This Selected Issues paper provides a real exchange rate and competitiveness assessment for Uruguay. It looks at the recent developments in key external competitiveness indicators such as the bilateral real effective exchange rates, export volumes, export market shares, export unit values, unit labor costs as well as foreign direct investment performance. The paper pursues an assessment of the real exchange rate following a broad-based strategy of applying four different approaches, including the purchasing power parity approach, the macroeconomic balance approach, the external sustainability approach, and the equilibrium real exchange rate approach.

Abstract

This Selected Issues paper provides a real exchange rate and competitiveness assessment for Uruguay. It looks at the recent developments in key external competitiveness indicators such as the bilateral real effective exchange rates, export volumes, export market shares, export unit values, unit labor costs as well as foreign direct investment performance. The paper pursues an assessment of the real exchange rate following a broad-based strategy of applying four different approaches, including the purchasing power parity approach, the macroeconomic balance approach, the external sustainability approach, and the equilibrium real exchange rate approach.

I. Exchange Rate and Competitiveness Assessment1

A. Introduction

1. This selected issues paper (SIP) provides a real exchange rate and competitiveness assessment for Uruguay. The assessment was conducted during the 2009 Article IV mission to comply with the requirements of the IMF’s 2007 Decision on Bilateral Surveillance. It comprises two parts. The first part looks at the recent developments in key external competitiveness indicators such as the bilateral real effective exchange rates, export volumes, export market shares, export unit values, unit labor costs as well as FDI performance. The second part pursues an assessment of the real exchange rate following a broad-based strategy of applying four different approaches, including the purchasing power parity approach, the macroeconomic balance approach, the external sustainability approach, and the equilibrium real exchange rate approach. For the last approach both panel data estimation techniques and a specific vector error correction model (VECM) for Uruguay are considered.

2. Despite the substantial appreciation of the Uruguayan peso since 2003, there are no signs of competitiveness problems. Following a marked real depreciation of the peso during the 2002 crisis, the real effective exchange rate (REER) has tended to appreciate since 2003. This appreciation has been partly the result of inflationary pressures in Uruguay relative to the ones in trading partners, in particular the US and Brazil. In spite of this, key indicators suggest that Uruguay has remained competitive. Export performance has been buoyant as confirmed by the increasing export volumes and market share in the world. There is also evidence of attractive profit margins in the export sector. In addition, Uruguay continues to attract increasing amounts of FDI, which is already high even by regional standards.

3. The real exchange rate is assessed to be broadly in equilibrium. The application of the four approaches mentioned above point to deviations of the REER from its equilibrium value that are smaller than six percent. Three out of the four approaches reveal that the peso would need to appreciate slightly to reach its equilibrium value, whereas the simple PPP approach suggests the opposite. These results are similar to those from the previous exchange rate assessment of 2008 the Article IV, which found that the REER was moderately undervalued.

B. Competitiveness Assessment Based on Key Indicators

4. Overall the real effective exchange rate (REER) has appreciated since 2003. After depreciating significantly in 2002-03, both the REER and the nominal effective exchange rate (NEER) have followed similar appreciation trends. However, in some years, the appreciation of the REER has been more pronounced than that of the NEER due to inflationary pressures in Uruguay relative to the ones in trading partners, in particular the U.S. and Brazil (see Figure 1). For instance, in 2007, the REER appreciated by 0.4 percent as a result of relative inflationary pressures of about 2.2 percent, while the NEER depreciated by 1.8 percent.

Figure 1.
Figure 1.

Uruguay

Citation: IMF Staff Country Reports 2010, 043; 10.5089/9781451839456.002.A001

Source: INS, Fund staff estimates

5. The bilateral REERs with respect to the main trading partners, namely Argentina and Brazil, reveal contrasting tendencies. While the bilateral REER with respect to Brazil has shown a tendency to depreciate, the bilateral REER with respect to Argentina has tended to appreciate since 2003. The depreciation of the REER with respect to Brazil has been mainly driven by a depreciation of the bilateral NEER, which has offset the positive inflationary differentials between Uruguay and Brazil. On the other hand, the appreciation of the REER between Argentina and Uruguay is largely explained by an appreciation of the bilateral NEER. Meanwhile, the bilateral REER with respect to the U.S. has also generally appreciated, although, in light of the global crisis, there was some depreciation in the second semester of 2008.

6. Uruguay’s export volumes, as well as the world market shares, have increased, despite the REER appreciation. Since 2003, growth in export earnings has been strong in an environment that benefited from booming commodity prices, particularly for three of the main traditional export products for Uruguay including meat, leather, and wool. In fact, volumes of exports have been on an increasing trend in the last six years, while Uruguay’s export market share has also somewhat risen, especially in 2008 (see Figure 2). Certainly, Uruguay’s market share in exports to its two main trading partners, Argentina and Brazil, has been declining over the last few years. However, this decline has been more than offset by an increase of the market share in exports to other countries including the US, Russia, China, and Japan.

Figure 2.
Figure 2.

Uruguay

Citation: IMF Staff Country Reports 2010, 043; 10.5089/9781451839456.002.A001

Source: Central Bank of Uruguay, WEO, and Fund staff estimates.

7. Moreover, the export sector continues to be attractive, as reflected by positive profit margins and strong foreign direct investment (FDI) inflows. Although wages have risen substantially since 2003, productivity, especially in the traded sector, has also improved. As a result, unit labor costs (ULC) have remained broadly constant since 2003 (see Figure 2). Export prices, on the other hand, have tended to go up pointing to increasing profit margins in the external sector. In addition, FDI inflows, which tend to develop favorably under conditions of sustained competitiveness, have soared in recent years reaching 5.7 percent of GDP in 2008. These inflows have been particularly concentrated in traded sectors such as agriculture and forestry. And although they are expected to decrease to 3.0 percent of GDP, due to the global crisis, they are still higher by regional standards.

C. Exchange Rate Assessment2

8. This assessment followed a broad-based approach based on a variety of methods. Since Uruguay is not currently covered by the IMF’s estimates of the consultative group in exchange rate issues (CGER) for real exchange rate evaluations, this assessment relied on the application and adaptation of the following four approaches: the purchasing power parity approach, the macroeconomic balance approach, the external sustainability approach, and the equilibrium real exchange rate approach. For some of the approaches, different estimations were considered. For instance, the application of macroeconomic balance approach considered the estimations by Vitek (2009) and Medina et al. (2009), as well as the CGER estimates presented in the IMF Occasional Paper 261. Similarly, the application of the equilibrium real exchange rate approach included the estimations based on panel data analysis by Vitek and CGER, and the results from a vector error correction model estimated for Uruguay. Table 1 presents the results derived from the application of these methodologies.

Table 1.

Uruguay: Assessment of the Real Effective Exchange Rate

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Source: Fund Staff estimates.

9. Across different approaches and estimations, the assessment reveals that the REER is not far from equilibrium. While the PPP approach suggests that the REER should depreciate by 1.2 percent to reach the equilibrium, the remaining three approaches point to a necessary appreciation of about six percent or even lower. In particular, the external sustainability approach implies an almost insignificant undervaluation of 0.5 percent, whereas the CGER estimates for the equilibrium real exchange rate approach suggests a very slightly undervaluation of 5.6 percent. Given that all of these deviations are within ten percentage points of zero, the conclusion is that the REER is broadly in equilibrium. This SIP proceeds to elaborate on the details of the application of the differing approaches.

The PPP Approach

10. According to the PPP approach, the value of the peso appears to be close to equilibrium. The 2008 regression line in Figure 3 reflects the notion that a country’s real exchange rate tends to appreciate as its productivity increases (see Box 1). By this measure, Uruguay’s exchange rate appears broadly in line with differences in productivity. Having depreciated substantially during the 2002 crisis, it appreciated in 2004-07, approximating the regression line from below. In 2008, the exchange rate surpassed the adequate level defined by this regression line. As a result, in 2008, Uruguay’s exchange rate appeared to be very slightly overvalued by 1.2 percent. Given that this approach has been strongly criticized by Zalduendo (2008), among others, it is important to apply other methodologies to inform the assessment.

Figure 3.
Figure 3.

Uruguay: PPP Approach

Citation: IMF Staff Country Reports 2010, 043; 10.5089/9781451839456.002.A001

Source: WEO and Fund staff estimates.

The Purchasing Power Parity (PPP) Approach

Rogoff (1996) argues that the PPP approach is based on the premise that the PPP concept serves as an anchor for long-run real exchange rates. The approach is reminiscent of the Balassa-Samuelson hypothesis, as it underscores the difference in relative productivity levels as the main driving factor of the deviations of the real exchange rate from its long-run equilibrium: higher productivity in the tradable sector tends to increase tradable sector wages, and as wages equalize across sectors, this induces higher prices for non-tradable goods and thus an increase in consumer prices relative to trading partners, leading to a real appreciation. The approach may be implemented by running a cross-country regression of the implied PPP exchange rates on the per-capita income levels (a proxy for productivity in the tradable sector). Countries above the regression line are interpreted to have a relatively more appreciated exchange rate than explained by differences in productivity.

The Macroeconomic Balance Approach

11. The macroeconomic balance (MB) approach indicates that the real exchange rate seems to be in line with fundamentals. This assessment reflects the estimates of both the equilibrium and the underlying current account balances as well as the adjustment of the real exchange rate that is necessary to close the gap between these two balances (see Box 2):

  • The underlying current account (CA) deficit in 2008 was found to be smaller than the estimated norm. The underlying CA was calculated to be about -0.3 percent of GDP in 2008, taking into account temporary factors such as the commodity price shock and the import effect of a positive output gap in the domestic economy, among others (see Box 3). On the other hand, staff considered three different estimations to calculate the equilibrium CA or norm (See Table 2): 1) CGER, 2) Vitek (2009), and 3) Medina et al. (2009). Vitek’s estimates implied a CA norm of -3.1 percent of GDP; Medina et al.’s estimates suggested that this norm is around -0.8 percent of GDP; and CGER’s estimates yielded a CA norm of -2.9 percent of GDP (see Table 3 and Figure 4).

  • The exchange rate adjustment that eliminates the difference between the underlying CA and the norm implies a very slightly undervaluation. This adjustment was calculated to be in the range of -4.4 percent and -0.8 percent (see Table 3). Key to calculate this adjustment is the elasticity of the current account to the real exchange rate. In these calculations staff used the most recent estimates of export supply and import demand elasticities for Uruguay by Tokarick (2009), which imply an elasticity of the current account to the real exchange rate of -0.64.3

Table 2.

The Macroeconomic Balance Approach

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Sources: OP 261, Medina et al. (2009), and Vitek (2009).
Table 3.

The Macroeconomic Balance Approach

article image
Source: Fund staff estimates.
Figure 4.
Figure 4.

Uruguay

Citation: IMF Staff Country Reports 2010, 043; 10.5089/9781451839456.002.A001

Source: Fund Staff estimates, using WEO, UN, and WBWDI data.

The Macroeconomic Balance Approach

The macroeconomic balance approach calculates the real exchange rate adjustment that is necessary to close the gap between the current account (CA) stripped from temporary factors, or underlying current account, and an estimated equilibrium CA balance or norm. This adjustment is obtained using the country-specific elasticity of the CA with respect to the real exchange rate, while the norm is calculated with an econometric model assuming that it depends on the following fundamentals:1/

Fiscal Balance. In the absence of full Ricardian equivalence, a higher government fiscal balance raises national saving, lowering the CA deficit.

Demographics (population growth rate, young-age and old-age dependency ratios). A higher share of economically inactive dependent population (young or old) reduces national saving and increases the CA deficit.

Oil Trade Balance. Higher oil prices increase the CA balance of oil-exporters and decrease the balance of oil-importers.

Relative Per Capita Income at PPP. Relatively poorer countries may need to invest more and thus import more capital leading to higher CA deficits.

Relative Income and Economic Growth. Among countries at a similar stage of development, the stronger is economic growth (relative to trading partners), the lower the CA balance.

Aid Inflows. In some countries, particularly low-income countries, aid is an important source of CA deficits.

Foreign Direct Investment. Higher FDI provides a stable source of external financing signaling improvements in the investment climate. It may lower CA balances through increased imports.

Economic Crises. During economic crises, sharp current account adjustments occur as a byproduct of macroeconomic contraction and the reduced availability of international financing, among others.

Lagged Net foreign assets (NFA). On the one hand, countries with higher NFA can afford to run larger CA deficits without jeopardizing their solvency. On the other hand, higher NFA imply higher net foreign income flows from abroad reducing the deficits.

Lagged CA. The lagged current account is intended to both proxy for NFA but also to capture the gradual nature of current account adjustments.

Using panel data techniques, the Occasional Paper 261 by the Fund’s Consultative Group in Exchange Rate issues (CGER), Vitek (2009) and Medina et al. (2009) provide estimates of the importance of these fundamentals in determining the CA norm. The econometric techniques, the length of the sample, the country sample, and the definitions of the variables vary across these estimations.

1 See the IMF Occasional Paper 261.

Calculating the Underlying Current Account Balance

The underlying current account balance can be calculated as the observed balance stripped from temporary factors at a particular point in time. Since the selected year for the analysis is 2008, then the calculations of this underlying measure involved some adjustment associated with higher commodity prices, which affect both exports and imports, as well as more imports due to the cyclical effect of a positive output gap, among others. The table below lists all the adjustments considered in the analysis. The underlying current account balance was calculated to be about -0.3 percent in 2008.

Underlying Current Account Balance in 2008

(in percent of GDP)

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Source: Central Bank of Uruguay, WEO, and Fund staff estimates.

The External Sustainability Approach

12. The external sustainability approach also suggests that the real exchange rate is broadly in equilibrium. As the SIP proceeds to explain, this result is based on the estimated adjustment of the real exchange rate that is required to close the difference between the net foreign asset (NFA) stabilizing current account balance and the underlying current account balance (see Box 4):

  • Two different measures of the NFA position were constructed, based on data from the International Investment Position (IIP) and Lane and Milesi-Ferretti (2006). Figure 5 shows that despite some differences in the databases, the NFA position of Uruguay has reached levels that are greater than -17 percent of GDP and is expected to improve further by 2014. The 2008 NFA position was selected as the benchmark level. For the IIP data, this level corresponds to -8.6 percent of GDP, whereas under the Lane and Milesi-Ferretti methodology, this level is around -10.7 percent of GDP.

  • Maintaining the NFA position at the end-2008 level would require a stabilizing current account (CA) deficit of about 0.5 percent of GDP. The NFA-stabilizing CA balance is calculated using equation (1) of Box 4. The inflation rate and the growth rate were set to medium term values of 2.2 percent and 3.9 percent. Table 4 presents the results for the end-2008 NFAs using IIP data and the level implied by Lane and Milesi-Ferreti (2006). The differences are not substantial. Using IIP data the NFA-stabilizing CA balance corresponds to -0.5 percent of GDP. On the other hand, for the NFA level implied by Lane and Milesi-Ferretti (2006), the stabilizing Ca is close to -0.6 percent.

  • The exchange rate adjustment necessary to equalize the NFA-stabilizing current account (CA) and the underlying CA is less than 1 percent. Table 4 shows that, given an underlying CA balance of -0.3 percent and an elasticity of -0.64, to achieve a NFA-stabilizing CA balance of -0.5 percent of GDP it would be necessary a real exchange rate appreciation of about 0.4 percent. On the other hand, to achieve a balance of -0.6 percent of GDP it would be necessary an adjustment of almost 0.6 percent.4 Clearly the real exchange rate adjustment depends on the level of the NFA-stabilizing CA balance, which in turn depends on the benchmark for NFA. Targeting a much lower benchmark of -28 percent would imply an adjustment of about -2 percent. This corresponds to a still very small undervaluation and reinforces the assessment that the real exchange rate is broadly in equilibrium (see Figure 6).

Figure 5.
Figure 5.

Uruguay

Citation: IMF Staff Country Reports 2010, 043; 10.5089/9781451839456.002.A001

Source: BPTSTSUB, WEO, Lane and Milesi-Ferretti (2006), and Fund staff estimates.
Figure 6.
Figure 6.

Uruguay

Citation: IMF Staff Country Reports 2010, 043; 10.5089/9781451839456.002.A001

Source: IMF staff estimates.
Table 4.

The External Sustainability Approach

article image
Source: WEO and BPTSTSUB Data, Fund staff estimates.

The External Sustainability Approach

The external sustainability (ES) approach calculates the real exchange rate adjustment that, over the medium term, is necessary to close the difference between the actual current account balance (CAB) stripped from temporary factors (underlying CAB) and the balance that would stabilize the net foreign assets (NFA) position of the country at some benchmark level. The approach relies on the intertemporal budget constraint for the economy, which states that changes in NFAs are due either to net financial flows or to changes in the valuation of outstanding foreign assets and liabilities. Ignoring capital gains from valuation changes and other factors such as capital transfers and errors and omissions, this constraint can be written as follows: BtBt1=CAt, where CAt is the CAB and Bt denotes NFA. Dividing this equation by GDP, it can be demonstrated that the CAB to GDP ratio cas that stabilizes the NFA at the benchmark level bs can be calculated as:

(1)casg+π1+g+πbs

where g is the growth rate of real GDP and π is the inflation rate. CGER uses the NFA/GDP level at the end of the prior year as the benchmark level and recommends to use the medium-term inflation rate of the US instead of the medium-term inflation of the domestic economy, as using domestic inflations could in some cases overstate the ability of a country to run deficits.

The Equilibrium Real Exchange Rate Approach

13. Different estimates of the equilibrium real exchange rate (ERER) point to a very slight undervaluation of the Uruguayan peso. To obtain these estimates, staff used parameters from cross-country studies and estimated a vector error correction model for Uruguay, which allowed to find a long-run cointegrating relationship between the real exchange rate and some fundamentals. Box 5 briefly explains this approach, while this SIP proceeds to elaborate on the details associated with its application.

  • Using cross-country studies to calculate the ERER indicates that the real exchange rate is in line with fundamentals. Staff used two different sets of estimated parameters corresponding to the studies by CGER (see IMF Occasional Papers 167 and 261), and Vitek (2009). Table 5 presents the list of variables considered in each estimation, while Figure 7 shows that the estimates of the ERER were found to be not very different over the medium-term. The real exchange rate misalignment was calculated to be around - 5.6 percent under CGER estimates and -4 percent under Vitek’s estimates (see Table 6).5 Therefore, both estimates suggest a rather mild undervaluation, implying that the real exchange rate is broadly in equilibrium.6

  • In the vector error correction model (VECM), a cointegrating relationship was found among the REER and two key fundamentals. Staff used quarterly data from 1980:3 to 2009:1 to find a long-run relationship between the real exchange rate and some of the fundamentals described in Box 5. Although Augmented Dickey-Fuller unit root tests revealed that all the variables that were considered were integrated of order 1, only one stable co-integrating relation was found between the real effective exchange rate, real GDP relative to trading partners and net foreign assets (see Table 7). The variables in the estimated long-run co-integrating relationship showed the expected signs. In particular, an increase in relative real per capita GDP by 1 percent is associated with a real appreciation of 2 percent, and an increase in net foreign assets of 1 percent of GDP is associated with a real appreciation of 0.01 percent. Moreover, 17 percent of the deviation of the REER from its estimated long-run relation is eliminated within one quarter.

  • The estimated long-run equilibrium relation based on the VECM also suggests that the REER is close to its equilibrium value. Figure 8 plots the estimated equilibrium rate, after filtering it using the Hodrick and Prescott filter. Relative to the estimated equilibrium relation, Uruguay’s REER was fairly well aligned throughout the second half of 1990s. From late 2000 until the crisis, the REER was then increasingly overvalued, as the exchange rate regime prevented the REER from depreciating. With the floating of the exchange rate in mid-2002, the REER returned close to equilibrium, and since then both the equilibrium REER and the REER have tended to go up. At end of the first quarter of 2009, the REER was slightly below equilibrium, implying a very slightly undervaluation of less than 5 percent.

Table 5.

The Equilibrium Real Exchange Rate Approach

(under panel data estimation techniques)

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Sources: OP 261 and Vitek (2009).
Table 6.

The Equilibrium Real Exchange Rate Approach

(under panel data estimation techniques)

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Source: Fund staff estimates.
Table 7.

Selected VECM Results

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Source: Central Bank of Uruguay, WEO and Fund staff estimates.
Figure 7.
Figure 7.

Uruguay

Citation: IMF Staff Country Reports 2010, 043; 10.5089/9781451839456.002.A001

Source: WEO and Fund staff estimates
Figure 8.
Figure 8.

Uruguay

Citation: IMF Staff Country Reports 2010, 043; 10.5089/9781451839456.002.A001

Source: Fund staff estimates.

The Equilibrium Real Exchange Rate Approach

The equilibrium real exchange rate (ERER) approach directly estimates an equilibrium real exchange rate for a country as a function of medium-term fundamentals including: 1/

Net Foreign Assets. Theory predicts that economies with relatively high NFA can afford more appreciated real exchange rates—and the associated trade deficits—while still remaining solvent.

Productivity Differential. If productivity in the tradables sector grows faster than in the non-tradables sector, the resulting higher wages in the tradables sector will put upward pressure on wages in the non-tradables sector, resulting in a higher relative price of non-tradables and therefore in a real appreciation (Balassa-Samuelson effect).

Openness and Trade restrictions. A less open trade regime is likely to be associated with a more appreciated real exchange rate. In particular, trade restrictions may induce real exchange rate appreciation as they may lead to higher domestic prices.

Commodity Terms of Trade. Higher commodity terms of trade should appreciate the real exchange rate through real income or wealth effects.

Government Consumption. Since higher government consumption falls more on non-tradables than tradables, then this consumption is likely to appreciate the real exchange rate.

Price controls. When price controls are removed, the rise in administered prices toward market levels induces a higher CPI, which would be accompanied by a real appreciation.

The Real Interest Rate Differential. Higher differentials may attract capital flows inducing appreciation pressures on the real exchange rate.

The approach can be implemented by using panel regression techniques. Based on these techniques, the Occasional Paper 261 by CGER and Vitek (2009) provide estimates of different models that include some of the previously discussed fundamentals. The estimation method, the length of the sample, the country sample, and the definitions of the variables vary across these works. An alternative method is based on estimating a vector error correction model for the country under consideration. In the estimation, Johansen cointegration techniques can be applied to determine how much of the long-run behavior of the real exchange rate, which is a measure of its equilibrium, is explained by the discussed fundamentals.2/

1 See the Occasional Paper 261.2 See McDonald and Ricci (2003).

D. Conclusions

14. This SIP finds that although the Uruguayan peso has appreciated since 2003, there is no evidence of competitiveness problems and a potential misalignment of the real exchange rate. In fact, most external indicators suggest that the Uruguayan remains competitive. The exchange rate is assessed to be near or possibly slightly below its equilibrium value. This finding is consistent across most of the differing methods applied to assess the real exchange rate.

References

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1

Prepared by Felipe Zanna.

2

These results are based on the WEO assumptions of August 2009.

3

Tokarick (2009) provides estimates of elasticities for several countries using GATP and ERALIC project data. The estimate for Uruguay is -0.64, assuming that, as a small country, its export demand and import supply elasticities are infinite. This contrasts with the CGER assumptions, which correspond to infinite export supply and import supply elasticities, implying that a country is able to influence foreign prices by how much they sell. Under these assumptions, the elasticity for Uruguay is close to -0.2, which appears to be on the low side and implies a required adjustment of the real exchange rate in the range of -14 and -2.5 percent.

4

Using the CGER implied elasticity for Uruguay of -0.2, which seems to be on the low side, would imply a required adjustment of the real exchange rate of -1.5 percent, on average.

5

The misalignment was computed as the deviation of the medium-term ERER from the medium-term real effective exchange rate (REER). The latter was held constant at the current level of -0.18, in log terms (corresponding to 83.6) and calculated as the average of the first 6 months of 2009. On the other hand, CGER’s and Vitek’s estimates project medium-term ERERs of -0.12 and -0.14 (in log terms), respectively.

6

Since the constant is country specific and Uruguay is not in the CGER sample, the constant to apply the CGER estimates was obtained by setting the sample-average ERER equal to the sample-average REER, for the post-liberalization period 1990-2008; thus, the implicit assumption was that the average misalignment in the estimation period is zero.