IMF Executive Board Concludes 2014 Article IV Consultation with Uruguay

Elections: The candidate of the ruling coalition Frente Amplio, former president Tabaré Vazquez, won the presidency and will take office in March 2015. With Frente Amplio retaining majority in both houses of Parliament, broad continuity in macroeconomic policy making is expected. Focus: Amid moderating but still solid growth, the 2014 consultation focused on four broad themes: confronting inflation, reinforcing fiscal sustainability, safeguarding financial stability, and bolstering strong and inclusive growth for the medium run. Main Policy Advice: ? A comprehensive disinflation strategy is needed to bring inflation to the mid-point of the target range. This would include maintaining a tight monetary policy stance, moving towards tighter fiscal policy, reducing the extent of backward-looking indexation of wages, wellcrafted central bank communication on the direction of monetary policy, and enhanced central bank autonomy. The present conjuncture provides an unusually good opportunity to achieve a paradigm shift in expectations. ? Fiscal sustainability would be reinforced by raising the primary balance by 2 percent of GDP over the medium term to ensure a downward trend in net public debt. ? Banks’ exposures to exchange rate depreciation risks bear continued close monitoring. It would be useful to strengthen risk weights for foreign currency loans to unhedged borrowers and incorporate greater exchange rate stress into the supervisory stress tests. ? Uruguay’s medium-term growth would benefit additionally from heightened efforts to boost infrastructure, strengthen education outcomes, and foster an innovation-friendly business environment. Past advice: In recent Article IV consultations, there has been broad agreement between the authorities and Fund staff on the macroeconomic policy objectives. Views have differed on the appropriate stance of fiscal policy, with staff favoring a tighter stance. The tightening in the monetary policy stance since mid-2013 has been in line with staff advice. The authorities have taken several steps to reduce the fiscal risks stemming from the impact of recurrent droughts on the balances of the state-owned electricity company, including by boosting investment in wind power, creating an energy stabilization fund, and purchasing weather related insurance. The authorities continue to make steady progress in implementing the 2012 FSAP recommendations to further strengthen financial regulation and supervision, and improve access to finance.

Abstract

Elections: The candidate of the ruling coalition Frente Amplio, former president Tabaré Vazquez, won the presidency and will take office in March 2015. With Frente Amplio retaining majority in both houses of Parliament, broad continuity in macroeconomic policy making is expected. Focus: Amid moderating but still solid growth, the 2014 consultation focused on four broad themes: confronting inflation, reinforcing fiscal sustainability, safeguarding financial stability, and bolstering strong and inclusive growth for the medium run. Main Policy Advice: ? A comprehensive disinflation strategy is needed to bring inflation to the mid-point of the target range. This would include maintaining a tight monetary policy stance, moving towards tighter fiscal policy, reducing the extent of backward-looking indexation of wages, wellcrafted central bank communication on the direction of monetary policy, and enhanced central bank autonomy. The present conjuncture provides an unusually good opportunity to achieve a paradigm shift in expectations. ? Fiscal sustainability would be reinforced by raising the primary balance by 2 percent of GDP over the medium term to ensure a downward trend in net public debt. ? Banks’ exposures to exchange rate depreciation risks bear continued close monitoring. It would be useful to strengthen risk weights for foreign currency loans to unhedged borrowers and incorporate greater exchange rate stress into the supervisory stress tests. ? Uruguay’s medium-term growth would benefit additionally from heightened efforts to boost infrastructure, strengthen education outcomes, and foster an innovation-friendly business environment. Past advice: In recent Article IV consultations, there has been broad agreement between the authorities and Fund staff on the macroeconomic policy objectives. Views have differed on the appropriate stance of fiscal policy, with staff favoring a tighter stance. The tightening in the monetary policy stance since mid-2013 has been in line with staff advice. The authorities have taken several steps to reduce the fiscal risks stemming from the impact of recurrent droughts on the balances of the state-owned electricity company, including by boosting investment in wind power, creating an energy stabilization fund, and purchasing weather related insurance. The authorities continue to make steady progress in implementing the 2012 FSAP recommendations to further strengthen financial regulation and supervision, and improve access to finance.

On February 20, 2015, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with Uruguay, and considered and endorsed the staff appraisal without a meeting.2

Recent Developments and Outlook

The Uruguayan economy continues to decelerate gradually. Real GDP growth is estimated to have softened to a still robust 3¼ percent in 2014 from 4½ percent in 2013, mostly reflecting the moderation in domestic demand growth amid a less favorable external environment. Weak economic conditions abroad have continued to weigh on Uruguay’s current account, particularly on the services side. At the same time, the surge in inflows to the local securities market abated and the Uruguayan peso has depreciated towards levels broadly consistent with fundamentals.

Inflation remains above the central bank’s 3–7 percent target range. After being pushed to near 10 percent in early 2014 by food price shocks and the pass-through of peso depreciation, consumer price inflation receded to 8¼ percent at the end of the year, in part due to subdued increases in administrative prices and one-off measures to ease inflation. Above target inflation reflects a shrinking but still positive output gap, upward shocks to food and fuel prices in 2010–13, and pervasive backward-looking wage indexation that embedded these shocks.

Monetary policy has been tight while fiscal policy has been slightly expansionary in 2014. The peso yield curve remained 400–600 basis points above inflation and credit growth has slowed markedly. Public sector spending continued to grow faster than real GDP in 2014, but the budget approved for 2015 will generate a fiscal withdrawal of about ¾ percentage point of GDP, mostly by slowing spending.

Bank resilience indicators are generally strong, but less so than a few years ago. In particular, foreign currency credit to borrowers in the nontradables sector has increased as a share of total credit, banks’ capital buffers have declined somewhat, and the share of nonperforming loans has inched up in 2014, albeit from a low level. Deposit dollarization remains elevated.

Economic activity is projected to decelerate further but remain solid. The pass-through of lower global oil prices to end-user prices will be gradual, as part of the windfall from lower oil prices will initially be used to shore up the operating balance of the state-owned petroleum enterprise. The programmed fiscal tightening and continued weak external conditions will outweigh the positive impact of reduced gasoline prices on domestic demand, with growth shifting down to about 2¾ percent in 2015. Inflation is projected to decline gradually to within the target range over the medium term as monetary policy remains tight, the output gap closes, and retail prices for gasoline decline. Net public debt is projected to crawl up to 43 percent of GDP in 2019 from 36½ percent in 2013, with the primary balance remaining below the level required to keep debt constant.

Key risks to the outlook relate to uncertainties regarding global and regional economic growth and U.S. monetary policy normalization. The strong liquidity buffers of the private and public sectors would facilitate an orderly adjustment to external shocks. Nevertheless, the high shares of nonresident-holdings of public debt and foreign currency denominated bank credit to borrowers in the nontradables sector could present vulnerabilities.

Executive Board Assessment

The Uruguayan economy is decelerating gradually after a decade of strong and inclusive growth. Export receipts are growing at a markedly lower clip than a few years ago and domestic demand growth is slowing towards a more sustainable pace. At the same time, inflation remains above the target range and the primary fiscal balance has weakened further in 2014.

The external environment presents risks as well as opportunities. As a small open economy that exports mostly agricultural products and has nonresidents holding a relatively high share of its public debt, Uruguay is exposed to the risk of lower global growth and tighter global financial conditions. At the same time, the recent drop in global crude oil prices will provide a welcome opportunity to improve the overall fiscal and balance of payments positions and reduce inflation.

Uruguay’s strong liquidity buffers would allow an orderly adjustment in the event of adverse external shocks. Public debt maturity is high, reserves comfortably exceed prudential benchmarks, and banks and the public sector have ample U.S. dollar liquidity. However, above-target inflation would leave little room for a countercyclical monetary policy response, and a primary balance that is insufficient to keep net public debt around its current level would limit the policy space to deploy discretionary stimulus.

A multi-dimensional disinflation strategy is needed to bring inflation to the mid-point of the target range. Such a strategy would involve maintaining a monetary policy stance tight enough to keep inflation on a downward trend, moving towards tighter fiscal policy, a reduction in the backward-looking component of wage setting to temper inflation persistence, and bolstering the central bank’s influence on inflation expectations through well-crafted communication efforts. Enhanced central bank autonomy would also be beneficial.

The upcoming five-year budget is an opportunity to reinforce fiscal sustainability. Improving the primary fiscal balance by about 2 percent of GDP over the medium term would help ensure that net public debt is put on a firmly declining path. The improvement in the fiscal balance could be achieved by keeping spending growth moderately below potential GDP growth over the next five years and modestly increasing revenues.

Financial regulation and supervision are solid, but could benefit from fine-tuning in some areas. The exposures to exchange rate depreciation risks bear continued close monitoring. There is scope to strengthen risk weights for foreign currency loans to unhedged borrowers, incorporate greater exchange rate stress into the supervisory stress tests, and require banks facing capital shortfalls in the stress tests to submit contingent capital plans for the approval of the Superintendency of Financial Services. In addition, measures to assist financial deepening could enhance growth and social inclusion.

A key challenge is to bolster strong growth in the medium run in order to continue deepening Uruguay’s social gains. The commitment of the incoming government to boost infrastructure investments, revamp secondary education and skill formation for the youth, and foster an innovation-friendly business environment is welcome.

Table 4.

Uruguay: Selected Economic Indicators

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Sources: Banco Central del Uruguay, Ministerio de Economia y Finanzas, Instituto Nacional de Estadistica, and Fund staff calculations.

Percent change of end-of-year data on one year ago. For 2014, latest available data.

Includes bank and non-bank credit.

Non-financial public sector excluding local governments.

Total public sector. Includes the non-financial public sector, local governments, Banco Central del Uruguay, and Banco de Seguros del Estado.

Gross debt of the public sector minus liquid financial assets of the public sector. Liquid financial assets are given by deducting from total public sector assets the part of central bank reserves held as a counterpart to required reserves on foreign currency deposits and the domestic currency claims of the non-financial public sector on resident financial institutions.

1

Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country’s economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board.

2

The Executive Board takes decisions under its lapse-of-time procedure when the Board agrees that a proposal can be considered without convening formal discussions.

Uruguay: Staff Report for the 2014 Article IV Consultation
Author: International Monetary Fund. Western Hemisphere Dept.