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).

III. Assessing Competitiveness in Uruguay1

A. Overview

1. International competitiveness is of key importance to Uruguay, given the significance of sustained export growth for its economic development potential. Given the small size of the Uruguayan economy, export markets are key for domestic companies to seek economies of scale. Moreover, foreign direct investment, which tends to develop favorably under conditions of sustained competitiveness, can play a vital role in boosting productivity. Following a marked real depreciation of the peso during the 2002 crisis, the real effective exchange rate (REER) has been appreciating since early 2004. While Uruguay’s REER remains around 20 percent below its pre-crisis level, some observers have asked whether the recent trend of real appreciation may have led to a problem of competitiveness.

2. This chapter assesses Uruguay’s competitiveness, against the backdrop of substantial fluctuations in exports and the REER during the last decade. Section B examines balance of payments trends, including recent export performance and market destinations. Section C looks at competitiveness from the perspective of several indicators, including the ratio of tradable to non-tradable prices, cost and profitability measures, as well as real exchange rates and their alignment with purchasing power parity (PPP) and the income level. Section D presents an estimation of the equilibrium REER and, while recognizing the limitations of this quantitative approach, provides an interpretation regarding the degree of the peso’s alignment. Section E presents Uruguay’s position in international competitiveness rankings. Conclusions are presented in Section F.

3. The majority of indicators suggests that Uruguay has remained competitive. Export performance has remained buoyant; Uruguay attracts increasing amounts of FDI; and most competitiveness indicators suggest that the tradable goods sector has remained attractive, including in relation to the non-traded sector. Uruguay’s CPI-based REER remains substantially more depreciated than before the crisis and appears to be roughly in line with international experience after accounting for productivity differentials. Quantitative analysis suggests that the REER is not far from its equilibrium level. While elements of judgment are inevitable, the presented indicators thus support the notion that Uruguay’s competitiveness is not out of line. However, some of the presented indicators, while pointing to continued competitiveness, are on a declining trend, and Uruguay should continue to improve its institutional and business environment that affect competitiveness from a structural angle.

B. External Sector Performance

4. A current account near balance, despite increased foreign investment and imports, suggests that Uruguay has remained competitive (Figure 1). Following the immediate post-crisis recovery, exports have continued to grow at a healthy pace, posting 20 percent annual growth (17 percent in volume terms) in 2005, well above the 30-year historical average of 9 percent. Imports, which had contracted more than exports during the crisis, have shown even higher growth since the recovery, reflecting higher investment, the revival of domestic demand, as well as increased import prices for commodities such as oil. The current account deficit of ½ percent of GDP was significantly smaller than the 30-year historical average (2 percent), and more than covered by FDI alone.

Figure 1.

Merchandise Trade and Current Account, 1997-2005

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A003

5. Uruguay’s share in world export markets declined through the recession and crisis years, but has started to recover since 2003 (Figure 2). While Uruguay’s market share in exports to its two large neighboring countries, Argentina and Brazil, has been declining over the last few years, it has been offset by an increased export market share in the U.S., with exports to the U.S. now of similar magnitude than those to Mercosur. While this has increased export market diversification, the concentration in agricultural exports, especially beef, has increased (Figure 3). Exports of wood and wood products have also been rising, while manufacturing exports have been essentially stable, with the exception of textile exports, which have been declining. Shifts are also evident in tourism revenue (Figure 4). While Argentina remains the most important source of tourism receipts, its importance has been declining relative to inflows from Brazil and the EU.

Figure 2.
Figure 2.

Market Shares in Selected Export Destinations, 1997–2005

(In percent)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A003

Figure 3.
Figure 3.

Structure of Merchandise Exports, 1993 and 2005

(In percent of total)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A003

Figure 4.
Figure 4.

Uruguay: Tourism Receipts, 1997-2005

(in percent of total)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A003

Source: Uruguayan Authorities

6. Inflows of foreign direct investment have increased strongly, a telltale for Uruguay’s attractiveness as a location for investment (Figure 5). From the late 1990s, and interrupted only briefly by the 2002 crisis, net foreign direct investment inflows have grown substantially, and are now higher than in Argentina and Brazil as percentage of GDP. While in 2005 this partly reflects initial investments of the pulp mill projects, the upward trend has been apparent during the last decade, illustrating that it is broad-based.

Figure 5.
Figure 5.

Foreign Direct Investment, 1997-2005

(in percent of GDP)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A003

Source: WEO

C. Competitiveness Indicators

7. Although the ratio of tradable to non-tradable goods prices has declined since the crisis, it remains substantially above pre-crisis levels (Figure 6). This ratio, derived from the components of the consumer price index, can be interpreted as an indicator of internal competitiveness between the tradable and non-tradable sectors. Sometimes referred to as the internal exchange rate, an increase in this ratio points to a rise in relative competitiveness of the tradable sector. After having increased markedly with the 2002 devaluation, the ratio has been on a declining trend, and by February 2006, it had returned to 1998/99 levels. Nonetheless, by this measure, the relative attractiveness of the tradable sector remains substantially above the levels observed before the crisis.

Figure 6.
Figure 6.

Uruguay: Ratio of Tradable to Non-Tradable Prices

(Index: 2000=100)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A003

Sources: National Statistical Institute, and Fund staff calculations

8. Proxies for profit margins of the tradable sector underscore its continued attractiveness. Figure 7 shows the ratio of export unit values to wages and unit labor costs (ULC). Relative to wages, export prices have been declining since 2004, but have remained above pre-crisis levels. Factoring in productivity increases, the ratio of export prices to ULC is a somewhat closer proxy for profit margins in the export sector. This ratio has improved more during the crisis and fallen by less since, remaining more than 80 percent above its pre-crisis level in 2001.

Figure 7.
Figure 7.

Uruguay: Export Price Ratios

(Index, 2000=100)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A003

Sources: BCU, National Statistical Institute, WEO, IFS, and Fund staff calculations

9. Bilateral real exchange rates (RER) with respect to major trading partners have shown markedly differing developments (Figure 8). The RER with respect to Argentina appreciated strongly in late 2001 when the Argentine peso devalued, but a pick-up in Argentina’s inflation rate and subsequently the devaluation of the Uruguayan peso quickly reversed a large share of that appreciation. Since 2003, the bilateral RER has been appreciating again, largely reflecting the nominal appreciation of the Uruguayan peso at a time when the Argentine currency did not appreciate much. By contrast, the RER with respect to Brazil has been depreciating since 2002, reflecting in part Uruguay’s devaluation and, more recently, the strength of the Brazilian real. The RERs with respect to the U.S. and the Euro area have depreciated through the crisis period, and have only partially recovered since.

Figure 8.
Figure 8.

Real Exchange Rate Relative to Selected Trading Partners, 1997-2005

(Index, 2000=100)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A003

10. The value of the peso appears broadly in line with differences in productivity. Figure 9 plots per-capita income levels—as a proxy for productivity in the tradable sector—against the ratio of market exchange rates to estimated PPP exchange rates for selected Latin American countries, and a regression line based on a cross section of 180 countries. The upward-sloping regression line reflects the notion that a country’s real exchange rate tends to appreciate as its productivity increases. Higher productivity in the tradable sector tends to induce an increase in tradable sector wages, and as wages equalize across sectors, this would induce higher prices for non-tradable goods and thus an increase in consumer prices relative to trading partners—and hence a real appreciation (Balassa-Samuelson effect). Countries above (below) the regression line could be interpreted to have a relatively more appreciated (depreciated) RER than explained by differences in productivity, proxied in the chart by per-capita income. By this measure, Uruguay’s RER appears broadly adequate: having depreciated substantially during the 2002 crisis, Uruguay’s exchange rate has recovered in 2004–05 to close to the regression line.

Figure 9.
Figure 9.

Uruguay: Exchange Rate and Per-Capita GDP, 2001-05

(compared to selected Latin American economies, 2005)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A003

11. The trade-weighted CPI-based REER remains around 20 percent below its pre-crisis level (Figure 10). After relative stability in the late 1980s and a long period of real appreciation throughout the 1990s, the REER depreciated by some 35 percent in 2002, and has since recovered to around 80 percent of its 2001 level.

Figure 10.
Figure 10.

Uruguay: CPI-Based REER, 1985-2005

(Index: 2000=100)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A003

Sources: INS, Fund staff calculations

12. The PPI and ULC-based REER measures also support the notion that Uruguay has remained competitive (Figure 11). Given the higher share of tradable goods in the PPI than in the CPI, the PPI-based REER has shown less variability in the face of nominal exchange rate movements. Nonetheless, it underwent similar trends as the CPI-based variant and remains more than 10 percent below pre-crisis levels. As an indicator of cost competitiveness, the ULC-based REER, which can be interpreted as an indicator of relative profitability in the production of traded goods in the domestic economy vis-à-vis trading partners, remains around 43 percent more depreciated than its pre-crisis level in 2001.

Figure 11.
Figure 11.

Uruguay: Real Effective Exchange Rates, 1997-2005

(Index: 2000=100)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A003

Sources: INS, WEO, Uruguayan authorities, and Fund staff calculations

D. Estimating an Equilibrium REER

13. The estimation of an equilibrium REER can shed light on whether the REER is currently misaligned. Among the large body of literature on the estimation of equilibrium REERs, a recent strand follows the “adjusted PPP” approach, relating the dynamics of REERs to a set of underlying economic fundamentals, typically including measurements for productivity differentials, the openness to trade, the external financial position, and other variables (see, for example, Bayoumi and others. (2005)).

14. The dataset consists of a number of commonly considered potential determinants of the equilibrium real exchange rate, using quarterly data from 1988–2005:

  • Per capita real GDP relative to trading partners (RGDP). This variable is calculated as Uruguay’s real per capita GDP divided by a trade-weighted basket of per capita real GDP of Uruguay’s trading partners. It is a proxy for productivity differentials in the traded sector between Uruguay and its trading partners, intended to capture the Balassa-Samuelson effect. An increase in this variable would be expected to be positively correlated with increases (i.e., an appreciation) in the REER.

  • Manufacturing output relative to trading partners (MANOP). Calculated as the ratio of Uruguay’s manufacturing output relative to a trade-weighted basket of manufacturing output in Uruguay’s trading partner countries, this variable proxies the relative supply of traded goods. Assuming imperfect substitutability between traded goods produced in different countries, an increase in domestic manufacturing output relative to trading partners would tend to reduce the domestic price of manufactured products, likely weighing more on the domestic CPI than on trading partners’ CPIs. An increase in relative manufacturing output would thus be expected to be associated with a declining REER.

  • Fiscal balance as percent of GDP (FIS). An improvement in the fiscal balance would normally be associated with a decline in domestic demand. To the extent that the decline in spending affects non-tradable goods, their prices, and thus also the REER, would be expected to decline.

  • Terms of trade (TOT). An increase in the terms of trade would normally be associated with an increase in the REER, given wealth effects on domestic demand.

  • Openness (OPEN). Calculated as the ratio of the sum of exports and imports to GDP, increased openness would tend to be associated with a more depreciated REER. As restrictive trade policies tend to increase the domestic price of traded goods, their removal would likely induce a decline in the domestic price level and thus in the REER.

  • Ratio of net foreign assets to exports (NFA). Net debtor countries would need a more depreciated REER to generate the necessary trade surpluses to service their external obligations. Decreases in NFA would therefore tend to be associated with a decreasing REER.

  • Real interest differential (RIDA). The difference between real interest rates in the domestic economy and its trading partners is expected to be positively correlated with the REER. An increase in real interest rates can reflect an increase in aggregate demand, increases in the productivity of capital, or tight monetary policy, all of which would tend to be associated with an appreciating REER.

15. Unit root tests point to the non-stationarity of all variables (Table 1). ADF tests support the notion of first-order integration at the 5 percent level for all variables except for OPEN and RIDA, which appear I(2). A prefix L indicates that the variable is expressed in logs. All variables (except for REER) enter as 8-quarter moving averages, attempting to smooth out short-term fluctuations that would distort an estimation of the equilibrium REER.

Table 1.

ADF unit root tests

article image

MacKinnon (1996) one-sided p-values

16. Estimating a vector error correction model (VECM), a co-integrating relation is found between the real effective exchange rate, real GDP relative to trading partners and net foreign assets. The existence of one co-integrating relation between these variables is confirmed by the Trace and Maximum Eigenvalue tests at the 5 percent level. The variables in the estimated long-run co-integrating relationship show the expected signs (Table 2). In particular, an increase in relative real per capita GDP by 1 percent is associated with a real appreciation of 2.4 percent, and an increase in net foreign assets of 1 percent of exports is associated with a real appreciation of 2 percent. Moreover, 37 percent of the deviation of the REER from its estimated long-run relation is eliminated within one quarter, suggesting that, in the absence of further shocks, half of the gap would be closed within about 4½ months.

Table 2.

Selected VECM Results

article image

17. The estimated equilibrium relation suggests that the REER is not overvalued. Figure 12 plots the estimated equilibrium rate and an estimated 95 percent confidence interval. Relative to the estimated equilibrium relation, Uruguay’s REER was fairly well aligned throughout much of the 1990s. From late 2000 until the crisis, the REER was then increasingly overvalued, as the exchange rate regime prevented the REER from depreciating while the equilibrium rate, induced by the recession, declined markedly. With the floating of the exchange rate in mid-2002, the REER returned close to equilibrium. At end-2005, the REER was slightly below equilibrium, but within the estimated 95 percent confidence interval.

Figure 12.

Actual and Estimated Equilibrium REER, 1988-2005

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A003

18. Taken in isolation, these results do not lend themselves to an overly firm interpretation, but jointly with other indicators they suggest that the exchange rate of the peso is not an issue for competitiveness. The presented exercise has merely demonstrated that the REER is currently slightly, but not significantly, below an estimate of the equilibrium REER, which is based on the average historical responsiveness to changes in relative real per capita GDP and NFA. Nevertheless, in conjunction with other evidence studied in previous sections, this exercise has lent further support to the hypothesis that Uruguay does currently not have a competitiveness problem.

E. International Competitiveness Rankings

19. This section presents Uruguay’s placement in international competitiveness rankings based on a variety of data and surveys. While the analysis presented so far has been based on an assessment of macroeconomic and financial data, the World Economic Forum’s (WEF) World Competitiveness Indicators and the World Bank’s Cost of Doing Business rankings used in this section focus on competitiveness from a structural angle, including institutional and business environment considerations.

20. Uruguay takes a midfield position in the WEF’s survey. Out of 117 countries covered in the survey, Uruguay ranks at position 54 (with 1 indicating the highest ranking) for growth competitiveness (Argentina: 72; Brazil: 65) and at 70 for its business competitiveness (Argentina: 64; Brazil: 49). Uruguay fares relatively well regarding its technology infrastructure (PCs, internet hosts and telephone lines), enrolment in tertiary education, low levels of organized crime, good judicial independence and low favoritism in decisions of government officials. However, macroeconomic environment factors weigh on that result, including the still high level of government debt, low credit ratings and limited access to credit. Similarly, some technology-related factors lower the ratings for Uruguay, including low company spending on research and development, and the low number of utility patents. Survey participants named as the most problematic factors for doing business in Uruguay the access to financing, inefficient government bureaucracy, tax rates and regulations, policy instability, restrictive labor regulations, and inadequate supply of infrastructure.

21. The World Bank’s “Doing Business in 2006” ranking for Uruguay is similar. Out of 155 countries, Uruguay ranks at position 85 for its ease of doing business (Argentina: 77; Brazil: 119). Uruguay ranks relatively favorable regarding the ease of hiring and firing workers and the ease of shareholder suits. However, factors weighing on the survey result include the relatively high effective profit taxes and cumbersome tax procedures, complex and time-consuming procedures for starting a business, registering property and enforcing contracts, and a low recovery rate in bankruptcy cases.

22. Many of the shortcomings identified in these surveys have already started to be addressed. The macroeconomic environment is being stabilized and debt levels are being reduced. Profit taxes are being simplified and reduced in the context of the tax reform. Spending on infrastructure is being gradually expanded in the current 5-year budget. Inefficiencies in bankruptcy procedures are being addressed in the context of the reform of the bankruptcy code. While a promising start has thus been made, it will be important to continue these efforts in order to further improve Uruguay’s competitiveness from the institutional and business environment angle.

F. Conclusions

23. Most indicators suggest that Uruguay remains competitive. Uruguay’s external performance has remained solid and ratios of tradable to non-tradable prices and of export prices to ULC point to the continued attractiveness of Uruguay’s traded sector. The REER based on CPI (ULC) has remained some 20 (43) percent more depreciated than before the crisis. Moreover, the real exchange rate appears to be roughly in line with other countries after accounting for productivity differentials. A quantitative estimate of the equilibrium REER has lent further support to the impression that Uruguay does not have a competitiveness problem.

24. However, some indicators point to a trend of somewhat deteriorating competitiveness, and international competitiveness rankings show room for improvement. While still better than before the crisis, a number of indicators have entered a slowly deteriorating trend, including notably the ratio of tradable to non-tradable prices. It will thus be necessary to continue monitoring closely future developments in competitiveness. Moreover, structural factors constraining competitiveness, as identified, for example, in the recent WEF and World Bank rankings, should continue to be addressed.

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1

Prepared by Harald Finger (PDR)

Uruguay: Selected Issues
Author: International Monetary Fund
  • View in gallery

    Merchandise Trade and Current Account, 1997-2005

  • View in gallery

    Market Shares in Selected Export Destinations, 1997–2005

    (In percent)

  • View in gallery

    Structure of Merchandise Exports, 1993 and 2005

    (In percent of total)

  • View in gallery

    Uruguay: Tourism Receipts, 1997-2005

    (in percent of total)

  • View in gallery

    Foreign Direct Investment, 1997-2005

    (in percent of GDP)

  • View in gallery

    Uruguay: Ratio of Tradable to Non-Tradable Prices

    (Index: 2000=100)

  • View in gallery

    Uruguay: Export Price Ratios

    (Index, 2000=100)

  • View in gallery

    Real Exchange Rate Relative to Selected Trading Partners, 1997-2005

    (Index, 2000=100)

  • View in gallery

    Uruguay: Exchange Rate and Per-Capita GDP, 2001-05

    (compared to selected Latin American economies, 2005)

  • View in gallery

    Uruguay: CPI-Based REER, 1985-2005

    (Index: 2000=100)

  • View in gallery

    Uruguay: Real Effective Exchange Rates, 1997-2005

    (Index: 2000=100)

  • View in gallery

    Actual and Estimated Equilibrium REER, 1988-2005