Uruguay: Staff Concluding Statement of the 2016 Article IV Mission

December 8, 2016

A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

Uruguay has demonstrated considerable resilience in the face of recessions in its two large neighbors. Prudent macroeconomic policies, strong institutions, and success in diversifying its markets and products within the dominant agriculture and forestry sectors have helped stabilize the economy. Furthermore, the country has maintained strong financial buffers that complement the flexible exchange rate in absorbing external shocks.

Nonetheless, no country is an island, and the Uruguayan economy has slowed significantly since end-2015 . Faced with this slowdown, the authorities avoided an overly contractionary policy stance in 2016, keeping fiscal policy fairly neutral. But room for countercyclical policies is limited , and the fiscal package for 2017 is projected to be pro-cyclical (if considered in isolation), as further delaying structural fiscal consolidation could jeopardize Uruguay’s hard-won credibility with international investors, and potentially force a tougher adjustment down the line. Given the low growth and announced fiscal plans, the current monetary stance seems appropriate. However, the authorities should stand ready to tighten monetary policy in 2017 as needed to help guide inflation towards the target range. In the medium term, solidifying the economic and social achievements of the past decade will require structural reform to boost diversified and inclusive growth. While several key prerequisites for this are in place, such as a trusted public sector and a high degree of social stability, gaps will need to be addressed in transportation infrastructure, skills formation, and the provision of credit for private sector investment.

I. Recent Developments, outlook and risks

1. Uruguay is demonstrating resilience in the face of sharp recessions in its large neighbors. With both Argentina and Brazil in deep recession in 2016, Uruguay’s projected growth of 0.7 percent is a marked departure from yesteryears when growth remained close to the average of its two neighbors. GDP growth is projected to exhibit a modest recovery to about 1.1 percent in 2017, as the external environment strengthens, together with private consumption. However, the planned contractionary fiscal stance may impose a drag on overall domestic demand.
2. After weakening against the U.S. dollar in nominal terms in early 2016, the Uruguayan peso stabilized and reversed course in April, broadly in line with regional peers. The currency appreciated about 6 percent in the year through end-October, but depreciation pressures reemerged in November. The current account deficit is expected to shrink to just under 2 percent of GDP in 2016, before gradually rising to 2½ percent in the medium-term as domestic demand recovers.

3. Despite the slowdown in activity, inflation persists at levels above the central bank’s target range. Driven by one-off increases in administered prices, and the nominal exchange rate depreciation at the start of 2016, inflation temporarily peaked at 11 percent (y-o-y) in May. The central bank tightened reserve requirements in April 2016 and lowered its reference range for narrow money (M1+) growth in April and July. Inflation is expected to remain below 9 percent in 2017, tapering to about 6 percent in the medium-term, while the output gap gradually closes.

4. Financial stability risks seem limited . Real credit growth to both corporates and households has come to a virtual halt since 2015 because of tepid demand and supply constraints in Uruguay’s segmented financial market. Non-performing loans have more than doubled as a share of gross loans since 2014, but remain relatively low, at 3.5% of total loans, while provisions are high. Staff stress tests confirm that credit and liquidity risks remain contained, and that the banking system could withstand even a large exchange rate shock that impaired loans to non-hedged borrowers.

5. Risks to the outlook are both external and domestic:

  • External risks. Although Uruguay’s regional economic ties have lessened, a slower-than-expected recovery in Argentina and Brazil could weigh on the economy, as could weaker-than-projected growth in China. Moreover, a tightening in global financial conditions could weaken growth across the region and raise Uruguay’s cost of financing. The high share of nonresident holdings of public debt could also pose some external risk, although maturities are long.

  • Domestic risks. If the recovery in 2017 were weaker than expected, the authorities could face a difficult trade-off between their fiscal consolidation plan and avoiding a strongly pro-cyclical fiscal stance that would exacerbate the slowdown. On the other hand, a potential large foreign investment (about 7 percent of GDP) in a third pulp mill presents an upside risk to growth.

6. Uruguay’s strong liquidity buffers and the flexible exchange rate should enable an orderly adjustment to shocks.

  • Public sector financing risks are limited by sizeable liquid financial assets, buttressed by the government’s access to contingent credit lines at international financial institutions.

  • The authorities’ willingness to allow the exchange rate to adjust in response to shifts in economic fundamentals has been key to absorbing external shocks.

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

II. POLICY RECOMMENDATIONS

Implementing fiscal consolidation

7. Implementing the authorities’ fiscal consolidation path will be critical to put net debt on a downward trajectory. The government avoided an overly pro-cyclical fiscal stance in 2016, while locking in the required fiscal adjustment for 2017. The announced measures are expected to have a lasting effect on the primary balance. As growth rebounds, staff projects the primary surplus to exceed 0.5 percent of GDP in 2019, allowing for a gradual reduction in gross and net public debt.

8. The government’s focus on fiscal consolidation is appropriate, although there is some space to respond to unanticipated shocks. Debt levels have risen sizably in recent years, and financial markets are keeping a close watch on the implementation of the fiscal adjustment, aimed at ensuring fiscal sustainability. The announced structural consolidation, to reduce the overall deficit to 2.5 percent of GDP by 2019, will help maintain strong financial buffers while stabilizing and trimming public debt relative to GDP. As fiscal credibility is preserved, there is space for automatic fiscal stabilizers to operate. In the long-run, population aging will hit Uruguay before other countries in the region, raising the annual deficit of the defined-benefit pillar of the pension system to well above 2 percent in 2050. This will necessitate further reforms, including to limit the deficit of special pension regimes.

9. Improvements in the management and profitability of public companies are essential to strengthening the fiscal balance. Following the recapitalization of ANCAP, the government has contracted a hedge to limit the financial risk from a large oil price increase in world markets. The scope for passing through such increases into (administered) domestic fuel prices may be constrained in the near term, given the limited pass through of the prior decline in oil prices in order to help restore ANCAP’s financial soundness. However, it would be useful to allow retail fuel prices to fully adjust with international oil prices as soon as feasible. Basing this on a transparent formula would remove the risks to the budget inherent to the stabilization of domestic fuel prices and promote efficient fuel usage. Consideration could be given to implementing such an approach once the current oil price hedge expires.

10. Fiscal adjustment should be designed to foster economic growth, including by supporting infrastructure investment plans. The 2017 tax package is expected to have a limited adverse effect on consumption, with an increase in personal income tax rates for middle-to-high-income earners, partly offset by lower VAT rates for electronic payments. On the expenditure side, a rationalization of the public wage bill and public enterprises’ expenditures will be important to ensure a durable consolidation, and would create space for critical public investment. The use of PPPs can alleviate the initial cost of investment to the budget, but will require effective monitoring and oversight, as well as strong control of explicit and contingent liabilities.

11. Active debt management remains important to reduce financial vulnerabilities and interest payments. Financial markets have acknowledged Uruguay’s prudent debt management strategy. However, the share of debt denominated in foreign currency has increased again. Building on the recently created Public Debt Management Committee, the fiscal and monetary authorities could usefully foster the development of a more liquid local-currency bond market which could help lower the dollarization of public debt. Useful steps could include the establishment of benchmarks for long-term peso debt instruments.

12. The authorities may wish to strengthen anchors to enhance the long-term credibility and counter-cyclicality of fiscal policy. An overall debt limit could become part of the existing rule, as a reference for determining the annual limit on the increase in net debt. This would strengthen confidence in the sustainability of Uruguay’s public finances. Furthermore, the annual limits on debt increases could adjust to the economic cycle, to permit the operation of fiscal stabilizers.

Making monetary policy more effective in curbing inflation

13. Inflation is projected to decline gradually, supported by a negative output gap and the ongoing wage discussions. Confronting inflation remains a priority, and is a precondition for de-dollarization, which would in turn improve the transmission of monetary policy. The new wage agreements offer a valuable opportunity to achieve a lasting reduction in inflation, as they are set in nominal terms, which should reduce inflation persistence, and as they include nominal wage increases that are lower for each subsequent year, gradually reducing cost pressures. Current staff projections foresee inflation moving into the 3–7 percent target range by 2019. Securing the expected gradual decline in inflation would be especially important at this juncture, as surprise inflation could jeopardize sustained progress in reshaping the wage regime.

14. Bringing inflation back to within the BCU’s target range requires a tight monetary policy. After increasing in April, short-term interest rates have fallen somewhat since mid-2016. That said, given a weak recovery, and the pro-cyclical fiscal tightening in 2017, a relatively less tight monetary stance could be justified going into 2017. However, the authorities should be proactive in tightening monetary conditions in 2017 if and when demand pressures pick up, to bolster price stability and the credibility of monetary policy.

15. There is scope to enhance the effectiveness of monetary policy in the medium term.

  • Reduce inflation persistence further. New wage agreements typically include backward indexation after 12 months or more to offset possible real wage losses. While a longer adjustment delay would be helpful in avoiding indexation in response to temporary price shocks, the full elimination of indexation provisions would be advisable as expeditiously as possible.

  • Strengthen the policy framework. Money demand has proven difficult to predict. This warrants a careful monitoring of changes in money demand to avoid an unduly relaxed policy stance. The authorities could also usefully explore options to reduce the volatility of short-term interest rates, for example by using standing facilities to create an interest rate corridor, as a more stable short-term yield curve could strengthen the policy signal and serve as a reference for developing peso debt instruments and derivatives.

16. The flexible exchange rate should remain the key mechanism to absorb external shocks. Exchange rate movements since early 2015 helped cushion the downturn and support competitiveness, as neighboring countries experienced similar depreciation pressures. Interventions in the exchange market should be used parsimoniously to counter disorderly market conditions, and not to counter trends driven by fundamentals.

Promoting financial development and maintaining stability

17. The ongoing steadfast implementation of the 2014 Financial Inclusion Law promises to help increase peso deposits and competition in the peso market. Private banks can capitalize on the generalization of payroll deposit accounts to increase their peso funding, and boost the peso credit market.


18. Market deepening and prudential policies to encourage domestic currency deposits and loans could support de-dollarization. The financing of public infrastructure projects could be designed to foster the development of new capital market instruments in peso, including for retail investors. On the regulatory side, reinstating differentiated reserve requirements on peso and foreign-currency deposits could encourage banks to favor peso deposits. Supervision should remain alert to monitoring banks’ exposures, and containing stability risks.

Supporting Inclusive Growth

19. Social policies and transfers have played a significant role in reducing poverty and inequality in Uruguay. Uruguay stands out as the country with the largest drop in the Gini coefficient in Latin America over the past decade. This reflects both government guidelines to bolster low wages, and increased redistribution through income taxes and transfers. Greater income equality can add to countries’ long term growth potential. However, looking ahead, further redistributive policies may be constrained by their fiscal costs, and should be designed with careful consideration of their impact on labor supply and incentives to seek training

20. Education reform is essential to sustain strong and inclusive growth. Despite a clearly higher teacher-to-student ratio, education outcomes are not better than regional averages, indicating room for improvement in the efficiency of education spending.

21. Further increasing female labor force participation could help tackle the challenges from population aging. Female labor force participation is fairly high in Uruguay compared to other Latin American countries. Nonetheless, in addition to increasing the supply of affordable public child care, extending paternity leave could also help reduce the gender gap.


22. New free trade agreements and progress in international integration could contribute to potential growth. Given the diversification of Uruguay’s export markets, and its focus on highly regulated and protected agricultural products, ensuring beneficial market access will be critical. The recent trade agreement with Chile, which complements the 1996 agreement between Chile and Mercosur, and the possible conclusion of trade negotiations between Mercosur and the European Union, should benefit Uruguay’s exports.

The mission thanks the authorities for the warm hospitality, the open discussions, and the quality of the engagement.

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