Background and Recent Developments

1. It is difficult to find cases in recent economic history in which a country has suffered so much in so little time, like Uruguay in 2002. In seven months, the country went from an investment grade status to one in which it found itself completely closed off from international financial markets, additionally, it lost almost half of its banking system deposits; experienced a sharp depreciation of the peso, up to 88 percent, while Treasury bill yields in local currency peaked at 190 percent; and there was a double-digit fall in output. Moreover, the deteriorating macroeconomic conditions and the loss of access to international markets generated serious uncertainties about debt rollover.

2. Finding a more effective response to overcoming the crisis is not easy either. In less than a year, financial markets have stabilized and the process of economic recovery is clearly under way. In this regard, the authorities would like to express their gratitude to the Fund’s staff and management for their continuous support, and to the Executive Board for the approval of significant financing support at a very critical time. Our authorities recognize that without the Fund’s support such a quick recovery would not have been possible.

3. The completion of the debt exchange operation has been crucial for the recovery, and since then, financial market conditions have significantly improved. Among the improvements, the country risk has dropped from close to 2,500 basis points to about 700; the Treasury bill yields in local currency are now below 20 percent; deposits have recovered by almost 10 percent from its minimum point; and the inflation rate for 2003, originally projected at 65 percent in the program, is now projected at around 20 percent. The authorities would like to underscore the impressive participation of the domestic creditors in this voluntary debt exchange, which reached 99 percent. As in the process of resolution on the banking crisis, consensus building has been very important, demonstrating that the cohesiveness of the Uruguayan society is an invaluable asset in dealing with major problems.

4. Economic activity has been showing some improvements and, as noted in the staff report, there are signs that the economy has bottomed out and that activity and demand are recovering. As would be expected, exports are being the most dynamic item, despite the fact that pressing domestic and external credit constraints have not let the export sector take full advantage of the depreciation of the Uruguayan peso. The development of some non-traditional credit channels, together with improvements in the prices of Uruguayan commodity exports, the strengthening of the euro, and some correction of the over-shooting in regional exchange rates have recently contributed to a remarkable increase in exports of 17 percent in April, as compared to the same month in the previous year; but the cumulative increase for the first four months of 2003, amounts only to 2 percent. The share of exports to Europe has already been brought in line with that of Mercosur, while the reopening of the beef market to Canada and the U.S. should imply a substantial increase in exports to those markets later this year.

5. On a seasonally adjusted basis, GDP increased at an annual rate of 0.5 percent in the first quarter of 2003, as compared to the last quarter of 2002. The monthly indicator of economic activity increased by 1.4 percent in April 2003, with respect to the previous month. This is one indicator of the gradual pick-up of growth expected for the second quarter of this year, partly due to the better export performance referred to above, but also to a gradual build-up of confidence.

Macroeconomic Policies

6. The government’s strategy has been successful in confronting the crisis. However, this is just a starting point, and the Uruguayan authorities are firmly committed to addressing the remaining vulnerabilities as well as the impediments for sustainable growth. Common to other democracies, the political process in Uruguay often exerts a strong influence on economic policies. Nevertheless, the authorities understand that there is no room for complacency and that fiscal discipline is the cornerstone of success of their economic strategy. Thus, they have called on the different political parties to concentrate work over the next year on the country’s efforts for a prompt economic recovery, leaving electoral issues for the last part of 2004.

7. Encouraged by the implementation of the fiscal adjustment, broadly on track with the program, and while maintaining a tight grip on discretionary spending, the authorities are working on rationalizing and improving the structure of expenditures. It is the authorities’ intention to devote part of the resulting spending cuts on improving the protection to the most vulnerable groups through enhanced social policies. The authorities are working to improve the targeting and effectiveness of social programs, including reforms in the unemployment insurance scheme, as well as in the health and educational sectors. Similarly, the authorities have taken some measures to reduce the size of the public sector, including an early retirement scheme, and a hiring freeze for permanent positions.

8. Tax revenues have increased 5 percent in real terms in the first five months of 2003, as compared with the last five months of 2002. Beyond this improvement, the authorities are committed to reforming the tax system and strengthening tax administration, which, in addition to contributing to the achievement of the fiscal target under the program, will help improve the business environment and investment incentives. In this vein, last June 30th, the authorities sent to Parliament a draft bill that, among other reforms, proposes derogating seven low-yielding taxes, broadening of the VAT base, and extending the corporate income tax to all sectors of the economy. Moreover, the draft bill authorizes the government to reduce the VAT rates in the future, to the extent that such action does not pose a risk for the fiscal targets.

9. Along with smaller fiscal financing needs, a substantial reduction in the expectations of inflation and of peso depreciation, have led to a sharp decline in Treasury bill yields in local currency, thus opening an opportunity for the recovery of credit to the private sector. Moreover, in order to favor financial intermediation in domestic currency and a gradual and voluntary de-dollarization of the financial system, the auctions of inflation-indexed Treasury bills, which were temporarily suspended due to uncertainty stemming from the debt exchange process, will be resumed. In addition, at the end of June, the authorities proceeded to reduce the reserve requirements on peso denominated deposits by five percentage points. Additionally, the overnight rate of the Central Bank was reduced from 10 percent to 5 percent, while the rate of three-day time deposits at the Central Bank, remunerated with 15 percent, was eliminated. Given that the acceptance of local currency is tied to monetary stability, the authorities plan, for the time being, to continue basing their cautious monetary policy on quantitative targets, while they remain committed to moving towards an inflation-targeting regime as soon as technical and institutional conditions allow it.

Structural Reforms

10. The Uruguayan authorities broadly agree with the staff assessment on the financial system and recognize that bank supervision and regulations need to be strengthened to correct the prevailing weaknesses and vulnerabilities of the system. The banking crisis has highlighted important shortcomings of the system, including a high level of non-performing loans that are mostly, but not only, the result of the considerable peso depreciation and the deep recession. It also reflects a strategic behavior of debtors in the face of expectations of refinancing schemes introduced by law. In this regard, the authorities remain firmly committed to avoid intervening in contracts among private agents and are acting against these types of perverse incentives. Meanwhile, the authorities have reached an agreement with the banks for the provision of relief to debtors, but only on a case by case and voluntary basis.

11. The authorities continue to work on a comprehensive restructuring of the public bank, BROU, aimed at improving corporate governance, reducing and rationalizing operating costs, strengthening credit risk administration, and improving the bank’s capital adequacy ratio. The mortgage bank, BHU, has been transformed into a non-bank entity and this has been a critical step. It is important to consider that BHU was seen by the Uruguayan public as an important institution that allowed them to have access to housing. However, the authorities are aware that reforms need to be completed and are working with the World Bank to accelerate them. Regarding the resolution of suspended banks, the Central Bank completed the definition of a strategy for the disposal of the remaining assets of the liquidated banks, to be implemented under the guidance of a steering committee. The authorities concur with the staff and believe that the completion of this process is critical for maintaining creditor discipline and a repayment culture in the Uruguayan financial sector. Being cautious, the authorities believe that an early repayment of the first tranche of reprogrammed deposits will provide a strong positive signal, contributing to eliminate those uncertainties leading to a larger wealth effect, which has been one of the elements affecting private consumption. During the first two weeks after the decision of unfreezing the reprogrammed deposits, the dollar-denominated deposits at the BROU increased.

12. As we have observed, a good portion of the authorities’ efforts has been put on recovering confidence in the economy and particularly in the financial system, since the lack of it has been a critical factor for the depth of the crisis and for a massive credit crunch that has been a major obstacle for resuming economic growth. While a greater macroeconomic and financial stability will contribute to alleviating the situation, the government is finding new ways to increase the access to credit. In this regard, the authorities expect approval of the draft law on trust funds and warrants, which will allow an interesting alternative to financial intermediation.

13. Uruguay has a liberal trading system, as reflected by its rating of 2 in the Fund’s index of aggregate trade restrictiveness. However, the existence of quotas and subsidies in industrialized countries has imposed significant constraints on Uruguayan export growth, particularly in agricultural goods. Unfair trade practices not only limit global growth and development but also give political groups in developing countries justifications to blame foreign conditions for their own problems, resulting in additional resistance to structural reforms. In this regard, further global trade liberalization would not only generate substantial direct benefits in developing and advanced economies, but also will signal more clearly the road of reforms by showing that open markets and globalization are a common practice and can work to the benefit of all.

14. Civil society’s reservations for openness and competition are mirrored in its reluctance to undertake some structural reforms, fearing privatizations may just end up replacing public monopolies with private ones. Therefore, the authorities have chosen to start by focusing on the deregulation and opening-up to competition activities previously reserved for the public sector. Meanwhile, with support of the World Bank, the authorities are working on the creation of strong regulatory agencies.

15. It is true that sometimes consensus building could lead to delays in enacting important reforms. However, a more active role of the citizens tends to produce better monitoring and control of the work of the politicians and the government. Among other things, such control and monitoring could establish barriers to corruption activities, which have proven to be so detrimental to growth and stability. But, more importantly, reforms with a strong consensual backing are long lasting and less subject to reversals due to changes in political winds, thus contributing to build stronger institutions.