Uruguay: Staff Report for the 2017 Article IV Consultation
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International Monetary Fund. Western Hemisphere Dept.
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Publication Date:
31 Jan 2018
eISBN:
9781484338322
Language:
English
Keywords:
ISCR; CR; Uruguay; exchange rate; financial asset; consumer price index; policy; banking sector; bank credit; foreign currency; output gap; private sector; Public sector; Inflation; Global; foreign direct investment
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2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Uruguay

Abstract

2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Uruguay

Context

1. 2017 has been a good year for Uruguay. With stronger GDP growth (in a volatile region), the increase in unemployment since 2014 has come to a halt. A relatively tight monetary policy stance and an appreciating exchange rate have contributed to a notable decline in inflation, bringing it within the central bank’s target range (3 to 7 percent) for the first time in seven years. The current account balance has been improving and is now in surplus, while the government has reduced its fiscal deficit and continues to be able to access international markets on favorable terms. In particular, since mid-2017 it has successfully, and for the first time, issued two bonds in international markets denominated in domestic currency. In addition, the country has maintained its strong record in promoting social inclusion, including gender equality. With the benign global environment expected to last for the time being, and building on Uruguay’s strong institutions and social cohesion, it is a good time to focus on medium-term priorities, in particular, reinforcing the sources of growth, strengthening policy anchors, and promoting de-dollarization.

uA01fig01

Real Gross Domestic Product

(Index, 2011=100)

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Source: IMF, World Economic Outlook.

Recent Developments

2. Since the Spring of 2016, appreciation pressures have reinforced the immediate benefits from the authorities’ prudent policies. Strong investor interest in emerging markets combined with a positive assessment of Uruguay’s risk profile, record tourism inflows, and also currency switching by domestic agents, contributed to the pressures on the currency. From April through October 2016, these forces resulted in a nominal appreciation of the peso (by 12 percent vis-à-vis the U.S. dollar), which reduced tradable goods inflation, and boosted real wages and (wage-linked) pensions and consumption (see Box 1). Subsequently, the inflows fueled a significant accumulation of international reserves as the authorities intervened in the exchange market through 2017 to limit further appreciation.

Uruguay: The Impact of Exchange Rate Movements on Consumption 1/

Exchange rate depreciations quickly reduce private consumption in Uruguay. Results from a vector autoregression (VAR) model and a vector error correction model (VECM) are that, on average, a 10 percent depreciation is accompanied by approximately a 1 percentage point fall in private consumption growth in the short run. Our estimations indicate that this demand effect also leads to a contractionary effect on GDP. This finding deviates from the standard view that depreciations are typically expansionary (through higher net exports).

We find two main explanations for the impact of exchange rate movements on private consumption:

• The first is a negative impact of depreciations on real incomes. Nominal wages are fixed in the short-run and with an immediate exchange rate pass-through of around 15 percent, real wages temporarily fall. A high share of Uruguayan households is liquidity constrained leading them to adjust consumption in response to temporary income shocks.

• Second, we find that exchange rate pass-through across goods is heterogenous, and close to 100 percent for durables. Depreciations thus imply a price hike for durable goods, and durable consumption reacts very strongly in the short run to exchange rate movements, possibly indicating inter-temporal substitution by households.

• By contrast, we see little evidence of changes in consumption through wealth effects or changes in expected permanent income.

uA01fig02

Exchange Rate Pass-Through by Item

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

uA01fig03

Car Sales and Exchange Rate Movements

(Percent change, q/q)

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: Asociación de Comercio Automotor del Uruguay, BCU and IMF staff calculations.
1/ Based on Toscani, F., “The Impact of Exchange Rate Movements on Consumption in Uruguay,” Selected Issues Paper, forthcoming.

3. As a result, inflation has declined to 6¼ percent, while growth is projected to rise to more than 3 percent in 2017. With a sharp fall in tradables inflation, and nontradables inflation on a tentative downward path, inflation fell to 5½ percent in July before edging up as the appreciation effect waned. Monetary policy effectively tightened between mid-2016 through the first quarter of 2017, as nominal interest rates remained fairly stable while inflation came down. Since then, interest rates have fallen, with short-term real rates moderating to 2–3 percent, which is in line with a calibrated Taylor rule. Real GDP growth is projected to increase, from 1.5 percent in 2016 to 3.1 percent in 2017, driven largely by private consumption, net exports (with an exceptionally strong tourist season, mostly from Argentina) and, on the production side, a good harvest. On the other hand, a prolonged closure of the oil refinery due to maintenance and a labor dispute dampened growth by more than ½ of a percentage point.

uA01fig04

Inflation, Target Range, and Expectations

(Percent change, y/y)

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: Instituto Nacional de Estadistica, and Fund staff estimates and calculations.

4. Fiscal adjustment is proceeding. The 2016 fiscal deficit—at 4.0 percent of GDP—was 0.3 percent of GDP smaller than budgeted, largely due to a lower interest bill. Fiscal policy has been countercyclical in 2017, with higher income taxes partly offset by rising pension and health care costs, and staff projects the overall deficit to decline to 3.3 percent of GDP.

5. Credit remains weak, and has not served as a source of growth. Bank credit to firms (in U.S. dollars, the typical denomination) declined by about 4¾ percent (y/y) by October, mostly reflecting weak demand, while credit to households edged up by more than 2 percent (y/y) in real terms. Indeed, the ongoing uptick in growth seems unrelated to financial conditions, which have tightened since 2015. More generally, bank credit remains relatively low in Uruguay (below 30 percent of GDP), and domestic bond markets do not provide significant private sector financing. Non-performing loans have increased since 2014 but remain moderate, at less than 4 percent, and are covered by provisions and excess capital.1

uA01fig05

Financial Conditions Index

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Note: The financial condition index provides a summary measure of the effect of financial variables on economic activity. The computation follows IMF Country Report 13/220.

6. While the exchange rate has appreciated, the current account has turned positive in 2016 and 2017.2

  • Strong investor interest has spurred nominal appreciation pressures vis-à-vis the U.S. dollar since early 2016. The multilateral real exchange rate appreciated by 9 percent between April 2016–September 2017, while the bilateral real exchange rates versus Argentina and Brazil, both key trading partners, depreciated over this period.

  • The diverging real exchange rate trends vis-a-vis Argentina versus the rest of the world are mirrored in diverging pressures on the current account. The increased competitiveness against Argentina has supported a rapid and strong increase in tourism inflows (despite an Argentinean recession) and a decline in consumer purchases by Uruguayans across the border. The real appreciation relative to the rest of the world combined with weak or declining world market prices of key export goods (including beef, rice and soy), has weakened export competitiveness for most manufacturing and agricultural products (even if actual export performance has shown a mixed picture, in particular owing to strong harvests in 2017). Manufacturing export growth has stagnated over the past 5 years for many products (countered by sharp growth of the second paper pulp plant), and overall (y/y) production growth by manufacturing exporters turned negative by mid-2017. After Uruguay managed to diversify its export products and destinations over the past decade and a half—which has greatly diminished its vulnerability to recurrent shocks in neighboring countries—a prolonged loss of competitiveness would put these gains at risk.

  • The current account is expected to maintain a surplus of more than 1.5 percent of GDP in 2017. The current account improvement has mostly reflected the surging net tourism and merchandise trade inflows from Argentina, while a contraction in merchandise exports would play out more slowly. The current account surplus has also been supported by the decline in oil import prices in 2015 and 2016 and by a sharp decline in inward FDI (with a high import component.

uA01fig06

Uruguay: Real Exchange Rates

(Index, Jan 2012=100)

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: Banco Central de Uruguay (BCU), World Economic Outlook, Instituto Nacional de Estadistica data, Haver Analytics, and Fund staff calculations.1/ The real exchange rate against Argentina is calculated using the unofficial CPI for Argentina until April 2016 and the official onwards; and the average of the unofficial and official exchange rates for the Argentine peso until November 2015 and the official exchange rate onwards.
uA01fig07

Uruguay: Ratio of Export Prices to Nominal Wages in U.S. Dollars

(Index, Jan-2010=100)

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: BCU, Haver Analytics and IMF staff calculations.
uA01fig08

Current Account 1/

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: Banco Central de Uruguay (BCU) and Fund staff calculations.1/ 2017E denotes an estimate.2/ The current account balance for 2017 reflects data until June 2017 under the recently published BPM6 method.3/ The bilateral balance against Argentina reflects merchandise trade and tourism only.
uA01fig09

Manufacturing Export Volumes

(Percentage change, 5-year)

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: Banco Central de Uruguay and IMF staff calculations

7. Staff’s assessment is that the external position is stronger than consistent with fundamentals and desirable policy settings, reflecting the unusually strong current account (see Annex I). Staff estimates a current account gap of 2–3 percent of GDP after adjusting for the impact of the overvaluation of the Argentinean peso. Given the typically greater reliability of the current account model, this would suggest that the external position is on the strong side. At the same time, the external sustainability approach—based on the projected rather than the present current account balance—suggests that the real exchange rate is broadly in line with fundamentals. The EBA ‘lite’ real effective exchange rate model—which does not depend on an assessment of the current account position—points to a 11 percent overvaluation, which broadly corresponds with the above-mentioned recent real appreciation. Additional uncertainties arise from the challenge of correcting for merchanting activities.3 Overall, the sizeable challenges for assessing the external position here add to the urgency of structural reform measures to boost productivity and competitiveness.

8. Financial flows have remained volatile. In late 2016 through early 2017, a large drop in nonresident holdings of government and central bank paper (more than $1 billion) due to a one-off portfolio adjustment by a single investor could have resulted in depreciation pressures on the peso, if not for an offsetting portfolio shift by Uruguay’s pension funds from U.S. dollars to local currency, which continued through the third quarter of this year. More generally, however, local and nonresident investor interest has been strong, with significant portfolio inflows in 2017 Q2 and Q3. The central bank intervened to accommodate these large portfolio shifts, adding US$3 billion to its stock of net reserves in the first three quarters of 2017. In other capital flows, since August 2016, a tax amnesty in Argentina has led to the orderly withdrawal of about US$1.3 billion in nonresident foreign-currency bank deposits, with Uruguayan banks reducing their foreign assets accordingly. Finally, revised foreign direct investment data shows that inflows slowed significantly in 2015, and turned to net outflows in 2016, partly as foreign-owned Uruguayan “merchanting” firms redeemed debt obligations owed to their parent companies. Excluding these merchanting firms, the slowdown in net FDI inflows amounted to 2.1 percent of GDP in 2015, and 2.6 percent of GDP in 2016.

9. To reduce public debt vulnerabilities, the authorities have successfully capitalized on financial markets’ benign view of the country and have diversified the investor base. In mid-2017, following the notable decline in inflation and buoyed by strong investor appetite, Uruguay issued nominal-peso bonds in the global market.4 The government raised over US$ 2billion at yields of 10 percent or below for five- and ten-year paper.5 The share of the public debt denominated in foreign currency is expected to remain at about 50 percent by end 2017. The resulting longer local-currency yield curve can assist in the pricing of long-term peso-denominated financial contracts, such as life insurance and pensions.

uA01fig10

LA7: Emerging Market Bond Indices

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Source: J.P. Morgan.

Outlook and Risks

10. Staff expects the recovery to continue. Growth is projected to remain somewhat above its 3-percent potential rate in 2018 and 2019, supported by planned investment in rail infrastructure, and the output gap is projected to turn slightly positive in these years. Over the medium term, the current account balance is expected to worsen gradually to a deficit of ¾ percent of GDP as investment and import volumes increase. Net FDI outflows are expected to turn to inflows again in 2017 and beyond, in line with historical savings patterns and expectations for domestic growth. Inflation is projected to pick up to 6½ percent by end-2017—as the effects of the 2015 spike in food prices and of the peso appreciation dissipate—and is subsequently expected to edge down to about 6 percent. Real domestic credit is projected to rebound modestly to a growth rate of 2–3 percent as investment picks up, nevertheless remaining subdued given structural impediments (see below).

uA01fig11

Uruguay: Contributions to Real GDP Growth

(Percentage Points)

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: BCU and IMF staff calculations.1/ Staff projections.

11. This largely benign outlook is subject to nontrivial upside and downside risks (see the Risk Assessment Matrix). On the upside, the authorities have reached agreement, in principle, with the Finnish company UPM on a possible foreign investment in Uruguay’s third paper pulp-processing plant—which, at about US$3 billion (5 percent of GDP) would be the largest FDI project in the country ever and could boost confidence and growth further, especially during the construction phase. On the downside, there is risk of dampened investor interest in emerging markets. A reversal of the recoveries in Argentina and Brazil, or a significant slowdown in China—with these three countries accounting for half of Uruguay’s merchandise exports, and Argentina alone for more than two-thirds of tourism receipts—would undermine investment and growth. These forces could also trigger a correction of the external imbalances in Argentina which, in turn, could result in depreciation pressures in Uruguay that would negatively impact consumption and inflation and reinvigorate dollarization. Furthermore, hedging options are limited, raising the cost of exchange rate volatility.

12. The country has the ability to weather conceivable short-term shocks. Uruguay’s large buffers—gross reserves of the central bank well above the upper bound of the IMF reserve adequacy metric range (see Annex I), liquid financial assets sufficient to cover debt service for 12 months, and contingent credit lines at international financial institutions of 4 percent of GDP—would allow the country to weather potential short-term shocks relatively unscathed. Against this background, and given the fiscal costs of sterilizing reserves, the authorities plan to reverse more than half of the net reserve increase of 2017 over the next three years, by selling foreign exchange to public companies (with large import needs) on a fixed schedule. Allowing the exchange rate to adjust in response to shifts in economic fundamentals offers another important shock absorber.

Risk Assessment Matrix

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13. The authorities underscored the combination in 2017 of a rebound in growth and lower inflation, within the target range. They considered that the decline in nontradables inflation was particularly important. They emphasized the economic risks stemming from developments in neighboring countries, as well as the risk that the search for yield in international markets might come to an end. At the same time, they considered that Uruguay was well positioned to manage such shocks, with a flexible exchange rate and ample financial buffers. The authorities stressed that the expected investments in a third paper pulp mill would offer a major impulse to investment and growth. They concurred that eroding competitiveness for parts of the export sector was a cause for some concern.

Policy Discussions

14. The authorities are in a position to consolidate the macroeconomic gains of 2017 and to address the medium-term growth bottlenecks. With a positive outlook for growth in the near term, both fiscal and monetary policy should be kept tight, in order to secure a stable and sustainable path for public debt as well as lower inflation within the target range. In the medium term, however, a persistent decline in public and private investment would result in lower potential growth (currently estimated at 3 percent). Staff recommends steps to (i) reinforce the de-indexation of wages; (ii) increase investment in infrastructure and strengthen the predictability of fiscal policy over the medium term; (iii) facilitate the de-dollarization process; and (iv) explore structural reforms aimed at raising Uruguay’s growth potential.

A. Keeping Inflation Low

15. The recent moderation of nontradables inflation and inflation expectations confirm the favorable prospects for enhancing price stability. After currency appreciation propelled the sharp decrease in inflation from its peak at 11 percent in May 2016, that impact has tapered since the summer of this year. However, the multi-year wage agreements reached in 2015–17—which put nominal wage increases on a declining path through 2018, replacing the earlier wage indexation mechanism—are expected to help anchor nontradables prices and temper inflation inertia.6 Inflation expectations revealed in surveys and in the yields on nominal versus inflation-linked government bonds foresee inflation declining after 2017 to 5–7 percent.

16. Some monetary tightening would be appropriate as expected demand pressure materialize in order to bring inflation close to the middle of the central bank’s 3-to-7 percent target range. The baseline projection of gradually falling inflation is predicated on prudent monetary policies, with short-term real interest rates staying above 2½ percent.

17. The transmission of monetary policy has been constrained by the high degree of dollarization and low level of peso credit, the volatility of the short-term interest rates, and wage indexation.

  • Keeping inflation within the target range would support central bank credibility and could set the stage for broader efforts towards de-dollarization. Dollarization has been engrained in the Uruguayan economy for decades. Experience of other countries indicates that in order to de-dollarize successfully, complementary policies can be helpful once macroeconomic stability has been achieved (see Box 2). Staff welcomed the restoration in August of higher reserve requirements on foreign currency (relative to domestic currency) deposits. The authorities could also foster de-dollarization by promoting that prices for domestic transactions are quoted in local currency.

  • Strengthening the policy signal. While the monetary stance has been broadly appropriate and inflation is on a downward trend, short-term interest rates have been relatively volatile since the 2013 move to an operational framework for monetary policy that includes a reference range for M1+ growth. The authorities have regularly adjusted the reference range and allowed money growth to deviate from it, informed by interest rate developments. Nonetheless the volatility of interest rates has increased due to the difficulty of predicting money demand (especially given the ongoing changes in deposit dollarization). The authorities should (i) continue to closely monitor and accommodate changes in money demand; and (ii) explore options to reduce the volatility of short-term interest rates further, for example by using standing facilities to create an interest rate corridor.

  • Eliminating the remaining wage indexation provisions. The move to nominal wage increases in the last wage round was a welcome step. While real wages are estimated to have risen sharply in 2017 due to the lower-than-expected inflation, wage growth is expected to moderate starting next year. Continued moderation of annual nominal wage growth in the 2018 (multi-year) wage agreements will be important for anchoring inflation expectations over the medium term (and real wage restraint could also help stem the trend decline in employment). Removing the remaining provisions that involve backward-looking wage indexation in case of higher-than expected inflation would be another step to reduce inflation inertia, and improve the effectiveness of monetary policy.

uA01fig12

Uruguay: Wage Growth

(Percent change, y/y)

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Source: Haver Analytics and Fund staff calculations.

Options for Supporting De-Dollarization in Uruguay 1/

Uruguay has a long history of financial dollarization. Many studies have found macroeconomic stabilization, especially lower inflation, to be a necessary ingredient for de-dollarization. Several found that nominal appreciation of the exchange rate was also a strong contributor, particularly for deposits; a trend that can be confirmed in the case of Uruguay (see chart).

uA01fig13

Uruguay: Dollarization and the Exchange Rate

(Percent of total)

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: BCU and Fund Staff calculations.

However, multiple studies have found that dollarization is a persistent phenomenon. In the case of Peru, for example, it took various prudential, supervisory, and pricing policies, to complement the macroeconomic environment, and successfully de-dollarize. Prudential policies to better internalize the risks of dollarization were put in place in the 1990s. Between 2000–05, the Peruvian authorities introduced a requirement for prices of goods and services to be listed in domestic currency. These measures, together with the introduction of inflation targeting in 2002 and the development of the domestic capital market, all played a role in the gradual de-dollarization.

uA01fig14

Uruguay and Peru: Dollarization

(Percent of total)

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: BCU and Fund Staff calculations.

More could be done in Uruguay to capitalize on current conditions in favor of de-dollarization. The BCU should maintain higher reserve requirements (RRs) foreign currency deposits relative to local currency deposits at the central bank, together with the higher provisioning and capital requirements on foreign currency loans, to help internalize the costs of dollarization. (Such prudential measures should not aim at restricting capital flows.) In addition, the authorities could consider mandating the listing of prices of goods and services in local currency, to start the long process of de-dollarizing popular “mentality”. Government communications could consistently refer to prices and amounts in terms of domestic currency rather than U.S. dollars.

1/ Based on Singh, D., “Next Steps for Promoting De-Dollarization in Uruguay,” Selected Issues Paper, forthcoming.

18. The authorities noted that that keeping inflation within the target range was an important challenge, against the background of ongoing strong demand. To help achieve this, monetary policy had remained reasonably contractionary, albeit less so than when inflation was still at higher levels. The results of the upcoming wage round would also be an important factor. The authorities emphasized that they had accommodated a large increase in money demand in 2017, with money growth rising beyond the central bank’s reference range. In this context, in August they had reduced the reserve requirements for domestic currency deposits, which could support the provision of peso credit.

B. A Flexible Exchange Rate

19. Sizeable and abrupt portfolio shifts by financial institutions have posed risks of large, sudden, and disruptive exchange rate movements, that can justify the recent interventions in the exchange market. In addition to portfolio inflows by nonresidents, significant portfolio shifts by domestic pension funds and other domestic players into pesos added to upward pressures on the exchange rate, especially during the second and third quarters of 2017. The central bank accommodated these portfolio adjustments by buying foreign currency directly in exchange for peso letras (central bank paper), in particular from the pension funds. Indeed, such portfolio shifts by domestic pension funds alone accounted for US$3 billion (5 percent of GDP, and equivalent to the increase in net reserves during this period), with sharp peaks in May and August. Without these interventions, the relatively small exchange market—with an average daily turnover of about US$25 million, well below the size of many of the specific portfolio shifts—would have likely experienced disruption involving undue exchange rate volatility. At the same time, staff emphasized that exchange rate flexibility remained important for stabilizing the economy in the face of shocks.

20. The authorities stressed that large capital flows and domestic portfolio shifts would have put excessive pressure on the country’s small exchange market, and therefore had to be absorbed. They noted that residents could switch between foreign and domestic currency assets without restrictions. The authorities confirmed the importance of maintaining a flexible exchange rate.

C. Reconciling Fiscal Consolidation and Investment Support

21. With the approved 2018 budget, the authorities’ deficit objective is within reach. Staff estimates that the cumulative structural fiscal effort during the current government period (2015–17) has amounted to 1.4 percent of GDP—split between years 2015 and 2017 (with minimal adjustment in 2016). The 2018 budget delineates relatively small changes—higher pension and education outlays, amounting to 0.4 percent of GDP—which will be offset by higher revenues due to the better-than-expected macroeconomic outcomes, as well as a temporary 3 percentage points increase in import fees for consumer goods and higher taxes on gambling. While the authorities viewed the import fees purely as a revenue measure, the staff argued against these as they go against Uruguay’s ongoing trade integration efforts that have supported productivity growth, and would have preferred alternative revenue measures. In addition, the 2018 outturn is expected to benefit from the full impact of the 2017 tax reform. The budget envisages a decline in the overall deficit from 4.0 percent of GDP in 2016 to 2.9 percent in 2018. The budget also reaffirms the government’s commitment to reducing the deficit to 2.5 percent of GDP by 2019.

22. Staff encouraged the authorities to reach their 2019 deficit target earlier. Historically, election years—such as 2019—have seen higher spending and deficits, suggesting that it could be challenging to rely on further adjustment in 2019 to reach the deficit target. Furthermore, staff argued that the steadfast implementation of the spending allocations in the budget combined with a stronger-than-expected recovery would allow the authorities to achieve their 2.5-percent-of-GDP fiscal deficit objective already in 2018 with a limited additional effort, and helped by lower interest costs.7 Staff advised the authorities to save the revenue windfall, should GDP growth exceed expectations. In addition, since the introduction of a mixed pension system in 1996, the implicit fiscal liability stemming from future deficits of the defined benefits pillar of the system has increased as a result of successive adjustments. The authorities should restore the sustainability of the system as soon as possible, in particular through parametric reforms.8

23. Reversing the reduction in public investment is becoming increasingly urgent. Starting in 2015, the authorities have reduced public investment by close to 1 percent of GDP—with the expectation that public-private partnerships (PPPs) would more than pick up the slack. However, a rapid rise in PPPs has not materialized, notwithstanding Uruguay’s well-documented infrastructure gaps, notably for transportation9 Staff’s estimates of fiscal multipliers support the notion that higher public investments could also invigorate private investment and growth10. Staff advised reorienting budget spending from the public wage bill to investment, and accelerating the preparation of PPPs (without relaxing safeguards). Furthermore, and regardless of the financing modality, it will be important to assess carefully the costs and benefits—including potential synergies—of each project, as well as of incentives to attract private investment.

24. As the end of the government term approaches, amending the existing fiscal rule could strengthen confidence in the sustainability of Uruguay’s public finances. A continuation of present fiscal plans would stabilize gross and net debt as a share of GDP (see Annex II). However, the government’s fiscal commitment only covers its term, which runs out in 2019. Moreover, even though the existing fiscal rule limits the annual increase in net debt, the frequent use of escape clauses accommodated a substantial increase in net debt before the current government period. An enhanced fiscal rule could include: (i) further safeguards to limit the use of escape clauses, (ii) constrain annual deficits (or debt increases) specified in structural terms to allow for the operation of automatic stabilizers, and (iii) be anchored on a medium-term objective for the level of debt.

25. Uruguay’s state-owned enterprises (SOEs) have to be carefully managed. SOEs have traditionally played an important role in economic life. However, SOEs require strong governance to avoid the accumulation of quasi-fiscal costs (such as the recent need to recapitalize the state oil company ANCAP).11 Ensuring that governance of SOEs is improved––with the focus on fiscal savings, investment prioritization, and strengthening management practices—would be an important step towards limiting fiscal risks.12 Furthermore, staff reiterated its advice to pass through changes in international oil prices to the domestic fuel prices charged by ANCAP, based on a transparent formula, now that the company has been brought back to financial soundness. This would promote efficiency in the use of fuel and remove fiscal risks—which can be alleviated only partly though the current practice of hedging oil import prices.

26. The authorities confirmed their fiscal objectives, involving a reduction in the public sector deficit to 2.5 percent of GDP by 2019, which they considered challenging but attainable. They noted that they were fully aware of the spending pressures that could arise in the coming pre-election and election years. The authorities explained that autonomous increases in pension costs had been the main driver of increases in fiscal spending, and they consider it necessary to assess parametric changes of the system to control its costs. The authorities highlighted the important contribution made by public enterprises to the improvement in the fiscal results during the current government period. In this context, they noted that in setting administered prices both the costs borne by the public utility companies and broader macroeconomic consequences were taken into account.

D. A More Functional Financial Sector

27. Even though Uruguay’s banking sector is well capitalized, bank credit remains weak. With the regulatory capital to risk-weighted assets ratio increasing since December 2015, the banking sector has comfortable buffers. At the same time, the extensive dollarization and a high degree of market segmentation render bank credit expensive and limited, especially in the peso market, where it could be most beneficial to the nascent business ventures. In particular, the large public bank BROU dominates the peso market, while the foreign banks have highly dollarized deposit bases and mostly engage in the dollar lending to commercial and higher-income segments.13

28. The ongoing implementation of the 2014 Financial Inclusion Law should help the banking sector to expand its reach. By promoting electronic transactions, generalized payroll deposit accounts, and encouraging competition in the banking sector, the law is expected to increase the supply of peso funding and access to credit by consumers—including in low-income and rural segments—and small businesses. At the same time, the use of new capital market instruments to finance public infrastructure, including through PPPs, and expected regulatory changes to facilitate the issuance of bonds by medium-sized private enterprises (rather than relying on self-financing), can help develop domestic financial markets, and promote competition within the financial system.

uA01fig15

Banks: Non-Interest Expenses to Gross Income, 2016

(Percent)

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Source: IMF, Financial Soundness Indicators database.1/ For Mexico, data for 2015.

29. Maintaining the stability of the banking sector is a priority. Banks’ operating costs are high; non-performing loans have risen; and bank profitability declined in the wake of the peso appreciation in 2016 (since most banks were long in U.S. dollars). Nonetheless, stability risks to the banking system remain limited, as evidenced by the authorities’ stress tests, and supported by rising capital-asset ratios (Table 1). Supervision should continue to closely monitor banks’ exposures, assisted by the implementation of the International Financial Reporting Standards (slated for 2018). The recent steps to implement Basel III—including the phased introduction of the 2.5-percent capital conservation buffer, capital surcharges for larger banks, and of liquidity ratio regulations—are useful risk-mitigation measures.

Table 1.

Uruguay: Selected Financial Soundness Indicators

article image
Sources: Banco Central del Uruguay, IMF Global Financial Stability Report, and Fund staff calculations.

Latest available data (October, unless otherwise specified).

For 2017 data as of August.

Foreign currency bank credit to borrowers without natural hedges as a share of total bank loans to the private sector. For 2017, data as of June.

Liquid assets with maturity up to 30 days in percent of total. liabilities

For 2017, data as of August.

30. The authorities considered that the financial system was stable and well- supervised. They noted that self-financing and foreign direct investment had been key sources of funding for private investment, while bank credit had played a relatively less important role. They mentioned their initiative to enhance the domestic securities market, with a joint public-private working group to prepare a blueprint for reform. They authorities had also created a fintech working group to analyze Uruguay’s noticeable position in this sector. The authorities also highlighted their six-month “e-peso” pilot project, for digital currency issued by the central bank.

E. Structural Issues

31. Uruguay’s business climate is backed by the country’s strong institutions and stability. Furthermore, the country has become increasingly integrated in world markets, benefitting from large inward FDI on most years, often for companies operating within free zones. There is also an ongoing transition into knowledge-intensive services, including fintech. The country has shifted to renewable sources for its power supply, in particular, hydropower and, to a lesser degree, wind energy, and has developed connections for exporting excess supply to Argentina and Brazil. It is also implementing a comprehensive care system that supports women’s participation in the broader economy. Nevertheless, Uruguay is ranked relatively low in the ease of doing business—94th worldwide according to the World Bank.

32. No single factor could account for Uruguay’s record of strong growth over the past two decades. A standard (Cobb-Douglas) decomposition shows that, unlike in other Latin American countries, growth in Uruguay has been largely driven by total factor productivity (TFP), which is typically the result of productivity improvements in some sectors or favorable terms-of-trade shocks, but can also result from underinvestment in capital (see Box 3).

uA01fig16

Contributions to Growth in Uruguay

(Percent)

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: Penn World Tables version (PWT) 9.0 and IMF staff calculations.

33. Ambitious structural reforms could help maintain robust medium-term growth against the background of a declining workforce due to population aging. The large contribution of TFP to growth in the past introduces a layer of uncertainty around the medium-term growth projections, and the high growth rates observed in the past may not necessarily persist in the future. To forestall such an outcome, the staff urged the authorities to (i) undertake reforms to improve both educational attainment and the quality of education—for instance, via enhancing teacher qualifications and expanding vocational training; and (ii) facilitate further economic integration with the countries in the region and elsewhere by upgrading the country’s transport and logistic infrastructure; (iii) enhance the flexibility of labor markets, to facilitate shifts to relatively productive sectors and firms and to ensure that wage increases reflect productivity improvements.14

34. The authorities explained their initiatives for supporting public and private investment. They highlighted the forthcoming public investment in railroads, associated with the expected FDI in a third paper pulp mill, and the major positive spillovers of this project for investments more broadly. They were also reviewing their investment promotion regime, with a view to enhancing its prioritization and management. They highlighted that Uruguay had become a major producer of international services, in particular software. The authorities confirmed that education reform remained a crucial policy priority. They welcomed and supported the renewed momentum in Mercosur for its further integration into the world economy, including through the negotiations on a free trade agreement with the European Union.

Sources of Growth in Uruguay 1/

Despite robust growth during the present decade, relative living standards of the average Uruguayan (compared with U.S. counterparts) are only now catching up to where they were in the 1960s. Furthermore, swings in living standards are more than twice what can be explained by movements in the available stocks of factors of production alone. The labor force and the physical capital stock together grew at about twice the rate of the Uruguayan economy during the 1980s. Then, in the decade since the 2001–2 economic crisis, these magnitudes reversed.

The excess volatility in Uruguayan production points to the importance of trends in productivity in the economy. One hypothesis for the post-crisis experience is that increasing global demand for Uruguayan products has benefited the terms at which Uruguayan exports can be traded for imports. The analysis supports this view somewhat, but finds that this feature can only explain about ½ of a percentage point of increased yearly growth since the crisis.

uA01fig17

Spread in Labor Productivities Across Sectors

(average coefficient of variation)

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: Groningen Growth and Development Center (GGDC) 10-Sector Database, INE and IMF Staff calculations.Note: the chart shows the average over time of the coefficient of variation across sectors of the level of labor productivity. In turn, labor productivity is measured as GDP per worker in 2005 U.S. dollars, using constant national prices and market exchange rates.

An explanation for Uruguay’s lack of long-run convergence could be that labor resources may not be efficiently allocated to sectors of production. Our research shows that labor productivities are almost twice as spread out across Uruguayan sectors as they are across sectors in the United States. In theory, such differences in productivity across sectors could reflect a lack of flexibility in the labor market.

1/ Based on Sher, G., “Productivity, Foreign Demand and Factor Allocation in Uruguay,” Selected Issues Paper, forthcoming.

Staff Appraisal

35. Through prudent policies, the authorities have capitalized on favorable external conditions to achieve good macroeconomic outcomes in 2017. As GDP accelerated, a combination of a tight monetary policy stance and an earlier exchange rate appreciation brought inflation within the central bank’s target range. The fiscal adjustment is proceeding broadly as planned, with the authorities’ 2.5-percent of GDP deficit target being within reach. On the upside, the envisaged paper pulp-processing plant could significantly boost growth beyond what is currently projected. Uruguay’s large buffers and exchange rate flexibility would allow the country to adjust to beneficial or adverse shocks in an orderly fashion.

36. To reinforce Uruguay’s resilience to shocks further, and to provide the conditions for sustained robust and inclusive growth, ongoing fiscal and monetary prudence should be combined with structural reforms. The country’s record of strong institutions and hard-won economic stability are recognized by financial markets as well as investors in the real economy. However, there is still scope to boost the credibility of monetary and fiscal anchors over the medium term. Furthermore, weakness in transportation infrastructure, skills formation, labor market flexibility, and access to foreign markets, constrain the economy’s ability to adapt to new opportunities in the face of rapid technological advances, and changes in global production patterns.

37. The loss of competitiveness in manufacturing and agriculture poses a longer-term policy challenge. While staff assesses the external position to be stronger than consistent with fundamentals and desirable policy settings, the outlook may change and further appreciation pressures could arise with the expected foreign investments in a new paper pulp plant. At a structural level, reforms to enhance the business climate will be critical for supporting a vibrant and diverse economic base. Enhancing firms’ access to credit and hedging instruments would also strengthen their resilience. As the public petroleum company regains its financial health, there could also be scope to adjust administered fuel prices.

38. Keeping inflation on a downward path over the medium term would greatly enhance the credibility of the central bank. To this end, some monetary tightening would be appropriate as expected demand pressure materializes. It would also set the stage for broader efforts towards de-dollarization. Keeping nominal wage growth on a declining path would be important for anchoring inflation over the coming years. The authorities may also wish to explore options to reduce the volatility of short-term interest rates.

39. Exchange rate flexibility should remain an important stabilizer for the Uruguayan economy in the face of shocks. Interventions should be limited to countering disorderly market conditions, and cannot substitute for necessary structural reforms to enhance productivity and flexibility. Clear communications are important to ensure that the interventions do not undermine the credibility of the central bank’s commitment to reducing inflation.

40. Uruguay’s main fiscal challenges are of a medium-term nature. In the short term, the authorities should seek to save the expected revenue windfalls and aim at achieving their 2.5-percent of GDP fiscal deficit target before the 2019 election year. In the medium term, an enhanced fiscal rule could be helpful to keep net debt on a sustainable and declining path, while the viability of the pension system will require further reforms. In view of Uruguay’s infrastructure gaps, reversing the reduction in public investment is becoming key. It will be important, however, to assess carefully the costs and benefits of each public and public-private project, as well as of incentives to attract private investment. Relatedly, strong governance of SOEs will be important for limiting fiscal risks.

41. Staff proposes that Uruguay remains on the 12-month Article IV consultation cycle.

Figure 1.
Figure 1.

Uruguay: Real Activity and Inflation

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: World Economic Outlook, Haver Analytics, Banco Central del Uruguay (BCU), Instituto Nacional de Estadistica, Bloomberg L.P., and Fund staff estimates and calculations.1/ For 2017, an average of monthly figures as of August is used.2/ The definition of Core Inflation follows BCU’s definition and excludes administered prices, fruits and vegetables, and tobacco.3/ BCU survey, median of expected inflation for the 12 months ahead.
Figure 2.
Figure 2.

Uruguay: External Accounts

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: Banco Central de Uruguay (BCU), World Economic Outlook, Instituto Nacional de Estadistica data, Haver Analytics, and Fund staff calculations.1/ The real exchange rate against Argentina is calculated using the unofficial CPI for Argentina until April 2016 and the official onwards; and the average of the unofficial and official exchange rates for the Argentine peso until November 2015 and the official exchange rate onwards.2/ Band spans 100 to 150 percent of the Fund’s reserve adequacy metric.
Figure 3.
Figure 3.

Uruguay: Fiscal Developments and Projections

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: World Economic Outlook, Banco Central del Uruguay, Haver Analytics, and Fund staff calculations.1/ Fiscal effort is defined as the change in the Structural Primary Balance.
Figure 4.
Figure 4.

Uruguay: Monetary Policy

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: IMF, World Economic Outlook; Banco Central del Uruguay (BCU); and Fund staff estimates and calculations.1/ The MCI is a weighted average of the changes in the real interest rate of 12-month Central Bank securities and the real effective exchange rate (REER) relative to their values in a base period, January 2012.2/ A standard Taylor Rule was calibrated ii = c + β(πt – π* + β(yt – yt*), where c is the nominal neutral rate calculated as the sum of the mid-point of the official inflation target range and the real potential growth rate; π* is the mid-point of the official inflation target range; (y-y*) is the estimated output gap.3/ 3-month moving average.4/ Average interest rates on new peso loans of up to one year.5/ Annual effective interest rates, monthly weighted average, excluding restructured operations.6/ Weighted average rate on totality of fixed term deposits.
Figure 5.
Figure 5.

Uruguay: Credit and Banking

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: IMF, World Economic Outlook; Banco Central del Uruguay (BCU); and Fund staff estimates and calculations.1/ Share of FX Loans to borrowers in the nontradable sector; data is through 2017Q3.
Figure 6.
Figure 6.

Uruguay: Yield Differentials

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: BCU, Bloomberg, and Fund staff calculations.
Table 2.

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.

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.

Table 3.

Uruguay: Balance of Payments and External Sector Indicators

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Sources: Banco Central del Uruguay and Fund staff calculations and projections.
Table 4.

Uruguay: Main Fiscal Aggregates

article image
Sources: Ministerio de Economia y Finanzas, Banco Central del Uruguay, and Fund staff calculations.

Banco de Prevision Social (BPS).

Non-financial public enterprises (NFPE).

Banco de Seguros del Estado (BSE).

Banco Central del Uruguay (BCU).

Table 5.

Uruguay: Public Sector Debt and Assets 1/

article image
Sources: Ministerio de Economia y Finanzas, Banco Central del Uruguay, and Fund staff calculations.

Stocks are converted into pesos using the end of period exchange rate and divided by GDP.

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.

Gross debt minus total financial assets of the public sector.

Table 6.

Uruguay: Statement of Operations of the Central Government 1/

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Sources: Banco Central del Uruguay, and Fund staff calculations.

Central government and Social Security Bank. Collection of above the line data for municipalities is not feasible at this moment. The below-the-line data for 2013 – 16 are not consolidated.

Not compiled by the authorities until 2013.

Table 7.

Uruguay: Central Government Stock Positions 1/

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Sources: Banco Central del Uruguay, and Fund staff calculations.

Central government and Social Security Bank. Data for 2013 – 16 are not consolidated.

Table 8.

Uruguay: Monetary Survey

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Source: Banco Central del Uruguay.

Latest available data (August 2017).

Peso monetary liabilities include base money and non-liquid liabilities.

The Banco de la Republica Oriental de Uruguay (BROU), Banco Hipotecario de Uruguay (BHU; mortgage institution), private banks, financial houses and cooperatives. Latest available data (August 2017).

For 2017, latest available data (August 2017).

Percent change since one year ago. For 2017, latest available data. In pesos, unless indicated otherwise.

Table 9.

Uruguay: Medium-Term Macroeconomic Framework

article image
Sources: Banco Central del Uruguay, Haver Analytics and Fund staff calculations.

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

Non-financial public sector excluding local governments.

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.

Annex I. External Sector Assessment

Due to a sizeable gap indicated by the standardized External Balance Assessment (EBA) current account model, staff assesses that the external position appears stronger than justified by fundamentals. At the same time, Uruguay is overvalued according to the EBA lite real effective exchange rate (REER) model. External stability risks remain contained given the sufficient level of reserves and the projected current account surplus in 2017.

The current account has achieved a historic surplus in 2016–17, due to strong demand from Argentina, weak FDI, and low import price valuation effects.1 The current account has steadily improved since 2014, to a surplus of 1.7 percent of GDP in 2016 and an expected surplus of 1.9 percent of GDP in 2017. The improvement in the current account is due to price and volume effects, as well as weak investment spending. The main price effect was the sharp fall in oil prices that reduced the value of imports between 2014 and 2016. The value of fuel imports fell by 1.5 percent of GDP over this period. A strongly appreciated Argentinean real exchange rate led to record net tourism inflows from that country in the first quarters of 2016 and, and even more so, 2017. The sharp improvement in the bilateral trade balance with Argentina explains much of the increase in the overall current account balance through 2017 (based on available data). Weak foreign investment inflows and weak government investment have also contributed to weakness in import volumes (given the high import component of investment spending). As the temporary foreign investment and bilateral trade imbalances unwind over the medium term, the current account balance is expected to worsen gradually to a deficit of ¾ percent of GDP.

uA01fig18

Current Account

(Rolling 4 quarters, in percent of GDP)

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: Haver Analytics, Central Bank data, and Fund staff calculations.
uA01fig19

Current Account 1/

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: Banco Central de Uruguay (BCU) and Fund staff calculations.1/ 2017E denotes an estimate.2/ The current account balance for 2017 reflects data until June 2017 under the recently published BPM6 method.3/ The bilateral balance against Argentina reflects merchandise trade and tourism only.

Uruguay: Merchandise Trade Balance

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Sources: Banco Central del Uruguay and Fund staff calculations.

4 quarters through 2017Q2

Net FDI flows were negative in 2016, weighed down by diminished export competitiveness and recessions in key neighbors, while portfolio and other investment flows have been volatile. Net FDI inflows (excluding the activity of merchanting firms) completely dried up in 2016, potentially reflecting the weakened competitive position of manufacturing and agricultural activities in Uruguay (see below) and deep recessions in Argentina and Brazil, which have been key sources of investment in the past decade, and contributing to weak import numbers in the current account. On the portfolio side, 2016 saw net capital outflows due to nonresident sales in the first half of the year that were part of a wider emerging market trend, although this trend reversed from the third quarter with strong portfolio inflows. In 2017, the first quarter saw sizeable outflows given nonresident sales of government securities, but this was reversed in the second and third quarters with strong nonresident interest in the government’s global bond issuances of June and September. Other investment inflows remained positive through the end of 2016 despite over US$1 billion in nonresident deposit outflows after August 2016 related to Argentina’s tax amnesty, as Uruguayan banks reduced their foreign assets. In the first half of 2017, Argentine nonresident deposits further reduced by US$1 billion, leading to net other investment outflows. The peso has remained stable relative to the U.S. dollar in 2017, appreciating by about 1 percent in the year through September. The sizeable nonresident portfolio outflows in the first quarter were more than offset by a shift by domestic pension funds into peso assets. These institutions continued this portfolio shift in the second and third quarters, reducing their foreign currency exposure by an estimated US$3 billion in favor of peso assets (to a large degree by shifting out of dollar deposits held at the central bank). The central bank facilitated such large and abrupt portfolio shifts by directly purchasing U.S. dollars from the pension funds and other large investors in exchange for central bank peso-denominated paper, without which the relatively small market may have experienced disruptions.

Uruguay faces a difficult confluence of relative depreciation vis-à-vis Argentina and a historically strong domestic multilateral real effective exchange rate. The multilateral real effective exchange rate has appreciated by some 10 percent since the beginning of 2012, worsening competitiveness relative to countries outside the region, and spurring worries about the continued viability of various export industries, especially in agriculture and manufacturing. Over the same period, the bilateral real exchange rate has depreciated by some 10 percent against Argentina, reflecting a sharp appreciation of that country’s real effective exchange rate, and the multilateral real effective exchange rate with trading partners excluding Argentina has appreciated by some 12 percent. The high sensitivity of regional tourism flows to relative prices has led to a bilateral current account surplus with Argentina despite the historically strong multilateral real effective exchange rate.

Staff assesses that the external position appears stronger than justified by fundamentals. This assessment is based, primarily, on a sizeable current account gap according to the standardized External Balance Assessment (EBA) current account model. At the same time, Uruguay is overvalued according to the EBA lite real effective exchange rate (REER) model.

  • The EBA current account model assesses the REER to be 14 percent undervalued, based on a 5.6 percent of GDP excess of the current account balance over the model’s current account norm. The model indicates a minimal 0.2 percent of GDP contribution of policy gaps to this current account gap. Staff judges that this estimate of the gap could be overly high. First, for this exercise, the reported current account balance may need to be adjusted for reported merchanting activities that may not reflect domestic value added (see also Annex IV), but that have raised the most recent reported annual current account surplus by 0.8 percent of GDP for 2016. Until corresponding revisions to the national accounts data have been made (planned for 2019) it is difficult to assess the new data and the appropriate magnitude of such adjustment. Second, the model exaggerates the strength of the external position due to rapid improvements in the trade balance vis-à-vis Argentina. The estimated bilateral trade balance with Argentina in 2017 is 2.6 percent of GDP above its historical average,2 which is almost half the size of the model’s current account gap. This reflects a stronger and faster adjustment of trade balances against Argentina than against other countries, with the latter balances expected to be relatively slow to adjust. In turn, this differential response is due to the large share of Argentina in tourism receipts (see charts). Implementing these two adjustments yields a staff estimate of the current account gap of 2.2–3.0 percent of GDP, and a corresponding REER undervaluation of 5.3–7.2 percent.3

  • The EBA lite REER model assesses the REER to be 11 percent overvalued, driven mostly by its actual appreciation. The model’s REER norm is lowered by a weak level of private sector credit.

  • The EBA External Sustainability (ES) model assesses the REER to be broadly neutral, because the projected medium-term current account balance (a 0.7 percent of GDP deficit) is close to the balance (a 0.9 percent of GDP deficit) that would stabilize the long-term value of net foreign assets relative to GDP.

  • To some extent, these varying results can be reconciled by the delayed response of non-Argentina trade to the loss of competitiveness, and the associated decline in FDI (which immediately lowers imports but constrains export capacity only in the longer run).

Uruguay: Exchange Rate Assessment

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Source: Fund staff calculations

Positive values indicate overvaluation.

Based on the October 2017 EBA results.

Desk calculations based on the EBA ES approach.

Using a CA elasticity of 0.415 (see IMF Country Report No. 15/81).

Cyclically-adjusted. Derived by adjusting the current account data for Uruguay prior to 2012 in line with revisions to the data since 2012.

Cyclically adjusted.

CA balance required to stabilize NFA in the medium-term.

2022 CA balance projection.

External stability risks for Uruguay remain contained. As of end-October, gross reserves had increased by US$1.8 billion since the start of 2017 to US$15.3 billion, and the BCU’s own reserves (net of the BCU’s foreign currency liabilities) had increased by US$3.2 billion to US$7.4 billion. Reserves remain well above the upper bound of the IMF reserve adequacy metric range, and various other prudential benchmarks. Staff considers this to be appropriate given that gross reserves, in part, reflect the high degree of dollarization and, hence, banks’ required reserves in foreign currency, while net reserves appear more than adequate to offset possible disorderly conditions in the foreign exchange market, if needed. The sum of the foreign assets of the central bank and commercial banks far exceeds the sum of non-resident deposits and short-term external debt, and amounts to 115 percent of the sum of foreign currency denominated bank deposits (resident and non-resident) and short-term external debt. Given the ample level of reserves, and the projected current account surplus this year, external stability risks remain contained.

Uruguay: Gross International Reserves

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Sources: Banco Central del Uruguay and Fund staff calculations.

Reserves-to-GDP ratio calculated after converting GDP to U.S. dollars.

Reserve adequacy metric range is the minimum reserve adequacy to 1.5 times the minimum.

uA01fig21

Uruguay: Current Account Elasticity Against Argentina

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: BCU and IMF Staff estimates.
uA01fig22

Uruguay: Current Account Elasticity Excluding Argentina

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: BCU and IMF Staff estimates.
uA01fig24

Uruguay: Correlation Between Current Account and Lags of the RER

(Percent correlation at each quarterly lag)

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: BCU and IMF Staff estimates.
uA01fig23

Tourist Spending in Uruguay

(USD million; 4-quarter moving average)

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Source: Banco Central del Uruguay

Annex II. Public Sector Debt Sustainability Analysis (DSA)

Uruguay is one of the few countries to report debt figures on a consolidated basis for the whole public sector, excluding public commercial banks, but including the central bank. Owing to this breadth of coverage, Uruguay is classified as higher scrutiny country, with gross financing needs and debt ratios exceeding the relevant benchmarks.1 Under the baseline scenario, gross debt of Uruguay’s public sector is projected to stabilize at around 63 percent of GDP in 2022. The long average maturity, favorable currency composition of the debt, as well as the high level of liquid financial assets of the public sector—19 percent of GDP at end-2016—mitigate short-term financing risks.

The gross debt of the public sector has a wide coverage. It includes:2

  • Central government debt, which stood at 47 percent of GDP at end-2016. The average maturity of central government debt was just under 14 years, and the share of local currency-denominated debt was close to one half.

  • Central bank debt, which declined from 12 to 10 percent of GDP in 2016 as, early in the year, the BCU used the proceeds from reserves sales to reduce its debt. The debt of the central bank is 2/3 short-term and 2/3 local currency-denominated. Its primary purpose is to manage liquidity.

  • Public enterprises’ debt, which stood at 3 percent of GDP at end-2016.

  • The debt of local governments and other public sector entities (such as Banco de Seguros del Estado), which represented less than one percent of GDP at end-2016.

Overall, 47 percent of the debt of the public sector at end-2016 was in local currency, almost 2/3 of which was in CPI-indexed units.

The public sector holds sizable financial assets (including international reserves), amounting to 32 percent of GDP at end-2016. In addition, the government has access to contingent credit lines from multilateral institutions, which represented 4½ percent of GDP in 2016.

  • The total financial assets of the central bank (including foreign reserve assets, at 25 percent of GDP) reached close to 27 percent of GDP at end-2016. About 13 percent of GDP in reserves were the counterpart to reserve requirements on foreign currency bank deposits.

  • The financial assets of the non-financial public sector amounted to 5 percent of GDP at end-2016, most of which held in liquid instruments (e.g., securities and deposits), in line with the government’s prefunding policy of holding enough liquid assets to cover at least 12 months of debt service.

The net debt of the public sector, defined as gross debt minus liquid assets, stood at 43 percent of GDP at the end of 2016. The stock of liquid assets of the public sector is computed as total gross public sector assets minus the reserves held by banks at the BCU against foreign currency deposits. This stock stood at 19 percent of GDP at end-2016.

Baseline scenario

With the primary deficit close to zero, debt dynamics in 2017 are largely driven by the projected accumulation of reserves, which is to some extent offset by strong growth. Accordingly, gross debt is projected to increase by almost 3 percent of GDP, while the stock of net debt will rise by only 1 percent GDP. In the outer years, both grows and net debt are projected to remain broadly stable as a share of GDP, as the small primary surpluses and the favorable growth/real interest differential support the steady accumulation of assets of the central bank. Assuming that real GDP growth, real interest rates, and other identified debt-creating flows remain at the level projected for 2022, the debt-stabilizing primary balance is estimated at close to 0.5 percent of GDP, broadly in line with the projected medium-term level of the primary balance.

The baseline assumptions are broadly plausible. Staff’s forecast track record is not systematically biased, as reflected in projection errors generally not being consistently on one side. Although inflation forecasts tended to underestimate actual inflation through 2016, growth forecasts were largely on target, and the median forecast errors over the period 2008–16 were broadly in line with those observed in other countries. The projected fiscal adjustment is consistent with experiences across surveillance countries.

The fan charts show limited uncertainty around the baseline. The width of the symmetric fan chart, estimated at around 15 percent of GDP, illustrates a certain degree of confidence for equal-probability upside and downside shocks.

Alternative scenario

A “historical” scenario, assuming that the key macroeconomic variables behave as in the last decade, yields a downward-sloping debt path, since Uruguay experienced high growth rates and exchange rate appreciation as it recovered from the 2002 financial crisis.

Vulnerability of the financing profile

Staff analyzed the vulnerability of the financing profile (as presented in the panel titled “Uruguay Public DSA Risk Assessment”) using data for the non-financial public sector only. In other words, debt of the central bank was excluded for this particular exercise, in order to establish a proper comparison of the data for Uruguay against the standardized benchmarks used for identifying possible stresses. In addition, this also makes these results for Uruguay comparable to those for the vast majority of countries that do not include debt of the central bank in their respective calculations of public sector debt.

The public sector’s financing needs do not imply near-term vulnerabilities. Even though the share of public sector debt held by nonresidents is above its benchmark, other indicators are within their respective benchmarks. Refinancing risks are limited further by the presence of large liquidity buffers, including the sizable liquid financial assets of the public sector and access to contingent credit lines. These considerations also apply to the assessment of external debt sustainability (Annex III). Short-term debt of the non-financial public sector is negligible, reflecting the authorities’ long-standing emphasis on extending maturities and minimizing roll-over risks.

Stress tests

Debt dynamics are moderately sensitive to shocks. In a stylized downside scenario that combines a permanent 20 percent exchange rate depreciation (relative to the baseline) with a temporary drop in growth and primary balances, and a permanent increase in real interest rates, the gross debt ratio rises by about 15 percentage points over the five-year forecast horizon. Net debt rises by 13 percentage points in the same scenario. The sensitivity of net debt to exchange rate shocks is lower than that of gross debt, as the valuation effects on assets from exchange rate changes partially offset the valuation effects on foreign-currency denominated debt. Fan charts of the projected debt distribution confirm that debt dynamics are generally manageable under statistical distributions of combined shocks. Gross public debt would remain below 73 percent of GDP in 90 percent of the cases, while net public debt would remain below 56 percent of GDP under the combined shock scenario previously described.

uA01fig25

Dynamics of Net Public Debt

(in percent of GDP)

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Source: Fund staff calculations.Note: Combined shock as described in the text.
uA01fig26

Uruguay Public DSA Risk Assessment

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Source: IMF staff.1/ The cell is highlighted in green if debt burden benchmark of 70% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant.2/ The cell is highlighted in green if gross financing needs benchmark of 15% is not exceeded under the specific shock or baseline, yellow if exceeded under specific shock but not baseline, red if benchmark is exceeded under baseline, white if stress test is not relevant.3/ The debt profile indicators are based on data for 2015 (except for the market perception indicators; see footnote 5).4/ The cell is highlighted in green if country value is less than the lower risk-assessment benchmark, red if country value exceeds the upper risk-assessment benchmark, yellow if country value is between the lower and upper risk-assessment benchmarks. If data are unavailable or indicator is not relevant, cell is white. Lower and upper risk-assessment benchmarks are: 200 and 600 basis points for bond spreads; 5 and 15 percent of GDP for external financing requirement; 0.5 and 1 percent for change in the share of short-term debt; 15 and 45 percent for the public debt held by non-residents; and 20 and 60 percent for the share of foreign-currency denominated debt.5/ EMBIG, an average over the last 3 months, 07-Sep-17 through 06-Dec-17.6/ External financing requirement is defined as the sum of current account deficit, amortization of medium and long-term total external debt, and short-term total external debt at the end of previous period.
uA01fig27

Uruguay Public DSA – Realism of Baseline Assumptions

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Source : IMF Staff.1/ Plotted distribution includes surveillance countries, percentile rank refers to all countries.2/ Projections made in the spring WEO vintage of the preceding year.3/ Not applicable for Uruguay, as it meets neither the positive output gap criterion nor the private credit growth criterion.4/ Data cover annual obervations from 1990 to 2011 for advanced and emerging economies with debt greater than 60 percent of GDP. Percent of sample on vertical axis.
uA01fig28

Uruguay Public Sector Debt Sustainability Analysis (DSA) – Baseline Scenario

(in percent of GDP unless otherwise indicated)

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Source: IMF staff.1/ Public sector is defined as consolidated public sector.2/ Based on available data.3/ EMBIG.4/ Defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.5/ Derived as [(r – π(1+g) – g + ae(1+r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).6/ The real interest rate contribution is derived from the numerator in footnote 5 as r – π (1+g) and the real growth contribution as -g.7/ The exchange rate contribution is derived from the numerator in footnote 5 as ae(1+r).8/ Includes valuation changes and interest revenues (if any). For projections, includes exchange rate changes during the projection period.9/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.
uA01fig29

Uruguay Public DSA – Composition of Public Debt and Alternative Scenarios

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Source: IMF staff.
uA01fig30

Uruguay Public DSA – Stress Tests

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Source: IMF staff.

Annex III. External Debt Sustainability Analysis

Improvements in the authorities’ data collection methods have led to an upward revision in Uruguay’s external debt relative to what was shown in last year’s Staff Report. These upward revisions amounted to some 20 percent of GDP in 2016, almost entirely due to wider survey coverage of firms in the non-financial private sector. It should be noted that revisions back to 2012 now create a structural break in the statistics on gross external debt between 2011 and 2012.1 It is questionable whether Uruguay’s external risk has risen with these data revisions, because gross external assets have been revised up commensurately and the new debt is predominantly owed to foreign parent firms within a larger corporate structure.2

Driven by exchange rate volatility, gross external debt peaked in 2015 at 90 percent of GDP and then fell to 75 percent of GDP in 2016 (see Table). In parallel, an improving current account balance in recent years has put slight downward pressure on the external debt. Some 45 percent of the external debt is owed by the public sector.

Gross external debt is projected to have declined in 2017 to 69 percent of GDP, attributable primarily to a current account surplus and exchange rate appreciation. In subsequent years, staff expects a stable ratio of external debt to GDP, where current account surpluses and favorable automatic debt dynamics are offset by reserve accumulation. In turn, reserve accumulation reflects continued de-dollarization transactions that are expected to be accommodated by the BCU.

Gross external financing needs are expected to increase gradually over the medium term with an amortization of longer-term debt and the normalization of the non-interest current account. Nevertheless, favorable debt dynamics from (non-debt creating) capital inflows and real GDP growth are expected to support a stable long-term ratio of gross external debt to GDP even in the event of current account deficits as high as 4.4 percent of GDP.

The main risk to this outlook is an exchange rate depreciation. A counterfactual one-off devaluation of 30 percent could increase the gross external debt-to-GDP ratio by a similar number of percentage points of GDP, but would not lead to unstable subsequent debt dynamics, holding other things equal (see Figure).

Uruguay: External Debt Sustainability Framework, 2012–2022

(In percent of GDP, unless otherwise indicated)

article image

External debt includes non-resident deposits.

Derived as [r – g – r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

uA01fig31

Uruguay: External Debt Sustainability: Bound Tests 1/ 2/ 3/

(External debt in percent of GDP)

Citation: IMF Staff Country Reports 2018, 023; 10.5089/9781484338322.002.A001

Sources: International Monetary Fund, Country desk data, and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead.3/ External debt includes non-resident deposits.4/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.5/ One-time real depreciation of 30 percent occurs in 2017.

Annex IV. The Revised BOP1

On 29 September 2017, the Banco Central de Uruguay (BCU) released a new version of Balance of Payments (BOP) and International Investment Position (IIP) data going back to 2012. These new data conform for the first time to the principles outlined in the sixth edition of the Balance of Payments Manual (BPM6). The BCU took advantage of the opportunity to make other improvements to its data collection methodology, with a widening of the sample of firms surveyed, from some 200 corporate groups to approximately 490. Uruguay’s system of national accounts currently published by the BCU does not yet reflect these data revisions.

Effects on the BOP and IIP

In broad terms, the two main data revisions are an upward shift in the current account balance (of approximately US$0.8 billion, on average) and an increase in gross external debt of the non-financial private sector (of approximately US$14 billion). Both of these effects are caused by the wider coverage of the sample of firms surveyed.

The increase in the current account balance in the BOP is due to primarily to an increase in measured exports. Many of the new survey firms responsible for this increase are so-called compraventas, or merchants (see below). Since many of these new exporters are owned by non-residents, the balance of the primary income account was revised downward to reflect profits accruing to these non-residents.

The widening of the sample of surveyed firms revised up the gross external debt of private sector non-financial firms. Much of the additional debt is held by parent companies within larger corporate ownership structures, and these newly surveyed firms hold significant external assets that limit the upward revision in the net external debt. The offsetting effect of external assets can be seen in the difference between the small upward revision in the net external debt of direct investment enterprises (US$2 billion in 2016) and the large upward revision in the gross external debt of the non-financial private sector (US$14 billion in 2016). Overall the net IIP is revised down by some US$2.5 billion.

Compraventas/Merchants

An important source of compositional changes in the BOP data occurs through expanded coverage of so-called ‘compraventas’ or merchant firms in the new surveys. Merchant firms purchase goods from non-residents and subsequently resell them to non-residents, without the goods entering the economic territory of Uruguay. Approximately four-fifths of Uruguayan merchant firms operate in grains, while the remainder sell industrial components for manufacturing processes, like pipes for petroleum refining processes. A merchant firm may not conduct merchanting activities every year, and may only engage in merchanting as a secondary business, so that any estimates of the effects of merchanting on the balance of payments are inherently uncertain. In Uruguay, merchant firms typically operate as subsidiaries of foreign-owned parent companies. And for those, the balance of payments would be affected by primary income transfers and transactions in financial assets. The authorities are assessing the impact of merchanting activities on GDP as part of updating the national accounts to the latest standards. The authorities’ calculations of balance of payments data including and excluding compraventas do show a sizable net current account impact of some 0.8 percent of GDP in 2016.

Uruguay: impact of merchanting/compraventas on the BOP

(percent of GDP)

article image
Source: national authorities and Fund staff calculations.
1

Non-performing loans refer to obligations that are overdue by at least 60 days (rather than 90 days).

2

The current account balance has been revised upward relative to the last staff report due to a move to Balance of Payments Manual 6 and an appreciable widening of the sample of firms surveyed, in particular, merchanting companies (“compraventas”). The newly included firms are also expected to make the behavior of FDI more volatile, and to add to gross external debt (See Annex IV).

3

An assessment of the impact of the newly measured merchanting activities on the Uruguayan economy is not yet available (see Annex I and Annex IV).

4

Previously, the country had issued only dollar-denominated and inflation-indexed bonds in the global market.

5

Furthermore, both bonds benefitted from being included in the JP Morgan GBI-EM index.

6

The agreements replaced the direct link between wage increases and inflation with a schedule of annual nominal wage increases that can subsequently be adjusted upward if inflation turns out to exceed the wage increase or a pre-set trigger.

7

In particular, the macroeconomic framework underpinning the 2018 budget assumed the real GDP growth of 2.0 percent in 2017 and 2.5 percent in 2018, below the staff’s forecast of 3.1 and 3.4 percent, respectively.

8

See IMF Country Report 17/29.

9

See, for example, World Bank. 2015. Uruguay—Systematic Country Diagnostic. Washington, D.C.: World Bank Group.

10

See Endegnanew, Y., “Uruguay: Estimates of Fiscal Multipliers,” Selected Issues Paper, forthcoming.

11

The recapitalization of ANCAP involved the forgiveness of its $0.6-billion (1 percent of GDP) debt to the government and the restructuring of some $0.7 billion of the company’s debt to commercial banks. See IMF Country Report 16/62.

12

For further discussion, see World Bank. 2015. Uruguay - Country partnership framework for the period FY16–20. Washington, D.C.: World Bank Group.

13

For a detailed discussion of Uruguay’s banking sector and firms’ access to credit, see IMF Country Report 16/63.

14

For further discussion, see IMF Country Report 16/62 and World Bank, 2015, Uruguay: Trade Competitiveness Diagnostic, Washington, D.C., World Bank Group.

1

In September 2017, substantial methodological changes led to an upward revision in the current account balance and more volatile net FDI inflows. These changes are discussed in detail in Annex IV.

2

This measure is similar to the estimated increase in the bilateral balance with Argentina between 2014 and 2017, which is 2.3 percent of GDP.

3

To calculate this adjustment, the initial current account gap of 5.6 percent of GDP is reduced by 2.6–3.4 percentage points, to reflect temporary factors. The remaining current account gap is 2.2–3.0 percent of GDP, which translates into the stated REER undervaluation using an elasticity of 0.415.

1

See IMF, Staff Guidance Note for Public Debt Sustainability Analysis in Market-Access Countries, May 9, 2013.

2

The numbers for the debt and assets of various components of the public sector are pre-consolidated and exclude debt and assets vis-à-vis other public sector entities.

1

The historical gross external debt statistics now double between the value available for 2011, which is under the old methodology, and the value available for 2012, which has been republished this year under the new methodology.

2

A detailed description of the change in methodology and its resulting data revisions appears in Annex IV.

1

Prepared by Galen Sher (WHD) in October 2017. For more information, see BCU, 2017, “Uruguay: Principales resultados Balanza de Pagos y Posición de Inversión Internacional 2012–2016,” mimeo, September.

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Cover IMF Staff Country Reports
Uruguay: 2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Uruguay
Author:
International Monetary Fund. Western Hemisphere Dept.
Volume/Issue:
Volume 2018: Issue 023
Publisher:
International Monetary Fund
ISBN:
9781484338322
ISSN:
1934-7685
Pages:
73
DOI:
https://doi.org/10.5089/9781484338322.002

Real Gross Domestic Product

(Index, 2011=100)

Exchange Rate Pass-Through by Item

Car Sales and Exchange Rate Movements

(Percent change, q/q)

Inflation, Target Range, and Expectations

(Percent change, y/y)

Financial Conditions Index

Uruguay: Real Exchange Rates

(Index, Jan 2012=100)

Uruguay: Ratio of Export Prices to Nominal Wages in U.S. Dollars

(Index, Jan-2010=100)

Current Account 1/

(Percent of GDP)

Manufacturing Export Volumes

(Percentage change, 5-year)

LA7: Emerging Market Bond Indices

Uruguay: Contributions to Real GDP Growth

(Percentage Points)

Uruguay: Wage Growth

(Percent change, y/y)

Uruguay: Dollarization and the Exchange Rate

(Percent of total)

Uruguay and Peru: Dollarization

(Percent of total)

Banks: Non-Interest Expenses to Gross Income, 2016

(Percent)

Contributions to Growth in Uruguay

(Percent)

Spread in Labor Productivities Across Sectors

(average coefficient of variation)
Figure 1.

Uruguay: Real Activity and Inflation
Figure 2.

Uruguay: External Accounts
Figure 3.

Uruguay: Fiscal Developments and Projections
Figure 4.

Uruguay: Monetary Policy
Figure 5.

Uruguay: Credit and Banking
Figure 6.

Uruguay: Yield Differentials

Current Account

(Rolling 4 quarters, in percent of GDP)

Current Account 1/

(Percent of GDP)

Uruguay: Current Account Elasticity Against Argentina

Uruguay: Current Account Elasticity Excluding Argentina

Uruguay: Correlation Between Current Account and Lags of the RER

(Percent correlation at each quarterly lag)

Tourist Spending in Uruguay

(USD million; 4-quarter moving average)

Dynamics of Net Public Debt

(in percent of GDP)

Uruguay Public DSA Risk Assessment

Uruguay Public DSA – Realism of Baseline Assumptions

Uruguay Public Sector Debt Sustainability Analysis (DSA) – Baseline Scenario

(in percent of GDP unless otherwise indicated)

Uruguay Public DSA – Composition of Public Debt and Alternative Scenarios

Uruguay Public DSA – Stress Tests

Uruguay: External Debt Sustainability: Bound Tests 1/ 2/ 3/

(External debt in percent of GDP)