Background

1. The Uruguayan economy continues making substantial progress in its transition from the deepest financial crisis in its history to a path of sustainable growth. The strong economic recovery and the upturn of financial indicators, including the improved indicators of financial and banking sector soundness, and the upgrade by Fitch and S&P of Uruguay’s foreign currency debt rating are clear signs of this process. The Uruguayan authorities are fully aware that much remains to be done and, in general, they share the staff’s comments that progress with structural reforms is still uneven. Nonetheless, it is necessary to keep in mind that over the past two years urgent measures have taken priority over other important ones. During this process, the authorities’ commitment to macroeconomic stability has been demonstrated by the significant measures taken and the rapid and effective progress obtained.

2. During the first half of this year, the Uruguayan economy has continued its strong recovery, while inflation remains subdued and the fiscal accounts show further improvements. According to the latest data, economic activity picked up about 14 percent in the first quarter of 2004, compared to the same period in the previous year. The authorities’ current projections for 2004 are indicating a robust GDP growth of more than 7 percent, substantially above the projected 5 percent presented last February in the fourth program review.

3. Exports continue to be the main engine of the recovery, growing 32 percent in dollar terms in January-July of this year, compared to the same period in 2003. Moreover, they are becoming increasingly diversified in terms of both external markets and the country’s export base. Exports to the U.S. now represent the largest share of the Uruguayan total external sales, while exports to Europe are currently in line with those to Mercosur countries, whose share has halved compared to that of four years ago. The authorities have continued making substantial progress towards integrating the country in the global economy. Furthermore, significant developments in infrastructure already underway–e.g. seaports- will be critical to support external sales.

4. Recovery is becoming more broadly based. Private consumption is picking up strongly, to the extent that the negative wealth effect has been substantially alleviated and credit restrictions are receding. In contrast to prior years, private investment has been growing vigorously in 2004, underlining the higher capacity utilization brought about by the recovery, as well as the interest of foreign investors in non-traditional sectors. Imports in machinery and equipment from the private sector increased about 100 percent in dollar terms in January-July 2004 as compared to the same period last year. Meanwhile, a bilateral investment treaty with Finland was ratified in May, and another treaty with the United States will be signed in a few weeks, which will complement the general framework that protects national and foreign investment. Moreover, the free trade agreement with Mexico, that includes a chapter on bilateral foreign investment, was also ratified in May.

5. The recovery has led to substantial improvements in labor market conditions with the unemployment rate falling from a peak of almost 20 percent in a year and a half, to 13.1 percent in April-June 2004. This is the lowest point in four years, while the average period of joblessness has fallen to half of what it was one year ago. Given the increased labor force participation, unemployment reduction is the result of a significant boost in employment.

Macroeconomic Policies and Structural Reforms

6. The authorities are fully committed to ensure the sustainability of public sector debt. They have increased the primary surplus target for 2004 from 3.2 percent to 3.4 percent of GDP. Moreover, under conservative assumptions, the authorities project for 2005 a primary surplus of the order of 3.7 to 3.9 percent of GDP. This reflects expenditure restraint, state enterprise tariffs adjusted in line with cost conditions, and robust revenue performance. Meanwhile, the authorities eliminated emergency surcharges and taxes introduced during the financial crisis. Given the distortive effects that these surcharges and taxes had on the supply side of the economy, the authorities considered that this decision would reinforce the economic recovery underway, thus partly offsetting the negative effects that this reduction might have on revenue performance. As noted in the staff report, the authorities have underscored that no further tax reduction will take place during this administration, while they have established a ceiling for discretional expenditures. The Uruguayan authorities consider that their expenditure plan and the current tax structure are consistent with the envisaged primary surplus targets for 2005. Tax revenue performance has been better than expected mainly due to the economic recovery and progress in modernizing the tax administration. In that vein, the government continues working for Parliament’s passage of a regulation that would allow the restructuring of the Tax Administration Department (DGI).

7. The Central Bank has pursued a prudent monetary policy, tightening the base money target as soon as inflation expectations increased above the Central Bank’s inflation target range. Furthermore, given the new scenario for international interest rates and the uncertainty that elections often generate, as well as the lower inflation target range of 6-8 percent for 12-month inflation through June 2005, the Central Bank set up a more tightened base money target range for the second half of the year, compared to that established earlier under the current program. At the same time, the authorities increased the program target on net international reserve accumulation for 2004 from US$ 100 million to US$ 180 million.

8. Another important objective of the Central Bank is related to favoring financial intermediation in domestic currency and a gradual and voluntary de-dollarization of the financial system. To attain that objective, the Central Bank has taken some measures, including a reduction in the reserve requirements for peso deposits and the introduction of inflation-indexed notes and bonds. However, it is clear that dollarization often has significant cultural roots, which is why the de-dollarization process takes time. Confidence on monetary policy and institutional framework is critical and, among other things, the authorities are committed to continue improving the financial safety net. In this regard, the authorities are analyzing the introduction of a limited deposit insurance scheme.

9. Critical progress has taken place in the BROU’s restructuring process aimed at addressing the balance sheet problems of the bank as well as reducing high operating costs. Meanwhile, interest rates on remaining reprogrammed deposits were reduced from 6 percent to 3.5 percent, thus improving BROU’s net operational earnings. Consequently, profits are exceeding the business plan, and operational costs are lower than programmed. It is also important to note that cash recoveries from NPLs through June already exceeded the 2004 target. Meanwhile, the release of the second tranche of reprogrammed deposits have yield positive results, with about 95 percent of deposits remaining in BROU. Moreover, as noted in the staff report, the World Bank staff reports good progress in restructuring the State mortgage company (BHU).

10. The Uruguayan authorities are making firm decisions for a successful bank resolution process, which, as noted in the staff report, represents a break with past practices of socializing losses. In that vein, they have faced significant obstacles posed by pressure groups, including labor unions and debtors of the liquidated banks. Meanwhile, substantial efforts have been made to minimize governance risks, having taken the needed actions to address them, including those concerned with prior actions for this review, as noted in paragraph 19 of the staff report. In particular, through a transparent bidding process, the Central Bank contracted a firm to manage the assets in the liquidation funds, establishing a mechanism that allows conciliating the firm’s and fund creditors’ incentives.

11. Consequently, the Uruguayan economy is on the way to taking full advantage of its solid institutions and consolidated democracy. Indeed, according to Latinobarómetro’s last survey, Uruguay is the country in the region with the largest share of its population supporting its democratic system. At the same time, Uruguay shows the largest share of people holding the government as the main responsible for the people’s welfare, and one of the smallest proportion considering that private enterprises are critical for development. The authorities have taken substantial actions to respond to these beliefs. While protecting the most vulnerable groups, the authorities have focused a good part of their efforts to avoid perverse incentives, increase transparency and competition, respect property rights, and make the rules of the game more predictable, as the only way to promote private investment and entrepreneurship and, thus, development.