This report includes five background studies with emphasis on vulnerabilities and growth, the focus of the 2006 Article IV Consultation with Uruguay. Stocks of key financial balance sheet vulnerabilities are also discussed. With the appreciation of the peso since early 2004, the discussion on competitiveness has intensified. To assess competitiveness, the paper looks at balance of payments trends, the ratio of tradable to nontradable prices, cost and profitability measures, and real exchange rates and their alignment with purchasing power parity (PPP).

Abstract

This report includes five background studies with emphasis on vulnerabilities and growth, the focus of the 2006 Article IV Consultation with Uruguay. Stocks of key financial balance sheet vulnerabilities are also discussed. With the appreciation of the peso since early 2004, the discussion on competitiveness has intensified. To assess competitiveness, the paper looks at balance of payments trends, the ratio of tradable to nontradable prices, cost and profitability measures, and real exchange rates and their alignment with purchasing power parity (PPP).

II. Balance-Sheet Mismatches and Cross-Sectoral Vulnerabilities in a Highly Dollarized Economy: The Case of Uruguay1

A. Introduction

1. The paper takes stock of key financial balance-sheet vulnerabilities in Uruguay and compares them to their crisis and pre-crisis levels. It focuses on the risks from maturity, currency, and capital structure mismatches in different sectors of the Uruguayan economy and explores interrelations among them. The paper divides the economy into four sectors: public sector (including the central bank), banking sector (excluding the central bank), pension funds, and private nonfinancial companies and households.

2. Many structural weaknesses have decreased since the crisis, but important balance-sheet fragilities remain. Uruguay’s external financial position has strengthened. Its exposure to reversals in external financing flows and withdrawals of nonresident deposits have declined. The FDI share in total external financing fell during the crisis, but has been recovering since then. Public debt has declined, but remains higher than before the crisis. Public debt and the financial system remain highly dollarized. Large currency and maturity mismatches persist at the sector level. For example, the public and corporate sectors have short open foreign exchange positions, while households and pension funds have long ones.

3. Balance-sheet interrelations transfer vulnerabilities across sectors. Two thirds of pension fund portfolios are invested in government debt, which exposes them to sovereign credit risk. In contrast with other countries in the region, banks’ holdings of public debt have been traditionally low in Uruguay. Banks have granted a third of their dollar loans to industries with little export activity and are indirectly exposed to sharp peso depreciation.

B. Economy-Wide Indicators

4. Uruguay’s external financial position has substantially strengthened since the onset of the crisis, but is still weaker than in 2001. Its net foreign debt position has declined by US$1.3 billion during 2002–2005, reaching US$7.5 billion (43 percent of GDP) in 2005. This, however, is still about US$2 billion larger than in 2001, when net foreign debt was equivalent to 31 percent GDP (Figure 1).

Figure 1.
Figure 1.

Net External Debt Position of the Uruguayan Economy 1/

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A002

Source: Staff calculations based on Central Bank data1/ The Figure plots, for each year: a) total external assets of the nonfinancial public sector and Central Bank (“Assets”), b) total external obligations of public and private sector (“Liabilities”) and c) Net external Assets (“Foreign Currency Mismatch”)

5. Uruguay’s exposure to reversals in short-term external financing flows and sudden withdrawals of nonresident deposits has declined, even compared to pre-crisis levels. The net short-term debt of US$2.8 billion in 2001 switched to a net short-term asset of US$1.7 billion in 2005 (Figure 2). Bank’ accumulation of short-term foreign currency assets and a significant reduction in nonresident deposits have made the banking system less vulnerable to changes in portfolio preferences in neighboring countries. While in 2001 nonresident deposits accounted for 50 percent of total private sector deposits, by end-2005 this ratio had declined to about 20 percent. Banks’ liquid assets now cover more than twice the level of nonresident deposits, compared with about 80 percent in 2001.

Figure 2.

External Maturity Mismatch of the Uruguayan Economy 1/

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A002

Source: Staff calculations based on Central Bank data1/ The Figure plots, for each year: a) the sum of short-term, foreign currency external assets of the public sector, central bank (net of monetary base) and commercial banks (“Assets”), b) total short-term external debt and short-term nonresident deposits (“Liabilities”) and c) Net short-term external assets (“Short Term FX Mismatch”).

6. The share of equity financing has been recovering toward pre-crisis levels. After falling sharply with the crisis, Uruguay’s “equity buffer” has systematically increased (Figure 3). The key advantage of FDI over debt financing is that its payoffs (profit and dividend remittances) are directly linked to the “capacity to repay.” While profits and dividends fall in bad times, debt-service payments generally remain unchanged.

Figure 3.
Figure 3.

Net Inward FDI Stock, as a share of Net Total External Financing 1/

(In percent)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A002

Source: Staff calculations based on Central Bank data.1/ Net Inward FDI stock, as a percent of net external debt stock plus net inward FDI stock.

C. Sectoral Balance Sheets

7. The four sectors identified in the paper vary in the magnitude of their currency and maturity mismatches. Some of these sectoral mismatches partly offset each other in the aggregate, as for example, long open foreign exchange position of households contrast with the short open foreign exchange positions of the government and nonfinancial companies.

Public sector (including the Central Bank)

8. Public debt as a share of GDP has declined significantly, but is still higher than before the crisis. Strong growth, lower interest rates, peso appreciation, and the improved fiscal position have lowered the debt of the nonfinancial public sector and the central bank to GDP from 93 percent at end-2002 to 83 percent at end-2005. Yet, Uruguay’s public debt-to-GDP ratio is still much higher than in 2001 (53 percent) and well above the median value for a sample of 30 other developing countries at end-2005 (46 percent). The improvement is much stronger at the nonfinancial public sector level: from 96 percent of GDP in 2002 to 69 percent of GDP in 2005.

Currency mismatches

9. The public sector has a substantial short net foreign currency position. Foreign currency liabilities of the public sector largely exceed its foreign currency assets. Foreign currency denominated debt accounts for about 72 percent of GDP, while gross reserves account for about 20 percent of GDP and government deposits in commercial banks for only a few percentage points of GDP. Despite the increase in peso-indexed debt since the crisis, Uruguay’s public debt is still one of the most dollarized in the world, with over 87 percent denominated in foreign currency (Figure 4). Balance-sheet risk arises from the natural mismatch between foreign currency debt obligations and peso revenue collection.

Figure 4.
Figure 4.

Share of Foreign-Currency Denominated Debt in Total Sovereign Debt, 2005

(In percent)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A002

Source: Staff calculations
Maturity mismatches

10. Following the end-May 2003 debt exchange, the authorities have lengthened the public debt average maturity and smoothed its amortization profile (Figure 5). Average maturity of debt has increased from 6.1 years at end-2002 to 7.6 years at end-2005. while high dollarization of sovereign debt is a source of vulnerability, it has also allowed the government to extend the maturity of outstanding obligations. Indeed, dollarization has helped Uruguay maintain a low share of contractual short-term debt (3 percent), unlike many other developing countries (Figure 6).

Figure 5.
Figure 5.

Changes in Sovereign Debt Structure 1/

(In percent of total debt outstanding, year-end)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A002

Source: Staff calculations based on Central Bank data1/ Most multilateral debt is indexed to a floating interest rate
Figure 6.
Figure 6.

Share of Contractual Short-Term Debt in Total Sovereign Debt, 2005

(In percent)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A002

Sources: Staff calculations and data provided by National Authorities.

11. The authorities have also increased liquidity cushions. At end-2005, gross reserves and government deposits in commercial banks exceeded short-term debt on a remaining maturity by US$1.4 billion. This liquidity cushion is slightly higher than in 2001, and a sharp contrast with the US$1.1 billion liquidity shortfall in 2002 (Figure 7).

Figure 7.

Foreign Currency Maturity Mismatch of the Consolidated Public Sector 1/

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A002

Source: Staff calculations based on Central Bank data1/ The Figure plots, for each y ear: a) the sum of short-term, foreign currency assets of the public sector and central bank (“Short Term FX Assests”), b) total short-term domestic and external debt of the public sector denominated in foreign currency (“Short Term FX Liabilities”) and c) Net short-term foreign currency assets (“FX Maturity Mismatch”).

Banking system (excluding the central bank)

Currency mismatches

12. Uruguayan banks have positive net open foreign exchange positions. Banks net open positions have increased from US$370 million in 2001 to US$450 million in 2005. Prudential regulations allow such positions to be positive or negative but limit their size to 1.5 times bank capital. Typically, the limits are not binding, although banks’ positions are usually positive; in 2005, they amounted to about 70 percent of capital. The value of dollar assets, however, can fall with peso depreciation (reducing the positive position) as some loans granted to companies with significant currency mismatches may become nonperforming and require provisions. Partly as a result of this, banks’ net open foreign exchange position became temporarily negative by US$1.5 billion during the 2002 crisis.

13. Financial sector dollarization has decreased only moderately, remaining among the highest in the world. Dollarization of outstanding resident deposits from the nonfinancial private sector has fallen from its peak of 90 percent to about 83 percent. Yet, it was among the highest among 121 developing countries, only below Cambodia and Liberia (Figure 8). Dollarization of credit has remained at about 70 percent in the period.

Figure 8.
Figure 8.

Share of Foreign Currency Deposits in Banking System, 2005

(In percent)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A002

Sources: Levy-Yeyati (2006) and IMF staff estimates.
Maturity mismatches

14. Bank assets and liabilities generally have become significantly more liquid and the maturity mismatch has decreased. Banks have increased holdings of liquid assets (short-term foreign assets, central bank deposits and securities, and short-term government securities) from 34 percent to 52 percent of total assets between 2001 and 2005. This partly reflects the high dollar liquidity requirements imposed on specific banks for prudential reasons. While maturity of term deposits was typically under a year before the crisis, sight deposits have increased their share in total deposits from 30 to 65 percent during the period. The ratio of liquid assets to total deposits has risen from 49 to 82 percent. The increased liquidity is the flip side of the coin of low credit, which is partly explained by low credit demand and tightened credit standards (see Chapter IV).

Pension funds

15. Pension funds have a substantial long dollar position. Private pension funds in Uruguay (AFAPs) manage their customers’ mandatory savings for retirement required by law. Pension funds compete with each other to attract contributors and provide an appropriate rate of return for these savings. The dollarization of pension fund portfolios has fallen from 81 percent in 2001 to 45 percent in 2005. The pension funds have a long foreign exchange position as they have basically no foreign exchange liabilities. In turn, pension funds have increased their share of inflation-linked securities to 48 percent of their portfolios, which only became available in larger supplies after the crisis (Tables 1 and 2).

Table 1.

Asset Composition of Pension Funds’ Portfolio

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Source: Staff calculations based on Central Bank data
Table 2.

Currency Composition of Pension Funds’ Portfolio

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Source: Staff calculations based on Central Bank data

Companies and Households

Companies

16. Uruguayan companies continue to have substantial short open foreign exchange positions. The 2005 annual survey of economic activity found that 80 percent of the companies (in a sample of 408 nonfinancial companies) had substantial dollar debt with short-term maturity at end-2004 (Table 3). Preliminary data suggests that the results carry over to 2005. The survey also found that about half the companies had short-term dollar obligations exceeding their annual dollar earnings. Of these companies, only 5 percent used derivatives to hedge its exposure to exchange rate risk. The companies with the highest net open foreign exchange positions were concentrated in manufacturing and transportation.

Table 3.

Currency Composition and Maturity Structure of Financial Liabilities of the Corporate Sector in Uruguay: December 2004

(In percent)

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Source: Staff calculations based on data collected in De Brun, Gandelman, Kamil, and Porzecanski (2006)

17. The corporate sector remains vulnerable to market changes. Liability dollarization and short-term maturity of debt has remained high and almost unchanged with respect to 2001, even after controlling for exchange rate valuation effects. Uruguayan companies feature the highest ratios of liability dollarization and debt structures with the shortest maturities in Latin America (Table 4). Stress tests show that Uruguayan firms are resilient to the direct impact of moderate exchange rate shocks (Appendix). However, the indirect effect arising from a sharp drop in the dollar value in the income of companies selling nontradable goods to the domestic market would have a large toll.

Table 4.

Dollarization and Residual Maturity of Total Liabilities of the Corporate Sector in Latin American Countries 1/

(Median values, in percent)

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Sources: De Brun, Gandelman, Kamil, and Porzecanski (2006), Kamil (2005) and Munyo (2005)

Includes financial debt, supplier credit, and other liabilities.

Households

18. Households have a substantial positive net open foreign exchange position. Savings of Uruguayan residents in the domestic banking system (of about US$ 7.6 billion) and in banks abroad (of some US$5.4 billion) are largely denominated in U.S. dollars.2 Household loans from the domestic banking system amount to US$530 million at end-2005, of which 75 percent is in domestic currency.

19. Households have accumulated significant assets in private pension funds since their introduction in 1993. As pension funds invest most of households’ savings in government securities, households have become more exposed to the public sector. Thus, a previously implicit public sector liability — the net present value of expected pension payments —has become explicit in the form of government securities held by pension funds.

D. Cross-Sectoral Linkages

Exposure to domestic government debt

20. Banks’ exposure to public sector assets has remained relatively small. Banks hold less than 10 percent of their assets in government debt and bank holdings account for only 5 percent of the stock of government securities. This direct bank exposure to the government is low compared with other emerging market countries (Figure 9). However, state banks’ exposure to the public sector has indirectly increased as a result of higher levels of state-guaranteed debt in the aftermath of the crisis. Considering the government guarantee on BROU’s claims on BHU and the trust funds with nonperforming loans formerly on the books of BROU, the exposure of the banking system to the sovereign would increase to 14 percent.

Figure 9.
Figure 9.

Domestic Bank Holdings of Government Debt in selected Emerging Market Countries: December 2004

(In percent of total government debt outstanding)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A002

Source: Global Financial Stability Report (2006)

21. Pension funds are heavily exposed to sovereign risk. They are the principal institutional investors in Uruguay, managing more than US$2 billion at end-2005. Some of the investment limits on the issuer, currency denomination, and jurisdiction of the securities pension funds are close to binding. About 60 percent of pension fund portfolios are invested in government securities, of which 40 percent are dollar-denominated and the remainder inflation-indexed. The share of government securities in pension fund portfolios is similar to that in Argentina, Colombia, and Mexico, but much larger than those in Brazil and Chile. Pension fund holdings of central government domestic debt account for half of the holdings of domestic residents (Table 5). Pension fund investments in nonfinancial private-sector instruments are about 3 percent and well below the limits, reflecting their small supply.

Table 5.

Holders of Central Government Bonds

(Stock of Domestically-Issued debt at year-end)

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Source: Staff calculations based on data from Central Bank

E. Exchange Rate-Induced Credit Risk of Domestic Banks

22. Bank’ exposure to credit risk arising from dollar lending to borrowers without dollar earnings has fallen. While banks would, in principle, benefit from peso depreciation given their long net open foreign exchange position, balance sheets would deteriorate because part of their portfolio would become nonperforming. Yet, banks credit risk exposure has diminished because the size of the dollar loan portfolio has declined and the share of dollar loans to the nontradable sector in total dollar credit has fallen from 46 to 31 percent during 2003–2005 (Table 6). Nevertheless, exchange rate-induced credit risk remains a significant issue for Uruguay.

Table 6.

Share of Foreign Currency Credit to the Nontradable Sector in Total Credit 1/

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Source: Superintendency of Banks.

Tradable sector proxied by agriculture and industry

Weighted average

F. Conclusions

23. Financial dollarization is at the heart of significant—albeit reduced—balance-sheet vulnerabilities in Uruguay. Savings of Uruguayan residents continue to be largely denominated in foreign currency, while the government and most Uruguayan companies, the users of these savings, do not have steady income streams in foreign currency terms. In terms of currency exposures, the long position of households has been used to help finance the short position of the government and companies. However, under a sharp drop in the real value of the Uruguayan peso, government and companies may not be able to honor their dollar debt. Banks would be indirectly affected through their exposure to companies, and if banks fail, stakeholders (including the public sector and households) will be ultimately hurt. Pension funds manage the mandatory savings of households and fluctuations in the real value of their portfolio would ultimately also affect households.

24. The high public debt also poses important challenges. While short terms risks have declined, large and sustained changes in market sentiment would pose risks for macroeconomic stability. Within the Uruguayan economy, the pension funds are particularly exposed to sovereign risk. While bank’ sovereign exposure is small, they would be affected by a worsening in economic conditions.

25. The government should stay the course to reduce dollarization and the high public debt. Continued large primary surpluses are needed to further bring down public debt as envisaged by the government. Consolidating a track record of prudent monetary management and flexible exchange rates would help entrench low inflation and discourage dollarization. Maintaining the policy of internalizing the risks of dollar lending to unhedged borrowers could further help reduce dollarization. Debt management could continue to gradually reduce the dollar share of public debt as peso savings increase and help offer attractive peso instruments.

26. Since currency preferences change slowly, developing markets for hedging Uruguayan peso risk could help reduce corporate and bank risks. Such a market would increase efficiency by transferring exchange rate risk to those better willing and able to bear it. The participation of foreign investors would be desirable given that Uruguay’s export base, while increasing, is still small. Beyond continued exchange rate flexibility, this would require further developing money markets and a reliable yield curve on peso securities.

References

  • De Brun, Julio, Néstor Gandelman, Herman Kamil, and Arturo Porzecanski, 2006, “The Fixed-Income Market in Uruguay,” mimeo IADB.

  • Kamil, Herman, 2005, “A New Database on the Currency Composition and Maturity Structure of Firms’ Balance Sheets in Latin America: 1990–2004,” mimeo IADB.

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  • IMF, 2005, “Debt-Related Vulnerabilities and Financial Crises: An Application of the Balance Sheet Approach to Emerging Market Countries,” IMF Occasional Paper, forthcoming.

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    • Export Citation
  • Levy-Yeyati, Eduardo, 2006, “Financial Dollarization: Evaluating the Consequences,” Economic Policy (forthcoming).

  • Munyo, Ignacio, 2005, “The Determinants of Capital Structure: Evidence from an Economy without a Stock Market,” Draft Universidad de la República (September).

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    • Export Citation

APPENDIX CORPORATE VULNERABILITY TO EXCHANGE RATE DEVALUATIONS: SENSITIVITY TEST RESULTS

This section analyzes companies’ vulnerability to peso depreciation at end-2004. It quantifies possible financial stress arising from unhedged currency mismatches in companie’ balance sheets using a unique data set of nonfinancial companies.

The data source is the 2005 official annual survey of economic activity conducted by the Uruguayan National Statistical Institute. The database provides detailed information for 2004 to measure balance-sheet currency mismatches in a sample of 408 nonfinancial companies. Available variables include the stock of foreign currency financial and nonfinancial debt, the share of short-term liabilities, the share of exports in total sales, the currency structure of interest expenses, the sources of financing (supplier credit, banks, bonds and retained earnings) and the companies’ forward exchange rate positions, if any.

The tests examine the effect of peso depreciation on nonfinancial companies’ liquidity and solvency. The portfolio of each company was stressed to nominal peso depreciation ranging from 5 to 100 percent. The tests define that a company becomes financially stressed when it cannot meet its short-term obligations (liquidity effect) or its equity position turns negative (solvency effect).

The results show that the corporate sector is resilient to the direct impact of moderate exchange rate shocks. Appendix Table 1 suggests only 6 percent of companies (accounting for 7 percent of sales) will be under financial distress with 20 percent peso depreciation. The share of affected firms increases with larger shocks, reaching 27 percent of the companies (accounting for 41 percent of sales) with 100 percent peso depreciation.

Appendix Table 1.

Stress Test Results of the Corporate Sector to an Exchange Rate Depreciation

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Source: Staff calculations based on data collected in De Brun, Gandelman, Kamil, and Porzecanski (2006)

These results should be considered as the smallest possible effect of depreciation on companies for several reasons. First, the tests only consider the direct effect of depreciation, disregarding the likely evolution of other variables, like an increase in interest rates. Second, the tests only consider the effect of depreciation on financial debt. Third, the tests only consider companies with initial healthy financial positions, not to contaminate the results with companies near bankruptcy. Finally, the tests assume that the value of dollar earnings does not change, whereas companies selling nontradable goods to the domestic market usually experience falls in their dollar income.

1

Prepared by Herman Kamil.

2

The paper assumes, for convenience, that resident nonfinancial private sector deposits belong to households. This assumption disregards working capital deposits by companies. Credit series distinguish between households and companies.

Uruguay: Selected Issues
Author: International Monetary Fund
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    Net External Debt Position of the Uruguayan Economy 1/

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    External Maturity Mismatch of the Uruguayan Economy 1/

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    Net Inward FDI Stock, as a share of Net Total External Financing 1/

    (In percent)

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    Share of Foreign-Currency Denominated Debt in Total Sovereign Debt, 2005

    (In percent)

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    Changes in Sovereign Debt Structure 1/

    (In percent of total debt outstanding, year-end)

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    Share of Contractual Short-Term Debt in Total Sovereign Debt, 2005

    (In percent)

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    Foreign Currency Maturity Mismatch of the Consolidated Public Sector 1/

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    Share of Foreign Currency Deposits in Banking System, 2005

    (In percent)

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    Domestic Bank Holdings of Government Debt in selected Emerging Market Countries: December 2004

    (In percent of total government debt outstanding)