Uruguay
2001 Article IV Consultation and First Review under the Stand-By Arrangement — Staff Report; Public Information Notice and News Brief on the Executive Board Discussion

After the recession, Uruguay continued to face difficult economic conditions under the Stand-By Arrangement. Executive Directors emphasized the need to promote sustainable growth with low inflation and high employment. They welcomed Uruguay's continued commitment to trade liberalization, and stressed the need for fiscal discipline, improved competitiveness, strong fiscal and monetary policies, structural reforms, and measures to strengthen the performance of public enterprises. They observed that the country's economic statistics are adequate for the assessment and monitoring of macroeconomic policies.

Abstract

After the recession, Uruguay continued to face difficult economic conditions under the Stand-By Arrangement. Executive Directors emphasized the need to promote sustainable growth with low inflation and high employment. They welcomed Uruguay's continued commitment to trade liberalization, and stressed the need for fiscal discipline, improved competitiveness, strong fiscal and monetary policies, structural reforms, and measures to strengthen the performance of public enterprises. They observed that the country's economic statistics are adequate for the assessment and monitoring of macroeconomic policies.

I. Introduction

1. A mission1 visited Montevideo during October 23—November 10, 2000 to conduct the 2001 Article IV consultation discussions and initiate the first review of the program supported by the 21-month stand-by arrangement that was approved on May 30, 2000. Discussions for the review were concluded in January 2001, The arrangement is in an amount of SDR150 million (27 percent of quota on an annual basis); the authorities are treating it as precautionary. Uruguay’s outstanding Fund credit is SDR 114 million (37 percent of quota).

2. The 1999 Article IV Consultation was concluded on July 28, 1999. On that occasion, Directors welcomed Uruguay’s quick policy response to the depreciation of the Brazilian real in January 1999, and recommended a partial relaxation of the public sector deficit objective of the program to reflect the effects of automatic stabilizers. During the discussion for approval of the current stand-by arrangement, Directors emphasized the need to accelerate structural reforms to adapt the economy to the more difficult cyclical circumstances, complete the lowering of inflation to industrial country levels, and increase economic efficiency.

3. President Batlle of the Colorado party, heading a Colorado/Blanco government, took office on March 1, 2000. The government holds a small majority in Congress. The authorities are aiming for a significant strengthening of competitiveness in the economy through medium- term fiscal consolidation, and market-oriented structural reforms. In Uruguay’s consensus based political culture, these plans will require broad support in Congress.

II. Background

The economy performed well during the 1990s. Real GDP growth averaged 3¼ percent a year, compared with population growth of ½ percent; inflation declined from nearly 140 percent in 1990 to 4 percent at end-1999; and the external current account deficit remained manageable. However, private investment was low, and the unemployment rate high at about 10 percent a year on average (Figure 1 and Table 1). For much of the 1990s, the external economic environment was benign—or the shocks, as in 1995, proved temporary—and Uruguay benefited from strong output growth in Brazil and Argentina. More recently, in 1999–2000, the regional economic situation turned adverse, with longer- lasting disturbances, whose impact on the Uruguayan economy has been felt largely on volumes (lower GDP, higher unemployment), in part because costs and structural factors have been slow to adjust in the context of Uruguay’s gradualist and consensus policies.

Figure 1.
Figure 1.

Uruguay: Selected Economic Indicators 1/

Citation: IMF Staff Country Reports 2001, 046; 10.5089/9781451839210.002.A001

Source: Ministry of Economy; Central Bank of Uruguay; and staff estimates.1/ Data for 2001 are program objectives and staff projections.
Table 1.

Uruguay: Economic and Financial Indicators

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Sources: Data provided by the Uruguayan authorities; and Fund staff estimates.

Currency plus demand and savings deposits in domestic currency.

M-2 plus foreign currency deposits of residents (valued at end-of-period exchange rate) and deposits in the Mortgage Bank.

Flows of credit in foreign currency are valued at end-of-period exchange rates.

Includes extrabudgetary operations (Fondos dc Libre Disponabilidad) from) 1998.

Public sector total revenue minus current expenditure.

Includes nonresident deposits in the banking system.

Cumulative change.

4. After a recession in 1999, Uruguay continued to face difficult economic conditions in 2000. A number of adverse external shocks plagued the economy, which the authorities quantified as having caused a loss of national income equivalent to US$800 million, or 4 percent of GDP. The problems in Argentina negatively influenced expectations, contributing to a sharp drop in domestic demand; the devaluation of the Brazilian real and of the euro depressed export earnings from these markets, while weak agricultural commodity export prices and the sharp jump in oil import prices implied a terms of trade drop of 7.5 percent (after dropping by 2.2 percent in 1999); international interest rates rose; and there were disruptions to Uruguay’s exports as a result of actions in Brazil and Argentina.2 Also, toward the end of the year, meat exports were halted following a local outbreak of foot-and-mouth disease. With these adverse developments, the expansion in output in the first quarter of 2000 was not sustained, and real GDP is estimated to have declined by at least 1 percent for the year. Together with the contraction in output in 1999 of 3¼ percent, this caused the output gap to turn negative at 3 percent of GDP by end-2000, according to staff estimates. The 12-month rate of consumer price inflation ended the year at 5.1 percent (4.2 percent in 1999), and the unemployment rate increased to 14.2 percent (11 percent at end-1999).

Uruguay: A Comparison of Shocks

Uruguay has faced substantial adverse economic shocks in 1982 (external debt/domestic banking crisis), in 1995 (Mexico crisis), and now in 1999–2000. Output declined in each episode, but the recessions were different in duration. The 1982 shock had repercussions throughout the 1980s, in the form of high inflation, and lingering debt problems. The 1995 shock was sharp but short, essentially overcome by the second half of that year. The recession of 1999–2000 has already depressed output for two years, and activity remains weak.

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The recession in 1982 was deep, with inflation and unemployment doubling in the year. The deficit increased further in 1983 at a time that foreign financing dried up and inflation was set on its way to sustained high levels. The recession of 1995 was alleviated somewhat by a positive terms of trade effect and national income continued to increase. The 1999/2000 recession is also severe, driven in part by the large terms of trade loss following the devaluation in Brazil and the sharp jump in oil prices. In just two years, national income has been cut by 11 percent in U.S. dollar terms.

5. However, the economy is showing clear signs of adjustment. Competitiveness is being addressed, labor costs are declining both in peso and U.S. dollar terms, and by end- 2000 about half of the appreciation in the real effective exchange rate of early 1999 had been reversed. Moreover, to reduce their dependence on the Mercosur, exporters made progress in diversifying their markets, especially to the NAFTA countries and to Asia, while maintaining adequate volume growth in the traditional markets (albeit at lower prices). Also, the structure of aggregate demand is changing, resulting in a contribution to growth from the foreign balance of over 3 percentage points of GDP, offering prospects for sustainable output growth.

Uruguay: Aggregate Demand

(Annual percentage changes)

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Contribution to growth.

6. With national income, and hence revenue, much weaker than expected, the authorities did not meet their fiscal objectives under the program. The consolidated public sector deficit was reduced to 3.7 percent of GDP (US$760 million), after 4.1 percent in 1999, but significantly exceeded the program target of 1.8 percent (Tables 2 and 3). However, the primary, or noninterest, deficit, was cut significantly, by 0.9 percentage points of GDP from 1999, underscoring the authorities’ adjustment effort under trying circumstances. The larger-than-programmed deficit corresponded mainly to a drop in revenue for the central and local governments; the overall government expenditure target under the program was observed.3 To finance the deficit, the government placed US$575 million in three foreign bond issues with an average spread of 290 basis points over comparable U.S. Treasury bonds,4 and met the remaining financing need with domestic funds. Virtually all structural reform benchmarks under the program were observed (with some delay on the one on public bank’s reporting to the BCU), but the publication of the state enterprises’ quarterly annotated financial reports was not observed and is now scheduled for end-March 2001.

Table 2.

Uruguay: Performance Under the 2000 Economic Program

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Sources: Data provided by the authorities; and staff calculations.

Observed with a small delay.

Rescheduled for end-March 2001.

Table 3.

Uruguay: Public Sector Operations

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Sources: Ministry of Finance; and Fund staff estimates.

Program figures were adjusted to include extra budgetary operations.

Excluding contributions that are transferred to the private pension funds.

Includes extrabudgetary revenue (Fondos de Libre Disponibilidad) from 1998.

Before interest expenditures.

Table 4.

Uruguay: Summary Accounts of the Banking System

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Sources: Central Bank of Uruguay; and Fund staff estimates.

Program figures and projections are not comparable because of some revisions in the base. However, the 2000 projections and 2001 program figures are comparable.

Gold valued at market prices.

The Bank of the Republic (BROU), the National Mortgage Bank (BHU), private banks and cooperatives.

Includes indexed deposits.

7. Private sector banks saw some erosion in their soundness indicators; those for the public banks deteriorated faster (Table 5). The profitability of private banks, which account for 60 percent of deposits and credit in the system, dropped by half, to around 6 percent on equity, and the share of loans with credit quality problems doubled to 8 percent of total loans.5 The public banks—the Bank of the Republic (BROU), and the National Mortgage Bank (BHU)—incurred a combined loss of over US$200 million (1 percent of GDP) during January-September 2000, and their problem loans increased to over 31 percent of total loans. Part of this increase is the result of a reclassification and downgrading of loans under the external independent audits that are underway for both banks. These numbers suggest a weaker position than was thought earlier, notwithstanding the large capital registered on the books of both banks (capital adequacy ratios are 20 percent for the BROU and 40 percent for the BHU). The liquidity position of both banks is adequate, and the public has confidence in them, as witnessed by the banks’ ability to capture deposits at competitive interest rates, and because the government is seen as their guarantor. Regarding the two intervened banks, several potential buyers have expressed an interest in La Caja Obrera, but the Banco de Crédito incurs losses, and needs to be restructured to secure viability.6

Table 5.

Uruguay: Banking Soundness Indicators 1/

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Source: Central Bank of Uruguay - Banking Superintendency.

Comprising private banks; Bank of the Republic and National Mortgage Bank; and two intervened banks.

September 2000 figures are annualized.

Loan classifications in the BROU and BHU have recently been revised in light of the independent audits underway for year 2000. As a result, the figures on NPL prior to 1999 are not strictly comparable with (tend to be lower than) those for 1999 and 2000. Also, public banks tend to take more time to write down unrecoverable assets, leading to a larger cumulation of the stock of these assets in the balance sheet. In (his context; it may also be noted that public banks tend to maintain about twice as much capital on their books relative to risk-adjusted assets, than private banks.

Loans with 1 rating are highest quality, 5 are lowest quality.

September 2000 figures correspond to June 2000 for these items.

Includes intervened banks.

Minimum is 8.5 percent, to increase to 10 percent by early 2001.

Minimum requirement is 4 percent.

8. Exchange rate and interest rate policies have held steady in 2000. Against the background of a highly dollarized economy, the adjustable band exchange rate regime worked well. The band is 3 percent wide and is depreciating at 7½ percent a year. On average, the peso remained in the most appreciated half of the band. The band is narrow, but the regime has not been subject to major pressures, partly because Uruguay tends to receive deposits from neighboring countries during times of regional economic uncertainty. The Central Bank lowered its call interest rate from 12 to 9½ percent in July 1999, in view of the slowing economic activity, and has maintained passive interest rate policies since then, The interbank call rate has been more volatile, because of occasional liquidity needs in a thin market, which can magnify short-term effects such as when wages are paid at the end of the month, or reflecting uncertainties, as during the election campaign at end-1999, or some contagion from the high interest rates in Argentina in late 2000 (Figure 2).

Figure 2.
Figure 2.

Uruguay: Daily Indicators

Citation: IMF Staff Country Reports 2001, 046; 10.5089/9781451839210.002.A001

Source: Central Bank of Uruguay.

9. The external current account deficit widened to 2.9 percent of GDP in 2000 (US$580 million). Merchandise exports and imports increased by around 3 percent in U.S. dollar terms (8 percent in volume for exports, unchanged for imports). Imports of oil were more than US$130 million (0.7 percent of GDP) higher than a year earlier; those of capital goods were down by US$70 million. Services have held up well, with more visitors from Argentina and Brazil contributing to a surplus in the nonfactor services balance of over US$500 million. The financial account, and net international reserves, turned out stronger than expected as Uruguay received nearly US$300 million in net inflows of nonresident deposits, and as the government placed debt abroad to help cover the wider fiscal deficit. Foreign direct investment, at US$180 million, was below 1 percent of GDP (Table 6).

Table 6.

Uruguay: Summary Balance of Payments

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Sources: Central Bank of Uruguay, and Fund staff estimates.

10. Uruguay faced competitiveness shocks with the drop in the Brazilian real, weakness in the euro, and higher energy import prices. In response, policies have been directed at lowering costs in the economy. The staff estimates that by year-end, the real effective exchange rate (based on relative consumer prices) had depreciated by 8 percentage points from the peak in February 1999 (Figure 3).7 The policy instruments have been fiscal expenditure restraint, tax relief, and wage moderation and deindexation. The government reduced some taxes for the agricultural sector, and lowered employer social security contributions to help reduce labor costs. Average wages dropped by 2 percent in real terms, and by 4 percent in U.S. dollar terms during 2000. Wages in the central government were increased once, in January 2000,8 and some employers and unions in the private sector agreed to moderate wages in favor of preserving jobs.

Figure 3.
Figure 3.

Real Exchange Rate Indicators (Jan 1986=100)

Citation: IMF Staff Country Reports 2001, 046; 10.5089/9781451839210.002.A001

Sources: IMF Information Notice System, and staff calculations.

11. The government restarted the structural reform agenda with (1) a decree containing forty measures to cut red tape in the economy and remove regulatory restrictions, including on travel services and the operation of drug stores, (2) the expansion of private concessions in water and sanitation works; (3) the creation of a regulatory agency for the electricity market; (4) the clearance for auction of two wireless telecom frequencies; and (5) the renouncing of existing contracts in fuels distribution so that this sector can be opened up to competition. The government also obtained legal authorization for (6) private sector participation in the national railway, and (7) to incorporate the Montevideo container wharf as a sociedad anónima (SA) under private sector law.9 Also, the authorities opened up access to foreign investors for cable television and other communication services that can be provided via coaxial cable.

III. Policy Discussions

12. Uruguay faces important decisions on the framework for medium-term fiscal policy and what role to assign the public sector in restructuring the economy for future growth. With 86 percent of deposits and loans dollarized, and nearly the entire public debt denominated in dollars, Uruguay has little flexibility in monetary and exchange rate policy. Nevertheless, external competitiveness needs to be strengthened, and with limited flexibility in the nominal exchange rate, this leaves fiscal and wage policies and structural reform as the main instruments of economic management. The external environment has become much less benign than it was during the 1990s, and, since end-1998, Uruguay has not had growth, inflation has crept up, and the external current account deficit is close to 3 percent of GDP. While severe negative external shocks have been at play, there remain important problems of a structural nature, including the low private investment ratio, the high rate of unemployment, and a public sector debt ratio that, in the absence of corrective measures, could reach 50 percent of GDP in the medium term.

13. The authorities have addressed some of the structural challenges in recent years. The social security reform made visible the implicit pension liabilities accruing to workers in the new private system, and the public system was put on an actuarially sounder footing. Indeed, the reform costs explain part of the recent increase in the official debt ratio.10 Also, a beginning was made at restructuring the public sector in the reform of the state; new instruments (such as mutual funds, negotiable obligations, mortgage paper, etc.) were introduced in the capital market to stimulate saving and investment; and measures were adopted to increase transparency in public sector activity and allow more private sector participation in activities hitherto reserved for public sector monopolies.

14. In other areas, however, progress has been hampered by the electoral and economic cycle or by political opposition. While fiscal policies have been, on the whole, cautious, the recessions and electoral spending have thrown the deficits off course, requiring fiscal contractions during times of weak economic activity. Also, the intensification of structural reform to mobilize the private sector in speeding up investment and job growth, has not yet fully occurred, and the role of the public sector in the economy remains large, both directly through government and state enterprises, and indirectly through public sector banks.

15. The difficult economic situation in the region calls for caution regarding the short-term outlook. Barring any further shocks, and with Argentina assumed to grow at 2½ percent, and Brazil at 4 percent in 2001, Uruguay would also emerge from the recession, with real GDP growth subdued during the first half of 2001, and around 2 percent for the year as a whole. Inflation is expected to remain close to 5 percent, with some further easing of domestic costs, offset by the full pass-through in consumer prices of the higher oil and other import costs, and some recovery of margins. The rate of unemployment is likely to hold steady until growth accelerates later in the year.

A. Fiscal and Wage Policies

16. The framework for medium-term fiscal policy is embedded in the budget for the period 2000–2005 that was just passed by Congress (Box 2). The authorities want to place fiscal policy on a path that permits a reduction in the gross debt-GDP ratio by 2003–04, mainly by controlling expenditure, while introducing structural reforms to assist the supply side of the economy. The staff supports this strategy as the debt/GDP ratio has been rising rapidly in recent years, to around 46 percent at present, and fiscal restraint is needed to halt the deterioration in the debt indicators for the medium term and preserve Uruguay’s investment credit rating.11 Also, the economy needs to adjust further to some of the external shocks, which are likely to be permanent (e.g., real depreciation in Brazil; higher oil prices; lower domestic demand growth in Mercosur). A stronger fiscal position supports saving in the economy, and wage moderation would support competitiveness, in turn boosting the prospects for exports and private investment-led growth.

17. For 2001, the discussions on fiscal policy focused on what scope there was for the operation of automatic stabilizers, while providing confidence that the medium-term path of the budget strategy would be observed. In the program approved by the Board in May 2000, the authorities had proposed an indicative fiscal deficit target for 2001 of 1¼ percent of GDP. However, given the revenue shortfall in 2000, and the sizable output gap relative to potential GDP, adhering to this objective would require large tax increases which would likely impede the resumption of growth. Consequently, the fiscal deficit objective in the program for 2001 was adjusted to 26 percent of GDP to recognize the weaker short-term cyclical position, while preserving a declining medium-term deficit path, consistent with the debt/GDP objectives shown in Box 2.

18. To limit tax increases during the recovery, a significant share of fiscal adjustment needs to come from expenditure restraint. Primary, or noninterest, expenditure is programmed to drop by 0.6 percentage points of GDP in 2001 to 31.9 percent of GDP. Social security expenditure would drop significantly as this is indexed to average wages, which dropped in real terms in 2000. Social security outlays are also falling as a result of the social security reform which is generating a smaller volume of beneficiaries. The public sector wage bill is programmed to decline slightly as a share of GDP, resulting from a general wage increase in January 2001 of 3 percent, a supplemental wage increase for teachers, university professors, and the judiciary (including this supplemental wage increase, average public sector wages will rise over 5 percent), and some attrition in the number of public sector employees. Expenditure on goods and services and capital would recover, as these bore the brunt of the expenditure restraint during 2000 (Table 3).

Uruguay: Medium Term Fiscal Strategy

The government of President Batlle has recently obtained approval from Congress, with some increases in spending, for its budget covering the period (2000–2005). The budget aims at reducing the fiscal deficit to achieve: (1) a turnaround in the public debt/GDP ratio; (2) an increase in saving and investment and (3) to support relative price changes to boost competitiveness and employment.

The figure below shows that the public debt/GDP ratio has increased markedly in recent years, reflecting high fiscal deficits during recent downturns in the economic cycle and during (he general elections.1/ The debt ratio since 1996 also reflects the cost of the social security reform, which established a private capitalized system alongside the public sector pay-as-you-go system, which led to a shift of 1 percent of GDP a year in revenue from the budget to the private pension funds. A third factor reflects the policy to strengthen the net international reserves, both in relation to trade flows, and in recognition of the increase in international capital mobility and of the high degree of deposit dollarization in the economy. As the fiscal balances were not strong enough to obtain the reserves, a part of them were obtained by placing more debt, A last factor has been the sensitivity of the debt/GDP ratio to the real exchange rate, which appreciated during the 1990s, thus masking the underlying rise in the dcbt/GDP ratio (the debt is mostly in dollars). Now that the real exchange rate is depreciating, the debt/GDP ratio is going up.

A stronger structural fiscal balance, as envisaged in the medium-term fiscal strategy, will support saving and investment in the economy. Lower deficits offer higher saving and less crowding out of the private sector. Uruguay has a low population growth rate and a high share of elderly, which limits private saving. During the 1990s, the growth performance was achieved in part by importing saving (building up external debt), and Uruguay has not yet achieved simultaneously a low rate of inflation, fast growth, and lower unemployment and debt. To do so, domestic savings need to increase, in part by cutting the structural fiscal deficit.

The authorities medium-term strategy also supports competitiveness and employment growth. The budget seeks a gradual decline in current expenditure relative to GDP. The two largest components of current expenditure are the public sector wage bill (7 percent of GDP), and social security transfers (16 percent of GDP) that are indexed to average wages in the economy. The reduction in current expenditure would permit a recovery of (public) investment and lower social security receipts (iabor taxes). Both are beneficial for competitiveness and employment.

1/Even during cyclical peaks, Uruguay has had fiscal deficits.

19. In 2001, consolidated public sector revenue is projected to increase by 0.6 percentage points of GDP to 31.9 percent. Virtually all of this increase would come from the recovery in the current surplus of the state enterprises, reversing the decline in 2000. Enterprise tariffs will be adjusted in line with average inflation in 2001. Tax increases are being kept to a minimum. A mandated increase in transfers to local governments (see below) will be financed with an increase in the gasoline tax equivalent to 0.2 percentage points of GDP. Also, the reduction in a VAT exemption for health care services (excluding basic health care) is expected to yield 0.1 percentage point of GDP; and the taxation of bank profits is being tightened up in response to a falling yield on bank profit taxes. Regarding tax reductions, the Mercosur 3 percent import tax surcharge was reduced by 0.5 percent on January 1, 2001—more slowly than the authorities would have preferred—and employer social security charges were lowered for new hires in the economy, and for all employees in the construction industry, for the period of one year. The program does not include the potential receipts from the auction of two telecom frequencies, as the timing of these receipts is uncertain, and the authorities prefer to use them for debt reduction.

20. During the budget discussions in Congress, there were pressures for increased spending, including through larger transfers to local governments under a decentralization scheme which recently came into effect. The staff noted the difficulties with decentralization schemes in other Latin American countries, and that some were now trying to move in the opposite direction. Moreover, the Uruguayan local authorities are not required to accept any offsetting expenditure responsibilities, nor are they providing adequate data on their fiscal performance to aid the central government in managing the consolidated public sector balance. In the staff’s view, the first-best approach would be to offset these expenditure increases with cuts elsewhere. Tn any event, the budget now includes 0.2 percentage points of GDP a year in new transfers to the local governments, and the authorities need to tighten the borrowing constraint of the local governments where possible, including to prevent them from borrowing against future revenue transfers.

21. Wage moderation is essential to support the fiscal objectives and help strengthen competitiveness of the economy (Box 3). Wage moderation has a multiplicative effect on the fiscal balance and on competitiveness, because social security outlays are indexed to average take-home wages in the economy. Thus wage moderation can directly lower costs, and reduce pressures on the fiscal deficit. The authorities are assisting employment through targeted reductions in social security contributions. This policy is understandable under the circumstances, but it needs to be coupled with wage moderation, because a cut in payroll taxes can increase take-home pay and boost social security outlays. As noted above, the authorities granted a moderate general wage increase in the central government in 2001, but in addition, as sought by Congress, there will also be the supplemental wage adjustment. This implies that weighted average public sector wages are expected to rise just above inflation, which is regrettable, as the efforts at wage moderation in real terms will thus fall entirely on those in the private sector, including the unemployed.

The Need for Generalized Wage Moderation

Wage rates have increased by 129 percent in U.S. dollar terms in the 1990s in Uruguay (figure below); a compounded average of 8.7 percent a year. At the same time, the investment ratio was only around 15 percent of GDP, and the stock of net capital available per worker has not risen fast. It is difficult to offset wage increases of this magnitude with productivity gains (unless it is through labor shedding), and, indeed, productivity as measured by real GDP per person employed increased by a more subdued 2.3 percent a year during the 1990s.

As the figure below also shows, the price of machinery and equipment in U.S. dollar terms has hardly changed during the 1990s, causing the relative price of machinery to drop by 55 percent during this period. When relative wages rise so markedly, there are incentives to ration labor, relative to capital, until labor productivity again reflects the higher wage/capital costs. This form of adjustment appears consistent with the facts in Uruguay. Also, when wages rise quickly, consumption becomes an important driver of growth, it draws in imports, and worsens the external current account—this too is consistent with events during the 1990s in Uruguay. Taken together, the case for wage moderation appears strong.

One way to bring wage costs in line with other prices would be to accelerate the rate of adjustment in the nominal exchange rate. but this is not a sound option for Uruguay, which is heavily dollarized and such a step could trigger large adverse balance sheet effects for households, the government, and the financial system. However, cost control and further productivity gains in the economy can lead to a significant adjustment in the real exchange rate. In macroeconomic policy terms, this could be supported with generalized wage moderation; cuts in government spending to permit a reduction in the lax burden; and through structural reform to bring in more private sector capital formation.

The required size of adjustment in relative price* is difficult to gauge, even if one had access to a general equilibrium model. for instance, the figure appears quite telling, but wages may have been depressed in 1990 and therefore the increase in dollars might be overstated. Also, Uruguay spent much more income in 1990 on foreign interest than it does today, and some of this gain in disposable income could accrue to labor. Nevertheless, in recent years, Uruguay has confronted simultaneously a current account deficit and high unemployment. This is evidence that relative dollar wages are high in the economy, and that competitiveness needs to be strengthened further to assist in resolving the burden of unemployment.

uA01fig02

Wages (W) and Capital Costs (K) in U.S. dollars 1/

Citation: IMF Staff Country Reports 2001, 046; 10.5089/9781451839210.002.A001

1/ Capital costs are proxied by the implicit deflator of machinery and equipment.

22. The Government does not anticipate major difficulties in meeting its financing plan for 2001 (Table 7). The gross borrowing needs are projected to be around US$1,400 million (7 percent of GDP), with net borrowing needs of US$530 million. The plan envisages placing (gross) US$660 million in debt abroad, and US$260 million in bonds domestically, including with the pension funds which receive an annual inflow of US$220 million in contributions. Borrowing from the World Bank and Interamerican Development Bank is projected to be US$97 million, with the remainder related to project financing for state enterprises; a small expansion in currency; and a drop of US$60 million in international reserves (to help reduce a bunching of debt falling due in 2003).

Table 7.

Uruguay: Public Sector Financing Plan for 2001

(In millions of U.S. dollars)

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Source: Ministry of Economy.

B. Money and Banking Policies

23. Monetary policy is largely subordinated to the exchange rate regime, and the authorities do not envisage any changes for 2001 in this regard. Domestic interest rates on dollar instruments, deposits and loans, are well-aligned with those in the international market. Those in the peso market are less well aligned (but spreads are narrowing), reflecting some segmentation, higher costs, and the small size of the peso market. Regarding the monetary aggregates, currency in circulation is projected to rise with nominal GDP, while the BCU’s net international reserves are programmed to remain virtually unchanged from their level at end-2000. The projections envisage that broad money will increase by 8–10 percent. This will permit bank credit to the private sector to increase by around 6 percent in real terms.

24. The authorities are pursuing several efforts to strengthen the banking system. The BCU has bolstered banking supervision with a permanent presence in the BROU and the BHU; is implementing the phased-in increase in minimum capitalization requirements from 8 percent (in 1998) to 10 percent (by early 2001); is publishing on the BCU web page the banking supervision bulletin, including individual profit and loss statements and balance sheets of the public banks; and is analyzing the results of the independent external audits in the BROU and BHU, which have already yielded important suggestions for strengthening these banks (Box 4). The public banks are reducing their operating costs, including through a reduction from 95 to 75 percent in the indexation of wages in the recently signed collective bargaining contract. Meanwhile, the BHU is now extending new mortgages only in U.S. dollars, to limit the losses from currency mismatches on its balance sheet (mortgages are indexed to wages while deposits are in U.S. dollars).12 These steps are welcome, and are being strengthened with additional measures. Specifically, the public banks are focusing on three issues: (1) strict adherence to credit manuals and procedures and the elimination of political interference in this process; (2) upon finishing the external audits, a reckoning of the nonperforming loan portfolio through the collection of collateral, where this exists, together with a one-off write-down against capital of truly unrecoverable assets (“sinceramiento”); and (3) the identification and publication of the quasi-fiscal activities now imposed on the banks, so that these can be discussed in Congress and shifted to the appropriate fiscal authorities.13 The authorities have requested a Financial Sector Assessment Program (FSAP) from the Fund and the World Bank, prior to the next Article IV consultation, to help them identify additional steps.

Preliminary Findings from the Independent External Audits for the Bank of the Republic (BROU) and the National Mortgage Bank (BHU)

As part of the Fund program and the Financial Sector Adjustment Loan from the World Bank, the BROU and the BHU are receiving independent external audits of their operations and balance sheets. The audits are not finished, but preliminary reports on the analysis of the respective loan portfolios already suggest some important Findings:

--the management of the BROU is not in a position to form a coherent real-time view of the financial state of the bank as different parts of the computer system are unable to communicate;

--credit manuals and procedures have not always been adhered to;

--there are some accounting weaknesses in the bank; and

--the loan portfolio has a larger-than-expected incidence of nonperformance, with about half of private sector credits incurring some form of arrears, while local governments also sometimes incur costly payment delays.

Management of the bank has begun a process, with outside technical assistance, to reform the bank’s information system; to restructure the bank to recognize those activities of a purely commercial nature versus those governed by development, or public policy, objectives; to identify quasi-fiscal activities in the bank; to reinforce the adherence to credit manuals and procedures; to recognize the larger amount of nonperforming assets in official statistics; and to harden budget constraints for clients of the bank, including through charging interest to the Treasury for its overdrafts in the BROU, something that had not been common practice.

The challenges for the BHU are also considerable:

--there is a currency mismatch on the books of the bank. Nearly all liabilities are denominated in U.S. dollars, whereas the bulk of mortgages on the asset side are denominated in Adjustable Units (UR), an index of average wages in the economy (designed to protect families against valuation changes relative to their earning capacity). During the 1990s, when wages in dollar terms were rising, the value of the UR appreciated in real terms and the bank recorded substantial valuation gains in its capital. However, the value of mortgages also rose above the underlying value of the real estate, nearly all traded in U.S. dollars, and mortgage holders had an incentive to fall into arrears. This behavior was rewarded at end-1998 when the Congress imposed a law to reschedule overdue mortgage loans at favorable terms and the bank lost US$175 million as a result. Moreover, now that the real exchange rate is depreciating and wages are lagging in U.S. dollar terms, the bank is incurring valuation losses on its portfolio.

--the bank is not only the dominant saving and loan institution in Uruguay, but also has responsibilities to stimulate the construction market and is the largest (speculative) developer in the country. The rules and regulations in place do not permit a distinction between the two main type of activities of the bank and cloud accounting and accountability;

-the bank does not have updated assessments of its properties in the country, nor on the real estate underlying its outstanding stock of mortgage loans; and

-the spreads the bank is achieving from its deposit and lending activities are small, in part because of usury legislation and in view of its mandate to encourage home-ownership in Uruguay.

In response to these findings, the BHU has stopped providing mortgages in URs and now only extends new mortgages in U.S. dollars. The bank is also considering with the BCU and the auditors what regulations can be adopted to reflect the dual nature of its mandate as a mortgage institution and a real estate developer. It is investigating mechanisms to re-asses the many thousands of pieces of real estate and real-estate bans on its books, a task that will take time. Also, management is becoming more open about the undesirability of unilateral political action to pardon arrears on payments to the BHU.

25. The Central Bank is also adopting measures to guard the financial system against money laundering. The authorities stressed that the integrity of Uruguay’s banking activity is paramount in view of the country’s role as a regional deposit taking system. The BCU has created an internal working group with access to confidential bank records, and the power to inform the courts about suspicious transactions. Moreover, in October 2000, the BCU issued two circulars, turning previously recommended banking procedures into obligatory banking procedures (record keeping, proper identification of depositors, soliciting and verifying information about the origin of funds, personnel training to detect illicit activities, etc.). In addition, banks are now also required to extend these procedures to their branches abroad; to establish regular internal auditing on issues pertaining to money laundering (with semi-annual reports to the external auditors); and to appoint a Compliance Officer (from senior management) responsible for all activities in this area.

C. External Policies

26. The government intends to reduce gradually the pace of adjustment in the exchange rate band in the medium term but, for the time being, it will continue adjusting the band at 7½ percent a year. Some observers in Uruguay argued that the pace needed to be slowed already in 2001, because they viewed the adjustment in the band as the guide for pricing behavior in the whole economy. While it is true that tradable goods prices closely follow those in world markets, adjusted for the devaluation in the exchange rate band, the absence of wage pressures (there is no formal indexation either to prices or the exchange rate), and the weakness in domestic demand, are likely to hold back domestic costs and the prices of nontradables in the economy—thus inducing a moderation in average prices in the economy. This should offer room to maintain the current pace of adjustment of the band and support the recovery of competitiveness.

27. The external current account deficit is expected to narrow to around 2.5 percent of GDP in 2001. With the resumption of output growth in the region and the lowering of domestic costs, merchandise exports are expected to rebound by 7-9 percent in dollar terms, while imports would increase by 4–6 percent. Based on WEO projections and local forecasts, the terms of trade are expected to be mildly favorable for Uruguay in 2001. The surplus in the financial account is expected to drop slightly, in part as some of the US$3 00-400 million in nonresident deposits that flowed in, in 2000, mainly during the recent uncertainties in the region, are likely to flow out again in 2001. Net foreign direct investment is expected to remain in the range of US$ 180–200 million (1 percent of GDP) until there is more significant progress in structural reform. Net portfolio inflows could increase to US$460 million, reflecting larger foreign bond placements by the government

28. The risks to Uruguay’s short-term external financing position are related to regional developments. Capital flows are dominated by government bond placements, and variations in private deposits. If confidence in the region does not recover, and/or the budget deficit in Uruguay is not reduced, the public sector would need to continue tapping domestic saving, crowding out the private sector and limiting output growth. However, if the budget deficit is reduced as planned, the deficit can be covered by external borrowing, and lending to the private sector could grow substantially. The largest risk would be associated with another regional shock, because this could hinder the recovery again, and begin to limit Uruguay’s hitherto favorable access to the international capital markets.

29. Uruguay’s trade policy reflects its membership in the Mercosur. There are no quantitative restrictions on trade of any kind, but there is a special regime for automobiles, and sugar, in Mercosur, and there are occasional significant trade disruptions of varying duration. As Uruguay has been negatively affected by these disruptions, the authorities favor setting up a formal dispute resolution body within Mercosur. Uruguay has been a persistent, but so far unsuccessful, voice for tariff reduction and trade liberalization in Mercosur. The average common external tariff is 13.5 percent, including the remaining 2.5 percent import surcharge. The common external tariff for the Mercosur automobile regime is 35 percent for passenger cars, the highest permitted under WTO rules, with certain transition features for Uruguay through 2006. The sugar regime was liberalized in Uruguay at end-2000, including with the elimination of minimum export prices. In general, Uruguay has a liberal trading system, and its membership in Mercosur has worsened somewhat the degree of free trade, as reflected in the slippage from 1 to 2 in the Fund’s index of aggregate trade restrictiveness. At the same time, however, these calculations do not reflect Uruguay’s prohibition of trade in areas reserved for public sector monopolies, a feature that the staff strongly recommends be liberalized soon, and which the authorities have undertaken in their program to remove by 2001.

D. Structural Reforms

30. Structural reforms offer some of the most promising opportunities for productivity enhancement, competitiveness gains, and higher output growth. Uruguay’s investment ratio of around 14–15 percent is low, and the inflow of FDI is meager. This is partly related to allowing the large public sector enterprises to operate in reserved monopolistic markets, or, conversely, by restricting the emergence of scale economies in private companies (for example, there are restrictions on large retail companies, to protect small shop owners).14 To bring out the full potential for investment and develop Uruguay’s competitive advantage requires strong economic and legal institutions with minimal distortion, appropriate regulation, and room for the private sector to “crowd in” and develop such activities. The thrust of this government’s structural reform policy intention is to shift from direct public sector involvement in the economy, toward emphasizing the appropriate regulatory framework, reducing monopolies, and promoting a freer play of market forces.

31. For 2001, the authorities will pursue deregulation and demonopolization of the main public sector enterprises. Specifically, they intend to revoke the state monopoly, and open up to competition (1) the importation, distribution, and sale of asphalt and its by- products; and (2) the importation, distribution, and sale of natural gas. They will also (3) remove the monopoly status of the State Insurance Bank (BSE) on insurance needs of public sector entities; (4) permit competition in the telecommunications sector for international long distance service, cellular telephony15, and all telecommunications services offered through new technology (but excluding domestic fixed-line service which remain