Third Review Under the Stand-By Arrangement and Request for Modification and Waiver of Nonobservance of Performance Criteria: Staff Report; Staff Statement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Uruguay

Strong economic policies and a supportive external environment have contributed to rapid growth, low inflation, strengthened external position, and an improved debt structure helping Uruguay perform well under the Stand-By Arrangement. Executive Directors commended the fiscal and monetary polices and urged to maintain exchange rate flexibility. They emphasized that restructuring of public banks would contain contingent fiscal liabilities. They appreciated the efforts to strengthen tax administration, and agreed that continued strong macroeconomic polices and progress with structural reforms will raise Uruguay’s growth prospects.


Strong economic policies and a supportive external environment have contributed to rapid growth, low inflation, strengthened external position, and an improved debt structure helping Uruguay perform well under the Stand-By Arrangement. Executive Directors commended the fiscal and monetary polices and urged to maintain exchange rate flexibility. They emphasized that restructuring of public banks would contain contingent fiscal liabilities. They appreciated the efforts to strengthen tax administration, and agreed that continued strong macroeconomic polices and progress with structural reforms will raise Uruguay’s growth prospects.

I. Background

1. The program is on track and economic developments remain favorable:

2. The authorities have taken advantage of favorable market conditions to reduce vulnerabilities further. With sovereign spreads near historical lows, the ministry of finance placed US$500 million in January, thus completing a substantial portion of the total international market issuance foreseen in the program baseline for 2006. The central bank also took advantage of strong capital inflows to purchase some US$450 million between November and February 2006. In addition, there has been an improvement in the level and structure of public debt, with the debt ratio declining to 70 percent of GDP by end–2005 in the wake of fiscal consolidation, solid growth, and a more appreciated currency; the average maturity of debt too has lengthened from 6 years at end–2004 to 7½ years at end–2005. Nevertheless, medium–term financing requirements, averaging 8½ percent of GDP in 2007–08, remain high.


Sovereign risk

(EMBI spreads)

Citation: IMF Staff Country Reports 2006, 197; 10.5089/9781451839340.002.A001

3. With remaining weaknesses in the financial system being addressed, markets reactedcalmly to the recent intervention of COFAC. Following the intervention of the small credit cooperative COFAC, no spillovers to other banks were observed. Insured deposits recently have begun to be paid. Indicators of the overall health of the banking system show steady improvement and public bank restructuring continues.

Uruguay. Banking System Indicators: 2002–2005

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Source: Superintendency of Banks and Fund staff estimates.

Excludes the housing bank BHU, which no longer conducts financial intermediation.

  • A detailed implementation plan for the restructuring of the housing bank BHU was adopted (structural benchmark for end–February).

  • The sale of Nuevo Banco Comercial (NBC) is expected to be completed by April (structural benchmark for end–June).

  • The draft law on the financial sector reform is currently being discussed in the Senate.

4. The implementation of the rest of the structural agenda is also broadly on track. The available data suggest that all quantitative end–December performance criteria were met, while those for end–March are well within reach.

  • The submission of the tax reform bill to congress (performance criterion for end– February) has been slightly delayed but is expected to take place shortly (prior action for the Board meeting).

  • The growth commission is about to publish a set of proposals to foster investment and growth (structural benchmark for end–March).

  • A five–year spending plan was enacted in December 2005 (structural benchmark for end–February) in the context of the adoption of the 2005–09 budget.

  • Progress is also being made in other areas of the structural agenda for 2006, including pension, revenue administration, bankruptcy, and budget reforms.

  • Final data on all performance criteria will be provided ahead of the Board meeting.

5. Some political risks have emerged, including a dispute with Argentina and some environmental groups that has stalled the cross–border road traffic. Protesting against the planned pulp mill projects on the river Uruguay, activists have been blocking the bridges connecting Argentina and Uruguay, disrupting the flow of goods and people. While the impact on the recent summer tourism season has been moderate, the economic effect of a sustained closure of the bridges could be significant.

II. Macroeconomic Outlook and Risks

6. The outlook for 2006–2008 and medium–term vulnerabilities remain broadly unchanged from the last review. Although continued rise in leading indicators suggest upside potential for growth, the recent bridge blockings on the Argentine border pose some risks. Accordingly the growth projection for 2006 has been left at 4 percent. End–2006 inflation is expected to be 5.5 percent. Projected international reserves have been revised upwards as a result of the stronger end–2005 outturn and continued capital inflows. High public debt, the dollarized financial system, and pressures for public expenditure remain important vulnerabilities.

Uruguay: Medium–term Macroeconomic Framework

(Percent of GDP, unless otherwise indicated)

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Sources: Uruguayan authorities; and Fund staff estimates.

III. Policy Discussions

7. In addition to the review of macroeconomic policies, discussions centered on key structural reforms for this year. The main focus was on tax reform, the restructuring plan for the state housing bank BHU, the situation of the credit cooperative COFAC, and on measures to enhance the business environment and promote investment.

A. Fiscal and Debt Management Policy

8. Revenue administration reforms are progressing well, and the authorities remain confident that their ambitious revenue targets for this year will be met. With administration efforts already yielding significant revenues (the social security agency and the tax directorate exceeded their targets for 2005), the reform plan for the tax directorate progressing well, and the plan to restructure customs expected to be ready around midyear (structural benchmark for end–August), the authorities expect to achieve their revenue collection targets for 2006. Public enterprises are expected to improve their performance significantly in 2006, following weather–related electricity generation cost overruns and the rapid pace of the international oil price increases in 2005, which temporarily resulted in tariff adjustment lags. Staff encouraged the authorities to devote adequate efforts and resources to ensure the tax reform is effective by 2007, in particular the administration of the new personal income tax.


Revenue 12–month cumulative net revenues

(in percent of GDP)

Citation: IMF Staff Country Reports 2006, 197; 10.5089/9781451839340.002.A001

9. An adjustor to the 2006 fiscal targets of up to US$50 million (¼ percent of GDP) is proposed to accommodate higher investment financed with privatization proceeds. To ease infrastructure bottlenecks to growth over the medium term, the authorities plan to undertake a few high–quality investment projects during July 2006–June 2007, with high financial and economic returns, in which the public sector would act as a catalyst to attract private participation. In this context, the authorities are planning to invest, in association with the private sector, up to US$25 million in railroad infrastructure to support the increased freight transportation demand derived from the new pulp/forestry projects; and about US$14 million in a dredging project in the port of Montevideo. Officials underlined that these and other potential projects would be subjected to stringent evaluation and monitoring standards. The authorities indicated that they do not expect to offer government guarantees, that potential risks would be appropriately shared with the private sector, and that all transactions, including any guarantees, would be transparently recorded in the fiscal accounts. The authorities reiterated that a primary surplus of 3.7 percent of GDP for 2006 and 4.0 percent for 2007 remained their goals, but regarded the adjustor as a safety valve to allow them to undertake these projects. They remain committed to saving any revenue over performance to reach the 4 percent medium term target as soon as possible.


Public Investment

(in percent of GDP)

Citation: IMF Staff Country Reports 2006, 197; 10.5089/9781451839340.002.A001

10. The draft tax reform package is expected to be submitted to congress in March, slightly later than envisaged under the end–February performance criterion. The authorities stated that the draft law would be broadly in line with the proposal made public earlier (see Country Report No. 06/123). Main revisions would include an additional personal income tax bracket (estimated to be revenue neutral) and limited deductions for health expenditures. To protect the fiscal objectives, the draft would envisage a smaller reduction in the top VAT rate (to 22 percent instead of 21 percent) until the revenue targets are achieved. The authorities explained that these modifications addressed the key comments received in the public consultation on the proposal. The authorities explained that, in light of a very full agenda in congress, they now viewed it as difficult that the law could be approved by June 2006, as envisaged. For this reason, they requested a modification of the performance criterion, changing the beginning of the implementation to end–October 2006. Lest the delay in congressional approval postpone the effective date in 2007, the authorities will work in parallel on the implementing regulations so that the law can still go into effect as planned next January.

11. The new debt office has begun operations, with key objectives including a reduction in dollar debt and a smoothing of the repayment profile. Officials explained that the unit had started to build a debt database and had been finalizing the financing plan for the government. The office already took the lead in successfully completing the recent issuance of US$500 million on international capital markets. A debt strategy is being prepared with Fund technical assistance, aiming at developing the local capital market, increasing the share of peso and inflation–indexed debt, lengthening maturities, and smoothing the amortization profile.

B. Monetary and Exchange Rate Policy

12. The authorities viewed recent exchange–rate stability as temporary. The nominal exchange rate vis–Ä–vis the U.S. dollar had remained flat for over a month as a result of foreign exchange purchases by the authorities, including as an indirect result of foreign exchange forward purchases by the Treasury to cover future debt service (The central bank, as the residual supplier in the forward market, hedges the higher forward exposure by purchasing equivalent amounts of foreign exchange in the spot market). Staff urged the authorities to allow the exchange rate to better reflect market conditions, highlighting the dangers of signaling a floor for the exchange rate and the difficulties in pursuing multiple objectives with one instrument. Officials stressed that the intervention had been opportunistic, to build gross reserves, and necessary to break a cycle of self–reinforcing appreciation expectations, but that this did not imply a fundamental change to monetary and exchange rate policy. They pointed out that the exchange rate had started to regain flexibility and explained that, while there was some concern about excessive appreciation, inflation remained the overriding objective of monetary policy.


Nominal Exchange Rate


Citation: IMF Staff Country Reports 2006, 197; 10.5089/9781451839340.002.A001

13. To increase the focus on the ultimate inflation objective, the central bank has begun to deemphasize base money targets in its public statements. The authorities are now announcing the annual growth rate of their intermediate target (M1) instead of base money target ranges for the four quarters ahead, while maintaining base money as their internal operational variable. The authorities explained that the change in the communication strategy intends to convey that their commitment is with the inflation target, and that the increased flexibility in money management would allow them to gradually move in the direction of a fully–fledged inflation targeting framework. The authorities agreed with staff that such a move would require further analytical work on inflation forecasting and channels of monetary policy influence on prices.

14. The authorities explained that the strong increase in monetary aggregates toward the end of last year was necessary to satisfy money demand. They stressed that inflation is well within their target range and the recent pick–up in part explained by temporary factors, including the timing of tariff and salary adjustments. They acknowledged risks, however, due to uncertainty about the evolution of money demand. They also pointed out that inflation expectations for 2006 were within the target range. Nevertheless, staff and the authorities agreed that inflationary risks had increased and that pressures needed to be monitored carefully over the next months. Against that background, the authorities reaffirmed their commitment to tighten policies as necessary to meet the inflation targets and decided that, for now, it would be more prudent not to accommodate last year’s overrun in M0 and to maintain the agreed targets for 2006, implying a substantial slowdown in money growth in the remainder of 2006. The appropriateness of this stance will be reassessed at the next review.

C. Financial Sector Reforms

15. The authorities have adopted a detailed implementation plan for reforming the housing bank BHU. The plan aims to transform BHU into a residential mortgage lender that operates on a commercial basis and ceases social activities, which will be transferred to the Ministry of Housing (Box 1). The authorities committed to transfer nonperforming loans to a fiduciary trust and to recapitalize BHU by end–August (new performance criterion), a necessary measure for the bank to have a clean balance sheet. By November, remaining problem assets will be transferred, regulatory measures put in place to refocus BHU business solely on residential mortgage lending on a commercial basis, and BHU will be required to meet all prudential standards and submit a viable business plan (new performance criterion).

16. The intervention of COFAC highlighted the strengthening of Uruguay’s financial system and its oversight. The authorities stressed that, for the first time in recent Uruguayan history, a bank intervention occurred (i) before a liquidity problem became a solvency problem; (ii) with the majority of depositors fully protected within a deposit insurance scheme; and (iii) without the use of government funds (other than through the previously envisaged US$60 million for capital and loans to the deposit insurance agency, to be recovered through deposit insurance premia and asset recovery). It was agreed that any newly created institution building on COFAC’s assets would have to be well–capitalized and provide a viable business plan. In this regard, the authorities noted that discussions with the Venezuelan Development Bank (Bandes) for a purchase and assumption operation were underway.

BHU Restructuring

In February 2006, the authorities adopted a detailed implementation schedule for the restructuring of the state mortgage bank. This follows restructuring efforts during 2002–2004, which had included adopting a modified charter to turn BHU into a nonbank mortgage lender, with deposit taking ability limited to mortgage pre–saving schemes, transferring part of the nonperforming loan portfolio (US$102 million book value) to a fiduciary trust fund whose beneficiary was the Ministry of Finance, and reducing BHU staff and labor costs by about 50 percent. While progress was achieved, these efforts, however, did not fully stabilize the financial condition of the institution as the improvement on the collection on remaining nonperforming assets and operational efficiencies expected under the restructuring Plan launched in December 2003 did not materialize and BHU was not able to secure new financing through securitization. By end 2005, BHU was not complying with prudential regulations, including reserve and capital requirements. Nevertheless, as a result of the restructuring efforts, BHU does not appear to pose a systemic liquidity risk.

The new restructuring plan of BHU aims to address the shortcomings of the previous effort by focusing BHU’s mandate on commercial activities, while transferring social housing policy to the Ministry of Housing. For consistency with its new mandate and to comply with all prudential regulations, the plan calls for:

  • Transferring BHU’s nonperforming assets to a fiduciary trust, with the mandate, incentives, and resources to maximize the net present value of its assets;

  • Transferring to the Ministry of Finance BHU’s liabilities to BROU and the public sector in the amount needed to capitalize and restructure BHU, and with a view to reducing currency and maturity mismatches; and

  • Adopting a business plan satisfactory to the Bank Superintendency that demonstrates BHU’s ability to generate positive cash flows and profits going forward.

The business plan will include measures to further reduce BHU’s overhead and other costs in line with the reduced size of its balance sheet, and to improve BHU’s managerial structure, corporate governance, and internal control systems. BHU will refrain from lending until the Bank Superintendency considers that BHU has the systems in place to resume sound lending.

D. Growth Agenda

17. The tripartite business environment commission is preparing to publish recommendations to boost growth and investment (end–March structural benchmark). The work of the commission will become part of a presidential growth initiative. In various areas covered by the proposals, the government has already started to take specific actions, such as the tax reform and private–public associations to improve public infrastructure (Box 2). Similarly, a new draft law to prevent anticompetitive behavior has recently been sent to congress. On bankruptcy legislation reform, the authorities are holding another expert seminar to help inform the working group that is preparing a draft law, the submission of which is an end–June structural benchmark. Staff and the authorities agreed to discuss further specific measures during the next review.

The Government’s Growth Reform Agenda

A tripartite commission comprising government, labor and industry has been working on a comprehensive agenda to improve the business climate, increase investment, and improve resource allocation in the economy to lift up Uruguay’s growth potential. Many of the commission’s preliminary recommendations have already been incorporated in the government’s reform agenda.

Key proposed reforms include:

  • Increasing competition and strengthening the legal framework by amending bankruptcy procedures to include a Chapter 11–type regime (to be submitted to congress by June); strengthening the competition law (proposal currently with congress) and the legal framework for dispute resolution; and improving disclosure requirements of corporate financial information.

    Uruguay: Assessment of the Environment for Business and Innovation

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    Sources: Global Competitiveness Report 2005–2006, World Economic Forum (rank out of 117 countries); World Bank Business Indicator (rank out of 155 countries).

  • Increasing the efficiency of the tax system and reducing inequities: by eliminating exemptions, introducing a personal income tax, simplifying and reducing corporate income taxation, and eliminating low revenue yielding taxes. A proposal that includes these changes has been submitted to congress. In addition, ongoing improvements in revenue administration are reducing tax evasion.

  • Public enterprise reforms: through improving governance, better linking wages to productivity, and transparent tariff setting, aiming to bring down the high cost of services provision.

  • Simplifying business start–up procedures: by facilitating business registration and creating an investor relations office.

  • Improving infrastructure: by strengthening the public investment framework (e.g., selection, execution, evaluation); establishing a sound framework for private participation in PPPs; and improving public expenditure management to make room for higher capital outlays in the budget.

18. The authorities emphasized that labor–business relations were sound. Staff expressed concern about reports on recent conflicts, which had led to the takeover of facilities by striking workers. The authorities explained that these had been isolated incidents, not representing a generalized trend and that legislation clarifying the rights and responsibilities of striking workers was being prepared. They also stressed that the tripartite wage councils had helped to stabilize labor relations, and that the authorities were keen on maintaining an environment that addressed genuine labor demands, while fostering an environment conducive to higher investment.

19. The authorities highlighted that the implementation of the large pulp–mill projects was proceeding as planned. Once fully operational, the plants will generate about 1.3 percent of GDP in additional exports (see Country Report No. 06/123, Box 2). Staff inquired about possible negative effects of the ongoing conflict in light of the recent road blockings. The authorities explained that, while the actions had disrupted tourism somewhat, the season as a whole had been good. Moreover, they were confident that current difficulties can be resolved and that the implementation of the projects would proceed smoothly.

IV. Program Financing and Monitoring

20. Close to half of the external bond placements assumed under the program baseline for 2006 have already been secured. In January 2006, the authorities issued a US$500 million international bond under high demand and favorable conditions. The proceeds were used, in part, to advance amortization payments to the World Bank and IDB (including US$237 million falling due in 2007). Nevertheless, large amortization payments from the 2003 debt exchange are falling due this year, and expected World Bank and IDB disbursements (US$307 million) will require firm implementation of associated conditionality.

Uruguay: 2006 Public Sector Financing

(Nonfinancial public sector, in US$ million)

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Source: Fund staff estimates and projections.

21. Two new performance criteria on BHU restructuring, a modification on the performance criterion on tax reform implementation, and a new adjustor on public investment are proposed. All other quantitative performance criteria for 2006 remain as established at the time of the last review. Performance criteria, structural benchmarks, and indicative targets are specified in the supplementary MEFP and TMU (Attachments II and III).

22. The authorities are committed to implementing the recommendations of the September 2005 safeguards assessment (Appendix II). Several recommendations 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. With the implementation of the financial sector law, currently in congress, the key recommendations of the safeguards assessment would be in place.


23. Sound policies and a supportive external environment have sustained strong economic performance. The economy has grown at healthy rates and real wages have been recovering, and inflation, while it has increased, remains within the target range. Continued strong capital goods imports augur well for economic activity this year. These favorable results largely reflect the authorities’ adherence to the macroeconomic policy commitments in theirFund–supported program.

24. Ensuring that growth is sustained into the medium term will require maintaining the momentum of the structural reform agenda. The government’s intention to tackle the broader structural conditions for growth is very welcome, and the identification of key microeconomic and institutional reforms to boost investment and productivity by the growth commission is an important step. Transforming these recommendations into a concrete policy will be a focus of the next review, and decisive implementation thereafter will be essential.

25. Fiscal performance should remain strong if administrative reforms continue to be implemented forcefully. Revenues in both the social security agency and the tax directorate continue to exceed expectations, partly reflecting an increase in economic activity and a larger formal sector of the economy, but also improved tax administration. It is, however, critical to maintain a cautious execution of expenditures, adjusting public tariffs as needed, while moving ahead with the ongoing administrative reforms of the collection agencies so as to ensure smooth implementation of the tax reform and attainment of the ambitious revenue targets.

26. The draft tax reform will be a major step toward a more equitable and less distortionary tax system. The tax burden will be better distributed across the economy through the introduction of a personal income tax, the reduction of rates and of the number of exemptions, and a simplification of the system. The gradual reduction of indirect taxation adequately addresses the need to preserve revenue objectives. Staff supports the authorities request to move the date for congressional approval of tax reform from June to October, especially as steps are being taken to ensure that the January implementation date for the new tax regime is preserved.

27. The government’s intention to attract private participation in public investment projects is welcome, but projects will need to be selected and monitored carefully. Staff supports the proposed adjustor to the fiscal targets given that, if well chosen, the investments will contribute to strengthen the foundation for medium–term growth and generate future fiscal revenues, as well as serve as models for future cooperation between the public and private sectors. The projects should not affect debt sustainability because they would be financed through privatization proceeds. It will, however, be key to ensure that the selected projects meet stringent quality criteria and minimize contingent fiscal risks.

28. Monetary policy has been successful, and needs to remain focused on achieving the inflation objective under a flexible exchange rate. Despite high oil prices and a strong economic expansion, inflation has remained subdued, which demonstrates the central bank’s ability to conduct monetary policy in a new and complicated environment. Staff supports the authorities’ strategy to deemphasize the role of base money targets in the context of an increased commitment to the inflation objective. Such a move, however, should be accompanied by a strengthened communication with the public on the central bank’s inflation projections. While the continued accumulation of reserves is welcome, it will be important to maintain sufficient exchange flexibility, and avoid sending a signal to the market that there is a floor on the exchange rate. In light of the recent up ticks in inflation, monetary policy will need to be vigilant to ensure that the inflation objective is achieved. In this regard, the decision to maintain the end–2006 indicative monetary targets, despite a higher–than–expected starting base is a welcome sign of prudence.

29. The current environment offers a unique opportunity to reduce further the still considerable risks. While vulnerabilities have been significantly lessened, debt levels remain high, reserves are still relatively low in light of the high dollarization of the economy, and substantial fiscal contingencies in the financial system remain. It is important that the government continues to use the opportunity provided by a strong economy and benign financial market conditions to accelerate debt reduction, improve the composition of the debt structure—particularly through a lengthening of maturities and increasing the share of domestic currency debt—and strengthening the financial sector.

30. Much has been achieved in the financial sector, but further restructuring of public banks is key to containing contingent fiscal liabilities. The prudent actions taken regarding COFAC and the announced payout of insured deposits helped maintain confidence in the banking system. Looking forward, approval of the financial sector reform package currently in congress will help to strengthen the financial system’s resilience to shocks further. The government is taking the right steps to transform BHU into a viable mortgage lending institution, and strict adherence to the adopted implementation plan will be crucial to minimize fiscal risks.

31. In light of the strong performance under the program, and the positive outlook going forward, staff recommends completion of the third review. All performance criteria have been observed, except for the submission of the tax reform, which is expected to be completed as a prior action for the Board discussion; staff supports the associated waiver.

Figure 1.
Figure 1.

Uruguay: External Sector

Citation: IMF Staff Country Reports 2006, 197; 10.5089/9781451839340.002.A001

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

Uruguay: Vulnerability Indicators

Citation: IMF Staff Country Reports 2006, 197; 10.5089/9781451839340.002.A001

Sources: Central Bank of Uruguay; Ministry of Economy and Finance; and Fund staff estimates.
Table 1.

Uruguay: Selected Economic and Social Indicators

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

2005 and 2006 numbers are large driven by the large scale FDI project in the forestry sector.

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 2005–06 Economic Program 1/

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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.

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

Excluding imports related to the construction of planned 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 estimates are finalized.