2003 Article IV Consultation and Third Review Under the Stand-By Arrangement and Request for Modification and Waiver of Applicability of Performance Criteria—Staff Report; Staff Supplement; Staff Statement; Public Information Notice and Press Release on the Executive Board Discussion; and Statement by the Executive Director for Uruguay

Uruguay's performance under the Stand-By Arrangement (SBA) has been favorable, and commendable progress has been achieved in containing the crisis and stabilizing the economy. Executive Directors welcomed this development, and stressed the need to implement policies in the fiscal, banking, and structural areas. They commended the floating exchange rate regime, and the efforts of political and legal institutions in dealing with the financial crisis. They agreed that Uruguay has successfully completed the third review under the SBA, and approved waiver.


Uruguay's performance under the Stand-By Arrangement (SBA) has been favorable, and commendable progress has been achieved in containing the crisis and stabilizing the economy. Executive Directors welcomed this development, and stressed the need to implement policies in the fiscal, banking, and structural areas. They commended the floating exchange rate regime, and the efforts of political and legal institutions in dealing with the financial crisis. They agreed that Uruguay has successfully completed the third review under the SBA, and approved waiver.

I. Background and Recent Developments

1. Uruguay experienced relatively high economic growth during most of the 1990s (Appendix I). This expansion followed a long period of adjustment in the aftermath of the 1982 crisis, and was underpinned by significant stabilization gains and trade liberalization. Inflation fell sharply and regional integration fueled a significant expansion of trade with neighboring countries and triggered healthy productivity growth. At the same time, however, important structural weaknesses remained (such as an oversized public sector), and new vulnerabilities emerged, including increasing financial dollarization, currency overvaluation, and growing dependence on the region. Beginning in 1999, the economy entered into a prolonged recession, driven to a large extent by exogenous shocks and contagion. The impact of these shocks on the domestic economy was compounded by the structural weaknesses that had remained unaddressed during the period of solid economic performance (Box 2). There are signs that activity bottomed out in early 2003, and the economy is expected to recover gradually in the months ahead.


Financial Intermediation in the Banking System

Citation: IMF Staff Country Reports 2003, 247; 10.5089/9781451839258.002.A001

A. Economic Expansion in 1990–98

2. Uruguay’s economy grew by 3.9 percent a year on average during 1990–98, significantly above long-term trends (2 percent during 1960–2000). Growth was fueled by domestic demand, mainly consumption, while the contribution of net exports was negative (Table 1).1 Private consumption was boosted by strong credit growth in the wake of economic stabilization, as bank intermediation recovered from a severe depression in the previous decade. Credit to the private sector doubled as a share of GDP, to 50 percent in 1998. Export performance benefited from strong rates of growth in Brazil and Argentina and from the creation of the Mercosur. Although Uruguay’s exports of goods and services rose by 90 percent during the period, imports rose twice as fast (170 percent).

Table 1:

GDP Growth 1990-2002

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Uruguay: Structural Weaknesses and Systemic Risks

Although Uruguay grew well above historical averages during most of the 1990s, a number of fragilities built up that made the economy increasingly vulnerable to exogenous shocks.

  • The economy had become highly exposed to the region. The Mercosur treaty opened growth opportunities for the economy, but heightened the dependence of Uruguay’s tradable sectors on Brazil (traditional exports) and Argentina (nontraditional exports and services). Much of the trade involved regional goods (e.g., fresh products and tourism), with limited scope for demand substitution from countries outside Mercosur. These links heightened the contagion risks from lower growth or exchange rate adjustments in neighboring countries. In addition, the redirection of exports towards other markets after Brazil’s devaluation in 1999 was hindered by the real appreciation of the peso against non-Mercosur currencies.


Real Effective Exchange Rate

(Jan. 1990=100)

Citation: IMF Staff Country Reports 2003, 247; 10.5089/9781451839258.002.A001

  • The large and heavily regulated public sector has been a drag on competitiveness and has limited the ability of the economy to adjust to external shocks. Expenditure by the nonfinancial public sector is close to 40 percent of GDP; total public sector employment represents almost one quarter of total employment; and about 60 percent of total deposits and half of total credit are intermediated by public financial institutions.

  • Currency mismatches accumulated in corporate, household, and public sector balance sheets. Dollarization of bank lending grew from 58 percent of total lending in 1995 to 87 percent in 2002, thus creating significant currency risks in households and corporations with local currency earnings. Similarly, the public sector’s financing relied almost exclusively on issuance of foreign currency instruments. While this enabled the government to benefit from low financing costs after Uruguay obtained an investment grade rating in 1997, it also increased exposure to currency risk. For instance, the public mortgage bank BHU was seriously exposed to currency and interest rate risk as it funded its long-term local currency lending with short-term foreign currency deposits.

  • Weak banking regulations contributed to the crisis of the domestic banking sector. Some private banks accumulated large exposures to Argentina. At the same time, while nonresident deposits had risen sharply, the regulatory framework did not establish stringent liquidity requirements. The public sector banks’ balance sheets had been weakened by high nonperforming loan ratios and quasi-fiscal activities, accommodated by regulatory forbearance.

  • The scope for active fiscal and monetary policy responses to shocks was severely constrained. Persistent fiscal deficits had contributed to substantial public sector borrowing requirements and a rising debt burden, increasing dependence on capital market access. The high degree of dollarization of bank deposits (90 percent in 2002) seriously limited the lender-of-last-resort capacity of the central bank, and large currency mismatches in private and public sector balance sheets constrained the scope for exchange rate flexibility.

3. Growth was concentrated in services. Regional trade integration and strong private consumption boosted the demand for financial services, tourism, and retail trade. As a result, the share of services in GDP grew from 58 percent of GDP in 1990 to 65 percent in 1998. Manufacturing declined considerably, in part reflecting the loss of competitiveness associated with a significant appreciation of the peso in real effective terms during this period. The primary sector’s share remained broadly stable, at about 10 percent of GDP (Table 2 and Appendix II). Despite the strong economic growth, unemployment remained relatively high throughout the period, at almost 10 percent on average.

Table 2:

Sectoral Composition of Real GDP Growth

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4. The strong growth performance was supported by an exchange rate-based stabilization effort. Beginning in 1992, the authorities allowed the domestic currency to move within a crawling currency band that was depreciated at a declining rate. This policy helped anchor inflationary expectations and brought inflation down from over 100 percent in 1990 to 11 percent in 1998. However, it also contributed to an appreciation of the peso in real effective terms, particularly in the early stages of the currency band. Although the appreciation was less than in neighboring Mercosur countries, it contributed to a sharp rise in imports.

5. The opportunity to deepen fiscal consolidation was largely missed. Although the overall deficit of the combined public sector was moderate, averaging 1.4 percent of GDP during 1990–98, the fiscal stance was expansionary in most years (Appendix III). Expenditure rigidities rose significantly, including through the indexation of pension benefits to wages and the transition costs of pension reform.2 Overall, noninterest expenditure grew by 5 percent of GDP. In response, the authorities raised the (already quite high) tax burden on the private sector. The public sector deficit was financed to a significant extent from abroad, both through bonds and IFI loans. This helped free domestic resources which, however, fueled mainly consumption growth, while adding to vulnerabilities by increasing the share of public sector debt in foreign currency. Other net capital inflows, including FDI, were relatively modest during the period (½ percent of GDP on average) as important sectors of the economy remained reserved for the public sector.


Capital Account 1990-98 (in percent of GDP)

Citation: IMF Staff Country Reports 2003, 247; 10.5089/9781451839258.002.A001

6. Progress on the structural front was mixed. Significant trade liberalization had taken place in the second half of the 1980s, contributing to strong productivity growth in the 1990s. In addition to the pension reform noted above, the authorities took partial steps to allow private sector participation in sectors previously reserved to the state, including in the markets for cement, cellular phone services, mortgages, insurance, port management, and the construction and management of toll roads. However, more decisive attempts to privatize failed after a law for the partial privatization of the state telecommunications company Antel was repealed by referendum in 1992. As a result, important parts of the economy remained reserved for, or dominated by, the state.

B. Recession and Financial Crisis in 1999–2002

7. The strong growth performance stopped in the late 1990s, when the economy was exposed to a series of shocks. The devaluation of the Brazilian real and the recession in Argentina depressed Uruguay’s exports and domestic investment, and the primary sector suffered from the impact of a severe drought and a sharp decline in international prices for several of its export products. As a result, the economy entered into recession in early 1999, with private consumption following soon thereafter as unemployment surged. An incipient recovery of economic activity in early 2001 was halted by the outbreak of foot-and-mouth disease, which led to the closing of important meat export markets. At the same time, the deepening crisis in Argentina further weakened business and consumer confidence. Uruguay’s real GDP declined by a cumulative 7½ percent during 1999–2001, and the deficit of the consolidated public sector rose to 4 percent of GDP as revenue suffered from the economic downturn while structural rigidities limited the scope for expenditure reduction.

8. In 2002, real GDP contracted further by 10.8 percent as the country experienced a severe financial crisis. The impact of external shocks affecting Uruguay during 1998–2002 may have been magnified by growing internal disequilibria, particularly the changing structure of bank balance sheets as a result of large inflows of nonresident deposits. Following the imposition of a deposit freeze and capital controls in neighboring Argentina, cash-strapped Argentine depositors began to withdraw their funds from Uruguay’s banking system. The run on deposits rapidly extended to resident depositors, after problems developed in two large private banks with strong links to Argentina. Uruguay’s sovereign debt rating suffered successive downgrades, and access to foreign capital markets was lost. The loss of reserves, driven by deposit outflows, forced the authorities to float the peso in June. A package of fiscal, monetary, and banking reform measures was adopted in early August, that helped stabilize the situation together with large financial support from IFIs (more details are presented in the companion report on the 2002 banking crisis).

9. The steep contraction in output was partly due to a severe credit crunch associated with the banking crisis. The liquidity squeeze resulting from sustained deposit outflows prevented banks from lending: in U.S. dollar terms, credit to the private sector fell by 31 percent during 2002. Economic activity declined in all sectors, except agriculture.3 Investment dropped by one-third in real terms. Private consumption also fell sharply, with private savings rising by 4 percentage points of GDP.4 Net exports, in turn, contributed positively to GDP growth, with a sharper contraction in import volumes (28 percent) than in exports (11 percent).

10. The increase in inflation following the float of the peso was moderate. During 2002, consumer prices rose by 26 percent while the peso depreciated by 85 percent against the U.S. dollar. The moderate price increases reflected the weakness of domestic demand and the lack of wage pressures—wages rose by only 3 percent in nominal terms during 2002. In real effective terms, the peso depreciated by 13 percent, as Uruguay’s regional trading partners experienced sharper rates of depreciation.5 In early 2003, the peso depreciated further by about 18 percent in real effective terms, reflecting mostly the appreciation of other regional currencies and the weakening of the U.S. dollar.

11. Public debt dynamics deteriorated significantly in 2002, raising concerns about sustain ability. The debt-to-GDP ratio of the consolidated public sector jumped from 54 percent in 2001 to 94 percent in 2002, reflecting the sharp depreciation of the peso against the U.S. dollar, the cost of government assistance to stabilize the banking system, and the fiscal deficit. In addition, the government faced a bunching of debt amortization in 2003–07 without reasonable prospects for regaining access to international markets. To address these problems, the authorities undertook a comprehensive debt exchange in May 2003, which extended the average maturity of virtually all market debt by about five years while maintaining the low interest rates contracted in previous years when Uruguay enjoyed investment grade ratings.6

12. Developments in 1999–2002 highlighted the presence of a number of macroeconomic and structural weaknesses that made the Uruguayan economy vulnerable to external shocks. These fragilities included: heightened dependence on the Mercosur region; large and rising asset and liability dollarization of the banking system and a significant increase in nonresident deposits; weak bank regulations and balance sheet weaknesses; insufficient fiscal consolidation; and vulnerabilities associated with the crawling peg exchange rate regime (see Box 2). These weaknesses left the country highly vulnerable to the sharp deterioration in the external environment that occurred during 1998–2002.

II. Policy Discussions

13. The authorities and staff concurred that, under current policies, the output gap would gradually narrow while medium-term potential growth would be lower than during the 1990s, at 2½–3 percent a year. This outlook is based on the recognition that, while successful stabilization will allow the economy to recover from the sharp recession, a number of structural and external conditions will likely be less favorable than during the past decade. In particular, Uruguay is expected to face a less supportive external environment and weaker contributions of labor and capital accumulation to growth.

14. Against this background, the discussions centered on the kind of policies and reforms needed to achieve higher and less volatile economic growth over the medium term. There was broad agreement between the staff and the authorities on the need for policies to stimulate productivity growth by promoting the reallocation of resources toward more productive uses, and to reduce financial and structural vulnerabilities in order to improve resilience to shocks. To achieve these goals, the staff encouraged the authorities to build political support for a comprehensive reform agenda that would seek to promote sound macroeconomic policies; encourage private sector development through a reduction of the size of the state; and further strengthen Uruguay’s institutional framework and investment climate.

A. Constraints to Economic Growth

Less supportive external environment

15. Uruguay’s external environment will likely be more challenging in the period ahead than in the 1990s. Economic conditions in the Mercosur region are expected to be less supportive than during the last decade. Developing new sources of growth will be all the more challenging as private capital flows to Latin America—FDI particularly—are expected to be lower, with foreign investors focusing on other regions of the world. It is thus likely that regional demand for Uruguay’s exports (a mainstay of growth in the 1990s) will remain subdued. Similarly, the financial sector’s ability to mobilize and intermediate savings will likely recover only gradually, and it will probably not regain its position as a main engine of growth, at least for some time.

16. Uruguay therefore needs to diversify its export base. The Mercosur agreement had resulted in a reorientation of exports to the region, with Brazil becoming the most important destination for Uruguay’s agricultural goods, and Argentina the main client for Uruguay’s key service industries (tourism and banking) and nontraditional exports (manufactured goods). While exports to Mercosur increased from 35 percent of total exports in 1990 to 55 percent in 1998, exports to Europe, the second largest destination for Uruguayan products, declined from 33 percent to 18 percent. Although the relative importance of exports outside Mercosur has risen again in recent years, this has been mostly due to the reduction in exports to Mercosur rather than increased exports to other markets. In recent months, the strengthening of the euro has boosted competitiveness vis-à-vis Europe, but export growth to this region is limited by binding quotas for Uruguay’s chief agricultural exports, particularly beef.


Uruguay: Exports by Destination

(in percent of total exports)

Citation: IMF Staff Country Reports 2003, 247; 10.5089/9781451839258.002.A001

17. Further trade liberalization will be key to product and market diversification for exports, as well as FDI and technology transfer. The authorities are pursuing free trade negotiations, within the framework of Mercosur, with the United States and the European Union, and bilaterally with Mexico. The staff supported these efforts, noting that trade integration with industrialized countries should accelerate the structural modernization of the economy through its links to innovation, FDI, and the transfer of technology. The staff encouraged the authorities to also play an active role in the multilateral trade discussions under the Doha Round.7

18. The authorities noted that recent improvements in external competitiveness should support a broad-based recovery in exports. Extra-Mercosur competitiveness has improved sharply since the floating of the peso in mid-2002. Nevertheless, improvements in export performance to markets outside Mercosur have so far been concentrated in agricultural goods (traditional exports), which benefited in part from a relaxation of health controls on Uruguayan beef. Further market expansion in these products will face persistent obstacles in the form of quotas, competition with other Mercosur exports, and nontariff barriers for many products (dairy products, rice, meat). The staff also noted that, moreover, while competitiveness outside the Mercosur region has improved markedly, the same has not been observed within the region, where more depreciated exchange rates may constrain Uruguay’s export buoyancy.

Adverse demographic trends

19. Uruguay’s population is ageing and the contribution of labor to growth will be less important than in the 1990s. Uruguay has the oldest population in Latin America, with the ageing trend continuing, including because of increased emigration in recent years (Box 3). The labor force grew somewhat faster during the 1990s than in the previous decades, due to increased participation rates for women. This trend is believed to have reached a limit and, as a result, the growth of the active population is expected to remain relatively low compared with other countries in the region, at 0.7 percent a year on average. This development takes into account emigration flows, which have increased sharply in recent years, due to the high unemployment rates and falling real wages.

Uruguay: Trends in Demography and Migration

Uruguay has the oldest population in Latin America. Official estimates show that 17½ percent of the population is 60 years or older, compared with 8 percent on average in Latin America, while 24 percent of the population is 15 years or younger, compared with a regional average of 31 percent. Projections by the U.N. Economic Commission for Latin America and the Caribbean suggest that the population below 15 years of age will fall to nearly 20 percent by 2030, while that over 60 will rise to 20 percent.

Chart 1.
Uruguay- Demographic Ageing

Uruguay’s ageing process has been led for some time by declining birth and mortality rates and, more recently, by emigration. Statistics from the U.S. Immigration and Naturalization Service show that the number of Uruguayan immigrants to the United States has risen sharply in recent years, after having fallen during the second half of the 1990s. Data on the number of nationals entering and exiting the country in 2002 through the international airport of Carrasco point to a net exodus of about 1 percent of the country’s population. Anecdotal evidence suggests that emigration is primarily toward the United States, Europe, and Mexico.

20. Uruguay’s active population remains well qualified, an important asset for growth. Education levels are high, and income distribution is more even than in other Latin American countries. However, the recent wave of emigration may impact the quality of the labor force and put further strain on the social security system, as there are indications that emigrants are on average younger and with higher education levels than the population at large. In addition, the surge in child poverty and youth unemployment registered in recent years could lead to a deterioration of Uruguay’s human capital base if not addressed in time through well-targeted policies.

Constraints to capital accumulation

21. With bank credit expected to remain depressed and access to international capital markets limited, the staff noted that it would also take time before capital accumulation could again support GDP growth. Although the existence of spare capacity after the long recession can initially provide room for a recovery in economic activity, several years of high investment growth would be needed to reverse the contraction in the capital stock of the past years. The investment outlook is constrained by low domestic savings (related partly to the ageing population), the weakened banking system, and challenges to attracting FDI. In particular, the capacity of the banking system to intermediate savings will recover only gradually, as capital positions and confidence in the banking system need to improve before broad-based credit growth can be expected to resume.

22. Informal financing is expected to be available for certain sectors, but its cost will likely remain high. The creation of direct vehicles of intermediation, such as specialized investment funds, could help speed-up a recovery of credit. In this context, the staff noted that prompt congressional approval of the draft law on trust funds and warrants would establish a legal framework for the operation of such vehicles. The staff also encouraged the authorities to accelerate the disposal of remaining assets from liquidated banks, to prevent the deterioration of credit culture and maximize the government’s recovery of previous financial assistance to these banks.

B. Policies to Enhance Growth Prospects

23. In the near term, growth will be guided chiefly by traditional sources, mainly production and exports of agricultural goods. This will be supported by the maintenance of sound financial policies and progress in banking system reform. The banking system is still recovering from the 2002 financial crisis, and remains fragile, due to weaknesses in the public banks. Hence, the reform of the BHU needs to be stepped up, particularly given its links to BROU’s financial soundness. Furthermore, the authorities concurred with staff that moving ahead with the reform of the public bank BROU is crucial to re-starting private sector credit and boosting economic activity.8

24. The medium-term scenario envisages a return to moderate growth, with a reduced debt burden and enhanced financial stability. As noted in the staff report for the third review, output is projected to grow at 2½–3 percent a year over the medium term, predicated on the maintenance of sound economic policies and the firm implementation of structural reforms, discussed below. The external current account would be in surplus over the medium term, but this surplus would gradually narrow as the economy recovers (Table 16). Gross reserves are targeted to rise significantly over the next few years, to provide some cushion against shocks and improved coverage for future debt service payments. Although debt servicing needs appear manageable over the next few years, they will start rising substantially over the medium term. Moreover, a sensitivity analysis9 shows that debt sustainability is highly vulnerable to deviations from the assumed macroeconomic framework. Taken together, these factors illustrate that there is little room for policy deviations in the medium term.

Table 1.

Uruguay: National Accounts at Current Prices

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Source: Central Bank of Uruguay.
Table 2.

Uruguay: National Accounts at Constant Prices

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Source: Central Bank of Uruguay.

Contribution to GDP growth

Table 3.

Uruguay: Gross Domestic Product at Current Prices

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Source: Central Bank of Uruguay
Table 4.

Uruguay: Gross Domestic Product at Constant Prices

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Source: Central Bank of Uruguay.