2006 Article IV Consultation, Fourth Review Under the Stand-By Arrangement and Request for Waiver of Nonobservance and Modification of Performance Criteria: Staff Report; Staff Statement; Public Information Notice and Press Release on the Executive Board Discussion; and Statement by the Executive Director for Uruguay

With the recovery from the 2002 crisis well advanced, discussions focused on policies to reduce remaining vulnerabilities and sustain growth. Sensitivity analysis suggests that the economy, while having become more resilient in recent years, is still vulnerable. The authorities agreed to continue increasing buffers and strengthening Uruguay’s underlying performance, noting that under current strong policies and expected continued favorable external conditions, vulnerabilities should decline considerably with time. The estimates of sustainable expenditure paths for Russia are assessed. This study concludes by summarizing the policy implications of the analysis.


With the recovery from the 2002 crisis well advanced, discussions focused on policies to reduce remaining vulnerabilities and sustain growth. Sensitivity analysis suggests that the economy, while having become more resilient in recent years, is still vulnerable. The authorities agreed to continue increasing buffers and strengthening Uruguay’s underlying performance, noting that under current strong policies and expected continued favorable external conditions, vulnerabilities should decline considerably with time. The estimates of sustainable expenditure paths for Russia are assessed. This study concludes by summarizing the policy implications of the analysis.

I. Background: Assessing Progress and Identifying Vulnerabilities

1. Focus. With the recovery from the 2002 crisis well advanced, discussions focused on policies to reduce remaining vulnerabilities and sustain growth. Even though near-term risks are relatively low in the current environment, strong policy implementation is needed to consolidate macrostability and confidence in the system, reduce further still important balance sheet vulnerabilities, including from high public debt and dollarization, and sustain growth over the medium term. The generally favorable domestic and external conditions, and continued political support for the program, provide an important opportunity.

A. Macroeconomic and Financial Trends

2. Macroeconomic indicators. Many of those have improved to better than pre-crisis levels.

  • Economic recovery. GDP has rebounded in the last two years (18 percent), reaching its 1998 pre-crisis peak, mainly led by exports and investment. Unemployment, while still high at 12 percent and mainly structural, has declined considerably with the reduced output gap, with labor participation rates now close to pre-recession levels. Real wages have started to recover, but are still some 13 percent below the 2001 levels.

  • Exchange rate. The peso has appreciated significantly since the sharp depreciation that followed its float in mid-2002. Still, it remains some 20 percent more depreciated in real effective terms compared with pre-crisis levels. In 2005, even as the central bank took advantage of strong capital inflows to rebuild foreign exchange reserves, the peso strengthened by 8½ percent vis-à-vis the U.S. dollar. BCU resistance to further peso appreciation led to a stable exchange rate in early 2006, but some flexibility has been restored since.

  • Low inflation. Inflation was quickly brought under control after spiking in 2002, aided by the peso appreciation, and since 2004 has been in single digits.

  • Improved financial indicators. Soundness indicators have improved markedly, including capital adequacy and loan performance. Credit has started to pick up slowly, but still amounts to only 50 percent of deposits (70 percent in 2001). Also, the share of sight deposits in total deposits is now well above that five years ago.

  • Strengthened external position. With buoyant export growth, the external current account ended with only a modest deficit in 2005, despite a steep rise in imports stemming partly from high oil prices and a pick-up in FDI. International reserves have reached US$3.4 billion, compared to US$3.1 billion before the crisis and a low of US$0.8 billion in 2002; and NIR has increased by over US$1.5 billion since.

  • Declining public debt. Strong growth, the improved fiscal position, lower interest costs, and currency appreciation have lowered the public debt-to-GDP ratio from 105 percent at end-2003 to 69 percent at end-2005.


Credit to the Resident Private Sector

Citation: IMF Staff Country Reports 2006, 425; 10.5089/9781451839357.002.A001

Uruguay: Banking System Indicators: 2001-2006

(in percent)

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Source: Superintendency of Banks and Fund staff estimates.

3. Underlying factors. These results have been driven by solid macro and structural policies, supported by favorable external conditions. Major policy achievements include:

  • Substantial fiscal adjustment. The primary balance has shifted from large deficits during 1998–2001, to surpluses rapidly approaching the 4 percent of GDP medium-term target. The adjustment fell mainly on expenditures, where wages, social security benefits and capital spending have significantly contracted in real terms (Figure 1). A five-year budget consistent with the medium-term primary surplus target of 4 percent of GDP was approved in 2005.

  • Strengthened public debt management. Following the end-May 2003 debt exchange, the debt structure has been gradually improved by lengthening maturities, and increasing the share of fixed rate and peso debt (mostly indexed to the CPI). Still, some 85 percent of public debt continues to be denominated in foreign currency. A debt management unit at the Ministry of Finance was recently established to prepare and implement a strategy to further reduce vulnerabilities.

  • Monetary policy geared at maintaining low inflation in the context of a flexible exchange rate. The adoption of a flexible exchange rate regime in mid-2002, after several years of a crawling band, has been a key accomplishment in allowing the economy to better adjust to shocks and in providing incentives for de-dollarization. Also, the new framework of preannounced one-year-ahead inflation target ranges, pursued by managing base money, has lowered inflation and inflationary expectations. Facing large private capital inflows, the authorities have intervened in the foreign exchange market to increase international reserves and slow down peso appreciation (Figure 2).

  • Financial sector reforms. Prudential norms were tightened to internalize risks from high financial dollarization and exposure to regional contagion, and to reduce credit risk. While the state bank BROU has improved some procedures, further progress with risk management and controls is still needed. The state mortgage bank BHU was transformed into a nondeposit taking institution and is being further restructured to restore its financial viability. NBC, the bank formed with performing assets of three of the failed banks was recently privatized. A bill being considered by Congress sets price stability as a main goal of the BCU and delinks the appointment of its board members from the political cycle; unifies financial supervision; and creates an agency outside the BCU to manage the deposit insurance fund and bank resolutions.

  • Sustainable income policies. To channel wage pressures, the new government reinstated wage councils, where agreements are reached at the industry level, with the government intervening in case of an impasse. The resulting real wage increases in 2005 of 4–5 percent have been broadly in line with productivity growth. Public sector wage rules were modified in the last five-year budget, linking increases to inflation and economy-wide productivity growth, and made conditional on attainment of the primary fiscal target.

  • Other reforms to lay the foundations for sustained growth are in train. A far-reaching tax reform bill currently being debated in Congress, while revenue neutral, is expected to improve significantly the tax structure and introduce a personal income tax. A new competition bill is also being considered by Congress and a bankruptcy framework bill establishing Chapter-11 type procedures is to be submitted shortly.

Figure 1.

Uruguay: Fiscal Developments: 1995-2005

Citation: IMF Staff Country Reports 2006, 425; 10.5089/9781451839357.002.A001

Source: Ministry of Finance; and Fund staff estimates.
Figure 2.

Uruguay Monetary Developments: December 2003-May 2006

Citation: IMF Staff Country Reports 2006, 425; 10.5089/9781451839357.002.A001

Source: Central bank of Uruguay.

Primary Balance

(in percent of GDP)

Citation: IMF Staff Country Reports 2006, 425; 10.5089/9781451839357.002.A001


Evolution of the average maturity of public debt

(in years)

Citation: IMF Staff Country Reports 2006, 425; 10.5089/9781451839357.002.A001


Currency composition of Global Public Sector debt

Citation: IMF Staff Country Reports 2006, 425; 10.5089/9781451839357.002.A001

B. Underlying Vulnerabilities and Sensitivity Analysis

4. Improvements. The economy’s capacity to weather shocks has increased since the crisis. In particular, risks have declined as a result of: (i) larger central bank reserves and commercial banks’ liquidity; (ii) lower exposure to nonresident deposits; (iii) higher export market diversification; (iv) a strengthened banking system and supervision; (v) policies to improve the economy’s capacity to adjust to shocks, notably a flexible exchange rate; and (vi) sound macro policies and structural reforms to set the debt on a downward trend and foster sustained growth.

5. Remaining vulnerabilities. These include:

  • Still low liquidity buffers for a dollarized economy

    • article image
      Central bank’s coverage. Reserves have increased to 33 percent of short-term debt and FX deposits, from 19 percent in 2001. However, compared with other economies in the region they remain low.

    • article image
      System liquidity. Central bank reserves and commercial banks’ liquidity cover now about 70 percent of banks’ deposits and external short-term debt, compared with 43 percent in 2001. More than twice the level of nonresident deposits is now covered by commercial bank liquidity, compared with about 80 percent in 2001. However, with the shift toward short-term deposits, coverage of short-term debt and sight deposits by commercial bank liquidity is well below pre-crisis levels. Moreover, high liquidity is also partially explained by the so far slower recovery in credit than in deposits.

  • High public debt and bunching of maturities. Public debt as a share of GDP has declined significantly, but it is still higher than before the crisis, with a high share in foreign currency (85 percent) and floating interest rates (40 percent), large gross financing needs (averaging 7½ percent of GDP during 2006–08) and lumpy amortization payments when the bonds of the 2003 debt exchange fall due (2011, 2022 and 2033).

  • High contingent financial sector liabilities. Continued recovery on BROU’s government-guaranteed assets important to minimize contingent fiscal costs of 5 percent of GDP. More generally, public bank charters offer full guarantees on deposits, representing over half of the financial system assets (20 percent of GDP), and the large presence of the government in the insurance and pension sectors poses also medium-term risks.

  • High financial dollarization and large share of sight deposits. Uruguay remains highly dollarized, with 90 percent of new resident deposits and 70 percent of bank loans in dollars, with important currency mismatches in the public and corporate sectors (with peso income and dollar debts). (See Selected Issues Paper—Balance Sheet Vulnerabilities). Also, the share of sight deposits is now even higher than before the crisis, likely explained by low interest rates on time deposits (linked to weak credit demand) and past experiences with reprogramming of time deposits in times of financial difficulties.

  • Dependence. Uruguay’s real and financial linkages to Argentina have been remarkably tight. For example, Argentine consumption and Uruguayan GDP are strongly cointegrated, and about 80 percent of fluctuations in Uruguay in a two-year horizon can be explained by changes in consumption in Argentina. Nevertheless, Uruguay is making strides in reducing vulnerabilities from changes in the region, with nonresident deposits representing now a much lower share in the financial system and a substantial increase in trade outside the Mercosur region. (See Selected Issues Paper—Uruguay’s Growth Story)

  • Commodity price dependency. The export composition is still highly commodity based (10 percent of GDP or half of exports) and the share of oil imports in the economy has risen to 6 percent of GDP.


Reserves in percent of ST debt and FX deposits


Citation: IMF Staff Country Reports 2006, 425; 10.5089/9781451839357.002.A001


Public Sector Debt

(in percent of GDP)

Citation: IMF Staff Country Reports 2006, 425; 10.5089/9781451839357.002.A001


Dollarization of New Deposits

(In percent)

Citation: IMF Staff Country Reports 2006, 425; 10.5089/9781451839357.002.A001


Merchandise export shares

Citation: IMF Staff Country Reports 2006, 425; 10.5089/9781451839357.002.A001


Real consumption in Argentina and GDP in Uruguay: 1993-2005


Citation: IMF Staff Country Reports 2006, 425; 10.5089/9781451839357.002.A001

Buffers: Central Bank Reserves and Commercial Banks FX Liquidity

(in percent)

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Source: Central Bank of Uruguay and Fund staff estimates.

6. Sensitivity analysis. This suggests that the economy, while having become more resilient in recent years, is still vulnerable:

Uruguay: Sensitivity Analysis of Financial Sector Indicators and Public Debt

(in percent)

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Source: Central Bank of Uruguay and Fund staff estimates.

Based on estimations from Uruguay’s Financial sector assessment.

  • Effects on liquidity buffers.

    • article image
      Greater resilience. Several tests show increased resilience: (i) a 20 percent drop in deposits or 50 percent in sight deposits would reduce banking system liquidity coverage of deposits and short-term debt to 56–65 percent (similar shocks would have reduced it from 43 percent to about 32 percent in 2001); (ii) a one-year loss of access to public external financing (2007) would reduce the system’s coverage by only 2 percentage points to 68 percent and by 5 percent in central bank’s coverage to 28 percent; and (iii) a full withdrawal of nonresident deposits would lead to a decline in the system’s coverage to 64 percent, which would still be above pre-crisis levels.

    • article image
      Areas of vulnerability. For instance, a large recovery in bank lending, leading to a return to the pre-crisis credit/deposit ratio, would reduce the liquidity coverage back to pre-crisis levels (50 percent). Also, sustained economic growth will be important to ensure the continued recovery of the financial sector, including by maintaining healthy loan portfolio and bank profitability.

    • article image
      Fund resources. These still provide important support. While coverage of deposits and short-term debt by banks’ liquidity and central bank reserves have increased significantly, excluding IMF resources, the coverage would be only 52 percent.

  • Debt sustainability. The debt-to-GDP ratios are particularly sensitive to the real exchange rate or a relaxation in fiscal policy—a 10 percent real depreciation or a sustained 1 percent lower primary balance would increase the debt by 6–7 percent of GDP by 2012.

  • Capital adequacy. The FSAP found that the capital-asset-ratios in the system would not be materially affected by a moderate depreciation or an interest rate increase. However, these shocks are likely to have a larger impact through credit risk, as about a third of all loans are extended to debtors with unstable foreign-currency incomes.

  • Combined effects. While the economy may be better prepared to deal with single and moderate shocks, in reality the effects of shocks are likely to be felt through more than one channel. Stress tests of the FSAP indicate that severe current or capital account shocks would reduce the capital of many financial institutions below minimum requirements and in the most extreme case lead to the insolvency of a few but not systemically important financial institutions.

C. Medium-Term Outlook and Alternative Scenarios

7. Macroeconomic outlook. Uruguay is expected to grow on average by 3–4 percent over the next years—above its historical rate of 2 percent—with inflation stabilizing below 4 percent. This is based on sustained policy implementation in the context of benign external conditions, with the world economy expanding, and Argentina and Brazil growing at or above potential rates, in an environment of international interest rates staying broadly at current levels, while the terms of trade would deteriorate slightly. Under these conditions, the primary surplus is envisaged to reach its 4 percent of GDP medium-term target in 2007, which will help reduce the public debt-to-GDP ratio to below 50 percent by end-2012. The current account deficit is projected to remain modest and only widen temporarily due to FDI-financed investment for two major pulp mill projects.

Uruguay: Medium-term Macroeconomic Framework

(Percent of GDP, unless otherwise indicated)

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Sources: Uruguayan authorities; and Fund staff estimates.

8. Scenarios. Changes in the external and domestic policy environment pose, however, considerable up and downside risks (Appendix I). Illustrative scenarios show that public debt by 2012 could be some 10–15 percent of GDP above baseline, assuming: (i) higher international interest rates in an environment of lower international liquidity; (ii) a sustained global slowdown of 1 percentage point and lower non-oil commodity prices; or (iii) a weakening in domestic fiscal policy by 1 percent of GDP. A positive shock related to stronger growth, however, would further reduce the debt ratio to 40 percent of GDP by 2012. While these scenarios would not affect materially the financial system, the FSAP presents more extreme scenarios with severe impact on financial institutions.

II. Policy Discussion: The Challenge of reducing vulnerabilities

9. Focus on vulnerabilities. The authorities agreed to continue increasing buffers and strengthening Uruguay’s underlying performance, noting that under current strong policies and expected continued favorable external conditions, vulnerabilities should decline considerably with time. They also highlighted that the political and institutional stability of Uruguay and its track record of sound policy implementation were important stabilizing factors.

A. Exchange Rate and Monetary Policies under Volatile Capital Flows

10. Large capital inflows. The authorities reiterated their commitment to a flexible exchange rate, while noting difficult policy trade-offs in light of large (about twice the size of base money in 2005) and uncertain capital inflows. In particular, they expressed concern about a possible loss of export competitiveness as a result of excessive appreciation. Against this backdrop, they had decided to step up foreign exchange purchases since late 2005. Staff noted that while rebuilding reserves and resistance to appreciation pressures linked to short-term capital inflows may be appropriate, exchange rate flexibility should be maintained. Targeting the exchange rate should be avoided in an economy that is highly exposed to external shocks.


Private Capital Inflows (net), 2003-2006

(quarterly, in millions of U.S. dollars)

Citation: IMF Staff Country Reports 2006, 425; 10.5089/9781451839357.002.A001


Sources of Base Money changes in 2005

(In million of US dollars)

Citation: IMF Staff Country Reports 2006, 425; 10.5089/9781451839357.002.A001

11. Competitiveness. The strong appreciation of the peso in the past year—while strengthening the debt sustainability outlook and supporting low inflation— has prompted some public concern over competitiveness. However, continued buoyancy of exports, econometric estimates of the equilibrium rate, and labor cost developments in the manufacturing sector indicate that Uruguay’s exchange rate is not overvalued (Box 1). Staff and authorities agreed that targeting an exchange rate below its equilibrium level would eventually lead to higher inflation and that lasting improvements in competitiveness depended on moving ahead with productivity-enhancing structural reforms.

Assessment of External Competitiveness1

Notwithstanding the significant appreciation of the REER since early 2004, several indicators suggest that Uruguay has remained competitive.

  • Exports. Since the 2002 crisis, the current account has remained nearly balanced, with exports performing vigorously (17 percent volume growth in 2005). Moreover, inflows of foreign direct investment have increased markedly, pointing to Uruguay’s attractiveness as a location for investment.

  • Real exchange rate. The PPI, CPI and ULC-based REERs have remained substantially more depreciated than before the crisis, with some 11, 19 and 43 percent below their respective 2001 averages. The CPI-based REER appears to be near its long-run equilibrium, with the current rate within the 95 percent confidence interval of the estimated equilibrium level (estimate based on a long-term relationship between the REER, real GDP relative to trading partners, and net foreign assets). The analysis also suggests that the exchange rate was significantly more appreciated than its long-term equilibrium level before the 2002 devaluation.

  • Other competitiveness indicators. The ratio of export unit values to unit labor costs, a proxy for profit margins in the tradable sector, has improved substantially, remaining more than 80 percent above its pre-crisis level. The ratio of prices for tradable to non-tradable goods, an indicator of competitiveness between the tradable and non-tradable sectors, has declined since the crisis, but remains 5 percent above pre-crisis levels.


Actual and Estimated Equilibrium REER, 1988-2005

Citation: IMF Staff Country Reports 2006, 425; 10.5089/9781451839357.002.A001


See Selected Issues Paper—Assessing Competitiveness in Uruguay.

12. Inflation targeting. There was agreement that monetary and exchange rate policies should remain focused on achieving the inflation objective, while moving to full-fledged inflation targeting over time. Achieving the inflation targets would further improve central bank credibility and over time help reduce financial dollarization. At this point, the authorities however did not feel ready to move to full-fledged inflation targeting, given remaining weaknesses in the financial system, high gross financing needs, and the still incomplete understanding of price formation. Nevertheless, they stressed that the proposed new central bank law and the planned central bank recapitalization would be important steps in this direction. Regarding monetary policy instruments, with high dollarization and remonetization, they have decreased emphasis on monetary aggregates and were monitoring an array of indicators, but were skeptical about the use of short-term peso interest rates in the immediate future, given the high degree of dollarization and the shallowness of the peso money market, and agreed that further development of local markets would be desirable.

13. Policy transparency. While the current framework has helped in lowering inflation, to consolidate central bank credibility it would be important that its actions be better understood by the market, including the mechanisms and rationale of foreign exchange interventions and their link to the inflation objective. The authorities agreed that improving the monetary framework and its transparency was key, and that they would welcome Fund TA in this area later this year.

14. Rebuilding foreign exchange. The high degree of dollarization, the government’s full deposit guarantee of state banks’ deposits, and remaining weaknesses in the banking system make it important to continue building reserves. The central bank has recently increased significantly its reserve target for 2006, and intends to build reserves further over the medium term, as opportunities from capital inflows arise and remain consistent with the inflation objective. While rules-based preannounced purchases of the central bank would have clear advantages of transparency, the authorities observed that such a policy had put the central bank in a weak position in 2005 in a shallow market and reduced the effectiveness of intervention.

B. Financial Sector Vulnerabilities

15. Dollarization. The authorities agreed that high dollarization remained an important challenge for the financial system, with most potential borrowers lacking a stable dollar income stream. They explained that the immediate vulnerability from high dollarization had decreased as low credit demand had resulted in high foreign exchange liquidity of banks. In addition, prudential rules that discourage dollarization and internalize the risks of dollar lending have been issued, and the deposit insurance scheme and new tax reform provide incentives to reduce financial dollarization through differential premiums and tax rates (Box 2). Encouraging the market to develop hedging instruments to transfer currency risk will also be important.

Measures Taken to Address Financial System Risks Arising from High Dollarization

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16. State banks. A more competitive and modern financial system will be key to ensure more effective financial intermediation, and the current large state-presence in the insurance, pension and banking sector distorts competition and poses macroeconomic risks. The authorities argued that given Uruguayan society’s preferences expressed in several referenda, they were not considering privatizing BROU. They however agreed to consider improvements in its governance, including making directors subject to fit-and-proper tests, but noted that significant improvements were already being made through better regulation and transparency.

17. New lending. Strong prudential policies and creditor discipline will be instrumental in ensuring sound financial intermediation, especially when lending starts picking up. Moreover, BHU loans and the small loans of BROU should be incorporated into the credit registry to improve credit culture, foreclosure and bankruptcy processes should be shortened to improve credit recoveries, and controls and risk management policies and practices of BROU further strengthened. The authorities explained that they had advanced in all these areas and that banks had extended new loans cautiously. Furthermore, coverage of the credit registry was being extended, and the new bankruptcy legislation would help in fostering sound financial intermediation. (See Selected Issues Paper—Post-Crisis Credit)


Real private credit growth after banking crises

(in percent)

Citation: IMF Staff Country Reports 2006, 425; 10.5089/9781451839357.002.A001

Source: IDB and staff

Main Findings and Recommendations from the FSAP

Main findings

  • Financial soundness indicators—have improved significantly and commercial banks are better prepared than in 2002 to withstand medium-sized shocks given their high liquidity and capital adequacy. The large liquidity at public bank BROU, accounting for half of system’s deposits, reduces the fiscal exposure arising from the full deposit guarantee established in its charter.

  • Regulation and supervision of the financial system— has improved significantly since the crisis (see Box 2 above). The bank resolution framework is also being strengthened.

  • Stress tests—show that while the system appears prepared to handle moderate shocks, severe current or capital account shocks would lead to a significant deterioration of the capitalization of several financial institutions in Uruguay.

  • State banks—insufficient resources and the predominance of public financial institutions presents informational, oversight, and governance challenges. The constitutional status of two public banks (at par with the central bank) remains an issue. While the supervisor can impose sanctions on these banks and their senior management, it has no influence on the appointment or removal of directors and management. Several Basel core principles have been rated materially noncompliant because the BCU cannot apply the full range of corrective actions. Predatory underpricing practices by some public financial institutions and government guarantees create unfair competition to private institutions.

  • Pension funds (AFAPs)—the market is highly concentrated and government guarantees (including a minimum investment return in the public AFAP) pose potential risks. Investment regulations governing the AFAPs allow little asset risk diversification of affiliates’ investments.

  • Payments and securities settlement systems— are being upgraded, but their oversight and legal frameworks need to be strengthened.

  • AML—formal cooperation and information exchange mechanisms with other overseas supervisors, particularly in neighboring countries, are not yet in place.

Main recommendations

  • Contingent liabilities. Conduct an independent analysis of the potential contingent liabilities that may arise from state-owned institutions in banking, insurance and pension fund sectors.

  • Supervision. Increase resources for effective supervision, improve information systems and provide training to staff.

  • State banks. Require directors and managers of public financial institutions to satisfy supervisory fit and proper requirements and to be subject to supervisory corrective actions.

  • Prudential policies. Address the factors contributing to the weak credit culture by making the credit registry easier to use and speeding up incorporation of BHU loans and the small loans of BROU, strengthening the lax credit and debt relief practices of public banks, and shortening foreclosure and bankruptcy processes.

  • Pension funds. Liberalize rules for AFAP investments in nongovernment obligations, including allowing limited, high-quality offshore investments. Eliminate the government-guaranteed minimum return in AFAP Republica.

  • Insurance system. Any mortgage default insurance system would need to be evaluated carefully and ensure that underlying risks are priced accurately.

  • Payments system. Form a small unit in charge of payments system oversight, separate from systems operations, and improve the legal framework in the areas of bankruptcy procedures, netting arrangements, and custody arrangements. Upgrade the RTGS payment system as planned.

  • AML. Engage in cooperation and information exchange agreements with foreign supervisors.

C. Sustainable Fiscal and Public Debt Framework

18. Fiscal policy framework. Sustaining high primary surpluses of 4 percent of GDP will continue to be at the core of the authorities’ fiscal strategy, but at times of high growth and strong capital inflows higher surpluses could be targeted, to lower the burden on monetary policy and further reduce debt. The authorities considered that they would meet their fiscal targets in 2006, as they had done in 2005, but also noted that the current targets already imposed considerable constraints. In their view, fostering long-term growth would also require allocating additional public resources to strengthen infrastructure and making room for other priority expenditures, including education. Further, while the ceilings in the recently passed net debt law would allow for a higher than currently targeted debt-to-GDP ratio, their fiscal strategy would continue to be guided by the budget framework.

19. Strengthening revenue. There was agreement that tax administration reforms were critical for attaining the ambitious revenue targets and sustaining fiscal performance into the medium term. The current practice of setting high tariffs for public utility services to generate fiscal revenues is inefficient, and should be replaced by a more rational tariff-setting mechanism. However, before tackling this issue, the plan is to consolidate the tax reform to minimize fiscal risks.


Public Sector Revenues

(in percent of GDP)

Citation: IMF Staff Country Reports 2006, 425; 10.5089/9781451839357.002.A001

20. Spending rigidities. Reducing budget rigidities can increase the resilience of public finances to shocks. While the expenditure levels are comparable to other emerging markets, spending on wages and social security benefits (70 percent of non-interest expenditure) is high. The authorities explained that, with the general pension system already reformed in 1996, high spending reflected Uruguay’s demographic structure, and not overly generous benefits. Moreover, the system’s deficit is expected to decline gradually over the long term as the effects of the reform kick in. On civil service reform, the government is considering measures to improve the quality of services and reduce costs, which could over the longer term include changes to the remuneration schemes and functional restructuring, but the discussion is still in its early stages.


Non-interest Expenditures and Pensions

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 425; 10.5089/9781451839357.002.A001

21. Public debt structure. There was agreement that implementing the government’s debt strategy was critical to increase resilience to shocks, with the authorities taking advantage of favorable market conditions to advance financing plans and improve the debt structure, including by issuing debt in local currency and smoothing the amortization profile. They also plan to further develop the local bond market by extending maturities, which should help to further shift the currency composition from foreign to local currency. Staff encouraged the authorities to move more aggressively to improve the currency and maturity composition of debt to lock in the current generally favorable conditions.

D. Growth, Competitiveness, and Diversification

22. Growth. Sustaining growth into the medium term will be critical to allow the continued improvement in social conditions, while ensuring fiscal and debt sustainability, and providing the basis for a healthy financial system. In this regard, the government has prepared an ambitious reform agenda (see Box 2, Country Report No. 06/197), of which many elements, such as tax and financial sector reforms, are already advancing. Further, a new competition bill is being considered by Congress and a new bankruptcy framework bill introducing a Chapter 11-type of regime would be submitted soon.

23. Openness and trade diversification. The authorities reaffirmed their commitment to seek further trade expansion to achieve scale economies, while diversifying to reduce exposure to the region. They pointed to their active role in the WTO’s Doha round, the bilateral trade agreement with Mexico since 2003 and increased trade relations with the EU, and that they would welcome an enlarged Mercosur. Also, they are exploring further ways to deepen economic ties with the US—consistent with Mercosur— beyond the recently signed Bilateral Investment Treaty.

24. Investment climate. Improving the business climate is key for attracting private investment to sustain growth. The recent work of the growth commission (Compromiso Nacional) had identified further measures, including establishing an investor relations office and reforming public procurement, which have been incorporated in the government’s agenda.

25. Labor market flexibility. In recent months there has been some public concern about the increased number of occupations of factories by striking workers and proposed minimum wage increases. The authorities pointed out that labor regulations were not rigid in comparison to the region, but acknowledged that strong unions and negotiated agreements imposed constraints in some sectors, especially in the banking sector. The number of strikes had actually declined to a decade-low in 2005 and the wage councils had helped bring stability to labor relations, and the recently discussed increase in the minimum wage of 20 percent would keep it nonbinding except for very few sectors. The government is also considering to allow for firm-level negotiations within the current framework.

26. Public-Private-Partnerships (PPPs). With fiscal constraints and limited scope for privatization, the authorities consider private participation in public infrastructure as important to close the large investment gap, expand capacity further, and improve the efficiency of public enterprises. They do not intend to set an overall legal framework for PPPs at this point, but rather move ahead with a few projects, which would be well-selected, carefully designed, and their contingent fiscal costs minimized. (See Selected Issues Paper—Options to Increase Infrastructure Investment in Uruguay).

27. Public Enterprises. Reform of public enterprises is important to reduce the high public tariffs and improve service delivery. While privatization is not being considered, the authorities are studying various options, including increased association with the private sector, establishing better links between remunerations and productivity, and shifting some of the enterprises to private law over the medium term.

III. Fourth Review Discussions

A. Recent Developments

28. Macroeconomic outcomes. Results and policy developments have been mostly favorable.

  • Growth. With continuous vigorous growth in early 2006, projections for the year have been revised upwards to 4½ from 4 percent,

  • Inflation. The annual inflation rate increased from 6 percent in April to just above 6½ percent in May, reflecting the pass-through of higher oil prices. It is expected to return to within the target range by year-end (4½–6½ percent), although emerging price pressures (including a recent electricity tariff increase) pose an upside risk to this outlook.

  • Fiscal performance. Preliminary data show a higher than programmed primary surplus in the first quarter (4.8 percent of GDP against 2.4 percent in the program, annualized), reflecting higher tax collection and social security contributions, which more than offset weaker performance by public enterprises; the outcome also reflects better local government performance and temporary delays in the social emergency program.

  • Monetary policy. The central bank exceeded the March indicative base money target by 7½ percent, and raised its 2006 M1 growth target from 12 percent in December 2005 to 28 percent, while leaving its one-year-ahead inflation target range unchanged from December (4½–6½ percent).

  • Exchange rate policy. Following periods of large central bank foreign exchange purchases, the exchange rate was constant during some periods in early 2006. Exchange rate flexibility has since resumed.

  • Country risk. With the recent tightening of international liquidity conditions, Uruguay’s sovereign spreads and domestic interest rates increased in line with neighboring countries, but the exchange rate was largely unaffected.

  • Program targets. Available information suggests the authorities have met all the continuous and quantitative performance criteria for end-March 2006. They will provide final data ahead of the Board meeting.


Sovereign risk

(EMBI Global)

Citation: IMF Staff Country Reports 2006, 425; 10.5089/9781451839357.002.A001

29. Structural reforms. There has been important progress in the structural area.

  • Tax reform law. This is the key reform priority in the near term. The lower house is discussing the bill and congressional approval (end-October performance criterion) is now expected by mid-September (modification proposed to advance approval date).

  • Revenue administration. The social security agency (BPS) is on track to prepare a plan to strengthen its auditing and collection functions (end-June benchmark). The authorities have also identified the main elements of the customs reform, and the preparation of a detailed plan, including institutional and legal changes, is on track (end-August benchmark).

  • Budget. A government group is working on the institutional budget process and will be assisted by Fund TA in developing a reform plan (end-August benchmark).

  • Specialized pension schemes. Working groups have been established to prepare draft legislation for the military and banking employee pension reforms to be submitted to congress by end-November (performance criterion).

  • Growth. The government published its pro-growth reform agenda in March, and a timetable for the implementation of the measures was published with a slight delay in early June (end-March benchmark).

  • Bank restructuring. NBC was privatized in early June (end-June benchmark). BHU restructuring is progressing well (end-August performance criterion).

  • Bankruptcy law. The draft law was presented for public consultation and will be submitted to congress in time (end-June benchmark).

30. Delays. With the government giving priority to passage of the all important tax reform law, the congressional agenda is being rescheduled to defer consideration of pension and central bank reforms.

  • Police pension reform law. Approval (end-May performance criterion) is now expected by end-October (waiver requested). However, the delay will have no impact on the attainment of the 2006 fiscal targets.

  • Financial sector law. Approval of the law is being delayed (end-June performance criterion) to give priority to the tax reform, and is now expected by end-November (modification proposed).

B. Discussions

31. Monetary policy stance. The authorities view the recent pickup in inflation as transitory, owing to a drought-related increase in food prices and the recent pass-through of higher international oil prices, and were confident to attain the end-year target range. Also, the targeted additional base money increase of 16 percent (equivalent to US$180 million) would be fully met through foreign exchange purchases, consistent with the observed remonetization. However, given the increase in inflation and market expectations for 2006 above the target range, uncertainties about continued strength in money demand, a reduced output gap, and some money market rates negative in real terms, staff argued that the risks to the inflation outlook have increased. Against this background, it urged the authorities to initially target a slower base money growth until inflation has settled well within the year’s end target range. The authorities explained that, while inflation is still within their quarterly target range (5–7 percent), they are monitoring developments closely and considering to tighten the stance even ahead of the next review.

32. Reserve target. The central bank has increased its reserve target for 2006 by US$410 million—and above original program projections for 2008—owing to larger than programmed foreign exchange purchases and the decision by the government to forgo foreign exchange available from forward operations maturing in 2006. The revised NIR accumulation target for 2005–06 of US$1.6 billion, compares with an original projection of US$1.1 billion during the three-year program.

33. FSAP. The authorities recognized that FSAP recommendations would further strengthen the financial sector and indicated that they would, after a thorough analysis, discuss incorporation of key recommendations into the program’s conditionality at the next review. They also explained that the approval of the financial sector law, which is now expected by end-November, would address several of the issues raised by the FSAP. Staff stressed that strengthening the authority of the supervisor over public banks, within the constitutional constraints, was important to meet international supervisory standards.

34. Fiscal targets. Exceeding the 2006 fiscal targets would be desirable to further lower the high public debt, help control inflation, and moderate appreciation pressures.. On public enterprises performance, the authorities are committed to continue fully passing through international oil prices to protect revenue targets; drought-related shortfalls in the electricity company would be offset by better performance in the telecommunications company and the central government. Staff urged to monitor the situation closely and to execute spending cautiously to prevent slippages.

35. Revenue administration. It is important to advance with the revenue administration preparations for the tax reform. Initial steps in the authorities’ action plan include delineating responsibilities between the DGI and the BPS to administer the personal income tax, appointing a high level working group to coordinate the actions of the collection agencies, drafting the regulations for the reform, and restructuring administration processes.

36. Growth measures. The SBA has already scheduled many important reforms of the recently published growth agenda, including bankruptcy legislation, tax reform, and bank restructuring. In addition, it is proposed to include establishing a private sector relations office by August 2006 and strengthening government procurement procedures by July 2007 as benchmarks in the program.

IV. Staff AppraisalThe need to stay the course

37. Strong policies. Uruguay’s strong policies, supported by favorable external conditions, have contributed to the sharp recovery since the 2002 crisis. Four years of large primary fiscal surpluses, financial sector restructuring, and prudent debt management have contributed to a significant fall in debt ratios and improved debt structure, and a strengthened liquidity position of the financial system. Careful monetary policy within a flexible exchange rate regime brought inflation quickly down and has helped stabilize inflationary expectations in the low single digits. This has been accompanied by important structural reforms, including in the fiscal, financial sector, and business climate areas and has resulted in a strengthened market confidence in Uruguay’s prospects.

38. Remaining vulnerabilities. The economy has generally become more resilient to shocks—macro policies are stronger; the flexible exchange rate allows the economy to better adjust to shocks; stricter prudential norms are in place; public banks have been or are being restructured; and key buffers, such as liquidity and reserve coverage, are higher. However, while rapidly declining, public debt remains high and largely dollarized, central bank reserves remain relatively low, and the financial system is still vulnerable. Thus, sustained strong policy implementation and advancing with structural reforms will be key. Current favorable global conditions provide a good opportunity to advance with this objective.

39. Low inflation. This is critical to further improve the credibility of the central bank and help reduce financial dollarization. Staff commends the central bank for keeping inflation in check and, while inflation risks have increased, supports the proposed modification of indicative targets for base money, given the authorities’ commitment to adjust policies as necessary to meet the inflation objectives. Moving toward full-fledged inflation targeting could help institutionalize the commitment to low inflation, and the new central bank law increasing its autonomy will be a significant step in this direction. It will be important to enhance transparency of monetary policy, strengthen inflation forecasting of the central bank and develop new instruments to better communicate the stance of monetary policy. In this context, staff commends the authorities for their ongoing efforts to develop deeper markets in local currency. The newly established debt management unit should play a key role in these endeavors.

40. Exchange rate flexibility. The real exchange rate appears to remain at competitive levels, as evidenced by strong exports, a near current account balance, and a real effective exchange rate well below pre-crisis levels. Nevertheless, given the risk that large capital inflows may not be sustained, some resistance to appreciation may be appropriate, but interventions should avoid signaling the existence of an exchange rate target. The restoration of exchange rate flexibility after brief periods of rigidity in early 2006 is encouraging, and the authorities should also explore methods to make interventions more transparent and better understood by market participants.

41. International reserves. Reserves should be increased considerably over the medium term. While now well above pre-crisis levels, reserve coverage of short-term debt and dollar deposits is still low compared to other dollarized economies. Continuing capital inflows provide an opportunity to strengthen reserves in the near future, and the large increases now expected for 2006, beyond the initial program indicative targets, will be an important near-term step in this direction. However, large capital inflows also constitute a challenge for monetary policy to ensure that both the inflation objectives are met and exchange flexibility is maintained.

42. State banks. Continued reforms are essential to reduce risks associated with the public sector’s large share in the banking sector, including because of full deposit guarantees. The ongoing restructuring of BHU should be completed as scheduled, and selection of managers in state banks should be subject to fit and proper criteria as set by the superintendency. Further, strong prudential policies and creditor discipline need to be in place once lending starts picking up. The recommendations of the FSAP provide useful guidance in these areas, and should be implemented.

43. Fiscal sustainability. Achieving high primary surpluses is necessary to bring about debt sustainability and further enhance the credibility of the overall policy framework. Stronger economic growth could provide an opportunity to overperform on fiscal targets, further reduce debt and help in reducing the burden on monetary policy in dealing with capital inflows. The revenue-neutral and efficiency-enhancing design of the tax reform needs to be protected. Swift progress in tax administration will be instrumental for successful implementation of the reform and attaining the ambitious revenue targets. Continuing to fully pass through in international oil prices will also be important. Public enterprise reform would also help reduce reliance on high tariffs. While large reductions in pension outlays are unlikely given Uruguayan demographics, the authorities could study options to improve the efficiency and reduce costs of the system. Also, a comprehensive civil service reform could result in important improvements in public services.

44. Growth. The risks to growth from current account shocks and possible loss of competitiveness also need to be addressed. Further trade liberalization and diversification of export markets should help reduce vulnerabilities from regional dependencies. Improving the investment climate, strengthening the bankruptcy framework and maintaining good labor relations and a competitive labor market will also be key. Finally, plans for PPPs provide a good opportunity for upgrading infrastructure but should be initially kept at a limited scale and be handled cautiously, including by adequately sharing risks with the private sectors and properly recording of the transactions in the fiscal accounts.

45. Next Article IV consultation. It is proposed that it will be held on a 24-month cycle, in accordance with the provisions of the July 15, 2002 decision on consultation cycles for countries with Fund arrangements.

46. Completion of the review. In light of the strong performance under the program, and the positive outlook, staff recommends completion of the fourth review. Available information suggests that all performance criteria have been observed, except for the implementation of the police pension fund reform, because of changes in the congressional timetable, involving early consideration of the tax reform and the postponement of the police pension and the financial sector reforms. The authorities have expressed their continued commitment to implement these reforms, and in light of these corrective actions, staff supports the authorities’ request for a waiver for the nonobservance of the end-May structural performance criterion and its resetting for end-October, and to change the tax and financial sector reforms test dates to mid-September and end-November, respectively.

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: 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 3.

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 includes US$40 million for the financing of the deposit insurance scheme. In 2006 includes US$20 million for financing of the deposit insurance scheme and US$407 million for the net value of the recapitalization of the BHU.

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