Background

1. Nearly three years ago, by the time the current program was approved, Uruguay was affected by a sort of economic earthquake that devastated many areas of the country. After suffering serious adverse shocks, and also due to some domestic problems, Uruguay lost its investment grade status. The country risk increased tenaciously -exceeding the level of 2,500 basis points-, thus the country found itself completely closed off from international financial markets. Meanwhile, the significant frauds carried out by two of the main private banks in Uruguay with strong links to Argentina led to the withdrawal of nearly half of the deposits of the banking system. Some banks were closed and the maturities of public banks’ time deposits in dollars were extended after a bank holiday. While the GDP fell deeply, decreasing by 11 percent in 2002, and unemployment rate was around 20 percent, some projections–including the IMF’s-that were prepared after the large devaluation of the peso, warned that inflation could climb up to 40% in 2002 and 50% in 2003. In the meantime, debt liquidity problems rapidly emerged.

2. Today, the situation is quite different. Uruguay exhibits an impressive broad-based recovery and the unemployment rate, although still high, has fallen eight percentage points. Moreover, the country risk has been below 375 basis points, inflation is under control, and public debt to GDP ratio shows a rapid decreasing path. The Uruguayan economy was able to turn around by implementing sound macroeconomic policies, and many reforms in different areas of the economy -including in the banking sector-, as well as achieving a successful debt exchange. More importantly, these policies and actions have set a solid basis on which to build upon a sustainable economic growth and a strong institutional framework.

Economic Policies and Structural Reforms

3. In an electoral year, the fiscal primary balance exceeded the target. In the past, Uruguay, as several other countries, showed expansionary economic policies prior to the elections, with the consequent deterioration of the fiscal position. On the contrary, in 2004 the authorities accomplished a significant increase in revenue collection in line with the GDP growth, while pursuing a very prudent expenditure policy and timely adjusting public tariffs. Similarly, the non-interest expenditure relative to GDP gradually decreased from 34% in 2001 to 25.7% in 2004. As a result, fiscal indicators substantially improved, as mirrored in a primary fiscal surplus of around 3.7 percent of GDP in 2004. Continuing with this policy, the authorities have limited real spending increase in the first quarter of 2005 to 1.5 percent. They would have liked to reach an even higher fiscal surplus, but it was not possible mainly due to the shortfall in collections at the social security institute since last June. In this regard, the authorities fully agree with the staff’s comments on the need to address this institute’s weak incentive to make collections.

4. The independency of the Central Bank has been respected. Given the likely uncertainties stemming from an electoral year, as well as others related to the global economy, which reflected in inflation expectations above the Central Bank’s target range, the authorities carried out a cautious monetary policy. The result was an additional reduction of the inflation to about 5.5 percent. Meanwhile, once the market demonstrated to be composed, and inflation expectations returned to the envisaged target, monetary policy was eased. Furthermore, as noted in the staff report, the authorities as well as the incoming Central Bank President participated in the December monetary policy meeting, where the inflation target range for 2005 was set, providing another clear sign of the very smooth transition that Uruguay is experiencing.

5. During the bank resolution process the authorities have broken with perverse practices of socializing private liabilities and losses. With regards to recent events, asset management company (AMC) has continued making repayments to Banco de la República Oriental del Uruguay (BROU) ahead of schedule, while the restructuring of the bank continues vigorously and its liquidity position substantially improves. As a result, BROU has started to unfreeze the last tranche of reprogrammed deposits, retaining nearly the whole amount released, with a good portion remaining in time deposits. While in general the authorities share the staff’s concern on the remaining vulnerabilities that the BHU’s weak position entails, it is fair to underscore the critical change observed in the transformation of the BHU. With respect to the liquidation funds, the authorities have made important progress in the recovery process, i.e. seizable assets of former owners of the failed banks will be auctioned in the near future, all of which is undertaken in a transparent manner. Furthermore, the authorities have already completed the semi-annual financial reports of these funds for auditing and publication. The government -main creditor of the liquidation funds- is devoting the recovered assets to repurchase debt, while the Central Bank has taken advantage of the increase in money demand to purchase reserves, which are employed to make debt payments. Similarly, the authorities will use this final disbursement under the Fund-supported program to make payments to the Fund.

6. The Superintendency of Banks has acted taking into account only technical aspects. Likewise, the authorities have strengthened this superintendency by increasing its staff and trying to make the institute more autonomous. This institute has been strict with the reserve requirements for public banks and NBC, which will be eased to the extent that these institutions improve on critical aspects, such as governance structure, risk management, and credit policies. Meanwhile, the banking superintendency is attempting to diminish one significant source of vulnerability that the country has traditionally had that is associated with banks’ loans in dollars to firms that only operate in the local market. Furthermore, the institute will seek to reach agreements with its peers in different countries to further improve supervision of the financial institutions.

7. The respect for property rights and the predictability of the rules of the game have been the centerpiece of the government’s strategy, as mirrored, for instance, in the debt-exchange operation. This strategy is allowing the country to gradually regain access to private markets and attract investment. As we noted in past reviews, the authorities wanted to complete their ambitious agenda of structural reforms. However, certain reforms were not possible to undertake due to different political and social constraints, and the need to prioritize some reforms during this very difficult period. Nonetheless, the significant amount of investment established in Uruguay in 2004, and a number of large-scale projects expected to take place in the coming years attests to the authorities’ success in, among other things, integrating the country in the global economy, opening up the economy to competition, promoting transparency and predictability, etc.

Conclusion

8. Finally, the authorities would like to thank the Executive Directors, Management, and the staff for their strong involvement in the Uruguayan case. The Fund-supported program has been critical in allowing Uruguay to overcome the worst economic and financial crisis in the country’s modern history. The authorities are also well aware of the remaining vulnerabilities and the reforms needed to minimize them. At the same time, they are proud of their achievements and are confident that they have left Uruguay with substantially better fundamentals and sound precedents to successfully cope with the remaining vulnerabilities. Last but not least, we would like to remark that beyond the intrinsic value that the Uruguayan democratic system has in fostering liberty and legal security, it is allowing for a very smooth transition, as evidenced by the current market behavior.