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The following item is a Letter of Intent of the government of Uruguay, which describes the policies that Uruguay intends to implement in the context of its request for financial support from the IMF. The document, which is the property of Uruguay, is being made available on the IMF website by agreement with the member as a service to users of the IMF website.

Montevideo, Uruguay
March 12, 1999

Mr. Michel Camdessus
Managing Director
International Monetary Fund
Washington DC, 20431

Dear Mr. Camdessus:

The attached policy memorandum and annexed table review the policies and developments under the Government's economic program for 1998, and describe the Government's objectives and policies for 1999. In support of the program, the Government requests a 12-month stand-by arrangement, which it intends to treat as precautionary, in an amount equivalent to SDR 70 million. The Government believes that such arrangement will help maintain a stable macroeconomic environment; strengthen confidence and reduce Uruguay's vulnerability to external shocks; and help improve Uruguay's economic prospects.

The Government believes that its policies are adequate to achieve the objectives of its program. Uruguay will maintain close relations with the Fund and consult on the adoption of measures that may be appropriate, in accordance with the Fund's practices on such consultations. A review of the program will be carried out with the Fund before end-August 1999 to assess progress under the program.

Sincerely yours,

Luis Mosca
Minister of
Economy and Finance
Humberto Capote
Central Bank of Uruguay

Policy Memorandum

1.  The key economic objective of the Government of Uruguay is to improve the standard of living of the population through lowering inflation and improving the conditions for sustained high output growth. To this end, when the government took office in early 1995, it initiated a medium-term program aimed at strengthening the public finances; maintaining monetary and expenditure restraint; slowing the rate of depreciation of the exchange rate band; and implementing structural reform to improve the allocation of resources, including in the social security and tax system, public administration, the financial sector, and through economic deregulation and privatization. Special efforts were made to assist vulnerable sectors of society such as children and the elderly, the unemployed, and the poor. Moreover, the government implemented a reform of the education system to improve opportunities for all in society to participate in future economic growth. The program was first monitored by Fund staff, and since 1996 has been supported by two stand-by arrangements.

The 1998 program

2.  The program aimed at reducing the 12-month rate of inflation from 15 percent at end-1997 to a single digit by end-1998, while maintaining a viable external current account position, and preserving gross official reserves at close to six months of imports of goods and services. The government also indicated its intention to move ahead with structural measures to modernize bankruptcy legislation; increase data availability, improve financial disclosure, and adopt international accounting practices in the enterprise sector; as well as sell an intervened bank. After real GDP growth of 5 percent both in 1996 and 1997, the program assumed a slowing of growth to 3 percent in 1998 owing to reduced regional economic activity and less-favorable international conditions following the Asia crisis.

3.  The government met all main objectives under the program. The 12-month rate of inflation dropped to 8.6 percent by December 1998; the external current account deficit was 2 percent of GDP and the stock of international reserves substantially exceeded its programmed level. Real GDP growth is estimated to have been at least 3½ percent, notwithstanding a sharp slowing of economic activity in the latter part of the year following the Russia debt crisis and the incipient difficulties experienced in Brazil. The government implemented all structural measures under the program to strengthen the domestic capital market, while the Central Bank (BCU) called for bids to sell one intervened bank (now expected to be completed in the first half of 1999). While not a benchmark under the program, in December 1998, the BCU also merged two other intervened banks to bolster the viability of the resulting institution and cease its intervention.

4.  The government is pleased with the performance of the Uruguayan labor market in 1998, as improving household incomes through increased employment is a key to raising living standards. The unemployment rate dropped from an average of 11½ percent in 1997 to just above 10 percent in 1998. Employment growth was around 6 percent in the year and the trend increase in participation of youths and women that has been observed since 1995 continued. Moderate real wage growth bolstered employment and supported the inflation objective. During 1998, average real wages in the economy grew by 1¾ percent, while strong productivity growth continued in the manufacturing sector. The government advocates local determination of labor agreements and today some 90 percent of private sector contracts are agreed through decentralized bargaining. Higher employment with moderate, steady wage policies and reduced public interference in the bargaining process, together with a terms of trade gain, increased average household incomes by 7 percent in 1998.

5.  The consolidated public sector deficit dropped from 1½ percent of GDP in 1997 to 1 percent in 1998, or slightly better than programmed. Excluding the costs associated with the reform of the social security system and severance payments in the reform of the public sector, the balance improved from a deficit of ¼ percent of GDP in 1997 to a surplus of ¼ percent in 1998. Revenue increased by nearly ¾ percentage point of GDP in 1998, reflecting strong demand for consumer durables during the first half of the year which boosted VAT and excise taxes; improvements in the operating result of the public enterprises, especially in the electricity and the petroleum company; and continued improvements in tax administration. Current expenditures decreased marginally, reflecting higher outlays on social security benefits that are indexed retroactively to average take home wages in the economy, offset by lower expenditures on wages and other current outlays. An increase in capital spending in part reflected stocking of oil reserves at year-end by the petroleum company to lock in favorable international oil prices.

6.  The BCU stabilized the quasi-fiscal deficit, which is included in the overall deficit mentioned above, at ½ percent of GDP notwithstanding increased interest rates on its foreign liabilities, a challenge to the exchange rate band in the third quarter of 1998, and the need to rebuild foreign exchange reserves (with assistance from the central government) in the fourth quarter of the year to meet the program NIR target. Moreover, for prudential reasons and to bolster banking system solvency, in late September 1998, the BCU increased minimum capital adequacy requirements from 8 to 10 percent (to be implemented in four equal semi-annual steps), and increased collateralization requirements attached to consumer lending, which had been expanding rapidly during the year.

7.  The external current account deficit widened from just over 1½ percent of GDP in 1997 to 2 percent in 1998. This widening is explained in the services account by the disappointing tourism season, owing to adverse weather conditions at the beginning of the year (el Niño), and by a drop in revenue from freight and transportation services. The growth in U.S. dollar merchandise trade slowed considerably from 1997; the value of exports grew by 2½ percent in 1998 and that of imports by 3 percent, reflecting weaker export commodity prices, a slowing of demand from Brazil and Argentina and, on the import side, the drop in oil import prices.

8.  The capital account surplus, including errors and omissions, strengthened from 3¼ percent in 1997 to 3¾ percent of GDP in 1998, reflecting, in part, deposit inflows and some pre-borrowing by the government of its financing requirement for 1999 with the placement in November 1998 of a US$200 million, five-year U.S. dollar debenture at an interest rate of about 7¾ percent. Also, unexpectedly large reserve inflows occurred during the last few days of December 1998 reflecting, inter alia, accumulations of deposits by the public enterprises in anticipation of amortization requirements falling due in early 1999, and possibly as some financial institutions reduced their exposure in Brazil in favor of Uruguay for year-end book-keeping purposes (international credit rating agencies recently confirmed Uruguay's investment grade rating). As a result, net international reserves as measured in the program (including adjustments) increased by US$416 million in 1998, compared with a target increase of US$150 million.

9.  The government continued to make substantial progress with structural reforms. The reform of the social security system, which began in mid-1996, has proceeded faster than expected. By end-1998 more than 500,000 employees had shifted to the private capitalized pension system (more than half the labor force covered by the national pension administration (BPS)). This rapid shift has produced unexpected costs to the government. At the same time, the growth in new net beneficiaries to the public pay-as-you-go system began to level off by end 1998, suggesting that social security entitlement outlays will soon reach their peak. The first phase of the reform of the state, which was initiated in early 1997, was completed and has resulted in the reduction of 14,000 public sector positions (8 percent of total) and in the number of budgetary units in the central administration. Public enterprises continued to expand their joint ventures with private sector firms in the gasoline, lubricants, and cement sectors, and with the construction of a gas pipeline from Argentina to Uruguay. The electricity market was deregulated in 1998, bringing competition in electricity generation and permitting lower average electricity tariffs in Uruguay.

The program for 1999

10.  Uruguay faces a challenging year in 1999. Brazil is the largest single trading partner, accounting for a third of merchandise exports, and the recent devaluation of the real is expected to have significant direct and indirect adverse price effects on the profitability of Uruguayan exports. Moreover, real GDP growth in the region may turn out to be negative, thereby imparting a contraction in output and income on Uruguay as well. Uruguay will have primary elections in April and congressional and presidential elections in October and November 1999, with the new government taking office in March 2000. Nevertheless, the outgoing administration intends to keep the economy firmly on track for achieving low inflation and high growth during the next five-year government period.

11.  The government believes that the best response to the latest external shock is to reaffirm its commitment to the medium-term economic framework that has served Uruguay well. This framework aims at a gradual but continued reduction in inflation and a consolidation of the gains in economic efficiency and is built on cautious fiscal, credit, and exchange rate policies. The economic program for 1999 is designed to find a balance how best to absorb the new external shock while preserving the significant gains of recent years and permitting the economy to rebound strongly as the external macroeconomic environment recovers.

12.  The program seeks to reduce the 12-month rate of inflation to 5-6 percent by year-end. The external current account deficit is projected to remain around 2 percent of GDP (with a drop in both exports and imports), and gross international reserves would be maintained at least at six months of imports of goods and services. The program assumes a significant contraction of economic activity in Brazil and no growth in Argentina, but a gradual settling down of the turbulence in the international capital market faced by the region since the Russia debt crisis. Real GDP growth in Uruguay is projected to be slightly negative by 1 percent, based on the loss in income from exports and a slowing of investment and in private consumption in the context of generally more subdued expectations.

13.  The consolidated public sector deficit is projected to increase to 1¾ percent of GDP. The deficit without reform costs will be around ½ percent of GDP. The widening of the deficit reflects the effects on the budget of the drop in output, which is only partially offset by measures adopted in response to the recent events in Brazil, and the need to accommodate some one-time expenditures related to the administration of the general elections. Taking into account cyclical developments, the structural deficit would narrow slightly. In line with the deficit target, the government has established quarterly limits on the consolidated public sector balance and on the discretionary total expenditure of the general government through December 1999.

14.  Public sector revenue is programmed to remain at nearly 34 percent of GDP in 1999. This results from a reduction in revenue from imports and consumption-based taxes, reflecting the cyclical downturn, from a cut in the bank asset tax, and a reduction in enterprise tariffs in real terms, necessary to prepare public enterprises for increased competition in the Mercosur. The reduction in revenue is offset by increased receipts of income and profit taxes following better than expected corporate profits during 1998. The program also includes some efficiency gains in the social security area as cross-checking of information is improving compliance in contribution payments.

15.  Public sector noninterest expenditure is programmed to increase by ¾ percentage points to 33½ percent of GDP notwithstanding the effects of emergency expenditure cuts amounting to 0.4 percent of GDP agreed in February 1999 to compensate in part for the projected loss in revenue. Outlays for social security entitlements will continue to increase in real terms reflecting backward indexation and the drop in inflation, and some increase in the number of beneficiaries associated with the reform of the state. The public sector wage bill is programmed to rise slightly, relative to GDP, as the cost of wage increases (explained below) will exceed the savings obtained from reduced employment following the reform of the state. As part of the emergency expenditure reductions, the government intends to reduce capital outlays by a ¼ percentage point of GDP in part by slowing the pace of execution of some large building projects.

16.  Notwithstanding the increase in the public sector wage bill, incomes policy remains consistent with the achievement of the program's fiscal and inflation objectives. Public sector basic wage rates were adjusted in January and will be adjusted again in July, as governed by law, by an amount that is equivalent to projected inflation during the next six months. (Consistent with the law, public sector wages can shift to once- a-year indexation in January 2000, if inflation remains below 10 percent in the second half of 1999.) In addition, the government is distributing 70 percent of the savings obtained from the state reform, and is granting a special adjustment in remunerations for teachers and the police force, most of which reflect commitments in the five-year budget law agreed with congress at the beginning of the government term in 1995. Owing to these special adjustments, real wage rates in the public sector are expected to increase by 2½ percent, but those in the private sector are expected to remain flat or turn slightly lower given the effects of the Brazil crisis.

17.  Credit policy will be geared towards achieving the inflation and balance of payments targets of the program. During 1999, currency in circulation is projected to rise by 4 percent, while the BCU's net international reserves are programmed to drop by around US$200 million. The latter is equivalent to the amount of government pre-financing for 1999 that was obtained in the last few days of 1998. Indeed, compared with the program objective for 1998, the program for 1999 implies a further gain of US$60 million in reserves. The program envisages that broad money will increase by 5½ percent, and that credit to the private sector will increase by 5 percent. On this basis, limits on the change in the net domestic assets of the BCU and targets for the gain in net international reserves of the BCU have been established through December 1999. The government will continue to allow flexibility of interest rates to ensure achievement of these targets.

18.  In recent years, and consistent with the financial and wage policies described above, the government has slowed gradually the rate of adjustment of the exchange rate band in line with the expected drop in inflation. However, given the increase in the real effective exchange rate of the peso in January, and because the situation in Brazil may remain fluid for some time, the government intends to proceed cautiously in this area in 1999 and, for now at least, maintain the pace of depreciation of the band at its current rate of about 7½ percent a year. The exchange market has remained calm after the depreciation of the real, with the peso-U.S. dollar exchange rate moving from the lower (most appreciated) limit to about the middle of the band. Moreover, the government does not believe that this slight adaptation of exchange rate policy to the more difficult external situation is inconsistent with lower inflation given the projected weakness in economic activity and absence of any external price pressures on the economy. The government intends to maintain Uruguay's exchange rate system free of restrictions on payments and transfers for international transactions. Uruguay is committed to implement on schedule all custom tariff reductions as agreed under the Mercosur convention, and the government will continue to argue for the removal at end-1999 of the 3-percent surcharge on the common external tariff as it believes that this surcharge hinders the competitiveness of the economy.

19.  The government continues to make efforts to solidify confidence in the overall financial position of Uruguay. To lengthen the overall maturity structure of the public debt, the 1999 financing plan envisages lending from the Inter-American Development Bank and the World Bank in support of Uruguay's structural reform program, and the net placement of US$200 million (1 percent of GDP) of medium- and long-term bonds in international capital markets. Moreover, the government would use the US$200 million in prefinancing obtained by end-1998. With this financing schedule, Uruguay will have virtually no short-term public debt and, consistent with the above, the government has established limits on the public sector's indebtedness.

20.  Given the electoral period, the government does not anticipate launching major new structural reform initiatives in 1999. Instead it will seek to consolidate those programs already under way. The social security reform will continue to develop in 1999, expecting a modest additional shift of employees from the public to the private system. The transfer of social security contributions from the public to the private system is expected to amount to just over 1 percent of GDP. The government will also consider widening the options among financial instruments that the private sector pension funds can invest in, but it will proceed with caution to ensure the financial strength of these funds. The government is receiving financial and technical assistance from the World Bank and the IDB in this area. The government will also implement an additional step in the state reform, involving a projected reduction of about 1,600 in military personnel (5 percent of total) against improved remuneration.

21.  Developing the domestic capital market and improving the financial system remain important objectives for the government in 1999. The government has already liberalized the mortgage and the insurance markets, improved the conditions for leasing operations, helped establish a mutual funds industry, the private capitalized pension funds, a market for commercial paper, and improved transparency and accountability in these markets. In 1999, the government will work with Congress to pass the proposed law on factoring, discounting, and the establishment of a market for receivables, as well as consider at the earliest occasion congressional comments on the draft law to overhaul the bankruptcy law.

22.  In the banking sector, the government-owned Bank of the Republic (BROU) will extend its contract with a private consultant to continue reforms and improve its efficiency and profitability. The bank has reduced its staffing by nearly 900 persons since mid-1995 (15 percent of total) and will continue this process in 1999; it is implementing a new centralized computer system which will, when finished, bring all branch offices in the country on line with headquarters in Montevideo; it has closed, or merged into 33 smaller branches (Minibancos), some 105 nonviable offices; and it is in the midst of a large-scale effort to safeguard the bank against the year-2000 computer problem. In 1999, the government intends to conduct an analysis and seek an independent external audit of the BROU, the National Mortgage Bank (BHU), and the National Insurance Bank (BSE) to assess the valuation of their assets and liabilities and improve further their operations and profitability. The Central Bank of Uruguay continues to seek ways to bolster its banking supervision and it is expecting a Fund technical assistance mission in this area to visit Montevideo in May 1999. The government is well aware of the need to finalize resolving the issue of the intervened banks and is expecting to conclude agreements with interested parties in the private sector and the banking labor union to end the intervention in the only remaining intervened bank by mid-1999.

23.  The government continues its efforts to improve the accuracy, timeliness, and comprehensiveness of statistical data on the Uruguayan economy. In the first quarter of 1999, the BCU, together with external experts, will begin a two-year project to revise and expand the national accounts statistics. Also, the BCU will revise the compilation and the structure of the monetary accounts of Uruguay, for which it is receiving technical assistance from the Fund. In this context, progress with the new computer system in the BROU is targeted to reduce the reporting lag of BROU data to the BCU to equal that of the private banking system by June 1999. Finally, by March 1999, the BCU will complete an action plan to prepare Uruguay's subscription to the SDDS. The government is concerned about the potentially serious effects of the Y2K computer software problem and has put in place a broad-based program to deal with this issue, including a comprehensive testing of the bank clearing system in February 1999.

Structural Benchmarks under the 1999 Program
Measure      Completion date

1.   Finalize a Two-Year Action Plan to prepare Uruguay's subscription to the SDDS March 1999
2. Reduce the BROU reporting lag of monetary data to the Central Bank of Uruguay to that equivalent of the reporting lag of private banks June 1999
3. End the intervention in three banks (BPA, Banco la Caja Obrera, Banco de Credito) June 1999
4. Revise the annual national accounts for 1988-97, develop monthly indicator of economic activity (IMEA), and institutional national accounts (general government and enterprises). Dec. 1999
5. Conduct an independent external audit of the state-owned financial institutions (BROU, BHU, BSE) Dec. 1999

Table 1. Uruguay: Quantitative Limits and Targets for the 1999 Economic Program
Dec. 31 Prel.
  Mar. 31 June 30 Sep. 30 Dec. 31

(Cumulative flows from December 31, 1998;

millions of Uruguayan pesos)

1. Combined public sector balance (floor) 1/   -450 -2,350 -2,500 -4,050
2. General government expenditure (ceiling) 2/   7,000 13,800 20,500 27,150
3. Change in the net domestic assets of the BCU
    (ceiling) 3/
  1,350 2,390 1,450 2,750

(Cumulative flows from December 31, 1998;
millions of U.S. dollars)

4. Net international reserves of the BCU (-decrease)
    (floor) 4/
  -150 -230 -230 -200
5. Public sector debt denominated in foreign
    currency and UR (ceiling) 5/
     a. All maturities 6,974 7,125 7,150 7,305 7,345
     b. Less than 1 year 196 216 236 256 276

1The combined public sector comprises the central government, the social security system, the municipalities and the public enterprises, together with the quasi-fiscal result of the central bank. This limit will be adjusted by any difference between projected and actual social security contributions transferred to the pension capitalization funds and expenditure on severance payments.
2Defined as total expenditure by the central administration and social security system, excluding outlays on interest, pensions and internal transfers. This limit will be adjusted by any difference between projected and actual social security contributions transferred to the pension capitalization funds and expenditure on severance payments.
3The net domestic assets of the Central Bank (BCU) are defined as the difference between (1) currency in circulation and (2) the net international reserves of the BCU as defined in footnote 4 below. The changes in NIR are to be valued at the average exchange rate (projected in the program) for the corresponding quarter. The limit on NDA will be adjusted for the equivalent in Uruguayan pesos of the adjustments made to the limits on the NIR of the BCU.
4The NIR of the BCU are defined as the difference between the foreign assets of the BCU and its reserve liabilities including swaps and outstanding purchases from the Fund. The gold holdings of the BCU will be valued at the accounting rate of US$42 per troy ounce. Gains or losses from gold-swap operations are to be excluded from the calculation of NIR. Non-U.S. dollar denominated foreign assets and liabilities are to be converted into U.S. dollars at the market exchange rates of the respective currencies as of December 31, 1998. The targets for NIR will be adjusted: (1) upwards by the amount in which free foreign currency deposits of the BROU, the BHU and the private commercial banks exceed their level of December 31, 1998; and (2) downwards (by up to US$150 million) by the amount in which those deposits fall short of their level of December 31, 1998.
5Refers to the stock of public sector debt denominated in foreign currency, external debt guaranteed by the public sector, and debt in UR ("Unidades Reajustables"). Excludes reserve liabilities of the BCU and short-term external liabilities of the BROU and the BHU; and excludes foreign currency deposits of nonresidents in the local banking system. The overall limit will be adjusted by (1) the difference between projected and actual debt at end-1998; (2) the difference between projected and actual amount of social security contributions that are transferred to pension capitalization funds; (3) the difference between projected and actual amount of indemnization payments; (4) the overperformance with respect to the targets on the BCU's net international reserves up to a limit of US$250 million; (5) any change in the amount of export prefinancing in the BCU in relation to the level of December 31, 1998 (also for the short-term debt); and (6) by an amount equivalent to the reduction (in excess of US$150 million) in free foreign currency deposits of the BROU, BHU, and the private banks in the BCU from their level of December 31, 1998.