Second Review under the Stand-By Arrangement, Requests for Modification, Waiver of Nonobservance and Applicability of Performance Criteria, and Extension of Repurchase Expectations in the Credit Tranches

Uruguay’s Second Review Under the Stand-By Arrangement and Requests for Modification, Waiver of Nonobservance and Applicability of Performance Criteria are discussed. Growth remains robust, inflation is subdued, and the external position continues to strengthen, with buoyant exports and upward pressure on the peso. Fiscal performance has been better than expected, with public debt continuing to fall as a percentage of GDP. Structural reforms are also progressing well, with key new reform initiatives under way in several areas.


Uruguay’s Second Review Under the Stand-By Arrangement and Requests for Modification, Waiver of Nonobservance and Applicability of Performance Criteria are discussed. Growth remains robust, inflation is subdued, and the external position continues to strengthen, with buoyant exports and upward pressure on the peso. Fiscal performance has been better than expected, with public debt continuing to fall as a percentage of GDP. Structural reforms are also progressing well, with key new reform initiatives under way in several areas.

I. Developments under the Program

1. The program is on track and economic developments have remained favorable.

  • With GDP growth above 6½ percent through September (y/y,), the programmed 6 percent GDP growth in 2005 is well within reach.

  • Inflation has risen from its low earlier this year to 4.8 percent in November (y/y), although it is still below the December 2005 central bank target range of 5½–7½ percent.1

  • The impact of higher oil prices has been absorbed quite well so far, in part reflecting the relatively low oil intensity of the economy (Box 1).

  • The peso has continued to appreciate (by 12 percent vis-à-vis the US dollar this year); nonetheless it is still some 19 percent more depreciated in real effective terms than before the crisis. Exports have remained buoyant, up 17 percent y/y through September.

  • External financing conditions have remained favorable, allowing Uruguay to place a new US$200 million global bond in November, which brought total international bond issues in 2005 to above US$1 billion.

  • All end-September quantitative performance criteria (PC) were observed and the end-December PCs are likely to be observed.2 The structural reform agenda has also progressed, with most structural PCs and benchmarks (BMs) observed. However, while the reform of the pension plan of the police was submitted to congress in November, its approval will take somewhat longer than envisaged (end-November PC); it is now envisaged for May 2006.

Effects of Oil Prices on the Uruguayan Economy

Uruguay is a non-oil-producing country with an oil import bill of some 5 percent of GDP (2004). This relatively low oil dependency is explained by its large hydropower resources.

To date, the sharp increase in international oil prices has been absorbed by the economy without significant disruptions.

  • Inflation has remained subdued, falling below the central bank’s target range, despite full pass-through of oil prices. This is attributable in part to the appreciation of the peso and the relatively small weight of oil products in the consumption basket (3.4 percent).

  • The impact on the balance of payments has been mitigated by strength in exports and the capital account. Exports have been supported by an increase in commodity prices, including beef and rice. In addition, renewed access to international capital markets and continued private capital inflows have resulted in larger-than-programmed accumulation of international reserves.

  • The fiscal impact has been limited, as the bulk of oil taxes are specific and a full pass-through mechanism is in place. In addition to the specific tax on all oil products, diesel and electricity are taxed at 14 and 23 percent VAT rates, respectively. Prices charged by the state-owned oil company ANCAP and electricity company UTE are periodically adjusted to fully pass on the increase in international oil prices.

Notwithstanding, continued oil price increases could have an impact. In this connection, the authorities:

  • Have signed an oil import agreement with Venezuela to finance oil purchases at preferential terms.

  • Are committed to continue with full pass-through of international price increases.

  • Are planning to expand domestic refinery capacity, possibly through private investment.

Figure 1.
Figure 1.

Uruguay: Output and Prices

Citation: IMF Staff Country Reports 2006, 123; 10.5089/9781451839333.002.A001

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

2. Fiscal performance has been better than expected. Based on preliminary data, the primary surplus of the consolidated public sector was 3.4 percent of GDP in the first 9 months of the year, 0.3 percent of GDP higher than programmed. Revenues were slightly lower than projected in nominal terms, but higher relative to GDP. Tax and social security collections were above program, and while the contribution of public enterprises was weaker in Q1–Q3, it is expected to improve in Q4 after recent gasoline tariff adjustments and lower world oil prices. Spending was lower than programmed, owing to initial delays in implementing the Social Emergency Program and underexecution of capital spending.

3. Public support for the program remains solid, although social and political pressures persist. After a near-cabinet crisis in August on the budget, pressures have focused on the effect of peso appreciation on export competitiveness, as well as demands for more government spending and forbearance on the still large amount of domestic debts in distress. The authorities are confident, however, that the core program elements are well understood and supported by a broad domestic consensus.

II. Outlook and Risks

4. The macro framework for 2006–10 is broadly unchanged from the last review. Real GDP growth in 2006 remains projected at 4 percent, with large FDI projects in the forestry sector (more than 8 percent of GDP, to be executed over 4 years) expected to contribute to medium-term investment and growth prospects (Box 2). The inflation objective for 2006 remains at 5½ percent, while for subsequent years the authorities now envisage a slightly more gradual disinflation path toward the medium-term objective of 3½ percent.

5. Near-term vulnerabilities have declined, with growing buffers against shocks. International reserves have risen to pre-crisis levels and are above program targets, partly reflecting further efforts to prefinance amortization payments coming due in 2006. Favorable external financing conditions have also reduced public debt rollover risks and the debt’s average maturity has been further increased.3

6. Although the debt outlook remains a major source of risk, robust growth, a stronger fiscal position, and peso appreciation have resulted in a faster decline of the public debt-to-GDP ratio than envisaged earlier (Appendix I). Compared with the outlook at the time of the 2002 crisis, the public debt-to-GDP ratio is already below the level envisaged for 2012. The outlook is also better than right after the 2003 debt exchange. Nevertheless, continued high primary surpluses, capital market access, and economic growth are needed to ensure medium-term debt sustainability. Debt-service payments due in the next few years remain large, and a reversal in emerging market sentiment and higher U.S. interest rates could rekindle financing risks. In addition, as noted in the last review, ambitious medium-term revenue targets and spending pressures heighten the vulnerability of the fiscal outlook and put pressure on the program fiscal targets. The highly dollarized financial system also needs to be further strengthened; while current projections already incorporate the likely cost of addressing BHU, the banking sector could harbor additional contingent fiscal costs. The program is focused on addressing these risks, through maintaining fiscal discipline, pushing ahead with financial sector reform, and improving the investment climate to promote growth.

Economic Impact of the Pulp Mill Projects1

Uruguay has attracted large-scale foreign projects in the forestry sector, with plans by two international groups (Botnia and ENCE) to have pulp mills fully operational by 2007/08.2 The projects would increase Uruguayan value added by manufacturing pulp locally, instead of exporting raw materials. The overall investment would amount to over 8 percent of GDP, with a sizeable impact on the economy:

Uruguay: Macroeconomic Impact of the Pulp Mill Projects 1/

(in percent of GDP, unless otherwise stated)

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Botnia and ENCE.

Cumulative beginning 2005.

  • Private foreign investment would increase by over 4½ percent of GDP in 2006 and about 1½ percent of GDP per year in 2007–08.

  • The projects are expected to permanently lift GDP up by some 2½ percent, mainly as a result of increased value-added from pulp processing.

  • The direct employment impact of the pulp mill factories with some 600 jobs at the production facilities will be small. However, the projects should have a sizeable indirect employment impact in the forestry sector with the creation of some 5,000 additional jobs (0.4 percent of the labor force).

  • The external current account would widen in the construction phase, fully financed by FDI. Once operational, the plants would generate additional net export revenues of about 1¼ percent of GDP per year.

  • The direct fiscal impact of the projects would be limited, as the projects are exempt from most taxation, except social security contributions. However, there would be an indirect effect through the second-round impact of higher domestic demand and the need for infrastructure investment.

1 Based on economic impact studies prepared by Deloitte & Touche (2004) for ENCE, by Botnia (2004), and IFC Economic Impact Assessment (2005).2 A possible third large forestry project has been announced.

Uruguay: Medium-term Macroeconomic Framework

(percent of GDP, unless otherwise indicated)

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Sources: Uruguayan authorities; and Fund staff estimates.

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

Current account balance excluding imports related to the construction of planned pulp mill projects (Botnia and ENCE).

III. Policy Discussions

7. The review discussions centered on the financial and structural program for 2006, including a comprehensive tax reform, restructuring the ailing BHU, pension reform and reforms of the central bank, deposit insurance, and the bank resolution framework.

A. Fiscal and Debt Management Policy

8. The authorities reaffirmed their commitment to the primary surplus targets under the program. They also noted their continued commitment to use higher-than-programmed revenues toward achieving a 4 percent of GDP primary surplus already in 2006. The 2006–10 budget submitted in August (see Country Report No. 05/431) has been approved by congress without major changes. Nevertheless, compared with the last review, revenue and expenditure projections for 2006 are higher by about 1.4 percent of GDP. On the expenditure side, about 1 percent of GDP reflects the lower nominal GDP, with another 0.2 percent due to higher social security outlays tied to higher contributions.4 Revenues (as a percentage of GDP) are projected to be higher than previously estimated because of a higher base5 and improved revenue administration, and by sustaining improvements in public enterprises’ operational results.

9. Staff expressed concern that the increase in spending relative to GDP would further strain the already ambitious revenue targets. It reiterated that more conservative revenue and expenditure objectives would have been preferable to safeguard the program’s fiscal targets. In addition, it stressed the need to carefully phase in intended tax rate reductions, to avoid possible temporary revenue losses arising from potential difficulties in administering new taxes. The authorities explained that they were taking decisive steps to ensure observance of the 2006 and medium-term fiscal targets. In particular, they pointed to the good progress with tax reform and strengthening revenue administration, which was already yielding a notably increased tax/GDP ratio. Moreover, they reiterated their readiness to adjust nonpriority current and capital expenditure, should revenues be lower than projected. They explained that, in preparation for such a contingency, the budget provides for semi-annual revenue performance assessments and explicitly authorizes executive spending cuts if revenues are lower than budgeted.

10. The authorities intend to improve the public debt structure further. Staff welcomed progress in lengthening average maturity, smoothing the amortization profile, and issuing inflation-indexed bonds, and encouraged further efforts to reduce the level of dollarization of public debt. Preparations for the creation of a debt-management unit at the Ministry of Finance by end-December are well advanced (in line with ICM/MFD recommendations), including by allocating resources in the budget and appointing its head. The authorities also submitted to congress draft legislation to strengthen the statutory public debt ceilings, expanding the coverage of debt subject to the ceilings (now including, among other things, debt to multilateral organizations), and applying the ceilings on net rather than gross debt.

11. The government has announced the broad parameters of the planned tax reform (Box 3). The reform was presented to the public in early November for consultation, in preparation for submitting the final draft to congress in February 2006. In line with previous discussions with Fund staff (including an FAD technical assistance mission), it would simplify the tax system, reduce distortions, and improve equity. Because the reform is designed to be broadly revenue neutral, based on current projections a gap of about ½ percent of GDP would remain in 2007 and 2008 toward the 4 percent primary surplus target. Measures needed to achieve this target will be discussed in the context of the program for 2007 (in late 2006).

Proposed Tax Reform

The reform aims at promoting equity and growth, by better distributing the tax burden across the economy through lower rates and reduced exemptions, and simplifying the system. The package, which is estimated to be broadly revenue neutral, is to be finalized and submitted to congress by February 2006, for implementation by June 2006. The announced measures would:

  • Introduce a personal income tax on all domestic sources of income (increasing revenues by an estimated 1.3 percent of GDP). Labor income would be taxed at rates ranging from 0 to 25 percent with no deductions allowed, but with about 60 percent of the population below the taxable threshold. Capital income would be taxed at 10 percent (excluding government bonds and the return on pension funds), with the exception of interest on peso deposits exceeding 1 year, which would be taxed at 3 percent. Nonresidents’ income generated in Uruguay would be taxed at 10 percent, excluding dividend remittances and interest income from public debt. This tax would replace the current tax on wages.

  • Rationalize the corporate income tax (reducing revenue by 0.2 percent of GDP). Four taxes affecting corporate income in different sectors would be consolidated into a new corporate income tax, with a rate of 25 percent.

  • Reduce the value added tax (VAT) rates and broaden its base (reducing revenue by 0.6 percent of GDP). The two VAT rates would be reduced from 23 to 21 percent and from 14 to 10 percent, respectively, while eliminating COFIS (a tax that acts as a 3 percent surcharge of the VAT at the wholesale level). The base would expand by incorporating the currently exempt tobacco products, fruits and vegetables, and financial services at the 21-percent rate, and health services, public transportation, and first sale of real estate properties at the 10-percent rate.

  • Unify the employer’s social security contribution rate and eliminate sectoral exemptions (broadly revenue neutral). The contribution rate, now ranging from zero to 15 percent across the private sector would be unified at 7.5 percent. The current exemptions for employers’ contributions in the rural, industrial, and transportation sectors would be eliminated; in the case of the rural sector through the adoption of a special regime.

  • Eliminate small taxes (expected to reduce revenues by 0.5 percent of GDP), including the current taxes on corporate income and wages, COFIS, and the taxes on banking assets, health services, and telecommunications.

12. Reforms to improve revenue administration are being deepened.6 The program assumes an increase in tax collections as a result of administration improvements equivalent to ½ percent of GDP in 2006, and 1 percent of GDP by 2008. In support of this objective (i) the ministry of finance and the tax administration authority have signed a memorandum of understanding setting tax collection objectives and performance incentives for 2006 (BM for end-2005); and (ii) the social security bank (BPS) will design, with FAD assistance, a strategy to strengthen its collection and auditing functions (proposed BM for end-June 2006). In addition, a committee has been set up to design a reform plan for the customs authority (BM for end-August 2006).

13. Reform of the police pension fund is going forward. Draft legislation has been submitted to congress, although its approval, originally expected by end-November 2005 (PC), is now proposed to be reset for end-May 2006 (waiver of nonobservance of this PC is being requested). The reform aims to improve equity and incentives, while reducing the fund’s deficit over time by, inter alia, incorporating all wage components in the computation of contributions and benefits and increasing the contribution and computation periods. Planned reforms to the military and bank employees’ pension funds will be submitted to congress by November 2006, for implementation in mid-2007 (proposed PCs). In addition, the authorities are working with the World Bank on possible reforms to the general pension system to improve its actuarial fairness and ensure fiscal sustainability; a commission is to issue recommendations by end-2006, for implementation beginning in 2007.

14. The government is exploring options for private participation in infrastructure investment. Specifically, it is considering a project with private participation to improve railroad freight transportation (a bottleneck, including for the new large forestry projects). Staff welcomed these efforts and urged them to create sound institutional and legal frameworks for project design and evaluation. The authorities noted that they were still studying possible implementation modalities, and agreed with the staff on the importance of ensuring transparency and sound project evaluation, while avoiding contingent fiscal liabilities. It was agreed to discuss any concrete projects during the next reviews.

15. Work on improving the budgetary framework is continuing. A committee will formulate a reform strategy, with Fund technical assistance (proposed BM for end-August 2006). Key goals of the reform are to expand coverage of the budget, improve classification, and enhance transparency and controls in budget execution.

B. Monetary and Exchange Rate Policy

16. The authorities reiterated their commitment to further gradual disinflation, with a flexible exchange rate regime and base money operational targets. They explained that, with inflation consistently below the target range and indications of a recovery in money demand (including continued peso appreciation), they had gradually eased the monetary policy stance in recent months through unsterilized foreign exchange purchases. Following a decision in November to allow base money to move to the upper end of the target range, the authorities raised in mid-December the end-year target range by another 3 percent to accommodate higher-than-anticipated seasonal money demand from the non-financial sector. The new ceiling provided room for base money to grow by up to 29 percent on average (y/y) during the last quarter of 2005. While inflation was still likely to close 2005 below the target range and inflation expectations for 2006 have been declining, the authorities and staff concurred that monetary policy should not be further eased until the impact of the recent measures can be assessed.


Uruguay: Monetary Developments, December 2003-September 2005

(In percent- 12-month growth rates)

Citation: IMF Staff Country Reports 2006, 123; 10.5089/9781451839333.002.A001

Source: Central Bank of Uruguay

17. Monetary policy in 2006 will aim at an inflation target range of 4.5–6.5 percent and further strengthening the international reserve position, in line with previous understandings, but a slightly more gradual disinflation path over the medium term. The staff urged the authorities to maintain the previously envisaged medium-term inflation path. However, the authorities indicated that they had decided that, after achieving low inflation rates in 2005–06, they would prefer to pursue a more cautious approach to further disinflation over the medium term to minimize possible output losses. For 2006, the central bank’s monetary program assumes base money growth of 10 percent (broadly in line with expected nominal GDP growth). It also targets an increase in NIR equivalent to US$230 million, building on the significant overperformance expected for 2005 (about US$640 million, of which some US$400 million correspond to prefinancing operations). The authorities intend to continue prefinancing future obligations, should market conditions permit. The authorities also intend to continue monitoring conditions and adjusting policies, as necessary, to ensure meeting the inflation objectives.

18. The authorities noted that, while the exchange rate remained broadly competitive, significant further appreciation could pose important risks. Staff concurred that most indicators suggest that the exchange rate level remained appropriate, including exports, which continue to grow at robust rates, and the REER is still well below its pre-crisis levels. The authorities stressed that managing sustained large capital inflows would be challenging, and expressed concern that continued appreciation could affect competitiveness. Against this background, they would conduct further foreign exchange purchases to lean against appreciation pressures and contribute to international reserves, while sterilizing their monetary impact, as necessary, to ensure meeting the inflation objectives. Staff noted that productivity growth could offset some of the adverse impact of real appreciation and encouraged the authorities to move aggressively in enhancing the investment climate to this end.

19. The authorities have expressed interest in developing foreign exchange futures markets to help market participants hedge their exchange rate risk. To jump-start the forward market, they have started to participate in it, in limited amounts, while hedging the exchange rate risk through (sterilized) spot market purchases. They intend to request Fund TA for the development of a futures market in Uruguay to ensure that it is in line with international best practices.

C. Financial Sector Reforms

20. Important reforms of the sector’s institutional framework are under way (Box 4). As programmed, draft legislation to strengthen the central bank, the superintendency of banks, the deposit insurance agency, and the bank resolution framework will be submitted to congress by year’s end (end-2005 PC). While the inflation objective would be set jointly with the ministry of finance, the authorities indicated that the central bank would have operational independence to achieve the objective. The independence of the central bank would be increased by setting and staggering the terms of its Board members,7 while strengthening its accountability to congress. In addition, a plan to improve the BCU’s financial position will be prepared by September 2006 (proposed BM). The new bank resolution framework would follow international best practices, and the deposit insurance scheme would be run by an agency outside the central bank.8 Staff concurred with the authorities that in the case of Uruguay, keeping the supervisory authority for the financial system within the central bank has advantages in terms of institutional strength and independence.9 A joint World Bank-IMF FSAP is under way, which will identify key elements for a medium-term structural reform agenda in the financial sector.10

Financial Sector Reforms

The authorities have decided on the key elements of draft legislation to strengthen central bank independence, financial sector supervision, and the bank resolution framework and deposit insurance.

Central Bank Independence

  • Establish price stability as the main central bank objective.

  • Create a macroeconomic coordinating committee with representatives of the central bank and the Ministry of Economy that will set the exchange rate regime and the monetary policy target.

  • Clarify the central bank’s independence in setting policies and conducting operations for achieving the monetary policy target.

  • Stagger the terms in office of board members (fixed at eight years).1

Financial Sector Supervision

  • Create a single superintendency within the central bank for all regulated financial institutions, encompassing banking, securities markets, pensions, and insurance.

  • Grant the superintendent increased autonomy in decision making regarding individual institutions and certain regulatory measures, while reporting to the BCU board.

Deposit Insurance and Bank Resolution

  • Create a new deposit insurance agency outside the central bank to implement the deposit insurance scheme introduced in March 2005. The agency will be independent and governed by a three-member board. Deposit insurance is limited to US$5,000 per depositor for dollar accounts and the peso equivalent of about US$16,000 for peso accounts.

  • Grant the deposit insurer responsibility for bank resolutions and liquidations.

  • Provide the bank resolution framework with a range of options that are less disruptive than straight liquidations and payouts to insured depositors.

1 Board members currently do not have fixed terms in office; their terms typically coincide with the government’s term in office.

21. Significant steps are being taken to advance the restructuring of public banks.

  • BHU action plan. Significant progress toward the adoption of an action plan to address the bank’s deteriorating financial situation has been made (PC for end-2005); a detailed implementation plan will follow in February 2006 (proposed new BM). The draft action plan envisions the removal of problem assets from BHU’s balance sheet to a fiduciary trust, while the government cancels its deposits at the bank and assumes many of the liabilities of BHU, including the note to BROU and a US$100 million bond. The cleaned-up BHU will operate on commercial terms with a leaner staff, and limit its activities to mortgage lending funded by savings for home purchase down payments and the securitization of its mortgages.

  • BROU’s trust funds. To ensure continued servicing of the funds’ government-guaranteed notes, the authorities have recently changed the funds’ governance structure, and appointed a Board member to represent the ministry of economy. The authorities reiterated their commitment to honor the government’s guarantee if the trusts cannot service their debt according to the agreed schedule.

22. The situation at COFAC remains a concern. The (previously intervened) small cooperative bank has continued to lose deposits and the risk of failure remains significant. In response, the authorities are preparing a strategy to address risks of liquidity shortages and capital insolvency. As the first line of action against capital insolvency, the Superintendency for Banking Supervision continues to work with COFAC on measures to improve the bank’s financial situation. Should these measures fail to produce the necessary improvements in earnings, various contingency scenarios are being prepared, including injection of capital by new shareholders. The authorities are also exploring options to ensure prompt payment to depositors in the event COFAC has insufficient liquidity to meet its obligations. In all cases, the authorities are committed not to use public funds, while covering insured deposits through the deposit insurance scheme.

IV. Financing Assurances and Extension of Repurchase Expectations

23. Staff supported the authorities’ request for an extension of repurchase expectations arising in February–December 2006. International reserves have improved faster than expected when the repurchase expectations originated in 2002 and external financing conditions are expected to remain benign in 2006. However, the financing requirements for 2006 are large; the difference between the expectations and obligations schedules during February–December 2006 is substantial (SDR 540,862,500, or 25 percent of gross reserves); it is premature to judge whether the observed improvements in external financing conditions prove permanent; and Uruguay’s reserve position is still relatively weak. Staff concurred that, on balance, the external position does not appear sufficiently strong to warrant repurchases on the expectations schedule without hardship or undue risk. The authorities reiterated their commitment to consider treating the arrangement as precautionary in the future, or making advanced repurchases, should external developments permit.

Uruguay: Indicators of External Position, 2004-06

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

Imports include goods and services.

Excluding imports related to the construction of pulp mill projects (Botnia and ENCE).

24. Program financing for 2006 is well in hand. With large amortization payments from the 2003 debt exchange falling due, the 2006 program is challenging. The program is expected to be financed through continued strong access to international capital markets and World Bank and IDB disbursements (about US$430 million), which will require firm implementation of associated donor conditionality, and in case of shortfall, through up to US$400 million of higher-than-programmed bond placements in 2005. Staff welcomed the authorities’ intention to take advantage of current favorable market conditions to further pre-finance 2007 financing needs.

V. Program Monitoring and other issues

25. Program monitoring. PCs, BMs, and indicative targets are specified in the supplementary MEFP and TMU (Attachments II and III).

  • New quarterly quantitative PCs through end-June 2006 (through December 2006 in the case of the fiscal targets) are proposed. While the monetary and debt PCs cover half a year ahead, the authorities preferred to set fiscal PCs through December, reflecting their full-year commitment under the budget. Although the existing systems for measuring floating debt have improved, they are not yet ready to allow for timely and accurate monitoring. Therefore, it is proposed to monitor the combined public sector primary balance including floating debt as an indicative target, and to adopt it as a performance criterion by 2007.

  • Two new structural PCs and four new BMs are proposed. Two structural PCs are proposed in the area of the specialized pensions systems (paragraph 13). BMs would focus on strengthening tax administration (paragraph 12), the institutional budget framework (paragraph 15), recapitalization of the BCU (paragraph 20) and restructuring BHU (paragraph 21).

26. Safeguards assessment. The authorities are committed to implementing the recommendations of the September 2005 safeguards assessment (see Appendix II); several of them have already been adopted, including incorporation of all Fund liabilities in the BCU’s balance sheet and amending the criteria for selection and appointment of the external audit firm.

VI. Staff Appraisal

27. The program remains on a strong path, but important challenges lie ahead. Strong policies coupled with a favorable external environment have allowed for an impressive economic recovery, low inflation, and a significant buildup in international reserves. Staff commends the authorities for their strong ownership of the program, maintaining the policy framework despite intense social and political pressures. Although vulnerabilities have declined, they remain substantial, leaving little room for policy slippages. Key structural reforms lie ahead, particularly to help sustain strong growth over the medium term. In the next months, the government faces many important tasks, including implementing key tax and financial sector reforms and developing a comprehensive growth agenda.

28. Monetary policy has been managed prudently, and needs to remain focused on achieving the program’s inflation objective. Consistent with the floating exchange rate regime, the central bank’s main goal remains to achieve the inflation objective, and it will be important that the authorities follow up on their commitment to adjust policies, if necessary to contain inflationary pressures. Within this framework, it is appropriate to use the opportunity of the strong external position to add to international reserves. Central bank participation in the forward foreign exchange market should remain limited and adequately hedged.

29. The fiscal program is on track, but revenue performance needs to be closely monitored. Higher spending/GDP ratios than previously expected call for stronger revenue efforts to achieve the all-important primary surplus objective, and thus increased risks. To address these risks, caution needs to be exercised in the execution of spending, particularly in the first half of 2006, and firm progress on tax policy and administration reforms, and maintaining tariffs consistent with the financial objectives of public enterprises, are therefore essential. The authorities’ commitment to adjust expenditure, as needed, in case of revenue shortfalls is welcome, as is their commitment to save any revenue overperformance toward achieving the 4 percent of GDP medium-term primary surplus target already in 2006.

30. Fiscal reforms are progressing. The draft tax reform announced in November would broaden the tax base and improve the efficiency of the tax system. It will be now important that the reform be implemented on time and in line with the principles contained in the announced package. Staff encourages the authorities to consider a gradual phase-in of tax rate cuts in order to minimize risks of potential gaps in 2007–08. On tax administration, significant and commendable efforts are being made to improve performance of the three revenue collection agencies; it is critical to sustain this momentum, especially in light of the ambitious revenue goals embodied in the medium-term fiscal framework. Staff welcomes progress in the creation of the new debt office in the Ministry of Finance, and encourages the authorities to focus their debt strategy on further dedollarizing and improving the maturity profile of the public debt.

31. Longer-term fiscal sustainability also depends on moving ahead with pension reforms. The police pension reform submitted to congress is now expected to be approved by May 2006. While regretting the delay and non-observance of this structural PC, staff supports the waiver of its nonobservance because it is temporary and does not jeopardize the achievement of the 2006 fiscal targets. Staff welcomes the commitment to proceed with reforms in the pension funds of the military and bank employees in 2006/07, and urges the authorities to adopt a reform plan for the general pension system, in collaboration with the World Bank.

32. Planned institutional reforms in the financial sector are well placed. Draft laws are to be submitted to congress by end-December on the deposit insurance and bank restructuring framework, supervisory institutions, and the central bank, which are designed to improve the institutional framework and stability of the financial sector. A waiver of nonobservance would be needed, as these draft laws are expected to maintain the superintendency of financial institutions within the central bank. Staff supports the authorities’ request for this waiver and modification of the associated June 2006 PC, as it agrees that in the Uruguayan case, the supervision of financial institutions would be more effective staying within the central bank. In implementing these reforms, it will be particularly important to further strengthen the independence and institutional capacity of the central bank and financial supervisory authorities. The planned recapitalization of the central bank will also be important to this end.

33. The restructuring of public banks must move ahead to ensure a resumption of sound credit flows and contain contingent fiscal costs. Progress in strengthening BROU’s credit procedures needs to continue, and should be underpinned by strengthened cash recoveries of the fideicomisos to ensure timely servicing of their notes to BROU. Pressures for forbearance of distressed domestic debts should continue to be firmly resisted. The plan to transform BHU into a scaled-down mortgage lending institution is appropriate and needs to be implemented strictly given its precarious financial situation. Staff welcomes the authorities’ efforts to set up a contingency plan for COFAC in order to minimize systemic risks.

34. The staff supports the authorities’ request for extension of repurchase expectations for the period February–December 2006, consistent with Fund policy. While the external position has strengthened, reserve coverage remains low, upcoming amortization payments—including to the Fund—are very high, and repurchases on an expectation basis would create undue hardship and risks. Staff welcomes the authorities’ intention to consider treating the arrangement as precautionary in the future should market access turn out higher than envisaged, and to continue to take advantage of favorable market conditions to cover future financing needs.

35. Given the strong performance under the program, staff recommends completion of the second review. Firm program implementation has yielded excellent macroeconomic results and good progress on the structural front. All but two structural performance criteria for this review are expected to be observed. As noted above, staff supports waivers of the nonobservance of these PCs. Approval of an action plan for BHU and submission of financial sector legislation are expected before end-2005. All end-September quantitative PCs have been observed and with recent information pointing at continued good performance, all end-2005 quantitative PCs are expected to be met. However, a waiver of applicability will need to be considered, as information to assess observance of quantitative PCs will not be available by the time of the review. Staff will update the Executive Board prior to the discussion. Although important risks and vulnerabilities remain, the authorities’ strong ownership of, and commitments to, the program as demonstrated by their readiness to adjust policies as needed, provides a solid basis for continued strong performance and a lasting exit from Fund financial support.

Table 1.

Uruguay: Selected Economic and Social Indicators

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

Program definition (end of period data).

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.

Table 2.

Uruguay: Performance under the 2005 Program 1/

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Table 2.

Uruguay: Performance under the 2005 Economic Program

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PC = performance criterion; IT=Indicative target.Sources: Ministry of Economy and Finance; and Central Bank of Uruguay.

As defined in the Technical Memorandum of Understanding.

Cumulative changes from end-December of the previous calendar year.

All maturities.

Nonobservance due to authorities’ decision to keep the financial sector supervisory authority within the BCU. Fund staff supports this decision.

Table 3.

Uruguay: Balance of Payments

(In millions of US$, unless otherwise stated)

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

Includes secondary market transactions between residents and non-residents.

2005: Projection is based on preliminary actual for Jan-Sep of US$419 million.

Includes all liabilities to the Fund and liabilities to residents; follows respective TMU definitions.

Excluding imports related to the construction of pulp mill projects (Botnia and ENCE).

Table 4.

Uruguay: Public Sector Operations

(In millions of pesos)

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Sources: Ministry of Finance; and Fund staff estimates.

This line was amended at the time of the second review to incorporate contributions collected by the BPS transferred to the AFAPs previously excluded.

In 2002 this 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 are credited in 2004. In 2005 and 2006 this includes US$60 million for the financing of the deposit insurance scheme. Contingent liabilities of BHU will be included once the restructuring plan has been finalized.

For quarters, amounts as percentage of one-fourth of annual GDP.