SIGNIFICANCE: By creating a precedent, the agreement would have greatly strengthened Paraguay's hand in its long-standing dispute with Brazil over the terms of the Itaipu Treaty.

ANALYSIS: In 1973, Paraguay signed treaties for joint construction and ownership of two major hydroelectric projects -- 12,600 megawatt (MW) Itaipu, with Brazil, and 3,100 MW Yacyreta, with Argentina. The unequal terms of the two agreements have since become a source of growing friction between Paraguay and its neighbours. The cost of both projects has soared and the bi-national hydro companies -- Entidad Binacional Yacyreta (EBY) and Itaipu Binacional (IB) -- have been saddled with excessive borrowing costs imposed by the Argentine treasury and Brazilian electricity company Eletrobras. Paraguay's complaints include the following:

* Despite the legal obligation for 'alternating directorships', Brazilian and Argentine officials have maintained control of both companies

* Financial transparency is lacking, and the Paraguayan national audit office does not review the accounts of either company.

* Paraguay is prohibited from selling its surplus energy to countries other than Brazil and Argentina (see PARAGUAY: Moves to modernise energy sector - August 13, 2004).

* Paraguayan energy sales to both countries are far below world market prices, generating benefits to Brazil and Argentina estimated at 3 billion dollars annually for Itaipu and 600 million dollars for Yacyreta.

1. Yacyreta. Although construction of Yacyreta began in 1981, all twelve turbines came on stream only in 1998. However, it produces at only 55% of capacity owing to Argentina's failure to raise the dam wall from 76 metres above sea level to the optimal level of 83 metres. EBY's officially reported debt is now 11 billion dollars, although Paraguay argues that the debt is inflated by accumulated unpaid interest payments resulting from:

* the decision of the Argentine government to postpone infrastructure work needed for completion; and

* the subsidised sale price of its energy to the Argentine grid.

The government of Paraguayan President Nicanor Duarte Frutos is the first officially to demand improved benefits from Itaipu and Yacyreta, although falling short of calls for full renegotiation. Until recently these diplomatic efforts fell on deaf ears. However, the Paraguayan bargaining position has been strengthened by the changed geopolitical situation in the region, including:

* Bolivia's successful move to raise the price of gas exports to Argentina and Brazil;

* the International Court of Justice's recent decision not to block construction of two paper mills in Uruguay, as requested by Argentina (see ARGENTINA/URUGUAY: Pulp plants pose pollution problem - February 7, 2006); and

* increasing pressure from both Paraguay and Uruguay over imbalances within Mercosur, which has led to warnings that both may sign bilateral free-trade accords with third countries.

Observers were thus expecting an Argentine concession to keep Paraguay within the Mercosur fold. Yet Argentine President Nestor Kirchner's visit to Asuncion on July 18-19 did not produce the widely expected agreement to write off half of the debt owed by EBY to the Argentine treasury. This was a severe embarrassment to Duarte, who had publicly announced the agreement hours before Kirchner's arrival. Instead, at Kirchner's insistence, a technical commission will be set up to study the problems of EBY and report within 90 days, a move that, he said, would help to obtain the necessary approval by the Argentine Congress.

2. Itaipu. An agreement on Yacyreta would have greatly strengthened Paraguay's position in seeking similar concessions by Brazil with regard to IB; some observers have even suggested that Kirchner's decision not to sign the agreement was the result of last-minute lobbying by Brasilia. In April 1986, in response to the Brazilian economic crisis, the IB board agreed to reduce the sale price of energy to the Brazilian grid from 14.75 dollars per kilowatt month to 10.00 dollars. Overnight this created what Paraguayan critics refer to as a "spurious debt" accumulated by IB as the Brazilian electricity sector benefited from a decade of subsidised energy imports thereafter.

In a secret debt rescheduling in March 1997, the 16.2 billion dollar debt arising from this subsidy was assumed by both countries, although the subsidy had overwhelmingly benefited Brazil, which purchases 95% of IB's energy. The rescheduling involved a calendar of repayments up to 2023 for which IB pays a 7.5% interest rate on debt owed to Eletrobras plus an adjustment for US inflation. Under this controversial system of 'double indexation', the outstanding debt has risen since 1997 -- reaching 19.1 billion dollars by mid-2006.

As recently as December 2005, Duarte had agreed to an annual increase in compensation payments for use of Paraguay's water from 30 million to 51 million dollars in exchange for accepting the continued application of the 'double indexation' system. However, days before the July 20-21 Mercosur summit, Paraguay threatened to take the issue to the International Court of Justice if negotiations with Brazil fail. Despite the rebuff days earlier from Kirchner, Duarte held a two-hour meeting at the summit with Brazilian President Luiz Inacio Lula da Silva at which he again pressed for an end to double indexation. As in the case of Argentina, the two governments agreed to set up a commission to study the matter and report swiftly.

Corruption crackdown. However, Brazil has a strong bargaining counter. With effect from August 15, the Brazilian tax authorities will introduce a strict computer-based control over the up to 30,000 people who daily cross into Paraguay, from where they are allowed to import duty-free goods up to a maximum of 300 dollars per year. The new measures are widely expected to put an end to the petty smuggling that has been the mainstay of the local economy for decades. Business leaders from the Paraguayan city of Ciudad del Este are lobbying Duarte to ensure that the economic future of the city is not sacrificed as a result. In mid-July a planned visit to Paraguay by Brazilian Foreign Minister Celso Amorim was cancelled after Brazil refused Paraguayan demands that the meeting should discuss the economic restructuring of Ciudad del Este as well as renegotiation of the Itaipu Treaty.

Renegotiation options. Critics of Duarte's efforts to reduce the debt of IB and EBY argue that the agreements are so unfavourable to Paraguay's national interest that complete renegotiation is needed. Two fundamental aspects of such a renegotiation would be:

* to allow Paraguay to sell its surplus energy to third countries; and

* a radical increase in the level of royalties and compensation payments that Paraguay receives, which totalled 294 million dollars for IB and 62 million for EBY in 2005.

A debt write-off deal over EBY would also have strengthened the hand of President Hugo Chavez of Venezuela, who acted as an intermediary between Kirchner and Duarte and reportedly encouraged Kirchner to make financial concessions to Paraguay. Chavez agreed a 100 million dollar soft loan to Paraguay and said that Venezuelan state oil company PDVSA would undertake oil exploration in the Paraguayan Chaco.

CONCLUSION: Paraguay will probably extract some concessions from Brazil and Argentina as they strive to maintain Mercosur unity. However, the resulting revenue increase is unlikely to be spent on urgently needed physical infrastructure and poverty reduction programmes, but rather on strengthening the patronage networks of the ruling Colorado Party to ensure its candidate's election in 2008.