Economic Health Check
Uruguay: Staying the Course in a Volatile Region
February 24, 2016
- After a decade of high and inclusive growth, Uruguay’s economy is slowing
- Solid liquidity buffers and deficit reduction plans help support the economy’s resilience
- Reducing inflation remains a key policy priority
Uruguay has become a bastion of stability. But it is not immune to the shocks and challenges of a volatile region, and the economy is slowing down, said the IMF in its annual health check of the Uruguayan economy.
“At this time of heightened regional uncertainty, we recommend enhancing the credibility of the medium-term objectives for fiscal and monetary policies, which would complement Uruguay’s buffers for weathering economic and financial shocks,” said Jan Kees Martijn, the IMF’s mission chief for Uruguay.
Having achieved more than a decade of high and inclusive growth since its financial crisis in 2002, Uruguay’s per capita income is among the highest in Latin America, while its level of inequality is among the lowest. The country also regained investment grade status in 2012, with further upgrades since then.
In their annual report, IMF economists recognized the economic and social achievements of the past decade but also the risks and challenges facing the country, calling for measures to strengthen Uruguay’s resilience to shocks.
“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,” noted the IMF staff report.
Uruguay’s economy slowed markedly in 2015—growing by only 1.5 percent from 3.5 percent in 2014. Despite the progress made toward greater economic diversification and reducing regional linkages, the economy is still hindered by slowing activity across Latin America, anemic growth in other export markets, and declining prices of its main commodity exports (such as soy, meat, and paper pulp). For 2016, the report expects the Uruguayan economy to remain tepid at 1.4 percent.
Like most currencies in the region, the Uruguayan peso has depreciated significantly against the U.S. dollar over the past year. Extensive central bank intervention in the foreign exchange market after July helped curb the pace of depreciation but the flip side of this has been a notable reduction in international reserves. The depreciation of the peso has fed into domestic prices. In spite of the slowdown in activity, inflation has exceeded 9 percent since July 2015, well above the central bank’s target.
Cushioning the impact
As external risks mount, Uruguay’s flexible exchange rate can help cushion the impact of external shocks. Indeed, the recent depreciation has helped maintain competitiveness and is thereby limiting the economic slowdown. In addition, the country enjoys the extra security blanket of strong liquidity buffers, including central bank reserves and access to contingent credit lines from international financial institutions, which could facilitate an orderly adjustment to severe shocks, if necessary.
Uruguay can also reap benefits from a decade of prudent debt management, which has not only increased the maturity of the public debt stock and smoothed the repayment flows, but also reduced the share of foreign currency denominated and floating rate debt.
Looking ahead, the government’s 5-year budget combines an emphasis on deficit reduction, with efforts to support infrastructure development and social objectives. Maintaining this firm commitment to fiscal consolidation over the medium term will secure confidence in the economy, and create room for more countercyclical fiscal policy in the future.
Reducing inflation remains a key policy priority. Low inflation would promote de-dollarization and thereby create scope for a more effective use of monetary policy to smooth out adverse shocks. It would also reduce the inflation tax on low-income households with no bank account, or only a peso checking account paying little if any interest.
IMF economists recommended a threefold strategy to bring inflation into the central bank’s target range and reduce inflation persistence: maintenance of a tight monetary policy stance, supported by a prudent fiscal stance; the full elimination of backward wage indexation; and further strengthening of the monetary policy framework.
Investing in stability
Beyond fiscal and monetary policies, greater economic diversification, infrastructure upgrades, and secondary education reform would contribute to boosting Uruguay’s growth potential. Specializing in higher value-added commodity production and processing would allow Uruguay to carve its own niche among Latin American commodity exporters, while increasing the diversification of export markets would reduce exposure to adverse external shocks. These innovations would, however, require significant upgrades to Uruguay’s transport and logistics infrastructure.
Finally, Uruguay has a lot of scope for financial deepening, which would help insulate the economy against external shocks, support growth, and enhance monetary policy transmission. In this regard, IMF economists assess the authorities’ initiatives as promising and emphasize that they must be accompanied by upgrades to Uruguay’s solid supervisory framework. A detailed analysis of some of those initiatives, in particular the 2014 financial inclusion law, can be found in two separate Selected Issues Papers written by IMF staff.