IMFSurvey Magazine: Countries & Regions
ANNUAL ECONOMIC HEALTH CHECK
Uruguay's Monetary Policy Effective Despite Dollarization
By Marco Pinon and Gaston Gelos
IMF Western Hemisphere Department
August 28, 2008
- Annual consultation sharpened focus on links between real, financial economies
- Small, open economy and recent financial crisis suited new-style review
- Higher credibility of monetary policy helping to de-dollarize economy
Monetary policy can be effective in Uruguay despite the importance of dollarization in the small South American nation, the IMF has concluded.
Moreover, the Fund found, a flexible exchange rate can help absorb external shocks even in a system as heavily dollarized as Uruguay's, largely because most nonfinancial transactions are carried out in pesos.
These were among a number of issues explored by the Uruguayan authorities and the IMF staff last year in one of the first consultations to reflect the IMF's increased emphasis on financial issues (Article IV consultations are carried out each year with nearly all member countries). The Fund is undertaking deeper financial analysis as part of its bilateral surveillance mandate to take account of a more integrated world in which links between the financial economy and the real economy, both domestic and external, play a critical role in explaining economic developments.
Uruguay, in the southern cone of South America, was picked to be one of the first consultations to combine financial sector surveillance and analysis of the relationship between the financial economy and the real economy for several reasons.
First, the nation of about 3.5 million people had a recent major crisis (in 2002) that began in the financial sector and was largely caused by external factors—primarily a financial crisis in neighboring Argentina, during which Argentines withdrew a large portion of their deposits in Uruguayan banks.
Second, Uruguay is a small open economy. While there have been significant studies of industrial economies and large emerging economies, little analysis has been conducted on smaller economies that are open to trade and financial relationships with the rest of the world.
Monetary policy and dollarization
Third, foreign currency plays an important role in the economy—close to 60 percent of bank lending is in U.S. dollars, for example. That so-called dollarization—reliance on a foreign currency for larger transactions and as a store of value—presents Uruguay with both vulnerabilities and policy questions.
There is a general concern about the effectiveness of monetary policy in such highly dollarized economies. In Uruguay, for example, the central bank can only issue pesos while much of the financial transactions take place in dollars. There are questions about how well exchange rate policy can cope with external shocks, such as import price increases, when much of the transmission of a shock is directly in dollars.
The consultation also sought to analyze how macroeconomic shocks are transmitted in a highly dollarized economy, and how they affect the soundness of the financial system, as well as ways to protect against external shocks in such an environment.
Uruguay pursues reforms
Uruguay has pursued important monetary and financial reforms since the 2002 crisis. It has abandoned an exchange rate peg in favor of a float, improved financial prudential norms and supervision of the banking system, and accumulated significant central bank reserves. Since the crisis, the dollarization of the banking system has declined, but it is still high.
In this environment, Uruguay has been modifying the way it conducts monetary policy, moving gradually from an exchange rate anchor toward an inflation-targeting regime in which the central bank's goal is to keep overall price increases within a target range.
Among the key findings of the analytical work that accompanied the consultation in 2007 were:
• There is potential for monetary policy to be effective in Uruguay, mainly through three channels—influencing inflation expectations, the exchange rate, and bank lending in pesos, which is limited but growing. Moreover, evidence indicates that good monetary policy contributes to reducing the role of the dollar: there is a clear correlation between measures of monetary credibility and the degree of dollarization. Still, dollar lending is found to be influenced by U.S. monetary policy.
• A flexible exchange rate can play a role as a "shock absorber" of external events, such as price increases, even in highly dollarized Uruguay. That's because most non-financial transactions are valued and carried out in pesos. The pass-through from exchange rates to domestic prices is not one-for-one and has declined over time. Exchange rate movements can help restore balances and deal with shocks. At the same time, instruments other than the exchange rate, such as interest rates, are likely to be more appropriate to manage monetary policy as Uruguay gradually moves toward a fully fledged inflation-targeting framework.
• International reserves are close to desirable levels from a prudential perspective, even after taking into account that dollar-denominated deposits, particularly those of nonresidents, could be potential demands on reserves.
• External financial developments still play a substantial role in Uruguay. Despite improved macroeconomic fundamentals and banking system indicators in recent years, Uruguay's fortunes are still tied to those of other emerging markets. Uruguay is now in a better position to withstand shocks than prior to 2002, including shocks that emanate from the region. That said, global developments still have an important impact. Indeed, looking at international market perceptions, as revealed by country spreads, Uruguay now moves more in tandem with other emerging markets than before the crisis.
Sustaining sound policies over the medium term will be essential to further increase the effectiveness of policy instruments. Much progress has been made in reducing vulnerabilities imposed by dollarization, including through banking regulations. However, medium-term vulnerabilities remain.
For example, many companies that do not earn in dollars have dollar debt and are thereby exposed to the risk of sharp exchange-rate movements, with ensuing risk for the financial system. Similar risks apply to the public debt-to-GDP ratio in the presence of foreign-currency debt.
A clear monetary framework and continued commitment to the inflation objectives, within a flexible exchange rate regime, appear important to increase central bank credibility further and reduce real costs of lowering inflation. In due time, this could also assist in reducing dollarization. This is good news for domestic policymakers, but also a challenge: fine-tuning of policies becomes a more delicate exercise as monetary policy becomes more powerful.
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