Mission Concluding Statement 

Uruguay: Staff Concluding Statement of the 2023 Article IV Mission

March 20, 2023

Washington, DC: An International Monetary Fund (IMF) staff team, led by Mr. Pau Rabanal, visited Montevideo and held discussions on the 2023 Article IV consultation with Uruguay’s authorities during March 6–17. At the end of the consultation, the mission issued the following statement, which summarizes its main conclusions and recommendations.

Economic recovery after the pandemic, amid new challenges

Uruguay showed strong resilience during the Covid-19 pandemic, owing to its high institutional quality, strong governance, and the authorities’ policy responses. Thanks to its robust institutions and adequate social safety net, Uruguay was able to provide a highly effective response to the health emergency triggered by the Covid-19 pandemic. After two severe infection waves in 2021, containment measures were relaxed in 2022, supported by successful vaccination campaigns, including for boosters. Scarring effects in real activity and the labor market were mitigated by the authorities’ well-designed policies, which provided the necessary support to affected household and corporate sectors transparently through the Covid-19 Solidarity Fund. Labor market informality declined during the pandemic and has remained at a lower level.

After reaching pre-pandemic levels in mid-2021, real GDP grew at a healthy pace in 2022, while inflation increased. Growth is expected to reach 4.9 percent in 2022, driven by strong exports of agricultural products and recovering service sectors, including tourism. Russia’s war in Ukraine had a limited direct impact due to small trade links, but agricultural exports benefited from increased demand and global prices. The economy decelerated in the second half of the year, due to the global slowdown and the effects of the drought. Employment creation rebounded in 2022, although uneven across sectors, while unemployment has hovered at around 8 percent. Inflation peaked at 9.95 percent in September 2022 and has declined to 7.5 percent in February 2023. The increase in inflation was less pronounced than in other countries, owing to a strong monetary policy response, the appreciation of the Uruguayan peso and the limited increase in administered prices.

The authorities’ strong track record of implementing sound macroeconomic policies in a challenging environment has improved the country’s resilience to shocks. Uruguay has maintained favorable market access and enjoys historically low spreads despite the succession of unfavorable shocks (including the pandemic, the war in Ukraine, the tightening of global financial conditions and the ongoing drought). Progress made since 2020 on the fiscal framework, including a solid track record of achieving the fiscal rule targets and the creation of the Fiscal Council, strengthened the credibility on the authorities’ commitment to fiscal prudence. Improvements to the monetary policy framework should enhance the transmission channels of monetary policy, while helping reduce dollarization overtime. Consolidating these gains should be an important priority, as they place the country in a more favorable position to address external risks.

A well-calibrated monetary and fiscal policy response

In response to increased inflationary pressures, the Banco Central del Uruguay (BCU) appropriately tightened monetary policy during 2022, while the peso appreciated. The BCU markedly raised the policy rate from 5.75 percent in December 2021 to 11.5 percent in December 2022, turning the monetary policy stance contractionary. As previously announced, the ceiling of the target range was reduced from 7 to 6 percent effective September 2022. Inflation expectations remained outside the target band in 2022 but have recently declined, particularly two-year ahead expectations. The peso appreciated by 13 percent against the US dollar in nominal terms, and by 20 percent in real effective terms in 2022, driven by interest rate differentials, favorable terms of trade, and increased US dollar liquidity. To support its overall upgrading of the monetary policy framework, the BCU has not intervened in the foreign exchange market, which has helped provide clarity on the objectives of monetary policy.

The fiscal deficit and government debt declined substantially over the last two years, reflecting the authorities’ efforts to stay within the targets of the fiscal rules, while protecting the most vulnerable. The overall deficit of the non-financial public sector (NFPS), excluding cincuentones¹, reached 2.8 percent of GDP in 2022, compared to 3.1 percent in 2021. While COVID-related spending was gradually unwound, the authorities deployed funds to protect vulnerable groups from the effect of high food and energy prices. After peaking at 69 percent of GDP in 2020, gross NFPS debt declined to 61 percent of GDP at the end of 2022, close to its pre-pandemic level, amid historically low sovereign spreads. The improvement since 2020 reflects the authorities’ efforts, which are key to preserve macroeconomic and financial stability and favorable market access, as well as the effect of higher-than-expected GDP growth and inflation, and the appreciation of the peso.

Outlook and risks

The economy is expected to decelerate, while risks are tilted to the downside. Real GDP growth is projected at 2 percent in 2023 amid high uncertainty due to the impact of the current drought. Despite external headwinds, tighter financial conditions, and the impact of the drought, growth would be supported by a strong tourism season, increased cellulose production and exports, and robust private consumption as real wages recover. Inflation is expected to decline to 7 percent in 2023 and fall within the target range in 2024. Main macroeconomic risks are derived from a worsening of external conditions, deterioration of international geopolitical tensions, and the severity and duration of the current drought.

Policies to rebuild buffers, maintain credibility, and boost medium-term growth

Fiscal Policy

In the near term, the authorities’ plan is consistent with achieving the targets of the fiscal rule while safeguarding social cohesion. The NFPS fiscal deficit is projected at 2.3 percent of GDP in 2023, while social spending remains a large fraction of total spending. The main short-term risk for fiscal policy is how the intensity and duration of the current drought will impact economic activity, but there is some fiscal space available if needed. Current fiscal plans would keep NFPS debt largely stable with limited near-term risks—as financing needs are manageable and market financing remains at favorable terms. The recently announced tax cut (0.2 percent of GDP) represents a structural reduction in revenues which will require real spending to grow at a slower pace, as already contemplated in the authorities’ plan.

After the effect of the drought abates, additional fiscal efforts would be needed to put debt on a firm downward path and rebuild policy space. The authorities’ efforts to reduce debt in the aftermath of the pandemic amid difficult external conditions are commendable, but the debt-to-GDP ratio is at historically high levels. IMF staff estimates that bringing NFPS debt to a range between 50-55 percent of GDP over the medium term would provide large enough buffers to respond to shocks. Within the current framework, the annual fiscal reports to Parliament ( “Rendición de Cuentas y Exposición de Motivos”) could incorporate more explicitly the link between the calibration of the three pillars of the fiscal rule and the authorities’ stated efforts to stabilize the debt-to-GDP ratio over the forecasting horizon. Going forward, in line with past IMF staff recommendations, a well-calibrated explicit debt anchor would help stabilize the debt-to-GDP ratio at a lower level over the medium term.

Monetary and Exchange Rate Policy

The current stance of monetary policy is appropriate. The BCU should maintain the current contractionary stance until inflation and inflation expectations have converged within the target range in a sustained manner, which will be crucial to keep building monetary policy credibility and support de-dollarization efforts. Recent enhancements to the monetary policy framework have increased the effectiveness of monetary policy transmission but enhancing de jure central bank independence would further improve credibility and support policy continuity. The exchange rate should continue to act as a shock absorber with FX interventions limited to respond to disorderly market conditions.

Financial Sector

The health of the financial sector remains sound. Banks have weathered the pandemic well, and support measures expired without visible signs of increased stress, reflected in low and stable non-performing loan ratios, high profitability, and strong liquidity indicators. Profitability declined in 2022 due to the appreciation of the exchange rate and banks’ positive FX net open position. Dollarization remains high, which hampers the effectiveness of the monetary policy transmission mechanism and aggravates FX credit and systemic liquidity risks. State-owned banks have strong capital and liquidity buffers, but due to their large presence in the financial system, special attention should be given to supervision, governance, crisis management and maintaining competition.

Despite recent progress, further efforts are needed to improve financial sector resilience. The authorities have updated the supervisory framework in line with international initiatives and implemented a broad range of macroprudential tools, strengthening the resilience of the banking sector and reducing dollarization risks. Ample liquidity buffers allow banks to sustain severe funding pressures while contagion risks appear limited. Further enhancing the macroprudential framework is an important priority. Closing large data gaps is needed to assess system-wide FX liquidity risk and recalibrate current de-dollarization measures. Solvency risks for some private banks should be addressed by Pillar 2 capital add-ons and restrictions on dividend distribution. Reforming the bank wealth tax would incentivize private sector banks to raise additional capital. The crisis management framework should also be updated.

Structural Policies

Structural reforms remain critical to increase productivity, educational attainment, investment, and growth. Current reform efforts are aimed at enhancing the sustainability of the pension system and improving education outcomes. Despite the recent improvements in the efficiency and productivity of state-owned enterprises, further efforts are needed. Their tariffs should be cost reflective and set by independent regulators, and the cost of their social programs should be transparently financed from the budget (instead of the current practice of using cross-subsidies). State-owned banks should be subject to the same resolution arrangements and corporate governance rules as private banks to reduce financial vulnerabilities. Recent initiatives to foster access to finance, promote capital market development and the innovation ecosystem, and modernize the digital payments system could also contribute to boost investment and growth. At the same time, new trade agreements under study could lead to important advances in trade integration.

Efforts to transform Uruguay into a climate-resilient, green, and sustainable economy should remain a priority . Uruguay remains at the forefront of the implementation of climate change policies. Meanwhile, Uruguay is vulnerable to climate hazards, being particularly exposed to excessive rainfall and droughts, and rising sea levels. The successful issuance of a sustainability-linked sovereign bond showcases the authorities’ commitment to environmentally sustainable policies and the emphasis on institutional coordination and transparency. To achieve the country’s goal of carbon dioxide neutrality by 2050, decarbonization efforts should focus on the transition to e-mobility and green hydrogen production. Promoting climate-smart agricultural and livestock practices are key to reduce methane emissions intensity. As a food supplier for an increasing world population, the authorities intend to meet the challenge of raising agricultural production, while reducing methane and nitrous oxide emissions intensity, preserving the country’s unique grassland ecosystem, and protecting its native forests.

The team would like to thank the Uruguay’s authorities and stakeholders for their hospitality, constructive policy dialogue, and productive collaboration during the Article IV mission to Montevideo between March 6-17, 2023.