Mission Concluding Statement 

Uruguay: Staff Concluding Statement of the 2015 Article IV Mission

December 10, 2015

December 10, 2015

Uruguay has weathered global and regional headwinds relatively well so far. Yet the economy is slowing down while inflation remains above target, and within the financial system deposit dollarization has risen. The fiscal agenda launched by the new government in 2015 envisages a welcome combination of budgetary consolidation and emphasis on supporting infrastructure development and key social objectives. Its steadfast implementation will be important for stabilizing public debt in the medium term and ensuring sustainable growth. More generally, and especially at this time of heightened regional uncertainty, enhancing the credibility of the anchors for fiscal and monetary policy would complement Uruguay’s policy buffers for weathering economic and financial shocks. In this context, bringing inflation into its target range remains a key policy priority, and exchange rate flexibility should be the central tool for absorbing external shocks. Financial deepening can also help better insulate the economy against external shocks, support growth, and strengthen the credit channel of monetary policy.

I. CONTEXT AND RECENT DEVELOPMENTS

1. Uruguay has experienced more than a decade of high economic growth, and has become a bastion of stability in a volatile region. Since the financial crisis of 2002, living standards have greatly improved, with a per capita GDP that is among the highest in Latin America, while inequality and poverty are among the lowest. This success owes much to broadly shared societal support for social stability and inclusion, combined with a growth model that emphasized diversification into new markets and new products, thereby reducing regional linkages, while embracing the opportunities in agriculture, forestry, and tourism offered by the country’s natural resources.

2. Uruguay’s stability and strong financial buffers have been recognized by international financial markets. With sound macroeconomic policies, Uruguay recovered quickly from the financial crisis in the early 2000s. It has also distinguished itself through prudent debt management. Its relatively steady sovereign spreads are indicative of the ongoing differentiation by international investors between Uruguay and other countries in the region, in a context of increased volatility. Indeed, Uruguay’s successful issuances of two dollar-denominated external public bonds in 2015 are a testament to this, as was the sovereign rating upgrade announced in June.

3. During 2015, economic activity in Uruguay has markedly slowed, triggered by a regional downturn. Growth is projected to decelerate to 1.6 percent in 2015 due to a cooling off in domestic spending from recent highs and weak external conditions. There is evidence of a decline in consumer and business confidence and weaker credit growth for both firms and households. Unemployment has risen during 2015, to 8 percent. Notwithstanding these developments, Uruguay’s economic performance is still poised to exceed the regional average. The current account deficit is projected to fall to 3¾ percent of GDP, supported by the lower oil import bill and higher pulp exports.

4. Inflation remains entrenched above the central bank’s 3-7 percent target range. Defying the closing output gap, a relatively tight monetary stance over the past two years, and low international food and energy prices, headline inflation has edged up to more than 9 percent (y/y) since July, while core inflation has exceeded 10 percent (y/y) since June.

5. Depreciation pressures intensified during 2015. After depreciating through 2014, the peso has weakened further against the U.S. dollar in 2015, broadly in line with the regional and global trend among emerging markets. After steadily weakening in the first half of 2015, pressures on the peso sharpened during July through October (before abating in November), with portfolio outflows and an acceleration in deposit dollarization.

6. Extensive central bank intervention in the foreign exchange market since July has contained the depreciation of the peso, lowering reserves. Gross international reserves have dropped by US$ 2.5 billion since June, despite the successful US$ 1.7 billion issuance of an external government bond in October. The central bank (BCU) has sold U.S. dollars in the spot and forward markets to support the peso and, in October, bought back peso securities from pension funds in exchange for foreign currency. These operations were aimed at reducing the cost of reserves far above the adequacy benchmark and at lowering exchange rate volatility. That said, reserves nevertheless remain above the upper bound of the IMF reserve adequacy metric (see below). The mission estimates that the real effective exchange rate remains in line with fundamentals.

7. The medium-term budget for 2015-19 projects a tightening of the primary fiscal deficit by 1½ percent of GDP over 5 years. An important deviation from earlier practices is that nominal spending levels have been stipulated for only the next two years. In 2017, the government will assess appropriate spending levels for the period 2018-19, allowing for adjustments as needed to meet the 5-year targets.

8. Since the new government took office in early 2015, it has initiated important reforms. Its initiatives would aim to improve education, boost infrastructure investment with private funding, and enhance the monitoring of public enterprises. The government has also proposed new wage-setting guidelines that could moderate wage growth and alleviate the indexation of wages to past inflation. The successful and timely implementation of these and other reforms are important although could be challenging.

II. OUTLOOK AND RISKS

9. GDP growth is expected to remain tepid at 1.4 percent in 2016 as external conditions remain weak. Adding to weak external conditions, the programmed further slowdown in fiscal spending and consumption is likely to temper domestic demand.

10. Risks to the outlook are mostly external:

• The immediate region. Although Uruguay’s regional economic ties have lessened, a worse-than-expected slowdown in Argentina and Brazil could significantly weigh on Uruguay’s economy.

• The global economy. A global slowdown would affect Uruguay’s commodity exports, and increased volatility in oil prices would affect import costs. A tightening in global financial conditions could also raise the cost of financing. The high share of nonresident holdings of Uruguay’s public debt may pose a potential external risk.

11. While domestic confidence indicators point to weaker demand, near-term financial risks seem limited. A further rise in deposit dollarization could contribute to pressure on the exchange rate. The banking system is adequately capitalized and highly liquid. An uptick in non-performing loans in 2015 does not, at this stage, seem a cause for significant concern. Foreign currency credit to unhedged borrowers in the non-tradable sector has also moderated from its 2013 high, although close monitoring of this ratio remains warranted, particularly given the recent peso depreciation.

12. Uruguay’s strong liquidity buffers should facilitate an orderly adjustment to shocks.

• Government financing risks are limited given access to contingent credit lines (4 percent of GDP) and liquid financial assets (6 percent of GDP). Furthermore, the average maturity of public debt is high, at 15.5 years, reducing short-term risks.

• The BCU’s gross reserves remain ample relative to standard prudential benchmarks and could help cushion severe external shocks.

III. POLICY RECOMMENDATIONS

Resilience to Macroeconomic shocks

13. Uruguay’s flexible exchange rate offers an important instrument for responding to inward spillovers.

• The flexible exchange rate should remain the key stabilizer that absorbs external shocks. The recent depreciation of the peso reflects a reassessment by financial markets of the region’s comparative external outlook. Maintaining competitiveness, in particular vis-à-vis regional markets and competitors, will be vital for supporting growth.

• The BCU’s ample gross reserves can help cushion severe external shocks. That said, interventions in the exchange market should be used sparingly, to avoid disorderly market conditions, and not to counter trends driven by fundamentals. In this regard, staff welcomes the sharp decline of central bank foreign exchange sales in November. Continued interventions would not be warranted if external depreciation pressures continued. Prolonged interventions could erode the country’s buffers prematurely, with substantial financial risks still ahead. Moreover, resisting market expectations of a further depreciation through interventions that delay the adjustment could feed into asset dollarization pressures.

14. Strengthening the credibility of the targets for monetary and medium-term fiscal policy could more firmly anchor expectations and confidence, both domestically and in international financial markets. Increased global risk aversion, Fed lift-off, and regional shocks could test the positive assessment of Uruguay’s financial position. In this context, reinforcing budgetary and monetary frameworks could promote more favorable international borrowing terms and reduce economic volatility.

15. In the near term—until fiscal consolidation has been fully entrenched, and inflation is comfortably within its target range— there is only limited room for countercyclical policies to counter adverse external shocks to growth.

The Macroeconomic Policy Mix

16. Reducing inflation remains a key policy priority. Lowering inflation would promote de-dollarization and create scope to use monetary policy as a countercyclical tool. It would also reduce the inflation tax on low-income households, with no bank account, or only a checking account paying little if any interest. Furthermore, given the current level of inflation, a relatively small price or exchange rate shock could trigger a rise to double-digit inflation.

17. A more effective and comprehensive disinflation strategy is needed to put inflation on a downward path. Tight monetary policy has helped contain inflationary pressures in recent years. The fiscal tightening that commenced in 2015 will complement this effort. As the output gap is expected to close, inflationary pressures are projected to show a gradual decline, with inflation remaining above target through 2018 due to inflation inertia.

• Keeping a tight policy stance. Given the imperative of reducing inflation and a still positive output gap, the tight monetary policy stance should be maintained.

• Reducing inflation persistence. The new wage-setting guidelines set by the government include a helpful focus on wage increases in nominal terms, but still include indexation provisions. It would be advisable to move toward the full elimination of backward indexation as expeditiously as possible to reduce inflation persistence.

• Strengthening the monetary policy framework. It is still too early to convincingly assess the efficacy of the new monetary framework in controlling monetary conditions and anchoring expectations. It will be important to closely monitor the performance of the framework and remain open to adjustments as needed. The M1+ growth target should be attuned to changes in money demand. In the near term, the impact of rising dollarization and lower economic growth implies a need for reducing the target for M1+ growth to avoid an undue relaxation of the monetary stance. Furthermore, a comprehensive strategy should not need price agreements to reduce inflation pressures temporarily.

• Enhancing central bank communication. Clear communication, in particular on the relationship between money growth (monetary policy’s operational target) and inflation, will be essential to strengthen the expectations channel of monetary policy.

18. The government’s commitment to fiscal consolidation over the 5-year government term will be critical for stabilizing public sector debt over the medium term. The adoption of the 5-year budget is an important step in this direction. Staff baseline projections foresee a gradual rise in net debt as a share of GDP through 2020 assuming that the revenue underperformance of 2015 persists through the budget period. However, achieving the full budgeted improvement in the primary balance to a surplus of 1 percent of GDP by 2019 would put net debt on a stable path by the end of the budget period, which staff would advise. The projected decline in the BCU’s net interest costs would complement the strengthening of the primary balance in achieving this goal (but would not on its own be sufficient given valuation effects).

19. Alongside a gradual further reduction of the cyclically-adjusted primary balance, there is scope for automatic stabilizers to operate. With an unwavering commitment to the structural adjustment path for the primary balance that is embedded in the budget, automatic fiscal stabilizers—stemming from the social safety net as well the progressive tax system—could be allowed to operate to cushion cyclical shocks.

20. The authorities may wish to consider options for fortifying the fiscal anchor over the longer run. The fiscal expansion since 2009 was accommodated within the existing rule that limits the increase in net debt, and debt levels are projected to edge up further over the next few years. Against this backdrop, a cap to indebtedness could be made part of the rule, to prevent debt from reaching uncomfortable levels. More generally, a periodic recalibration of the fiscal path will be important for ensuring that debt targets are met given the sensitivity of the debt outlook to shocks, especially to growth or interest rates.

21. The consolidation effort is focused on enhancing the efficiency of public enterprises and increasing reliance on the private sector for infrastructure investments. Effective execution plans for improving the monitoring and corporate governance of public enterprises will be important to support the targeted improvement in their financial performance. The use of PPPs can help to improve project management and risk-sharing with private entities. However, proper contract design and strong controls of explicit and contingent liabilities will be essential.

22. Low oil prices provide an opportunity to improve the performance of ANCAP before moving towards a more transparent system of passing through oil price changes. Restoring ANCAP’s financial soundness is a policy priority. ANCAP is currently benefiting from lower global oil prices that, given the limited pass through allowed to domestic prices, should help the company restore its financial position. Looking ahead, further efficiency gains will be critical, and should create room to allow prices to adjust in line with the world market, based on a transparent formula (and incorporating an appropriate tax that covers the environmental cost of fuel). This would restore financial discipline and remove the risks to the budget inherent in the stabilization of domestic fuel prices.

Boosting Uruguay’s Growth Potential

23. While Uruguay has achieved relatively high living standards, supported by strong social policies, recent developments have prompted a reassessment of Uruguay’s medium-term growth outlook. In particular, staff’s projection of potential growth has been revised down from 3.3 percent to 3.1 percent, reflecting lower domestic investment growth. This adjustment puts a premium on the identification of policy options for boosting growth.

24. Further diversification of export markets and quality upgrades to existing products and services can boost Uruguay’s growth potential. Greater diversification of markets would also help reduce exposure to adverse external shocks. An upgrade of Uruguay’s transport and logistics infrastructure, improvements in the quality and enrollment of secondary education, expansion of vocational training programs, and increase in labor market efficiency to better tie wages to productivity are key factors to raise Uruguay’s medium- and long-term growth potential.

Investing in Financial stability and Deepening

25. The authorities’ initiatives to promote financial deepening have the potential to enhance resilience to shocks, policy transmission, and growth. The low level of bank credit to GDP in Uruguay suggests there is scope for strengthening the credit channel. Credit access costs and collateral requirements are high. The segmented and concentrated structure of the banking market also limit bank lending in pesos. The implementation of the 2014 financial inclusion law is expected to remove some of those obstacles and foster more competition in the peso market

26. Government projects for infrastructure investment can be designed to foster the development of new capital markets instruments. New instruments to finance infrastructure can be devised to aid the development of capital markets—with more investment opportunities for retail investors—and enhanced competition in the credit market.

27. These financial innovations require related upgrades in the prudential framework. The supervisor’s increased attention to monitoring nontraditional entrants into the financial system is essential. The ongoing implementation of the Basel III standards and the recommendations of the 2012 FSAP should help guide efforts for maintaining and further strengthening Uruguay’s robust prudential framework.