This 2011 Article IV Consultation—Selected Issues paper focuses on estimating potential output and the output gap and spillovers from agriculture in the case of Uruguay. It introduces additional economic information and theory to estimate potential output, shedding some light on the discussion of current monetary and fiscal policies. The objective is to take advantage of economic data to disentangle the most recent economic performance by introducing multivariate techniques. The paper also presents an overview of the labor market and pension system of Uruguay.

Abstract

This 2011 Article IV Consultation—Selected Issues paper focuses on estimating potential output and the output gap and spillovers from agriculture in the case of Uruguay. It introduces additional economic information and theory to estimate potential output, shedding some light on the discussion of current monetary and fiscal policies. The objective is to take advantage of economic data to disentangle the most recent economic performance by introducing multivariate techniques. The paper also presents an overview of the labor market and pension system of Uruguay.

II. Investment Grade for Dollarized Countries: The Uruguayan Case1

A. Introduction

1. In recent years, Uruguay has taken firm strides towards regaining investment grade status—lost in the aftermath of the 2002/03 crisis. The country’s efforts have been supported by a record-high growth performance and a generally strong fiscal and monetary policy framework—which has helped entrench macroeconomic stability, reduce the debt level and significantly improve the perception by credit rating agencies of the country’s credit worthiness, which is ranked just one notch below investment grade.

2. Uruguay’s progress toward investment grade has been solid but gradual—in contrast with the marked reduction in spreads delivered by the market. The gradual progress in credit ratings has been justified by the rating agencies based on pending tasks for Uruguay—including the need to further reduce public debt and to lessen both debt and financial dollarization. At the same time, Uruguay’s low spread levels—which are now below the average for emerging markets with investment grade—seem to suggest that the market has implicitly awarded Uruguay such a status, ahead of the rating agencies.

3. This paper investigates the relationship between dollarization and investment grade status. Specifically, a panel data study of 42 countries shows that the external public debt burden and a trend of public debt and financial de-dollarization are significant determinants of investment grade. It also suggests that Uruguay’s efforts to reduce the public debt ratios and dollarization levels in recent years are well in line with those observed in other dollarized economies with investment grade status as they worked toward the upgrade.

4. The paper also analyzes the benefits that a dollarized country can expect when reaching investment grade. In line with previous research, the panel study of 35 emerging markets suggests that countries with investment grade have spreads that are 80-85 percent lower than those of countries that are one-notch below investment grade. Dollarized countries, however, benefit from a lower reduction in spreads than their peers as they cross the investment grade threshold—facing “dollarization penalties” of up to 40 percent the spreads of a non-dollarized investment grade country. Thus, Uruguay’s efforts to de-dollarize should help it not only reach investment grade, but achieve the full benefits of this status.

5. Finally, the paper studies what are the implications of trading “ahead of the rating”, as Uruguay is. In particular, it asks whether Uruguay can expect its spreads levels to remain within the “investment grade range” during periods of global stress. An event study suggests that that countries in the region trading ahead of their rating (once they are one notch below investment grade) prior to crisis events generally tend to show resilience and remain in-group with investment grade countries through periods of stress.

6. The rest of the paper is organized as follows. Section B presents some background on Uruguay’s performance. Sections C to E present the empirical analyses on the questions of determinants and benefits of investment grade, as well as on the resilience of “trading ahead of the rating”. Section F concludes.

B. Background

7. Sovereign credit ratings are assessments of the probability that a borrowing government will default on its obligations. These assessments are elaborated by a number of rating agencies worldwide,2 and summarize the perception of government risk in a series of categories that can be comprised into three main groups: “investment grade”—for the highest quality borrowers; “speculative grade”—for the lower quality borrowers that continue to serve their obligations—and “in default” (Table 1). The ratings are not only considered a key determinant of the borrowing costs faced by the sovereign, but also set a floor for the costs that private agents operating under that same sovereign will face in the global markets. Reaching specific ratings also opens the door to wider pools of investors, which may face legal restrictions to risk participation in their portfolios (Jaramillo, 2011).

Table 1.

Uruguay: Description of Credit Ratings 1/

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Source: Jaramillo (2010) and Wikipedia.

Uruguay’s ratings as of July 30, 2011 are marked in bold red.

8. Ratings are usually compiled based on a wide host of factors. The main agencies tend to rely on a combination of quantitative models—which provide a measure of risk based on the borrower’s key economic fundamentals—and the judgment of analysts who weigh a number of qualitative factors. The latter vary among rating agencies, and may range from political risk and institutional quality, to macroeconomic and debt management.

9. Uruguay’s strong economic performance and policy framework of recent years has been recognized by the main credit rating agencies. They have pointed to the sharp and sustained recovery in economic activity (with real growth averaging some 6½ percent in 2004-10), and the prudent macroeconomic framework, which has enhanced the economy’s resilience to shocks. Falling debt levels, improvements in the debt structure (including on currency composition and amortization schedule), limited rollover risks, and a comfortable external reserve buffer have all been noted as strengths (Figures 1). Thus, the country has gradually risen through the ladder of sovereign credit ratings, to a level just one-notch below investment grade (Table 1).

Figure 1.
Figure 1.

Uruguay: Recent Performance

Citation: IMF Staff Country Reports 2011, 376; 10.5089/9781463926601.002.A002

10. The improvement in Uruguay’s ratings has gone hand-in-hand with a reduction in market spreads. Uruguay’s EMBIG spreads are both below the EMBIG-Global and the EMBIG for Latin America.3 The market has “moved ahead” of the rating agencies, as Uruguay’s spreads in January-April of 2011 were under the average observed in emerging market peers that were already at the first step of investment grade status (Figure 2).

Figure 2.
Figure 2.

Uruguay: Market vs. Ratings

Citation: IMF Staff Country Reports 2011, 376; 10.5089/9781463926601.002.A002

Source: Bloom berg, for a sample of 35 emerging markets, in January-April 2011.

C. How Important is Dollarization as a Determinant for Credit Ratings?

11. Several studies have sought to identify the key determinants of sovereign credit ratings, but very few have focused on dollarization. These studies have identified three sets of variables that are critical in the determination of the ratings (Appendix 1). These relate to: (1) economic performance and development (e.g., real growth, GDP per capita);

(2) macroeconomic stability and vulnerability (e.g., inflation, debt- and debt-service ratios, international reserve levels), and (3) institutional factors and political risk (e.g., default history, corruption). Very few studies have explicitly considered the relative impact of high debt and/or financial dollarization on the ratings, although these are often raised as critical issues to be addressed by dollarized countries when assessed by the rating agencies. Most recently, Borraz et al (2011) have taken a look at the impact of dollarization concluding that it can affect the ratings—including through a cyclical channel through which it can impact on the country’s fundamentals.

12. This section examines whether the debt and financial dollarization levels are significant determinants in the credit agencies’ decisions. We use two alternative approaches. First, we follow Afonso et al (2007), and run an ordered Probit model (estimated through maximum likelihood with robust standard errors) to verify whether debt and financial dollarization impact the definition of general credit ratings. The model is:

(1)Rit*=α+βXit+λZit+μit,i=1,N;t=1,T

where Xit is a vector of explanatory variables, Zit is a vector of time-invariant variables (including regional and default dummies), and μit is a random error. R*it is an unobserved latent variable embodying the country’s credit worthiness that is captured by the rating agencies through n cutoff points, defining the boundaries of each category:

Rit={AAA ifR*>cnAA+ifcn>R*>cn-1AA ifcn-1>R*>cn-2CCC+ifc1>R*

Second, we extend the model developed by Jaramillo (2010) on the determinants of investment grade. We use both a binomial Probit and a binomial Logit specification:

(2)IGit=α+βXit+λZit+ai+μit,i=1,N;t=1,T

where IGit is a binomial variable equal to 1 when a country has investment grade by at least two of the three main agencies and zero otherwise, Xit is a vector of explanatory variables, Zit is a vector of time-invariant variables (including regional and default dummies), ai is a vector of individual country effects and μit is a random error. The model was estimated in a simple pooled version and with random effects.4

13. The set of explanatory variables builds from previous research to account for dollarization. We follow Jaramillo (2010) in testing the determinants identified consistently by earlier research. Aside from indicators on the external and domestic debt ratios (relative to GDP), the novelty is to include an explicit indicator of debt dollarization (the ratio of external public debt over total) and an indicator of financial dollarization (defined as the share of foreign currency deposits over total deposits in the banking system) as potential determinants. The dataset includes an (unbalanced) panel of annual data for 42 countries in the period 1993-2010 (Appendix 2, Table 1).

Table 2:

Uruguay: Explanatory Variables and Expected Sign

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Sources: IMF (WEO, IFS), World Bank’s WDI, ICRG, and country authorities.

Data analysis and estimation results

14. Data analysis confirms that investment grade and speculative grade countries significantly differ in most key economic fundamentals—including their dollarization levels. Tests of equality of means and medians across the sample indicate that investment grade countries generally grow more, have lower inflation and unemployment, a stronger export performance and greater financial depth than speculative grade countries (Table 3). There are also significant differences with regard to the public external and domestic debt-to-GDP ratios, as well as on the degree of public debt dollarization (with a difference of some 15 percentage points on average) and of financial dollarization (greater in speculative grade countries by 18 percentage points).

Table 3.

Uruguay: Characteristics of the Sample

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*** Stands for significance at 1 percent level, ** stands for significance at 5 percent, and * at 10 percent.

15. Econometric estimates confirm the relevance of the public external debt ratios in the determination of both credit rating in general and investment grade status in particular. Table 4 summarizes the results of all models. In each case, a first estimation was completed including all variables of the initial set of determinants, plus the dollarization indicators; a second estimation excludes the variables with little explanatory power on the basis of Wald tests, while maintaining the dollarization indicators. The results strongly confirm that the public debt-to-GDP is a highly significant determinant of both credit ratings and investment grade status—in contrast with the level of domestic public debt-to-GDP, which is statistically insignificant in most of the estimations, suggesting a lower-risk perception by the rating agencies on this type of debt.

Table 4.

Uruguay: Results: Model on Determinants of Sovereign Credit Ratings 1/

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*** stands for significance at 1 percent level, ** stands for significance at 5 percent, and * at 10 percent.

The restricted model includes all variables, while the unrestricted excludes variables without explicative power based on Wald Tests.

16. Results also suggest that a trend of public debt and financial de-dollarization are significant determinants of investment grade. In particular, an increasing trend in the debt dollarization ratio tends to reduce the probability of reaching investment grade, even if there seems to be a positive relation between a higher debt dollarization level and investment grade, other things equal.5,6 Estimates also show that financial dollarization levels—and their trends—are both variables that seem to matter as credit ratings issue their opinions on a specific country level of risk.

17. Data suggests that progress toward investment grade status has been supported by external public debt reduction and financial de-dollarization in our sample. Inspection of six countries that were granted investment grade during the sample period shows particular progress in reducing the external public debt-to-GDP burden, as well as on financial dollarization in the five years prior to the upgrade (Figure 3). In all of the cases, efforts to reduce the domestic public debt burden and, in particular, debt dollarization, were somewhat less pronounced.7

Figure 3.
Figure 3.

Uruguay: Fundamentals at Time of IG Upgrade and Five Years Earlier

Citation: IMF Staff Country Reports 2011, 376; 10.5089/9781463926601.002.A002

Source: Author’s calculations, based on WEO and IFS data.

18. Uruguay’s fundamentals fare well in many respects relative to countries with investment grade status, including those that are highly dollarized. A comparison of the key determinants of investment grade (presented as an average for 2005-10) suggests that most indicators of Uruguay’s macroeconomic performance are broadly in line with those of peers that are more highly ranked by credit agencies. From this perspective, pending challenges would appear to be the debt-to-GDP ratios and dollarization levels.8 At the same time, progress in this area over the last five years seems broadly in line with that observed in investment grade countries in the years preceding their own upgrade—albeit from a somewhat higher starting point (Figure 4). Against this background, Uruguay appears well placed to achieve investment grade, as it continues to lower its external debt and dollarization vulnerabilities, while sustaining its other key fundamentals.

Figure 4.
Figure 4.

Uruguay: Comparative Key Fundamentals, Average 2005-10 1/2/

Citation: IMF Staff Country Reports 2011, 376; 10.5089/9781463926601.002.A002

Sources: Authors’ calculations based on data from WEO, IFS and rating agencies.1/ For countries that were Investment Grade in 2010.2/ Cutoff of financial dollarization chosen at 30 percent of deposits denominated in foreign currency.

D. What Are the Benefits of Achieving Investment Grade?

19. Available evidence suggests that moving up the credit rating ladder tends to lower sovereign borrowing costs. The literature generally assesses whether a change in credit ratings conveys any additional information about the risk of a sovereign to the market, beyond what can be extracted from global financial conditions (and varying risk appetite) and the country’s economic fundamentals (Appendix 1, Table 2). Most studies find that rating upgrades tend to lower spreads (see, for instance, Cantor and Packer (1996), Kaminsky and Smuckler (2002) and Jaramillo and Tejada (2011)). Some others, however, have found ratings to be largely endogenous to changes in spreads, and note that credit rating agencies appear to follow the market (Levy Yeyati and Gonzalez Rozada, 2008).

20. This section expands the model developed by Jaramillo and Tejada (2010) to examine the impact of reaching investment grade on spreads, and whether this is the same regardless of a country’s dollarization level. The model relies on a simple specification for a fixed effects panel regression with robust standard errors:9

(2)sovit=α+βratingit-n+λXit+δit+niti=1,N;t=1,T

where sovit reflects the log of sovereign spreads, ratingit-n denotes a set of dummy variables matching the scale of credit ratings (lagged one period, to control for possible endogeneity of ratings to spreads)10, Xit is a set of explanatory variables (including global conditions and the country’s specific fundamentals), δit stands for the vector of fixed effects and ηit is a random error.

21. The set of explanatory variables in the model includes a relevant subset of the usual determinants of credit ratings. This includes the most significant determinants in the literature, particularly indicators of economic performance (real GDP growth), and vulnerabilities (reserve buffer, and external and domestic public debt burden). This paper also adds the indices of public debt and financial dollarization as relevant determinants (Table 5). The left-hand side variable is the (log) EMBIG. Monthly data is gathered for a sample of 35 countries with varying periods in the time span 1997:01-2011:04 (Appendix 2, Table 2).

Table 5.

Uruguay: Explanatory Variables and Expected Sign

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Sources: Rating agencies, Bloomberg, IMF (WEO and IFS), World Bank (WDI), ICRG, and country authorities.

Data analysis and estimation results

22. Estimates show a significant effect on spreads as countries cross the investment grade threshold (Table 6a-b, Figure 5). The model is estimated sequentially. We first verify whether the results delivered by Jaramillo and Tejada (2010) hold in our expanded sample (Model A), and after controlling for the levels of debt and financial dollarization as additional determinants of the spreads (Model B). We then estimate whether there is a “penalty” imposed by the market against dollarized countries as they moved through the credit rating ladder, measured by the coefficients of the credit rating dummies interacted with the public debt dollarization ratio and the financial dollarization levels (Models C-E).

Table 6a.

Results: Model on Impact of Credit Rating Upgrades 1/

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*** stands for significance at 1 percent level, ** stands for significance at 5 percent, and * at 10 percent.

Table 6b.

Results: Model on Impact of Credit Rating Upgrades 1/

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*** stands for significance at 1 percent level, ** stands for significance at 5 percent, and * at 10 percent.

Figure 5.
Figure 5.

Uruguay: Impact of Achieving Investment Grade

Citation: IMF Staff Country Reports 2011, 376; 10.5089/9781463926601.002.A002

Sources: Authors’ own calculations

23. Results confirm that, on average, movements through the credit rating ladder still have a significant impact of spreads (Model B). All coefficients for the ranking BB and above are negative and significant; with sovereigns in this credit rating category benefiting from spreads that are some 80-85 percent lower than those in the BB category. Further, for all countries on average, the upgrade to investment grade (the move from BB+ to BBB-) generates a pronounced reduction in spreads (of about 80 percent) that is more pronounced than that arising from additional rating upgrades within such an asset class (Panel A).11

24. Estimates also suggest that the benefits of achieving investment grade are not the same for countries regardless of their dollarization level. Models C - E estimate the “penalties” imposed by the markets on countries as they cross the threshold toward investment grade. In both cases, the coefficients for the credit rating dummies that are not interacted can be considered those applying to countries when dollarization equals zero, while the additional impact from the interacted credit rating provides the impact when there is full dollarization. While the estimation results cannot confirm the presence of a statistically significant penalty on debt dollarization, they suggest that there is a significant penalty by the markets to financial dollarization. Figure 4 depicts the “average” impact of achieving investment grade (Panel A): a non-dollarized country with a spread of, say, 440 bps at BB+ would see its spreads reduced to just under 100 bps when reaching BBB-. However, a country with a very highly dollarized financial system could see spreads some 40 percent (10-15 bps in the example) above those of non-dollarized countries (Panel B).

E. What Are the Implications of “Trading Ahead of the Rating”?

25. What happens to countries that “trade ahead of their rating” during periods of stress in international capital markets? To answer this question, this paper prepares an event study by looking at a sample of 35 emerging markets with daily data from January 1997 to October 2011. Specifically, the methodology is as follows:

  • Identify stress episodes. These correspond to periods in which the VIX is greater than the VIX trend (obtained through a Hodrick-Prescott filter) plus a quarter of its standard deviation. A total of 14 episodes are identified during the period under analysis.

  • Identify the “frontier group countries.” These are the countries in the sample that were, at any point in time, ranked at one notch below investment grade by at least two rating agencies. Focus is set on Uruguay’s regional peers (Brazil, Colombia, Mexico, Panama and Peru) and on Uruguay itself.

  • Identify the “investment grade benchmark spread.” For this purpose: (i) all countries that are ranked at investment grade or above by at least two rating agencies are identified; (ii) the daily average spread for those countries in the “benchmark group” are calculated; (iii) two bands are constructed around this average: (a) +/- one standard deviation, or (b) +/- half a standard deviation.

26. Results show that markets are frequently ahead of the ratings. The regional “frontier group” often had days in which spreads were within the “investment grade range”; Brazil, Colombia and Uruguay have been the three countries that remained within the investment grade band for the longest time for the whole period in which they were in the “frontier group”, that is, at one notch below investment grade granted by at least two rating agencies. In particular, Uruguay has traded at investment grade spreads for some 60 percent of the days since it became a “frontier” country (Table 7).

Table 7:

Evidence from Event Study

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Ranked by at least two rating agencies one notch down below Investment Grade

From the test at one or more standard deviation from the IG group

In all cases in which the spread was Out of Group during the episode, it was also Out of Group preceding the episode

27. Results also suggest that countries that trade ahead of the rating tend to stay within the benchmark investment grade group during stress episodes. Of the total 25 country/episode pairs identified, only during 6 were countries in the “frontier group” outside the benchmark range of the emerging market spreads. Importantly, in 100 percent of these cases, the country in the frontier group had not been trading at emerging market spreads prior to the episode. In contrast, every single episode in which the frontier countries remained within group together at investment grade spread levels, they were also trading in group prior to the episode. Uruguay has clearly remained within group throughout all the relevant episodes.

28. These results seem to indicate that countries trading ahead of their rating can be resilient to market volatility, especially as they become closer to investment grade. While it is not possible to generalize the result and conclude that countries in the frontier group trading at investment grade level cannot separate during events of stress, it is also true that the results suggests that this may be caused more by idiosyncratic factors (specific to the country’s policies or fundamentals, that trigger an reclassification by the market) than by the credit rating per se.

F. Final Remarks

29.Empirical evidence shows that dollarization can be key determinant of sovereign credit ratings. In particular, the public external debt burden, and the trends observed in public debt and financial dollarization seem to “matter” as credit rating agencies assess whether a country’s creditworthiness is at investment grade level.

30. Reaching investment grade generally reduces the sovereign’s borrowing cost sharply, but this benefit can be reduced somewhat for highly dollarized countries. Estimates show that penalties for high financial dollarization can amount to an excess market spreads of 40 percent over those of non-dollarized countries, as they gain investment grade status.

31. The findings suggest that Uruguay is well placed to reach investment grade, and could benefit from such an upgrade in terms of further spread reductions. They also imply that ongoing efforts to reduce debt and financial dollarization would help it exploit such benefits more fully. Finally, the results suggests that as long as Uruguay sustains a strong set of policies, it will be likely to maintain its trading ahead of the rating—even if uncertain global conditions were to continue and bouts of volatility were to emerge.

References

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Appendix I. Summary of Relevant Literature

Table 1:

Summary of Empirical Literature on Determinants of Credit Ratings

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Sources: Jaramillo (2010) and own preparation.
Table 2:

Summary of Empirical Literature on the Impact of Credit Rating Changes on Spreads

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Source: Prepared by the authors.

Appendix II. Data

Table 1.

Model of Determinants of Investment Grade: Country Sample

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Table 2.

Model of Impact of Ratings on Spreads: Country Sample

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1

Prepared by María Gonzalez and Lulu Shui.

2

The three major agencies are Fitch Ratings, Standard and Poor’s (S&P), and Moody’s Investor Services.

3

CDS spreads for Uruguay are not available.

4

The sample did not have enough variability of the dependent variable to allow for a fixed-effects estimation.

5

This last result may be explained by the higher degree of access that investment grade countries have to international capital markets. It is not inconsistent with the tests of means and medians presented in Table 3, as the latter only compares the absolute levels of dollarization between investment and speculative grade countries, without taking into account the differences and similarities in other fundamentals and institutional variables.

6

It has been suggested by some observers that this type of result may obey to the use of “external debt” rather than “foreign currency denominated debt” in the regressions. Indeed, emerging markets gaining greater access to the international capital markets have been able to issue external debt in domestic currency. This is not the case here, as we concentrate on foreign currency denominated public debt from the WEO database.

7

This result (based on a stock comparison) seems in line with the observation in our estimated model (Table 4), which suggests that greater access to international capital markets by investment grade countries may in fact counterbalance debt dollarization efforts, unless the country can issue internationally in local currency.

8

The comparison also suggests that Uruguay could deepen its financial system, although the measure of Broad Money/GDP was not significant in our assessment of determinants of investment grade status.

9

Standard errors are clustered by country.

10

We run alternative estimations with lags at 3 months, confirming that the results are robust.

11

Jaramillo and Tejada (2010) note that Wald tests show that the coefficients A- to A+ are not statistically different from one another (although the AAA grades are statistically different from the BBB grades).