## _cr05202

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---

### Background and economic developments
- Over the past decade, Uruguay pursued broadly prudent macroeconomic policies and an exchange-rate-based stabilization that reduced inflation but resulted in some real exchange rate appreciation.
- Rapid growth in 1990–98; recession beginning in 1999.
- By 2002 Uruguay faced its most severe financial crisis: widespread banking illiquidity and insolvencies, a sharp depreciation, and a doubling of the debt-to-GDP ratio to about 100 percent.
- Post-crisis: the economy rebounded strongly and inflation returned to the single digits; vulnerabilities remain substantial, notably the high debt burden and widespread dollarization.

### The 2002 crisis — triggers, evolution, and IMF engagement
- Immediate trigger:
  - Deposit withdrawals by cash-strapped Argentine residents after Argentina’s deposit freeze in late 2001 and pesification in early 2002.
- Banking sector structure and exposures:
  - Almost half of deposits were held by nonresidents, largely Argentines.
  - Core domestically-owned banks (two state-owned: BROU and BHU; and four domestic private banks: Comercial, Banco de Montevideo, Caja Obrera, Banco de Crédito) jointly accounted for 55 percent of resident deposits.
  - Widespread dollarization of deposits and lending; many borrowers lacked dollar earnings.
- Crisis evolution and major actions:
  - By February 2002, Uruguay’s real effective exchange rate had appreciated to 120 percent of its end-1998 level and 150 percent of its end-1992 level.
  - Authorities widened the crawling band and accelerated central rate depreciation; bond spreads doubled and ratings fell from investment grade.
  - March 28, 2002: authorities drew US$200 million accumulated under a precautionary SBA; IMF approved a new SBA for almost US$800 million over 2 years with an upfront purchase of US$150 million.
  - June–August 2002: peso depreciated cumulatively by 60 percent against the U.S. dollar; public debt-to-GDP ratio doubled to near 100 percent from about 45 percent at end-2001.
  - June 25, 2002: SBA augmented by US$1.5 billion (1/3 under SRF terms, with US$500 million disbursed upon approval).
  - Creation of the Fund for Fortifying the System of Banks (FFSB) with resources of US$500 million; FFSB provided US$450 million in liquidity support by end-July.
  - By end-July 2002: 42 percent of bank deposits had been withdrawn; most domestic banks became illiquid; authorities imposed a bank holiday for July 30–August 4.
  - August 8, 2002: IMF augmented the SBA again by US$500 million; all remaining SRF purchases were cancelled and rephased under SBA terms; IMF made a total of US$800 million available upon approval. IADB and the World Bank committed US$500 million and US$200 million, respectively. A new FSBS (Fund for the Stability of the Banking System) was established for US$1.4 billion and fully covered dollar sight and savings deposits at core banks.
- IMF assessment of its support:
  - IMF support in 2002 was unprecedented in magnitude and in explicitly supporting a central bank’s lender-of-last-resort function in a highly dollarized economy.
  - EPA view: larger early access under stronger policy would have been desirable; standard IMF arrangements tend to disburse too little upfront and continue disbursing after a crisis has subsided.

### Banking-sector vulnerabilities and reform history
- Long-standing weaknesses summarized:
  - Dollarization: foreign currency deposits rose from about 80 percent in the early 1990s to about 90 percent in the late 1990s.
  - State-owned banks (BROU and BHU) jointly account for more than one third of total deposits and loans.
  - Quasi-fiscal lending and high NPLs in state banks; insufficient collections.
  - Lack of prudential rules specific to dollarization and large nonresident deposits; domestic banks held dollar deposits but only a small portion of assets liquid and denominated in U.S. dollars.
  - Supervisory constraints: supervisory control of state banks by the central bank was enhanced only in December 2002.
  - Lack of clear exit mechanisms for failing banks slowed resolution; intervened banks were often merged and rarely privatized.
- Conditionality and reform progress under precautionary SBAs (selected outcomes, 1996–2005):
  - Some structural benchmarks observed (e.g., reduce public sector employment — Observed; complete external independent analysis of the loan portfolio of BROU and BHU — Observed).
  - Several banking-related benchmarks were Not observed or Partially observed (e.g., sale of Banco La Caja Obrera — Not observed; end intervention in three banks — Not observed).
  - IMF technical assistance on banking did not take place until late 2001; FSAP preliminary mission in December 2001; full FSAP began March 2002 but was never completed.

### Crisis containment strategy and debt restructuring
- August 2002 containment strategy elements judged appropriate:
  - Identify and support the core banking system.
  - Reprogram dollar time deposits of state-owned banks.
  - Fully back up sight and savings deposits at core banks; no public support for foreign banks.
  - Earlier adoption of this August strategy was suggested by the EPA as a possible way to reduce costs if a larger early package had failed to prevent resident deposit runs.
- Debt exchange (April–May 2003) features and assessment:
  - Postponed the bulk of payments to private creditors by about five years.
  - Implied net present value reduction of 10–20 percent (April–May 2003) and EPA notes a net present value reduction of 20 percent with a discount rate of 16 percent or 13 percent with a discount rate of 12 percent in the debt-exchange assessment.
  - The exchange emphasized liquidity rather than solvency, sharply reduced gross financing requirements for 2003–07, and was widely viewed as market-friendly; market access was regained almost immediately.
  - After the exchange, public debt still stood at almost 90 percent of GDP, of which 42 percentage points of GDP are owed to multilaterals.

### Economic and social costs
- Output and labor market:
  - More than 10 percent of GDP was lost in 2002.
  - Real wages fell by 20 percent between December 2001 and September 2002 and have not recovered since then.
  - Unemployment rose from 15 percent in early 2002 to 20 percent in late 2002.
- Poverty and social impact:
  - Household poverty rose from 12 percent in 2001 to 21 percent in 2003.
  - Individual poverty rose from 19 percent in 2001 to 31 percent in 2003.
  - About one half of children below 6 years of age are below the poverty line (National Statistical Institute definition).
- Fiscal costs of banking resolution:
  - Costs to date amounted to 17 percentage points of GDP, with additional costs of up to 5 percentage points of GDP possible in the next few years.
  - The public debt stood at almost 90 percent of GDP at end-2004; about 20 percent of GDP was owed to the IMF and 22 percent of GDP owed to other multilaterals.

### Policy lessons and IMF implications
- Need for intensive IMF engagement:
  - Continued IMF financing and policy advice will likely be required for a few years; a successor program will likely be needed when the current program expires.
  - Exit from IMF arrangements depends on Uruguay’s ability to tap international markets at reasonable spreads, which requires a forceful program and strong signals of commitment to fiscal consolidation.
- Debt sustainability condition:
  - Debt sustainable only under stringent assumptions, notably primary fiscal surpluses of the order of 4 percent of GDP in the medium term (DSA reference).
  - Historical figures: average primary surplus in 1990-2001 was "0.3 percent of GDP"; historical maximum had been "2.8 percent of GDP".
  - Staff and authorities cited that primary fiscal surpluses around "4 percent" are unprecedented in Uruguay’s history; August 2002 staff indicated a primary surplus of "4.5 percent of GDP" would be needed in some scenarios.
- Recommended immediate structural priorities for a new program:
  - Complete banking system resolution and restructuring to restore normal banking intermediation.
  - Strengthen prudential regulation and supervision (more resources, training, compliance with international standards, independence from political interference).
  - Revamp the central bank’s lender-of-last-resort function; strengthen the central bank’s financial position through recapitalization or similar measures.
  - Establish less disruptive bank exit rules and improve authorities’ ability to intervene in crises.
  - Gradual reduction in reserve requirements as economic activity and prudent lending normalize.
  - Improve credit monitoring, risk controls at BROU and NBC, and continue dealing with outstanding nonperforming loans.
  - Maintain full, transparent, and timely provision of information to preserve public confidence.
- Fiscal, pension, and tax reforms:
  - Reform the tax system and improve tax administration: widen the tax base and reduce exemptions.
  - Reform special pension funds for military and police and consider changes to parameters in the general pension system.
  - Target an ambitious primary fiscal surplus especially in 2005 when growth is expected to be above potential.
- Medium-term structural challenge:
  - Reduce the role of the state in the economy to foster lasting growth; consider joint ventures, public-private partnerships, liberalization, and privatization where appropriate.
  - Governance: consider fixed term, staggered contracts for key board positions in public enterprises, the state bank, and the central bank to reduce electoral-cycle dependence.
- Institutional recommendations:
  - Move toward an independent central bank (precondition for inflation targeting).
  - Ensure the banking supervision entity is independent from government while possibly retained within the central bank.
  - De-dollarization is a medium-term objective; issuance of local currency denominated, inflation-indexed government bonds is a welcome development.

### Indicators and selected economic statistics (as reported)
- Real GDP (percentage changes): 1995: -1.4; 1996: 5.6; 1997: 4.9; 1998: 4.7; 1999: -2.8; 2000: -1.4; 2001: -3.4; 2002: -11.0; 2003: 2.5; 2004: 12.0.
- GDP (U.S. dollar billion): 1995: 19.3; 1996: 20.5; 1997: 21.7; 1998: 22.4; 1999: 20.9; 2000: 20.1; 2001: 18.6; 2002: 12.3; 2003: 11.2; 2004: 13.3.
- Consumer prices (e.o.p., percentage changes): 1995: 35.4; 1996: 24.3; 1997: 15.2; 1998: 8.6; 1999: 4.2; 2000: 5.1; 2001: 3.6; 2002: 26.0; 2003: 10.2; 2004: 7.6.
- Exchange rate (Ur$/U.S.$, e.o.p.): 1995: 27.0; 1996: 22.5; 1997: 15.2; 1998: 7.7; 1999: 7.4; 2000: 7.7; 2001: 18.0; 2002: 84.2; 2003: 7.3; 2004: -2.8.
- Credit to the private sector (constant exchange rate, percentage changes): 1995: 21.9; 1996: 21.5; 1997: 12.2; 1998: 5.8; 1999: 4.5; 2000: 0.2; 2001: -6.5; 2002: -13.7; 2003: -25.5; 2004: -20.1.
- Public sector primary balance (Percent of GDP): 1995: 0.7; 1996: 0.2; 1997: 0.9; 1998: -2.2; 1999: -2.1; 2000: -1.5; 2001: -1.2; 2002: 0.0; 2003: 2.7; 2004: 3.8.
- Public sector debt (Percent of GDP): 1995: 29.8; 1996: 29.0; 1997: 28.7; 1998: 30.2; 1999: 31.1; 2000: 35.7; 2001: 42.8; 2002: 85.1; 2003: 105.3; 2004: 88.4.
- Gross official reserves (U.S. dollar million): 1995: 1,813; 1996: 1,892; 1997: 2,067; 1998: 2,587; 1999: 2,604; 2000: 2,776; 2001: 3,099; 2002: 772; 2003: 2,087; 2004: 2,512.
- Gross international reserves in percent of short-term debt and FX deposits (selected years): 1999: 17.3; 2000: 17.1; 2001: 17.5; 2002: 7.0; 2003: 20.0; 2004: 27.7.
- REER (percentage depreciation -, e.o.p.): 1995: 1.7; 1996: -0.8; 1997: 1.6; 1998: 1.1; 1999: 10.0; 2000: -0.9; 2001: -5.4; 2002: -13.2; 2003: -15.0; 2004: 9.4.
- Banking-sector specific figures and shocks:
  - By end-July 2002: 42 percent of bank deposits withdrawn.
  - Dollar deposits fell by 65.4 percent for non-residents and 30.1 percent for residents between January 2002 and August 2002.
  - Costs of resolving the banking crisis amounted to 17 percentage points of GDP thus far, with possible additional costs up to 5 percentage points of GDP.

*Source: Executive Summary and selected excerpts from IMF staff report (document title: Executive Summary)._

### Executive Summary ......................................................................................................

### _cr05202 - Executive Summary

### Background and economic developments
- Over the past decade, Uruguay pursued broadly prudent macroeconomic policies and an exchange-rate-based stabilization that successfully reduced inflation but resulted in some real exchange rate appreciation.
- Uruguay experienced rapid growth in 1990–98, then entered recession beginning in 1999.
- By 2002 Uruguay faced its most severe financial crisis: widespread banking illiquidity and insolvencies, a sharp depreciation, and a doubling of the debt-to-GDP ratio to about 100 percent.
- Post-crisis: the economy rebounded strongly and inflation returned to the single digits; however, vulnerabilities remain substantial, notably the high debt burden and widespread dollarization.

### The 2002 crisis: triggers and systemic factors
- Immediate trigger: deposit withdrawals by cash-strapped Argentine residents unable to access Argentine bank accounts following a deposit freeze in late 2001 and pesification in early 2002.
- Banking sector exposure and structure:
  - Almost half of deposits were held by nonresidents, largely Argentines.
  - Core domestically-owned banks (two state-owned: BROU and BHU; and four domestic private banks: Comercial, Banco de Montevideo, Caja Obrera, Banco de Crédito) jointly accounted for 55 percent of resident deposits.
  - Widespread dollarization of deposits and lending; many borrowers had no dollar earnings.
  - Long-standing weaknesses: dollarization, insufficient prudential regulation and supervision (notably with respect to the public banks).
- Macroeconomic pressures:
  - By February 2002, Uruguay’s real effective exchange rate had appreciated to 120 percent of its end-1998 level and 150 percent of its end-1992 level.
  - The exchange rate weakened to the edge of the crawling band; the authorities widened the band and accelerated the central rate of depreciation.
  - Government bond spreads doubled; rating agencies downgraded Uruguay’s debt from investment grade.
- Crisis evolution:
  - Initial mitigation: urging banks (especially foreign-owned) to use internal liquidity arrangements; central bank provided liquidity assistance to core banks; authorities raised interest rates, increased fiscal revenues, cut expenditures, and accelerated structural reforms.
  - On March 28, 2002: authorities drew US$200 million accumulated under a precautionary SBA; the IMF approved a new SBA for almost US$800 million over 2 years with an upfront purchase of US$150 million.
  - Deposits outflows accelerated after an April bank holiday in Argentina; as losses mounted, the authorities abandoned the crawling band on June 20, 2002.
  - June–August 2002: the peso depreciated cumulatively by 60 percent against the U.S. dollar; public debt to GDP ratio doubled to near 100 percent from about 45 percent of GDP at end-2001.
  - On June 25, 2002: the SBA was augmented by US$1.5 billion (1/3 of which under SRF terms, with US$500 million disbursed upon approval), making this the largest IMF program as a share of GDP ever extended to any member country.
  - Creation of the Fund for Fortifying the System of Banks (FFSB) with resources of US$500 million; FFSB provided US$450 million in liquidity support by end-July.
  - By end-July 2002: 42 percent of bank deposits had been withdrawn; most domestic banks became illiquid; authorities imposed a bank holiday for July 30–August 4.
  - Additional support was arranged with contributions from the World Bank and IADB and a one-week bridge loan by the United States.

### The precautionary SBAs (1996–early 2002)
- Uruguay had a series of SBAs treated mostly as precautionary between March 1996 and early 2002.
- Functions and effects:
  - Served as a "seal of approval" and a vehicle for intensive IMF monitoring.
  - Authorities undertook significant reforms during this period: pension reform, reduction in public employment, and lengthening of wage indexation lags.
  - Key reforms not completed or delayed: reforms in specialized pension funds and, critically, banking system reform.
- Retrospective assessment:
  - Vulnerabilities in the banking system were addressed beginning in the late 1990s but insufficiently forcefully.
  - In retrospect, authorities’ policies would probably not have been much different in the absence of the precautionary SBAs.

### Crisis management and resolution: assessment
- Access and IMF support:
  - The IMF's support in 2002 broke new ground with respect to the level of access and the decision to explicitly support the lender of last resort function of the central bank in a dollarized economy.
  - IMF programs have limitations for banking crises: they tend to disburse too little upfront and can continue disbursing after a crisis has subsided.
- Exchange rate policy:
  - The move to a float in June 2002 was decisive in unwinding the crisis and was a close call given very low reserves and an exchange rate that had been somewhat overvalued.
  - It was understood that floating would cause major losses in the banking system and increase the burden of largely foreign-currency public debt.
- Debt restructuring:
  - A debt exchange that extended bond maturities by about five years provided breathing room, but public debt remains high, requiring strong fiscal policies over many years to ensure sustainability.

### Vulnerabilities building up (summary)
- High public debt: public debt was 45 percent of GDP at end-2001 and doubled to about 100 percent during the crisis.
- Widespread dollarization of deposits and lending.
- Banking system weaknesses: insufficient prudential regulation and supervision, especially for public banks; inadequate dollar liquidity in domestically-owned banks; exposure to Argentine shocks.
- High share of nonresident deposits (~half of deposits, largely Argentines).

### Lessons and implications for IMF engagement going forward
- Given the unprecedented IMF support in 2002, intensive IMF engagement (financial support and policy advice) will likely be required for a few years; a program will likely be needed when the current program expires.
- Debt sustainability is conditional:
  - The debt is sustainable only under stringent conditions, notably primary surpluses that Uruguay has not previously attained.
  - Exit from IMF arrangements will depend on Uruguay’s ability to tap international financial markets at reasonable spreads, which in turn depends on a forceful program and strong signals of commitment to fiscal consolidation.
- Priority policy measures to foster sustainable growth and reduce vulnerability:
  - Complete resolution and restructuring of the banking system and return to normal banking intermediation.
  - Ensure prudential regulation and supervision are strengthened to avoid future crises.
  - Reduce the scale of the public sector.
  - Reform the tax system to ensure a more equitable and efficient distribution of the tax burden.

*Source: Executive Summary of IMF staff report (document title: Executive Summary).*

### 9.      On August 8, the IMF thus augmented the SBA a second time, by another

### _cr05202 - 9.      On August 8, the IMF thus augmented the SBA a second time, by another

### IMF support, FSBS creation, and debt restructuring
- On August 8, the IMF augmented the SBA a second time, by another US$500 million.
- All remaining SRF purchases were cancelled and rephased under SBA terms.
- The IMF made a total of US$800 million available upon approval.
- The IADB and the World Bank committed US$500 million and US$200 million, respectively.
- A new facility, the “Fund for the Stability of the Banking System” (FSBS), was established for US$1.4 billion.
  - The FSBS was a separate account from the central bank’s reserves.
  - The FSBS’s sole purpose was covering dollar sight and savings deposits at core banks, and it covered such deposits fully.
- Two state-owned banks had dollar time deposits subjected to government-mandated reprogramming over three years.
- Four private domestically-owned banks were deemed insolvent and had their operations suspended.
- Sight deposits and peso deposits remained unrestricted.
- No restrictions were placed on foreign banks; foreign banks were expected to rely on their own resources.
- Some additional drain of deposits occurred after the bank holiday was lifted (August 5); a reflow, mostly from residents, began in October.
- In April–May 2003, a debt exchange postponed the bulk of payments to private creditors by about five years, implying a net present value reduction of 10–20 percent.
- The debt exchange was widely viewed as well executed and relatively market friendly; market access was regained almost immediately.

### Economic and social costs of the crisis
- More than 10 percent of GDP was lost in 2002.
- Real wages fell by 20 percent between December 2001 and September 2002, and have not recovered since then.
- Real incomes of pensioners also dropped substantially.
- The unemployment rate rose from 15 percent in early 2002 to 20 percent in late 2002.
- Poverty rates:
  - For households: rose from 12 percent in 2001 to 21 percent in 2003.
  - For individuals: rose from 19 percent in 2001 to 31 percent in 2003.
  - Poverty is especially widespread among households with young children, and less common among individuals above 65 years of age.
  - About one half of children below 6 years of age are currently below the poverty line according to the National Statistical Institute’s definition.
- The costs of resolving the banking crisis have amounted to 17 percentage points of GDP thus far, and additional costs of up to 5 percentage points of GDP could materialize in the next few years.
- The public debt stood at almost 90 percent of GDP at end-2004.
  - About 20 percent of GDP was owed to the IMF.
  - 22 percent of GDP was owed to other multilaterals.

### EPA focus questions (IMF ex-post assessment)
- Key questions the EPA addresses:
  - While contagion played a major role, was it inevitable for an investment grade, relatively stable emerging market to become engulfed in a major banking and debt crisis after six years of precautionary SBAs? What was the rationale for the series of precautionary stand-bys in the 1990s, and did they fulfill their objectives? (Sections III and IV)
  - Were Uruguay’s vulnerabilities foreseen, and were sufficient actions taken to reduce such vulnerabilities? (Section V)
  - Could the crisis have been halted earlier, lowering economic and social costs and perhaps IMF exposure? Could the sequence of augmentations have been avoided by combining steps (e.g., abandonment of the crawling peg and banking resolution)? What policies are needed to ensure medium-term fiscal debt sustainability given the still very high level of public debt even after the 2003 debt exchange? (Section VI)
  - What policies and program design would facilitate Uruguay’s speedy return to private capital markets and avoid prolonged IMF reliance? What areas should be the focus of the authorities’ program and IMF conditionality to reduce future vulnerabilities? (Section VII)

### Facts and long-standing challenges — overview
- Uruguay’s economic performance in the 1990s:
  - Average growth was 3⅓ percent annually despite a recession beginning in 1999.
  - Inflation fell from over 100 percent in 1990–91 to the single digits in the late 1990s.
- Vulnerabilities built up over time:
  - Real exchange rate appreciation contributed to banking system and fiscal vulnerabilities.
  - Structural weaknesses in the tax system and state-owned banks and enterprises constrained performance and need to be addressed to restore fiscal and external sustainability.

### Economic linkages with trading partners
- Uruguay’s growth is highly correlated with developments in Argentina and, to a far lesser extent, Brazil.
- Argentine residents account for more than two-thirds of total visits to Uruguay’s large tourism sector.
- Share of exports to Argentina and Brazil in Uruguay’s total merchandise exports rose from one third in 1991–92 to one half in 1997–98.

### The crawling band, exchange rate policy, and inflation stabilization
- The crawling band exchange rate system was a key element to gradually reduce inflation.
- In 1990–95, the inflation rate differential vis-à-vis Uruguay’s trading partners exceeded the rate of nominal depreciation, resulting in substantial real effective appreciation.
- In 1996–98, the real effective exchange rate remained broadly constant.
- Considerations and assessments:
  - A move to a float would have seemed inconsistent with the objective of curbing inflation until well into the recession that preceded the crisis.
  - Widening the exchange rate band in early 1999 would, in hindsight, have cushioned the economy from the subsequent recession and would not have stoked inflation, but this was not known at the time.
  - The main vulnerability was failure to undertake sufficient prudential measures in the banking system to prepare for consequences of a sharp exchange rate depreciation, not the exchange rate regime itself.

### Banking system vulnerabilities and reform efforts
- Known structural weaknesses:
  - Exposure to exchange rate risk and weaknesses in state banks had previously contributed to severity of the 1982 banking crisis.
  - Precautionary SBAs in the late 1990s highlighted vulnerabilities, but conditionality measures were, in retrospect, too timid.
  - Conditionality was imposed at a speed compatible with Uruguay’s consensus-based polity; structural benchmarks in banking were often missed.
  - Authorities were reluctant to challenge the status of state-owned banks, including prudential supervision of such banks.
- Mid-1990s authority assessment (1995 Article IV summary):
  - Plans included bringing state banks into compliance with reserve ratios, minimum capital requirements and portfolio regulations; restructuring state banks to consolidate operations, curtail employment, and reduce currency and maturity mismatches.
  - Staff viewed these actions as “essential.”
- Nonresident deposits:
  - Large nonresidents’ deposits were evidence of strengths but a source of vulnerability due to potential sudden withdrawals.
  - Staff reports from 1999 onward consistently highlighted vulnerability from short-term foreign deposits.
  - Previous regional turbulence episodes had led to further net inflows, creating a false sense of security.
- Other key vulnerabilities:
  - Dollarization with associated balance sheet mismatches.
  - Quasi-fiscal activities by state-owned banks.
  - Weaknesses in prudential regulation and banking supervision.
- Reform efforts:
  - World Bank Financial Sector Adjustment Loan (approved in February 2000) aimed to:
    - Establish a level playing field between public and private banks and reduce public sector role in financial area.
    - Strengthen banking supervision and regulation and financial transparency.
    - Establish mechanisms for orderly exit of banks from the market.
  - Some measures became IMF structural benchmarks and were mostly undertaken but often after substantial delay.
  - IMF technical assistance missions on banking did not take place until late 2001.
  - An FSAP was requested for 2001; a preliminary mission occurred in December 2001 and a full FSAP began in March 2002 but was never completed because the banking crisis was well underway.

### Medium-term fiscal issues
- Fiscal structure and challenges:
  - Uruguay’s share of taxes (or expenditures) in GDP was about one third.
  - Social security benefits rose from about 10 percent of GDP in the early 1990s to more than 15 percent of GDP in the late 1990s.
  - Large public sector and inefficiencies in tax system and administration constrained growth and exerted medium-run pressure on expenditures.
- Reforms in mid- and late 1990s:
  - Revision of public pay-as-you-go system and establishment of a private capitalized pension system alongside it.
  - Efforts to reduce and improve efficiency of the public sector through employment reduction and increased private competition.
  - Lengthening of wage indexation lags (the only one of these covered by IMF program conditionality).

*Ex-post assessment (EPA) text from the IMF country report excerpt.*

### Box 1. Long-Standing Weaknesses and Related Measures in the Banking System

### Box 1. Long-Standing Weaknesses and Related Measures in the Banking System

### Dollarization
- Uruguay is one of the most dollarized economies in Latin America.
- Share of foreign currency deposits in total bank deposits rose from about 80 percent in the early 1990s to about 90 percent in the late 1990s, despite the impressive decline in inflation.

### Weak financial position of the state-owned banks
- State-owned banks BROU and BHU jointly account for more than one third of total deposits and loans in the banking system.
- Lending (and refinancing of overdue loans) by the state-owned banks was often motivated by political economy / sectoral policy considerations (such as helping the agricultural sector), resulting in quasi-fiscal activities and a relatively high proportion of non-performing loans (NPLs).
- NPLs also resulted in part from insufficient efforts to collect.
- Independent external audits of the state banks conducted in the late 1990s (a structural benchmark met after some delay) helped identify specific areas for improvement.
- Employment in the state-owned banks was reduced (by about 20 percent in BROU between 1994 and 2000), despite opposition by the powerful bank employees union.
- Productivity in the state-owned banks remained lower than in the private banks.

### Weaknesses in prudential regulation and banking supervision
- Lack of specific prudential rules to mitigate risks associated with high dollarization and large inflows of non-resident deposits:
  - No special liquidity requirements on such deposits, nor limits on exposure to currency risk or foreign currency lending.
  - Domestic banks accepted nonresidents’ deposits in U.S. dollars, but only a small portion of their assets was liquid and denominated in U.S. dollars.
  - Domestic banks were exposed to exchange rate depreciation risk because they held deposits mostly in U.S. dollars, but lent to the non-tradable sector, which would likely default in the event of a sharp depreciation.
  - Exposure to the non-tradable sector was especially high for the state banks, notably mortgage bank BHU.
  - Lending by BHU was in domestic currency, indexed to wages. Plans to improve currency and maturity mismatches at BHU were already discussed in early 1996.
- Failure by the state banks to comply with prudential regulations to the same extent as other banks, possibly tolerated owing to their special role in pursuing political economy objectives.
  - Staff emphasized the need to bring the state banks into compliance with prudential regulation as early as the initial program covered by this EPA.
  - One key recommendation of the 1993 MAE TA mission was to give the central bank full supervisory control over the state banks.
  - Early programs set specific limits on the expansion of credit by BROU and the Mortgage Bank.
  - Beginning in the late 1990s, BROU and BHU improved information provision (reduction of lags in data reporting to the central bank and, for the first time, publication of annual profit and loss statements).
  - Supervisory control of the state banks by the central bank was enhanced only in December 2002.
- Vulnerabilities from excessive concentration of country risk:
  - For a number of banks, the share of loans to Argentine residents (or bonds issued by Argentine entities) in total assets represented a vulnerability that they would not withstand.

### Lack of clarity in the mechanism for orderly exit of banks
- Lack of clear exit mechanism slowed resolution of crises (including the 2002 crisis).
- Intervened banks were often merged and rarely privatized.
- Privatization of two intervened banks (jointly accounting for almost 10 percent of the banking system) featured as a structural benchmark for three years in a row, until 1999; staff decided not to list privatization again.
- Staff urged the authorities to “find a way to permit market-based exit of banks or a reduction in banking capacity,” though no more specific proposal was outlined.

*Source: _cr05202 - Box 1. Long-Standing Weaknesses and Related Measures in the Banking System*

### 37.      One exception is the area of banking, where conditionality by the IMF and other

### _cr05202 - 37.      One exception is the area of banking, where conditionality by the IMF and other

### Banking conditionality and structural benchmarks
- Conditionality by the IMF and other multilaterals "may have helped speed up reform," but the precautionary SBAs "failed to bring about the changes that might have prevented the 2002 banking crisis."
- Programs in the late 1990s "placed considerable emphasis on banking," and conditionality "seems to have fostered, to some extent, desirable reforms."
- Possible explanation for continuation of programs despite slow banking reform:
  - By the time banking concerns became more severe, "the Brazilian crisis had already taken place."
  - Resulting heightened vulnerability increased incentives for the authorities to comply with IMF conditionality, and for the IMF "not to be seen as abandoning a generally well-performing and cooperative country."

- Structural Benchmarks and Performance Criteria (selected program outcomes, 1996–2005):
  - SBA 1996–97: No structural measures included.
  - SBA 1997–99: "Reduce public sector employment" — Dec 97 — Fiscal — Observed.
  - SBA 1997–99: "Sale of Banco La Caja Obrera" — Dec 97 — Financial — Not observed.
  - SBA 1997–99: "Submit new bankruptcy law to Congress" — Sept 97 — Business — Not observed.
  - SBA 1999–00: "Finalize action plan to subscribe to the SDDS" — March 99 — Statistics — Observed.
  - SBA 1999–00: "Reduce the BROU's reporting lag of monetary data" — June 99 — Statistics — Not observed.
  - SBA 1999–00: "End intervention in three banks (BPA, Banco la Caja Obrera, Banco de Credito)" — June 99 — Financial — Not observed.
  - SBA 1999–00: "Revise national account statistics and develop indicators of economic activity" — Dec 99 — Statistics — Partially observed.
  - SBA 2000–02: "Complete external independent analysis of the loan portfolio of BROU and BHU" — Sept 00 — Financial — Observed.
  - SBA 2000–02: "Publish quarterly reports of public enterprises and financial institutions" — March 01 — Fiscal — Observed, originally set for Dec 00.
  - SBA 2000–02: "Complete independent external audit of BROU, BHU, and BSE" — March 01 — Financial — Missed BSE.
  - SBA 2000–02: "Private and public sector banks to place debentures in the capital market equivalent to a minimum of 2 percent of their deposits." — Sept 01 — Financial — Dropped, missed in June and Sept.
  - SBA 2002–05: "Develop peso-denominated, inflation-indexed securities." — June 02 — Financial — Observed with delay.
  - SBA 2002–05: "Do not open unviable banks" — Continuous — Financial — Observed.
  - SBA 2002–05: "Publish monthly bank balance sheets with a two month lag" — Continuous — Statistics — Observed (after modifications).
  - SBA 2002–05: "Complete the transfer to the fiduciary trust of all Category 4 and 5 NPLs" — Dec 04 — Financial — Observed.
  - SBA 2002–05: "Incorporate information on nonperforming borrowers into the credit registry" — Dec 04 — Financial — Not obsrved, prior action for next review.
  - SBA 2002–05: "Establish a Large Taxpayer Unit at the DGID" — Dec 04 — Fiscal — Not observed.

### Role of precautionary SBAs and market perception
- Precautionary SBAs "may have played a helpful role in preventing contagion prior to the 2002 crisis."
  - In late 1998, amid uncertainties from Russia and Brazil, the authorities drew US$150 million promptly under the SBA (previously treated as precautionary) and obtained additional support from the IADB and the World Bank. Combined with an interest rate hike and fiscal tightening, "this stabilized the situation."
  - Precautionary SBAs "may also have reduced contagion in previous years," though few Latin American countries experienced full-blown crises at the time.
- IMF programs provided a "seal of approval" that made it easier for Uruguay to borrow at lower interest rates on global markets.
  - Uruguay obtained its investment grade rating in 1997, maintaining it until early 2002.
  - Sizable international bond issues were undertaken in late 2001: US$300 million in November and US$110 million in December at spreads of 250–300 basis points.
  - The index (EMBIG) of Uruguay’s bond spreads remained relatively low, at 350 basis points, until mid-February 2002.
  - The first downgrade by one of the main rating agencies did not occur until February 2002.
  - "It seems that international investors did not anticipate the crisis, nor did the rating agencies warn them about it."

### Vulnerabilities building up (timing and recognition)
- Current account deficits in 1995–98 were "equivalent to 1½ percent of GDP."
- Brazil's move to a float (January 1999) led the real exchange rate to appreciate by another 10 percentage points.
- Beginning in 1999, banking soundness indicators worsened:
  - Profitability dropped and the share of nonperforming loans rose substantially, especially in state-owned banks.
  - Independent audits (structural benchmarks under the IMF program) showed that the true level of capital in state-owned banks was lower than previously estimated.
  - February 2001 staff assessment: private banking system "appear[ed] sound," but raised concerns about vulnerability, "especially for the state-owned banks" (Country Report No. 01/47).
- July 2001 IMF staff scenario estimating impact of a sharp depreciation of the peso:
  - Foreseeable increase in Uruguay’s debt-to-GDP ratio to 92 percent by end-2002.
  - Staff warned that valuation effects on dollar debts could "lead almost inevitably to the need for financial assistance from the public sector to the banks."
  - September 2001 staff report characterized Uruguay as "highly vulnerable," noted a "recent sharp rise in the public debt," and that the state-owned banks were "not sound."
- Market signals lagged official concern:
  - Asset prices signaled likelihood of an Argentine crisis beginning in spring–summer 2001, but markets did not become concerned about Uruguay until early 2002.
  - Nonresident deposits were still flowing into Uruguay on a net basis as late as fall 2001.
- Immediate crisis triggers were hard to foresee:
  - Deposit freezes in Argentina and an unexpected alleged fraud in a Uruguayan bank compounded the crisis.

### The 2002 crisis: proximate causes and IMF response
- IMF support in 2002 was "unprecedented in magnitude" and broke new ground:
  - First program essentially aimed at strengthening a central bank’s lender of last resort function in a highly dollarized economy.
  - IMF raised its exposure in Uruguay "to the highest among member countries (relative to the size of the economy)."
  - Support involved "undertaking major risks that would unwind, even under favorable scenarios, only over a number of years."
  - General assessment: "there is broad agreement that the support by the IMF and other IFIs helped Uruguay adjust to the consequences of its worst financial crisis," although "major risks and challenges to restore the country to sustainability will persist in the medium term."
- EPA assessment and access sizing:
  - The EPA considers that "somewhat larger access under an IMF arrangement in support of stronger policy and more comprehensive action would have been desirable in early 2002."
  - In early 2002 it was "somewhat uncertain whether the crisis underway was systemic," but "with a major crisis in Argentina, the resulting major risks for the Uruguayan economy were well understood."
  - Hindsight suggests a larger early package "could have prevented panic among residents, who had not yet started withdrawing their deposits en masse."
- Limitations of standard IMF arrangements for banking crises:
  - Typical IMF arrangements disburse tranches over time subject to conditionality and therefore:
    - They "do not make sufficient funds available upfront and with certainty."
    - They "make funds available even after the crisis may have subsided."
  - Even with considerable frontloading in 2002, maintaining the customary tranche structure "tended to weaken the program’s ability to stop the banking crisis, and to maintain access to additional resources after the deposit withdrawals had ended."
  - The SRF used in June 2002 was "closer to meeting the objective of providing large amounts of financial assistance for a relatively limited time," but its use was "somewhat questionable" given the nature of the crisis.
- Exchange rate decision (float) assessment:
  - Decision to let the exchange rate float "seems to have been a close call" but was "a decisive and reasonable course of action"; the exact rationale "does not seem to have been fully explained in subsequent staff reports."
  - Medium-term trade-off: "possibly a number of years of slower growth owing to an overvalued exchange rate, and a more damaging crisis in the initial years followed by more rapid export growth."
  - By May 2002, the real effective exchange rate was "20–25 percent above its level of late 1998."
  - Crisis-management trade-off: whether to use large financing to defend the exchange rate or to avoid "wasting reserves in a possibly futile attempt to defend the exchange rate."
- August 2002 crisis containment strategy judged appropriate:
  - Identify the core banking system to be supported.
  - Reprogram dollar time deposits of the state-owned banks.
  - Fully back up sight and savings deposits.
  - Let foreign banks handle their situations with "no freezes but no public support" — described as "the right decision" with wide consensus early on.

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05202.pdf*

### 52.      It is worth asking whether such a strategy should have been adopted earlier.

### _cr05202 - 52.      It is worth asking whether such a strategy should have been adopted earlier.

### Earlier adoption of alternative strategy
- The EPA suggests a desirable alternative strategy would have been to have a somewhat larger package in early 2002.
- Had this failed to prevent a deposit run on the part of residents, the more interventionist August approach should have been adopted in June.
- Specific measures that might have been adopted earlier:
  - Adopt the August strategy and the bank holiday in June.
  - Possibly float the Uruguayan peso earlier.
  - Permit earlier launching of procedures to address the debt situation.
  - Earlier closure of problem banks to reduce fiscal costs.
- Critique: The crisis-resolution approach attempted to fix problems one at a time rather than anticipate linkages and tackle intertwined problems simultaneously.

### B. The Debt Exchange — findings and technical features
- Context and necessity:
  - Public debt-to-GDP ratio was nearly 100 percent in the late summer of 2002.
  - Annual debt service payments due amounted to about 20 percentage points of GDP in 2003–07.
  - The IMF is precluded from providing further financing absent a credible program entailing restructuring of the debt that ensures medium-term sustainability.
  - The August 2002 augmentation was provided with the understanding that a solution would be found to ensure sustainable debt dynamics over the medium term.
- Authorities’ objectives in designing the operation:
  - Maintain Uruguay’s reputation as a country that honors contracts.
  - Preserve good relations with creditors.
  - “Take the long view” regarding future market access.
  - Concern that perceptions of failing to honor contracts could trigger deposit runs on state-owned banks.
- Design and IMF role:
  - IMF left the design of the operation to the authorities and their advisers, focusing on assurances that financing gaps and debt sustainability were addressed.
  - The deal relied on lengthening maturities of the bonds, while eschewing haircuts on principal or coupons.
  - Resulting net present value reduction is estimated at 20 percent with a discount rate of 16 percent (the implied yield when the exchange was launched) or 13 percent with a discount rate of 12 percent (the implied yield at the settlement date).
  - Some technical features were innovative: exit consents, collective action clauses, and aggregation clauses.
  - Efforts to involve investors at an early stage in the design of the deal were widely viewed as beneficial.
- Assessment:
  - The debt exchange brought welcome breathing room, though the debt remains high and will require strong fiscal policies and structural reforms to promote growth to bring the debt down rapidly over the medium term.
  - The exchange emphasized liquidity rather than solvency considerations and was successful in sharply reducing gross financing requirements for 2003–07.
  - After the exchange, public debt still stood at almost 90 percent of GDP, of which 42 percentage points of GDP are owed to multilaterals.
  - Uruguay’s return to a sustainable debt position depends on strong policies, including an ambitious fiscal effort, and leaves little scope for policy slippages and for automatic stabilizers to work in the event of an economic downturn.

### C. The Post-Crisis Program — accomplishments and remaining weaknesses
- Overall program assessment:
  - The 2002–05 program appropriately focused on bank restructuring, with a quantum leap in structural conditionality.
  - The most pressing priority—stopping the bank run—has been attained.
  - Compliance with numerical targets in fiscal and monetary areas has been good, despite occasional and temporary underperformance on the primary surplus in 2002–03.
  - Much progress has been made in the structural area, including banking, but substantial delays in program implementation and completion of some reviews occurred.
- Banking sector achievements (detailed):
  - BROU:
    - Balance sheet cleaned up by transferring a substantial amount of its nonperforming loans to a fiduciary trust.
    - An outside manager was appointed to handle asset recovery by the fiduciary trust.
    - Business strategy refocused onto the peso business.
    - Operating costs reduced.
    - Risk management and operating efficiency improved.
  - BHU:
    - Progress toward transforming the public mortgage bank into a nonbank entity with World Bank assistance.
    - Process not yet completed; important weaknesses remain, including a large non-performing loan portfolio.
    - Uncertainty whether BHU will be able to service its obligations; failure would imply additional fiscal costs.
  - Nuevo Banco Comercial:
    - A new bank formed with the performing assets of three liquidated domestic private banks.
    - Government seeking a strategic private investor.
    - A private firm contracted to manage disposal of the assets of the liquidated banks.
  - Bank Supervision:
    - With IADB assistance, the central bank’s ability to supervise the banking system—and specifically to oversee the state-owned banks—has been somewhat strengthened.
    - State banks are not yet subject to fully equal treatment as private banks: central bank supervisors do not have the ability to order removal of managers of state banks, or suspend licenses of these banks, in the event of insolvency or violation of supervisory orders or regulations.
- Structural and fiscal reform status:
  - Competition fostered in the telecommunications sector.
  - A tax reform and reform of the special pension plans for the military and police have been submitted to Congress, though not yet approved.
  - A number of measures envisaged as structural benchmarks were dropped; much remains on the agenda.

### VII. Questions and Lessons — IMF policy issues arising from the crisis
- IMF policy issues identified:
  - Uruguay was essentially the first case in which an IMF arrangement supported the central bank’s lender of last resort function in a context of high de facto dollarization. Existing Fund facilities were not designed with this setting in mind; implications for IMF strategy in similar future cases merit consideration.
  - The judgment that the program would not have been sustainable under the existing exchange rate regime was reasonable, if close; the underlying rationale did not seem to have been fully spelled out, pointing to the broader question of conditions under which an exchange rate could be supported using IMF resources.
  - Whether a member’s debt should be restructured is a decision of the member and its creditors; the IMF is precluded from providing further financing unless the debt is sustainable in the medium term. Assessing debt sustainability involves difficult judgments regarding a number of macroeconomic assumptions, suggesting a potential role for a more systematic approach where debt sustainability is a serious concern.

### B. Lessons for IMF engagement in Uruguay — priorities, risks, and policy recommendations
- Need for a strong program:
  - A program with strong policies will be required to make a forceful move toward reducing Uruguay’s reliance on IMF credit.
  - A new arrangement will be needed when the current arrangement expires; Uruguay would need to find private financing far in excess of amounts it could realistically obtain at this time.
  - Uruguay’s smooth return to a sustainable path will likely require intensive IMF engagement—in the form of financing and policy advice—for a few years.
  - Crucial reforms, notably in the banking sector, need to be completed before macroeconomic stability can be durably assured.
  - Program design should aim at rapidly restoring Uruguay’s ability to rely fully on global capital markets rather than IMF credit.
- Major risks to a new program:
  - Debt sustainability is conditional: the most recent DSA (Country Report No. 05/14) shows debt is sustainable only under stringent assumptions regarding interrelated variables—real exchange rate; economic growth; and especially primary fiscal surpluses, which are required to be of the order of 4 percent of GDP in the medium term.
  - Primary fiscal surpluses of this size are unprecedented in Uruguay’s history and have rarely been maintained in other countries for longer than a few years.
  - Scenarios where intertwined macroeconomic variables turn out worse than expected could result in higher bond spreads and a depreciation of the exchange rate.
  - If compliance with IMF conditionality deteriorates, choices would arise between letting a program go off track and making it less ambitious; a weaker program might lead to excessively prolonged use of IMF resources.
  - The IMF may face temptation to err on the side of leniency in setting targets or assessing compliance to avoid triggering new difficulties.
- Market access and IMF exposure:
  - A key criterion for exit from IMF arrangements will be Uruguay’s ability to tap international financial markets for necessary amounts at reasonable spreads.
  - Ability to tap private financing is hard to predict; IMF should be ready to re-evaluate possible future access under IMF arrangements in light of evolving market conditions.
  - The IMF should be alert to upside risks and design programs allowing more rapid reduction in IMF exposure should market access turn out higher than in the central scenario of the most recent DSA.
  - Historical context: In 2000–01, Uruguay placed an annual average of US$850 million in long-term bonds on international markets (US$550 million net of amortization) at spreads of 200–300 basis points; these gross placements were more than twice as large as those foreseen in 2005–09 by the most recent DSA.
- Immediate structural priorities for a possible new program:
  - Continue banking system resolution and restructuring to restore normalcy and intermediation.
  - Gradual reduction in reserve requirements as economic activity and prudent lending normalize.
  - Continued improvement in credit monitoring and risk controls at BROU and NBC.
  - Continue efforts to collect and deal with outstanding nonperforming loans to enhance creditor discipline.
  - Maintain full, transparent, and timely provision of information to preserve public confidence.
- Recommended banking-sector reforms:
  - Strengthen bank supervision further with more resources for staff and training, greater efforts to comply with international standards, and full independence from political interference.
  - Prudential regulation should reduce risks from non-resident deposits, dollar deposits, and currency mismatches.
  - Improve authorities’ ability to intervene in future banking crises.
  - Revamp the central bank’s lender of last resort function, allowing the central bank to lend more than 100 percent of a troubled bank’s net worth.
  - Strengthen the central bank’s financial position through recapitalization or similar measures.
  - Establish bank “exit rules” that are less disruptive than straight liquidation.
- Fiscal, pension, and tax policy recommendations:
  - Leverage recent economic growth, the absolute majority in Congress, and a change in political support to pursue politically difficult reforms, especially in the fiscal area.
  - Reform the tax system and improve tax administration: widen the tax base and reduce exemptions to improve efficiency and promote a more equitable distribution of the tax burden.
  - Reform special pension funds for the military and police and other groups such as bank employees.
  - Consider changes to parameters in the general pension system; pressures remain substantial and the most recent reform took place almost a decade ago.
  - Target primary fiscal surplus especially ambitiously in 2005 when economic growth is expected to be above potential, to convey commitment to fiscal prudence.
- Medium-term structural challenge:
  - Reduce the role of the state in the economy to foster lasting economic growth.
  - Launch a fresh, thorough review of the current and desirable extent of state involvement across economic sectors.
  - Consider appropriate options for greater private involvement: joint ventures, public-private partnerships, further liberalization, and privatization (including consideration of the state bank and public entities in other sectors).
  - On governance of public enterprises, the state bank, and the central bank, consider introducing fixed term, staggered contracts for key board positions to reduce dependence on the electoral cycle.

*Source: _cr05202 - 52.      It is worth asking whether such a strategy should have been adopted earlier.*

### 70.      Greater independence will be especially important for key institutional functions

### _cr05202 - 70.      Greater independence will be especially important for key institutional functions

### Monetary policy and banking supervision
- Greater independence for key institutional functions in monetary policy and banking supervision is recommended.
- A move toward an independent central bank is described as "highly desirable" and a precondition for inflation targeting, which the authorities have expressed interest in.
- The entity supervising the banking system should be independent from the government; the report notes this objective has been attained in several countries while keeping the supervisory entity within the central bank.

### De-dollarization and local-currency debt instruments
- De-dollarization is identified as a medium-term challenge; it is "likely to prove difficult" but would deliver benefits such as lower vulnerability and increased ability to conduct an independent monetary policy.
- A recent welcome development: issuance, at reasonable cost, of local currency denominated, inflation-indexed government bonds.

### Trade and labor market measures to reduce vulnerability
- Promote trade beyond Mercosur to reduce vulnerability to external shocks and improve geographic diversification of trade.
- Consider measures to make the labor market more flexible:
  - The unemployment rate has been "well above 10 percent for more than a decade," with substantial social costs.
  - Labor market flexibility is necessary to help cushion the economy from shocks, particularly while de facto dollarization constrains scope for truly independent monetary policy.

### Indicators of vulnerability and real exchange rate (REER) misalignment
- The appendix presents estimates of the equilibrium REER as a function of fundamentals: real export prices (Px), real GDP per capita relative to major trading partners (Rgdppc), and the ratio of net foreign assets to GDP (NFA). All variables are in logarithms, except for NFA. Dataset: 1980–2003.
- Estimated long-run equation coefficients (Table 1):
  - Px: 1.77 (HAC standard error (0.42))
  - RGDPPC: 1.61 (HAC standard error (0.38))
  - NFA: -0.003 (HAC standard error (0.002))
- Interpretation:
  - Increase in real export prices is associated with REER appreciation.
  - Increase in real output per capita relative to trading partners is associated with REER appreciation (Samuelson effect).
  - Increase in NFA to GDP tends to depreciate the REER, but not significantly.
- Fitted-versus-actual REER results:
  - REER was overvalued by about 10 percent relative to its equilibrium at end-1999 and about 6 percent at end-2001.
  - Cautions: methodology restricts average overvaluation in 1980–2003 to zero; short sample and influential years make precise interpretation difficult.
  - The depreciations of the Brazilian real in January 1999 and the Argentine peso in January 2002 had a marked impact on Uruguay’s REER.

### Banking system vulnerabilities (1994–2004) and reserve adequacy
- From 1999, vulnerabilities in the banking system became substantially more pronounced.
- Key indicators showing worsening from 1999 on, especially in state-owned banks BHU and BROU:
  - Nonperforming loans; provisions as a share of nonperforming loans; capital to unweighted assets ratio—consistent worsening pattern.
  - Nonresident dollar deposits as a share of total deposits rose considerably in foreign banks, private domestic banks, and BROU.
  - BHU exposure to foreign exchange rate risk rose substantially—hypothetical losses from a given devaluation of the Uruguayan peso vis-à-vis the U.S. dollar would have grown.
- Gross international reserve (GIR) adequacy notes:
  - Dollar deposits fell by 65.4 percent for non-residents and 30.1 percent for residents between January 2002 and August 2002.
  - Gross international reserves include free reserves deposited at the central bank by commercial banks and other agents; this is a considerable overestimate of the central bank's ability to direct reserves to specific banks at its own discretion.

### Potential BHU losses scenarios
- Valuation loss for BHU computed as depreciation times the difference between liabilities and assets in US dollars; exchange rate pass-through to salaries (to which BHU loans are indexed) is assumed to be negligible.
- Scenario references:
  - 60 percent scenario corresponds to the depreciation that followed the peso's floating (June 2002).
- Charts and staff estimates show potential losses in BHU expressed in percent of GDP (1994–2004).

### Authorities' statement and policy priorities (Statement by Hector Torres and David Vogel, March 18, 2005)
- Authorities reiterate strong commitment to macroeconomic stability as necessary for higher sustainable growth, improved employment, poverty mitigation, and social equity.
- Structural reform agenda to strengthen institutions and improve investment climate.
- Exchange rate system reflections:
  - Crawling band system was a pillar of strategy to reduce inflation, but contributed to deepening financial dollarization.
  - Dollar deposits rose from "80 percent in 1990 to 92 percent in 2002".
  - Dollar credits increased from "58 percent to 83 percent" over the same period.
  - Dollarization impeded the Central Bank’s ability to act as lender of last resort during the 2002 crisis.
- Financial sector reforms and supervision:
  - Superintendency of Banks to deal only with technical aspects; central bank supervision has been strengthened in the last two years (authorities contest staff phrasing that it has been "somewhat strengthened").
  - Prudential rules to be reinforced to diminish exposure to exchange rate risk from dollar loans to the non-tradable sector.
  - Plans to increase the Central Bank’s reserve position as soon as possible.
- Crisis response and debt operations:
  - Debt-exchange operation implied a net present value haircut of "20-30 percent discounted at 16 percent".
  - August 2002 staff assumptions cited for DSA: nominal exchange rate depreciation of "99 percent in 2002, 62 percent in 2003, 12 percent in 2004", and a country risk "above 1,000 basis points between 2002 and 2005, and 700 basis point until 2012".
  - Even with a primary surplus of "4.5 percent of GDP", the August 2002 DSA indicated the debt to GDP ratio would have been "75 percent by 2012".
- Debt sustainability and fiscal discipline:
  - Debt-to-GDP ratio remains high and a significant source of vulnerability.
  - Authorities emphasize importance of GDP growth and a primary surplus consistent with debt sustainability.
  - Historical fiscal figures: average primary surplus in 1990-2001 was "0.3 percent of GDP"; historical maximum had been "2.8 percent of GDP".
  - Staff note that primary fiscal surpluses around "4 percent" are unprecedented in Uruguay’s history; the August 2002 staff report warned a necessary condition for stabilizing the debt ratio was maintaining very large primary surpluses of about "4.5 percent of GDP".
- Post-2002 financial system improvements noted:
  - Restructuring of Banco de la República Oriental del Uruguay (BROU) advanced; asset management company progress in recovering nonperforming loans; liquidation funds have shown considerable advances.
  - Authorities acknowledge remaining vulnerabilities and commit to strengthen regulation, supervision, governance, risk management, and credit policies in public banks.

*Source: _cr05202 - 70.      Greater independence will be especially important for key institutional functions*

### 9. Boosting investment and higher growth rates may not be sufficient to alleviate the

### 9. Boosting investment and higher growth rates may not be sufficient to alleviate the most extreme poverty conditions.

### Social impact of the crisis and government response
- Poverty rates almost doubled between 2000 and late 2002.
- The government will implement a social emergency plan aimed at providing the most vulnerable sectors with a higher quantity and better quality of education and health.
- The social emergency plan will be:
  - Implemented in a transparent manner.
  - Designed with serious consideration of providing appropriate incentives.
- Improving quality of life and prospects for social insertion of the poor is necessary to build ownership for pending structural reforms.

### Fiscal reorientation and revenue administration
- Authorities will aim to reorient expenditures and to improve targeting.
- Authorities agree on the need to introduce adequate improvements to the budgetary process and welcome assistance from Fund’s staff.
- Box 2 of the staff report (as referenced) indicates the necessity of reforming the revenue administration to efficiently achieve objectives of a comprehensive tax reform.
- The revenue administration reform will be gradually undertaken so as not to affect revenue performance, and will be strongly oriented by efficiency as well as vertical and horizontal equity considerations.

### Private sector role and external diversification
- Authorities believe increasing the role of the private sector is necessary for sustainable and higher economic growth.
- Public reluctance toward greater private sector involvement in traditionally public activities could be reduced by:
  - Improving transparency.
  - Establishing more efficient regulations to promote more and better competition.
- Uruguay’s strong commitment to the Mercosur is fully compatible with intentions to continue diversifying external markets and the export base to reduce vulnerability to external shocks.

### Views on IMF engagement and facilities
- IMF engagement was critical to overcome the severe crisis but was not perfect due to lacks or absence in the Fund’s facilities.
- Staff posed whether a somewhat larger package early on could have prevented panic among residents before massive deposit withdrawals.
- Standard IMF programs do not make sufficient funds available upfront and make funds available even after the crisis may have subsided.
- The lifting of the holiday bank could be completed only after a bridge loan provided by the U.S. government; otherwise, Fund procedures for a new augmentation might have come when the crisis reached a dead end.
- There is a clear need for a facility like the former Contingent Credit Lines (CCL), which had not been used not because it was not useful, but because of significant deficiencies in its design.

### Conclusion on program ownership
- Authorities assert the necessity of a successor Fund-supported program while regaining access to external financial markets.
- Uruguayan authorities state they firmly believe in the need for macroeconomic stability and structural reforms and will have full ownership of the program.
- Authorities hope for close and fruitful cooperation with the Fund.

---

### Public Information Notice (PIN) No. 05/77 — Executive Board review (June 15, 2005)

### Background and crisis overview
- Uruguay undertook broadly prudent macroeconomic policies over the last decade; an exchange rate-based stabilization in the 1990s reduced inflation but resulted in some real exchange rate appreciation.
- Since 1996, Uruguay had a series of Stand-By Arrangements treated mostly as precautionary.
- In 2002, Uruguay faced its most severe financial crisis, characterized by:
  - Widespread illiquidity and insolvencies in the domestic banking system.
  - A sharp depreciation of its currency followed by high inflation.
  - A doubling of the public debt-to-GDP ratio to about 100 percent.
- Purchases under the existing Fund arrangement were activated and a new arrangement was approved and augmented twice, making it the largest Fund arrangement as a share of a country’s GDP.
- The economy rebounded strongly since the crisis and inflation returned to single digits, but substantial vulnerabilities remain from the high debt burden and widespread dollarization.
- The ex post assessment concludes continued Fund involvement will likely be needed; exit from Fund financial support depends on ability to tap international capital markets, hinging on a forceful program aimed at fiscal consolidation and fostering sustainable growth, including wide-ranging structural reforms notably in the tax and financial sector areas.

### Executive Board Assessment — key findings
- Precautionary arrangements helped buttress commitment to prudent macroeconomic policies and secure political support for difficult reforms.
- In retrospect, deep-rooted vulnerabilities—especially in the banking system and fiscal accounts—should have been tackled more forcefully to build a larger cushion against shocks.
- The gradual, consensus-building approach to structural reforms led to slow progress in needed areas, constraining economic performance and ability to withstand external shocks in late 2001 and early 2002.
- Directors regretted that arrangements did not address banking system vulnerabilities in a more timely manner.
- Precautionary arrangements should be subject to the same standards as regular arrangements in program conditionality and compliance.

### Crisis resolution and program timing
- The 2002 crisis, with large withdrawals of dollar deposits, required a novel approach involving support of the central bank’s lender of last resort function in a highly dollarized economy.
- The combination of strategy and exceptional access to Fund resources eventually halted the banking crisis, but a comprehensive approach was adopted only after a few months.
- Uruguay’s experience points to the need for early implementation of comprehensive and strong programs addressing banking, external accounts, and fiscal position simultaneously.
- The move to an exchange rate float was considered decisive and reasonable, though its rationale should have been explained fully in subsequent staff reports.
- The debt exchange extended bond maturities by about five years, providing breathing room, but debt remains high and will require strong fiscal policies and structural reforms to promote growth and reduce debt rapidly over the medium term.

### Directors’ recommendations and priorities
- Fund financial support was instrumental in stabilizing the economy, though many Directors would have preferred larger access combined with stronger measures at the start.
- A successor arrangement should entail an exit strategy from Fund resources and adhere strictly to the exceptional access framework.
- A strong program is needed to create conditions for improved access to capital markets at reasonable spreads and progressively reduced exposure to the Fund as market access improves.
- Key policy priorities for a successor Fund-supported program:
  - Continued fiscal consolidation to generate sufficiently large primary surpluses to restore medium-term debt sustainability while safeguarding social spending.
  - Reforms to simplify the tax system and strengthen the tax administration.
  - Reform of the special pension funds.
  - Improvement of the budget framework and procedures.
  - Reduce the role of the state and encourage competition.
  - Further banking system reforms and enhancement of prudential regulations and supervision to restore sound credit flows and reduce vulnerabilities from dollarization and nonresident deposits.
  - Increase the independence of the central bank and of the banking supervision function.
  - Enhance flexibility in trade and labor markets.
  - Adopt a clear communications strategy to ensure broad-based consensus for difficult reforms.

---

### Uruguay: Selected Economic Indicators (as reported)
- Real GDP (percentage changes):
  - 1995: -1.4
  - 1996: 5.6
  - 1997: 4.9
  - 1998: 4.7
  - 1999: -2.8
  - 2000: -1.4
  - 2001: -3.4
  - 2002: -11.0
  - 2003: 2.5
  - 2004: 12.0
- GDP (in U.S. dollar billion):
  - 1995: 19.3
  - 1996: 20.5
  - 1997: 21.7
  - 1998: 22.4
  - 1999: 20.9
  - 2000: 20.1
  - 2001: 18.6
  - 2002: 12.3
  - 2003: 11.2
  - 2004: 13.3
- Consumer prices (e.o.p., percentage changes):
  - 1995: 35.4
  - 1996: 24.3
  - 1997: 15.2
  - 1998: 8.6
  - 1999: 4.2
  - 2000: 5.1
  - 2001: 3.6
  - 2002: 26.0
  - 2003: 10.2
  - 2004: 7.6
- Exchange rate (Ur$/U.S.$, e.o.p.):
  - 1995: 27.0
  - 1996: 22.5
  - 1997: 15.2
  - 1998: 7.7
  - 1999: 7.4
  - 2000: 7.7
  - 2001: 18.0
  - 2002: 84.2
  - 2003: 7.3
  - 2004: -2.8
- Currency issued (percentage changes):
  - 1995: 32.5
  - 1996: 26.6
  - 1997: 22.0
  - 1998: 13.8
  - 1999: 6.9
  - 2000: -3.9
  - 2001: -0.2
  - 2002: 5.8
  - 2003: 22.4
  - 2004: 15.7
- Credit to the private sector (constant exchange rate, percentage changes):
  - 1995: 21.9
  - 1996: 21.5
  - 1997: 12.2
  - 1998: 5.8
  - 1999: 4.5
  - 2000: 0.2
  - 2001: -6.5
  - 2002: -13.7
  - 2003: -25.5
  - 2004: -20.1
- Public sector operations (Percent of GDP):
  - Revenue:
    - 1995: 30.2
    - 1996: 29.8
    - 1997: 30.1
    - 1998: 32.7
    - 1999: 32.2
    - 2000: 28.8
    - 2001: 32.7
    - 2002: 31.1
    - 2003: 31.1
    - 2004: 30.0
  - Non-interest expenditure:
    - 1995: 29.5
    - 1996: 29.6
    - 1997: 29.3
    - 1998: 34.9
    - 1999: 34.4
    - 2000: 30.4
    - 2001: 34.0
    - 2002: 31.1
    - 2003: 28.4
    - 2004: 26.3
  - Primary Balance:
    - 1995: 0.7
    - 1996: 0.2
    - 1997: 0.9
    - 1998: -2.2
    - 1999: -2.1
    - 2000: -1.5
    - 2001: -1.2
    - 2002: 0.0
    - 2003: 2.7
    - 2004: 3.8
  - Interest:
    - 1995: 2.1
    - 1996: 1.9
    - 1997: 2.0
    - 1998: 1.9
    - 1999: 2.1
    - 2000: 2.6
    - 2001: 2.9
    - 2002: 4.7
    - 2003: 6.0
    - 2004: 6.0
  - Overall balance:
    - 1995: -1.4
    - 1996: -1.8
    - 1997: -1.1
    - 1998: -4.1
    - 1999: -4.2
    - 2000: -4.1
    - 2001: -4.2
    - 2002: -4.6
    - 2003: -3.2
    - 2004: -2.2
  - Public sector debt (Includes nonfinancial public sector debt plus liabilities to the IMF, Percent of GDP):
    - 1995: 29.8
    - 1996: 29.0
    - 1997: 28.7
    - 1998: 30.2
    - 1999: 31.1
    - 2000: 35.7
    - 2001: 42.8
    - 2002: 85.1
    - 2003: 105.3
    - 2004: 88.4
- External indicators (U.S. dollar million unless otherwise noted):
  - Merchandise exports, f.o.b.:
    - 1995: 2,148
    - 1996: 2,449
    - 1997: 2,793
    - 1998: 2,829
    - 1999: 2,291
    - 2000: 2,384
    - 2001: 2,139
    - 2002: 1,922
    - 2003: 2,273
    - 2004: 3,025
  - Merchandise imports, f.o.b.:
    - 1995: 2,711
    - 1996: 3,135
    - 1997: 3,498
    - 1998: 3,601
    - 1999: 3,187
    - 2000: 3,311
    - 2001: 2,915
    - 2002: 1,874
    - 2003: 2,092
    - 2004: 2,990
  - Current account balance (in percent of GDP):
    - 1995: -1.1
    - 1996: -1.1
    - 1997: -1.3
    - 1998: -2.1
    - 1999: -2.4
    - 2000: -2.8
    - 2001: -2.6
    - 2002: 3.1
    - 2003: -0.3
    - 2004: -0.8
  - External debt (in percent of GDP):
    - 1995: 27.6
    - 1996: 28.7
    - 1997: 30.8
    - 1998: 33.8
    - 1999: 35.7
    - 2000: 40.7
    - 2001: 52.2
    - 2002: 87.7
    - 2003: 98.3
    - 2004: 87.4
  - Gross official reserves (U.S. dollar million):
    - 1995: 1,813
    - 1996: 1,892
    - 1997: 2,067
    - 1998: 2,587
    - 1999: 2,604
    - 2000: 2,776
    - 2001: 3,099
    - 2002: 772
    - 2003: 2,087
    - 2004: 2,512
  - Gross official reserves in percent of short-term debt and FX deposits (selected years shown):
    - 1999: 17.3
    - 2000: 17.1
    - 2001: 17.5
    - 2002: 7.0
    - 2003: 20.0
    - 2004: 27.7
  - REER (percentage depreciation -, e.o.p.):
    - 1995: 1.7
    - 1996: -0.8
    - 1997: 1.6
    - 1998: 1.1
    - 1999: 10.0
    - 2000: -0.9
    - 2001: -5.4
    - 2002: -13.2
    - 2003: -15.0
    - 2004: 9.4

*Sources: Data provided by the Uruguayan authorities; and IMF Staff estimates.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05202.pdf_