Uruguay - Staff Concluding Statement of the 2019 Article IV Mission

IMF News, December 17, 2019

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Uruguay - Staff Concluding Statement of the 2019 Article IV Mission

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• Published: December 17, 2019

Context: Enviable achievements but emerging challenges

• Uruguay enjoys a well-functioning democracy, political stability, strong governance and institutions, and a high degree of social cohesion.
• After a decade and a half of robust growth, Uruguay has high per capita income, and low rates of poverty, inequality, and informality.
• Financial sector resilience supported by prudent supervision and regulation, despite regional financial market volatility.
• Emerging imbalances and external headwinds:
  • Growth, investment, and labor participation have been on a declining trend.
  • Internal imbalances: higher fiscal deficits, rising unemployment.
  • Debt has increased and inflation remains outside of the target range.
  • Current account has fluctuated at around zero with sufficient reserve buffers.
  • Global environment: sluggish global and regional growth, subdued commodity prices, elevated uncertainty, volatile capital flows, and financial turmoil in neighboring Argentina; low global interest rates provide breathing space.
• Political and domestic opportunity:
  • New government assumes office in March 2020.
  • Growth boost expected from construction of a new paper pulp plant and upcoming PPP projects.
  • Consensus across political spectrum on key challenges.
• Policy imperative:
  • Reduce debt and bring inflation towards the mid-point of the target range.
  • Improve fiscal and inflation targeting frameworks and implement structural reforms.
  • Revive productivity growth to sustain welfare coverage and intergenerational fairness.
  • Target areas: education outcomes, youth employment, private investment, SOE efficiency, and pension adequacy.

Recent developments: Softened economy

• Economic activity and inflation:
  • Economic activity began to decelerate in 2018Q2.
  • Annual growth in the first half of 2019 was around zero percent.
  • Consumption stagnated; expected rebound in capital formation failed to materialize.
  • Exports recovering from 2018 trough; current account fluctuating at around zero.
  • Inflation increased to 8½ percent in November, outside of the target range, despite a negative output gap.
• Argentina spillovers and external metrics:
  • Tourism receipts from Argentina dropped by 34 percent in the first half of 2019 compared with the same period in 2018.
  • Peso depreciated against the U.S. dollar by 17 percent since end-2018; intervention two-sided and aimed at disorderly market conditions.
  • Reserves declined from US$15.6 billion in December 2018 to US$14.3 billion in December 2019 (25 percent of GDP).
  • Financial sector remains robust; sovereign spreads contained at low levels.
  • Deposit dollarization has edged up with currency depreciation.
• Fiscal deterioration:
  • 2020 budget foregoes the 2.5-percent-of-GDP deficit target; foresees CPS fiscal deficit of 4.6 percent of GDP in 2019 (excluding cincuentones transactions) and 3.8 percent of GDP in 2020.
  • Twelve-month CPS deficit (excluding cincuentones) stood at 4.6 percent of GDP as of October, aided by a debt management operation in September (0.3 percent of GDP) and by lower interest payments from the central bank.
  • Excluding the debt management operation, CPS deficit (excluding cincuentones) would have been 4.9 percent of GDP.
  • Authorities issued longer-term bonds at favorable rates to cover financing needs.
• Fiscal reporting focus:
  • Authorities and the IMF switched fiscal reporting focus from CPS to NFPS.
  • IMF fiscal analysis based on NFPS fiscal aggregates excluding cincuentones; WEO data present NFPS fiscal aggregates including cincuentones.

Outlook and risks: Expected recovery but sizable risks

• Long-term potential:
  • Economy’s long-term growth potential estimated at around 2–2.5 percent.
  • Since 2015, growth averaged about 1½ percent, compared with about 5 percent during 2006–14.
• Staff projections:
  • Growth projected to rebound from an estimated 0.5 percent in 2019 to 2.1 percent in 2020 and 2.5 percent in 2021, as investment projects ramp up.
  • Growth expected to decline after 2021 as investments run their course, but real GDP level expected to be permanently higher by around 1 percent due to productivity impact.
  • Inflation expected to remain at around 8 percent next year and then decline gradually towards the upper limit of the target range.
• External position:
  • External position broadly consistent with fundamentals and desirable policy settings.
  • Current account deficit projected to widen as tourism receipts from Argentina settle at a lower level and imports rise with investment projects and recovery; exports expected to increase after completion of the paper-pulp plant.
• Risks:
  • Downside risks: developments in Argentina, global factors (trade disruptions, lower growth, abrupt declines in risk appetite, large swings in energy prices), and local risks (loss of credibility from insufficient fiscal adjustment or delayed reforms and PPPs).
  • Upside risks: larger-than-expected growth boost from investment projects and possible indirect effects.

Policies: Safeguarding sustainable and inclusive growth

A. Maintaining fiscal sustainability

• Debt and fiscal trajectory:
  • Staff projects NFPS overall deficit (excluding cincuentones) to decline from estimated 4.1 percent of GDP in 2019 to 3.9 percent of GDP in 2020 and settle at around 3.1 percent of GDP.
  • Availability payments related to PPP projects expected to reach ½ percent of GDP by 2024.
  • NFPS debt expected to increase from an estimated 67 percent of GDP in 2019 to 68 percent of GDP in 2024.
• Financing and fiscal space:
  • Gross financing needs manageable via coordinated public-sector asset-liability management, stable local currency funding, pre-financing policy, and buffers (nonfinancial-public-sector liquid assets and contingent credit lines).
  • Shares of foreign-currency debt and of nonresident holdings remain relatively high, leaving debt vulnerable to exchange rate pressures and changes in risk sentiment.
  • Fiscal space is at risk given worsened fiscal position, elevated debt, and sizable downside risks.
• Need for credible adjustment plan from 2020:
  • Target: bring debt to 2012–14 levels (about 10 percentage points of GDP lower than currently) over the longer term to align with investment-grade peers.
• Frontloading adjustment given investment support:
  • Bring NFPS primary deficit from current level of 1.7 percent of GDP to a surplus of 0.9 percent of GDP by 2024 would stabilize debt.
  • Average adjustment of a ½-percent-of-GDP per year would reduce debt by about 10 percentage points in 10 years.
  • If upside risks materialize, windfall revenues should be saved to stabilize the economy and reduce debt.
• Combination of measures and communication:
  • Transparent public information and communication strategy to build consensus.
  • Measures:

a. Limit increase in current expenditures; example: if current expenditures increase with inflation rather than with or faster than nominal GDP, debt would decline by 8 percentage points by 2024 relative to current levels. Maintain adequate provision of key public services and safety nets. Options include keeping public wages in line with the private sector, reducing public employment in non-critical sectors through natural attrition, and improving spending efficiency. b. Preserve capital expenditures. c. Reduce tax expenditures—exemptions, reduced rates and tax credits—estimated at about 7 percent of GDP; about three quarters of these expenditures are for the value added tax, where tax expenditures represent about 40 percent of collections. Use cost-benefit analysis to streamline exemptions, particularly those benefiting higher-income groups or not achieving desired outcomes.

• Pension spending:
  • Pension spending around 11 percent of GDP, about a third of total expenditures.
  • Reforms needed based on comprehensive review of the entire system, supported by informed social dialogue; early action recommended.
• Medium-term fiscal framework (MTFF):
  • Introduce revamped MTFF with a binding fiscal rule to establish credibility.
  • Possible MTFF elements:

(i) rolling 3-to-5-year projection period irrespective of government term; (ii) strengthened fiscal rule (possibly an expenditure rule combined with a debt anchor); (iii) limited use of escape clauses in exceptional circumstances; (iv) strengthened accountability mechanisms; (v) regular spending reviews; (vi) more frequent updates of forecasts; (vii) greater budget unity by setting a spending ceiling binding for autonomous (Article 220) entities; (viii) better coordination between the Office of Planning and Budget and the budget office of the Ministry of Economy and Finance; (ix) disclosure of risks, including those associated with PPPs.

• Budgetary targets should be set for the NFPS.

B. Lowering inflation and reducing financial dollarization

• Current inflation dynamics and policy stance:
  • Monetary policy tightened in October: indicative reference for the growth rate of the M1+ monetary aggregate lowered from 8-10 percent in 2019Q3 to 7-9 percent in 2019Q4.
  • Interest rates increased by about 100 basis points at the short end and by about 20 basis points at the longer end.
  • Inflation and medium-term inflation expectations currently standing at 8.4 percent and 8 percent, respectively.
• Policy recommendations:
  • Further tighten monetary indicative references so real interest rates rise above the range of estimated neutral rates until inflation and expectations are firmly at the mid-point of the target range.
  • Continue to use the exchange rate as a shock absorber; reserve buffers should be kept above prudential norms; interventions reserved for disorderly market conditions.
• Enhancements to inflation targeting framework:
  • Consider clearer hierarchy of objectives with primacy of price stability at the mid-point of the target range and more detailed communication of the central bank’s reaction function to guide expectations.
• Reduce dollarization and indexation:
  • Revised wage bargaining council guidelines introducing productivity considerations and delinking wages from past inflation are an important step.
  • Macro and price stability, plus regulatory measures, deeper financial markets, and hedging opportunities, would encourage local currency holdings.

C. Financial sector: Preserving resilience and supporting growth

• Strengths and challenges:
  • Financial sector resilient; financial intermediation chronically low with wide margins between credit and deposit rates.
  • Credit markets segmented for dollar and peso loans (very high rates for peso loans), weakening monetary transmission.
• Regulatory measures:
  • Net stable funding ratio regulation became effective in December.
  • Regulation on countercyclical buffers to be submitted for public consultation in December.
  • Investment limits for pension funds modified to incorporate exposures to PPP projects to limit concentration risks.
• Financial market deepening:
  • Efforts include creating benchmark curves, increasing liquidity in secondary markets, fostering financial inclusion and innovation (free access to bank accounts, encouraging electronic transactions, improving payments system).
  • Electronic points of sale almost doubled between 2014 and 2019; cash withdrawals began to decline in 2018.
• Fintech and regulation:
  • Regulation on peer-to-peer lending enacted; no fintech company has registered since introduction.
  • Continued collaboration across state agencies, the central bank, and industry recommended to balance innovation and risk management.

D. Structural reforms for sustainable and inclusive growth

• Structural strengths:
  • Strong governance and institutions, well-functioning democracy, social cohesion, commitment to free trade, low poverty, inequality, and informality.
  • High performance on many ESG indicators (based on World Bank’s Sovereign ESG data framework).
• Reform priorities:
  • Closing infrastructure gaps insufficient alone to restore past growth; vibrant private sector essential.
  • Improve education outcomes and business environment.
  • Corporate governance reform to improve management and efficiency of SOEs.
• Labor market concerns:
  • Employment and labor force participation falling in key sectors; unemployment risen, particularly among the young (to around 30 percent).
  • Younger generations disproportionately affected; need to address intergenerational equity and insider-outsider issues.
  • Perception surveys indicate room for improving wage flexibility, labor-employer cooperation, and worker attraction/retention conditions.
• Labor and social policies:
  • Wage council guideline changes introducing productivity considerations and greater flexibility are positive.
  • Consider further flexibility for small firms, low-productivity regions, and during downturns while preserving worker protection.
  • Align wage increases with productivity, improve business-labor cooperation, and focus on education and training to recalibrate skills.
  • Address youth unemployment in coordination with education reform.
  • Integrate migrants and female labor to offset pressures from population aging.
• Crime and AML/CFT:
  • Increase in crime from a low base needs addressing before it becomes macro-critical.
  • Prompt implementation of GAFILAT’s AML/CFT recommendations encouraged, particularly to address risks from foreign proceeds of crime.

IMF staff concluding statement of the 2019 Article IV mission for Uruguay

References

• Argentina and the IMF
• Uruguay and the IMF
• IMF Policy Advice -- A Factsheet
• Mission Concluding Statements
• PRESS CENTER
• https://www.imf.org/en/home