## 2. PPPs ## Source details **Canonical URL:** [2. PPPs](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06427.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06427.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06427.pdf.json) --- ### Overview - Five background studies emphasized vulnerabilities and growth, the focus of the 2006 Article IV Consultation with Uruguay. - Papers cover longer-term structural questions and short-term issues. - Chapter highlights: - Need to stay the course with prudent policies as vulnerabilities have declined since the crisis but remain important. - Public debt-to-GDP ratio has fallen, but is still higher than before the crisis. - Savings of Uruguayan residents remain largely short term and denominated in foreign currency, while government and most Uruguayan companies lack steady foreign currency income streams and have most assets installed for the long term. - Hypothetical sharp drop of the Uruguayan peso could create difficulties for government and companies honoring dollar debt, with indirect effects on banks and stakeholders. - Developing markets for hedging Uruguayan peso risk could help reduce corporate and bank vulnerabilities. - Competitiveness assessment: - Most indicators suggest Uruguay has remained competitive; equilibrium REER estimation supports peso near equilibrium. - Some indicators show declining trends; recommended continued improvement in institutional and business environment to enhance international competitiveness. - Credit and financing: - Bank credit stocks fell for three years and have stabilized at low levels. - Stricter prudential rules and cautious bank lending; companies may be postponing investments. - Econometric disequilibrium framework does not suggest prevalence of credit rationing. - After banking and currency crises, companies typically find other finance sources with bank credit picking up gradually after about three years. - Recommendation: further institutional reforms and use of trust funds to facilitate companies’ access to finance. - Public infrastructure: - Infrastructure generally of good quality and coverage, but decline in public investment since the crisis raises concerns. - Indications of emerging infrastructure bottlenecks that could impede medium-term growth. - Recommendation: address investment needs with both public and private sector participation; strengthen institutional framework for fiscally solid PPPs. - Growth performance: - Per capita growth low and volatility high since the 1960s; growth episodes short and followed by deep recessions closely tracking Argentina. - Long-term growth attributable mainly to total factor productivity rather than capital accumulation. - Positive influence from high education; negative influence from volatile external environment. - Vulnerabilities include high financial integration with Argentina, regional dependencies, and reliance on commodities; vulnerabilities have declined recently but further reduction is needed. ### II. Balance-sheet mismatches and cross-sectoral vulnerabilities in a highly dollarized economy: the case of Uruguay - Purpose: - Take stock of key financial balance-sheet vulnerabilities in Uruguay and compare to crisis and pre-crisis levels. - Focus on maturity, currency, and capital-structure mismatches across four sectors: public sector (including the central bank), banking sector (excluding the central bank), pension funds, and private nonfinancial companies and households. - Key findings: - Structural weaknesses have decreased since the crisis, but important balance-sheet fragilities remain. - Uruguay’s external financial position strengthened but remains weaker than in 2001. - Exposure to reversals in external financing flows and withdrawals of nonresident deposits has declined. - FDI share in total external financing fell during the crisis but has been recovering since then. - Public debt declined but remains higher than before the crisis. - Public debt and the financial system remain highly dollarized. - Large currency and maturity mismatches persist at sector level: public and corporate sectors have short open foreign exchange positions; households and pension funds have long ones. - Inter-sectoral linkages: two thirds of pension fund portfolios invested in government debt, exposing them to sovereign credit risk. - Banks’ holdings of public debt traditionally low in Uruguay compared with region. - Banks have granted a third of their dollar loans to industries with little export activity, creating indirect exposure to sharp peso depreciation. - Recommendation: develop markets for hedging peso risk to reduce corporate and bank vulnerabilities. ### Economy-wide indicators (selected exact figures) - Net foreign debt position: - Net foreign debt declined by US$1.3 billion during 2002–2005, reaching US$7.5 billion (43 percent of GDP) in 2005. - This is about US$2 billion larger than in 2001, when net foreign debt was equivalent to 31 percent GDP. - Short-term external financing and nonresident deposits: - Net short-term debt of US$2.8 billion in 2001 switched to a net short-term asset of US$1.7 billion in 2005. - In 2001 nonresident deposits accounted for 50 percent of total private sector deposits; by end-2005 this ratio had declined to about 20 percent. - Banks’ liquid assets now cover more than twice the level of nonresident deposits, compared with about 80 percent in 2001. - Equity financing: - “Equity buffer” (Net Inward FDI Stock as a share of Net Total External Financing) has been recovering toward pre-crisis levels. ### Sectoral balance sheets — public sector (including the Central Bank) - Public debt dynamics: - Debt of nonfinancial public sector and central bank to GDP fell from 93 percent at end-2002 to 83 percent at end-2005. - Nonfinancial public sector improved from 96 percent of GDP in 2002 to 69 percent of GDP in 2005. - Public debt-to-GDP ratio remains much higher than in 2001 (53 percent) and above the median for a sample of 30 developing countries at end-2005 (46 percent). - Currency mismatches and dollarization: - Public sector has a substantial short net foreign currency position. - Foreign currency denominated debt accounts for about 72 percent of GDP. - Gross reserves account for about 20 percent of GDP. - Uruguay’s public debt is highly dollarized: over 87 percent denominated in foreign currency. - Maturity mismatches: - Average maturity increased from 6.1 years at end-2002 to 7.6 years at end-2005. - Share of contractual short-term debt is 3 percent. ### Liquidity cushions and foreign-currency maturity mismatch - At end-2005, gross reserves and government deposits in commercial banks exceeded short-term debt on a remaining maturity by US$1.4 billion. - This liquidity cushion is slightly higher than in 2001, and contrasts with a US$1.1 billion liquidity shortfall in 2002. ### Banking system — currency mismatches and positions - Banks’ net open foreign exchange positions increased from US$370 million in 2001 to US$450 million in 2005. - Prudential limit: net open positions limited to 1.5 times bank capital; in 2005 banks’ net open foreign exchange positions amounted to about 70 percent of capital. - During the 2002 crisis, banks’ net open foreign exchange position became temporarily negative by US$1.5 billion. ### Financial dollarization — banks, pension funds, and household deposits (selected exact figures) - Dollarization of outstanding resident deposits from the nonfinancial private sector fell from 90 percent (peak) to about 83 percent (2005). - Dollarization of credit remained at about 70 percent over the period. - Banks increased holdings of liquid assets from 34 percent to 52 percent of total assets between 2001 and 2005. - Sight deposits increased their share in total deposits from 30 percent to 65 percent over the period. - Ratio of liquid assets to total deposits rose from 49 percent to 82 percent. - Pension funds (AFAPs): - Dollarization of pension fund portfolios fell from 81 percent in 2001 to 45 percent in 2005. - Pension funds increased share of inflation-linked securities to 48 percent of their portfolios. - Asset composition (value of portfolio): 2001 US$1,045 million; 2005 US$2,153 million. - Currency composition (percent): Local currency 19.0 / 54.9; Foreign Currency 81.0 / 45.1 (2001 / 2005). ### Households and companies — dollarization and maturity structure - Households: - Savings of Uruguayan residents in the domestic banking system about US$7.6 billion; in banks abroad about US$5.4 billion — largely denominated in U.S. dollars. - Household loans from the domestic banking system amount to US$530 million at end-2005, of which 75 percent is in domestic currency. - Corporate sector (2004 survey of 408 firms): - 80 percent of companies had substantial dollar debt with short-term maturity at end-2004. - About half the companies had short-term dollar obligations exceeding their annual dollar earnings. - Only 5 percent used derivatives to hedge exchange rate risk. - Table highlights (December 2004, percent; mean / median): - ALL FINANCIAL LIABILITIES: Mean 72.1 / Median 100.0 ; Short Term Maturity Mean 69.2 / Median 94.5 - Bank Financial Liabilities: Mean 77.0 / Median 100.0 ; Short Term Maturity Mean 69.4 / Median 99.0 - Bond Financial Liabilities: Mean 96.6 / Median 100.0 ; Short Term Maturity Mean 38.6 / Median 33.1 - Comparative position: - Uruguay features among the highest ratios of liability dollarization and shortest debt maturities in Latin America (example: Uruguay 2001 Share of Foreign Currency 74.0 / Share of Short Term Liabilities 74.1; Uruguay 2004 Share of Foreign Currency 95.8 / Share of Short Term Liabilities 90.3). ### Cross-sectoral linkages and exposure to domestic government debt - Banks hold less than 10 percent of their assets in government debt. - Bank holdings account for only 5 percent of the stock of government securities; including guarantees and trust funds exposure to the sovereign would increase to 14 percent. - Pension funds manage more than US$2 billion at end-2005; about 60 percent of pension fund portfolios invested in government securities (40 percent dollar-denominated, remainder inflation-indexed). - Pension fund holdings of central government domestic debt account for half of the holdings of domestic residents. - Holders of central government bonds (stock of domestically-issued debt at year-end, in millions of U.S. dollars): total investors 2,285 / 1,690 / 2,336 / 2,433 / 2,467 (2001–2005). Held by Foreign Investors (percent): 41.5 / 38.4 / 48.6 / 41.0 / 26.8 (2001–2005). Pension funds (percent): 6.9 / 19.3 / 27.9 / 28.1 / 34.6 (2001–2005). ### Exchange rate-induced credit risk of domestic banks - Size of the dollar loan portfolio has declined. - Share of dollar loans to the nontradable sector in total dollar credit fell from 46 percent to 31 percent during 2003–2005. - Table 6 (Share of Foreign Currency Credit to the Nontradable Sector in Total Credit): - Banking System: 45.9 / 34.3 / 30.7 (2003 / 2004 / 2005). - Banks: 44.9 / 32.7 / 29.7. - mean (simple average): 49.1 / 38.7 / 36.0. - Despite reductions, exchange rate-induced credit risk remains significant. ### Conclusions — vulnerabilities and policy recommendations (selected exact prescriptions) - Key vulnerabilities: - Financial dollarization remains central: household savings largely in foreign currency, while government and most companies do not have steady foreign currency income streams. - Long position of households finances short positions of government and companies; a sharp drop in the real value of the peso could leave government and companies unable to honor dollar debt, creating indirect bank losses and household impacts via pension funds and bank failures. - High public debt presents ongoing challenges: short-term risks have declined but large and sustained market-sentiment shifts could threaten macroeconomic stability; pension funds particularly exposed to sovereign risk. - Policy recommendations: - Reduce dollarization and high public debt by sustaining large primary surpluses to further bring down public debt as envisaged by the government. - Consolidate a track record of prudent monetary management and flexible exchange rates to entrench low inflation and discourage dollarization. - Maintain policy of internalizing risks of dollar lending to unhedged borrowers to further reduce dollarization. - Debt management should continue to gradually reduce the dollar share of public debt as peso savings increase and help offer attractive peso instruments. - Develop markets for hedging Uruguayan peso risk to reduce corporate and bank risks; this requires further developing money markets and a reliable yield curve on peso securities and would benefit from foreign investor participation. ### Appendix — Corporate vulnerability stress tests (summary) - Data and method: - Based on 2005 official annual survey of economic activity (sample of 408 nonfinancial companies) measuring balance-sheet currency mismatches at end-2004. - Tests stress nominal peso depreciation from 5 to 100 percent, defining financial distress as inability to meet short-term obligations (liquidity effect) or equity turning negative (solvency effect). - Primary stress-test results (percent of sample / percent of sales / percent of employment / percent of assets / percent of financial liabilities): - Firms in distress (percent of sample) at percent nominal depreciation: 5%: 1 ; 10%: 3 ; 20%: 6 ; 40%: 11 ; 60%: 18 ; 80%: 22 ; 100%: 27. - Importance in terms of sales (percent of sales): 5%: 2 ; 10%: 3 ; 20%: 7 ; 40%: 12 ; 60%: 36 ; 80%: 41 ; 100%: 47. - Importance in terms of employment (percent): 1 / 2 / 12 / 15 / 21 / 21 / 26 / 29 (matching depreciation buckets). - Importance in terms of assets (percent): 2 / 4 / 11 / 17 / 33 / 38 / 43. - Importance in terms of financial liabilities (percent): 4 / 9 / 17 / 28 / 45 / 51 / 60. - Interpretation and caveats: - Corporate sector resilient to direct impact of moderate exchange rate shocks: only 6 percent of companies (accounting for 7 percent of sales) would be under financial distress with 20 percent peso depreciation. - With 100 percent peso depreciation, 27 percent of companies (accounting for 41 percent of sales) would be in distress. - Results are lower-bound estimates because tests: - Consider only direct effects of depreciation (ignore accompanying increases in interest rates). - Consider only effect on financial debt. - Include only companies with initially healthy financial positions. - Assume dollar earnings’ value does not change (ignoring likely drops in dollar income for firms selling nontradables). ### III. Competitiveness assessment — summary findings and interpretation - Majority of indicators suggests Uruguay has remained competitive. - External-sector performance: - Exports growth: 25 percent annual growth (17 percent in volume terms) in 2005, compared with a 30-year historical average of 9 percent. - Current account: deficit of ½ percent of GDP in 2005, smaller than historical average of 2 percent. - Net FDI inflows now higher than in Argentina and Brazil as percent of GDP; 2005 increase partly reflects pulp mill projects. - REER and productivity alignment: - CPI-based REER remained around 20 percent below its pre-crisis level; depreciated by some 35 percent in 2002 and recovered to around 80 percent of its 2001 level. - ULC-based REER: remains around 43 percent more depreciated than its pre-crisis level in 2001. - Quantitative VECM estimation (quarterly data 1988–2005) finds one cointegrating relation between LREER, LRGDP and NFA. - Long-run coefficients (selected): LRGDP (-1): -2.4304 (t-statistic -7.7699); NFA (-1): -0.0198 (t-statistic -1.6301); Trend: -0.0069 (t-statistic -4.5049); Const.: 4.0926. - Interpretation: An increase in relative real per capita GDP by 1 percent is associated with a real appreciation of 2.4 percent. - Estimated speed of adjustment: CointEq1: -0.3655 (t-statistic -3.6602): 37 percent of deviation of the REER from its long-run relation is eliminated within one quarter; half of the gap closed within about 4½ months absent shocks. - At end-2005 the REER was slightly below equilibrium but within the estimated 95 percent confidence interval. - Structural rankings and reform needs: - WEF rank: 54 out of 117 for growth competitiveness; 70 for business competitiveness. - World Bank Doing Business (2006): Uruguay ranks 85 out of 155 countries for ease of doing business. - Identified bottlenecks: access to financing, inefficient government bureaucracy, tax rates and regulations, policy instability, restrictive labor regulations, inadequate supply of infrastructure. - Recommendation: continue to improve institutional and business environment; pursue tax reform, public investment increases, bankruptcy code reform, and procurement improvements. ### IV. Post-crisis credit: facts, lessons, and prospects — key facts and policy implications - Credit evolution: - Bank credit to the private sector dropped by 60 percent in real terms from its peak in 2001 and has only recently stopped falling. - New credit flows have grown about 4 percent a year in real terms since 2003, but remain about half their 2001 levels. - NPL ratio dropped from 60 percent in 2002 to 18 percent in 2005; excluding BHU, NPLs fell to less than 5 percent from a crisis peak of 25 percent. - Degree of credit dollarization fell from 83 percent in 2002 to 69 percent in December 2005 (partly reflecting peso appreciation). - Supply and demand drivers: - Supply-side: stricter prudential rules, increased liquidity requirements, shorter deposit maturities (sight deposits rose from 30 percent to 65 percent), foreign-owned banks’ risk aversion, and reduced lending capacity during crisis. - Demand-side: firms postponing investments given spare capacity; econometric disequilibrium estimates suggest demand constrained credit growth since 2003 (sensitive to specification). - Disequilibrium model conclusions: - Framework: C_t = min(D_t, S_t); maximum likelihood disequilibrium estimation for 1998:12 - 2005:12 (84 observations). - Estimation results (selected exact coefficients from supply and demand equations, Table A1): - Supply: Real lending capacity coefficient 0.144 (1) / 0.144 (2) / 0.098 (3) / 0.129 (4). - Supply: Non performing loans ratio: -0.078 (1) / -0.078 (2) / 0.010 (3) / -0.029 (4). - Demand: Real local currency lending rate: -0.004 (1) / -0.004 (2) / 0.010 (3) / 0.002 (4). - Demand: Foreign currency lending rate: 0.226 (1) / 0.225 (2) / 0.123 (3) / 0.165 (4). - Log likelihood: 129.425 (1), 129.825 (2), 151.950 (3), 153.875 (4). - Qualitative inference: since 2003, credit supply at prevailing interest rates has exceeded demand; constrained lending capacity during the crisis and a subsequent stronger supply recovery imply supply has not been binding since 2003 (robust to several specifications but sensitive to exchange-rate treatment). - International comparisons and recovery prospects: - After banking crises, bank lending often takes more than three years to recover; Uruguay’s experience consistent with international patterns. - Output recovered faster than credit; companies find alternative financing sources and credit picks up gradually. - Uruguayan banks generally well capitalized, except BHU. - Policy recommendations to facilitate access to finance (selected exact steps): - Further strengthen the financial system to consolidate confidence and increase maturity of deposits. - Improve the credit registry and expand its coverage. - Reform bankruptcy procedures to reduce inefficiencies and speed liquidation/reorganization. - Enhance corporate transparency and enforce debt-service obligations. - Develop short-term money markets: bonds, certificates of deposits, commercial paper. - Promote dedollarization and development of hedging instruments. - Use trust funds (fideicomisos) and securitization to isolate project financing and facilitate market access. - Do not relax prudential norms in ways that undermine market discipline. ### V. Options to Increase Infrastructure Investment — constraints, options, and PPP strategy - Fiscal and investment context (selected exact figures): - Public debt still high at around 70 percent of GDP; large primary surpluses will continue to be needed. - Fiscal retrenchment reduced government capital spending from above 4 percent of GDP down to 2.3 percent of GDP in 2005. - Current five-year budget envisages increases in investment of about 1 percent of GDP financed by higher revenues. - Revenue-to-GDP ratio targeted to reach almost 34 percent in 2009. - Public investment declined by about 30 percent between 1999 and 2005, from 2.2 percent of GDP to 1.6 percent. - Primary balance increased by 6 percentage points of GDP (1999–2005). - Public investment and institutional issues: - Government capacity constraints: OBP staff insufficient to assess about 600 projects included in the current budget; limited project appraisal except for large transportation and externally financed projects. - Budget rigidities: close to 60 percent of all spending on wages and social security benefits; about 1/3 of revenues earmarked in some form. - Monitoring and evaluation: financial reporting adequate; physical progress data scarce; ex-post evaluations largely absent except for externally financed projects. - Role and limits of private participation: - Private Participation in Infrastructure (PPI) averaged only 0.5 percent of GDP in 1990-2004. - Political constraints: constitutional referenda in 1992, 2003, and 2004 blocked or reversed privatizations/concessions in several sectors. - Mixed experience: road concessions, gas transportation, port services and airport management generally fared relatively well; sanitation concessions revoked after 2003 referendum. - PPPs — rationale, risks, and recommended institutional approach: - PPPs can increase investment and efficiency given fiscal constraints. - Necessary conditions for fiscally sound PPPs: - Build capacity of government entities to develop PPPs. - Adequately share risks with the private sector and value government guarantees. - Properly evaluate and record fiscal costs of PPPs; use public-sector comparators to assess value for money. - Establish a central PPP unit and a gateway procedure for PPP approval (Uruguay in process of setting up such a unit at the Ministry of Finance). - Risk allocation and disclosure: - PPP contracts should allocate risks to the party best suited to manage them; when government provides guarantees they need to be valued and included in debt sustainability analysis. - IMF (2005a) recommendations: disclose known and potential costs; record expected net present value of contingent payments as primary expenditures where applicable. - Practical recommendations: - Focus initially on PPP projects that do not involve complex design and construction issues or difficult risk-sharing arrangements to build government reputation and societal confidence. - Work with IDB to strengthen investment process: centralized database of projects, reinforce appraisal capabilities, strengthen procurement practices, and develop an upgraded institutional budget process. ### VI. Openness, growth, and vulnerabilities (selected empirical findings and policy implications) - Openness and growth: - Imports and exports amounted to about 30 percent of GDP in 2005. - Increased openness helped spur growth via economies of scale, competition, external demand, and financing. - Structural vulnerabilities: - High export concentration and regional dependence: goods exports to Argentina and Brazil reached 60 percent of total exports in 2000 (compared to 35 percent in 1990). - About 60 percent of the tourist industry depends on visitors from the region; tourism accounted for about 4 percent of GDP in 2005. - Argentina linkages: nonresident deposits from Argentines were 40 percent of banking system deposits in the 1990s; now nonresident deposits account for 17 percent of total deposits (10 percent of GDP). - Commodity dependency: about half of Uruguay’s exports are agricultural commodities (15 percent of GDP). - Energy dependence: Uruguay is fully dependent on oil imports, which accounted for 6 percent of GDP or one-fourth of imports in 2005. - Dollarization: Uruguay is highly dollarized with 85 percent of financial system assets in dollars (system-wide figure cited in vulnerabilities section). - Empirical correlations and VAR results: - Correlation of Uruguay’s GDP and Argentine consumption growth is 80 percent. - VAR results: about 80 percent of variance in Uruguay’s GDP in a two-year horizon explained by Argentine consumption and 10 percent by U.S. consumption (1985–2005). - Extended VAR: Argentine consumption explains 50 percent of Uruguay’s growth variance within a two-year horizon; terms of trade 20 percent; U.S. interest rates 10 percent; real exchange rate 5 percent. - Policy implications: - Reduce medium-term risks through dedollarization, local capital-market deepening, consolidation of macroeconomic stability, structural fiscal reforms, improved investment climate, bankruptcy reform, and promotion of private participation in infrastructure. *Prepared by IMF staff and based on IMF staff calculations and data in the provided content unit.* ### 2. PPPs .......................................................................................... ### 2. PPPs ### Overview - The report includes five background studies emphasizing vulnerabilities and growth, the focus of the 2006 Article IV Consultation with Uruguay. - Papers cover longer-term structural questions and short-term issues. - Chapter highlights: - Need to stay the course with prudent policies as vulnerabilities have declined since the crisis but remain important. - Public debt-to-GDP ratio has fallen, but is still higher than before the crisis. - Savings of Uruguayan residents remain largely short term and denominated in foreign currency, while government and most Uruguayan companies lack steady foreign currency income streams and have most assets installed for the long term. - Hypothetical sharp drop of the Uruguayan peso could create difficulties for government and companies honoring dollar debt, with indirect effects on banks and stakeholders. - Developing markets for hedging Uruguayan peso risk could help reduce corporate and bank vulnerabilities. - Competitiveness assessment: - Uruguay depends on international competitiveness; peso appreciation since early 2004 has intensified competitiveness discussion. - Most indicators suggest Uruguay has remained competitive; equilibrium REER estimation supports peso near equilibrium. - Some indicators show declining trends; recommended continued improvement in institutional and business environment to enhance international competitiveness. - Credit and financing: - Bank credit stocks fell for three years and have stabilized at low levels. - Stricter prudential rules and cautious bank lending; companies may be postponing investments. - Econometric disequilibrium framework does not suggest prevalence of credit rationing. - After banking and currency crises, companies typically find other finance sources with bank credit picking up gradually after about three years. - Recommendation: further institutional reforms and use of trust funds to facilitate companies’ access to finance. - Public infrastructure: - Infrastructure generally of good quality and coverage, but decline in public investment since the crisis raises concerns. - Indications of emerging infrastructure bottlenecks that could impede medium-term growth. - Recommendation: address investment needs with both public and private sector participation; strengthen institutional framework for fiscally solid PPPs. - Growth performance: - Per capita growth low and volatility high since the 1960s; growth episodes short and followed by deep recessions closely tracking Argentina. - Long-term growth attributable mainly to total factor productivity rather than capital accumulation. - Positive influence from high education; negative influence from volatile external environment. - Vulnerabilities include high financial integration with Argentina, regional dependencies, and reliance on commodities; vulnerabilities have declined recently but further reduction is needed. ### II. Balance-sheet mismatches and cross-sectoral vulnerabilities in a highly dollarized economy: the case of Uruguay - Purpose: - Take stock of key financial balance-sheet vulnerabilities in Uruguay and compare to crisis and pre-crisis levels. - Focus on risks from maturity, currency, and capital structure mismatches across four sectors: public sector (including the central bank), banking sector (excluding the central bank), pension funds, and private nonfinancial companies and households. - Key findings: - Structural weaknesses have decreased since the crisis, but important balance-sheet fragilities remain. - Uruguay’s external financial position strengthened but remains weaker than in 2001. - Exposure to reversals in external financing flows and withdrawals of nonresident deposits has declined. - FDI share in total external financing fell during the crisis but has been recovering since then. - Public debt declined but remains higher than before the crisis. - Public debt and the financial system remain highly dollarized. - Large currency and maturity mismatches persist at sector level: public and corporate sectors have short open foreign exchange positions; households and pension funds have long ones. - Inter-sectoral linkages: two thirds of pension fund portfolios invested in government debt, exposing them to sovereign credit risk. - Banks’ holdings of public debt traditionally low in Uruguay compared with region. - Banks have granted a third of their dollar loans to industries with little export activity, creating indirect exposure to sharp peso depreciation. - Recommendation: develop markets for hedging peso risk to reduce corporate and bank vulnerabilities. ### Economy-wide indicators - Net foreign debt position: - Net foreign debt declined by US$1.3 billion during 2002–2005, reaching US$7.5 billion (43 percent of GDP) in 2005. - This is about US$2 billion larger than in 2001, when net foreign debt was equivalent to 31 percent GDP. - Short-term external financing and nonresident deposits: - Net short-term debt of US$2.8 billion in 2001 switched to a net short-term asset of US$1.7 billion in 2005. - In 2001 nonresident deposits accounted for 50 percent of total private sector deposits; by end-2005 this ratio had declined to about 20 percent. - Banks’ liquid assets now cover more than twice the level of nonresident deposits, compared with about 80 percent in 2001. - Equity financing: - “Equity buffer” (Net Inward FDI Stock as a share of Net Total External Financing) has been recovering toward pre-crisis levels. - Advantage of FDI: payoffs linked to capacity to repay; debt-service payments remain unchanged in bad times while profits and dividends fall. ### Sectoral balance sheets - Variation in currency and maturity mismatches across four sectors; some sectoral mismatches partly offset in aggregate (e.g., long household FX position vs short public and corporate FX positions). Public sector (including the Central Bank) - Public debt dynamics: - Debt of nonfinancial public sector and central bank to GDP fell from 93 percent at end-2002 to 83 percent at end-2005. - Public debt-to-GDP ratio remains much higher than in 2001 (53 percent) and above median for a sample of 30 developing countries at end-2005 (46 percent). - Nonfinancial public sector improvement: from 96 percent of GDP in 2002 to 69 percent of GDP in 2005. - Currency mismatches: - Public sector has a substantial short net foreign currency position: foreign currency liabilities of the public sector largely exceed its foreign currency assets. - Foreign currency denominated debt accounts for about 72 percent of GDP. - Gross reserves account for about 20 percent of GDP. - Government deposits in commercial banks account for only a few percentage points of GDP. - Uruguay’s public debt is highly dollarized: over 87 percent denominated in foreign currency. - Balance-sheet risk arises from mismatch between foreign currency debt obligations and peso revenue collection. - Maturity mismatches: - After the end-May 2003 debt exchange, authorities lengthened public debt average maturity and smoothed amortization profile. - Average maturity increased from 6.1 years at end-2002 to 7.6 years at end-2005. - High dollarization of sovereign debt has allowed government to extend maturity of outstanding obligations. - Dollarization has coincided with a low share of contractual short-term debt (3 percent). - Uruguay’s share of contractual short-term debt is low relative to many other developing countries. *Prepared by Herman Kamil.* ### 11. The authorities have also increased liquidity cushions. At end-2005, gross reserves ### _cr06427 - 11. The authorities have also increased liquidity cushions. At end-2005, gross reserves ### Liquidity cushions and foreign currency maturity mismatch - At end-2005, gross reserves and government deposits in commercial banks exceeded short-term debt on a remaining maturity by US$1.4 billion. - This liquidity cushion is slightly higher than in 2001, and contrasts with a US$1.1 billion liquidity shortfall in 2002. - Figure construct (as described): for each year, the sum of short-term, foreign currency assets of the public sector and central bank ("Short Term FX Assests"), total short-term domestic and external debt of the public sector denominated in foreign currency ("Short Term FX Liabilities"), and Net short-term foreign currency assets (“FX Maturity Mismatch”). ### Banking system — currency mismatches and positions - Uruguayan banks have positive net open foreign exchange positions. - Banks’ net open positions increased from US$370 million in 2001 to US$450 million in 2005. - Prudential regulation: - Net open positions may be positive or negative but are limited to 1.5 times bank capital. - In 2005, banks’ net open foreign exchange positions amounted to about 70 percent of capital. - Risk dynamics: - Peso depreciation can reduce the value of dollar assets and increase nonperforming loans among borrowers with currency mismatches, requiring provisions. - During the 2002 crisis, banks’ net open foreign exchange position became temporarily negative by US$1.5 billion. ### Financial dollarization — banks, pension funds, and household deposits - Banking system deposit dollarization: - Dollarization of outstanding resident deposits from the nonfinancial private sector fell from 90 percent (peak) to about 83 percent (2005). - Dollarization of credit remained at about 70 percent over the period. - Bank liquidity and maturity structure: - Banks increased holdings of liquid assets (short-term foreign assets, central bank deposits and securities, and short-term government securities) from 34 percent to 52 percent of total assets between 2001 and 2005. - Sight deposits increased their share in total deposits from 30 percent to 65 percent over the period. - The ratio of liquid assets to total deposits rose from 49 percent to 82 percent. - Pension funds (AFAPs): - Dollarization of pension fund portfolios fell from 81 percent in 2001 to 45 percent in 2005. - Pension funds increased share of inflation-linked securities to 48 percent of their portfolios. - Table 1 (Asset Composition of Pension Funds' Portfolio, 2001 vs 2005, in percent): - Total: 100.0 / 100.0 - Central government: 61.2 / 59.5 - BCU and BHU: 5.1 / 24.7 - Time deposits and CDs: 16.6 / 7.9 - Corporate bonds and stocks: 4.3 / 1.1 - CRIs, financial trusts: 0.0 / 2.2 - Loans to affiliates: 1.7 / 0.9 - Cash: 11.1 / 3.7 - Memo: Value of portfolio (In millions of U.S. dollars): 1,045 / 2,153 - Table 2 (Currency Composition of Pension Funds' Portfolio, 2001 vs 2005, in percent): - Total: 100.0 / 100.0 - Local currency: 19.0 / 54.9 - Nominal Pesos: 18.4 / 7.0 - Indexed Pesos: 0.6 / 47.9 - Foreign Currency: 81.0 / 45.1 - Memo: Value of portfolio (In millions of U.S. dollars): 1,045 / 2,153 - Households: - Savings of Uruguayan residents in the domestic banking system are about US$7.6 billion; in banks abroad about US$5.4 billion — largely denominated in U.S. dollars. - Household loans from the domestic banking system amount to US$530 million at end-2005, of which 75 percent is in domestic currency. - Households have accumulated significant assets in private pension funds since 1993; pension funds invest most household savings in government securities, increasing household exposure to the public sector. ### Companies — dollarization and maturity structure of liabilities - Corporate sector currency and maturity profile: - The 2005 annual survey (sample of 408 nonfinancial companies) found 80 percent of companies had substantial dollar debt with short-term maturity at end-2004. - About half the companies had short-term dollar obligations exceeding their annual dollar earnings; only 5 percent used derivatives to hedge exchange rate risk. - Companies with highest net open foreign exchange positions concentrated in manufacturing and transportation. - Table 3 (Currency Composition and Maturity Structure of Financial Liabilities of the Corporate Sector in Uruguay: December 2004, in percent; mean/median): - ALL FINANCIAL LIABILITIES: Mean 72.1 / Median 100.0 ; Short Term Maturity Mean 69.2 / Median 94.5 - Bank Financial Liabilities: Mean 77.0 / Median 100.0 ; Short Term Maturity Mean 69.4 / Median 99.0 - Bond Financial Liabilities: Mean 96.6 / Median 100.0 ; Short Term Maturity Mean 38.6 / Median 33.1 - Other Financial Liabilities: Mean 52.1 / Median 92.0 ; Short Term Maturity Mean 72.0 / Median 100.0 - Comparative position in Latin America (share of foreign currency and short term liabilities, median values in percent): - Uruguay features among the highest ratios of liability dollarization and shortest debt maturities in Latin America (values shown in Table 4 for 2001 and 2004; example entries include Uruguay 2001: Share of Foreign Currency 74.0 / Share of Short Term Liabilities 74.1; Uruguay 2004: Share of Foreign Currency 95.8 / Share of Short Term Liabilities 90.3). - Corporate vulnerability: - Liability dollarization and short-term maturity of debt remained high and almost unchanged relative to 2001. - Stress tests indicate resilience to direct impact of moderate exchange rate shocks but large indirect effects possible through reduced dollar income for firms selling nontradable goods. ### Cross-sectoral linkages and exposure to domestic government debt - Banks’ direct exposure to public sector assets: - Banks hold less than 10 percent of their assets in government debt. - Bank holdings account for only 5 percent of the stock of government securities. - Considering government guarantees on BROU’s claims on BHU and trust funds with nonperforming loans formerly on BROU’s books, exposure of the banking system to the sovereign would increase to 14 percent. - Pension funds’ exposure to sovereign risk: - Pension funds manage more than US$2 billion at end-2005. - About 60 percent of pension fund portfolios are invested in government securities: 40 percent dollar-denominated and the remainder inflation-indexed. - Pension fund holdings of central government domestic debt account for half of the holdings of domestic residents. - Pension fund investments in nonfinancial private-sector instruments are about 3 percent. - Table 5 (Holders of Central Government Bonds, stock of domestically-issued debt at year-end, in millions of U.S. dollars and percent of total debt): - INVESTOR BASE, TOTAL (2001–2005, in millions): 2,285 / 1,690 / 2,336 / 2,433 / 2,467 - Held by Foreign Investors: 949 / 650 / 1,135 / 997 / 661 - Held by Domestic Investors: 1,336 / 1,041 / 1,201 / 1,435 / 1,806 - Held by Foreign Investors (percent): 41.5 / 38.4 / 48.6 / 41.0 / 26.8 - Held by Domestic Investors (percent): 58.5 / 61.6 / 51.4 / 59.0 / 73.2 - Banks and quasi-banks (percent of total debt): 19.1 / 17.3 / 4.2 / 13.6 / 5.1 - Pension funds, social security schemes (percent): 6.9 / 19.3 / 27.9 / 28.1 / 34.6 - Non-financial corporate (percent): 16.1 / 9.8 / 16.0 / 14.3 / 17.5 - Retail (percent): 12.5 / 11.6 / 1.7 / 1.5 / 14.3 ### Exchange rate-induced credit risk of domestic banks - Exchange rate-induced credit risk has fallen: - Size of the dollar loan portfolio has declined. - Share of dollar loans to the nontradable sector in total dollar credit fell from 46 percent to 31 percent during 2003–2005 (Table 6). - Table 6 (Share of Foreign Currency Credit to the Nontradable Sector in Total Credit, 1/): - Banking System: 45.9 / 34.3 / 30.7 (years 2003/2004/2005 as reported in table columns) - Banks 2/: 44.9 / 32.7 / 29.7 - mean (simple average): 49.1 / 38.7 / 36.0 - Financial Houses 2/: 44.9 / 32.7 / 29.7 ; mean (simple average): 40.2 / 34.5 / 34.4 - Cooperatives 2/: 36.4 / 31.8 / 34.2 ; mean (simple average): 57.5 / 48.8 / 34.5 - Source: Superintendency of Banks. (Tradable sector proxied by agriculture and industry; weighted averages where indicated.) - Despite reductions, exchange rate-induced credit risk remains a significant issue for Uruguay. ### Conclusions — vulnerabilities and policy recommendations - Key vulnerabilities: - Financial dollarization remains central to balance-sheet vulnerabilities: household savings are largely in foreign currency, while government and most companies do not have steady foreign currency income streams. - Long position of households finances short positions of government and companies; a sharp drop in the real value of the peso could leave government and companies unable to honor dollar debt, creating indirect bank losses and household impacts via pension funds and bank failures. - High public debt presents ongoing challenges: short-term risks have declined but large and sustained market-sentiment shifts could threaten macroeconomic stability; pension funds are particularly exposed to sovereign risk. - Policy recommendations: - Reduce dollarization and high public debt by sustaining large primary surpluses to further bring down public debt as envisaged by the government. - Consolidate a track record of prudent monetary management and flexible exchange rates to entrench low inflation and discourage dollarization. - Maintain policy of internalizing risks of dollar lending to unhedged borrowers to further reduce dollarization. - Debt management should continue to gradually reduce the dollar share of public debt as peso savings increase and help offer attractive peso instruments. - Develop markets for hedging Uruguayan peso risk to reduce corporate and bank risks; this requires further developing money markets and a reliable yield curve on peso securities and would benefit from foreign investor participation. ### Appendix — Corporate vulnerability stress tests (summary) - Data and method: - Based on 2005 official annual survey of economic activity (sample of 408 nonfinancial companies) measuring balance-sheet currency mismatches at end-2004. - Tests stress nominal peso depreciation from 5 to 100 percent, defining financial distress as inability to meet short-term obligations (liquidity effect) or equity turning negative (solvency effect). - Primary stress-test results (Appendix Table 1, in percent of total firms/sales/employment/assets/financial liabilities): - Firms in distress (percent of sample) at percent nominal depreciation: - 5%: 1 - 10%: 3 - 20%: 6 - 40%: 11 - 60%: 18 - 80%: 22 - 100%: 27 - Importance of distressed firms in terms of sales (percent of sales): - 5%: 2 - 10%: 3 - 20%: 7 - 40%: 12 - 60%: 36 - 80%: 41 - 100%: 47 - Importance in terms of employment (percent): 1 / 2 / 12 / 15 / 21 / 21 / 26 / 29 (matching correspondingly by depreciation buckets) - Importance in terms of assets (percent): 2 / 4 / 11 / 17 / 33 / 38 / 43 - Importance in terms of financial liabilities (percent): 4 / 9 / 17 / 28 / 45 / 51 / 60 - Interpretation and caveats: - Corporate sector is resilient to the direct impact of moderate exchange rate shocks: only 6 percent of companies (accounting for 7 percent of sales) would be under financial distress with 20 percent peso depreciation. - With 100 percent peso depreciation, 27 percent of companies (accounting for 41 percent of sales) would be in distress. - These results are lower-bound estimates because tests: - Consider only direct effects of depreciation (ignore accompanying increases in interest rates). - Consider only effect on financial debt. - Include only companies with initially healthy financial positions. - Assume dollar earnings’ value does not change (ignoring likely drops in dollar income for firms selling nontradables). *Source: IMF staff calculations and data as presented in the provided content unit.* ### 2. This chapter assesses Uruguay’s competitiveness, against the backdrop of ### 2. This chapter assesses Uruguay’s competitiveness, against the backdrop of ### Summary findings and interpretation - The majority of indicators suggests that Uruguay has remained competitive. - Export performance has remained buoyant; Uruguay attracts increasing amounts of FDI; and most competitiveness indicators suggest that the tradable goods sector has remained attractive, including in relation to the non-traded sector. - Uruguay’s CPI-based REER remains substantially more depreciated than before the crisis and appears to be roughly in line with international experience after accounting for productivity differentials. - Quantitative analysis suggests that the REER is not far from its equilibrium level. - Some competitiveness indicators are on a declining trend; Uruguay should continue to improve its institutional and business environment that affect competitiveness from a structural angle. ### B. External Sector Performance — key facts and trends - Exports growth: 25 percent annual growth (17 percent in volume terms) in 2005, compared with a 30-year historical average of 9 percent. - Imports: grew even faster than exports since the recovery, reflecting higher investment, revival of domestic demand, and increased import prices for commodities such as oil. - Current account: deficit of ½ percent of GDP in 2005, significantly smaller than the 30-year historical average of 2 percent, and more than covered by FDI alone. - Market shares and destinations: - Uruguay’s share in world export markets declined through recession and crisis years, but started to recover since 2003. - Market share to Argentina and Brazil has declined in recent years, offset by an increased export market share in the U.S.; exports to the U.S. now similar in magnitude to those to Mercosur. - Export concentration: increased concentration in agricultural exports, especially beef. - Sector shifts: exports of wood and wood products rising; manufacturing exports essentially stable except textile exports, which have been declining. - Tourism receipts: Argentina remains the most important source but its importance has been declining relative to inflows from Brazil and the EU. - Foreign direct investment (FDI): - Inflows have increased strongly since the late 1990s, interrupted only briefly by the 2002 crisis. - Net FDI inflows are now higher than in Argentina and Brazil as percent of GDP. - In 2005, part of the increase reflects initial investments of the pulp mill projects; upward trend is broad-based. ### C. Competitiveness Indicators — measures and interpretations - Tradable to non-tradable prices: - The ratio declined since the crisis but remains substantially above pre-crisis levels. - After increasing markedly with the 2002 devaluation, the ratio returned by February 2006 to 1998/99 levels; nonetheless it remains substantially above pre-crisis levels. - Profitability proxies for tradable sector: - Export unit values relative to wages: export prices have been declining since 2004 but remained above pre-crisis levels. - Export prices relative to unit labor costs (ULC): improved more during the crisis and fallen by less since; remained more than 80 percent above its pre-crisis level in 2001. - Bilateral real exchange rates (RER) relative to major partners: - RER vs Argentina: appreciated strongly in late 2001 when Argentine peso devalued; subsequent Argentine inflation and Uruguayan devaluation reversed much of that; since 2003 bilateral RER appreciating again due largely to nominal appreciation of the Uruguayan peso. - RER vs Brazil: depreciating since 2002, reflecting Uruguay’s devaluation and the strength of the Brazilian real. - RERs vs U.S. and Euro area: depreciated through the crisis period and only partially recovered since. - REER levels: - CPI-based REER remained around 20 percent below its pre-crisis level; depreciated by some 35 percent in 2002 and recovered to around 80 percent of its 2001 level. - PPI-based REER: remains more than 10 percent below pre-crisis levels. - ULC-based REER: remains around 43 percent more depreciated than its pre-crisis level in 2001. - Alignment with productivity (Balassa-Samuelson perspective): - Plotting per-capita income against market/PPP exchange rates for selected Latin American countries shows Uruguay’s RER broadly adequate: depreciated during 2002 crisis and recovered in 2004–05 close to the regression line. ### D. Estimating an Equilibrium REER — data, model, and results - Approach: “adjusted PPP” style estimation relating REER dynamics to fundamentals using quarterly data 1988–2005. - Dataset variables and expected signs: - Per capita real GDP relative to trading partners (RGDP): proxy for productivity differentials; increase expected to be positively correlated with REER (appreciation). - Manufacturing output relative to trading partners (MANOP): proxy for relative supply of traded goods; increase expected to be associated with declining REER. - Fiscal balance as percent of GDP (FIS): improvement expected to be associated with declining REER. - Terms of trade (TOT): increase expected to be associated with an increase in the REER. - Openness (OPEN): calculated as (exports + imports)/GDP; increased openness expected to be associated with a more depreciated REER. - Ratio of net foreign assets to exports (NFA): decreases in NFA expected to be associated with a decreasing REER. - Real interest differential (RIDA): expected to be positively correlated with the REER. - Unit root properties (ADF tests, MacKinnon one-sided p-values): - LREER: t statistic 0.6840, p-value 0.8612 (level); t statistic -7.4549, p-value 0.0000 (first difference). - LRGDP: t statistic -0.3193, p-value 0.5671 (level); t statistic -2.1325, p-value 0.0326 (first difference). - LMANOP: t statistic 1.1655, p-value 0.9360 (level); t statistic -3.4659, p-value 0.0007 (first difference). - FIS: t statistic -0.7563, p-value 0.3853 (level); t statistic -3.4256, p-value 0.0009 (first difference). - TOT: t statistic -1.5302, p-value 0.1174 (level); t statistic -4.1804, p-value 0.0001 (first difference). - OPEN: t statistic 0.6862, p-value 0.8617 (level); t statistic -0.8158, p-value 0.3592 (first difference). - NFA: t statistic -1.4252, p-value 0.1425 (level); t statistic -2.2881, p-value 0.0223 (first difference). - RIDA: t statistic -3.0965, p-value 0.1150 (level); t statistic -3.2590, p-value 0.0815 (first difference). - Note: ADF tests support first-order integration at the 5 percent level for all variables except OPEN and RIDA, which appear I(2). - All variables (except REER) enter as 8-quarter moving averages. - VECM and cointegration: - A co-integrating relation is found between LREER, LRGDP and NFA; existence of one cointegrating relation confirmed by Trace and Maximum Eigenvalue tests at the 5 percent level. - Long-run cointegrating relationship coefficients (selected VECM results): - LREER (-1): 1.0000 - LRGDP (-1): -2.4304 (t-statistic -7.7699) - NFA (-1): -0.0198 (t-statistic -1.6301) - Trend: -0.0069 (t-statistic -4.5049) - Const.: 4.0926 - Interpretation of coefficients: - An increase in relative real per capita GDP by 1 percent is associated with a real appreciation of 2.4 percent. - An increase in net foreign assets of 1 percent of exports is associated with a real appreciation of 2 percent (note: coefficient reported for NFA is -0.0198; the text interprets an increase in NFA of 1 percent of exports associated with a real appreciation of 2 percent). - Estimated speed of adjustment: - CointEq1: -0.3655 (t-statistic -3.6602): 37 percent of the deviation of the REER from its estimated long-run relation is eliminated within one quarter; half of the gap would be closed within about 4½ months in the absence of further shocks. - Equilibrium REER implications: - The estimated equilibrium REER and 95 percent confidence interval show Uruguay’s REER fairly well aligned throughout much of the 1990s. - From late 2000 until the crisis the REER was increasingly overvalued relative to equilibrium; with the floating of the exchange rate in mid-2002 the REER returned close to equilibrium. - At end-2005 the REER was slightly below equilibrium but within the estimated 95 percent confidence interval. - Overall interpretation: - The REER is currently slightly, but not significantly, below an estimate of the equilibrium REER based on historical responsiveness to relative real per capita GDP and NFA. - Jointly with other indicators, the exercise supports the view that Uruguay’s exchange rate is not a competitiveness problem. ### E. International Competitiveness Rankings — structural factors - World Economic Forum (WEF) results: - Uruguay ranks 54 out of 117 countries for growth competitiveness (1 indicates highest ranking). - Argentina: 72; Brazil: 65. - Uruguay ranks 70 for business competitiveness. - Argentina: 64; Brazil: 49. - Strengths noted in the WEF survey: - Technology infrastructure (PCs, internet hosts and telephone lines). - Enrolment in tertiary education. - Low levels of organized crime. - Good judicial independence. - Low favoritism in decisions of government officials. - Weaknesses noted in the WEF survey: - Macroeconomic environment factors: still high level of government debt, low credit ratings, limited access to credit. - Technology-related: low company spending on research and development, low number of utility patents. - Survey respondents identified the most problematic factors for doing business in Uruguay as: access to financing, inefficient government bureaucracy, tax rates and regulations, policy instability, restrictive labor regulations, and inadequate supply of infrastructure. ### F. Conclusions (as presented) - Multiple indicators (external sector performance, FDI inflows, tradable sector profitability proxies, REER measures, and equilibrium REER estimation) jointly indicate that Uruguay has not experienced a broad-based loss of competitiveness. - Some indicators show declining trends; Uruguay should continue to improve its institutional and business environment to bolster competitiveness from a structural perspective. *Prepared by Harald Finger (PDR).* ### 21. The World Bank’s “Doing Business in 2006” ranking for Uruguay is similar. Out ### _cr06427 - 21. The World Bank’s “Doing Business in 2006” ranking for Uruguay is similar. Out ### World Bank “Doing Business in 2006” ranking and identified constraints - Uruguay ranks at position 85 out of 155 countries for ease of doing business. - Argentina: 77 - Brazil: 119 - Relative strengths cited: - Ease of hiring and firing workers. - Ease of shareholder suits. - Factors weighing on the survey result: - Relatively high effective profit taxes and cumbersome tax procedures. - Complex and time-consuming procedures for starting a business, registering property and enforcing contracts. - Low recovery rate in bankruptcy cases. ### Ongoing reforms to address survey shortcomings - Macroeconomic and fiscal measures: - The macroeconomic environment is being stabilized and debt levels are being reduced. - Tax reform: - Profit taxes are being simplified and reduced in the context of the tax reform. - Public investment and infrastructure: - Spending on infrastructure is being gradually expanded in the current 5-year budget. - Bankruptcy and insolvency: - Inefficiencies in bankruptcy procedures are being addressed in the context of the reform of the bankruptcy code. - Policy implication: - While a promising start has been made, it will be important to continue these efforts to further improve Uruguay’s competitiveness from the institutional and business environment angle. ### Conclusions on competitiveness - Most indicators suggest Uruguay remains competitive: - Uruguay’s external performance has remained solid. - Ratios of tradable to non-tradable prices and of export prices to ULC point to continued attractiveness of Uruguay’s traded sector. - The REER based on CPI (ULC) has remained some 20 (43) percent more depreciated than before the crisis. - The real exchange rate appears to be roughly in line with other countries after accounting for productivity differentials. - A quantitative estimate of the equilibrium REER has lent further support to the impression that Uruguay does not have a competitiveness problem. - Signs of deteriorating trends and need for continued monitoring: - Some indicators show a slowly deteriorating trend, notably the ratio of tradable to non-tradable prices. - International competitiveness rankings show room for improvement. - Structural factors identified in WEF and World Bank rankings should continue to be addressed. --- ### IV. Post-crisis credit: facts, lessons, and prospects — Introduction and key questions - The fall in bank credit to the private sector since the 2002 crisis has been about 60 percent in real terms. - Key questions addressed: - How has bank credit and other sources of financing evolved since the crisis? - What are the reasons behind this behavior? - Has there been a credit crunch? - How does Uruguay’s experience compare with other countries suffering banking crises? - What do these developments imply for investment and output? - What policy lessons can be learned from other countries? ### Summary findings on credit evolution and its macro implications - Combined supply and demand factors explain low credit flows; evidence does not suggest clear prevalence of credit rationing. - Supply-side factors: - Banks subject to stricter prudential rules. - Most foreign-owned institutions have become risk-averse after the crisis. - Banks reluctant to lend to indebted borrowers; lending capacity reduced by fall in overall deposits and rise in share of short-term deposits. - Demand-side factors: - Some companies may postpone investments given large spare capacity. - An econometric disequilibrium framework suggests that since 2003, demand has constrained credit growth (results to be interpreted with caution). - Currency composition and flows: - Peso credit is rising; dollar-denominated credit is declining. - Credit dollarization has fallen more strongly in the nontradable sector, reducing vulnerabilities. - Recovery prospects: - Present lack of credit should not endanger continuation of the recovery. - International experience: after banking and currency crises, companies typically find other financing sources and credit picks up gradually after about three years. - Alternative sources of credit have helped finance the recovery; domestic bank credit has not been the only source. - Industries that typically depend heavily on financing do not explain a large fraction of output in Uruguay. - Banks in Uruguay are generally well capitalized, with the exception of housing bank BHU. ### Policy recommendations to facilitate access to finance - Further strengthen the financial system to consolidate confidence and increase maturity of deposits. - Improve the credit registry. - Reform bankruptcy procedures to reduce inefficiencies. - Enhance corporate transparency to improve the credit culture and financial intermediation. - Develop more advanced short-term money markets to allow banks to reduce liquidity holdings and lend more. - Promote dedollarization and the development of hedging instruments to reduce currency mismatches and allow banks to lend with lower credit risk. - Use trust funds (fideicomisos) as financing instruments while balance sheets are still recovering. ### Evolution of credit to the private sector — specific indicators and magnitudes - Credit stocks: - Bank credit to the private sector has dropped by 60 percent in real terms from its peak in 2001, and has only recently stopped falling. - New credit flows: - New credit flows have grown about 4 percent a year in real terms since 2003, but remain only about half their 2001 levels. - Nonperforming loans (NPLs): - The NPL ratio dropped from 60 percent in 2002 to 18 percent in 2005. - Excluding BHU, NPLs have fallen to less than 5 percent from a crisis peak of “only” 25 percent. - Factors behind NPL improvement include improvement in economic conditions, carving out of bad loan portfolios through restructuring, and a government guarantee on assets in BROU’s balance sheet allowing classification of previously nonperforming loans as performing. - Dollarization of credit: - Degree of credit dollarization fell from 83 percent in 2002 to 69 percent in December 2005 (partly reflecting peso appreciation). - Excluding BHU, the degree of dollarization reverted to its precrisis average level of 80 percent. - Construction sector foreign-currency debt fraction fell from 96 percent in 2002 to 81 percent in 2005. - Commerce sector foreign-currency debt fraction fell from 97 percent in 2002 to 87 percent in 2005. - Nonbank sources and firm financing structure: - For small companies, the share of trade credit in total debt rose from 17 percent to 22 percent. - For small companies, the share of “other” credit rose from 43 percent to 57 percent (other credit includes debt with private individuals, the government, payables due, provisions, unpaid dividends and early receipts). - Repatriated capital and external financing: - Deposits that left the financial system during the 2002 crisis rose from US$3.6bn prior to the crisis to US$4.5 billion in the second quarter of 2002 and kept increasing since then in BIS reporting banks. - Loans from BIS reporting banks fell from US$1.9 billion in early 2002 to about US$1.2 billion in late 2005. - Balance of payments data, including a sizeable change in errors and omissions, suggest return of capital that had fled the domestic financial system and was partly held “under the mattress”; these funds likely were partly used, without intermediation, to finance consumption and investment. ### Has there been a credit crunch? — institutional and economic factors - Supply-side constraints documented: - Deposits have fallen slightly; a 20 percent drop in dollar value offset by a similar real depreciation of the peso over the period. - Maturities of deposits have shortened: share of sight in total nonfinancial private sector deposits increased from about 30 percent in 2001 to about 65 percent in early 2006. - Banks faced tighter prudential limits to lending: - Supervisor forbade BHU from lending until it complies with prudential rules. - BROU and NBC faced additional liquidity requirements. - Both peso and dollar reserve requirement rates are now larger than in 2001, though peso rates declined since their peak in 2002. - Banks continue to hold liquid assets exceeding reserve and liquidity requirements. - Foreign-owned banks adopted tighter risk-management directives and anecdotal evidence suggests increased risk aversion. - Creditworthy borrowers may still be scarce; improved prudential regulation raised costs of lending to highly indebted borrowers. - Rules require banks to classify corporations with nonperforming loans to any single bank as risky. - Corporations remain indebted and carry liabilities to liquidation funds for failed banks; written-off loans remain as off-balance-sheet assets. - Only small companies have reduced indebtedness substantially compared with pre-crisis levels; debt-to-sales ratio of large firms broadly constant, medium-sized firms’ ratio has risen. - Closure of failed banks may have affected credit supply through customer difficulties obtaining credit elsewhere. - Demand-side constraints documented: - Output only now returned to 1998 levels, implying limited demand for investment and credit as firms exploit spare capacity. - After the crisis, potential borrowers limiting leverage; companies and households reluctant to incur new debt, particularly in foreign currency. - Market signals: - Banking spreads have fallen; deposit rates for U.S. dollars are close to pre-crisis levels while spreads are much tighter, suggesting stronger competitive pressures rather than reduced competition. *Prepared by Jorge Iván Canales-Kriljenko and Gastón Gelos; content extracted from the supplied IMF document.* ### 17. This section examines more formally, using a disequilibrium model, the question ### _cr06427 - 17. This section examines more formally, using a disequilibrium model, the question ### Model and empirical approach - Framework: Disequilibrium model following Kiefer (1980) and Maddala and Nelson (1974) to test whether supply or demand for credit is binding under credit rationing (Stiglitz and Weiss (1981)). - Realization of credit: C_t = min(D_t, S_t). (Equation (1) as in source.) - Estimation method: Maximizing the likelihood derived from the unconstrained density of C_t using the probability that an observation is supply-constrained: Pr(D_t > S_t) = Φ((S_t - D_t)/sqrt(σ_s^2 + σ_d^2)), where σ_s^2 and σ_d^2 are the standard errors of the supply and demand functions and Φ(•) is the cumulative normal distribution function (notation per Ghosh and Ghosh (1999)). ### Credit supply specification - Supply function (Equation (2) in source): C_t^s = β_0 + β_1 r_t^l + β_2 r_t^{deposits} + β_3 lending_t + β_4 NPL_{t-1} + β_5 PROV_{t-1} + ε_t^s (Following Ghosh and Ghosh (1999) and Barajas and Steiner (2002); dollar and peso spreads enter.) - Variables and definitions preserved from source: - r_t^l: lending rate (both dollar and peso). - r_t^{deposits}: deposit rate. - y_t: current output (real GDP, seasonally adjusted) proxies firms’ balance-sheet health. - l_t: Commercial banks’ real lending capacity (minimum of (i) total bank liabilities plus net worth minus required reserves and liquidity requirements minus equity capital, and (ii) maximum possible loans permitted by prevailing capital adequacy requirement and existing bank capital), measured at exchange rates with constant purchasing power. - NPL_{t-1}: ratio of nonperforming loans to total loans in bank books. - PROV_{t-1}: ratio of provisions to nonperforming loans. - Credit measured as gross credit in banks and cooperatives, at exchange rates with constant purchasing power, deflated by the CPI. ### Credit demand specification - Demand function (Equation (3) in source): C_t^d = β_0 + β_1 r_t + β_2 E_t[y_{t+1}] + β_3 gap_t^y + β_4 Π_t + β_5 UBI_t + ε_t^d (Preserved schematic per source: d_t terms correspond to real lending rate, expected future output, output gap, expected inflation, and country risk.) - Variables and definitions preserved from source: - r_t: real lending rate (peso and dollar credit). - gap_t^y: output gap (deviation of current industrial production from its Hodrick-Prescott filtered long-run trend, or alternatively the CERES leading indicator). - Π_t: expected inflation. - UBI_t: Country risk measured by the Uruguay Bond Index from República AFAP. ### Estimation results and interpretation - Lending capacity dynamics: - Lending capacity falls strongly during the crisis due to bank difficulties, tightening of liquidity requirements, and increased demand for liquid assets. - In 2003, lending capacity begins to recover, showing a steady and moderate increase, staying below pre-crisis levels and above actual observed loan stocks thereafter. - Supply vs. demand since 2003: - Estimations indicate that since 2003, credit supply at prevailing interest rates has exceeded demand. - Both demand and supply fall with the crisis, but supply recovers more strongly, driven by the improvement in lending capacity. - Adjustments and checks: - Similar qualitative picture obtained when estimating peso and dollar credit separately. - Qualitative result holds when credit series are adjusted for loan writeoffs and the loan portfolio of banks liquidated during the crisis (in liquidation funds and under recovery by asset management firms). - Sensitivity to exchange-rate treatment: - The conclusion does not hold when using current exchange rates (likely producing measurement errors). - Using a 12-month moving average of the exchange rate, credit tends to be demand-constrained until around mid-2004, becoming supply constrained thereafter. - Overall interpretation: The evidence does not suggest that the decline in bank lending after the crisis reflects mainly a credit-rationing phenomenon; instead, constrained lending capacity during the crisis and a subsequent stronger supply recovery imply supply has not been binding since 2003. ### Comparison with international experience (implications for Uruguay) - Typical pattern after banking crises: - Output recovers relatively quickly; bank lending takes longer to resume. - Bank lending often takes more than three years after the crisis to recover (cited literature: Demirgüç-Kunt, Detragiache, and Gupta, 2000; Hoggarth and Reidhill, 2003). - GDP growth typically accelerates earlier (cited: Calvo, Izquierdo, and Talvi, 2006), leaving credit-to-GDP ratios low for extended periods. - The drop in lending is stronger when banking crisis coincides with a currency crisis (IDB, 2004) and in dollarized economies (Gulde and others, 2003). - Deposits vs. credit: - After banking crises, deposits fall somewhat, but the fall in bank credit relative to deposits is much larger. - With four years after the onset of the crisis without recovery of bank credit, Uruguay’s experience appears consistent with that of other countries suffering banking crises. - Drivers of output recovery: - Use of spare capacity and postponement of investment decisions typically explain output recovery; capital stock remains relatively constant during collapse-recovery while investment collapses and recovers weakly (Calvo, Izquierdo, and Talvi, 2006). - Exporters can access international credit and capital markets more quickly; producers of nontradables must find other financing sources (Krueger and Tornell (1999); Tornell and Westermann (2002)). - Factors suggesting the recovery could be sustained in Uruguay: - Fixed investment has shown an upward trend since early 2003, suggesting delay in investment and use of spare capacity are not the main reasons for low credit demand. - Historically, domestic bank credit was not the only source of finance; nondeposit-taking institutions reportedly provided loans to consumers and companies. - Industries that heavily depend on financing (machinery and chemicals) are small in Uruguay (Dell’Ariccia, Detragiache, and Rajan (2005) show worse crisis effects where industries depend more on borrowed funds). - Except for BHU, Uruguayan banks are well capitalized; failure to recapitalize banks after crises has sometimes contributed to prolonged credit crunches (Gulde and others, 2003). ### Policy recommendations (what should be done) - Overarching principle: Foster a resumption of credit without increasing or creating new vulnerabilities; do not relax prudential norms in ways that undermine market discipline (Lindgren and others, 1999). - Specific recommendations from source: - Encourage dedollarization of the economy and development of hedging markets. Over 80 percent of deposits are in dollar, while only a small fraction of companies have foreign-currency denominated earnings, limiting banks’ room to lend without incurring corporate-sector currency-mismatch credit risk. - Improve the credit culture: - Enforce debt service obligations across sectors. - Extend coverage and dissemination of credit registry information. - Create incentives to build a good credit history. - Execute collateral in severely nonperforming loans. - Explore shortening foreclosure processes, accelerating out-of-court procedures for debt collection, and adopting proceedings that minimize judicial intervention. - Encourage the development of short-term money markets so banks can hold less precautionary liquidity and lend more; develop bonds, certificates of deposits, and commercial paper markets (see Feyzoglu and Gelos, 2000). - Assist development of trust funds and securitization (fideicomisos) to isolate financing of specific projects from borrowers’ bad balance sheets and enable companies to obtain direct market financing; reduce tax and regulatory burdens that impede securitization development. - Practical policy steps already undertaken by government (as reported in source): - Modified prudential regulations to internalize risks from dollar lending to unhedged borrowers, including through higher capital and provisioning requirements. - Gradual expansion of credit registry coverage. - Submission to congress of a bankruptcy law reform aimed at reorganizing viable firms and liquidating nonviable ones faster and more efficiently. *Source: _cr06427* ### References ### _cr06427 - References ### Key Bibliographic Sources - Barajas, Adolfo, and Roberto Steiner, 2002, “Credit Stagnation in Latin America,” IMF Working Paper 02/53. - Calvo, Guillermo A., Alejandro Izquierdo, and Ernesto Talvi, 2006, “Phoenix Miracles in Emerging Markets: Recovering Without Credit From Systemic Financial Crises” (unpublished manuscript). - Catão, Luis, 1997, “Bank Credit in Argentina in the Aftermath of the Mexican Crisis: Supply or Demand Constrained,” IMF Working Paper 97/32. - De Brun, Julio; Néstor Gandelman; Herman Kamil; and Arturo Porzecanski, 2006, “The Fixed-Income Market in Uruguay,” mimeo IADB. - Demirguc-Kunt, Detragiache, and Poonam Gupta, 2000, “Inside the Crisis: An Empirical Analysis of Banking Systems in Distress,” IMF Working Paper 00/156. - Feyzoglu, Tarhan, and Gaston Gelos, 2002, “Why is Private Sector Credit so Low in Bulgaria,” in Bulgaria: Selected Issues and Statistical Appendix. - Ghosh, Swati R., and Atish Ghosh, 1999, “East Asia in the Aftermath: Was There a Credit Crunch?” IMF Working Paper 99/38. - Gilli, B., 2005, “Estructura de Capital de las Empresas Uruguayas en el Marco de la Teoría de Jerarquía de Preferencias.” - Gulde and others, 2003, “Dealing with Banking Crises in Dollarized Economies,” in Managing Financial Crises: Recent Experience and Lessons for Latin America, IMF Occasional Paper No. 217. - Hoggarth, Glenn; Jack Reidhill; and Peter Sinclar, 2004, “On the Resolution of Banking Crises: Theory and Evidence,” Bank of England Working Paper 229. - Inter-American Development Bank, 2004, “Unlocking Credit––The Quest for Deep and Stable Bank Lending.” - Kiefer, Nicholas, 1980, “A Note on Regime Classification in Disequilibrium Models,” Review of Economic Studies, Vol. 17, pp. 637–639. - Krueger, Anne, and Aaron Tornell, “The Role of Bank Restructuring in Recovering from Crises: Mexico 1995–98,” NBER Working Paper 7042. - Laffont, Jean-Jacques, and Rene García, 1977, “Disequilibrium Econometrics for Business Loans,” Econometrica, Vol. 45. - Levine, Ross, 2005, “Finance and Growth: Theory and Evidence,” in Handbook of Economic Growth. - Licandro, Gerardo, 2006, “Los balances y el crédito bancario,” El País – Opinión (Montevideo), May 15. - Lindgren and others, 1999, “Financial Sector Crisis and Restructuring,” IMF Occasional Paper No.188. - Maddala, G., and Forrest Nelson, 1974, “Maximum Likelihood Methods for Models of Markets in Disequilibrium,” Econométrica, Vol. 42, No. 6, pp. 1013–1030. - Munyo, Ignacio, 2005, “The Determinants of Capital Structure: Evidence from an Economy without a Stock Market,” Draft Universidad de la República (September). - Pazarbasioglu, Ceyla, 1996, “A Credit Crunch? A Case Study of Finland in the Aftermath of the Banking Crisis,” IMF Working Paper 96/135. - Sealey, C.W., 1979, “Credit Rationing in the Commercial Loan Market. Estimates of a Structural Model Under Conditions of Disequilibrium,” Journal of Finance, Vol. 34, pp. 689–702. - Stiglitz, Joseph, and Andrew Weiss, 1981, “Credit Rationing in Markets with Imperfect Information,” American Economic Review, Vol. 71, pp. 393–410. - Tornell, Aaron, 1999, “Common Fundamentals in the Tequila and Asian Crises,” NBER Working Paper No. 7139. - Tornell, Aaron, and Frank Westermann, 2002, “The Credit Channel in Middle Income Countries,” NBER Working Paper No. 9355. ### Appendix — Estimation Results (Table A1) - Estimation method: Maximum Likelihood disequilibrium estimation. - Dependent variable variants reported: - Real total credit to the private sector (columns (1), (3), (4)). - Real total Adj. credit to the private sector (column (2)) — (*) Credit series in that column was adjusted with loan writeoffs and the loan portfolio of the banks liquidated during the crisis. - Estimation period: 1998:12 - 2005:12. - Number of observations: 84. - Notation: t-statistics shown in parentheses. Foreign currency credit stock and foreign currency amounts in lending capacity definition are converted using an exchange rate that maintains the purchasing power constant throughout the estimation period. - Supply equation coefficient highlights (selected exact values): - Constant: 10.412 (1), 10.404 (2), 7.434 (3), 13.848 (4). - Real lending capacity: 0.144 (1), 0.144 (2), 0.098 (3), 0.129 (4). - Local currency spread: 0.007 (1), 0.007 (2), 0.001 (3), 0.004 (4). - Foreign currency spread: 0.005 (1), 0.005 (2), 0.012 (3), 0.007 (4). - Non performing loans ratio: -0.078 (1), -0.078 (2), 0.010 (3), -0.029 (4). - Provision ratio: -0.27 (1), -0.273 (2), 0.041 (3), -0.134 (4). - Real GDP: -0.19 (1), -0.189 (2), 0.593 (3), -0.786 (4). - Leading activity indicator: not included in columns (1)–(3); not reported in (4). - Demand equation coefficient highlights (selected exact values): - Constant: 9.848 (1), 9.851 (2), 9.834 (3), 13.138 (4). - Dummy (**) : 0.398 (1), 0.397 (2); not included in (3)–(4). (**) Dummy variable captures the level effect on credit demand during the outlier explosive period of local currency lending rate: Dec.2001-Mar.2003. - Real local currency lending rate: -0.004 (1), -0.004 (2), 0.010 (3), 0.002 (4). - Foreign currency lending rate: 0.226 (1), 0.225 (2), 0.123 (3), 0.165 (4). - Leading activity indicator: not included in (1)–(3); -0.458 (4). - Output gap: 0.020 (1), 0.020 (2), 0.012 (3), not included in (4). - Expected inflation: -0.022 (1), -0.022 (2), -0.030 (3), -0.029 (4). - Sovereign risk index: -0.071 (1), -0.071 (2), 0.038 (3), -0.182 (4). - Log likelihood: 129.425 (1), 129.825 (2), 151.950 (3), 153.875 (4). ### Notes on Estimation - Foreign currency credit stock and foreign currency amounts in lending capacity definition are converted using an exchange rate that maintains the purchasing power constant throughout the estimation period. - (*) Adjustment note: Credit series in column (2) adjusted with loan writeoffs and the loan portfolio of the banks liquidated during the crisis. - (**) Dummy variable captures the level effect on credit demand during the outlier explosive period of local currency lending rate: Dec.2001-Mar.2003. ### V. Options to Increase Infrastructure Investment in Uruguay — A. Introduction; B. Public Investment and Growth in the Literature; C. Investment Developments - Policy challenge and context - Public debt still high at around 70 percent of GDP; large primary surpluses will continue to be needed. - Fiscal retrenchment reduced government capital spending from above 4 percent of GDP down to 2.3 percent of GDP in 2005. - Recovery: After falling by 16 percent during 1999-2002, the economy rebounded in 2003-2005, averaging 7 percent GDP growth per year. - Current five-year budget envisages increases in investment of about 1 percent of GDP financed by higher revenues. - Revenue-to-GDP ratio targeted to reach almost 34 percent in 2009. - Main findings and constraints - Uruguay maintains good quality of public infrastructure despite recent decline in public investment. - To sustain medium-term growth and address emerging bottlenecks, both increased public investment (financed by higher public savings) and increased private sector participation will be required. - Given the high public debt, no room for loosening the fiscal stance. - Further revenue increases beyond current plans could risk imposing an excessive burden on the private sector; additional room for investment should be created through reductions in other expenditures and more efficient government spending. - Private participation in infrastructure (PPI) in Uruguay has been low: PPI averaged only 0.5 percent of GDP in the period 1990-2004. - Between 1999 and 2005 public investment in infrastructure declined by about 30 percent, from 2.2 percent of GDP to 1.6 percent. - Public investment overall: capital spending fell by more than 40 percent, from 4 to 2.3 percent of GDP (1999–2005). - Between 1999 and 2005 the primary balance increased by 6 percentage points of GDP. - Table 1 (Selected Fiscal Indicators. 1999-2005) exact entries: - Revenue: 33.3 | 31.8 | -1.4 - Non-interest expenditure: 35.4 | 27.9 | -7.5 - Current expenditure: 31.1 | 25.6 | -5.5 - Capital expenditure: 4.3 | 2.3 | -1.9 - Primary balance: -2.1 | 3.9 | 6.0 - Public saving: 2.1 | 6.2 | 4.1 - Role and limits of private participation - Significant public opposition to expanded private sector role in infrastructure: constitutional referendum mechanism has led to successful referenda in 1992, 2003, and 2004 to block or reverse privatizations/concessions (telecommunications, Ancap association and monopoly changes, concessions for water and sanitation). - Experience with PPI has been mixed: - Concessions in road construction and management, gas transportation and distribution, port services, and airport management have generally fared relatively well, despite some contract cancellations and renegotiations. - Private provision of sanitation services was vetoed by referendum held in 2003, leading to withdrawal of main private operators. - Private participation in mobile communications and long distance calls improved quality and lowered tariffs. - State-owned airline partially privatized in 1995 (sale of 51 percent) but suffered recurrent financial difficulties. - Policy implications and recommended directions - Increase public savings to finance higher investment while maintaining fiscal discipline. - Create additional room for investment by reducing other expenditures and improving government spending efficiency. - Develop an attractive environment for the private sector to expand PPI; government is planning increased use of public-private partnerships (PPPs). - Necessary conditions for efficient and fiscally sound PPPs include: - Building capacity of government entities to develop PPPs. - Adequately sharing risks with the private sector. - Properly evaluating and recording the fiscal costs of PPPs. - International experience indicates PPPs can be effective in expanding infrastructure but may pose risks if not properly structured and managed. _Italicized: Source — _cr06427 - References (IMF PDF chapter/section)._ ### Box 1. Private Participation in Infrastructure in Uruguay ### Box 1. Private Participation in Infrastructure in Uruguay ### Overview of private participation projects - Roads - Since 1993 there have been four road concessions. - Private operators committed to invest in construction and maintenance, financed through tolls and, in some cases, government subsidies. - Montevideo-Punta del Este concession awarded in 1994 is the oldest and the only one relying solely on toll revenues. - Contracts for Roads 5 and 8 provide operators a fixed government subsidy in construction materials. - Contract for road 1 was recently revoked due to delays in construction execution. - Port - Port of Montevideo operates under a landlord model: state-owned ANP owns basic infrastructure while private concessionaires build superstructures, furnish equipment, operate facilities, and pay a canon to the State. - Airport - Concession to operate and maintain Uruguay’s main airport awarded to a private company in 1993. - Natural gas - One of the two lines transporting gas from Argentina was built and is operated under a 30 year concession by a private company, with a minority stake owned by Ancap. - The three existing gas distribution networks are private. - Telecommunications - Two private mobile operators compete with state-owned Antel. - Antel competes with the private sector in data services and retains the monopoly of fixed-line telephony. - Oil - Gasoline distribution involves three private operators, but Ancap still distributes the largest share of the total. - Ancap retains the monopoly of oil and oil derivatives imports and refining. - Drinking water and sanitation - Concessions awarded in 1992 and 2001. - A 2003 referendum introduced a constitutional reform banning provision of these services by the private sector; since then one of the two largest concessions was revoked and the other partially taken over by the state. ### Infrastructure performance, gaps, and vulnerabilities - General assessment - Uruguay has been able to maintain infrastructure generally in good condition, though some weaker areas exist. - The World Bank (2005a) reports high coverage, access, and quality of basic services. - Strengths - Road network density and condition of the primary road network are among the best in Latin America. - Port services are competitive within the region. - Telephony coverage is high. - Electricity reaches the entire population. - Water quality is good, with almost universal coverage. - Weaknesses and vulnerabilities - Lack of investment to keep up with increased demand has left the electricity system vulnerable to adverse weather; droughts in 2005 and 2006 resulted in significantly higher generation costs and measures to ration electricity. - Sewerage access is very low outside of Montevideo. - Problems with access to natural gas, mainly due to the small size of the distribution network. - Railway services are not competitive and freight volumes are low. - Public enterprises often set high tariffs due to low efficiency and to generate fiscal revenues; gasoline prices are among the highest in the region. ### Emerging bottlenecks requiring increased investment - Electricity - Generation capacity could become a major bottleneck; ensuring reliable supplies requires installing additional generating capacity and upgrading the interconnection with Brazil. - Railways - Increased freight demand after the pulp mills begin operations in 2007 will require investments to upgrade the railway network and equipment. - Roads - Current budgeted spending on maintenance and rehabilitation is considered insufficient to prevent deterioration; pressures may increase with pulp-mill–related transport. - Ports - To position Uruguay as a regional port hub would require dredging the port of Montevideo, upgrading terminal facilities, and developing smaller ports. - Sanitation - Sewerage coverage outside of Montevideo needs to be significantly expanded. ### Public investment options, fiscal constraints, and institutional issues - Fiscal space and financing - Given high debt, little room exists to relax the fiscal stance. - The 2005-2009 budget increases public investment by about 1 percent of GDP, financed by increased revenues. - Revenues are projected to reach 34 percent of GDP in 2009; further increases could overburden the economy. - Additional space for investment should come from reforms to lower current spending and strengthen institutional budget and investment processes. - Budget rigidities and composition - About 1/3 of revenues have some sort of earmarking, though largely non-binding; proposed tax reform reduces earmarking but introduces minimum spending requirements that maintain current spending levels. - The main rigidity is the high level of non-discretionary spending: close to 60 percent of all spending is on wages and social security benefits. - Meaningful savings would require politically difficult cuts to wages or social security; civil service reform aims to improve efficiency and service delivery rather than immediate large savings. - Pension outlays are high by international standards; system reformed in 1996 and outlays are projected to decline gradually over the medium term. - There is scope for savings on discretionary spending via procurement reform. - Budget execution practices that affect investment protection - Government can cap spending below ceilings by decree based on periodic revenue assessments; caps can be imposed on all spending except wages. - Given large non-discretionary spending, cuts tend to fall on a few items, particularly capital spending; government also limits SOE capital spending to meet fiscal targets. - Institutional weaknesses in budget process - Improvements made in last budget cycle: clearly stated priorities, a medium-term macroeconomic framework, and revenue projections for the period. - Remaining weaknesses: - Medium term budget framework is inadequate: a five-year budget coincides with the presidential term but there are no annual updates; a rolling medium-term framework is needed. - Limited annual reassessment of priorities: annual execution assessments allow modifications but in practice few changes made. - Coordination risks: MEF and Office of Budget and Planning (OBP) prepare current and capital budgets respectively, creating potential coordination issues. - Appraisal, selection, and evaluation of investment projects - Central government - Spending units submit proposals to OBP, but except for large transportation projects and projects financed by international organizations, no adequate cost-benefit analysis is performed. - OBP staff are insufficient to assess a large number of projects (about 600 included in the current budget), precluding adequate prioritization. - Local governments - Limited capacity to develop and assess projects; local investment is approved by local councils and largely financed by central transfers; local governments often need central assistance to design projects. - State-owned enterprises (SOEs) - Investment projects are generally well prepared and submitted as part of business plans. - Projects above US$ 1 million or 10 percent of the company’s investment budget are subject to adequate cost-benefit analysis, including economic and social returns. - Monitoring and ex-post evaluation - Assessment is carried out annually in budget execution reports: financial information is good but data on physical progress are scarce. - No ex-post evaluations are performed except for externally financed projects; expanding monitoring and ex-post evaluation would help assess productivity of public investment and inform future projects. ### Public-Private Partnerships (PPPs): rationale, risks, and Uruguay’s approach - Rationale for PPPs - PPPs can increase investment and efficiency given fiscal constraints and public opposition to outright privatization. - A successful PPP can deliver high-quality services at lower cost due to private-sector coordination, innovation, and risk management. - PPPs relieve fiscal constraints by providing financing for projects. - Risks of PPPs - Identified risk categories: construction risk, financial risk, performance risk, demand risk, and residual value risk. - When governments retain part of risks, including guarantees, significant contingent liabilities may arise. - International experience shows flaws in PPP design can generate significant fiscal costs. - Uruguay’s intended approach - Government intends to expand private sector role initially through limited PPPs. - Current development includes a railway project to meet freight demand from pulp mills and other transportation projects to build confidence in PPPs and allow future expansion. - Legal and institutional framework - Uruguay currently has a limited legal framework: private equity participation and/or association with SOEs is authorized by the Constitution, subject to congressional confirmation. - Current laws set only very general terms for concessions; conditions for each project largely left to implementation decrees and contracts. - As Uruguay gains experience, it should consider developing a unified legal framework for PPPs. ### Lessons from international experience - Colombia - Early PPPs (until 1997) included significant demand guarantees; triggered guarantees resulted in cumulative payments of US$2 billion. - Second-generation PPPs (from 1998) transferred more risk to the private sector, used government guarantees sparingly, and were embedded in new legal frameworks requiring disclosure of contingent liabilities and risk-allocation guidelines. - Chile - Concessions program covers 44 contracted projects with total value US$5.7 billion. - Chile provides minimum revenue guarantees in several contracts, combined with revenue-sharing once thresholds are exceeded. - Success attributed to a comprehensive concessions law (1991 Concessions Law) with competitive bidding, clear rights and obligations, property appropriation provisions, dispute resolution, and contract transfer/cancellation rules. - International practice highlights importance of a sound legal framework that addresses bidding, rights and obligations, property appropriation, dispute resolution, and transfer/cancellation of contracts. - Evidence that PPP contracts are less likely to be renegotiated when regulatory framework is embedded in law. *Source: Ministry of Finance.* ### 28. International experience also indicates that the institutional framework could ### _cr06427 - 28. International experience also indicates that the institutional framework could ### Institutional framework for PPPs - International experience indicates strengthening the institutional framework by setting a central PPP unit and a gateway procedure for PPPs. - Central PPP units exist in Chile and Brazil; their purposes: acquire and share expertise on negotiation and management of contracts, provide oversight and avoid duplication of efforts, and establish a single point of contact for the agents involved in PPPs. - Uruguay is in the process of setting up such a unit at the Ministry of Finance. - Recommendation: establish a gateway procedure by which the Ministry of Finance would have veto power to stop PPPs that do not offer value for money or could endanger overall fiscal sustainability. ### Project evaluation and selection (public sector comparator) - Proper project evaluation involves two stages: - Appropriate investment planning and project appraisal to determine project viability. - Decision whether a viable project is best implemented as PPPs or through public procurement. - Best practice: use of public sector comparators to evaluate which alternative provides better value for money for the government (U.K. Treasury (2004) referenced). - Regional practice: Chile is increasingly relying on public sector comparators. - Evidence indicates PPPs are better suited to provide economic infrastructure (e.g., roads, railways, ports) rather than social infrastructure (e.g., hospitals, schools). ### Risk allocation, guarantees, and valuation - PPP contracts should allocate different risks to the party best suited to manage them. - Construction and operation risks: typically borne by the private sector. - Government should bear risks under its control, like regulatory and political risks. - Demand, exchange rate, and residual value risks: may or may not be borne by the government. - Colombian regulations cited as a good example of risk assignment. - When the government provides guarantees, they need to be valued and factored into the debt sustainability analysis because they may entail large contingent costs. - Chile and Colombia have developed sophisticated valuation techniques, treating guarantees as a financial option (IMF (2005c) described techniques and their application in Chile). - Chile, Colombia, and Brazil have set up separate funds to reduce the exposure of private partners if guarantees are called. ### Fiscal accounting, disclosure, and recording of PPPs - PPPs should be adequately reflected in fiscal accounts and information on known and potential costs of PPPs disclosed. - No accepted international accounting and reporting standards for PPPs currently exist. - IMF (2005a) provides recommendations to ensure comprehensive disclosure of PPP transactions for public finance and incorporation in debt sustainability analysis. - Specific recording recommendations from IMF (2005a): - For PPPs recorded as private investments, known and certain payment obligations of both parties should be taken into account in the budget and the expected net present value of contingent payments be recorded as primary expenditures. - For projects recognized as public investment, the service component of future payments under the contract should be counted as primary spending, while the debt service component should be separated out and included in the overall projected interest and amortization payments. - Eurostat 2004 decision: public-private association projects should be classified as non-government assets and recorded off-balance sheet for the government under two conditions: the private partner bears the construction risk and either of the availability or demand risk. ### Concluding remarks — infrastructure investment, fiscal space, and PPP strategy - Satisfying infrastructure needs will require increased public and private investment. - With a still high level of debt, higher public investment will require creating fiscal space by increasing public saving, through lower current expenditures and improved efficiency of spending, especially by strengthening investment procedures. - Given fiscal constraints, improving infrastructure to desired levels will be difficult without increased private sector participation; government needs to: - Put in place a friendly business environment and a solid regulatory framework to attract private interest, - Establish efficient PPPs, - Limit fiscal risks. - Government agenda measures to increase resources for investment and improve spending efficiency include: - (i) working with the IDB on strengthening the investment process, in particular by creating a centralized database of investment projects and reinforcing appraisal capabilities to allow better prioritization; - (ii) working towards strengthening procurement practices and expanding the use of online tools to improve spending efficiency; - (iii) developing a plan to upgrade the institutional budget process. - Uruguay’s cautious approach toward PPP program is judged appropriate. - Recommendation: focus initially on PPP projects that do not involve complex design and construction issues, or difficult risk sharing arrangements. - Rationale: such projects help develop a reputation of the government as a trustworthy partner and boost societal confidence in the positive role of the private sector. *Source: _cr06427 - 28. International experience also indicates that the institutional framework could* ### 10. Increased openness has helped spur Uruguay’s growth. There is a large empirical ### _cr06427 - 10. Increased openness has helped spur Uruguay’s growth. There is a large empirical ### Openness and growth - International trade and financial integration increased significantly in the mid-1970s following strengthened trade linkages with the region, reduction of tariff and non-tariff import barriers, and opening of the capital account. - Growth increased as Uruguay benefited from economies of scale, efficiency gains from increased competition, strong external demand, and augmentation in financing. - Openness milestones: - Further increases with Mercosur during the 1990s and, since 2001, deepening trade relations with the U.S., the European Union and Mexico. - Both imports and exports amounted to about 30 percent of GDP in 2005. - By 2005 Uruguay was “a fairly open economy by regional and international standards.” ### Vulnerabilities associated with openness and economic structure - Summary of structural vulnerabilities: high export market concentration, high financial linkages, large real exchange rate volatility, commodity dependency, and dollarization. Many vulnerabilities declined in recent years but remain large relative to other economies. - Export market concentration: - Goods exports to Argentina and Brazil reached 60 percent of total exports in 2000 (compared to 35 percent in 1990). - About 60 percent of Uruguay’s tourist industry depends on visitors from the region; tourism accounted for about 4 percent of GDP in 2005. - Financial linkages with Argentina: - During the 1990s nonresident deposits mainly from Argentines accounted for 40 percent of banking system deposits (or 35 percent of GDP) in 2001. - Today nonresident deposits account for 17 percent of total deposits (10 percent of GDP). - Argentine demand for real estate in Uruguay has been a key driver of asset price booms and busts. - Prudential measures taken to reduce risks from financial linkages (Box 1): - 30 percent liquidity requirements for non-resident deposits (replacing average 25 percent reserve requirements). - Limits imposed on country exposures, implicitly limiting exposure to Argentina. - Signed memorandum of understanding with the banking supervisor of Spain; initiated discussion to sign one for Argentina. - Exchange rate regimes and competitiveness: - Past depreciations of the Argentine peso in the early 1980s and 1991 produced sharp real appreciations of the Uruguayan peso, contributing to deep recessions. - During the crawling band of the 1990s devaluations in neighboring currencies led to significant Uruguayan peso real appreciations and loss of export competitiveness. - Today Uruguay and its neighbors have floating regimes, increasing the ability to absorb shocks. - Commodity dependency and energy imports: - About half of Uruguay’s exports are agricultural commodities (15 percent of GDP). - Beef (Uruguay’s main agricultural export) prices in real terms have fluctuated with a standard deviation of 60 percent over the last 40 years. - Uruguay is fully dependent on oil imports, which accounted for 6 percent of its GDP or one-fourth of its imports in 2005. - Dollarization and interest rate linkages: - Uruguay is highly dollarized with 85 percent of financial system assets in dollars. - In highly dollarized economies domestic interest rates are sharply influenced by U.S. ones, limiting countercyclical monetary policy space. - Efforts to dedollarize include development of local capital markets and domestic currency instruments. ### Empirical evidence: correlations, cointegration, and VAR results - Business cycle correlations and causality: - Correlation of Uruguay’s GDP and Argentine consumption growth is high (80 percent) and has increased over time. - Correlation is about 30 percent with Brazil, and 10 percent with the U.S. - Argentine and U.S. consumption clearly Granger-cause Uruguay’s GDP, but Brazil’s consumption does not (Table 3, Appendix). - Cointegration results: - Argentine consumption and Uruguay’s GDP are strongly cointegrated, with an elasticity of 1.0. - The elasticity with U.S. consumption is about 0.1. - 65 percent of the deviation of Uruguayan GDP from the long-run relationship is corrected within one year, indicating very fast pass-through of changes in Argentine consumption to the Uruguayan economy. - VAR variance decompositions and impulse results: - A VAR on logs of Uruguay’s GDP and Argentine and U.S. consumption for 1985-2005 shows about 80 percent of the variance in Uruguay’s GDP in a two-year horizon is explained by Argentine consumption and 10 percent by U.S. consumption (note: Brazilian consumption was not significant in the long-term cointegrating relationship and was excluded). - Extended VAR including terms of trade, the REER, and U.S. Libor rates indicates: - Argentine consumption explains 50 percent of Uruguay’s growth variance within a two-year time horizon. - Terms of trade explain 20 percent. - U.S. interest rates explain 10 percent. - Real exchange rate explains 5 percent. - Directional effects from the VAR: - Increases in Argentine consumption and improvements in the terms of trade have a strong positive impact on Uruguay’s growth. - Increases in U.S. interest rates or of the real exchange rate have a negative impact. - Granger causality F-statistics (selected): - ARG does not Granger Cause URY: F-Statistic 3.03, Probability 0.08. - USA does not Granger Cause URY: F-Statistic 2.75, Probability 0.10. ### Conclusions and policy recommendations - Growth characterization: - Uruguay’s growth performance features low long-term rates, high volatility, and close correlation with Argentina. - Domestic factors: less developed financial markets, low investment, and volatile fiscal policies have contributed to low long-term growth; much of long-term performance is attributed to total factor productivity with physical capital accumulation significantly below other countries. - External factors: openness contributed to growth via economies of scale and external demand, but integration with volatile regional economies, commodity price dependence, and past fixed exchange rate regimes increased vulnerability to external shocks. - Recent policy progress and remaining needs: - Trade and financial dependencies to Argentina have been reduced by extending trade beyond Mercosur and by prudential regulations internalizing cross-border risks, though trade linkages to Argentina remain significant and non-resident deposits remain large. - High public debt has been set on a declining path; reserves are being rebuilt to strengthen external liquidity. - Flexible exchange rate regime adopted, reducing risks of overvaluation and sudden corrections. - Continued progress needed to reduce medium-term risks to growth. - Recommended further domestic reforms to achieve lasting growth: - Improve the investment climate, including strengthening the bankruptcy framework and establishing a private sector relations office. - Deepen local capital markets and develop domestic currency instruments to dedollarize the economy. - Consolidate macroeconomic stability. - Advance structural fiscal reforms to ensure a stable fiscal framework and increase room for public investment. - Adopt tax reform expected over the next months to improve structure and efficiency of the tax system. - Promote private participation in public infrastructure projects to spur efficiency and increase investment. - Strengthen government procurement procedures. *Source: IMF staff report excerpt (chapter 10).* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06427.pdf_