Fitch Upgrades Paraguay's IDRs to 'BB'; Outlook Stable

Fitch Ratings has taken the following rating actions on Paraguay:

--Long-term foreign and local currency Issuer Default Ratings (IDRs) upgraded to 'BB' from 'BB-';

--Senior unsecured foreign and local currency bonds upgraded to 'BB' from 'BB-';

--Country Ceiling upgraded to 'BB+' from 'BB';

--Short-term foreign currency IDR affirmed at 'B'.

The Rating Outlook is Stable.

KEY RATING DRIVERS

The resilience of Paraguay's external accounts and economic growth has increased, underpinned by export diversification and productivity enhancements in the primary sector, which accounts for 25% of GDP. The country's export receipts are generated by three industries that are relatively uncorrelated and less exposed to the current downturn in global commodity prices: soy, beef and electricity. Fitch expects the sovereign to remain a net external creditor and international reserves to cover over five months of current external payments in 2015-2016, providing a cushion against adverse terms-of-trade shocks.

Paraguay's five-year average growth of 7% exceeded the 'BB' median of 4% in 2014. Higher growth has facilitated the convergence of the country's per capita income with the 'BB' median. Fitch forecasts that economic activity will keep pace at 4.5% in 2015-2016, driven by the dynamism of construction, infrastructure, private consumption and a rising maquila industry. Despite the recent fall in soybean export prices, the agriculture sector maintains high profitability margins, low leverage and adequate capitalization. These factors mitigate the potential for negative spillovers to the rest of the economy and the financial system.

Monetary authorities have been able to maintain moderate inflation rates despite the challenges imposed by low financial intermediation, high dollarisation and underdeveloped local capital markets. The central bank has met its inflation target since the adoption of the regime in 2011, and expectations point to consumer price increases in line with the new official reference mid-point of 4.5% in 2015-2016. International reserves accumulation and greater currency flexibility have enhanced the capacity of the exchange rate to serve as a shock absorber.

Fitch projects that Paraguay's debt burden will approach 23% of GDP by 2016 but remain well below the 'BB' median of 40% even after factoring in a moderate deterioration in fiscal accounts. Fitch expects the central government deficit to widen to 2.4% of GDP in 2014-2015, after recording average surpluses of 1% in 2004-2011. In addition, the revenue base is expected to increase gradually in the coming years with the gradual introduction of personal income and agriculture taxes. The sovereign's demonstrated capacity to access international bond markets and multilateral funding at favorable conditions support fiscal financing flexibility.

However, Fitch notes that implementation of the new fiscal responsibility law has already proved challenging, weakening its role as an institutional anchor for fiscal policy. The first budget (2015) approved by congress after the law calls for a central government deficit of 3.5% of GDP, above the legal limit of 1.5%. Real wage adjustments awarded to teachers and doctors and increased transfers to sub-national governments in an electoral year make it difficult to abide by the primary current spending growth ceiling of 4% above inflation. The authorities seem willing to accept deviations from the legal deficit threshold if they are derived from public investment projects with secure external financing.

The banking sector has strengthened since the 2003 crisis and presently maintains adequate levels of capitalization, liquidity and credit quality. Credit is largely concentrated in the export-oriented agriculture and livestock industries, two sectors with solid collateral and without currency mismatches. Nonetheless, rapid lending growth, rising household indebtedness and high dollarization of credit could become sources of vulnerability for financial institutions.

Paraguay's ratings balance a long track record of fiscal prudence through different economic and political cycles and strong fiscal solvency indicators against high output volatility due to weather-related shocks, a low tax revenue base and comparatively weak structural factors in terms of investment rates, GDP per capita, institutional quality and social development indicators.

RATING SENSITIVITIES

The Stable Outlook reflects Fitch's assessment that upside and downside risks to the rating are currently balanced. The main factors that individually, or collectively, could trigger a rating action are:

Positive:

--Higher growth trajectory in the context of macroeconomic and financial stability. Improvements in the business environment and the execution of public infrastructure projects that lead to higher investment rates will be positive;

--Strengthening of the economy's external liquidity position in line with the peer median;

--Structural improvements in public finances in terms of revenue base, expenditure rigidity and a continued moderate debt burden.

Negative:

--Commodity production shocks or severe export price falls that materially impair external and fiscal solvency ratios;

--Sustained fiscal deterioration in the context of financing constraints.

KEY ASSUMPTIONS

The ratings and Outlooks are sensitive to a number of assumptions:

--Fitch assumes weak economic growth in Brazil and a recession in Argentina in 2015. A sharper than expected deterioration in economic conditions could affect Paraguay's economic and export performance given the important trade links with these countries.

--Fitch's economic growth and external forecasts assume continued softening of international soybean prices in 2015-2016, after the 20% correction observed in 2013-2014. The shift towards agriculture exports of higher value-added and higher beef production could partially offset the decline in soy prices.

--Fitch assumes that Paraguay will maintain access to external sources of financing.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'Sovereign Rating Criteria' (August 2014);

--'Country Ceilings' (August 2014).

Applicable Criteria and Related Research:

Sovereign Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=754428

Country Ceilings

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=752194

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=978806

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