Request for Stand-By Arrangement—Staff Report; Staff Supplements; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Uruguay

This paper examines Uruguay’s Request for a Stand-By Arrangement. Although the external current account shifted to a moderate deficit, mainly reflecting the recovery in imports, export performance has been robust, and gross international reserves are now about three-fourths their pre-crisis level. The authorities’ program appropriately focuses on fiscal consolidation keeping inflation low through prudent monetary policy, promoting sound credit flows in a strengthened financial system, and other growth-oriented reforms. Key to maintaining macrostability will be achieving sufficiently large primary surpluses over the medium term to keep the public debt on a firm downward path.


This paper examines Uruguay’s Request for a Stand-By Arrangement. Although the external current account shifted to a moderate deficit, mainly reflecting the recovery in imports, export performance has been robust, and gross international reserves are now about three-fourths their pre-crisis level. The authorities’ program appropriately focuses on fiscal consolidation keeping inflation low through prudent monetary policy, promoting sound credit flows in a strengthened financial system, and other growth-oriented reforms. Key to maintaining macrostability will be achieving sufficiently large primary surpluses over the medium term to keep the public debt on a firm downward path.

I. Background

1. Uruguay has shaped an impressive recovery from the deep economic and financial crisis of 2002. 1 Key achievements under the Fund-supported program include:

  • Economic growth rebounded sharply following the 1999-2002 recession, with real GDP growth exceeding 12 percent in 2004.

  • Inflation was quickly brought under control. After the float of the currency in 2002, inflation fell steadily and reached single digits in 2004. Real wages fell sharply during the crisis, but have begun to recover since late-2004.

  • The external position has strengthened, and the peso first stabilized and then came under pressures to appreciate. Since late 2003, the peso has appreciated 15 percent in real effective terms, although it remains some 25 percent below its pre-crisis level. The external current account, after improving strongly in 2002, shifted to small deficits in 2003-04—despite rapid export growth—reflecting the sharp recovery in imports. The capital account has also progressively strengthened, on account of both FDI and portfolio inflows. Together with large IFI assistance, this contributed to a buildup of international reserves to US$2.5 billion at end-2004, some 75 percent of the pre-crisis (2001) level.

  • The fiscal primary balance has strengthened significantly, and the public debt has been set on a downward path. The primary balance improved from a deficit of 1.2 percent of GDP in 2001 to a surplus of 3.8 percent of GDP in 2004. The adjustment mainly reflected expenditure restraint, especially on wages and pensions, timely increases of public tariffs, and temporary surcharges on specific taxes. Rebounding growth and peso appreciation also helped bring down the debt-to-GDP ratio from its peak of 104 percent in 2003 to 92 percent at end-2004.

  • The banking system has been stabilized. Resident bank deposits of the private sector recovered to about 80 percent of their pre-crisis level by end-2004, although nonresident deposits (almost exclusively off-shore) have recovered only modestly. Dollarization remains high (at about 90 percent of deposits), and real credit growth was still negative in 2004.

  • Good progress was made in restructuring the financial system. The state commercial bank (BROU) has been implementing a comprehensive restructuring program and made profits in 2004. The state mortgage bank (BHU) began the transformation process into a mortgage company (with World Bank support). The bank created from the good assets of the failed banks (NBC) is well-capitalized and liquid, with asset recoveries of the failed banks well underway. Financial system oversight was strengthened, with a new focus on managing the risks from dollar lending to clients that earn income in pesos.

Figure 1.
Figure 1.

Uruguay: Real Sector and Price Developments

Citation: IMF Staff Country Reports 2005, 235; 10.5089/9781451839319.002.A001

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

Uruguay: External Sector Developments

Citation: IMF Staff Country Reports 2005, 235; 10.5089/9781451839319.002.A001

Sources: Central Bank of Uruguay; Ministry of Economy and Finance; and Fund staff estimates.1/ Includes all liabilities to the Fund and short-term liabilities to resident financial institutions.
Figure 3.
Figure 3.

Uruguay: Fiscal, Monetary and Financial Sector Developments

Citation: IMF Staff Country Reports 2005, 235; 10.5089/9781451839319.002.A001

Sources: Central Bank of Uruguay; Ministry of Economy and Finance; and Fund Staff estimates.1/ Covers private non-liquidated banks.

2. Developments in 2005 continue to be favorable.

  • Leading indicators point to a continuing recovery in Q1-2005. Domestic demand is benefiting from rising real wages and falling unemployment (12 percent in March, about half the crisis peak).

  • Annual inflation has been running at 5½ percent since the beginning of the year, helped by the appreciation of the peso. In March, the central bank (BCU) announced an inflation target of 5–7 percent for March 2006 (½-percentage point lower than the December 2005 target). Domestic short-term interest rates are at their lowest levels in decades, reflecting stabilized inflationary expectations and still-high liquidity in the system.

  • The external position remains robust. Export growth in Q1-2005 remained strong (16 percent). Official reserves dropped somewhat in early 2005, reflecting advanced repayments to the Fund and buybacks of Brady bonds,2 but have rebounded lately with continuing capital inflows. Net international reserves (program definition) are still negative, however, mainly reflecting the large Fund credit outstanding.

  • Fiscal performance in Q1-2005 was in line with the program. Real nondiscretionary spending growth was capped at 1.5 percent (y/y), including the January wage and pension increases (nominal) of 3.5 percent and 5 percent, respectively. Revenues were in line with projections, and public tariffs (petroleum products and energy) were adjusted in April to reflect increased input costs.

  • Banking reforms have proceeded as planned, although the recent suspension of a small cooperative bank indicates the still fragile state of the system.

    • Cooperative bank (COFAC).3 The bank was suspended in March 2005, which touched off fairly widespread, albeit relatively small, deposit withdrawals in the banking system. The new government quickly implemented a resolution strategy that involved the capitalization of deposits and introduction of a deposit insurance scheme to protect small depositors.4 Deposit flows in the banking system subsequently stabilized, and have been recovering since end-March.

    • BROU. The bank continued to make profits in the first quarter of 2005, and a new Board was appointed in March. The release of reprogrammed deposits was completed in April, and 93 percent of them were retained. The bank’s asset management company (AMC) is making good progress in working out the nonperforming loan (NPL) portfolio, allowing BROU’s trust fund to continue making repayments to BROU on the government-guaranteed note ahead of schedule.

    • BHU. Steps have been taken toward its conversion into a mortgage company, but vulnerabilities remain, including a large NPL portfolio (which is being addressed) and high operating costs (coming down, albeit only slowly). The bank serviced its government-guaranteed note to BROU in Q1-2005, but risks remain as scheduled repayments will rise over the next few years.

    • NBC and the liquidated banks. The authorities are moving forward with the sale of NBC, and potential buyers have submitted preliminary proposals. The private asset manager of the liquidation funds has moved forward in the collection process, broadly on schedule.

    • Financial system oversight. The banking superintendency (SIIF) published its annual work plan that focuses on bolstering on- and off-site supervision, improving the bank resolution process, strengthening accounting and audit standards, and assessing the adequacy of minimum capital requirements. Also, the incorporation of information on non-performing borrowers of the liquidation funds into the credit registry is to be completed by end-May and will be disseminated to creditors in June.

II. Vulnerabilities and Medium-Term Outlook

3. Despite the good macroeconomic performance in 2004, important vulnerabilities remain that pose risks to the medium-term outlook.

  • The public debt is still high, mostly denominated in foreign currency, with about half carrying variable interest rates. The recent volatility in emerging market sentiment caused the authorities to postpone an envisaged debt placement in March (which was later completed in May),5 and upside risks on interest rates underscore the sensitivity of Uruguay’s financing outlook.

  • Large amortization payments to the Fund, World Bank, and IDB are coming due over the next three years that will need to be financed in part from new lending—requiring strong implementation of associated IFI-programs. Gross financing needs will average US$2.2 billion (some 12 percent of GDP) over 2005–08.

  • Public spending pressures are high following the compression of real wages and pensions (by 20 percent) in recent years. The social situation remains difficult, owing to lingering dislocations from the crisis, with some measures of the poverty rate at over 30 percent.

  • Dollarization in the financial system remains widespread and currency mismatches persist (albeit reduced) on the balance sheets of households, corporations, and the public sector. Central bank reserves cover about a quarter of short-term external debt and dollar deposits, while banking system foreign assets cover about 70 percent, below coverage levels in other dollarized economies in the region.

  • Contingent liabilities in the banking sector remain significant. Legal claims have been initiated against the government to compensate for losses suffered during the financial crisis,6 and the BHU’s ability to service its government-guaranteed note to BROU (about US$600 million in principal and interest) is a near- and medium-term risk. More generally, the presence of a large public bank (BROU), with over half of banking system deposits, is a continuing medium-term risk in the system.

Figure 4.
Figure 4.
Figure 4.

Uruguay: Vulnerability Indicators

Citation: IMF Staff Country Reports 2005, 235; 10.5089/9781451839319.002.A001

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

Comparisons of Banking System Reserve Adequacy Indicators

article image

4. The key medium-term challenge is to boost growth in a lasting way, requiring continued macrostability and structural reforms (Box 1). Growth in 2005 is estimated at 6 percent, bringing real GDP to about its peak during the 1990s, with growth converging to its underlying rate thereafter.7 The medium-term potential growth rate is estimated at 3 percent, which assumes continued sound macroeconomic policies and the implementation of the government’s structural reform agenda. This agenda centers on strengthening the public finances, promoting efficient financial intermediation, and raising investment and productivity in both the private and public sectors. Downside risks to the growth outlook include a possible downturn in external demand, higher oil prices, a sharp rise in U.S. and domestic interest rates, and slower progress with structural reforms. A near-term risk for 2005 is continued lack of rain that could cause electricity shortages.

5. While the debt outlook has improved markedly since the height of the crisis, it remains the key medium-term risk (Box 2). Staff’s DSA suggests that medium-term primary surpluses of at least 4 percent of GDP and sustained growth are needed to reduce the public debt below 60 percent of GDP by 2009, and 50 percent by 2012. The outlook is sensitive to exchange rate, interest rate, and growth shocks, as well as to contingent liabilities in the banking system—suggesting that every opportunity should be used to strengthen the public finances further, to buffer against those risks.

Uruguay: Sensitivity of Public Sector Debt 1/

(In percent of GDP)

article image
Sources: Ministry of Finance; Banco Central del Uruguay; and Fund staff estimates.

Framework covers the nonfinancial public sector plus the BCU.

Includes deposit insurance costs of US$60 million and legal judgment costs of US$120 million.

The Growth Outlook

Uruguay’s weak growth performance since 1960 is largely explained by low investment coupled with low productivity growth. Uruguay’s growth per capita averaged about 1.3 percent, almost half the growth rate of strong regional performers such as Brazil and Chile. This is partly explained by low investment, which hovered around 14 percent of GDP—significantly below other countries. Also, growth in total factor productivity lagged, in part reflecting pervasive state intervention and the existence of barriers to private competition.

Uruguay: Growth and Investment

(Average during 1960-2004)

article image
Source: WEO.

Growth is now projected to increase to a medium-term rate of 3 percent by 2008. Growth for 2005 is projected at 6 percent, reflecting the recovery from the last recession. In 2006, growth would remain high, at 4 percent, as a large forestry project takes place, and would then converge to its medium-term potential of 3 percent.

Uruguay: Assessment of the Environment for Business and Innovation 1/

article image

World Economic Forum (2005). Rank out of 104 countries.

The increased potential assumes implementation of the government’s comprehensive structural reform agenda. The agenda aims at increasing the capital stock through private investment, and raising total factor productivity by improving resource allocation and augmenting human capital. It covers the following areas:

  • Developing efficient capital markets through the establishment of a market for corporate stock and fixed-income instruments, a strengthened regulatory environment, and diversification of pension fund investments in order to provide firms with new sources of financing, which to date are mainly retained earnings and bank lending;

  • Fiscal reforms to improve the structure and efficiency of the tax system, improve the effectiveness of public institutions, and improve public expenditure management to make room for higher capital outlays;

  • Public enterprise reforms through improving governance and opening up these sectors for private competition, to bring down the high cost of infrastructure services currently provided by them;

  • Simplifying business start-up procedures by facilitating business registration and creating an investor relations office;

  • Strengthening corporate governance, in part by amending bankruptcy procedures to include a Chapter 11 regime;

  • Expanding trade opportunities by strengthening Mercosur and increasing exports outside the region, including by improving access to industrial countries’ agricultural markets;

  • Improving labor market conditions by facilitating collective bargaining through consultative wage councils at the industry level; and

  • Strengthening the human capital base by improving education and health services, and promoting scientific research and new technologies.

Public Debt Sustainability

  • Baseline scenario. In the DSA baseline scenario (Appendix I), staff assumes a medium-term primary surplus of 4 percent of GDP in line with the fiscal program; potential real GDP growth of 3 percent; a return of the real value of the peso vis-á-vis the U.S. dollar to 85 percent of its pre-crisis level (from 75 percent at end-2004); and sovereign spreads remaining in line with current levels. Under these assumptions, public debt would decline from 92 percent of GDP in 2004 to 50 percent by 2012 (assuming no contingent liabilities from bank restructuring come due). With nominal debt staying broadly at the 2004 level, this reduction would be mainly achieved through economic growth and appreciation of the real exchange rate.

  • Standard sensitivity analysis. 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 after 2008. The large share of foreign currency-denominated debt (90 percent) and floating rate debt (50 percent) and the high amortization payments coming due in the next few years make the debt-to-GDP ratio vulnerable to interest rate, exchange rate and growth shocks. In particular, the standard DSA analysis (Appendix I, Table 2) shows that large shocks to these variables would lead to significant increases in the public debt-to-GDP ratio (to 75–130 percent of GDP in 2010) that would exacerbate doubts about debt sustainability.

  • Additional sensitivity analysis. In addition, staff has analyzed the impact of: (i) contingent liabilities in the banking system coming due; (ii) lower real GDP growth by 1 percent a year; (iii) weaker fiscal performance of ½ percent of GDP a year; (iv) a constant real exchange rate; and (v) a 200-basis point increase in interest rates over the medium term. In these cases, the public debt ratio rises generally by between 5–10 percent of GDP above the baseline. The debt is particularly vulnerable to the path of the real exchange rate and interest rates. On the other hand, additional fiscal effort of ½ percent of GDP a year would lower the 2012 debt ratio by 4 percentage points and possibly by significantly more, to the extent that the stronger fiscal performance has positive repercussions on interest rates and sovereign spreads.

Figure 1.
Figure 1.

Uruguay: Gross Public Sector Debt 2004-2012

Citation: IMF Staff Country Reports 2005, 235; 10.5089/9781451839319.002.A001

III. Policy Discussions and the Authorities’ Economic Program

A. Program Objectives

6. The overarching goal of the authorities’ program is to improve social conditions by raising growth and sharing its benefits more widely—based on a strategy of prudent macropolicies, deep structural reforms, and well-targeted improvements in the social safety net. In support of their program, the authorities have requested a three-year SBA from the Fund, which they view as essential in helping them meet these objectives. Domestic political support for the program is strong, as President Vázquez and his left-leaning coalition (FA-EP) hold a majority in congress, with 52 seats (out of 99) in the lower house and 17 seats (out of 31) in the senate. Even so, the program will need to show early positive results for this support to be sustained and entrenched; hence, the authorities’ emphasis on strong frontloaded policies combined with visible actions of social support for the least fortunate.

  • Macroeconomic stability. The authorities’ program focuses on fiscal consolidation to keep the public debt on a firm downward path; a buildup of international reserves while maintaining continued exchange rate flexibility and low inflation; and promoting sound credit flows and de-dollarization in a strengthened financial system.

  • Growth. The government aims to boost growth through a comprehensive microeconomic reform program, supported by the World Bank and IDB. Both institutions’ lending programs will aim at improving infrastructure, in particular, energy, ports, roads, and sewerage. World Bank lending will also cover, inter alia: (i) improving governance and management in the public enterprises, to strengthen their ability to compete with the private sector and prepare some of them for joint ventures with the private sector, and (ii) developing the domestic capital market; while the IDB will also lend in support of continued opening of the economy to domestic and foreign competition.

  • Investment climate. The authorities see an improved investment climate as key for boosting growth in a sustainable way. Their strategy of prudent macropolicies, strengthening the financial sector, developing capital markets, fiscal reforms, and further trade opening is designed to provide a supportive environment for increased private investment. In addition, with the support of the World Bank, they will carry out an investment climate assessment that would cover, among other areas, corporate governance; and they intend to strengthen the protection of creditor and debtor rights, including by modernizing bankruptcy legislation, while the IDB is supporting a restructuring of business start-up procedures, including the creation of an investor relations office.

Uruguay: New Lending Areas of Multilateral Development Banks, 2005–10 1/

article image

Still subject to Board approvals.

7. A key near-term challenge for the government is to effect a lasting improvement in social conditions consistent with its macroeconomic objectives. To meet this challenge, the government has embarked on a temporary (two-year) social emergency program (SEP). The program targets those living in extreme poverty and covers healthcare and education, direct income and housing support, and a temporary employment program (Box 3). The SEP has been allocated US$200 million (0.6 percent of GDP on an annual basis). Staff underscored that the SEP needs to be well-targeted, and that preventing it from becoming a permanent institution is crucial for the medium-term fiscal program (described below). The authorities emphasized that efficiency of the SEP is a key concern to ensure rapid progress on improving social conditions, and they recognized the potential risk regarding the SEP’s timely phase-out. They intend to work closely with the World Bank and IDB to ensure that room can be made under the social-sector fiscal envelope to incorporate any elements of the SEP that merit extension, and thus, make sure that the program is terminated as envisaged.

Social Emergency Program

The social emergency program (SEP) responds to a core mandate of the government. Since its announcement during the presidential campaign, it has been framed as a temporary program to address the widespread social dislocation from the 2002 financial crisis (about 30 percent of the population is still below the poverty line, and 3 percent live in extreme poverty conditions). The SEP is composed of seven major programs targeting some 20 percent of the one million people living in poverty. The government has committed to spend US$200 million over a two-year period. The SEP will be implemented by the Ministry for Social Development, created in March 2005, and will be supported under the World Bank and IDB social sector reform programs aimed at strengthening social institutions and improving the efficiency of budgetary resources in these areas.

Social Emergency Program: Cost Estimates

article image
Source: Uruguay government and staff estimates.

Number of households

  • Education. Targets 66,000 students at risk and includes extracurricular support, weekend programs, school lunches, and coupons for secondary-school students.

  • Minimum Income Guarantee. Targets 35,000 households for a guaranteed minimum household income of UR$1,363 (US$55.5) per month, and includes professional training programs for mothers.

  • Nutrition. Targets 200,000 people, and includes programs for malnutrition, school lunches, and education on nutrition matters.

  • Temporary Employment. Targets 16,500 four-month work contracts.

  • Housing. Targets 150,000 people in needy neighborhoods, through improving infrastructure, basic services, and housing conditions.

  • Primary Health. Targets 200,000 people through providing preventive health care, and includes programs for infrastructure, medical and dental care, and medicines.

  • Homeless. Targets 2,350 homeless individuals by providing night shelters and day centers.

B. Macroeconomic Framework

Uruguay: Medium-term Macroeconomic Framework

(percent of GDP, unless otherwise indicated)

article image
Sources: BCU; and Fund staff estimates.

Includes debt of the nonfinancial public sector and the central bank.

8. The authorities’ medium-term framework is anchored on a primary surplus target of 4 percent of GDP. They explained to staff that the underlying surplus would already be at that level from 2005, while the “headline” surplus would be somewhat lower in 2005-06 (3.5 percent of GDP and 3.7 percent of GDP, respectively), taking into account one-off expenditures and surcharges introduced during the economic emergency as well as the SEP, which they consider to be strictly temporary (Box 4). The fiscal path reflects the planned tax reform (see below), tight control on expenditure including for wages and pensions,8 and timely public tariff adjustments in line with cost developments. Staff urged the authorities to achieve a 4 percent primary surplus already from 2005 to anchor expectations of fiscal discipline under the new government, and urged the authorities to make every effort to achieve this goal as soon as possible. The authorities agreed to save any revenue overperformance under the program, and are committed to pushing ahead with their plan to strengthen tax administration and to refrain from any significant tax reduction before the planned tax reform.9 They also noted that the fiscal program envisages a significant decline in the overall deficit, from 2.2 percent of GDP in 2004 to 0.8 percent of GDP in 2007 that, along with growth and real appreciation of the peso, would help lower the public debt from 92 percent of GDP to about 65 percent of GDP by end-2007. Staff welcomed these commitments and pointed to the importance of having fiscal contingency measures given the significant risks on both revenues (such as weaker growth) and expenditures (mainly wages, pensions, and debt service). The authorities explained that the main contingency measure would be spending restraint, as demonstrated in their spending plans for 2005—although recourse could also be taken to increasing revenues if needed.

Factors Influencing Analysis of Fiscal Performance in 2004-05

In 2004, the 3.8 percent of GDP primary surplus of the consolidated public sector included transitory components, estimated at 0.4 percent of GDP, implying an underlying primary surplus of 3.4 percent of GDP. Transitory items on the revenue side of 0.9 percent of GDP, associated with concession revenues and the elimination of various emergency surtaxes, were partly offset by transitory spending items of 0.4 percent of GDP, related to last year’s general election and regularization of arrears incurred during the 2002 crisis.

A similar calculation for 2005, starting from the program primary surplus target of 3.5 percent of GDP, shows an underlying primary surplus of 3.7 percent of GDP. Assuming social-emergency-program spending of 0.4 of GDP is strictly temporary, the underlying primary surplus would be 4.1 percent of GDP.

Underlying Primary Balance of the Public Sector: 2004-05

article image

9. The framework for monetary policy (monetary targets and flexible exchange rate) will be maintained, aiming at a steady lowering of the target range for inflation to 2½–4½ percent by end-2008. Staff supported the authorities’ intention to maintain the current framework for monetary policy until conditions are in place to move to a formal inflation targeting framework. In preparation for such a move, the authorities intend to advance institutional reforms of the central bank (see below), and MFD will provide technical assistance (TA) on strengthening monetary policy instruments and operations. Staff supported the authorities’ near–term inflation objectives (5½–7½ percent for end-2005 and 5–7 percent for March 2006) and considered the present monetary policy stance as consistent with these objectives, given current inflation and recent surveys of inflationary expectations in line with the 12-month targets. The authorities indicated that inflationary pressures could build over the next few months in light of the ongoing recovery in real wages, higher energy prices, and an economy approaching its pre-recession levels of output and unemployment, and stressed their readiness to tighten the policy stance if necessary.

10. The program envisages a further strengthening of the international reserves position. The authorities saw merit in bolstering the central bank’s international reserves somewhat, given the high level of financial dollarization, and aim to raise gross reserves over the program period by US$300 million.10 The program conservatively assumes that this increase of international reserves will be achieved through longer-term debt issuance. The authorities considered that, if monetary conditions permit, the BCU could purchase foreign exchange to accumulate additional reserves, but without announcing a formal intervention strategy. The authorities stressed that such purchases would not aim at influencing the path of the real exchange rate and would be consistent with the program’s inflation objective.

C. Structural Fiscal Policies and Debt Management

11. Structural fiscal reforms are to bolster the public finances’ resilience to shocks and improve efficiency. The authorities’ program includes four pillars of fiscal reform: (i) comprehensive tax reform, (ii) modernization of tax administration, (iii) overhaul of the budgetary framework, and (iv) reform of the specialized pension funds.

12. Tax reform. The authorities plan to rationalize and broaden the tax base to make revenue collections more robust and distribute the tax burden more equitably. Specifically, they intend to introduce a personal income tax, revamp the corporate income tax to accommodate the personal income tax and unify tax rates across sectors, streamline the current system of tax exemptions and subsidies, rationalize the plethora of minor taxes (of the 30 different taxes, 5 account for 90 percent of total collections), and eventually begin to lower the high statutory rates on indirect taxes. A draft law will be sent to congress by end-2005, for implementation from mid-2006. Staff and the authorities concurred that indirect tax rates should only be reduced after the yield of the tax reform is assured.

13. Strengthening tax administration. The authorities intend to implement pending reforms from the last program, including issuance of a decree to implement the domestic revenue service (DGI)’s modernization law (establishing, inter alia, a professional career stream at the DGI) and the establishment of a large taxpayers unit (LTU). They will also formulate an action plan to coordinate tax audits between the DGI, BPS and the Ministry of Labor to reverse last year’s weakening of collections of social security contributions. In 2005, joint FAD/World Bank TA will be provided to strengthen the institutional capacity of the DGI, with a view to transforming it into a semi-autonomous agency with responsibility for social security contribution and trade tax collections.

14. Reforming the budgetary process.11 During the first program year, the authorities will incorporate the recommendations of the 2001 fiscal ROSC by complementing the five-year expenditure plan with the submission of revenue projections, deficit targets, and a medium-term macroeconomic framework consistent with the program’s fiscal targets. They will also carry out a tax expenditure analysis. In addition, FAD is providing TA to lay the ground for a new budgetary framework that should include a new organic financial management law, introduction of annual budgets within a rolling five-year framework, and improvements in budget classification and coverage, including moving off-budget items on budget and reducing earmarking of revenue. The authorities agreed that once the TA is completed later this year, key elements of the strategy could become part of the government’s reform agenda.

15. Pension reform. Reforms are needed of the specialized pension funds as well as the general public pension plan, which jointly required Treasury support of 7 percent of GDP in 2004.12 The reform of the specialized pension fund of the police is most advanced and will be implemented before end-2005. This would be followed by reforms of the pension funds of the military (by end-2006) and of bank employees (by end-2007). Staff cautioned that second-generation reforms of the general pension system (which was overhauled in 1995) are needed to reduce the burden on the Treasury. The authorities saw merit in this view and intend to discuss in June with World Bank staff a reform agenda in this area.

16. Debt management. The authorities will establish a debt management unit and investors relation office at the Ministry of Finance, by year-end, with assistance from ICM, MFD, and the IDB. The unit will formulate an appropriate medium-term debt plan, while managing the strategy on the interest, currency, and maturity composition of public debt. Staff supported the authorities’ general objective to lengthen the maturity of debt issues (to at least 12 years), and encouraged them to make further progress toward de-dollarizing the debt (including by issuing inflation-indexed peso-denominated debt) and build a local yield curve as part of its strategy to develop local capital markets. Staff urged the authorities to take advantage of favorable market conditions in 2005 to pre-finance at least part of 2006 financing needs.

D. Central Bank and Financial Sector Reforms

17. Improving BCU autonomy is high on the authorities’ reform agenda. They recognized that this step is critical to further raising the credibility of monetary policy and preparing the move to inflation targeting. To this end, they intend to: (i) submit a law to congress by end-2005 that would strengthen central bank legal independence, including through the staggering of the appointments of BCU board members (de-linking them from the electoral cycle) and establishing price stability as the primary objective; (ii) submit a law to divest the BCU’s supervisory responsibilities to allow it to concentrate on monetary policy and avoid any conflict of interest;13 and (iii) study (with MFD assistance) strategies for strengthening its financial position.14

18. Financial sector supervision will be strengthened further and the framework for bank restructuring overhauled.

  • Regulatory and supervisory framework of the financial system. The authorities intend, with assistance from MFD, to create separate supervisory institutions to regulate and supervise banks, insurance companies, and pension funds through a law that will be sent to congress by December 2005, for implementation from mid-2006. Staff welcomed the authorities’ decision to request a joint World Bank/IMF FSAP, which will take place in the second half of 2005.15

  • Bank resolution framework. The recent suspension of a cooperative bank underscored the need for a new bank resolution framework. Staff commended the authorities for the prompt action taken in resolving that situation, but also noted the ad-hoc nature of those actions—including the deposit insurance scheme introduced—and the risks and potential moral hazard problems of not having a clear and transparent framework. The authorities shared staff’s concern and will send to congress by end-2005 a law (on which MFD will provide TA) to establish a formal bank resolution framework (including a refined deposit insurance scheme), for implementation from mid-2006.16 Staff recommended that deposit insurance coverage of dollar deposits be expressed in pesos (rather than in U.S. dollars), in line with best practices, but the authorities thought that at this juncture this might raise confidence concerns and spur systemic problems.

19. De-dollarizing the economy is an important goal. There was broad agreement between staff and the authorities that this will, most importantly, require a sustained period of macrostability to strengthen private sector confidence in the peso. At the same time, the process will be supported by: (i) regulatory oversight to ensure that banks take into account the credit risk of dollar lending to unhedged borrowers; (ii) higher reserve requirements and deposit insurance premia on dollar deposits; and (iii) capital market development to provide a broader range of savings instruments in pesos, including inflation-indexed government bonds and savings instruments in the banking system.

20. The bank restructuring program is continuing, for the public as well as the intervened private banks.

  • BROU. The authorities shared staff’s concern about the risks of having a public bank dominate the banking system. To address these risks, they intend to pursue vigorously the current restructuring plan of the bank,17 noting that the recently appointed board, selected solely on the basis of professional qualifications, will help ensure that the bank is well run.18 The authorities expressed their firm commitment that the bank will not return to politically-influenced lending practices, and that any potential subsidies should be made explicit in the budget. They also agreed with staff that the trust funds managing BROU’s nonperforming loans need to remain independent, with their main objective being to maximize loan recoveries, to ensure that they service the government-guaranteed note to BROU of about US$350 million in full.

  • Housing bank (BHU). Staff noted that while progress had been made in restructuring BHU, it was still not operating as a mortgage company and burdened with elevated operating costs and NPLs. It is, therefore, a major risk to the public finances: current projections show that the bank might not be able to service its government-guaranteed note to BROU in the coming years. The authorities shared staff’s concern and intend to accelerate the reform of BHU. Specifically, they hope to make a first securitization of part of the bank’s mortgage portfolio before the end of this year, and the bank will continue to refrain from taking deposits.19 They also reaffirmed that the bank’s obligations to BROU will be financed according to the present timetable and terms.

  • Nuevo Banco Comercial (NBC). The government’s strategy is to divest its controlling interest in NBC; although good progress has been made in initiating this process, it could take some time to conclude (the authorities hope by no later than mid-2006). In the meantime, they intend to strengthen the bank’s governance by appointing an interim CEO and board with appropriate professional experience.

  • Liquidation funds. Staff advised the authorities to closely monitor these collection efforts to ensure that the manager meets its targets, and that revenue should be saved to provide for unforeseen bank restructuring costs or other fiscal contingencies. The authorities agreed with staff’s recommendations and noted that to ensure transparency, they will continue to publish audited semi-annual financial reports of the liquidation funds.

IV. Access, Balance of Payments Need, Capacity to Repay the Fund, and Financing Assurances

21. Proposed access under the SBA balances the need to ensure that the program is adequately financed while providing for a reduction in Fund exposure consistent with a lasting exit from future Fund financial support. The total gross financing need (including for the programmed buildup in international reserves) during the program period will average about US$2.2 billion a year (12 percent of GDP). Of this, on average, US$400 million a year would be covered by the World Bank and IDB, US$1.4 billion from the market (corresponding to net government bond placements of some US$500 million a year, about 3 percent of GDP, and of which some US$600 million would be financed externally), and the remainder by the Fund (16 percent of the total gross financing need). The proposed access of SDR 766 million (250 percent of quota) would leave Fund exposure at SDR1,134 million (370 percent of quota) by mid-2008 (covering about 60 percent of the repurchases falling due during the period), and requires approval under the exceptional circumstances clause under the Fund’s access policy (Appendix II).20 Phasing would be tailored to external financing needs and somewhat concentrated in 2006 (45 percent of proposed access) when large amortization payments fall due on the shorter-term placements made soon after the 2002 crisis.

Uruguay: External Financing Requirements and Sources

(In millions of U.S. dollars)

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

Includes change of commercial banks’ NFA, short-term flows and trade credits, and errors and omissions.

22. Uruguay should be able to fully discharge its obligations to the Fund following the program and exit from further Fund financial support. While Fund exposure at program’s end would remain high (debt service to the Fund would still amount to 20–25 percent of total external debt service in 2009-12), the DSA shows that Uruguay should be able to fully cover its obligations coming due to the Fund—which will average about US$365 million during 2009-12—through placements in international and domestic capital markets (averaging some US$500 million a year on a net basis and implying gross placements in line with those projected during the program period). This will require firm implementation of the proposed program and structural reforms supported by the World Bank and IDB. The authorities will consider reducing Fund exposure at an accelerated pace if external and market conditions turn out more favorable than anticipated.

Uruguay: Public Sector Financing Outlook (2005–2012)

(In millions of U.S. dollars)

article image

Includes disbursments under the new program.

23. The program has adequate financing assurances in place. Financing needs through August 2005 have been secured, through placements in the domestic market of inflation-linked and dollar-denominated notes, the temporary use of government deposits at the central bank, and the recent international bond placement. The residual financing gap for 2005 and the buildup in international reserves would be closed through an international bond issue of US$200 million later in the year. Gross financing requirements for the remainder of the program will need to be met through sustained fiscal discipline, increasing access to domestic and international financial markets, and continued IFI support.

24. A new full safeguard assessment is underway. An on-site safeguards assessment of the Central Bank of Uruguay was completed in July 2002, and most of its recommendations have been implemented (see Appendix III on Fund Relations for details). Under the proposed SBA, Uruguay is subject to a new full safeguards assessment of the Central Bank. The authorities have provided the necessary documentation, and the assessment is expected to be completed by end-September 2005.

V. Program Monitoring

25. The proposed program would be monitored through quarterly reviews, owing to the vulnerabilities of the Uruguayan economy and high Fund exposure. Conditions permitting, bi-annual reviews could be considered after the first program year.

26. The proposed program contains standard quantitative performance criteria (PCs), indicative targets and benchmarks, and structural conditionality, including prior actions, which focus on policy priorities and address program risks (Tables 1 and 2 of the MEFP):

  • Prior actions aim at safeguarding the needed fiscal adjustment in 2005 and advancing financial sector restructuring. In the fiscal area, these cover the issuance of a decree to implement the DGI modernization law, the establishment of a large taxpayer unit at the DGI, and a plan to coordinate audits between the DGI. BPS, and Ministry of Labor. In the financial sector, an interim CEO and board members with appropriate experience are to be appointed at NBC.

  • Quantitative PCs would focus on the program’s fiscal, debt, monetary, and international reserve objectives. The PC on the combined public sector primary balance is supplemented by a ceiling on non-interest government expenditure to ensure that any revenue overperformance would be saved.21 Overall budgetary developments will be monitored through an indicative ceiling on the overall fiscal deficit. Debt developments will be monitored through a PC on the stock of the gross debt of the nonfinancial public sector (NFPS),22 and an indicative target on the stock of floating debt. Standard PCs on the NIR and NDA of the central bank, and an indicative ceiling on base money growth will serve for monitoring monetary and international reserve performance. Quarterly PCs and targets have been set through end-2005, and indicative targets for 2006 and 2007.

  • Structural conditionality has been established for the first program year and focuses on priority reforms identified by the EPA. PCs and benchmarks would cover reforms aimed at bolstering the public finances, increasing the autonomy of the central bank, and improving financial sector soundness.

27. Statistical issues. Uruguay’s statistical database has been broadly adequate for program monitoring, but lags in fiscal and public debt data generally exceeded the two-month limit under the previous arrangement. The two-month limit has been maintained under the proposed SBA, and the authorities are committed to taking the necessary steps for timely data provision, which should also help avoid further recourse to waivers of applicability of PCs.

VI. Staff Appraisal

28. The Fund-supported program that expired in March was successful in overcoming the 2002 financial crisis, promoting a strong economic recovery and improving the outlook for debt sustainability, but key challenges remain. The authorities need to build on the progress made to date, and their program rightly focuses on boosting medium-term growth prospects, reducing the still high public debt, and addressing remaining weaknesses in the financial system. Delayed or incomplete structural reforms were disappointments under the previous program, and it is crucial that the government’s ambitious reform agenda not lose momentum. Early success in implementing the program and achieving results will also be key to maintaining and strengthening the consensus that has been forged on the policy framework.

29. Boosting growth in a lasting way will require maintaining macrostability and reforms to attract more private investment. The authorities view a substantial increase in private investment as the linchpin of their strategy for growth and social progress over the medium term. Staff commends the authorities for the quick and close collaboration with the IDB and World Bank in designing a reform strategy that aims at developing capital markets, preparing public enterprises for competition and strategic partnerships with the private sector, strengthening property and creditor rights, facilitating foreign investment, improving infrastructure, and increasing trade opportunities.

30. A key policy challenge will be to sustain sufficiently large primary surpluses. Staff supports the authorities’ medium-term primary surplus target of 4 percent of GDP, which should be viewed as a floor, and urges them to reach the target as soon as possible, to help anchor expectations of fiscal discipline and take advantage of the current favorable environment. In this context, staff welcomes the authorities’ commitment to save any revenue overperformance in 2005-06. Staff underscores that the debt outlook leaves no room for fiscal policy slippages, which could quickly derail the debt dynamics and undermine the credibility of the entire program.

31. Achieving the fiscal targets will require firm control over discretionary spending and timely adjustments to public tariffs. Containing wage and pension spending and generating adequate surpluses in the public enterprises is key for creating space in the fiscal program for the authorities’ planned increase in social spending. Staff encourages the authorities to work closely with the World Bank and IDB to ensure that the social emergency program is effective and can be phased out as envisaged.

32. Strengthening tax administration will help achievement of the revenue targets and support the forthcoming tax reform. Staff welcomes the actions taken to modernize the domestic revenue service (DGI) and create a large taxpayer unit. The coordination plan between the DGI, the social security bank, and the Ministry of Labor should reverse the recent decline in social security collections. Looking forward, strengthening the institutional capacity of the DGI will help reduce evasion, maximize the benefits of the planned tax reform, and improve the efficiency of revenue collections.

33. A comprehensive tax reform is key to improving the resiliency of the public finances. Staff supports the authorities’ plan to introduce a personal income tax, rationalize the corporate income tax, and streamline the extensive system of tax exemptions and subsidies and large number of small taxes. In this context, the authorities are right to consider reducing indirect taxes only after the tax reform’s revenue impact is properly assessed.

34. Pending reforms of the specialized pension funds and second-generation reforms of the general pension system are needed to improve fiscal flexibility. Reforms of the police and military pension funds are long overdue, and staff welcomes the authorities’ intention to follow through on these pending reforms. To eliminate the risk that the weak finances of the bank employees’ pension fund becomes a future fiscal burden, staff encourages the authorities to move expeditiously in reforming this pension plan. Reform of the general pension system will require a broad consensus, which will take time to build; nevertheless, staff welcomes the authorities’ intention to work with the World Bank on possible reforms of the system and urges that, once appropriate measures are identified, they be included in the reform agenda.

35. Staff supports the authorities’ strategy of moving over time toward an inflation-targeting framework for monetary policy. The high priority the authorities have given to strengthening the independence and finances of the central bank is well placed. Staff supports the goal of reducing inflation gradually toward a range of 2½–4½ percent by 2008. The current stance of monetary policy is appropriate, and staff supports the authorities’ intention to maintain the current framework for monetary policy (monetary targets and a flexible exchange rate) until conditions are in place for moving to formal inflation targeting. The programmed buildup in international reserves is needed to bolster reserve coverage of dollar-denominated short-term debt and dollar deposits, and staff encourages the authorities to add to this target should conditions permit.

36. After bringing the banking system back from crisis, financial sector policies are now shifting toward longer-term systemic reforms and development needs. The forthcoming FSAP will be a good opportunity to take stock and review the strategy. Clear immediate priorities are revamping the institutional setting of financial system oversight and creating a new bank resolution framework, two key items in the first-year program. Staff welcomes the authorities’ plans in this context.

37. Completing the bank restructuring process is essential to restoring sound credit flows and limiting fiscal contingencies. The reform agenda is well set: resolve the bad asset overhang from the crisis transparently and rigorously; strengthen the finances of the public banks; and fortify the management of NBC. Staff welcomes the smooth release of the final tranche of reprogrammed deposits at BROU, and the authorities’ intention to accelerate the pace of reforms at BROU and BHU. An expeditious transformation of the BHU into a viable mortgage company is key to minimizing contingent fiscal risks. Staff is encouraged by the progress being made toward divesting the government’s controlling interest in NBC, and encourages the authorities to bring the process to an early conclusion. The current arrangements for asset recovery are appropriate, and staff welcomes the authorities’ commitment to continue publishing semi-annual financial statements of the liquidation funds.

38. In general, Uruguay’s statistical information is adequate for program monitoring purposes, but the provision of fiscal and debt data must become more timely. Staff welcomes the authorities’ commitment to improve the coordination among agencies reporting fiscal and debt data to ensure that they are provided in a timely manner.

39. Firm implementation of the program is essential to further reduce the vulnerabilities of the Uruguayan economy. The main macro vulnerabilities stem from the high public debt; continued risks in the banking system; and pressures for increased spending. There is also the risk of inadequate growth and social stagnation which—besides undermining the debt outlook—would sap domestic consensus on the entire policy framework. It is therefore crucial that prudent macro-management be paired with deep micro-reforms—as is the government’s strategy—to trigger the needed response of investment and productive enterprise. The authorities have already shown resolve in implementing the program, and staff is confident that their policies, as described in their Letter of Intent of May 24, 2005, are the right ones to achieve these goals. Staff views the proposed level of access as appropriately balancing the need to ensure that the program is adequately financed, while preparing for a lasting exit from Fund financial support. On this basis, staff recommends approval of the requested three-year SBA.

Table 1.

Uruguay: Selected Economic and Social 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.

Covers debt of the NFPS and the central bank (excluding monetary policy instruments and free reserves).

Excludes nonresident deposits.

Includes reserve buildup through reserve requirements of resident financial institutions.

Includes all outstanding liabilities to the IMF, and liabilities to resident financial institutions.

Table 2.

Uruguay: Medium-Term Balance of Payments

(In millions of US$, unless otherwise stated)

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

Includes all liabilities to the Fund and liabilities to resident financial institutions.

Excludes Botnia project that will require imports of US$700 million in 05-06 fully covered through FDI and generate export revenue of about US$250 million a year over the medium term.

Table 3.

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 extra-budgetary operations.

Amounts as percentage of one-fourth of annual GDP.

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. Asset recoveries in 2004 are credited.