Background and Recent Developments

2. Uruguay’s economic program has been framed around the respect for property rights, the predictability of the rules of the game, as well as the avoidance of perverse incentives, and expressed in ambitious macroeconomic targets that led to a prudent management of monetary and fiscal policy. This has been manifested by the debt exchange operation, characterized in the last issue of Euromoney, as one of the smoothest and most elegant operations seen in international finance, which constituted a turning point in the crisis. In addition, the rapid fall of inflation, the stabilization of the exchange rate, the reduction of country risk to about 600 basis points from about 2.200 in February 2003, the recovery of local deposits and economic activity also attested to the success of our authorities’ efforts.

3. After four years of recession and falling GDP, the Uruguayan economy grew robustly in the second part of 2003, leading to an annual growth rate of above 1 percent. It is worth noting that the recovery in economic activity exceeded program projections made early last year (-2 percent), and most notably the original program projections defined in 2002 (-4.5 percent). These better than expected results should help to overcome the skepticism about the results that a well designed program and the financial support of the international community can achieve.

4. Growth has been led by exports, particularly to markets outside the region. The rapid growth of exports of goods and services is partly the response to a substantially improved external environment as compared to the past few years, during which the country was continuously affected by adverse external shocks. Higher global growth has resulted in better export prices, the regional recovery has been critical for tourism activity that continues to accelerate, and lower risk aversion has allowed a significant reduction in the cost of external financing. However, beyond the more favorable external environment, clearly, the increase in competitiveness accomplished in recent years has been critical for boosting exports.

5. Although not as fast as exports, domestic demand is also picking-up, in part, through the incipient recovery of credit to the private sector. As the staff note, the 2002 financial crisis caused a sharp drop in consumer spending, mostly associated with a wealth effect and credit contraction. However, to the extent that the measures resulted in fewer losses to depositors and bondholders than they previously expected, the wealth effect has been receding. Furthermore, official figures are showing increasing activity in the real estate market that could eventually result in a rebound of asset prices, favoring a higher wealth perception and consumption growth. Investment, that was also severely reduced by the deep recession, has been, as is often the case, the last demand component to initiate the recovery. Nonetheless, since uncertainties have been significantly reduced under policies that have demonstrated once again a serious commitment with a friendly business environment, and the credit crunch has been largely overcome, it is possible to foresee a recovery in investment, once the sizeable output gap resulting from the past recession is sufficiently absorbed. There are already strong signals of a recovery of investments in the infrastructure and agricultural sectors.

6. The recovery has been accompanied by a strong increase in employment of 5.5 percent, and a reduction in the unemployment rate to 15.4 percent in the last quarter of 2003, compared to 18.6 percent in the same period of the previous year, and also by a substantial reduction in the average period of joblessness. At the same time, the inflation rate has fallen to somewhat above 10 percent from nearly 30 percent a year ago, much lower than projected under the program.

Fiscal Policy

7. Encouraged by the fiscal achievements in 2003, that represented a turn around of about 3 percent of GDP in the primary fiscal balance, to a surplus of about 3 percent, the authorities are fully committed to achieving this year’s objective. The fiscal target for 2003 was marginally missed as a result of lower than expected nominal revenues owing to lower than programmed inflation and wages and also higher international oil prices. The expenditure targets were met and non-interest expenditure fell by 3 percentage points of GDP in 2003, and will continue decreasing this year. Meanwhile, the interest burden envisaged at 6.6 percent of the GDP, was 5.9 percent of the GDP more than offsetting the slight deviation of the primary fiscal surplus. At the same time, social expenditures will continue to be protected, while the authorities keep on working to enhance the efficiency of social policies. It is also expected that the modernization of the Tax Administration Department, in line with FAD technical assistance recommendations could strengthen tax administration and increase revenues. Nonetheless, the authorities will continue working toward a broader reform aimed at rationalizing the tax system and improving tax collection, even though they recognize the constraints engendered by current political environment. Though the authorities consider that the planned restraint in the expenditure and projected increase of revenues will be sufficient to reach the primary surplus objectives, they agree to keep the adequacy of the fiscal surplus target under continuous review to ensure debt sustainability.

8. Precisely, regarding debt sustainability, Appendix III of the staff report starts underscoring that at end-2003, Uruguay’s debt-to-GDP ratio was close to 100 percent of GDP, more than double its level at end-2001. The increase in debt reflects the severe impact of the crisis that will require sustained policies to be reversed. Our authorities remain convinced that by maintaining a prudent fiscal policy that is consistent with economic growth and poverty reduction, debt sustainability indicators will improve and market access fully regained. The baseline medium-term scenarios for public sector debt show a substantial reduction in the debt-to-GDP ratio. Moreover, looking at the debt issue from a dynamic point of view, it is important to consider that since 2001 Uruguay has overcome the constraints to growth imposed by the appreciated exchange rate, making further real exchange rate depreciation quite unlikely to the extent that the program continues to be implemented. Furthermore, the crisis implied the realization of contingent liabilities related to banking, while the policies implemented, as a response, have further reduced those remaining. All in all, the probability of occurrences of scenarios that superimpose large adverse shocks to an economy that is recovering from previous ones is much lower than in the standard case. As the staff clearly point out, some of the stress tests appear inappropriately pessimistic in light of the fact that Uruguay is just emerging from a crisis.

Monetary Policy

9. A strong increase of the Central Bank’s international reserves has taken place. Gross reserves increased from US$ 555 million in February 2003 to US$ 2,100 million at present, requiring a greater use of monetary instruments to sterilize the monetary impact of the reserve accumulation. Base money growth has been contained within the program’s indicative targets. More importantly, the increased confidence on fiscal and monetary management has also been reflected in the increase in the maturity of the sterilization instruments. Whereas the Central Bank was issuing Treasury bills with an average maturity of 10 days in February 2003, currently these bills have an average maturity of 90 days. At the same time, a substantial reduction in the yield of Treasury bill denominated in local currency has taken place from about 70 percent one year ago to around 15 percent in recent auctions. Moreover, the Central Bank has continued with a weekly auction of inflation-indexed notes, which together with peso denominated liabilities now represents 15 percent of the stock of Notes and Bonds, in contrast to the 1 percent registered in 2002. In addition, in October, Uruguay resumed its access to international financial markets issuing a three-year pesodenominated and inflation-indexed bond.

10. A sustained increase in money demand, associated with the recovery of economic activity and the lower interest rates and inflationary expectations, has allowed a gradual reduction in reserve requirements on peso denominated deposits. This has contributed to initiate a voluntary de-dollarization of the financial system. Since last June, the reserve requirements have been reduced by about 10 percentage points for peso deposits with a maturity of less than 30 days, while requirements for 31 to 180 day peso deposits have been object of an even greater reduction. These measures contributed to an increase of more than 30 percent in peso denominated deposits in 2003, leading to a gradual recovery of the lending in local currency. Furthermore, some commercial banks have already announced their intention to launch inflation-indexed loans, thus substituting the foreign currency denominated loans in their lending operations.

11. It is the authorities’ intention to base the monetary program on quantitative targets in 2004, while continuing forward to establish the foundations for adopting an inflation-targeting regime. The authorities agree that all the foundations for inflation targeting are not yet in place, as Box 5 of the staff report notes, but consider that the additional comments in the aforementioned Box do not exactly reflect the progress made in this area. In particular, the fiscal position and institutional framework have improved substantially, and Central Bank independence has been strengthened.

Structural Reforms

12. The Uruguayan authorities broadly agree with the staff’s comments about the need to accelerate the reform process of the banking system and continue lowering financial vulnerabilities. They have been focusing greatly on the restructuring of the BROU. The fiduciary trust was established in December 2003, and a general manager was hired recently by the Bank, who will contract the specialized services of experienced professionals in dealing with non performing loans. Moreover, the strategic plan approved by the Executive Board of the bank aims at decreasing risk through sound practices to provide loans, as well as to monitor and recover them. Furthermore, some other measures including a rationalization plan will be carried out to reduce operating costs. The authorities believe that reforming the BROU will be crucial to change some behaviors related to creditor discipline and reducing moral hazard.

13. The authorities also agree on the importance of the transformation process of the mortgage bank, BHU. While they are fully aware of the challenges that the transformation of the BHU conveys, they consider fair to recognize the progress achieved since August 2002. Among other issues, the institution has almost halved its personnel from 1,400 employees less than two years ago to about 750 currently, and further cuts are expected this year, as its transformation into a non-bank entity will imply managing assets of only US$ 80 million in contrast to the US$ 2,000 million managed in the past. With regard to the liquidated banks, the launch of bids to outsource asset disposal for the three liquidated banks was carried out. The government-owned bank, created with part of the assets of three liquidated banks, has been able to attract new private sector deposits, and it is being offered for sale to some institutional investors. In the case of the fourth liquidated bank which was closed, the government is completing the sale of its remaining assets.

14. It is possible to find many explanations for the recall of a law that would have made it possible for the state oil company to engage in a partnership with the private sector, including the voter’s reaction to the crisis and the harsh measures taken to confront those hard times. Obviously, the authorities regretted the result of the plebiscite, but on the positive side, they consider that this episode once again made evident that political disputes in Uruguay are solved through the democratic process, and that political stability is clearly one of the most important elements to attract investment. At the same time, the authorities remain convinced of the need to advance deregulation and opening-up activities to competition. To overcome reluctance to some structural changes, the authorities continue working on the development of strong regulatory agencies and promoting transparency and competition. In addition, and as the staff report underscores, the negotiations for a number of concessions to the private sector have been recently completed, including Montevideo’s International Airport and two seaports. Similarly, two new ports are being developed by private companies and a tender has been issued for the rehabilitation of the public railroad, all of which will reinforce the momentum of some activities, like forestry, that has received a significant amount of foreign investment.

15. The free trade agreement with Mexico, the ongoing negotiations with the United States, and the recent visit of the Uruguayan President to Spain to invite local companies to invest in Uruguay under a friendly business environment, are part of the authorities’ strategy to fully integrate the country in the global economy. Finally, few days ago, the authorities notified the Uruguay’s subscription to the IMF’s Special Data Dissemination Standard, which is a new step to improve the transparency and quality of the country’s data, a critical condition to attract foreign investment.