Fifth Review Under the Stand—By Arrangement and Requests for Modification of the Arrangement and Waiver of Nonobservance and Applicability of Performance Criteria—Staff Report; Staff Supplement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Uruguay

This paper examines Uruguay’s Fifth Review Under the Stand-By Arrangement and Requests for Modification of the Arrangement and Waiver of Nonobservance and Applicability of Performance Criteria. The macroeconomic framework is broadly on track, but progress with structural reform remains uneven. Fiscal performance has been better than programmed, reflecting buoyant revenues. The monetary and balance-of-payments targets of the program have been met. Although program risks have diminished further since the last review, important vulnerabilities remain, leaving no room for policy slippages.


This paper examines Uruguay’s Fifth Review Under the Stand-By Arrangement and Requests for Modification of the Arrangement and Waiver of Nonobservance and Applicability of Performance Criteria. The macroeconomic framework is broadly on track, but progress with structural reform remains uneven. Fiscal performance has been better than programmed, reflecting buoyant revenues. The monetary and balance-of-payments targets of the program have been met. Although program risks have diminished further since the last review, important vulnerabilities remain, leaving no room for policy slippages.

I. Background

Political situation

1. The political environment is increasingly focused on the upcoming national elections. Presidential and congressional elections will be held on October 31, 2004. Recent polls show a large lead—albeit somewhat reduced from earlier highs—for the opposition coalition led by the Frente Amplio (Box 1). The new government will take office on March 2, 2005; the current Stand-by Arrangement (SBA) expires March 31, 2005. Reflecting the elections, legislative work on economic reforms has slowed sharply, while proposals for additional expenditure have increased; so far, however, spending has been kept within program limits.

Election Modalities and Outlook

A victory in the first round of the presidential elections requires a majority of all votes cast. If no candidate achieves such a majority in the first round (October 31), a runoff is held between the top two candidates. In the second round (November 28), a President is elected by a majority of all valid votes. Congressional seats are determined in the first round through proportional representation. The new president will take office on March 2. Also on October 31, a plebiscite will be held on whether to remove private participation in the processing and supply of potable water, similar to the December 2003 referendum on the recall of a law allowing the state oil company (ANCAP) to engage in partnerships with the private sector.

According to most opinion polls, the left-leaning Frente Amplio-led (FA) coalition enjoys a strong lead. However, its support has fallen slightly below 50 percent, raising the possibility of a second-round vote, which polls suggest could be a closely contested race between the FA and National Party candidates. The main presidential candidates are:

FA. Dr. Tabaré Vázquez, former mayor of Montevideo and presidential candidate in 1994 and 1999. His policy focus is on combating poverty and income redistribution. He favors an active role for the state in the economy to generate employment and promote strategic sectors, while maintaining macroeconomic stability and honoring debt commitments.

•National (Blanco) Party. Senator Jorge Larrañaga is running second in the polls. He supports a primary fiscal surplus of “no less than 3 percent of GDP” and maintaining single-digit inflation, while pursuing policies to promote domestic production and decentralization.

•Colorado Party. Mr. Guillermo Stirling, interior minister of the past two Colorado governments, has pledged to broadly continue the current economic policy approach, including macroeconomic stability and stable rules for investors, and advocates a strengthening of the social safety net.

Developments under the program

2. The economic recovery is stronger than anticipated at the time of the last (fourth) review, supported by the favorable external environment.

  • Growth and employment. Real GDP grew by 2½ percent in 2003 (compared with a previous estimate of 1 percent). First-quarter growth reached 14.3 percent (y/y); private consumption and investment expanded strongly as the recovery has broadened beyond exports. Unemployment fell in June to 13.1 percent, almost 4½ percentage points lower than a year ago.

  • Wages and inflation. Wage pressures remain modest, with the 12-month increase in June at 8 percent. Inflation declined through the first quarter, but has picked up somewhat since to 10.2 percent in July (y/y), in part reflecting higher utility and petroleum product prices, and above the central bank’s target range for end-2004 of 7-9 percent. Core inflation in July was 7.2 percent.

  • External current account. The external current account surplus declined to 0.7 percent of GDP in 2003 mainly due to a spike in imports in the second half of the year and increased profit repatriation by foreign banks. During the first half of 2004, the current account posted a modest surplus as strong tourism and export earnings outpaced the rebound in imports.

Uruguay: Selected Macroeconomic Indicators

(12-month percentage change, unless otherwise indicated)

article image
Sources: BCU, and Fund staff estimates.

Staff estimate.

Through May 2004.

3. Most financial indicators have continued to improve.


(Uruguayan pesos/foreign currency unit Dec 2000=100)

Citation: IMF Staff Country Reports 2004, 327; 10.5089/9781451839265.002.A001

  • Exchange rate. Since end-2003, the peso has been fairly steady, with the BCU purchasing some US$100 million through July in the foreign exchange market (in line with the program). Uruguay’s real effective exchange rate remains some 30 percent more depreciated than its average in the run up to the financial crisis, and 15 percent more depreciated than its average during the 1990s.

  • International reserves. Gross international reserves of the BCU have been maintained in 2004. Gross reserves of the banking system cover almost 60 percent of short-term debt and dollar deposits (about the same as in Argentina, but lower than in Paraguay and Peru).

Comparisons of Banking System Reserve Adequacy Indicators

article image
  • Debt and sovereign spreads. In February, Uruguay reopened its three-year, peso-denominated, inflation-indexed global bond for US$100 million at an interest rate 200 bps below the original issuance in October 2003; in July 2004, US$250 million of 18-month peso-denominated notes were issued.1 Fitch and S&P raised Uruguay’s foreign currency debt rating one notch to B, in March and July, respectively. Uruguay’s sovereign spreads have widened somewhat since the first quarter, in line with those for other emerging market debt, and are now around 600 bps. The stock of total short-term public debt declined slightly through end-June to about 6 percent of GDP.2

  • Domestic interest rates. Rates on peso- and dollar-denominated T-bills have increased somewhat since end-2003, reflecting the increase in U.S. interest rates and the rise in Uruguay’s sovereign risk premium. Interest rates on 6-month peso-denominated T-bills now stand at around 20 percent.


Sovereign risk (EMBIG Global)

Citation: IMF Staff Country Reports 2004, 327; 10.5089/9781451839265.002.A001

4. The monetary program is on track. Monetary policy was tightened in the first quarter and again in July. Early in the year, in view of elevated inflation expectations and measures of underlying inflation pointing to year-end inflation of almost 11 percent, the central bank (BCU) cut its quarterly (average) base money targets for 2004. At the same time, the BCU switched from a point target to a target range for base money to provide more flexibility in dealing with volatility in money demand. In July, base money targets were cut again when the BCU announced a target range of 6-8 percent for 12-month inflation through June 2005. The end-June PCs on NIR and NDA were observed with comfortable margins.

5. Fiscal performance has been stronger than programmed owing to robust revenue performance. The primary surplus of the consolidated public sector reached 1.1 percent of annual GDP in the first quarter, 0.6 percent of GDP higher than programmed, with a commensurate improvement in the overall deficit. The overperformance reflected better-than-expected revenue (0.6 percent of GDP), while expenditure was kept within the program limits and state-enterprise tariffs were adjusted in line with cost conditions. Preliminary second-quarter data indicate that revenue has continued to outperform the program, mainly due to buoyant corporate income tax receipts, and expenditure restraint has been maintained. In light of this performance, in May-July, the authorities eliminated emergency surcharges (on the wage tax and corporate income tax) and taxes (on commissions and public utilities), which will cost the budget about 0.5 percent of GDP in 2004 (1.4 percent of GDP on an annual basis).3

6. Private sector deposits in the banking sector have continued to recover. Dollar deposits rose by US$463 million during the first half of this year, rising further above their level in July 2002, when the bank holiday was declared. Bank credit has yet to revive, however, as banks continue to focus on cleaning their balance sheets. Moreover, dollarization remains high, with about 90 percent of deposits in dollars, despite measures introduced over the past year to reduce incentives for dollarization.4

Uruguay: Changes in Deposits

article image

7. Progress on bank restructuring has been mixed.

  • BROU. The bank’s restructuring is advancing. Profits are exceeding the business plan, and operational costs are lower than programmed. The fiduciary trust to work out BROU’s nonperforming loans (NPLs) began operations in April, and the end-March and end-June PCs on the transfer of NPLs to the trust were observed.5 While the end-March PC on the contracting of specialized asset recovery services was not observed, this action was taken in April.

  • Reprogrammed deposits. In mid-April, BROU began the early release of the second tranche of reprogrammed deposits of about US$700 million.6 The release went smoothly—some 95 percent of freed funds remained with BROU, with 75 percent in time deposits. Interest rates on remaining reprogrammed deposits were reduced from 6 percent to 3½ percent, which—while somewhat higher than market average—is consistent with a viable medium-term outlook for the bank.

  • Liquidation funds of Banco Montevideo, Banco comercial, and Banco caja Obrera. Little progress had been made in disposing the remaining assets in these banks’ liquidation funds until mid-year. The end-March PC to select a winning bid for outsourcing asset disposal of these banks was not met. This measure was first envisaged for completion in July 2003 and subsequently rescheduled on several occasions. In June, the authorities began undertaking a series of steps to rejuvenate the process (see Attachment I, paragraph 8).

  • Banco de Crédito (BDC). In June and again in July, the BCU attempted to auction assets of the BDC’s liquidation fund to generate resources to extinguish remaining depositor claims, but no offers met the authorities’ expectations. The authorities revised their strategy and, in mid-August, covered these claims with government bonds (face value) that the liquidation fund received in exchange for assets of the fund.7 These assets and those remaining in the liquidation fund will be disposed of by end-December 2004. Performing loans will be securitized, while the management of NPLs will be outsourced.

  • Nuevo Banco Comercial (NBC). In May, the BCU approved NBC’s final 2003 accounts, which showed a profit of US$8 million, driven by NPL recoveries. The IFC has recently indicated that its interest in acquiring a minority equity stake in the bank remains under review, and the authorities intend to continue discussions with the IFC on this matter.

  • State mortgage company (BHU). World Bank staff reports good progress in restructuring the bank. Operating costs have been reduced considerably, an improved loan-servicing framework has been adopted, and stronger recovery modalities for NPLs are being put in place. The BHU is withdrawing from construction and commercial real estate lending and is focusing on limited residential lending. A new information system is being introduced, paving the way for disbursement of the second tranche (US$50 million) under the SAL-I operation.

  • Bank supervision. While the BCU has continued to improve its regulatory framework, the hiring of additional staff to strengthen the supervisory capacity of the Bank Superintendency (SIIF) has been slow, holding up a disbursement under the IDB’s Financial Sector Loan (which is now expected in the fourth quarter).

8. Progress in other areas of structural reform has been largely disappointing. The tax reform proposal submitted to Congress last year has not moved forward, and is unlikely to do so ahead of the elections. Structural benchmarks for congressional approval of reforms to the special pension regimes for the police and the military have not been met. Congressional approval of regulatory frameworks for the water and gas sectors, which are conditionality under the World Bank’s SAL-II operation, is also pending. However, the authorities successfully auctioned in May a set of cellular phone licenses (for US$30 million). In July, the free trade agreement with Mexico came into effect.

II. Policy Issues

9. Discussions focused on actions needed to sustain the recovery and stabilization gains achieved under the program, to provide a solid framework for the new government that will take office in March 2005. Despite the better-than-anticipated economic performance, fragilities persist in a number of areas. Accordingly, the discussions centered on the need to maintain prudent fiscal and monetary policies and advance key structural reforms, particularly in the banking sector.

10. The macroeconomic framework for 2004 has been revised to incorporate the stronger-than-anticipated recovery of growth. Real GDP is now projected to grow at 7 percent (up from 5 percent in the program) to take account of the expansion through the first quarter of 2004. Inflation is projected to remain at the high end of the authorities’ 7-9 percent target range for end-2004, and the external current account to post a small surplus, with high growth in both exports and imports. While there are upside risks to this outlook (leading indicators point to growth higher than 7 percent), there are also a number of downside risks, including world oil prices; uncertainties related to the upcoming elections; and possible electricity shortages due to a rainfall deficit and reduced electricity exports by Argentina.

A. Fiscal Policy and Debt Management

11. To enhance prospects for debt sustainability, the authorities have committed to a higher primary surplus target for 2004. The authorities are now targeting a primary surplus of 3.4 percent of GDP, which implies an improvement of about ¾-percentage point of GDP over last year. Staff welcomed the strengthening of the target, although it noted that the much better-than-expected revenue performance provided a good opportunity to bolster the fiscal position even further, given the still-fragile medium-term debt outlook. In this vein, staff recommended against the recent elimination of the emergency surcharges and taxes. The authorities explained that the tax cut was consistent with the higher 2004 primary surplus target, despite the negative fiscal implications of the sharp rise in world oil prices and power generation costs (Box 2). To ensure that the primary surplus target for this year will be met, the authorities committed to keeping primary expenditures strictly within the limits of the program (the July wage increase of 5½ percent was broadly in line with the program) and to continue adjusting public tariffs in a timely manner in line with cost developments.

Fiscal Implications of the Regional Energy Shortage and Higher World Oil Prices

Regional energy shortage

• Uruguay’s power generation capacity is mostly based on hydroelectric energy that comfortably exceeds demand under normal weather conditions. To accommodate drought risks, the state-owned power company, UTE, maintains an “insurance” contract for back-up power from Argentina.

• Low rainfall in the first part of the year and energy shortages in Argentina resulted in shortfalls in backup energy supplies, forcing UTE to rely on old thermal-power generators and imported power from Brazil, both considerably more costly.

• To accommodate these higher costs, which have eased somewhat in light of recent rains, the authorities have postponed part of UTE’s investment program (by some 0.2 percent of GDP) and raised tariffs by 6 percent (on average) in June (the programmed 4.5-percent increase plus a 1.5-percent premium for unforeseen additional costs), with higher increases for large consumers and lower increases for residential consumers and smaller businesses.

Higher oil prices

• Uruguay imports, on average, 1. 5 million barrels of crude oil per month. For each one-dollar increase in the price of crude oil, costs of the state oil company, ANCAP, are estimated to rise by US$18 million (0.15 percent of GDP) on an annual basis.

• The government has some discretion in adjusting fuel prices. By law, ANCAP cannot change prices on its own accord; rather, it must submit proposed changes to the Office of Planning and Budget for approval. In the absence of exceptional circumstances, price changes can only be done at the time of public wage adjustments. Petroleum products are subject to specific taxes, which currently yield 1.4 percent of GDP.

• In 2004, the authorities have raised fuel prices by a cumulative 20 percent to mitigate the financial impact of higher crude oil prices on the fiscal program. Fuel prices at the pump are now among the highest in the region. Nevertheless, due to lags in adjusting prices, ANCAP’s operating balance is expected to be lower by 0.3 percent of GDP.

12. To ensure sustainable debt dynamics, the primary surplus should be at least 3½ percent of GDP in 2005 and rise to no less than 4 percent of GDP in the medium term. Staff cautioned that any further tax reduction measures should only be taken in the context of a comprehensive tax reform and consistent with the envisaged medium-term fiscal path. The authorities confirmed that there would be no further tax reductions during their time in office, and stressed that, while near-term prospects for tax reform are poor, they remain committed to foster dialogue and seek consensus toward its adoption.

13. The elimination of the 2002 emergency surcharges and taxes presents downside risks for the fiscal program, mainly for 2005. For 2004, on current trends, the revised primary surplus target may well be exceeded, as the full impact of the tax cuts will only be felt next year. Projections for 2005 indicate that the loss of revenue from the eliminated surcharges and taxes would be partly offset by the absence of one-off expenditures in 2004 and higher corporate income tax receipts (because of the strong recovery in 2004);8 as a result, the 2005 primary surplus target would be achieved based on the authorities’ 2005 budget plan that calls for a real increase in spending of 1.5 percent.

14. Improving tax administration and strengthening the institutional framework for the budget will be key to meeting the medium-term fiscal objectives without having to increase already high tax rates.

  • While the authorities are continuing to modernize tax administration, staff expressed disappointment with the delays in the reform agenda. The Tax Administration Department’s (DGI) modernization plan (supported by a grant from the EU) is behind schedule, due to administrative and legal delays. The creation of an internal audit unit—to improve internal governance and curb evasion, mainly through increased field audits in high-risk sectors—has also been delayed, implying that the establishment of a Large Taxpayers Unit (a structural benchmark for end-September) is now proposed for end-December 2004 (structural benchmark).

  • Staff recommended (in line with the fiscal ROSC) that the central government budget law be enhanced to require that: (i) budget documentation include a statement of fiscal policy objectives and a qualitative assessment of the sustainability of fiscal policy; (ii) annual tax expenditure be specified explicitly in the budget to make transparent the costs of tax exemptions and incentives; and (iii) annual revisions to the budget include updated medium-term macroeconomic and expenditure frameworks and a discussion of fiscal risks.9 The authorities argued that their budgetary framework provides an adequate forward-looking perspective of fiscal policy, but agreed that including tax expenditure explicitly in the budget would improve transparency of tax policy, and that they would explore the necessary legal channels to require that such spending be included in the budget.

15. Uruguay’s debt management strategy focuses on extending the maturity of domestic debt placements, securing timely disbursements from IFIs, and taking advantage of opportunities to issue longer-term debt in the international markets. In addition to the reopening of their global 3-year bond, the authorities have extended the original maturity of dollar-denominated T-bills to 18 months and started issuing inflation-indexed T-notes with a maturity of 3 years. The recent US$250 million bond issue will cover short-term debt rollover needs through March 2005. The authorities have also stepped up efforts to implement policies linked to the pending tranches under World Bank’s SAL I facility and the IDB’s Financial Sector Loan, which they now expect to be disbursed in the second half of the year. Staff welcomed these steps and urged the authorities to take advantage of opportunities to extend the maturity of the relatively large stock of peso T-bills, and issue longer-term instruments in the international markets if market conditions permit.

Uruguay: Scheduled Disbursements from Multilateral Development Banks, 2004-05

article image

B. Monetary and Exchange Rate Policies

16. The authorities intend to continue with the peso float, with base money as the intermediate target of monetary policy. The authorities noted that the tightening of the base money target in early 2004 was in response to concern about signs of a pickup in inflation and the BCU’s monthly survey showing inflation expectations above the target range. While the strong economic recovery could lead to higher-than-projected money demand, the authorities thought that this could be offset by rising domestic interest rates and uncertainty during the election period. Staff broadly concurred with this assessment, and it is proposed to revise the base money targets under the program (as shown in Table 3). Staff also supported: (i) the shift toward a target range for base money, in light of the uncertain impact of the elections on money demand; (ii) the creation of a repo facility to improve the BCU’s capacity to manage liquidity; and (iii) the recent lowering of the BCU’s inflation target range for June 2005.

BCU Base Money Target Range, 2004

(in Ur$ million)

article image

17. The strong external environment has allowed the BCU to raise modestly (by US$80 million) its targeted build up of reserves this year. Staff suggested a larger increase in the end-year NIR target that would lock in the overperformance with respect to the program target in the first half of the year.10 Staff pointed out that a further build up was warranted in light of the relatively low level of coverage of deposits and short-term debt. The authorities agreed that a further NIR increase would be desirable over time but noted the risk of some volatility in money demand and the balance of payments in the run up to the elections, and that a higher target would result in the issuance of additional central bank debt and a widening of the quasi-fiscal deficit. The authorities reiterated their commitment to reduce financial dollarization, noting that the required strengthening of confidence in the peso would take time.

C. Banking Reforms

18. Progress in reforming the banking system has been uneven, with advances in restructuring the public banks but disappointing results so far in asset disposal and recovery (Box 3). Staff welcomed the continued improvement in financial soundness indicators, the regulatory framework, and the public banks, while regretting the repeated delays with the bank liquidation process and the failure to meet the end-March PC on the outsourcing of asset disposal of the liquidation funds. This lack of progress risks undermining creditor discipline and increasing the fiscal costs of bank restructuring, and staff expressed concern about governance risks resulting from inadequate financial reporting by the liquidation funds and the poor information flow between the funds and the BCU (preliminary information suggest that the stock of nonreconciled items stand at around US$20 million).11 The authorities recognized the delays and explained that they resulted mainly from the lack of cooperation from unionized labor in the liquidation funds (for fear of job losses) as well as resistance by interest groups to the strategy for asset disposals (sales or outsourcing), which represents a break with the past practice of socializing losses in bank resolutions.

19. To address governance concerns and bring asset disposal back on track, the authorities have committed to the following steps as prior actions for this review:

  • Appointing a full-time supervisor to oversee the implementation of the asset disposal strategy;

  • Completing an inventory of assets, as well as end-May balance sheets for each of the liquidation funds;

  • Submitting information on NPLs obtained from the asset inventory to the SIIF for inclusion in the credit registry;

  • Hiring audit and accounting firms for the preparation of: (i) financial statements for the funds’ operations since inception; and (ii) an external audit of these statements;

  • Contracting a firm through a competitive bidding process to manage the assets in the liquidation funds of Banco Comercial, Banco Montevideo, and Caja Obrera and transferred to the firm a first tranche of NPLs of at least US$300 million; and

  • Transmitting the liquidation funds’ end-July financial statements to the Ministry of Economy and Finance (MEF) and BCU.

Bank Liquidation Funds

During the 2002 banking crisis Uruguay’s four largest private domestic banks experienced serious financial difficulties, and they were ultimately liquidated (Country Report No. 03/247, Supplementary Information). Their assets (mainly NPLs after the good assets were shifted to NBC) were transferred to four liquidation funds under the BCU’s administration.

Banco Comercial, Montevideo, and Caja Obrera

The liquidation funds for these banks were created in December 2002, but asset disposal, except for those purchased by NBC, has lagged.

Under the original program, the outsourcing of the disposal of at least two asset groups was set as a structural PC for end-July 2003, but this PC was not observed. The authorities then revised their strategy and decided to outsource the management of the entire stock of assets by end-March 2004 (structural PC). Five asset management companies were pre-qualified, but the auction could not be held because the liquidation funds were unable to assemble the required information for due diligence.

To accelerate the asset disposal process, the BCU terminated in May 2004 most of the liquidation funds’ employees and hired an external consulting firm to undertake an inventory, document the assets for their auction, and prepare end-May balance sheets. The recently concluded inventory shows that the remaining assets in the funds have a book value of approximately US$325 million.

Any recoveries from the remaining assets will be distributed on a pro-rata basis among the claims against the liquidation funds. The government and the BCU own close to two-thirds of these claims. Recently, the liquidation funds made a pro-rata cash distribution to their creditors. Although staff had recommended deferring the distribution until the funds’ financial statements were finalized, the authorities explained that the information on the liability side of the funds to determine the distribution was well documented.

Banco de Crédito

Its liquidation fund was created in February 2003. Disposal of the assets in this fund is more advanced following: (i) agreement in 2003 with creditors to trade their claims against government bonds at face value; (ii) repayment by the former minority shareholder of its large stock of outstanding loans; and (iii) the repayment in August 2004 of remaining claims with government bonds. As described in paragraph 7, the authorities envisage that the remaining assets will be disposed of by end-2004.

20. Continued progress in asset disposal and oversight of the liquidation funds is expected as follows:

  • Financial statements from the inception of the liquidation funds will be completed by end-September; and their financial audits by end-October (structural PC).

  • All remaining assets in the liquidation funds of Banco Comercial, Banco Montevideo, and Banco Caja Obrera will be transferred to the asset manager by end-October (structural PC).

  • The liquidation funds will produce monthly financial statements (by the 20th of the following month) and transmit these to the Ministry of Economy and Finance (MEF) and BCU (monthly structural PC beginning September).

  • As of the last quarter of 2004, the liquidation funds will begin publishing quarterly financial reports within 30 days of the close of the quarter (end-January 2005 structural PC).

Staff welcomed the authorities’ decision to close out the bank stabilization fund (FSBS), which had been used as envisaged to back sight and savings deposits at qualifying banks, and to apply the unused balance toward an early repurchase to the Fund. Staff expressed concern, however, about a number of congressional initiatives which aim at extending compensation to creditors of the liquidated banks.12 The authorities informed staff of their opposition to such compensation plans for depositors and other creditors, although they recently offered bondholders and depositors with claims above US$100,000 a swap of these claims and various dollar-denominated government bonds maturing over the medium term for new, longer-term, inflation-indexed, peso-denominated government bonds. Staff expressed concern that this could be seen as a bailout of bondholders and large depositors that runs counter to the authorities’ earlier limited compensation plan and to good bank resolution practices. Preliminary estimates suggest that the swap would be broadly NPV neutral, while smoothing the maturity profile and improving the currency composition of the public debt; albeit, at a cost of a higher nominal stock of debt. The authorities underscored that this was not a bailout, as the swap was market-based and included no special incentives for participation in the swap.

21. BROU’s financial performance has begun to improve and its restructuring is advancing (Box 4). Staff reviewed BROU’s performance during the first quarter, which was better than foreseen, and confirmed that BROU would be viable under its business plan.

  • Staff verified that progress is being made in setting up an asset management company (AMC) to manage BROU’s fiduciary trust with NPLs. Staff stressed that successful recovery of NPLs would require substantial delegation of powers to the AMC’s staff, reserving direct involvement by the Executive Board only to strategic matters.

  • The authorities confirmed their plan to release the final tranche of reprogrammed deposits according to the original schedule (which would begin in July 2005), and committed to consult closely with staff on any changes to this plan.

Progress under BROU’s Restructuring Plan

In December 2003, BROU adopted a restructuring plan to address balance sheet weaknesses and ensure the bank’s viability through operational restructuring (see Country Report No. 04/172, Appendix II). Progress to date includes:

  • Recovery of NPLs. An asset management company (AMC) was established to manage the NPLs removed from BROU’s books and transferred to the fiduciary trust. Under its business plan, the AMC would work out large NPLs while the recovery of smaller NPLs would be outsourced. The AMC has retained a consultant to produce recovery manuals and hired collection agents and legal services to help with asset recovery. NPL documentation is being gradually transferred from BROU to the AMC. Cash recoveries from NPLs through June already exceeded the 2004 target.1

  • Operational restructuring. To reduce operating costs, almost 300 employees (out of 4,000) went into early retirement during the last quarter of 2003 and the first quarter of 2004, and BROU continued to streamline its extensive branch network. In April, interest rates on reprogrammed deposits were reduced from 6 percent to 3½ percent, closer to market levels.

  • Business focus and strengthening risk management. BROU is refocusing lending and deposit activities in the peso market. During the first half of 2004, local-currency lending rose in line with the business plan, while dollar-denominated lending was flat. At the same time, BROU began offering savings instruments in local currency. BROU continues to work on adopting credit-scoring mechanisms, improving credit risk assessment, and implementing credit monitoring procedures.

1/The targeted recovery schedule for the first tranche of transferred NPLs is as follows: US$32 million in 2004; US$148 million in 2005; US$160 million in 2006; and US$48 million in 2007 (excluding interest).

22. The transformation of BHU into a nonbank mortgage lending institution is beginning, but BHU’s financial situation will remain weak for some time. Staff welcomed the implementation of reforms in line with conditionality under the World Bank SAL I and the servicing of BHU’s obligations to BROU. However, it noted that BHU will still require support from the government to make this year’s amortization payment to BROU, and will remain in a relatively weak financial position for several years to come. The authorities shared this assessment and underscored their commitment to steadfast implementation and close monitoring of the bank’s restructuring plan.

23. The setup phase of NBC has been completed, and the bank’s focus must now shift towards achieving its business plan targets. NBC is highly liquid and well capitalized, but its operating costs are somewhat higher than envisaged. Staff expressed its disappointment over the slow progress in the negotiations with the IFC for its acquisition of an equity stake in the bank, and encouraged the authorities to continue pursuing discussions with them. IFC participation would facilitate a strengthening of NBC’s governance, including by increasing the size of the bank’s Executive Board and ensuring the appointment of Board members with a strong background in commercial banking.

24. The authorities remain committed to continue strengthening bank supervision, but progress has been slow in hiring needed staff. The regulatory environment has been improved, especially regarding credit risk resulting from lending in foreign currency to borrowers with peso incomes. However, staff stressed that for the strengthened regulations to be effective, the SIIF needs sufficient staffing levels and capacity. The authorities agreed and noted the ongoing efforts to improve supervisory capacity, with technical support from the IDB and the Fund, and to hire additional SIIF staff, which has been delayed mainly by BCU statutory hiring procedures.

25. The authorities are considering the introduction of a limited deposit insurance scheme, which would need to be implemented in a cautious manner given the current structure of the banking system. The plan, being formulated with the assistance of Canadian experts, would include differential charges and/or coverage for peso and dollar deposits. The authorities agreed with staff that the design and implementation of such a scheme would have to be carefully prepared in light of Uruguay’s current circumstances and the dominating role played by a large public bank with an explicit government guarantee of deposits (i.e., BROU).

III. Vulnerabilities and Program Risks

26. While program risks have further diminished since the last review, important vulnerabilities remain, and maintaining sound policies is essential to contain these risks. Most indicators of financial vulnerability have continued to improve, including the stock of deposits, gross reserve coverage, and capitalization and loan quality of the banking system, suggesting increased resilience to external or domestic shocks. Nevertheless, the public debt is still high (110 percent of GDP as of end-March) and mostly dollar-denominated, with a significant short-term component; and the recent tax cuts leave little room for any deviation from continued tight control over expenditure if the 2005 primary surplus target is to be met. Financial dollarization remains entrenched; and weaknesses remain in the banking system. In particular, the majority of dollar-denominated deposits are sight deposits and the public banks (which hold half of total deposits) are still in the process of restructuring. Delays in the resolution of the liquidated banks raise governance concerns in the restructuring process that could adversely affect prospects for the establishment of a sound banking system, and additional costs of bank restructuring might be beginning to surface, while there are already large fiscal contingent liabilities associated with the banking system. In addition, the upcoming election period could see heightened market volatility; weakened fiscal discipline; and slower progress in restructuring the banking system.

27. Uruguay is exposed to interest rate and oil price risks. Roughly one-half of the public debt is at variable rates, but this risk is mitigated somewhat as the largest part of this debt is to IFIs (as a result, interest rates are diversified and increases in sovereign spreads would not affect debt service costs). Staff estimates that the full-year effect of a one-percentage point increase in U.S. interest rates on Uruguay’s interest bill amounts to 0.3 percent of GDP. An additional source of interest rate vulnerability stems from the 0.5 percent of GDP (assuming no volume change) and, if fully passed through, an estimated first-round impact on inflation of 1¼ percentage points.

28. Baseline medium-term debt dynamics are sustainable but remain vulnerable to shocks. The updated debt sustainability analysis shows that under the baseline scenario, the debt-to-GDP ratio will decline gradually, but still remain above 65 percent through 2012 (Box 5). Sustainability concerns could therefore arise in case of a longer-term economic slowdown or a deterioration in the government accounts.

29. Fund exposure to Uruguay is likely to remain high for some time. Despite the authorities’ welcome decision to forego one disbursement under the current program, credit outstanding to the Fund would reach 656 percent of quota (over 20 percent of GDP) at the end of the arrangement in March 2005. The repayment burden to the Fund will rise steeply in 2006 and 2007 when payment obligations are projected at about 7¼ and 5½ percent of GDP, respectively. Several of the presidential candidates have already announced that if elected they would seek a new Fund-supported program.

Public Debt Sustainability Analysis

In updating the baseline DSA analysis presented in Country Report No. 04/172 (Appendix III), staff considered it appropriate to continue to assume an average medium-term primary surplus of 3½ percent of GDP, real GDP growth of 3 percent, and a modest real appreciation of the exchange rate. Under these assumptions, public debt would decline over the medium term from 97 percent of GDP in 2003 to around 65 percent by 2012 (assuming all contingent liabilities owing to bank restructuring come due; if there are no additional bank restructuring costs, it would decline to around 60 percent). Financing gaps, which begin emerging in 2005, will require additional market and IFI financing.

Uruguay’s high public debt continues to be a major vulnerability. Large shocks to key variables in the standard DSA analysis such as real growth, real interest rates, and the real exchange rate (depreciation) would lead to increases in the public debt-to-GDP ratio that are either unsustainable or would raise serious doubts as to debt sustainability. However, it must be recognized that Uruguay recently experienced important shocks and has adjusted policies in response so that these shocks are unlikely to unfold.

Staff has analyzed three alternative shocks to key macroeconomic variables: (i) an average decline of real GDP growth by 1 percent; (ii) a 200-basis point increase in interest rates over the medium term; and (iii) weak confidence in the peso that prevents the expected appreciation in the real exchange rate. Even in these cases, the public debt ratio is generally not resilient. Lack of appreciation of the real exchange rate would leave the public debt at dangerously high levels. Slower growth, combined with a policy response that aims at offsetting the slow-down by lowering the primary surplus targets, would lead to a rising debt ratio. Moreover, even if additional fiscal efforts were undertaken to meet the primary balance path under the baseline, the debt ratio would only decline to around 75 percent by 2012. Finally, higher interest rates over the medium term, under the baseline primary surplus path, would leave the debt ratio above 70 percent by 2012 (Figure 1).

Figure 1:
Figure 1:

Gross Public Sector Debt 2003-2012

(in percent of GDP)

Citation: IMF Staff Country Reports 2004, 327; 10.5089/9781451839265.002.A001

IV. Program Financing, Monitoring, and Safeguards

30. Financing Assurances. Financing needs through March 2005 have been secured, and prospects for next year are closely linked to domestic financial conditions. The medium-term outlook is dependent on the extent of market access and financial assistance from the IFIs. Staff’s baseline scenario for 2005 assumes modest access to domestic and international financial markets, which depends, of course, on maintaining sound policies.

31. Program Monitoring. While Uruguay’s statistical database has been generally adequate for assessing and monitoring macroeconomic policies, there have been long data lags in the fiscal area. To remedy the problem, the authorities have created a coordinating committee consisting of representatives from the MEF, BCU, BROU, and BHU to ensure timely provision of fiscal data in line with the commitments set out in the TMU (a prior action for this review). Prior actions, performance criteria, benchmarks, and indicative targets under the program are specified in the attached MEFP and TMU (Attachments I and II). The sixth review is expected to take place in November 2004.

32. Safeguards. The recommendations of the 2002 Safeguards Assessment are being implemented, albeit with delay. The external audit of the BCU’s 2003 financial statements was finalized in March, and a supplemental audit of the FSBS, focusing on the resource use by recipient banks, is ongoing. In addition, the BCU has created an independent audit committee to oversee the bank’s financial reporting practices.

V. Staff Appraisal

33. Uruguay is emerging from a long period of economic recession at a faster-than-expected pace. The improved situation is a product of the sound macroeconomic policies pursued by the authorities and the supportive external environment. Staff encourages the authorities to further capitalize on the current favorable environment, continue with sound macroeconomic policies, and push ahead with structural reforms to set the basis for a sustained expansion of the economy.

34. Uruguay’s fiscal accounts have continued to improve, and achieving the revised higher primary-surplus target under the program will buttress the medium-term outlook for fiscal consolidation. Staff welcomes the strengthened primary-surplus target for 2004, although it considers that the stronger growth dividend for revenue would have been a good opportunity to reinforce the fiscal position even further, given the still-fragile medium-term debt outlook. Staff commends the authorities’ commitment to maintain expenditure restraint, keep public utility tariffs broadly aligned with operating costs, and refrain from any further tax reductions. Delivering on these commitments will be essential to maintain market confidence and meet the medium-term fiscal consolidation goals, as there is little scope for fiscal slippage.

35. Staff regrets the slow progress on fiscal reforms. Meeting the medium-term fiscal objectives will depend crucially on addressing structural fragilities of Uruguay’s public finances by strengthening revenue administration, reforming the tax system and the specialized pension funds of the police and military, and improving the institutional

35. Staff regrets the slow progress on fiscal reforms. Meeting the medium-term fiscal objectives will depend crucially on addressing structural fragilities of Uruguay’s public finances by strengthening revenue administration, reforming the tax system and the specialized pension funds of the police and military, and improving the institutional budgetary framework. Staff encourages the authorities and other concerned parties to continue working toward a consensus on these reforms.

36. Monetary policy is being conducted in a prudent manner. Staff supports the tightening of monetary targets in 2004 designed to stem any sustained deviation of inflation from the BCU’s target range. Actions taken to improve the conduct of monetary policy, such as the introduction of a repo facility, are also welcome. While the authorities have raised the 2004 NIR target under the program, staff encourages them to use the opportunity of a stronger-than-programmed balance of payments to bolster Uruguay’s NIR position even further, in anticipation of the large medium-term debt service obligations.

37. Maintaining momentum for restructuring the public banks is essential to ensure their viability, improve creditor discipline, and minimize potential fiscal costs. Staff welcomes progress made in the restructuring of BROU and BHU. For a successful workout of BROU’s nonperforming loans, the asset management company (AMC) will need sufficient independence and delegation of powers to its staff. In addition, the AMC should report on a quarterly basis on its activity and performance. The unfreezing of the second tranche of reprogrammed deposits went smoothly, and staff supports the authorities’ intention to maintain the schedule for the release of the third and final tranche (scheduled for mid-2005). Strict adherence to the BHU reform program is essential to ensure that the bank can service its obligations without recourse to budget support.

38. The lack of progress in the bank liquidation funds has cast doubt on the bank restructuring process and should be addressed without delay. Staff is very concerned about the absence of appropriate financial record-keeping at the funds, which in turn raises questions on governance in the liquidation process. Dealing with the remaining assets in the liquidation funds in a transparent way is important to raise creditor discipline, limit fiscal costs, and normalize credit conditions. The actions taken by the authorities prior to the Board’s consideration of this review provide an important step toward rectifying the situation, by initiating the asset disposal process and bolstering financial disclosure. However, the authorities must follow these actions with timely implementation of the remaining steps under the program, which will be closely monitored in the remaining reviews. Moreover, staff is concerned over the potential rise in nominal debt from the recent swap offer given to bondholders and large depositors of these banks, and the authorities should refrain from granting any further relief.

39. Appropriate resources need to be devoted to ensure the timely provision of fiscal data. The decision to create a formal monitoring committee, with participation of the MEF, BCU, BROU, and BHU, is a welcome step to help ensure timely reporting of fiscal performance under the program.

40. While the risks to the program have diminished, significant vulnerabilities remain and leave no room for policy slippages. The authorities’ decision to forego one disbursement under the arrangement reflects a strengthening of Uruguay’s external position. Nonetheless, important risks remain from the high degree of financial dollarization, the large public debt, and remaining weaknesses in the banking system. To manage these risks, it will be crucial to protect the main elements of the program, particularly during the upcoming election period.

41. Notwithstanding these risks, staff supports the authorities’ request for waivers and completion of the fifth review. Performance under the program has been broadly satisfactory, remedial measures have been taken to address the missed structural performance criteria, and the authorities are strongly committed to sound macroeconomic policies and the necessary reform of the banking sector.

Figure 1.
Figure 1.

Uruguay: Activity and Prices

Citation: IMF Staff Country Reports 2004, 327; 10.5089/9781451839265.002.A001

Source: Central Bank of Uruguay; Ministry of Economy and Finance; CERES; and Fund staff estimates.
Figure 2.
Figure 2.

Uruguay: External Sector Indicators

Citation: IMF Staff Country Reports 2004, 327; 10.5089/9781451839265.002.A001

Source: Central Bank of Uruguay; Ministry of Economy and Finance; CERES; and Fund staff estimates.
Figure 3.
Figure 3.

Uruguay: Financial and Vulnerability Indicators

Citation: IMF Staff Country Reports 2004, 327; 10.5089/9781451839265.002.A001

Source: Central Bank of Uruguay; Ministry of Economy and Finance; and Fund Staff estimates.
Figure 4.
Figure 4.

Uruguay: Fiscal and Monetary Indicators

Citation: IMF Staff Country Reports 2004, 327; 10.5089/9781451839265.002.A001

Source: Central Bank of Uruguay; Ministry of Economy and Finance; and Fund Staff estimates.
Table 1.

Uruguay: Selected Economic and Financial Indicators

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

Evaluated at program exchange rates for 2004.

Part of the sharp drop in 2003 is due to the removal of the three liquidated banks from the database in May 2003.

Defined as changes in reserve assets.

Defined for combined public sector.

Excludes nonresident deposits.

Table 2.

Uruguay: Summary Balance of Payments

(In millions of U.S. dollars)

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

Including nonresident deposits.

Table 3.

Uruguay: Performance Under the 2004 Economic Program 1/

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

As defined in the attached Technical Memorandum of Understanding.

Cumulative changes from end-December 2002 for 2003; and from end-December 2003 for 2004.

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

Adjusted upward/downward for changes in collections of Fondos de Libre Disponibilidad (FLD), as defined in the TMU.

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 MEF and BROU. The 2003 base includes all loans guaranteed by the government. For December 2003, the debt ceiling has been adjusted upward to reflect the transfer of Brady bonds from the central bank to the government.

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

Cumulative change from December 2002 average for 2003; from December 2003 average for 2004.

article image
Sources: Ministry of Economy and Finance; and Central Bank of Uruguay.
Table 4.

Uruguay: Public Sector Operations

article image
article image
Sources: Ministry of Finance; and Fund staff estimates.


Excludes contributions that are transferred to the private pension funds.

Includes extrabudgetary operations.

Includes the following bank-restructuring costs: US$33 millionn of capital transfers for bank recapitalization, US$564 million of liquidity supplied by BCU, US$444 million for the Fondo de Fortalezimiento del Sistema Bancario (FFSB), and US$993 million for the FSBS.

Table 5.

Uruguay: Cash Flow of the Nonfinancial Public Sector

(In millions of U.S. dollars)

article image

Includes use of financial assets, assistance bonds to banks, and intra-quarter float.