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.
1. Uruguay’s economy keeps showing a satisfactory performance, which is based on sound pillars of prudent macroeconomic policies, structural reforms, and proper incentives established by the authorities’ measures. Thus, Uruguay’s government continues going forward with its objectives of higher and sustainable growth, high level and better quality of employment, and more social equity.
Recent Economic Developments
2. In the first quarter of the year, GDP increased robustly (7.2 percent) compared to the same period in 2005. In this broad-based growth there have been outstanding performances as in industry (increase of 18 percent) and construction (16 percent). Meanwhile, investment (33 percent) and exports (10 percent) are leading the activity expansion. At the same time it is important to note that private consumption increased by a healthy 6.4 percent, showing upward trend rates. This reflects higher consumer confidence, consistent with the prudent expenditure policies that will make possible a new tax system which, whereas permitting a more equitable and efficient distribution, will not impose a higher tax burden.
3. Inflation is within the target range established by the Central Bank for September 2006 (5–7 percent). Admittedly, inflation rates have risen in recent months reflecting the full pass-through of oil prices, along with the effect on food prices of a drought that is currently receding. However, the Central Bank is following these developments closely and is ready to take all adjustments in monetary policy that may be needed to meet the Central Bank’s inflation target. Meanwhile, the authorities are adhering to a flexible exchange rate system, even though, if necessary, they will intervene to mitigate possible short-term volatility due to large capital inflows. This approach is clearly supported by the staff’s assessment on competitiveness. At the same time, we would like to reiterate that our authorities have no exchange rate target and are determined to avoid signaling the existence of any.
4. Primary surplus in 2005 exceeded the authorities’ target, and the same behavior has been observed during this year, with figures approaching to the government’s medium-term targets. It is important to note that the social emergency plan, although it was not fully implemented in 2005 because of temporary delays, has been critical to allow the country to reduce the poverty rate by three percentage points, generating more social inclusion and a better environment for reforms.
5. Strong fiscal performance has made possible a steady and ambitious reduction of the debt-to-GDP ratio that is currently already under the 70 percent figure. Admittedly this is still a high ratio that needs to be further reduced, but it is far below the ratio observed less than three years ago (105 percent). Meanwhile, the recently created Debt Management Unit continues to make efforts to further reduce debt cost, increase maturities, and diminish exchange rate risks.
6. Our authorities do not fully agree with the staff on some assessments regarding underlying vulnerabilities. In particular, comparisons among different countries’ reserves relative to short-term debt and foreign exchange deposits does not take duly into account different circumstances. For instance, unlike what happened to other countries in the region, when Uruguay underwent the climax of its 2002 financial crisis, foreign-owned banks responded to deposit withdrawals with their own reserves. The Central Bank did not have to assist those banks with its reserves. Moreover, all of the private banks are currently owned by first rank international banks, accounting for about the half of the banking system assets. Meanwhile, it is a little bit strange that the staff report underscores the bunching of maturities on debt exchange falling due 2022 and 2033 as a vulnerability without recalling that the debt exchange itself was a big success.
Our Authorities’ Firm Commitment to Structural Changes
7. A long series of efforts over the last sixteen months clearly reflect the government’s strong ownership of the reforms. In the Uruguayan government’s view reforms must be lasting and well-implemented, which requires an adequate discussion in Congress, and a good dissemination and explanation to the people about the benefits that such changes will bring about. This is the reason why the authorities have preferred to introduce some minor variations to their comprehensive structural agenda.
8. As in any democratic country, in Uruguay the Congress is free to schedule priorities and the time it needs to consider each of the bills that are put forward by the Administration. In this regard, it has decided to consider our authorities’ core reform, the new tax system, prior to other reforms. We are confident that the small time adjustment that we are requesting will help the Congress to better discuss reforms whose architectures are quite sophisticated.
Further Inserting Uruguay into the Global Economy
9. Another critical structural issue involves Uruguay’s further insertion into the global economy. The Uruguayan government gives high priority to trade diversification since it will allow Uruguay to continue minimizing its dependency on one region. In this respect we would like to stress the significant improvement made since 1998 when exports to Mercosur represented 55 percent of total exports in goods whereas this percentage was reduced to just 23 percent in 2005. Consequently, Nafta countries’ share is showing an expansion (7.5 percent in 1998 and 29 percent in 2005), as is Europe (18 percent in 1998 compared to 20 percent in 2005). Furthermore, since the recent visit of the President of Uruguay to the United States of America, a process towards deepening trade relations between both countries has begun, which would complement the investment agreement ratified by the Uruguayan Congress in December 2005. Uruguay has already signed a Free Trade Agreement with Mexico, and will continue efforts to negotiate trade agreements with many other countries in order to diversify not only markets but also Uruguay’s export product base.
Reforming and Establishing Proper Incentives in the Financial System
10. After a deep economic and financial crisis as the one Uruguay suffered in 2002, it takes some time to rebuild confidence, putting together a strong banking sector with reduced vulnerabilities. However, there has been a steady and substantial improvement in confidence and the system is already harvesting benefits from an important number of structural changes. While the financial system still presents a high proportion of sight deposits, this is mainly due to the fact that demand for credit is still low. In this context, the banking sector has not had strong incentives to offer high interest rates to attract longer-term deposits, which in turn affects depositors’ decisions. This situation is no different from many other experiences of post-crisis recoveries in which bank credit tends to pick-up with some delay. In Uruguay, something similar has occurred. While credit is starting to delineate a slightly positive trend, it is expected that the continuation of macroeconomic stability and, particularly, the projected reforms in the financial system and capital market (many of which are included in the staff recommendations made in Chapter IV of the Selected Issues report) will allow the Uruguayan economy to enjoy a higher access to finance.
11. Much greater confidence in the system can be observed in some indicators and events, but we would like to underscore two of them. First, the episode of Cofac – negative in itself - was isolated and did not have any effect on the rest of the financial system. Second, the privatization process of Nuevo Banco Comercial (NBC) was successfully completed. It is important to recall that NBC was created after the 2002 financial crisis with the good assets of three failed banks, and approximately three years later the process was concluded after arranging a very convenient operation, considering the buyers’ reputation and the fair price. As our authorities have underscored, this operation continues to demonstrate investor confidence in Uruguay, and particularly in its financial system.
12. We would like to reaffirm that our authorities are fully aware that much more remains to be done to further improve the financial system and mitigate remaining vulnerabilities. In this regard, as recognized by the staff, recent efforts include the significant strengthening of the regulation and supervision of the financial system. Likewise, the government continues progressing towards critically transforming Banco Hipotecario del Uruguay (BHU) into a viable institution. Regarding Banco de la Republica Oriental del Uruguay (BROU) our authorities are setting aside dogmatic approaches (“public banks are intrinsically good, or intrinsically bad”). For them it is good governance that counts most. The existence of a strong public bank based on sound pillars should not discourage private competence but rather entice it while serving the interests of the country and its people. In this vein, the authorities continue making significant advancements, among others, in risk management and internal controls.
13. The Uruguayan government aims to reinforce habits of honoring debts and, in general, accountability on both sides, banks and their customers. It is important to recall that over the last decades, many laws have been passed establishing debt refinancing with lax conditions for the generality of debtors. Our authorities have underscored that they are firmly committed to break these kind of detrimental solutions, and that policies will not reward those who are unwilling to honor their debts, waiting for the next debt amnesty. Instead, the reward will be aimed at encouraging people to meet their obligations, hence avoiding a burden on the whole community.
Further Improving the Investment Climate
14. Considering the critical need for Uruguay to attract private investment, our authorities’ strategy is designed to forge a favorable investment climate. As noted by the staff, after completing the work of the growth commission (Compromiso Nacional), our authorities have incorporated many of the identified measures in their agenda, which will help them to fulfill their objectives. In this regard, the creation of an investor relations office at the Ministry of Economy, and the adoption of a detailed plan to strengthen government procedures have been incorporated as new structural benchmarks. These will add to other critical reforms such as a new bankruptcy law.
15. Despite a not entirely favorable external environment (high oil prices and a drop in tourism due to occasional blockades of bridges connecting with Argentina) Uruguay has been showing a very positive performance -outstanding if compared to the country’s economic patterns during the last decades. Among other things, GDP has grown robustly, inflation has been within the Central Bank’s target range for September 2006, fiscal performance has exceeded original projections, and poverty - though still high - has decreased. The authorities are fully aware that much remains to be done in all of these areas. At the same time, the Uruguayan government has pointed out that macroeconomic achievements do not make sense if they are not accompanied by critical reforms included in the authorities’ comprehensive agenda.