid-August 2018 and the end of June. These declines in price and demand impact the companies carrying out feed operations that supply the pork industry of China. Corn prices should also be under pressure but, for different reasons (climates, planting, etc.), the limited supply of corn allows the price not to feel the impact of the ASF. Even a trade deal between China and the US could not balance the price given the significant fall in demand.
To conclude, the ASF is a real game changer in the agribusiness sector. While it only affects one kind of animal, an entire economic ecosystem is turned upside down. The situation could even worsen. And even if the disease were to disappear from China, it could come back at any moment, especially since other Southeast Asian countries have been affected (Vietnam, Hong Kong, Laos, Mongolia, etc.). Given the sharp drop in prices and sales, the competition will be all the harder between the different players in the sector. The survival of some companies is in jeopardy and the sector is expected to consolidate. All that while the year of the pig has barely begun…
Papua New Guinea
New PM committed to a more redistributive pro foreign-investment policy
In early June, PM O’Neill stepped down before facing an expected vote of no confidence in Parliament. In power since 2011, he was replaced by former Finance Minister James Marape.
O’Neill’s resignation highlights the country’s persisting political volatility. Though he won the 2012 and 2017 elections, his position had often been under threat due to corruption or mismanagement accusations which resulted into shifting support from within his government coalition. Marape’s appointment could allow a return to political stability until the next elections scheduled in 2022 as he even has the support from the opposition. While he is investor-friendly like O’Neill, Marape made it clear that his government policy will aim to get a more balanced share of commodity revenues in favour of the state, landowners and population. Weak redistribution of commodity revenues is indeed a recurrent source of social instability.
The change of PM has occurred at a time of a gradually rebounding economy (the IMF expects a 3.8% growth this year). Last year, a severe earthquake brought the economy to a standstill as annual real GDP didn’t grow. Also, the resource-dependent economy is suffering from weaker commodity prices in a context of slowing global demand. Still, medium- to long-term growth prospects could become more positive as several mining projects are in the pipeline and production of LNG (the first source of foreign currency receipts) promises stronger earnings after the government reached an agreement with oil majors last April on a second significant LNG project. All those projects will raise future government and export revenues.
Main downside risks to the outlook are related to commodity price evolution and the completion of commodity projects. PM Marape’s intention to review resource laws and upcoming projects could lead to delays in LNG projects and further harm investor confidence in addition to high corruption, heavy bureaucracy and erratic legal protection. Foreign exchange rationing has long been an issue as the authorities intervene to stabilise the kina and the country faces capital outflows from resource-related private-debt repayments. Nevertheless, the foreign currency backlog for importers has been considerably curtailed over the past year and is expected to further improve in the coming months. Beside the overall difficult business environment, Papua New Guinea’s external debt is elevated and exposed to tighter financing conditions and a strong USD. However, a potential easing of the US monetary policy as from this year, Papua New Guinea’s successful first-ever issuance of a USD 500 m sovereign bond in September 2018, and the downward trend in external private debt – as private loans are being repaid by resource receipts – could mitigate external debt stress in the next 12 months. Therefore, in the current circumstances, the change of PM is unlikely to have an impact on Credendo’s political risk ratings in the very short term.
OECD premium categories
Vietnam upgraded, Namibia and Zambia downgraded
In accordance with the country risk classifications of the OECD Arrangement, Credendo has upgraded Vietnam’s premium category for political risks on medium- to long-term export transactions from category 5/7 to 4/7 (on a scale from 1 to 7, where 7 represents the highest risk and premium category). However, Namibia’s premium category has been downgraded from category 4/7 to 5/7 and Zambia’s from category 6/7 to 7/7.
The acceptance policy remains unchanged.
Overview of changes in premium categories
Upgrade of medium-/long-term political risk classification from 5/7 to 4/7
A history of war due to its location
Paraguay is a small landlocked country, sandwiched between two regional superpowers: Argentina and Brazil. To no one’s surprise, both countries compete for influence in Paraguay. In the 19th century tensions led to a bitter and disastrous war, and between 1864 and 1870 the Triple Alliance (which comprises Argentina, Brazil and Uruguay) enacted one of the bloodiest wars in Latin American history against Paraguay. In the end, Paraguay lost 140,000 km2 of territory, and according to some records up to 90% of its male population. Another war with another neighbouring country erupted in the 1930s: this time Bolivia was attempting to control the arid Chaco region. Since then, Paraguay has been focusing on economic integration with its neighbouring countries. An important example is its membership of Mercosur, a South American trade bloc with Argentina, Brazil, Paraguay and Uruguay as full members. Furthermore, Paraguay has built hydroelectric dams together with Brazil and Argentina on its Paraná River, which has helped the country to foster good relations in the region. Therefore, the risk of interstate war nowadays is low.
There is political stability, but re-election ambitions could trigger unrest
The ruling Colorado Party (Partido Colorado, PC) has a strong grip on political power. The party has ruled Paraguay for most of the last 71 years, including 34 years under the dictatorship of General Alfredo Stroessner. Its reign was only interrupted recently by a five-year interregnum (between 2008 and 2013) when a leftist coalition of opposition parties won the elections, before then-President Fernando Lugo was impeached and ousted from power in 2012 in what neighbouring countries denounced as a coup.
The current President – Mario Abdo Benítez – is part of the PC and assumed office last year. Benítez has committed to maintaining the pro-business policy and cautious macroeconomic policies and combatting the high level of corruption. The government is relatively stable, but Benítez faces four important challenges that render policy-making difficult. Firstly, the government does not enjoy a legislative majority. Hence, it needs to co-operate with opposition groups to pass reforms. Secondly, Benítez does not have unconditional support within his party. The ruling party is divided following the wish of former President Cartes (2013-2018) to pursue constitutional changes that would permit re-election, which has been prohibited since the end of the Stroessner dictatorship (1954 -1989). Not unsurprisingly, the attempt of Cartes in 2017 to pursue constitutional changes led to violent protests, which only ended when Cartes stated he would no longer seek re-election. However, Cartes retains his ambition to seek re-election in 2023 and new attempts to change the constitution could trigger potentially violent protests. Furthermore, Cartes also has considerable political influence, so given that Benítez is against re-election, the rivalry between Cartes and Benítez is mounting, which in turn increases the likelihood of the PC fracturing further. Thirdly, land distribution is a serious issue in Paraguay. Less than 3% of the population controls 85% of the land, illustrating the fact that Paraguay is one of the most unequal countries in terms of land distribution in Latin America. Conflict and protests over land ownership flare up regularly, hence political stability is likely to be tested although it is unlikely to be derailed by the issue. Lastly, the government is also likely to be faced with terrorism from the guerrilla movement the Paraguayan People’s Army, a small organisation which is carrying out attacks in the north of the country. However, the peril is too small to threaten government survival.
The fastest-growing country in the region
Paraguay has been one of the fastest-growing countries in the region in the past decade. With an average annual real GDP growth rate of 4.5% versus 1.75% for Latin America, the country has clearly outperformed its neighbours. The strong performance is related to several factors. Firstly, strong real GDP growth is the result of a bounce-back from a severe banking crisis in the late 1990s. Secondly, the country has enacted good macroeconomic policies, which were enabled by several IMF programmes between 2003 and 2008. Thirdly, the country could be driven by a boom in agricultural commodity prices – it has been able to more than double its sowing areas compared to 15 years ago. The robust real GDP growth of about 4% in the past four years is especially remarkable given that two of its biggest trading partners, Brazil and Argentina, have been suffering from major recessions. As shown in Graph 1, Brazil suffered a recession in 2015 and 2016, while Argentina recorded negative growth in 2014 and 2018. This year a healthy real GDP growth of 3.5% is expected in Paraguay, down from 3.7% in 2018 as drought is likely to affect the soybean harvest. In the coming years, robust real GDP growth is expected to be around 4%, although external shocks, particularly severe droughts, low agriculture prices and negative developments in neighbouring countries could wreak havoc on growth rates.
The external balance is vulnerable to droughts, Brazil and Chinese pig culling
From an external perspective, in the past 15 years Paraguay has mainly recorded current account surpluses. Only in 4 out of 15 years was a rather small current account deficit noted, although the current account balance will slip into negative territory this year with a minor deficit of 0.8% of GDP. This is due to reduced soy exports following a drought in the country. As of 2020, the current account balance is expected to increase to around 0.5% of GDP, reflecting the expected rebound in soybean production and a likely modest regional recovery.
Analysing the current account balance in more detail (see Graph 2), we can see that almost 50% of current account receipts come from food. In this category, soy is the main export product, accounting for almost a third of export revenues. Worldwide, Paraguay is in fact the world’s fourth largest soybean exporter. Hence it shouldn’t come as a surprise that soy largely explains the movement of the current account balance. The second largest source of current account revenues is hydroelectricity, accounting for almost a fifth of current account receipts. Paraguay operates two binational hydroelectric dams. The Itaipu dam, the largest hydroelectric plant in the world, is operated with Brazil, and can compete with China’s Three Gorges dam in terms of annual production. Yacyretá, the second largest hydroelectric facility in the country, is operated with Argentina. As Paraguay produces more electricity than it can consume, it sells its overcapacity to its neighbouring countries.
The current account balance is vulnerable to weather shocks, because the agricultural sector and hydroelectricity are both vulnerable to droughts. Furthermore, a negative shock to commodity prices would also affect the current account balance dramatically. Although Paraguay and China have no diplomatic relations, soybeans flow through to China through re-exports from Uruguay and Argentina, and therefore Paraguay is also vulnerable to negative developments in China, the largest importer of soy bean globally. It is, however, worth noting that China is likely to lower its demand for the crop in the coming months, firstly because a widespread outbreak of African swine flu in the country has led to large-scale pig culling, and soybean is an important part of their diet, and secondly because Chinese economic growth could slow down more quickly than expected due to the intensification of the trade war with the USA. On the other hand, a potential trade deal between the USA and China is not without risks. As the USA is the largest exporter of soybean to China, agriculture is likely to play an important role in a potential trade deal between the two countries.
Slow Brazilian growth could also have a negative impact on the current account balance. Export destinations have diversified over time, but Brazil still accounts for roughly a third of Paraguay’s export products. Furthermore, potential changes in the current preferential treatment for Paraguayan exports from the Brazilian government could also negatively impact the current account balance.
Is Paraguay the China of South America?
The country is trying to diversify away from its agricultural and hydroelectricity sectors, and hopes to become a low-cost manufacturing hub in the region, as China is for the world. It has low wages, cheap electricity and the second lowest taxation level in the Americas. Moreover, it has a history of macroeconomic stability, and thus the country is attractive for Brazilian businesses relocating plants, especially in the maquiladora sector, and is significant in relation to Brazil’s car industry. The sector has been growing rapidly in recent years, with average annual export growth of over 20%. However, the share is still small as it accounts for only 4% of export revenues. According to the IMF, it will take consistent expansion at the current rate over the next 15 to 30 years for the sector to rival the traditional export sectors in terms of their economic significance. To become more attractive, the country needs to eradicate its high corruption levels (Paraguay is ranked 132 out of 180 countries on the Corruption Perceptions Index 2018), and the somewhat weak institutions remain a serious concern for investors. Lastly, policies that focus on improving transport infrastructure could also be helpful. According to the IMF, total infrastructure investment needs are USD 1 billion to USD 3 billion per year (3% to 8% of GDP).
Sound public finances but dependent on energy revenues
Paraguay has sound public finances. The country kept a conservative and countercyclical fiscal policy during the commodity price boom, and thus it was able to avoid the boom-bust cycle that most of its neighbouring countries experienced. In the coming years a small fiscal deficit is expected, close to the ceiling of 1.5% of GDP under the Fiscal Responsibility Law. The country has enshrined the limits of government spending and fiscal deficit into law, which lowers the risk of future fiscal unsustainability significantly. A prudent fiscal policy in past years has reduced the consolidated public-sector debt from 52.6% of GDP in 2003 to 21.6% of GDP at the end of 2018, which is a low level and in fact the lowest level in South America. Looking ahead, public debt is expected to remain relatively stable and low, at roughly 22% of GDP. However, public debt issued in foreign currency has increased considerably since 2012, and at the end of 2018, 81% of public-sector debt was external debt denominated in foreign currency. As such, the country has increased its vulnerability to exchange rate shocks. The high infrastructure need also represents a risk for the evolution of public debt.
The government relies significantly on hydroelectricity revenues. The Itaipu and Yacyretá hydroelectric plants account for roughly 15% of government income, and thus a weather shock will also negatively affect public finances. However, more fiscal revenue could become available as of 2023, when the binational loan for building the binational hydroelectric plant is paid off – Paraguay borrowed heavily from Brazil to build the binational plant. Under the 1973 Treaty, both countries agreed to pay equal amounts for the construction, while each country owns half of the energy produced. Paraguay uses less than half of Itaipu’s electricity production that it is entitled to, but since sales to third countries are banned, it exports the remainder to Brazil at production cost (which is lower than the regional price). Paraguay also needs to service the debt of the Itaipu dam to Brazil. So in essence, it pays off the debt through electricity exports. Currently, two thirds of the revenue from the dam pays off the debt for its original construction. In the coming years, the renegotiation of the 50-year Itaipu Treaty with Brazil is likely to be tough because Brazil will demand a lower sale price of hydroelectricity to both countries, whereas Paraguay already enjoys the lowest electricity tariffs in Mercosur and wants to maintain the existing prices. The ability to sell to third countries is likely to be another of Paraguay’s demands, which Brazil is opposed to. It remains to be seen how the negotiations between the two countries will play out.
External debt levels on the decline despite the high risk appetite of the financial markets
External debt declined from a very high 284% of GDP in 2003 to a moderate 39.4% at the end of 2018. The reduction in external debt was the result of the amortisation of the debt from the binational hydroelectric plant. Going forward, external debt is expected to continue to fall, in line with the reduction of the binational hydroelectric loan. When the loan is paid off in 2023, it is expected that external debt will have declined to less than 30% of GDP. Short-term external debt has also decreased in relative terms since 2003 – when it stood at an extremely high level – to a stable but still elevated level. External debt service has been moderate; however, external debt and external debt service may increase again depending on the government’s appetite to tap the financial markets. On the one hand, the government has an incentive to borrow on the financial markets as it sees large infrastructure gaps, but on the other hand, investors’ risk appetite towards Paraguay has been large, despite relatively higher global risk aversion, thanks to Paraguay’s low government debt.
A healthier banking sector but with a high dollarisation
The health of the banking sector has been restored after the banking crisis in the late 1990s. According to the IMF, the banking sector is well capitalised, liquid and profitable. Nevertheless, as in many countries in Latin America, the Paraguayan financial system is relatively highly aligned with the US dollar. Foreign-exchange-denominated liabilities accounted for 48.1% of total liabilities at the end of 2018, and along with the floating exchange-rate regime, a huge depreciation of the Paraguayan guaraní vis-à-vis the US dollar could impact banks and borrowers’ balance sheets. That being said, the Central Bank of Paraguay is attempting to smoothen out exchange-rate volatility through the use of foreign exchange reserves (which stood at roughly seven months of import cover in April 2019, a comfortable buffer). Lastly, weather-related shocks could also affect the sector due to the bank’s relatively high lending to the agricultural sector.
Upgrade from 5/7 to 4/7 for medium-/long-term political risk
On the back of favourable developments, Credendo has decided to upgrade the medium-/long-term political risk classification from 5/7 to 4/7. Primarily, the country has displayed robust economic growth despite serious external headwinds in recent years, and the vast improvement in external debt has improved the country’s solvency. In addition, public finances are sound, with small fiscal deficits and reduced and low public debt. Lastly, the country enjoys relative political stability and there is a stable outlook. However, reliance on soybean and Brazil, the re-election ambitions of former President Cartes and droughts are still the main risk drivers in the medium term.
Credendo – Export Credit Agency’s ‘AA/A-1+’ ratings affirmed by S&P Global
On 19 July, Standard & Poor’s (S&P Global) affirmed Credendo – Export Credit Agency’s ratings. Both the ‘AA’ long-term issuer credit rating and the ‘A-1+’ short-term issuer credit rating are maintained. The outlook remains stable.
If you want to read the full report, you can download it here.
Copyright © 2019 Credendo , All rights reserved.