Monetary policy can be effective in Uruguay despite the importance of dollarization in the small South American nation, the IMF has concluded. Moreover, the Fund found, a flexible exchange rate can help absorb external shocks even in a system as heavily dollarized as Uruguay’s, largely because most non-financial transactions are carried out in pesos.
These were among the issues explored by the Uruguayan authorities and IMF staff last year in one of the first consultations to reflect the IMF’s increased emphasis on financial issues. Uruguay was selected for such a consultation for several reasons.
First, the country had a recent major crisis (in 2002) that began in the financial sector and was largely caused by external factors—primarily a financial crisis in neighboring Argentina, during which Argentines withdrew a large portion of their deposits in Uruguayan banks.
Second, Uruguay is a small open economy. Little analysis has been conducted on smaller economies that are open to trade and financial relationships with the rest of the world.
Third, foreign currency plays an important role in the economy—close to 60 percent of bank lending is in U.S. dollars, for example. That so-called dollarization—reliance on a foreign currency for larger transactions and as a store of value—presents Uruguay with both vulnerabilities and policy questions.
There is a general concern about the effectiveness of monetary policy in such highly dollarized economies. In Uruguay, for example, the central bank can only issue pesos while many financial transactions take place in dollars. There are questions about how well exchange rate policy can cope with external shocks, such as import price increases, when much of the transmission of a shock is directly in dollars.
The consultation also sought to analyze how macroeconomic shocks are transmitted in a highly dollarized economy, and how they affect the soundness of the financial system, as well as ways to protect against external shocks in such an environment.
Uruguay has pursued key monetary and financial reforms since 2002. It has abandoned an exchange rate peg in favor of a float, improved financial prudential norms and banking supervision, and accumulated significant central bank reserves. Since the crisis, the dollarization of the banking system has declined, but it is still high.
In this environment, Uruguay has been modifying the way it conducts monetary policy, moving gradually from an exchange rate anchor toward an inflation-targeting regime in which the central bank’s goal is to keep overall price increases within a target range.
The consultation yielded several findings:
• There is potential for monetary policy to be effective in Uruguay, mainly through three channels—influencing inflation expectations, the exchange rate, and bank lending in pesos, which is limited but growing. Moreover, evidence indicates that good monetary policy contributes to reducing the role of the dollar: there is a clear correlation between measures of monetary credibility and the degree of dollarization. Still, dollar lending is found to be influenced by U.S. monetary policy.
• A flexible exchange rate can play a role as a “shock absorber” of external events, such as price increases, even in highly dollarized Uruguay. This is because most non-financial transactions are valued and carried out in pesos. The pass-through from exchange rates to domestic prices is not one-for-one and has declined over time. Exchange rate movements can help restore balances and deal with shocks. At the same time, instruments other than the exchange rate, such as interest rates, are likely to be more appropriate to manage monetary policy as Uruguay moves to inflation targeting.
• International reserves are close to desirable levels, even after taking into account that dollar-denominated deposits, particularly those of nonresidents, could be potential demands on reserves.
• External financial developments still play a substantial role in Uruguay. Despite improved macroeconomic fundamentals and banking system indicators, Uruguay’s fortunes are still tied to those of other emerging markets. Uruguay is now in a better position to withstand shocks, including those from the region. That said, global developments still have an important impact. Indeed, looking at international market perceptions, as revealed by country spreads, Uruguay moves more in tandem with other emerging markets now than before the crisis.
Sustaining sound policies over the medium term will be essential. Much progress has been made in reducing vulnerabilities imposed by dollarization, but medium-term vulnerabilities remain. For example, many companies that do not earn in dollars have dollar debt and are thereby exposed to the risk of sharp exchange rate movements, with ensuing risk for the financial system. Similar risks apply to the public debt-to-GDP ratio in the presence of foreign currency debt.
A clear monetary framework and continued commitment to the inflation objectives, within a flexible exchange rate regime, appear important to increase central bank credibility and reduce real costs of lowering inflation. In time, this could help reduce dollarization.
Marco Pinon and Gaston Gelos
IMF Western Hemisphere Department