At the outset, on behalf of the Uruguayan authorities we would like to thank staff and management for the continued and thorough support that Uruguay has received from the Fund during very challenging times. This support and our authorities’ ownership of the program have allowed the country to overcome a severe banking crisis and undertake some important reforms and policy adjustments. As a result of these cooperative efforts, financial market conditions have stabilized since the last Board review, completed in August 2002, with the sole exception of an episode in early February, when doubts about the continuation of the program led to renewed pressures on the local banking system and, in general, towards the depreciation of Uruguayan assets. Those pressures have been overcome and the situation albeit fragile, is back to normal.

The exchange rate has remained stable and the effective depreciation has been much lower than initial projections under the program. Treasury bill yields in local currency have declined from around 150 percent in August 2002 to around 55 percent these days, mirroring a substantial reduction in expectations of inflation and peso depreciation. The country risk spreads have remained stubbornly high, but after having risen to a peak of around 3.000 basis points in July 2002 have declined to around 2000 basis points. Dollar-denominated deposits in local private as well as public banks were flowing back to the system until the end of January of this year when, for a few days, the financial system experienced a new episode of deposit outflows that could be attributed, in part, to anxiety caused by the long negotiations towards reaching an agreement with the Fund.

The effect of the crisis on domestic demand and economic activity has been strong, but has bottomed-up and it is beginning to be reversed. The economy has faced a strong adjustment in private consumption, which is estimated to have fallen by 15 percent in 2002 reflecting not only the very deep reduction in income, but also a sharp wealth effect associated to the banking crisis and the depreciation of the peso. It is possible, however, that the wealth effect would end-up being more limited than current perceptions to the extent that the authorities’ efforts to address the crisis result in fewer losses to depositors than anticipated. Investment has been reduced sharply as a result of a massive credit crunch, large out-put gap and the prevailing uncertainties, and government expenditure has been sharply reduced as part of the adjustment program.

Despite the improved competitiveness resulting from the floating of the peso and the substantial fiscal adjustment, export growth and the recovery of economic activity have been limited by the credit crunch and by the even larger depreciation of currencies of main trading partners in the region. In that vein, the normalization of banking conditions and the gradual intensification of financial intermediation in pesos along with better access to credit by exporters should accelerate the recovery. In addition, the normalization of conditions in the region and the gradual correction of the over-shooting in other currencies should also help to consolidate export growth.

Exports are already showing signs of improvements, and in December 2002, for the first time in the year, the value of exports exceeded that of the same month in 2001. It is expected that this trend will be reinforced to the extent the program implementation progresses, helping to dissipate the uncertainties thus softening credit conditions. In addition, significant progress in the diversification of external markets is taking place. While at the end of 1999 -almost a year after the devaluation of the Real that substantially affected Uruguayan exports to Brazil—the share of exports to the Mercosur was 45 percent of total, Mercosur share in total Uruguayan exports was only 32 percent in 2002. In the same period, the share of exports directed to the European market increased by 6 percentage points, that to the Asian markets by 4 percentage points and to the NAFTA by 2 percentage points. This diversification of exports reflects more than a reduced regional market but the result of efforts to explore and penetrate other market. So far, the increase of exports to Europe has been particularly important. Uruguay’s share of exports to NAFTA countries is expected to increase substantially as a result of the recent reopening of the Canadian market for beef and the upcoming reopening of the Mexican and the U.S. markets. Moreover, the possibility of negotiating bilateral or multilateral trade agreements, with the U.S. and other partners, might strengthen the process of export growth and market diversification.

The policy response has primarily focused on the containment of the crisis and on the dissipation of the related uncertainties that are undermining the recovery. Thus, policies in the different areas are aiming to return Uruguay to a stable macroeconomic condition and to normalize the financial system while respecting to the extent possible existing contracts and property rights.

Although a very significant fiscal adjustment has taken place, including the adoption of two tax packages and containment of nominal expenditures in the face of a transitory pick-up in inflation, the primary fiscal surplus apparently will end-up being marginally lower than envisaged under the program for 2002. Even though noninterest expenditure has fallen significantly, both in nominal terms and as proportion of the GDP, the impact of the deep recession in public sector revenue severely limited the reflection of the adjustment in the fiscal balance.

As indicated in Table 4 of the main staff report, tax collections increased as a proportion of GDP in 2002, showing the partial effects of tax measures implemented in the second half of the year. The reduction of public sector revenue relative to GDP responds to exogenous shocks and not policy slippages. The reduction of social security contributions as a percent of GDP resulted from the higher unemployment rate and lower real wages, while the lower operational surplus of public enterprises resulted from the cost hike related to the rise in international prices of inputs, mainly oil, and the depreciation of the peso.

The strength of the fiscal effort is better represented considering the significant shift of the primary fiscal balance during 2002, that jumped from a deficit of 1.1 percent of GDP in the first half of the year, to a surplus estimated at 1.6 percent of GDP in the second half. Encouraged by this progress, the authorities are committed to achieve the targeted primary surplus of 3.2 percent of GDP for this year and continue the adjustment until reaching the medium-term goal of 4 percent of GDP. The tight wage and pension policies that have been announced are strong signals in this regard. So, too, are the tariff adjustments in public enterprises, and the authorities’ intention to strengthen the tax reform package with assistance from FAD.

Beyond expenditure containment, special provisions have been given to protecting certain socially oriented expenses. The effect of the crisis and the recession on the population at large has been severe, and the effects of the recovery in economic activity may take long to spill over from exports to the rest of the economy. As Box 1 of the main staff report underscores, Uruguay has traditionally enjoyed strong social indicators. In order to preserve these good fundamentals that would help the country to exit from the current circumstances, the government has given priority to a social program in education, health and social protection, focusing on mitigating the negative impact of the recession on the most vulnerable groups.

The Central Bank has continued with an active monetary policy through daily auctions of Treasury bills in pesos, whose yields, as we noted, have been declining significantly. Meanwhile, the authorities have initiated weekly auctions of inflation-indexed Treasury bills, introducing a debt denomination that should favor a gradual de-dollarization of the financial system. For now, the authorities are analyzing the introduction of inflation-indexed instruments with longer maturities, though they understand that the main steps in the development of the local capital markets cannot be effectively carried out before the public debt negotiations are not completed. Additionally, the authorities continue to study the appropriate conditions for moving to an inflation-targeting framework to guide monetary policy. The commitments implied by the inflation target regime would certainly contribute to dissipate uncertainties in the financial market, but it represents a major structural change that will require some time to implement.

Managing the banking crisis has been very challenging, and from the beginning the Uruguayan authorities have tried to base their working plan on sound pillars. As a recent issue of The Economist concludes, Uruguay’s democracy is showing exemplary maturity, and the strategy to confront the crisis has counted with strong political support, which, for example, allowed the approval of a banking law in 2002, facilitating the restructuring of the four suspended banks. Moreover, the authorities’ steps were guided by the firm intention to liquidate non-viable institutions, allowing only those with strong capitalization and able to fulfill all the prudential regulations to be reopened. In this regard, the authorities decided definitively to close one of the suspended banks, Banco de Credito, and to merge the other three suspended banks into a new banking institution that will be government-owned, but it will operate under the legal framework of private banks. After a very rigorous and independent analysis, this institution was found to have viability and sufficient capitalization and not to be a source of risk to the banking system or to the public finances. Furthermore, before re-opening it will have to meet all the prudential norms and regulations, and when market conditions permit will be offered to the private sector.

The mortgage public bank (BHU) has been closed and is in process of radical reforms to be transformed into a non-bank housing institution. BHU’s deposits have already been transferred to the other public bank, the BROU, and its budget has been dramatically adjusted.

The authorities also have based their strategy on the principle of equity and fair treatment, resisting pressures to intervene in contracts among private agents or to establish schemes that provide debt relief to specific sectors which, in the end imply costs for creditors, other debtors and the society in general. The authorities are fully aware that maintaining that behavior is particularly important for the BROU that, in August, should repay the first tranche of reprogrammed deposits. The authorities understand that the fulfillment will provide a strong signal, helping to eliminate those uncertainties leading to perceptions of a larger wealth effect that has contributed to a depressed private consumption.

The same basis has been used to make the debt proposal. The Uruguayan authorities are fully aware of the need to address the financing gaps and ensure debt sustainability. At the same time, they believe that debt reprofiling should not be incompatible with the preservation of one of the most important assets that Uruguay has, its long history of protecting and respecting property rights. Therefore, the authorities have announced a voluntary debt exchange, maintaining the same principle of equity and fair treatment. In this regard, the proposal involves domestic and external bondholders and will not change the original currency of the bonds, extending the maturity of existing instruments with the roll-over interest rates of the order of the original coupons, much lower that current market rates.

The debt operation will further contribute to debt sustainability and will close the financing gaps for this and the next three years. According to the Staff Report Supplement 2, in the baseline scenario gross public debt as a percent of GDP falls from 100 in 2003 to 67 percent in the next five years and further to 59 percent of GDP in 2012. A good participation in the debt exchange will imply a further reduction of the debt level of around 6 percent of GDP towards the end of the period, but more importantly will provide the remaining financing to the program closing the existing gaps.

There are risks associated with the debt operation, mainly a low participation in the exchange. The authorities and their advisors are aware about the free rider behavior, and they have foreseen some contractual aspects to discourage it. It is important to note that some domestic institutional investors have already shown their inclination to participate in the program and the authorities are in a consultation process with external creditors. Even though some local banks hold government bonds, it does not seem a real risk, taking into account that the participation of public sector bonds in their asset portfolios is relatively small and, as some analysts have underscored, the main problem for holders is the uncertainty about future repayment. The implementation of the debt proposal and of the rest of the program should significantly reduce that uncertainty. Furthermore, as the staff report underscores the political reaction to the government’s initiative has been supportive.

Structural reforms should contribute to sustain growth over the medium-term. Some reforms are already important elements in the program, including the opening-up to competition of activities previously reserved exclusively for the public sector. In addition, the law on economic recovery promulgated last September is allowing the government to issue concessions in the mining sector as well as auction the concession for operations of services including the international airport of Montevideo. Also, the authorities have been taking further steps to encourage investment in public infrastructure through a regime of private concessions. In every case, the law clearly underscores the need to follow a well defined process that demands great transparency.

A little more than a year ago, Uruguay lost the investment grade status as a result of a deep crisis ignited by severe exogenous shocks. The crisis was like an earthquake that devastated many areas of the country, but Uruguay counts on very sound pillars that will help the recovery back to sustained growth. Among them, a long lasting democratic tradition and solid institutions, and a well integrated society that facilitate reaching consensus. It is the authorities’ commitment to continue implementing the program to address the current situation, based on these pillars and with the invaluable support of the Fund and the international community.