Uruguay
Sixth Review Under the Stand-By Arrangement and Requests for Modification of the Arrangement, Waiver of Nonobservance and Applicability of Performance Criteria, and Extension of Repurchase Expectations in the Credit Tranches—Staff Report; Staff Statement; Press Release on the Executive Board Discussion; and Statement by the Executive Director

This paper examines Uruguay’s Sixth Review Under the Stand-By Arrangement and Requests for Modification of the Arrangement. The macroeconomic framework is 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 are being met as well. GDP growth is now forecast at 11 percent in 2004. The restructuring of the public banks and disposal of assets in the bank liquidation funds are moving forward.

Abstract

This paper examines Uruguay’s Sixth Review Under the Stand-By Arrangement and Requests for Modification of the Arrangement. The macroeconomic framework is 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 are being met as well. GDP growth is now forecast at 11 percent in 2004. The restructuring of the public banks and disposal of assets in the bank liquidation funds are moving forward.

I. Background

Political Situation: October 31 Presidential and Congressional Elections

1. The candidate of the left-leaning Frente Amplio-led coalition (FA), Dr. Tabaré Vazquez, was elected resident in the first election round on October 31. Dr. Vazquez’s policy focus during the campaign was on poverty alleviation, income redistribution, and state support to promote employment and strategic sectors; throughout the campaign, he also stressed the need to maintain macroeconomic stability and honor the nations’ debt commitments. The president-elect has announced that Sen. Danilo Astori would head his economic team; Sen. Astori is well-respected by markets. In congress, the FA will hold 52 seats (out of 99) in the lower house and 17 seats (out of 31) in the senate. Since the elections, sovereign spreads have continued to decline and the exchange rate has been relatively stable. The new government will take office on March 1, 2005; the current Stand-By Arrangement (SBA) expires on March 31, 2005.1

Developments under the program

The economic recovery is robust, despite the rise in oil prices, while inflation is running within the target range of 7–9 percent.

  • Growth and employment. Real GDP grew 13½ percent (y/y) in the first half of the year, with continued strength in leading indicators pointing to robust growth in the second half as well. The recovery has been broad based, with strong growth in consumption, investment, and exports. Unemployment stood at 13.3 percent in September; some 3½-percentage points lower than a year ago.
  • Wages and inflation. Wage pressures remain modest, with real wages in the private sector down slightly in the year ending September 2004. Inflation was 8.7 percent at end-October (within the central bank’s target range of 7–9 percent), despite higher petroleum and energy prices.
  • External current account. Both export and import growth has been strong throughout the year, and the external current account is expected to post a modest deficit in 2004.
uA01fig01

GDP and Unemployment

Citation: IMF Staff Country Reports 2005, 014; 10.5089/9781451947625.002.A001

uA01fig02

Inflation and real private wage growth

Citation: IMF Staff Country Reports 2005, 014; 10.5089/9781451947625.002.A001

Uruguay: Selected Macroeconomic Indicators

(12-month percentage change, unless otherwise indicated)

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Sources: BCU, and Fund staff estimates.

3. Financial indicators continue to improve.

  • Exchange rate. The peso was fairly steady in the year through August, but since then it has appreciated by about 7 percent against the U.S. dollar. Despite this appreciation, Uruguay’s real effective exchange rate remains some 30 percent more depreciated than its average in 2001 (before the financial crisis), and 11 percent more depreciated than its average during the 1990s.
uA01fig03

Uruguay: Real Effective and Real Bilateral Exchange Rates

Citation: IMF Staff Country Reports 2005, 014; 10.5089/9781451947625.002.A001

Source: INS and Fund staff estimates.
  • International reserves. Gross international reserves of the central bank have risen during the year and now stand above US$2 billion. Gross reserves of the banking system cover 60 percent of short-term debt and dollar deposits, a lower rate of coverage than in most dollarized economies in the region.

Comparisons of Banking System Reserve Adequacy Indicators

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  • Debt and sovereign spreads. Sovereign spreads have been falling since May, in line with regional trends, and were under 500 bps at end-October. The stock of short-term public debt has declined in recent months, owing to the amortization of peso- denominated T-bills, which have only been partially replaced by dollar- denominated T-bills. This has helped improve the maturity profile of short-term debt, since dollar-denominated T-bills have a weighted average residual maturity of ten months compared with one month for peso-denominated T-bills.
uA01fig04

Sovereign risk (EMBIG Global)

Citation: IMF Staff Country Reports 2005, 014; 10.5089/9781451947625.002.A001

  • Private sector deposits in the banking system continue to recover. Dollar deposits have risen during the year; however, there has been some shift toward shorter maturities, and the level of dollarization remains very high (with over 90 percent of deposits in dollars). Bank credit has yet to revive, as banks continue to focus on cleaning their balance sheets.

Uruguay - Nonfinancial Private Sector Deposits

(Flows in millions of each currency)

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Excludes Banco Galicia Uruguay.

The decline in time deposits during 2003 and 2004 is influenced by the return of reprogrammed deposits at BROU and the amortization of CDs at Nuevo Banco Comercial.

During September Nuevo Banco Comercial booked the exercise of its option to put back NPLs to the bank liquidation funds. This operation led to a decline in foreign currency time deposits to residents of US$ 102 million.

  • Domestic interest rates. Rates on peso- and dollar-denominated Treasury- and central bank-bills have increased somewhat since end-2003, mainly reflecting the increase in U.S. interest rates and the relatively tight monetary policy stance. Interest rates on 6-month peso-denominated T-bills now stand at 18 percent.

4. The monetary program is on track. Monetary targets have been tightened in the course of the year, as the balance of inflation indicators have been pointing to inflation rates above the BCU’s target range (which is set each quarter with a 12-month policy horizon). In September, the BCU announced an inflation target of 6–8 percent for September 2005, unchanged from the June 2005 target. In late August, the central bank initiated a market for forward purchases of dollars and pesos by offering contracts at rates consistent with interest rate differentials in the two currencies, but so far the daily volume transacted has been very limited. The end-September PCs on NIR and NDA were met with comfortable margins.

5. Fiscal performance has been better than programmed, reflecting strong revenue performance and strict control over expenditure. The primary surplus of the consolidated public sector reached 2 percent of annual GDP in the first half of the year, 0.9 percent of GDP above the target. The overperformance in the overall deficit was even higher, owing to lower-than-programmed interest outlays. Revenues have outstripped program targets djusted state-enterprise tariffs in line with cost conditions.2 Preliminary data point to continued strong fiscal performance in the third quarter, despite lower-than-programmed revenues at the social security administration and periodic work stoppages at the internal revenue service (DGI) in protest of the agency’s restructuring plan. The government recently announced the establishment of a fund, comprising resources recovered in the bank restructuring process, to buy back debt (mainly domestic, illiquid series). In late- October, the first buy back (face value of US$1 million) was carried out.

6. Progress on structural fiscal reforms has been disappointing. Creation of a large taxpayer unit is moving slowly, and meeting the end-December structural benchmark will be challenging. Congress ended its legislative session in mid-September without acting on tax and special pension fund reforms (end-December structural benchmarks), and it is very unlikely that the Permanent Commission in congress will take up these measures before a new congress meets in mid-February 2005.

7. Progress continues to be made in bank restructuring. Reform of the public banks is moving forward (albeit, greater progress is being made at the commercial bank, BROU, than at the state mortgage company, BHU), the long-delayed process of asset disposal of the liquidated banks has begun, and bank supervision is being strengthened. The strategy for reforming the government-owned commercial bank (NBC) has been revamped following the decision by the IFC not to seek a minority stake in the bank.

  • BROU
    • Restructuring plan. The plan is advancing, with the bank showing profits and operating costs falling. BROU’s asset management company (operating since April) has surpassed its (modest) 2004 performance target on asset recovery.
    • Reprogrammed deposits. The early release of the second tranche of reprogrammed deposits during April–July went smoothly, with 95 percent of deposits staying in the bank and 75 percent remaining in time deposits. In light of this experience, the solid liquidity position of the bank, and the authorities’ view that frozen deposits should not be retained any longer than necessary, BROU has advanced the release of the third and final tranche of reprogrammed deposits (US$773 million). Originally scheduled to start next August, the release began in October and will continue in a gradual manner through April of next year. So far, the results have been encouraging, with the retention rate about the same as with the second-tranche release.3
  • BHU. Despite some progress in reducing operating costs and improving the loan- servicing framework, BHU remains with important underlying weaknesses, including a still large non-performing loan portfolio. BHU’s note to BROU has been serviced on time (continuous PC), but amortization payments still required Treasury support. Following the completion of due diligence of BHU’s investment portfolios and in light of the progress made in upgrading its information systems, in October the World Bank disbursed US$50 million under its SAL-I operation.
  • Liquidation funds of Banco Montevideo, Banco Comercial, and Banco Caja Obrera. After long delays in outsourcing the disposal of the assets of these funds, a private firm was contracted in August 2004 to manage the assets. The end-October PC on transferring all the assets of the liquidation funds to the asset manager was met. To begin addressing concerns regarding management and recordkeeping of the funds, an inventory of assets and balance sheets were prepared in July–August. The funds’ historical financial statements (end-September PC) are being completed as prior actions for this review, and two of three external audits of the funds’ activities have been completed, with the third to be finished by year’s end (the authorities are requesting that the end-October PC on completing the audits be reset for end- December). The delay in meeting the PCs was related mainly to problems in resolving recordkeeping weaknesses in Banco Comercial. Staff will update the Board on the completion of the financial statements and audit results prior to the Board discussion. The liquidation funds have been submitting to the Ministry of Economy and Finance (MEF) and BCU monthly cash flow statements and estimated balance 3 Deposits totaling US$113 million were released between October 13 and November 5, and another US$51 million will be released in the rest of November. The remainder (US$609 million) will be released over December 2004-April 2005. sheets, but these reports have not fully met the monthly PC (for September and October) and will not meet the November PC on submitting financial reports.4 The authorities are requesting that this PC be eliminated, as semi-annual audited financial statements will be published beginning with the end-December 2004 reports.
  • Banco de Crédito (BDC). After several failed attempts to auction the assets of BDC, the government outsourced the management of the nonperforming assets to the private firm managing the assets of the other liquidation funds, and the authorities intend to securitize the performing assets by early next year.
  • Nuevo Banco Comercial (NBC). Following the IFC’s decision in August not to pursue a minority stake in the bank (the authorities had hoped that IFC participation would help strengthen governance in the bank), the authorities hired an investment bank to seek a strategic investor before leaving office.
  • Bank supervision. The BCU has improved the regulatory environment, especially in strengthening credit risk assessment.5 Also, progress has been made in hiring staff to strengthen the Bank Superintendency’s (SIIF) supervisory capacity. Information on debtors of the liquidation funds was transferred to the SIIF’s credit registry in July, but technical problems have delayed its incorporation in the registry. The authorities intend to complete the credit registry updating byend-December (structural PC).

II. Policy Issues

The review focused on: (i) macroeconomic performance under the program; (ii) the fiscal outlook for 2004–05 and updating the debt sustainability analysis (DSA); (iii) the stance of monetary policy; and (iv) progress in key structural reforms in the banking and fiscal areas.

8. Preserving the stabilization and reform gains through the political transition is essential to provide a solid framework for the next administration. Despite the good economic performance so far this year, the economy remains vulnerable from the high level of public debt and remaining weaknesses in the banking system. To address these risks, the discussions emphasized the need to: (i) lock in at least part of the revenue overperformance to solidify the basis for further fiscal consolidation in the years ahead; (ii) continue to conduct monetary policy in a prudent manner to achieve the programmed buildup in international reserves and return inflation to its target range; and (iii) advance key structural reforms, especially in the banking and fiscal areas.

9. The improved economic situation in 2004 has lowered the public debt-to-GDP ratio to close to 90 percent, some 5-percentage points of GDP less than previously envisaged.6 The improvement reflects: (i) higher growth (11 percent compared with 7 percent in the revised program); (ii) a more appreciated real exchange rate (partly because of higher-than-targeted domestic inflation and a nominal appreciation of the peso); and (iii) a smaller overall fiscal deficit (2.4 percent of GDP in 2004, compared with 3.3 percent of GDP in the original program). For next year, growth is expected to moderate to 4 percent and the overall fiscal deficit is programmed to fall further to 1.1 percent of GDP, which along with modest assumptions regarding the real exchange rate, would lower the debt-to-GDP ratio to below 80 percent of GDP.

10. An update of the DSA suggests that maintaining primary surpluses of 4 percent of GDP is consistent with a sustainable debt position by the end of the decade. Under revised yet still cautious assumptions on growth, interest rates, sovereign spreads, and the exchange rate, the DSA shows that the total public debt-to-GDP ratio would be brought down to below 50 percent of GDP by 2012 (compared with 60 percent of GDP in the previous DSA).7,8 However, debt would only fall below 60 percent of GDP in 2008, and the DSA result depends crucially on maintaining sound policies. To sustain primary surpluses of 4 percent of GDP over an extended period will require implementing the structural fiscal reforms envisaged under the current program.

Revised DSA Parameters

(Average 2004-2012)

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Public Debt Sustainability Analysis

In updating the DSA analysis (Country Report No. 04/327, Appendix V), staff assumed a medium-term primary surplus of about 4 percent of GDP (in line with the projected outturn for 2005), potential real GDP growth of 2 percent (somewhat lower than in the original DSA; see Appendix II for a more detailed discussion of growth prospects), and a return of the real value of the peso vis-á-vis the U.S. dollar to its 1991 level (before the real appreciation of the peso began under the exchange-rate-based stabilization program of the 1990s; although, some of the competitiveness gains registered against Brazil and Argentina could be eroded, see Chart on page 7). Cautious assumptions about interest rates and sovereign spreads were maintained. Under these revised assumptions, public debt would decline from a projected 91 percent of GDP in 2004 to below 50 percent by 2012 (assuming no contingent liabilities owing to bank restructuring come due; if there are additional bank restructuring costs, this could add up to about 5 percent of GDP).

uA01fig05

Gross NonFinancial Public Sector Debt, 2001-2012

(Percent of GDP)

Citation: IMF Staff Country Reports 2005, 014; 10.5089/9781451947625.002.A001

Uruguay’s high public debt will continue to be a significant vulnerability over the next few years. The debt-to-GDP ratio will only fall below 60 percent of GDP in 2008. 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 significant increases in the public debt-to-GDP ratio that would exacerbate doubts about debt sustainability. However, it must be recognized that Uruguay recently experienced major shocks and has adjusted policies in response, so that a repeat of such shocks and an ensuing crisis is unlikely.

Staff has analyzed three alternative shocks to key macroeconomic variables: (i) an average decline of real GDP growth by 1-percentage point and lower primary surplus by ½-percentage point; (ii) a 200-basis point increase in interest rates over the medium term;1 and (iii) weak confidence in the peso that prevents the expected appreciation in the real exchange rate. In these cases, except the real exchange rate, the public debt ratio is still somewhat resilient. Lack of appreciation of the real exchange rate, however, would leave the public debt above 60 percent of GDP by 2012.

1 About 50 percent of public debt is at variable rates, but the largest part is to IFIs; thus, much of the debt has diversified interest rates and would not be affected by increases in sovereign spreads. Staff’s sensitivity analysis indicates that a 200 bps increase in dollar interest rates raises fiscal interest costs by 0.5 percent of GDP, on an annualized basis.

A. Fiscal Policy and Debt Management

11. Exceeding the primary surplus target for 2004 would help the incoming administration meet next year’s targets. Staff welcomed the authorities’ commitment to refrain from any further tax cuts or tax exemptions and to save any overperformance in revenue, with a view to surpassing the primary balance target for this year. The authorities reaffirmed their intention to continue to keep expenditure in line with the program and adjust public tariffs in a timely manner in line with cost developments. Continued spending restraint is essential for modest fiscal consolidation next year. Staff supported the authorities’ planned budget decree for the first quarter of 2005 (to be issued by year’s end) that caps real spending growth at 1.5 percent (y/y), and underscored the need to adjust petroleum product prices in line with crude oil prices. The authorities noted that the July adjustment to petroleum prices was based on crude oil prices of US$41 per barrel, but given the appreciation of the peso since then, no adjustment was needed unless crude oil prices remained above US$46 per barrel (Box 2.).

Fiscal Implications of Higher World Oil Prices

  • Uruguay imports, on average, 1.1 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$13 million (0.1 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 1.2 percent of GDP.
  • In 2004, the authorities have raised fuel prices by 20 percent to reflect world oil prices of US$46 per barrel at the current exchange rate. Fuel prices at the pump are now among the highest in the region.

12. Over the medium term, it will be crucial to push ahead with structural fiscal reforms. In particular, staff emphasized the importance of strengthening tax administration and reforms of the tax system, the specialized pension funds for the military and police, and the institutional budgetary framework. While many of these reforms require congressional approval and, hence, will need to be taken up by the next government, staff urged the authorities to pursue those reforms they could implement. Specifically, staff highlighted the need to concentrate efforts at the internal revenue service (DGI) to establish a large-taxpayer unit (LTU) by end-December (structural benchmark), and to incorporate recommendations of the Fiscal ROSC regarding supplementary documentation on an updated macroeconomic framework, fiscal risks, and an estimate of the costs of tax expenditure in annual budget decrees. The authorities noted that they are moving ahead with the LTU and expect it to be in place by year’s end. They also agreed with the suggestion to supplement next year’s budget decree with a revised macroframework and a discussion of fiscal risks, but noted that an estimate of tax expenditure would take time and would not be feasible for this budget cycle.

13. Uruguay’s debt management strategy continues to focus on extending the maturity of domestic debt placements, securing timely disbursements from IFIs, and issuing longer-term debt in the international markets. In addition to the 18-month peso- denominated note issued in July (US$250 million), 9 the authorities have extended the residual maturity of dollar-denominated T-bills by about 6 months and started issuing inflation-indexed T-notes with a maturity of 3 years. These placements cover short-term debt rollover needs through June 2005. The authorities have also stepped up efforts to implement policies linked to World Bank and IDB disbursements, and have secured new lending commitments for next year to ease the financing burden for the incoming administration. Staff welcomed these steps and encouraged the authorities to take advantage of opportunities to issue longer-term instruments in the international markets if market conditions permit. The authorities noted that they would consider a bond issue in international capital markets after the elections, to prefinance part of the 2005 gross financing needs (US$1.9 billion). 10

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

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B. Monetary and Exchange Rate Policies

14. The authorities intend to continue with the peso float, with base money as the intermediate target of monetary policy. Staff supports the current cautious stance on monetary policy, and views as appropriate the inflation target range of 6–8 percent for September 2005. Regarding the authorities’ plans to move to inflation- targeting, they explained that this could be implemented very soon, but the decision should be left to the next BCU directorate.11 Staff recommended that the BCU not be involved in establishing a market in forward foreign exchange, as this should be left to private banks. The authorities pointed out that such contracts can help spur development of a private market, and stressed that the BCU has made fully transparent the mechanics of forward contract pricing, and that its internal rule to cover all open positions through immediate offsetting transactions in the spot market eliminates any exchange rate risk.12

uA01fig06

Actual and Target CPI

Citation: IMF Staff Country Reports 2005, 014; 10.5089/9781451947625.002.A001

15. The strong external environment and absence of election-induced volatility have allowed the BCU to meet its targeted build up of international reserves with comfortable margins. Staff urged the authorities to exceed the program target, pointing out that a further build up was warranted (including over the medium term) in light of the still relatively low level of coverage of deposits and short-term debt compared with other dollarized economies in the region. The authorities agreed that a further NIR increase would be desirable over time, but noted that a higher buildup would result in the issuance of additional central bank debt and a widening of the quasi-fiscal deficit. The authorities reiterated their commitment to reducing financial dollarization, noting that the required strengthening of confidence in the peso would take time.

C. Banking Reforms

16. Progress in bank restructuring needs to continue to minimize contingent costs for the public finances. Staff welcomed progress in: outsourcing asset management of the liquidation funds and examining their past operations; reforming the public banks; and strengthening bank supervision. Staff stressed the need to improve governance at NBC and urged that the authorities move cautiously with establishing a deposit insurance scheme.

  • Liquidation funds. Staff welcomed the important steps to advance the liquidation of the funds’ assets and encouraged the authorities to build on this progress. Staff advised that the asset liquidation process be carried out transparently, with appropriate oversight of the asset manager, who should have full access to the credit files, and stressed the need for close coordination between the liquidation funds and the asset manager. The authorities concurred with staff and noted that since the beginning of November, the asset manager has had full and timely access to all credit files. Staff welcomed the authorities’ decision to establish a structural benchmark (for end-January 2005) to monitor the performance of the asset manager (LOI, paragraph 6 and Table 2). Staff noted that the swap scheme offered in July had attracted very few offers to participate, and welcomed the authorities’ commitment to avoid offering any additional compensation to creditors of the funds.13
  • BROU
    • Restructuring. Staff underscored the need to sustain the momentum of reforms at BROU, as the bank’s deposits account for half of all deposits in the banking system, with large contingent costs for the government if the reforms do not prosper. Moreover, strengthening the bank’s risk management and credit policies and practices will enable sustained lending by the bank for support of economic growth. Staff welcomed the progress at BROU’s asset management company (AMC), while stressing the need for the AMC to receive full cooperation from BROU staff to efficiently manage the assets. The authorities assured staff that the working relationship between BROU and the AMC was solid and affirmed that all new and remaining Category 4 and 5 nonperforming loans would be transferred to the AMC by end-December, in line with the structural PC under the program.
    • Reprogrammed deposits. Staff concurred with the authorities’ assessment that BROU had sufficient liquidity to support the early release of the last tranche of reprogrammed deposits, while noting that the release should wait until electoral uncertainty ends. The authorities explained that any uncertainty related to the election outcome had no discernible economic or market impact, and that the freeze should not be maintained any longer than was necessary; therefore, their seven-month release schedule was appropriate. Staff welcomed the authorities’ commitment to stand ready to take all necessary actions in the unexpected event of deposit outflow and to release only a small part of the deposits before the elections.
  • BHU. The transformation of BHU into a nonbank mortgage company needs to be stepped up. Staff noted the progress in the bank’s restructuring and that the bank’s loan with BROU has been fully serviced this year. Nevertheless, staff highlighted that the bank’s fundamentals remain weak and service of its note to BROU (which is guaranteed by the government) is a key medium-term fiscal risk. The authorities shared staff’s concerns, but pointed out that BHU has been servicing the interest component of its debt with BROU six-months ahead of schedule, and they expect to have no problem with BHU meeting next year’s obligations.
  • NBC. The authorities need to address governance issues at NBC, including appointing a CEO and board members with necessary qualifications and banking experience. Staff regretted that the IFC would not become a minority shareholder in the bank, which had been envisaged as a means of strengthening governance in the bank, and supported the authorities’ new strategy to find a majority shareholder for the bank. However, the authorities noted that finding a suitable buyer so close to a change in government would be challenging.
  • Bank supervision. Staff welcomed the recent progress in hiring staff for the SIIF and in strengthening bank regulations on assessing credit risk. The objective to hire 40 new staff by February 2005 is within reach, but will require focused efforts. Staff underscored the need to further improve risk assessment by incorporating exchange rate risk explicitly into the assessment process. Staff stressed the need to fully update (as soon as feasible) the national credit registry with information from the liquidation funds’ asset inventory.
  • Deposit insurance. Staff cautioned that upfront funding for an ambitious insurance program would result in a significant increase in dollar-denominated public debt (as the stock of dollar deposits in the banking system is over US$7.5 billion), and recommended to proceed cautiously. Staff also pointed out that the structure of the Uruguayan banking system presents significant implementation challenges (such as the explicit government guarantee on BROU deposits). The authorities agreed that design and implementation of such a scheme would need to be carried out in a cautious manner, and that this would likely be taken up by the new administration.
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 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)

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

Including nonresident deposits.

III. Vulnerabilities and Program Risks

17. While Uruguay has recovered well from the 2002 crisis, its economy remains vulnerable from the high public debt, exposure to interest rate and oil price shocks, and banking sector weaknesses. While most indicators of financial vulnerability continue toshow improvement, fragilities remain in the banking system; in particular, dollarization remains high, with the majority of dollardenominated deposits in sight deposits, and the public banks (which hold half of total deposits) are still in the process of restructuring. Financial intermediation has yet to fully recover, and proper credit and risk management policies will be essential to avoid a resurgence of NPLs. Banking system reserves are relatively low compared with other dollarized economies in the region.

Vulnerability Indicators

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

For 2004, end-May.

Includes obligations to the IMF.

By remaining maturity.

18. 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, Fund credit outstanding would reach 609 percent of quota (around 20 percent of GDP) at the end of the arrangement in March 2005. While Uruguay’s balance of payments has strengthened in recent years, gross reserves of the central bank need to be bolstered further (they remain well below their level before the crisis), and capacity to repay the Fund on an expectations basis in 2005 is limited. Full-year repayment on an expectations basis would reach 9 percent of GDP; therefore, to smooth out repayments to the Fund, the authorities intend to repay the Fund on an expectations basis through May 2005 and are requesting conversion of remaining purchases due in 2005 to an obligations basis. The authorities also explained that establishing now the repayment schedule for the entire year will facilitate debt management in 2005. Nevertheless, even under their proposed repayment schedule, the repayment burden to the Fund will rise steeply in 2005–07, when annual payment obligations are projected to average about SDR 485 million, roughly 4 percent of average GDP over the period.

Uruguay: Payments to the Fund, 2004-07

(In millions of SDRs)

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Assumes obligations basis 2006-07.

IV. Program Financing, Monitoring, and Safeguards

19. Financing Assurances. Financing needs through June 2005 have been secured. Staff’s baseline scenario for the remainder of 2005 assumes modest access to domestic and international financial markets that depends, of course, on maintaining sound policies—in particular, meeting the fiscal target. Financing requirements for the remainder of the decade, which will average about US$1.5 billion a year (7.5 percent of average annual GDP), will need to be met through private capital market placements and continued IFI support.

20. Program Monitoring. Uruguay’s statistical database has been generally adequate for assessing and monitoring macroeconomic policies, but the lag in providing fiscal data from below the line (albeit reduced since a coordinating committee on fiscal data was established at the time of the last review) still exceeds the 60-day limit in the TMU. Staff welcomed the shortening of the period (from two months to one) in publishing data on central government operations and the publication of information on the stock of floating debt, but urged that further efforts be made to reduce the reporting lag on below-the-line fiscal data. Prior actions, performance criteria, benchmarks, and indicative targets under the program are specified in the attached LOI and TMU (Attachments I and II). The seventh review is expected to take place in February 2005.

21. Safeguards. The recommendations of the 2002 Safeguards Assessment are being implemented, albeit with some delays. The external audit of the BCU’s 2003 financial statements was finalized in March, and the BCU has created an independent audit committee to oversee the bank’s financial reporting practices. However, only limited progress has been made in adopting fully International Financial Reporting Standards in BCU financial statements, and implementation of the recommendation to publish by end-April of each year the audited financial statements of the central bank of the previous year depends on the approval of the Tribunal de Cuentas (national audit office). Only one out of four supplemental audits of the bank stabilization fund (FSBS) has been completed (end-March 2004 structural benchmark).

V. Staff Appraisal

22. Uruguay is recovering well from the 2002 financial crisis, with a significantly strengthened outlook for debt sustainability. 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 and a smooth transition to a new government that will take office in 2005.

23. Exceeding the primary surplus target under the program will buttress the medium-term outlook for continued fiscal discipline and debt sustainability. Staff welcomes the authorities’ commitment to save part of the growth dividend for revenue and achieve a primary surplus in excess of the program target for 2004. They intend to achieve this by refraining from any further tax reductions, maintaining expenditure restraint, and keeping public utility tariffs broadly aligned with operating costs. In particular, the authorities need to continue to ensure timely pass through of world oil prices to domestic fuel prices. Delivering on these commitments will be important to facilitate continued fiscal discipline next year and beyond, which in turn will be critical for maintaining market confidence. The favorable growth and fiscal outturn projected for this year have made important contributions to promoting debt sustainability over the medium-term, but there is no room for fiscal slippage.

24. Staff regrets the slow progress on fiscal reforms. Delivering the necessary primary surplus targets over the medium term will depend crucially on addressing structural weaknesses in 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 parties to the political process to work toward a consensus on these reforms that will need to be taken forward by the next government.

25. Monetary policy is being conducted in a prudent manner. Staff supports the present stance of monetary policy that aims at reducing inflation to the target range of 6–8 percent within the 12-month policy horizon. While the authorities raised the 2004 NIR target under the program during the last review, 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. Staff recommends against direct participation of the central bank to create a forward foreign-exchange market, which should develop through private initiative as confidence in the peso strengthens.

26. Maintaining momentum in restructuring the public banks is essential to ensure their viability, improve creditor discipline, minimize potential fiscal costs, and support a sustainable return to financial intermediation. Staff welcomes efforts made in the restructuring of BROU and BHU and urges continued progress. For a successful workout of BROU’s nonperforming loans, the asset management company will need full cooperation of BROU staff. The unfreezing of the third and final tranche of reprogrammed deposits is proceeding smoothly following a cautious schedule. Acceleration of the BHU reform program to ensure that the bank can service its obligations is essential to address a key medium-term fiscal risk.

27. Liquidation of the assets of the failed banks is finally underway, and the steps taken to ensure transparency of the liquidation funds’ operations are essential to address governance concerns. Dealing with the remaining assets in the liquidation funds in a transparent way is important to raise creditor discipline, limit fiscal costs, and maintain public confidence. Although there has been some delay with financial statements and audits of the liquidation funds, the financial statements are being completed as prior actions for this review and two of the three audits are finished, with the third to be completed by year’s end. Continued close monitoring of the liquidation funds’ activities is necessary to ensure that any potential further problems are quickly addressed and the asset disposal process proceeds as foreseen in the contract with the asset manager. The authorities should continue to refrain from granting any further compensation schemes to bondholders and large depositors of the liquidated banks.

28. Appropriate resources need to be devoted to ensure the timely provision of fiscal data. While fiscal data lags have diminished, they are still over 60 days. Staff welcomes the advance by one month of published data on central government operations and the publication of information on the stock of floating debt.

29. While the risks to the program have diminished, significant vulnerabilities remain, leaving no room for policy slippages. Important risks remain from the still high public debt, the high degree of financial dollarization, and remaining weaknesses in the banking system. To manage these risks, it will be crucial to protect the main elements of the program through the political transition.

30. For the new government, the key challenge will be to pursue its economic and social priorities in a way that preserves and builds on the stabilization gains achieved. This will require, in particular, continued focus on fiscal consolidation and medium-term debt sustainability, rebuilding the Uruguayan banking system, and reforms that boost the economy’s growth potential by strengthening productivity and competitiveness, as Uruguay integrates further into the region and the global economy. Staff hopes that the new government and congress will reach a consensus and move decisively in carrying out the necessary structural reforms to ensure sustained high growth and financial stability.

31. Staff supports the authorities’ request for waivers and completion of the sixth review and their request for an extension of repurchase expectations to an obligations schedule for June 2005-December 2005. Performance under the program has been broadly satisfactory, especially with the key macroeconomic policies and banking reforms. The missed structural PC on preparation of financial statements of the liquidation funds is a prior action for this review, Staff supports the request for waiver of nonobservance of the end- October PC on completing external audits of these statements and the resetting of this PC to end-December, as two of the three audits have been completed and the third is well advanced. Staff also supports the waivers of nonobservance of the monthly PCs for September, October, and November on submitting financial statements of the liquidation funds; looking forward these monthly PCs can be dropped as the authorities will begin publishing audited semi-annual financial statements beginning with the December 2004 statements. Waivers of applicability of end-September fiscal and debt performance criteria are requested as final data will not be available at the time of the review; staff expects that the targets will be observed.

Table 3.

Uruguay: Quantitative Performance Criteria and Indicative Targets Under the 2004–05 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 changes from end-December 2003.

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

Adjusted upward/downward for changes in collections of the 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 2003 base includes all loans guaranteed by the government. For December 2003, the debt ceiling has been adjusted upwards 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 2003 average.

Table 3.

Uruguay: Performance Under the 2004-05 Economic Program (concluded)

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Table 4.

Uruguay: Public Sector Operations

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Sources: Ministry of Finance; and Fund staff estimates.

Preliminary.

Excludes contributions that are transferred to the private pension funds.

Includes extrabudgetary operations.

Includes the following bank-restructuring costs: US$33 million of capital transfers for bank recapitalization, US$564 million of liquidity supplied by BCU, US$444 million for the Fondo de Fortalecimiento 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)

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Sources: Ministry of Finance, Central Bank of Uruguay; and Fund staff estimates.
Table 6.

Uruguay: Summary Accounts of the Banking System 1/

(In millions of Uruguayan pesos, unless otherwise indicated)

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Sources: Banco Central del Uruguay; and Fund staff estimates.

Presentation used for program monitoring. May differ from presentation and definitions used in IFS.

The Banco de la Republica Oriental de Uruguay (BROU), Banco Hipotecario de Uruguay (BHU; mortgage institution), private banks, and cooperatives.

Excludes nonresident deposits.

Table 7.

Uruguay: Medium-Term Outlook

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

Combined public sector includes nonfinancial public sector and central bank.