Uruguay: Third Review Under the Stand-By Arrangement and Request for Modification and Waiver of Applicability of Performance Criteria

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. On May 29, Uruguay successfully completed a comprehensive and voluntary debt exchange. The exchange covered almost all of Uruguay’s market debt in foreign currency (US$5.4 billion). The overall participation rate reached 93 percent, well above the 80-percent threshold established for completion, and was particularly high for domestically-issued bonds (99 percent). The exchange lengthened the maturity of the bonds by about five years while roughly maintaining coupon rates, thus reducing the net present value of participating bonds by about 20 percent on average.1 These results are consistent with the program projections at the time of the second review (EBS/03/27, Supplement 2). Following completion of the exchange, several credit rating agencies upgraded Uruguay’s sovereign rating.

2. There are signs that the economy has bottomed out. While real GDP contracted by 10.8 percent in 2002, it recovered slightly (½ percent, quarter-on-quarter, seasonally adjusted) during the first quarter of 2003. Leading indicators point to a stronger increase in activity during the second quarter, driven by an improvement in exports (Tables 12). During the remainder of this year, Uruguay is expected to benefit further from improvements in the regional environment and the reopening of the North American markets to beef exports. Unemployment fell from a peak of 19.8 percent in November to 18.9 percent in April.

Table 1.

Uruguay: Selected Economic and Financial Indicators

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

Evaluated at the accounting exchange rate of Ur$29/US$ for 2003.

Defined as changes in reserve assets.

Defined for combined public sector.

Excludes nonresident deposits.

Residual maturity. Does not include nonresident deposits.

Table 2.

Uruguay: Summary Balance of Payments

(In millions of U.S. dollars)

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

Uruguay: Selected Macro economic Indicators

(12-month percent change, unless otherwise indicated)

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Except for CPI and merchandise imports, which are for May.

3. Although financial indicators have continued to improve, the situation remains vulnerable. After registering net outflows at the beginning of this year, private sector deposits have increased by about US$400 million since end-February, nearly returning to their end-July 2002 level, when a bank holiday was declared. In the immediate future, the main risk is that of a loss of confidence which could reignite a bank run and, in turn, quickly deplete reserves and threaten the economic recovery. Reflecting the reflow of deposits as well as sizeable IFI disbursements,2 gross official reserves have more than doubled since mid-March, to US$1 billion in late June (5 months of imports of goods and services). Even so, non-borrowed reserves (which exclude bank and pension fund deposits at the central bank) are still close to zero.3 The end-March NIR and NDA performance criteria were observed (Table 3).

Table 3a.

Uruguay: Performance Under the 2002 Economic Program 1/

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Sources: Ministry of Economy and Finance; and Central Bank of Uruguay.

As defined in the Technical Memorandum of Understanding.

Cumulative from end-December 2001.

Cumulative from end-June 2002.

Adjusted for upward4/ downwards for any increase/decrease in disbursements from the World Bank and IDB.

Indicative target.

All maturities. Adjusted for debt issued for recapitalization of banks.

Table 3b.

Uruguay: Performance Under the 2003 Economic Program Through March 1/

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Sources: Ministry of Economy and Finance of Uruguay; and Central Bank of Uruguay.

As defined in the Technical Memorandum of Understanding (EBS/03/27)

Cumulative changes from end-December 2002.

Adjusted upward/downward for changes in social security contributions, as defined in the TMU.

Preliminary figures.

Adjusted upward/downward for changes in program disbursements from the World Bank and IDB, as defined in the TMU.

All maturities. The 2002 base includes US$294 million of unsecuritized debt arising from an agreement between the Ministry of Economy and Finance and BROU. For September and December, the debt ceiling will be adjusted upwards to reflect the transfer of Brady bonds from the central bank to the government (at end-May 2003, these transfers amounted to US$237 million).

Adjusted upward/downward for changes in interest payments, as defined in the TMU.

Cumulative change from December 2002 average.

Uruguay: Changes in Dollar Deposits

(in US$ million)

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4. In nominal terms, the peso has recently appreciated against the U.S. dollar, broadly returning to its level at the end of last year. During January–May, the peso had depreciated by close to 18 percent in real effective terms, reflecting mostly the appreciation of the Argentine peso and the Brazilian real. While base money growth has been in line with program projections, inflation has come down faster than programmed, averaging 1.2 percent a month during January–May (2.1 percent in the program). The demand for money has been higher than anticipated and, with NIR on track, the central bank has recently curtailed its purchases of foreign exchange, putting upward pressure on the peso.

5. Fiscal developments have remained broadly on track with the program. Central government tax collections were somewhat stronger than programmed during the first quarter of 2003, mostly due to buoyant VAT revenue and wage and pension tax collections, but the current surplus of public enterprises was lower than anticipated (Tables 45).4 While wage and pension outlays were kept under control, spending on goods and services exceeded program projections. The end-March performance criterion on the primary surplus of the combined public sector was not observed by a small amount.

Table 4.

Uruguay: Public Sector Operations

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Sources: Ministry of Finance, and Fund staff estimates.

Excludes contributions that are transferred to the private pension funds

Includes extrabudgetary operations from 1998.

Includes transfers central government transfers to BFS, Caja Militar and Caja Policial.

In 2002, includes bank assistance of the central bank and the central government through Articles 36, 47, the CND, overdrafts and the FSBS.

Table 5.

Uruguay: Nonfinancial Public Sector Cash Flow

(In millions of U. S. dollars)

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Includes US$87 million in accrued interest on old bonds participating in the exchange and US$24 million on the commission to advisors.

Excludes IMF; includes amortization on project loans to World Bank and IDB.

As paid by BCU.

Includes disbursements from official and bilateral creditors, including project loans from IDB and WB.

6. The government has regained some access to the domestic financial market, with net placements of short-term paper of US$340 million through mid-June. One-fourth of these placements have been in U.S. dollar bills, carrying interest rates of about 5 percent. However, most of the remainder was in peso Treasury bills, of relatively short duration (three months on average) and at high, albeit declining, interest rates (about 40 percent in early June, down from 50 percent in February). To reduce the interest burden, the authorities are seeking to improve debt management, including by issuing longer-term instruments in indexed units, which carry lower interest rates.

7. Progress in the reform of the banking system has been slow. The new bank (NBC—Nuevo Banco Comercial) created in March with the assets of three liquidated banks has been able to attract moderate amounts of new deposits (US$60 million). However, the end-March structural benchmark on the completion of a strategic plan for the disposal of the remaining assets of the liquidated banks was missed. Regarding the fourth liquidated bank (Banco de Crédito), the government reached agreement in early June with the former minority shareholder, under which the latter will cancel loans extended by the bank, mostly with government bonds. Restructuring of the state mortgage institution BHU has been delayed; about one third of its workforce is to be laid off but, to minimize social tensions, most of them will be rehired by BROU, the central bank, and the government.

8. Financial market confidence in the economic program has firmed up, but political pressure to relax efforts has mounted. Pressures have arisen in congress to provide relief on bank loans in foreign currency, suspend foreclosures, and roll back recent increases in the tariffs charged by public utilities. As the October 2004 presidential election approaches, political opposition is likely to mount, making it harder for the government to maintain congressional support for its economic program.

II. Policy Discussions

9. The authorities were very pleased with the results of the debt exchange. They noted that participation exceeded the targets they had set when launching the exchange. Principal on medium and long-term debt due for the remainder of 2003 has been reduced from US$469 million to US$23 million, and for the period 2003–07, from US$2.1 billion to US$300 million. As a result, the authorities were confident that the overall deficit of the combined public sector could be financed by disbursements from international financial institutions and moderate access to the domestic financial market for the remainder of the period covered by the SBA (2003–05). The authorities attributed the success of the exchange to a variety of factors, including the risk of default, the authorities’ explicit warnings about holdouts, and changes in the regulatory framework (Box 1 and Appendix II).

Uruguay: Key Factors in the Success of the Debt Exchange

Several factors help explain the high participation rate of 93 percent:

  • Default risk. There was widespread appreciation by investors that Uruguay’s existing debt service needs were not manageable. The authorities explicitly warned that, if unable to meet all debt service obligations, they would service the new debt in preference to the old. The relatively modest NPV reduction probably facilitated investor’s agreement.

  • Credibility. Uruguay’s debt problem was seen as largely caused by an external shock, and the authorities retained credibility with investors over their economic policies. On the domestic leg of the exchange, participation among retail holders may have been encouraged by patriotic considerations.

  • Legal features. Holders exchanging the external bonds were asked to approve exit consents which would reduce the ability of holders of the old bonds to enforce debt service payments. The new bonds contained cross-default clauses triggered by failure to service any of the new bonds, but not by default on the old bonds.

  • Liquidity. Investors were attracted by the greater liquidity of the new benchmark domestic and external bonds (over US$2 billion of the new bonds qualify for the EMBI indices, or four times more than before the exchange).

  • Regulatory incentives. Participation by domestic banks was encouraged by the announcement that the old bonds would no longer be traded and would, therefore, be subject to a 100 percent risk weighting in the computation of bank’s capital adequacy ratios. The central bank also announced that it would not accept old bonds as collateral for liquidity assistance. The announced delisting of the old bonds also spurred pension funds to participate, as they are not allowed to hold unlisted securities.

  • Support of domestic financial intermediaries. The apparent conviction that the success of the exchange was crucial for the health of the Uruguayan financial system, bolstered by the incentive-compatible fee structure, fostered participation of domestic financial institutions and stimulated their efforts to reach out to the (typically inert) retail sector.

  • Fund conditionality and support. The perception that the exchange was necessary was bolstered by the fact that completion of the third review was conditional on achievement of the cash flow and debt sustainability objectives contemplated for the exchange. The Fund also provided support in the form of the Managing Director’s letter to the financial community.

  • Rally in bond markets. Emerging market securities rallied during the offer period, with the EMBI+ index of spreads falling by around 100 basis points between early April and mid-May. This buoyed expectations of the exchange’s success, and raised the mark-to-market losses that holdouts would face if the old debt were not paid.

10. The authorities concurred that, after the success of the debt exchange, firm implementation of the other components of the program was critical. In particular, they shared the staff’s view that achieving the primary surplus targets of the program was key to ensuring the return to debt sustainability. Achieving these targets will require an enhanced revenue effort and continued expenditure restraint. The authorities are fully aware that further strengthening of the banking system is crucial, and they have agreed to accelerate the asset disposal of liquidated banks and take steps to strengthen the public bank BROU. In line with developments so far this year, the macroeconomic outlook for 2003 has been revised, to take into account lower inflation (year-end inflation is projected at 20 percent instead of 26 percent) and somewhat better growth prospects (a decline in real GDP of one percent instead of two percent).

A. Fiscal and Monetary Policies

11. The authorities are firmly committed to achieving a primary surplus of 3 percent of GDP in 2003. The primary surplus objective has been reduced by 0.2 percent of GDP to accommodate the impact on primary spending of the one-off commissions and fees related to the debt exchange, which had not been included in the original program. To meet the primary surplus target against the backdrop of lower inflation (and thus lower projected tax revenue), expenditure targets have been revised downward, while the operating surplus of public enterprises has been raised, taking into account performance so far this year. During the second half of 2003, the authorities plan to set electricity and telephone tariffs broadly in line with program targets, and to increase the prices charged by the state oil company ANCAP if world oil prices move above their early-June level. The authorities are committed to adopting additional measures if tax collections in the second half of this year turned out to be weaker than contemplated because of a further slowdown of inflation.

12. The government is committed to keeping a tight rein on expenditure. Social security and pension outlays (which are adjusted with the economy-wide wage index) have been revised downward, owing to lower-than-anticipated increases in the wage index (so far this year, wages have risen by only 2.6 percent, and revised projections are based on wage increases of about 10 percent in 2003, instead of 18 percent in the original program). Other current expenditures, which have been running somewhat above program, will be reined in through reductions in cash allocations for discretionary outlays (Paragraph 6 of the MEFP) to better align them with program targets.

13. The authorities are committed to advancing with tax reform, but cautioned that the lack of consensus in congress may delay its approval. With technical assistance from the Fund, a revision to the draft tax reform package pending in congress will be submitted by end-June (a structural performance criterion). Reforms are aimed at enhancing revenue through a rationalization and simplification of the tax system, including a broadening of the VAT base; eliminating low-yielding taxes and incorporating them into the main excise tax; and broadening the coverage of the corporate income tax. The staff advised the authorities against reducing VAT rates as envisaged, as this would lead to a revenue loss over the medium term of about 1½ percent of GDP. Technical assistance from the Fund to help strengthen tax administration will also be provided in coming weeks.

14. The authorities reaffirmed their commitment to a floating exchange rate regime, with base money as the intermediate target. As noted, inflation to date has been lower than programmed, reflecting higher real money demand. Despite lower inflation prospects, the increase in base money envisaged in the original monetary program for 2003 (25 percent) has been retained to accommodate this ongoing remonetization of the economy (Table 6). To improve the implementation of monetary policy, the central bank will continue to strengthen open market operations, including through fostering a deeper and more liquid market for peso-denominated and inflation-indexed instruments. The current monetary policy framework is designed to help build a track record that would facilitate a future move to inflation targeting.

Table 6.

Uruguay: Summary Accounts of the Banking System 1/

(In millions of Uruguayan pesos)

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

Presentation used for program monitoring. Differs from presentation in IFS.

Banco de la Republica Oriental del Uruguay, Banco Hipotecario de Uruguay (mortgage institution), private banks, and cooperatives.

Excluding nonresident deposits.