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).

VI. Uruguay’s Growth story1

A. Introduction

1. This chapter assesses Uruguay’s growth performance during the last decades. Average per capita growth in Uruguay since the 1960s has been low and volatile, both for regional and international standards. Periods of strong growth have been short-lasting and were followed by deep recessions, closely tracking developments in Argentina. The paper first briefly discusses Uruguay’s growth patterns, then reviews the findings from growth accounting studies and assesses the extent to which cross-country regressions explain Uruguay’s performance. It then looks more closely at the external factors that have impacted on Uruguay’s growth.

A06ufig01

Growth Developments

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A006

2. A key conclusion of the paper is that growth in Uruguay has been supported by increased openness, but adversely affected by the country’s exposure to shocks in the region. While policies have been put in place to reduce vulnerabilities, such as a flexible exchange rate regime, diversification of trade and strengthened prudential regulations for the financial system, external risks still remain considerable. Also, domestic factors such as low investment, less developed financial markets and, in the past, volatile fiscal policies have been important constraints to growth. Policies to further improve the investment climate and local capital markets, and consolidate macroeconomic stability will therefore also be key to strengthen Uruguay’s medium-term growth outlook.

B. Volatility and Growth Trends—The Facts

3. Average per capita growth in Uruguay has been low compared to countries outside the region, but also for Latin American standards. Within the region, Uruguay stands out with weak per capita growth in the 1960s; it started to catch up in the 1970s, after Uruguay had implemented market-oriented reforms and opened the economy up to trade. As elsewhere in Latin America, the 1982 debt crisis led to a deep recession in Uruguay, resulting in negative per capita growth during the 1980s. Positive growth has since resumed, but has remained significantly below both the region as well as the Asian and industrialized economies. As a result, Uruguay’s per capita income adjusted for purchasing power relative to the U.S. has fallen from 45 percent in 1960 to about 30 percent in 2000.

A06ufig02

PPP-adjusted per capita GDP 1/

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A006

1/ Heston and Summers, World Penn Data, 2002.

Average Real GDP Per Capita Growth

article image
Source: Penn World Table

4. Uruguay’s economy has followed closely developments in its neighboring countries, particularly Argentina. While before the 1970s, Uruguay’s growth performance diverted from its neighboring countries, it has converged since, with Uruguay experiencing the same booms and busts as Argentina did. This may be related to increased regional financial and trade integration (deepened bilateral arrangements in 1985 and establishment of Mercosur in 1991), similar commodity export dependencies (beef and wool products), and similar exchange rate policies (Tablita, Argentine Convertibility Plan).

A06ufig03

Real GDP

(1963=1)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A006

5. Uruguay’s growth has been highly volatile. Uruguay’s per capita growth has been more volatile than the Latin American average, and in particular compared to other economies outside the region. Volatility in Uruguay has significantly increased beginning in the 1980s, broadly in line with increased volatility in Argentina. This higher volatility could have negatively weighted on long-run growth, as suggested by several empirical studies (see, for example, Loayza et al. (2004)).

A06ufig04

Uruguay: GDP Growth

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A006

Volatility of GDP Per Capita Growth 1/

article image
Source: Penn World Table

Standard deviation.

C. Explaining Uruguay’s Growth—Traditional Models

6. Growth accounting studies for Uruguay suggest that low physical factor accumulation was a factor limiting growth. For instance, estimates from Bosworth and Collins (2003) show that while annual total factor productivity (TFP) growth has been above Latin American averages, physical capital accumulation has fallen short, explaining Uruguay’s low growth performance. This is consistent with investment levels significantly below both regional and international standards. Further, when accounting for human capital measured by the years of schooling or labor income, De Brun (2001) and Fosattie Hughes et al. (2005) find that most of Uruguay’s TFP growth can be attributed to it.

Average Annual Investment Levels

(in percent of GDP)

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Source: IFS.

Growth Accounting-International Comparison 1/

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Source: Data from Bosworth and Collins (2003)

Unweighted averages.

A06ufig05

Growth Accounting

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A006

Source: Boworth and Collins.

7. Uruguay’s long-run growth performance is well explained by standard cross-country growth regressions (Table 1, Appendix). First, the relevance of key growth determinants as identified by Sala-i-Martin (2004) is tested in explaining Uruguay’s average growth performance during 1960–2000. Including variables such as the conditions in 1960 for income, education, the fraction of tropical area, the density of population in coastal areas, the share of mining in GDP and cost of investment, the years an economy has been open, about 55 percent of average cross-country growth in 1960–2000 can be explained. A dummy for Uruguay is included, which is statistically insignificant, pointing to the fact that Uruguay’s growth is well explained within the standard regression framework.

8. Other characteristics could further help explain Uruguay’s growth.

  • Fiscal policy volatility. Mody and Schindler (2005) conclude in a cross-section study that high fiscal policy volatility has negatively affected growth. In the case of Uruguay, while the fiscal deficit has been contained, overall fiscal policy volatility relative to other countries has been significant.

  • High vulnerability to international liquidity conditions. There is a substantial literature on the link between external conditions and balance of payment pressures on growth. Rodrik and Velasco (1999) established that almost all countries affected by the financial turmoil of the 1990s had low ratios of international reserves to short-term external debt prior to the crisis, making them vulnerable to sudden stops, with sharp impacts on growth. Comparing an indicator of external liquidity of Adrogue et al. (2006) (reserves to external debt ratio) across countries, Uruguay stands out with its low liquidity ratio and its high volatility.

  • Terms of trade volatility. Mendoza (1997), for example, finds that terms of trade volatility is important in explaining a country’s long-term growth performance, capturing the external demand for exports. Uruguay’s terms of trade volatility has been high in an international comparison.

  • Limited financial markets. There is a wide literature on the link between financial development and growth.2 To date, Uruguay does not have a well-developed stock market or market for fixed-income instruments. As a result, firms have relied mainly on domestic bank lending as well as foreign funds and retained earnings as sources of financing. While the private sector credit-to-GDP ratio has been broadly in line with other Latin American countries, with about 27 percent, it has been significantly below the one of the OECD countries.

A06ufig06

Discretionary Fiscal Policy and Overall Balance 1/

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A006

1/ Measure of procyclicality of fiscal policySource: Mody and Schindler (2005)

9. Adding these additional growth determinants to the cross-country regressions helps to further improve the fit of the model. In particular, the explanatory power increases significantly when external variables, such as the volatilities of the terms of trade and liquidity is added. Equations 2-12 point to the following correlations:

Domestic factors

  • ➢ Growth is positively correlated with the level of private credit.

  • ➢ Growth is negatively correlated with fiscal volatility.

External factors

  • ➢ Growth is positively correlated with the degree of openness of the economy, but negatively with terms of trade volatility.

  • ➢ Growth is positively correlated with better liquidity conditions, but negatively with the volatility of liquidity and the level of external debt.

D. Impact of External Factors on Uruguay’s Growth—A Closer Look

10. Increased openness has helped spur Uruguay’s growth. There is a large empirical literature suggesting that openness to trade and financial integration has a positive impact on growth. This is also supported by the cross-country regressions in the previous section. In Uruguay, international trade and financial integration increased significantly in the mid-1970s, when trade linkages with the region strengthened, tariff and non-tariff import barriers were reduced, and the capital account was opened. Following this, growth in Uruguay increased significantly, as it allowed Uruguay to benefit from economies of scale, efficiency gains from increased competition, strong external demand, and augmentation in financing. Economic openness has further increased since, initially with Mercosur during the 1990s, and since 2001 with deepening of trade relations with the U.S., the European Union and Mexico. Both imports and exports amounted to about 30 percent of GDP in 2005, making Uruguay a fairly open economy by regional and international standards.

A06ufig09

Financial Integration

(in percent of GDP, average during 1970-2004)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A006

Source: Philip R. Lane and Gian Milesi-Ferretti
A06ufig10

Uruguay: Openess

(in percent of GDP)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A006

A06ufig11

Openness, 2005

(in percent of GDP)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A006

11. At the same time, Uruguay’s openness and the structure of its economy have made it vulnerable to developments in the region, commodity prices, and international interest rates. In a nutshell, it features high export market concentration, high financial linkages, large real exchange rate volatility, commodity dependency and dollarization. While many vulnerabilities have been declining over the last years, they remain large relative to other economies.

  • Export market concentration. Uruguay’s export dependency on the region had increased significantly in the 1990s, with goods exports to Argentina and Brazil reaching 60 percent of total exports in 2000, compared to 35 percent in 1990. While this share has dropped sharply over the last years with increased exports to the U.S. and the European Union, as noted above, concentration is still high compared to other countries (Table 2, Appendix). Further, about 60 percent of Uruguay’s tourist industry (which accounted for about 4 percent of GDP in 2005) depends on visitors from the region.

  • Strong financial linkages with Argentina. Uruguay has attracted fewer foreign portfolio investors than other countries in the region, owing in part to its less developed capital markets. This has reduced risks of herding behavior and speculative flows. At the same time, Uruguay’s financial linkages with Argentina were particularly high, and increased significantly during the 1990s, with nonresident deposits mainly from Argentines accounting for 40 percent of banking system deposits (or 35 percent of GDP) in 2001. While this brought some benefits—such as rapid growth of the financial service industry—it also made the financial system highly vulnerable to sudden withdrawals as demonstrated during the 2002 crisis. Also, Argentine demand for real estate in Uruguay has been a key driver of asset price booms and busts. Today, financial linkages with Argentina have been reduced significantly and prudential regulations have been put in place to limit the linkages to the local economy (Box 1); nevertheless, they remain important, with nonresident deposits accounting for 17 percent of total deposits (10 percent of GDP).

  • Fixed exchange rate regimes. Loayza et. al (2004) show in cross-country studies that real exchange rate overvaluation has negatively impacted growth by producing misallocation of resources and increasing the risk of a balance-of-payments crisis. In the case of Uruguay, the depreciations of the Argentine peso in the early 1980s and 1991 resulted in sharp real appreciations of the Uruguayan peso and a loss in exports to and increase in imports from Argentina, leading to deep recessions. Similarly, during the crawling band of the 1990s when the Brazilian real in 1999 and the Argentine peso in 2001 were devalued, the Uruguayan peso appreciated significantly in real effective terms, contributing to a loss of export competitiveness (see Chapter III). Today, Uruguay and its neighbor countries have floating regimes, increasing the ability to absorb shocks.

  • Commodity dependency. About half of Uruguay’s exports are agricultural commodities (15 percent of GDP), which are subject to large price fluctuations in international markets. In particular, prices of beef (in real terms)—Uruguay’s main agricultural export commodity—have fluctuated widely with a standard deviation of 60 percent over the last 40 years. Also, Uruguay is fully dependent on oil imports, which accounted for 6 percent of its GDP or one-fourth of its imports in 2005.

  • Interest rate linkages. Baliño et al. (1999) point out that in highly dollarized economies—such as Uruguay with 85 percent of financial system assets in dollars—there is very little room for countercyclical monetary policy, with domestic interest rates sharply influenced by U.S. ones. While efforts are underway to dedollarize the economy through development of local capital markets and domestic currency instruments, currency preferences change only slowly over time.

A06ufig12

Exports to the Region

(in percent of total exports)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A006

A06ufig13

Uruguay: Non-resident Deposits in Total Deposits

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A006

Measures Taken to Reduce the Risks associated with Financial Linkages

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A06ufig14

Uruguay: Bilateral Real Exchange Rate

(2000=100)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A006

A06ufig15

Commodity Prices

(1961 prices=100)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A006

12. As a result, Uruguay’s business cycle correlation with Argentina has generally been very high.3 For instance, the correlation of Uruguay’s GDP and Argentine consumption growth is high (80 percent) and has increased over time. The correlation is about 30 percent with Brazil, and 10 percent with the U.S. Argentine and U.S. consumption clearly Granger-cause Uruguay’s GDP, but Brazil’s consumption does not (Table 3, Appendix). A VAR estimated on logs of Uruguay’s GDP and Argentine and U.S. consumption for the time period 1985-2005, shows that about 80 percent of the variance in Uruguay’s GDP in a two-year horizon is explained by Argentine consumption and 10 percent by U.S. consumption. 4 Further, Argentine consumption and Uruguay’s GDP are strongly cointegrated, with an elasticity of 1.0, whereas the one with U.S. consumption is about 0.1 (Table 4, Appendix). Moreover, 65 percent of the deviation of the Uruguayan GDP from the long-run relationship is corrected within one year, suggesting a very fast pass-through of changes in Argentine consumption to the Uruguayan economy.

A06ufig16

GDP in Uruguay and Real Consumption in Argentina

(1985=100)

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A006

A06ufig17

Variance Decomposition of URY

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A006

13. VAR analysis further suggests that besides Argentine consumption the terms of trade have played a significant role in determining Uruguay’s short–term growth. We test to what extent Uruguay’s GDP growth is explained by other external variables by including the terms of trade, the REER, and U.S. Libor rates in the VAR. The results show that an increase in Argentine consumption and improvements in the terms of trade have a strong positive impact on Uruguay’s growth, and an increase in U.S. interest rates or of the real exchange rate have a negative impact. The results also suggest that Argentine consumption has the largest impact on Uruguay’s GDP, with 50 percent of Uruguay’s growth variance within a two-year time horizon explained by it, followed by the terms of trade with 20 percent, U.S. interest rates with 10 percent, and the real exchange rate with 5 percent.

A06ufig18

Accumulated Response of GDP to Cholesky One S.D. Innovations

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A006

A06ufig19

Variance Decomposition of GDP

Citation: IMF Staff Country Reports 2006, 427; 10.5089/9781451839364.002.A006

E. Conclusions—Looking Ahead

14. Uruguay’s growth performance is characterized by low long-term rates, high volatility, and close correlation with Argentina. This pattern is well explained by domestic and external factors.

  • Domestic conditions, such as less developed financial markets, low investment, and volatile fiscal policies have contributed to Uruguay’s low long-term growth rates. Much of Uruguay’s long-term growth performance can be attributed to total factor productivity, with physical capital accumulation significantly below other countries.

  • External factors such as openness have been important contributors to growth, reflecting the benefits of economies of scale, external demand, and efficiency gains from increased competition. At the same time, trade and financial integration with volatile economies in the region, commodity price dependencies, and, until recently, fixed exchange rate regimes have made the economy vulnerable to external shocks.

15. Recent policies have contributed to reduced external growth vulnerabilities, but need to be sustained into the medium term. Trade and financial dependencies to Argentina have been reduced by extending trade beyond Mercosur and by putting prudential regulations in the financial sector in place to internalize cross-boarder risks, but trade linkages to Argentina remain significant and non-resident deposits large. The high public debt has been set on a declining path, and Uruguay continues to rebuild reserves to strengthen its still relatively weak external liquidity position. Further, Uruguay, like its neighboring countries, has switched to a flexible exchange rate regime, reducing the risks of exchange rate overvaluation with possible adverse impacts on exports, and the risks of sudden corrections, which have often led to financial crises followed by deep drops in GDP. While much has been achieved, progress needs to continue to reduce the still significant medium-term risks to growth.

16. Also, further improving domestic conditions would be important to achieve lasting growth. This covers improving the investment climate, including by strengthening the bankruptcy framework and establishing and establishing a private sector relations office, deepening local capital markets, and consolidating macroeconomic stability. The government is also advancing important structural fiscal reforms to ensure a stable fiscal framework and increase room for public investment in the budget. A tax reform is expected to be adopted over the next months which would improve the structure and efficiency of the tax system. Also, Uruguay is working toward private participation in public infrastructure projects, which should further spur efficiency and help increase investment, and is planning to strengthen government procurement procedures.

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APPENDIX

Table 1:

Uruguay: Cross-Country Growth Regressions

(1960-2000)

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Robust p values in parentheses

significant at 10%;

significant at 5%;

significant at 1%

Description of Key Variables in Cross-Country Regressions

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Table 2:

Index of Export Diversification

(share of total exports)

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Source: Fund staff estimates.
Table 3:

Granger Causality Test 1/

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First differences of the logs of Uruguay GDP and Argentine, Brazilian and US consumption between 1985-2005. Tested for statinarity using the Dickey-Fuller test.

Table 4:

Cointegration Vector

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1

Prepared by Stephanie Eble.

2

See, for example, King and Levine (1993); Levine, Loayza and Beck (1999); and Levine (2005).

3

See Fanelli and Gonzalez-Rozada (2003), Voelker (2004), Kamil and Lorenzo (1998), and Masoller (1998).

4

Brazilian consumption was not significant in the long-term cointegrating relationship and thus excluded. This is in line with the findings of Fossati Hughes et al. (2005). Also, Masoller (1998) finds that Uruguay’s GDP is mainly explained by Argentine consumption.

Uruguay: Selected Issues
Author: International Monetary Fund