Uruguay: Staff Concluding Statement of the 2018 Article IV Mission

IMF News, December 12, 2018

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Published: December 12, 2018

Key assessment and resilience

Uruguay’s economy remains resilient owing to strong institutions, prudent policies, and large buffers.
Differentiating factors from neighbors: export market diversification, prudent and coordinated public-sector asset-liability management, pre-financing of sizeable external financing needs, lower banking sector vulnerabilities, and ample reserves.
Public sector borrowing costs have remained subdued despite significant depreciation pressures; growth has slowed but remains positive.

Recent developments

Growth and demand
- Economic activity grew by 2.4 percent in the first half of the year, after expanding by 2.7 percent in 2017.
- Private investment has remained sluggish; consumption has continued to support domestic demand.
- Manufacturing activity weak (excluding reopening of the oil refinery).
- Severe drought in Q1 led to lower summer crop yields (particularly soybeans).
- Labor market: unemployment fluctuating between 8 and 9 percent.
Inflation and monetary conditions
- 2017 inflation fell to 6.6 percent (within central bank 3-to-7-percent target range).
- Inflation exceeded the target since May 2018 and currently stands at 8 percent, reflecting drought, peso depreciation, and higher fuel prices.
- Staff estimates monetary conditions are not yet sufficiently tight; real short and medium-term rates remain lower than guidance from Taylor rules and neutral rates.
- Medium-term inflation expectations are somewhat above the target range.
Fiscal outcomes
- 2017 overall fiscal deficit (including central bank interest payments) was 3.5 percent of GDP, an improvement of 0.3 percentage points relative to 2016.
- Current budget envisages deficits of 3.3 percent of GDP in 2018 (up from 2.9 percent), and 2.8 percent of GDP in 2019 (up from 2.5 percent).
- 12-month rolling fiscal deficit stood at 2.9 percent of GDP; excluding cincuentones transactions, it amounted to 3.8 percent of GDP in October.
External sector and reserves
- Current account has posted surpluses since 2016; surplus shrunk to 0.2 percent of GDP in Q2 2018 from 0.7 percent of GDP in 2017.
- Drivers of current account deterioration: higher oil prices, lower exports to Argentina and Brazil, lower agricultural exports due to drought, and negative investment income.
- Capital inflows volatile; recent portfolio outflows consistent with many emerging markets.
- Gross reserves declined from $17.9 billion to $15.5 billion; at 26 percent of GDP they remain substantially above prudential norms.
- Peso depreciated by about 14 percent since April; central bank interventions began in August.
- About $0.5 billion of reserve decline reflects repurchases of central bank paper to accommodate pension-fund portfolio reallocation.

Outlook and risks

Business cycle and growth forecasts
- Uruguay’s business cycle is less correlated with Argentina; China is a rising key trading partner.
- Growth expected to moderate to 2.1 percent in 2018 and 1.9 percent in 2019.
- Near-term moderation drivers: slowdown in consumption in H2 2018 due to peso depreciation, declining confidence and real wages; decline in tourism revenue and goods exports in H1 2019 due to expected contraction in Argentina and currency appreciation vs. regional partners.
- Expected rebound of agriculture from drought will support growth; private investment expected to gradually recover after contracting for four years.
- Subsequent years: economy expected to grow slightly above potential, gradually closing the output gap.
External position
- Current account expected to register a small deficit in 2018 (-0.2 percent of GDP).
- Staff assesses external position broadly consistent with fundamentals; current account balance slightly exceeding its norm in 2018.
Inflation projections
- In 2019, inflation expected to moderate but remain at 7.5 percent, above the central bank’s ceiling of the target range established by the Macroeconomic Policy Coordination Committee.
- Inflation projected to stay at 7 percent beyond 2019, the upper limit of the central bank’s target range, given medium-term inflation expectations above target.
Risks
- Downside risks: abrupt tightening in global financial conditions, sharp increase in international risk premia, further strengthening of the U.S. dollar, and slowdown in trading partners.
- Upside risks: large infrastructure projects (construction of a large cellulose plant, associated railway system, and other projects).
- Structural medium-term risks: low investment and declining employment could lower potential growth if not reversed.

Policy recommendations

A. Maintaining Fiscal Sustainability

Fiscal stance and targets
- Staff projects an overall fiscal deficit (without cincuentones transfers) of 3.7 percent of GDP in 2018.
- Projected fiscal deficit decline of 0.2 percentage points per year in 2019 and 2020 due to reduced sterilization costs and lower current expenditures from wage negotiations.
- Thereafter, overall fiscal deficit (without cincuentones) projected to remain at 3.3 percent of GDP absent additional measures.
- Excluding cincuentones transfers, achieving the authorities’ overall fiscal deficit target of 2.5% of GDP by 2020 is difficult without additional measures.
Cincuentones transactions
- October 2018 public pension system received a transfer of about 1 percent of GDP; recorded as revenue, lowering the fiscal deficit and the stock of public debt in the short term.
- Transfers placed in a trust fund ring-fenced for 6 years; continue over next three years.
- Authorities estimate that after 5 years the operation will weaken the government’s balance sheet; burden on public pension system from this operation will be about 4 percent of GDP (in net present value terms over the next 30 years).
Financing and debt
- Under baseline, non-financial public sector debt projected to reach 54 percent of GDP in 2018 and to stabilize at 53 percent thereafter. [2]
- Large financing needs for 2019 are expected to be comfortably met due to coordinated asset-liability management, stable local currency funding from domestic institutional base, pre-financing policy, and buffers.
- Debt level below relevant benchmarks but elevated; share of debt in foreign currency held by non-residents remains relatively high.
- Fiscal space is at risk.
Recommended measures
- Introduce measures to put public debt on a firm downward path: delivering budgetary targets would reduce non-financial public sector debt to 49 percent of GDP in 5 years and to about 44 percent of GDP in 10 years, but would require 0.8 percentage points of GDP in measures until 2020 (total adjustment of 1.2 percent of GDP).
- Authorities should introduce measures of 0.3 percent of GDP in 2019 (amounting to a 0.5 percent-of-GDP total adjustment in 2019) to help put debt on a downward path.
- Fiscal adjustment could come from reducing elevated current expenditures and adjusting utility tariffs in line with cost structures and investment needs of public enterprises.
- Improve efficiency of social spending over the medium term to create space for increased capital spending.
- Introduce a medium-term fiscal framework supported by a binding fiscal rule, anchored on a medium-term debt objective and focusing on the nonfinancial public sector to limit volatility from central bank liquidity operations.
- Medium-term priorities: comprehensive pension-system review (to address high pension spending and constitutional wage indexation) supported by informed social dialogue; continued improvements in governance, risk-management, and consolidated monitoring of public enterprises.

B. Lowering Inflation

Short- to medium-term measures
- Bring inflation close to the middle of the central bank’s 3-to-7 percent target range to anchor expectations.
- Tighten monetary indicative references further so short and medium-term real rates increase to within staff’s estimated neutral rate range.
Longer-term monetary framework
- Further strengthen monetary policy framework amid high dollarization, low credit-to-GDP ratios, and remaining wage indexation.
- Improvements could focus on strategies, instruments, and communication practices to enhance commitment to targets, better anchor inflation expectations, reduce dollarization, and refine communication strategies.

C. Exchange rate policy

The exchange rate should remain the key shock absorber; allow the peso to adjust in line with fundamentals.
Interventions should be reserved for disorderly market conditions; reserve buffers should be kept above or in line with prudential norms.

D. Financial sector stability and intermediation

Supervision and monitoring
- Continue close monitoring of banks’ asset quality and exposures given exchange rate volatility.
- Nonperforming loans have increased somewhat and need monitoring.
- Adoption of net stable funding ratio regulation is welcome.
Financial inclusion and Fintech
- Boost financial inclusion and intermediation by promoting electronic transactions and competition (2014 Financial Inclusion Law).
- Authorities have introduced regulation for peer-to-peer lending and piloted an e-peso; efforts to improve inclusion while limiting risks are welcome.

E. Enhancing inclusive growth and competitiveness

Structural reforms and priorities
- Create fiscal space to close infrastructure gaps.
- Improve financial intermediation and the business environment to support private investment.
- Reform education to enhance human capital and strengthen competitiveness.
- Continue diversifying export products (including non-commodity sectors) and destinations; pursue multilateral and bilateral free trade agreements to improve market access.
- Address manufacturing sectors that lost market share and remain sensitive to exchange rate movements.

Source: Uruguay: Staff Concluding Statement of the 2018 Article IV Mission, December 12, 2018.